 
# Mutual Funds For Dummies®, 6th Edition

**Table of Contents**

Introduction

What's New in This Edition

How This Book Is Different

Foolish Assumptions

How This Book Is Organized

Part I: Mutual Funds: Sharing Risks and Rewards

Part II: Evaluating Alternatives to Funds

Part III: Separating the Best from the Rest

Part IV: Crafting Your Fund Portfolio

Part V: Keeping Current and Informed

Part VI: The Part of Tens

Icons Used in This Book

Where to Go from Here

Part I: Mutual Funds: Sharing Risks and Rewards

Chapter 1: Making More Money, Taking Less Risk

Introducing Mutual Funds

Making Sense of Investments

Lending investments: Interest on your money

Ownership investments: More potential profit (and risk)

Surveying the Major Investment Options

Savings and money market accounts

Bonds

Stocks

Overseas investments

Real estate

Gold, silver, and the like

Annuities

Life insurance

Limited partnerships

Reviewing Important Investing Concepts

Getting a return: Why you invest

Measuring risks: Investment volatility

Diversifying: A smart way to reduce risk

Chapter 2: Mutual Funds: Pros and Cons

Getting a Grip on Mutual Funds

Financial intermediaries

Open-end versus closed-end funds

Opting for Mutual Funds

Fund managers' expertise

Funds save you money and time

Fund diversification minimizes your risk

Funds undergo regulatory scrutiny

You choose your risk level

Fund risk of bankruptcy is nil

Funds save you from sales sharks

You have convenient access to your money

Addressing the Drawbacks

Don't worry about these . . . 

Worry about these (but not too much) . . . 

Chapter 3: Funding Your Financial Plans

The Story of Justine and Max

Lining Up Your Ducks Before You Invest

Pay off your consumer debts

Review your insurance coverage

Figure out your financial goals

Determine how much you're saving

Examine your spending and income

Maximize tax-deferred retirement account savings

Determine your tax bracket

Assess the risk you're comfortable with

Review current investment holdings

Consider other "investment" possibilities

Reaching Your Goals with Funds

The financial pillow — an emergency reserve

The golden egg — investing for retirement

The white picket fence — saving for a home

The ivory tower — saving for college

Part II: Evaluating Alternatives to Funds

Chapter 4: Selecting Your Own Stocks and Bonds

Choosing Your Own Stocks and Bonds

Beware the claims of stock-picking gurus

Know the drawbacks of investing in individual securities

Understand the psychology of selecting stocks

How to Pick Your Own Stocks and Bonds

Chapter 5: Exchange-Traded Funds and Other Fund Lookalikes

Understanding Exchange-Traded Funds

Understanding ETF advantages

Eyeing ETF drawbacks

Seeing the pros and cons of trading ETFs

Identifying the best ETFs

Mimicking Closed-End Funds: Unit Investment Trusts

Customizing Your Own Funds Online

Chapter 6: Hedge Funds and Other Managed Alternatives

Hedge Funds: Extremes of Costs and Risks

Getting the truth about hedge funds

Investigating hedge funds

Wrap (Or Managed) Accounts: Hefty Fees

Private Money Managers: One-on-One

Part III: Separating the Best from the Rest

Chapter 7: Finding the Best Funds

Evaluating Gain-Eating Costs

Losing the load: Say no to commissions

Considering a fund's operating expenses

Weighing Performance and Risk

Star today, also-ran tomorrow

Apples to apples: Comparing performance numbers

Recognizing Manager Expertise

Chapter 8: Using Fund Publications

Reading Prospectuses — the Important Stuff, Anyway

Cover page

Fund profile

Other fund information

Investment objectives and risks

Investment adviser

Financial highlights

Reviewing Annual Reports

Chairman's letter and performance discussion

Investment adviser's thoughts

Performance and its components

Investment holdings

Investigating the Statement of Additional Information (SAI)

Chapter 9: Buying Funds from the Best Firms

Finding the Best Buys

The Vanguard Group

Fidelity Investments

Dodge & Cox

Oakmark

T. Rowe Price

TIAA-CREF

Other fund companies

Discount Brokers: Mutual Fund Supermarkets

Buying direct versus discount brokers

Debunking "No Transaction Fee" funds

Using the best discount brokers

Places to Pass By

Hiring an Adviser: The Good, Bad, and Ugly

The wrong reason to hire an adviser

The right reasons to hire an adviser

Beware of conflicts of interest

Your best options for help

If you seek a salesperson

Part IV: Crafting Your Fund Portfolio

Chapter 10: Perfecting a Fund Portfolio

Asset Allocation: An Investment Recipe

Allocating to reduce your risks

Looking toward your time horizon

Taxes: It's What You Keep That Matters

Fitting funds to your tax bracket

Minimizing your taxes on funds

Fund Investing Strategies

Timing versus buy-and-hold investing

Active versus index fund managers

Putting Your Plans into Action

Determining how many funds and families to use

Matching fund allocation to your asset allocation

Allocating when you don't have much to allocate

Investing large amounts: To lump or to average? 

Sorting through your existing investments

Chapter 11: Money Market Funds: Beating the Bank

Money Market Funds 101

Comparing money funds with bank accounts

Finding uses for money funds

Refuting common concerns

Grasping what money funds invest in

Choosing a Great Money Market Fund

Why yield and expenses go hand in hand

Looking at your tax situation

Deciding where you want your home base

Keeping your investments close to home

Considering other issues

Finding the Recommended Funds

Taxable money market funds

U.S. Treasury money market funds

Municipal tax-free money market funds

Chapter 12: Bond Funds: When Boring Is Best

Understanding Bonds

Sizing Up a Bond Fund's Personality

Maturity: Counting the years until you get your principal back

Duration: Measuring interest rate risk

Credit quality: Determining whether bonds will pay you back

Issuer: Knowing who you're lending to

Management: Considering the passive or active type

Inflation-indexed Treasury bonds

Investing in Bond Funds

Why you might (and might not) want to invest in bond funds

How to pick a bond fund with an outcome you can enjoy

How to obtain tax-free income

Eyeing Recommended Bond Funds

Short-term bond funds

Intermediate-term bond funds

Long-term bond funds

Exploring Alternatives to Bond Funds

Certificates of deposit

Individual bonds

Guaranteed-investment contracts

Mortgages

Exchange-traded bond funds

Chapter 13: Stock Funds: Meeting Your Longer Term Needs

The Stock Market Grows Your Money

Be patient

Add regularly to your stock investments

Using Mutual Funds to Invest in Stocks

Reducing risk and increasing returns

Making money: How funds do it

Seeing your stock fund choices

The Best Stock Funds

Mixing it up: Recommended hybrid funds

Letting computers do the heavy lifting: Recommended index funds

Keeping it local: Recommended U.S.-focused stock funds

Being worldly: Recommended international funds

Expanding your horizon: Recommended global stock funds

Chapter 14: Specialty Funds: One of a Kind

Sector Funds: Should You or Shouldn't You Invest in Them? 

Landlording Made Easy: Real Estate Investment Trust (REIT) Funds

Profiting from What Everyone Needs: Utility Funds

Arming for Armageddon: Precious Metals Funds

Commodity Funds

 Hedging: Market Neutral (Long-Short) Funds

Matching Morals to Investments: Socially Responsible Funds

Evil is in the eye of the beholder

Ways to express your social concerns

Chapter 15: Working It Out: Sample Portfolios

Getting Started

Starting from square one: Melinda

Silencing student loans: Stacey the student

Living month to month with debt: Mobile Mark

Competing goals: Gina and George

Wanting lots and lotsa money: Pat and Chris

Changing Goals and Starting Over

Funding education: The Waltons

Rolling over (but not playing dead): Cathy

Wishing for higher interest rates: Nell, the near retiree

Lovin' retirement: Noel and Patricia

Dealing with a Mountain of Moola

He's in the money: Cash-rich Chuck

Inheritances: Loaded Liz

Getting Unstuck . . . 

Chapter 16: Applications, Transfers, and Other Useful Forms

Taking the Nonretirement Account Route

Filling in the blanks: Application basics

Buying in to discount brokerage accounts

Preparing for Leisure: Retirement Accounts

Retirement account applications

What to do before transferring accounts

Filling out transfer forms

Investing on Autopilot

Finding Help for a Overwhelmed Brain

Part V: Keeping Current and Informed

Chapter 17: Evaluating Your Funds and Adjusting Your Portfolio

Deciphering Your Fund Statement

Trade date or date of transaction

Transaction description

Dollar amount

Share price or price per share

Share amount or shares transacted

Shares owned or share balance

Account value

Interpreting Discount Brokerage Firm Statements

Portfolio overview

Account transaction details

Assessing Your Funds' Returns

Getting a panoramic view: Total return

Focusing on the misleading share price

Figuring total return

Assessing your funds' performance

Deciding Whether to Sell, Hold, or Buy More

Handling bear markets

Dealing with fund company consolidations

Tweaking and Rebalancing Your Portfolio

Chapter 18: The Taxing Side of Mutual Funds

Mutual Fund Distributions Form: 1099-DIV

Box 1a: Total ordinary dividends

Box 1b: Qualified dividends

Box 2a: Total capital gains distributions

Box 3: Nondividend distributions

Box 4: Federal income tax withheld

Box 6: Foreign tax paid

When You Sell Your Mutual Fund Shares

Introducing the "basis" basics

Accounting for your basis

Deciding when to take your tax lumps or deductions

Looking at fund sales reports: Form 1099-B

Getting help: When you don't know how much you paid for a fund

Retirement Fund Withdrawals and Form 1099-R

Minimizing taxes and avoiding penalties

Making sense of Form 1099-R for IRAs

Withdrawing from non-IRA accounts

Understanding form 1099-R for non-IRAs

Chapter 19: Common Fund Problems and How to Fix Them

Playing the Telephone Game

Trouble-Shooting Bungled Transactions

Specifying Funds to Buy at Discount Brokers

Making Deposits in a Flash

Verifying Receipt of Deposits

Transferring Money Quickly

Losing Checks in the Mail

Changing Options after Opening Your Account

Making Sense of Your Statements and Profits

Changing Addresses

Finding Funds You Forgot to Move

Untangling Account Transfer Snags

Eliminating Marketing Solicitations

Digging Out from under the Statements

Getting Older Account Statements

Chapter 20: Fund Ratings and Forecasters

Avoiding the Bad Stuff

Looking into market timing and crystal balls

Keeping them honest and providing new fodder: The Hulbert Financial Digest

Using bogus rankings, token awards, and mystery testimonials

Pitching a product: Filler and ads in newsletter form

Investing newsletter Hall of Shame

Getting In on the Good Stuff

Morningstar Mutual Funds

No-Load Fund Analyst

The Independent Adviser for Vanguard Investors

EricTyson.com

Chapter 21: Harnessing Your Computer's Power

Using Computer Software

Getting-and-staying-organized software

Accessing investment research software

Entering Cyberspace: Internet Sites

Investment Company Institute

Morningstar.com

T. Rowe Price

Securities and Exchange Commission

Vanguard.com

Part VI: The Part of Tens

Chapter 22: Ten Common Fund-Investing Mistakes and How to Avoid Them

Lacking an Overall Plan

Failing to Examine Sales Charges and Expenses

Chasing Past Performance

Ignoring Tax Issues

Getting Duped by "Advisers"

Falling Prey to the Collection Syndrome

Trying to Time the Market's Movements

Following Prognosticators' Predictions

Being Swayed by Major News Events

Comparing Your Funds Unfairly

Chapter 23: Ten Fund-Investing Fears to Conquer

Investing with Little Money

Investing in Uninsured Funds

Rising Interest Rates

Missing High Returns from Stocks

Waiting to Get a Handle on the Economy

Buying the Best-Performing Funds

Waiting for an Ideal Buying Opportunity

Obsessing Over Your Funds

Thinking You've Made a Bad Decision

Lacking in Performance

Chapter 24: Ten Tips for Hiring a Financial Adviser

Communicator or Obfuscator? 

Financial Planner or Money Manager? 

Market Timing and Active Management? 

Who's in Control? 

Fees: What's Your Advice Going to Cost? 

How Do You Make Investing Decisions? 

What's Your Track Record? 

What Are Your Qualifications and Training? 

What Are Your References? 

Do You Carry Liability Insurance? 

Appendix: Recommended Fund Companies and Discount Brokers

Eric Tyson's Keys to Personal Financial Success

  Take charge of your finances.  Procrastinating is detrimental to your long-term financial health.  Don't wait for a crisis or major life event to get your act together.  Read this book and start implementing a plan now! 

  Don't buy consumer items (cars, clothing, vacations, and so on) that lose value over time on credit.  Use debt only to make investments in things that gain value, such as real estate, a business, or an education. 

  Use credit cards only for convenience, not for carrying debt.  If you have a tendency to run up credit-card debt, then get rid of your cards and use only cash, checks, and debit cards. 

  Live within your means and don't try to keep up with your co-workers, neighbors, and peers.  Many who engage in conspicuous consumption are borrowing against their future; some end up bankrupt. 

  Save and invest at least 5 to 10 percent of your income.  Preferably, invest through a retirement savings account to reduce your taxes and ensure your future financial independence. 

  Understand and use your employee benefits.  If you're self-employed, find the best investment and insurance options available to you and use them. 

  Research before you buy.  Never purchase a financial product or service on the basis of an advertisement or salesperson's solicitation. 

  Avoid financial products that carry high commissions and expenses.  Companies that sell their products through aggressive sales tech- niques generally have the worst financial products and the highest commissions. 

  Don't purchase any financial product that you don't understand.  Ask questions and compare what you're being offered to what you can get from the best sources, which I recommend in this book. 

  Invest the majority of your long-term money in ownership vehicles that have appreciation potential, such as stocks, real estate, and your own business.  When you invest in bonds or bank accounts, you're simply lending your money to others, and the return you earn probably won't keep you ahead of inflation and taxes. 

  Avoid making emotionally based financial decisions.  For example, investors who panic and sell their stock holdings after a major market correction miss a buying opportunity.  Be especially careful in making important financial decisions after a major life change, such as a divorce, job loss, or death in your family. 

  Make investing decisions based upon your needs and the long-term fundamentals of what you're buying.  Ignore the predictive advice offered by financial prognosticators — nobody has a working crystal ball.  Don't make knee-jerk decisions based on news headlines. 

  Own your home.  In the long run, owning is more cost-effective than renting, unless you have a terrific rent-control deal.  But don't buy until you can stay put for a number of years. 

  Purchase broad insurance coverage to protect against financial catastrophes.  Eliminate insurance for small potential losses. 

  If you're married, make time to discuss joint goals, issues, and concerns.  Be accepting of your partner's money personality; learn to compromise and manage as a team. 

  Prepare for life changes.  The better you are at living within your means and anticipating life changes, the better off you will be financially and emotionally. 

  Read publications that have high quality standards and that aren't afraid to take a stand and recommend what's in your best interests.  Avoid those that base their content on the hottest financial headlines or the whims of advertisers. 

  Prioritize your financial goals and start working toward them.  Be patient.  Focus on your accomplishments and learn from your mistakes. 

  Hire yourself first.  You are the best financial person that you can hire.  If you need help making a major decision, hire conflict-free advisors who charge a fee for their time.  Work in partnership with advisors — don't abdicate control. 

  Invest in yourself and others.  Invest in your education, your health, and your relationships with family and friends.  Having a lot of money isn't worth much if you don't have your health and people with whom to share your life.  Give your time and money to causes that better our society and world. 

Praise for Eric Tyson

"Eric Tyson is doing something important — namely, helping people at all income levels to take control of their financial futures.  This book is a natural outgrowth of Tyson's vision that he has nurtured for years.  Like Henry Ford, he wants to make something that was previously accessible only to the wealthy accessible to middle-income Americans." 

— James C. Collins, coauthor of the national bestsellers Built to Last and Good to Great

"Personal Finance For Dummies is the perfect book for people who feel guilty about inadequately managing their money but are intimidated by all of the publications out there.  It's a painless way to learn how to take control." 

— Karen Tofte, producer, National Public Radio's Sound Money

"Eric Tyson . . .  seems the perfect writer for a...For Dummies book.  He doesn't tell you what to do or consider doing without explaining the why's and how's — and the booby traps to avoid — in plain English. . . .  It will lead you through the thickets of your own finances as painlessly as I can imagine." 

— Chicago Tribune

"This book provides easy-to-understand personal financial information and advice for those without great wealth or knowledge in this area.  Practitioners like Eric Tyson, who care about the well-being of middle-income people, are rare in today's society." 

— Joel Hyatt, founder of Hyatt Legal Services, one of the nation's largest general-practice personal legal service firms

"Worth getting.  Scores of all-purpose money-management books reach bookstores every year, but only once every couple of years does a standout personal finance primer come along.  Personal Finance For Dummies, by financial counselor and columnist Eric Tyson, provides detailed, action-oriented advice on everyday financial questions. . . .  Tyson's style is readable and unintimidating." 

— Kristin Davis, Kiplinger's Personal Finance magazine

"this is a great book.  It's understandable.  Other financial books are too technical and this one really is different." 

— Business Radio Network

More Bestselling For Dummies Titles by Eric Tyson

Investing For Dummies®

A Wall Street Journal bestseller, this book walks you through how to build wealth in stocks, real estate, and small business as well as other investments. 

Mutual Funds For Dummies®

This best-selling guide is now updated to include current fund and portfolio recommendations.  Using the practical tips and techniques, you'll design a mutual fund investment plan suited to your income, lifestyle, and risky; preferences. 

Personal Finance in Your 20s For Dummies®

This hands-on, friendly guide provides you with the targeted financial advice you need to establish firm financial footing in your 20s and to secure your finances for years to come.  When it comes to protecting your financial future, starting sooner rather than later is the smartest thing you can do. 

Home Buying For Dummies®

America's #1 real-estate book includes coverage of online resources in addition to sound financial advice from Eric Tyson and frontline real-estate insights from industry veteran Ray Brown.  Also available from America's best-selling real-estate team of Tyson and Brown — House Selling For Dummies and Mortgages For Dummies. 

Real Estate Investing For Dummies®

Real estate is a proven wealth-building investment, but many people don't know how to go about making and managing rental property investments.  Real-estate and property management expert Robert Griswold and Eric Tyson cover the gamut of property investment options, strategies, and techniques. 

Personal Finance For Dummies®, 7th Edition

by Eric Tyson, MBA

Personal Finance For Dummies®

Published by  
John Wiley & Sons, Inc.  
111 River St.  
Hoboken, NJ 07030-5774

www.wiley.com

Copyright © 2012 by John Wiley & Sons, Inc.

Published simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher.  Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at <http://www.wiley.com/go/permissions>. 

Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!,  The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com, Making Everything Easier, and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission.  All other trademarks are the property of their respective owners.  John Wiley & Sons, Inc., is not associated with any product or vendor mentioned in this book. 

Limit of Liability/Disclaimer of Warranty: The publisher and the author make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose.  No warranty may be created or extended by sales or promotional materials.  The advice and strategies contained herein may not be suitable for every situation.  This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services.  If professional assistance is required, the services of a competent professional person should be sought.  Neither the publisher nor the author shall be liable for damages arising herefrom.  The fact that an organization or Website is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Website may provide or recommendations it may make.  Further, readers should be aware that Internet Websites listed in this work may have changed or disappeared between when this work was written and when it is read. 

For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

For technical support, please visit www.wiley.com/techsupport. 

Wiley also publishes its books in a variety of electronic formats and by print-on-demand.  Not all content that is available in standard print versions of this book may appear or be packaged in all book formats.  If you have purchased a version of this book that did not include media that is referenced by or accompanies a standard print version, you may request this media by visiting <http://booksupport.wiley.com>.  For more information about Wiley products, visit us at www.wiley.com. 

Library of Congress Control Number is available from the publisher

ISBN 978-1-118-11785-9 (pbk); ISBN 978-1-118-26261-0 (ebk); ISBN 978-1-118-22444-1 (ebk); ISBN 978-1-118-23817-2

Manufactured in the United States of America

10 9 8 7 6 5 4 3 2 1

About the Author

Eric Tyson first became interested in money more than three decades ago.  After his father was laid off during a recession and received some retirement money from his employer, Eric worked with his dad to make investing decisions with the money.  A couple years later, Eric won his high school's science fair with a project on what influences the stock market.  Dr. Martin Zweig, who provided some guidance, awarded Eric a one-year subscription to the Zweig Forecast, a famous investment newsletter.  Of course, Eric's mom and dad share some credit with Martin for Eric's victory. 

After toiling away for a number of years as a management consultant to Fortune 500 financial-service firms, Eric finally figured out how to pursue his dream.  He took his inside knowledge of the banking, investment, and insurance industries and committed himself to making personal financial management accessible to all. 

Today, Eric is an internationally acclaimed and best-selling personal finance book author, syndicated columnist, and speaker.  He has worked with and taught people from all financial situations, so he knows the financial concerns and questions of real folks just like you.  Despite being handicapped by an MBA from the Stanford Graduate School of Business and a BS in Economics and Biology from Yale University, Eric remains a master of "keeping it simple." 

An accomplished personal finance writer, his "Investor's Guide" syndicated column, distributed by King Features, is read by millions nationally, and he is an award-winning columnist.  He is the author of five national best-selling financial books in the For Dummies series, on personal finance, investing, mutual funds, home buying (coauthor), and taxes (coauthor).  A prior edition of this book was awarded the Benjamin Franklin Award for best business book of the year. 

Eric's work has been featured and quoted in hundreds of local and national publications, including Newsweek, the Wall Street Journal, the Los Angeles Times, the Chicago Tribune, Forbes, Kiplinger's Personal Finance magazine, Parenting, Money, Family Money, and Bottom Line/Personal; on NBC'S Today Show, ABC, CNBC, PBS Nightly Business Report, CNN, and FOX-TV; and on CBS national radio, NPR's Sound Money, Bloomberg Business Radio, and Business Radio Network. 

Eric's website is `www.erictyson.com`. 

Dedication

This book is hereby and irrevocably dedicated to my family and friends, as well as to my counseling clients and customers, who ultimately have taught me everything that I know about how to explain financial terms and strategies so that all of us may benefit. 

Author's Acknowledgments

Being an entrepreneur involves endless challenges, and without the support and input of my good friends and mentors Peter Mazonson, Jim Collins, and my best friend and wife, Judy, I couldn't have accomplished what I have. 

I hold many people accountable for my perverse and maniacal interest in figuring out the financial services industry and money matters, but most of the blame falls on my loving parents, Charles and Paulina, who taught me most of what I know that's been of use in the real world. 

I'd also like to thank Michael Bloom, Chris Dominguez, Maggie McCall, David Ish, Paul Kozak, Chris Treadway, Sally St. Lawrence, K.T. Rabin, Will Hearst III, Ray Brown, Susan Wolf, Rich Caramella, Lisa Baker, Renn Vera, Maureen Taylor, Jerry Jacob, Robert Crum, Duc Nguyen, Maria Carmicino, and all the good folks at King Features for believing in and supporting my writing and teaching. 

Many thanks to all the people who provided insightful comments on this edition and previous editions of this book, especially Bill Urban, Barton Francis, Mike van den Akker, Gretchen Morgenson, Craig Litman, Gerri Detweiler, Mark White, Alan Bush, Nancy Coolidge, and Chris Jensen. 

And thanks to all the wonderful people at my publisher on the front line and behind the scenes, especially Erin Mooney and Elizabeth Rea. 

Publisher's Acknowledgments

We're proud of this book; please send us your comments at <http://dummies.custhelp.com>.  For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and Vertical Websites

Project Editor: Elizabeth Rea

(Previous Edition: Chad R. Sievers)

Acquisitions Editor: Erin Calligan Mooney

Copy Editor: Christine Pingleton

Assistant Editor: David Lutton

Editorial Program Coordinator: Joe Niesen

Technical Editor: David J. Campbell, CFA

Editorial Manager: Michelle Hacker

Editorial Assistant: Alexa Koschier

Cover Photo: © iStockphoto.com / George Paul

Cartoons: Rich Tennant (www.the5thwave.com)

Composition Services

Project Coordinator: Sheree Montgomery

Layout and Graphics: Jennifer Creasey, Joyce Haughey

Proofreader: Jessica Kramer

Indexer: BIM Indexing & Proofreading Services

Publishing and Editorial for Consumer Dummies

Kathleen Nebenhaus, Vice President and Executive Publisher

Kristin Ferguson-Wagstaffe, Product Development Director

Ensley Eikenburg, Associate Publisher, Travel

Kelly Regan, Editorial Director, Travel

Publishing for Technology Dummies

Andy Cummings, Vice President and Publisher

Composition Services

Debbie Stailey, Director of Composition Services

# Personal Finance For Dummies®, 7th Edition

Visit www.dummies.com/cheatsheet/personalfinance to view this book's cheat sheet. 

**Table of Contents**

Introduction

> About This Book
> 
> Conventions Used in This Book
> 
> What You Can Skip or Skim
> 
> Foolish Assumptions
> 
> How This Book Is Organized
>
>> Part I: Assessing Your Financial Fitness and Setting Goals
>> 
>> Part II: Spending Less, Saving More
>> 
>> Part III: Building Wealth through Investing
>> 
>> Part IV: Insurance: Protecting What You Have
>> 
>> Part V: Where to Go for More Help
>> 
>> Part VI: The Part of Tens
> 
> Icons Used in This Book
> 
> Where to Go from Here

Part I: Assessing Your Financial Fitness and Setting Goals

> Chapter 1: Improving Your Financial Literacy
>
>> Talking Money at Home
>> 
>> Identifying Unreliable Sources of Information
>>
>>> Understanding the dangers of free financial content online
>>> 
>>> Recognizing fake financial gurus
>>> 
>>> Publishers pandering to advertisers
>> 
>> Jumping over Real and Imaginary Hurdles to Financial Success
>>
>>> Discovering what (or who) is holding you back
>>> 
>>> Developing good financial habits
> 
> Chapter 2: Measuring Your Financial Health
>
>> Avoiding Common Money Mistakes
>> 
>> Determining Your Financial Net Worth
>>
>>> Adding up your financial assets
>>> 
>>> Subtracting your financial liabilities
>>> 
>>> Crunching your numbers
>>> 
>>> Interpreting your net worth results
>> 
>> Examining Your Credit Score and Reports
>>
>>> Understanding what your credit data includes and means
>>> 
>>> Obtaining your credit reports and score
>>> 
>>> Improving your credit reports and score
>>> 
>>> Getting credit report errors corrected
>> 
>> Knowing the Difference between Bad Debt and Good Debt
>>
>>> Consuming your way to bad debt
>>> 
>>> Recognizing bad debt overload
>>> 
>>> Assessing good debt: Can you get too much? 
>>> 
>>> Playing the credit-card float
>> 
>> Analyzing Your Savings
>> 
>> Evaluating Your Investment Knowledge
>> 
>> Assessing Your Insurance Savvy
> 
> Chapter 3: Managing Where Your Money Goes
>
>> Examining Overspending
>>
>>> Having access to credit
>>> 
>>> Misusing credit cards
>>> 
>>> Taking out car loans
>>> 
>>> Bending to outside influences and agendas
>>> 
>>> Spending to feel good
>> 
>> Analyzing Your Spending
>>
>>> Tracking spending the low-tech way
>>> 
>>> Tracking your spending on "free" websites and your PC
> 
> Chapter 4: Establishing and Achieving Goals
>
>> Creating Your Own Definition of "Wealth"
>>
>>> Acknowledging what money can't buy
>>> 
>>> Managing the balancing act
>> 
>> Prioritizing Your Savings Goals
>>
>>> Knowing what's most important to you
>>> 
>>> Valuing retirement accounts
>>> 
>>> Dealing with competing goals
>> 
>> Building Emergency Reserves
>> 
>> Saving to Buy a Home or Business
>> 
>> Funding Kids' Educational Expenses
>> 
>> Saving for Big Purchases
>> 
>> Preparing for Retirement
>>
>>> Figuring out what you need for retirement
>>> 
>>> Understanding retirement building blocks
>>> 
>>> Crunching numbers for your retirement
>>> 
>>> Making up for lost time

Part II: Spending Less, Saving More

> Chapter 5: Dealing with Debt
>
>> Using Savings to Reduce Your Consumer Debt
>>
>>> Understanding how you gain
>>> 
>>> Discovering money to pay down consumer debts
>> 
>> Decreasing Debt When You Lack Savings
>>
>>> Reducing your credit card's interest rate
>>> 
>>> Understanding all credit-card terms and conditions
>>> 
>>> Cutting up your credit cards
>>> 
>>> Discovering debit cards: The best of both worlds
>> 
>> Turning to Credit Counseling Agencies
>>
>>> Beware biased advice at credit counseling agencies
>>> 
>>> Ask questions and avoid debt management programs
>> 
>> Filing Bankruptcy
>>
>>> Understanding bankruptcy benefits
>>> 
>>> Coming to terms with bankruptcy drawbacks
>>> 
>>> Deciphering the bankruptcy laws
>>> 
>>> Choosing between Chapter 7 and 13
>>> 
>>> Seeking bankruptcy advice
>> 
>> Stopping the Spending/Consumer Debt Cycle
>>
>>> Resisting the credit temptation
>>> 
>>> Identifying and treating a compulsion
> 
> Chapter 6: Reducing Your Spending
>
>> Unlocking the Keys to Successful Spending
>>
>>> Living within your means
>>> 
>>> Looking for the best values
>>> 
>>> Eliminating the fat from your spending
>>> 
>>> Turning your back on consumer credit
>> 
>> Budgeting to Boost Your Savings
>> 
>> Reducing Your Spending
>>
>>> Managing food costs
>>> 
>>> Saving on shelter
>>> 
>>> Cutting transportation costs
>>> 
>>> Lowering your energy costs
>>> 
>>> Controlling clothing costs
>>> 
>>> Repaying your debt
>>> 
>>> Indulging responsibly in fun and recreation
>>> 
>>> Lowering your phone bills
>>> 
>>> Technology: Spending wisely
>>> 
>>> Curtailing personal care costs
>>> 
>>> Paring down professional expenses
>>> 
>>> Managing medical expenses
>>> 
>>> Eliminating costly addictions
>>> 
>>> Keeping an eye on insurance premiums
>>> 
>>> Trimming your taxes
> 
> Chapter 7: Trimming Your Taxes
>
>> Understanding the Taxes You Pay
>>
>>> Focusing on your total taxes
>>> 
>>> Recognizing the importance of your marginal tax rate
>>> 
>>> Defining taxable income
>>> 
>>> Being mindful of the second tax system: Alternative minimum tax
>>> 
>>> Watching for tax reform
>> 
>> Trimming Employment Income Taxes
>>
>>> Contributing to retirement plans
>>> 
>>> Shifting some income
>> 
>> Increasing Your Deductions
>>
>>> Choosing standard or itemized deductions
>>> 
>>> Purchasing real estate
>>> 
>>> Trading consumer debt for mortgage debt
>>> 
>>> Contributing to charities
>>> 
>>> Remembering auto registration fees and state insurance
>>> 
>>> Deducting miscellaneous expenses
>>> 
>>> Deducting self-employment expenses
>> 
>> Reducing Investment Income Taxes
>>
>>> Investing in tax-free money- market funds and bonds
>>> 
>>> Selecting other tax-friendly investments
>>> 
>>> Making your profits long-term
>>> 
>>> Does funding retirement accounts still make sense? 
>> 
>> Enlisting Education Tax Breaks
>> 
>> Getting Help from Tax Resources
>>
>>> Obtaining IRS assistance
>>> 
>>> Consulting preparation and advice guides
>>> 
>>> Utilizing software and websites
>>> 
>>> Hiring professional help
>> 
>> Dealing with an Audit
>>
>>> Getting your act together
>>> 
>>> Surviving the day of reckoning

Part III: Building Wealth through Investing

> Chapter 8: Considering Important Investment Concepts
>
>> Establishing Your Goals
>> 
>> Understanding the Primary Investments
>>
>>> Looking at lending investments
>>> 
>>> Exploring ownership investments
>> 
>> Shunning Gambling Instruments and Behaviors
>>
>>> Forsaking futures, options, and other derivatives
>>> 
>>> Ditching day trading
>> 
>> Understanding Investment Returns
>> 
>> Sizing Investment Risks
>>
>>> Comparing the risks of stocks and bonds
>>> 
>>> Focusing on the risks you can control
>>> 
>>> Discovering low-risk, high- return investments
>> 
>> Diversifying Your Investments
>>
>>> Spreading the wealth: Asset allocation
>>> 
>>> Allocating money for the long term
>>> 
>>> Sticking with your allocations: Don't trade
>>> 
>>> Investing lump sums via dollar-cost averaging
>> 
>> Acknowledging Differences among Investment Firms
>>
>>> Focusing on the best firms
>>> 
>>> Places to consider avoiding
>> 
>> Seeing through Experts Who Predict the Future
>>
>>> Investment newsletters
>>> 
>>> Investment gurus
>> 
>> Leaving You with Some Final Advice
> 
> Chapter 9: Understanding Your Investment Choices
>
>> Slow and Steady Investments
>>
>>> Transaction/checking accounts
>>> 
>>> Savings accounts and money-market funds
>>> 
>>> Bonds
>> 
>> Building Wealth with Ownership Vehicles
>>
>>> Socking your money away in stocks
>>> 
>>> Generating wealth with real estate
>>> 
>>> Investing in small business (and your career)
>> 
>> Off the Beaten Path: Investment Odds and Ends
>>
>>> Precious metals
>>> 
>>> Annuities
>>> 
>>> Collectibles
> 
> Chapter 10: Investing in Funds
>
>> Understanding the Benefits of Mutual Funds and Exchange-Traded Funds
>> 
>> Exploring Various Fund Types
>>
>>> Money-market funds
>>> 
>>> Bond funds
>>> 
>>> Stock funds
>>> 
>>> Balancing bonds and stocks: Hybrid funds
>>> 
>>> U.S., international, and global funds
>>> 
>>> Index funds
>>> 
>>> Specialty (sector) funds
>> 
>> Selecting the Best Funds
>>
>>> Reading prospectuses and annual reports
>>> 
>>> Keeping costs low
>>> 
>>> Evaluating historic performance
>>> 
>>> Assessing fund manager and fund family reputations
>>> 
>>> Rating tax friendliness
>>> 
>>> Determining your needs and goals
>> 
>> Deciphering Your Fund's Performance
>>
>>> Dividends
>>> 
>>> Capital gains
>>> 
>>> Share price changes
>> 
>> Evaluating and Selling Your Funds
> 
> Chapter 11: Investing in Retirement Accounts
>
>> Looking at Types of Retirement Accounts
>>
>>> Employer-sponsored plans
>>> 
>>> Self-employed plans
>>> 
>>> Individual Retirement Accounts (IRAs)
>>> 
>>> Annuities: An odd investment
>> 
>> Allocating Your Money in Retirement Plans
>>
>>> Prioritizing retirement contributions
>>> 
>>> Setting up a retirement account
>>> 
>>> Allocating money when your employer selects the investment options
>>> 
>>> Allocating money in plans you design
>> 
>> Transferring Retirement Accounts
>>
>>> Transferring accounts you control
>>> 
>>> Moving money from an employer's plan
> 
> Chapter 12: Investing in Taxable Accounts
>
>> Getting Started
>>
>>> Paying off high-interest debt
>>> 
>>> Taking advantage of tax breaks
>> 
>> Understanding Taxes on Your Investments
>> 
>> Fortifying Your Emergency Reserves
>>
>>> Bank and credit union accounts
>>> 
>>> Money-market mutual funds
>> 
>> Investing for the Longer Term (A Few Years or More)
>>
>>> Defining your time horizons
>>> 
>>> Bonds and bond funds
>>> 
>>> Certificates of deposit (CDs)
>>> 
>>> Stocks and stock funds
>>> 
>>> Annuities
>>> 
>>> Real estate
>>> 
>>> Small-business investments
> 
> Chapter 13: Investing for Educational Expenses
>
>> Figuring Out How the Financial Aid System Works
>>
>>> Treatment of retirement accounts
>>> 
>>> Treatment of money in the kids' names
>>> 
>>> Treatment of home equity and other assets
>> 
>> Strategizing to Pay for Educational Expenses
>>
>>> Estimating college costs
>>> 
>>> Setting realistic savings goals
>>> 
>>> Tips for getting loans, grants, and scholarships
>> 
>> Investing Educational Funds
>>
>>> Good investments: No-load mutual funds and exchange-traded funds
>>> 
>>> Bad investments
>>> 
>>> Overlooked investments
> 
> Chapter 14: Investing in Real Estate: Your Home and Beyond
>
>> Deciding Whether to Buy or Rent
>>
>>> Assessing your timeline
>>> 
>>> Determining what you can afford
>>> 
>>> Calculating how much you can borrow
>>> 
>>> Comparing owning versus renting costs
>>> 
>>> Considering the long-term costs of renting
>>> 
>>> Recognizing advantages to renting
>> 
>> Financing Your Home
>>
>>> Understanding the two major types of mortgages
>>> 
>>> Choosing between fixed- and adjustable-rate mortgages
>>> 
>>> Shopping for fixed-rate mortgages
>>> 
>>> Inspecting adjustable-rate mortgages (ARMs)
>>> 
>>> Avoiding the down-payment blues
>>> 
>>> Comparing 15-year and 30-year mortgages
>>> 
>>> Finding the best lender
>>> 
>>> Increasing your approval chances
>> 
>> Finding the Right Property
>>
>>> Condo, town house, co-op, or detached home? 
>>> 
>>> Casting a broad net
>>> 
>>> Finding out actual sale prices
>>> 
>>> Researching the area
>> 
>> Working with Real-Estate Agents
>>
>>> Recognizing conflicts of interest
>>> 
>>> Looking for the right qualities in real-estate agents
>> 
>> Putting Your Deal Together
>>
>>> Negotiating 101
>>> 
>>> Inspecting before you buy
>>> 
>>> Remembering title insurance and escrow fees
>> 
>> After You Buy
>>
>>> Refinancing your mortgage
>>> 
>>> Mortgage life insurance
>>> 
>>> Is a reverse mortgage a good idea? 
>>> 
>>> Selling your house

Part IV: Insurance: Protecting What You Have

> Chapter 15: Insurance: Getting What You Need at the Best Price
>
>> Discovering My Three Laws of Buying Insurance
>>
>>> Law I: Insure for the big stuff; don't sweat the small stuff
>>> 
>>> Law II: Buy broad coverage
>>> 
>>> Law III: Shop around and buy direct
>> 
>> Dealing with Insurance Problems
>>
>>> Knowing what to do if you're denied coverage
>>> 
>>> Getting your due on claims
> 
> Chapter 16: Insurance on You: Life, Disability, and Health
>
>> Providing for Your Loved Ones: Life Insurance
>>
>>> Determining how much life insurance to buy
>>> 
>>> Comparing term life insurance to cash value life insurance
>>> 
>>> Making your decision
>>> 
>>> Buying term insurance
>>> 
>>> Considering the purchase of cash value life insurance
>>> 
>>> Getting rid of cash value life insurance
>> 
>> Preparing for the Unpredictable: Disability Insurance
>>
>>> Deciding whether you need coverage
>>> 
>>> Determining how much disability insurance you need
>>> 
>>> Identifying other features you need in disability insurance
>>> 
>>> Deciding where to buy disability insurance
>> 
>> Getting the Care You Need: Health Insurance
>>
>>> Choosing the best health plan
>>> 
>>> Buying health insurance
>>> 
>>> Dealing with insurance denial
>>> 
>>> Understanding Obamacare
>>> 
>>> Looking at retiree medical care insurance
> 
> Chapter 17: Covering Your Assets
>
>> Insuring Where You Live
>>
>>> Dwelling coverage: The cost to rebuild
>>> 
>>> Personal property coverage: For your things
>>> 
>>> Liability insurance: Coverage for when others are harmed
>>> 
>>> Flood and earthquake insurance: Protection from Mother Nature
>>> 
>>> Deductibles: Your cost with a claim
>>> 
>>> Special discounts
>>> 
>>> Buying homeowner's or renter's insurance
>> 
>> Auto Insurance 101
>>
>>> Bodily injury/property damage liability
>>> 
>>> Uninsured or underinsured motorist liability
>>> 
>>> Deductibles
>>> 
>>> Special discounts
>>> 
>>> Little-stuff coverage to skip
>>> 
>>> Buying auto insurance
>> 
>> Protecting against Mega-Liability: Umbrella Insurance
>> 
>> Planning Your Estate
>>
>>> Wills, living wills, and medical powers of attorney
>>> 
>>> Avoiding probate through living trusts
>>> 
>>> Reducing estate taxes

Part V: Where to Go for More Help

> Chapter 18: Working with Financial Planners
>
>> Surveying Your Financial Management Options
>>
>>> Doing nothing
>>> 
>>> Doing it yourself
>>> 
>>> Hiring financial help
>> 
>> Deciding Whether to Hire a Financial Planner
>>
>>> How a good financial advisor can help
>>> 
>>> Why advisors aren't for everyone
>>> 
>>> Recognizing conflicts of interest
>> 
>> Finding a Good Financial Planner
>>
>>> Soliciting personal referrals
>>> 
>>> Seeking advisors through associations
>> 
>> Interviewing Financial Advisors: Asking the Right Questions
>>
>>> What percentage of your income comes from clients' fees versus commissions? 
>>> 
>>> What portion of client fees is for money management versus hourly planning? 
>>> 
>>> What is your hourly fee? 
>>> 
>>> Do you also perform tax or legal services? 
>>> 
>>> What work and educational experience qualifies you to be a financial planner? 
>>> 
>>> Have you ever sold limited partnerships?  Options?  Futures?  Commodities?  Invested with Madoff? 
>>> 
>>> Do you carry liability (errors and omissions) insurance? 
>>> 
>>> Can you provide references from clients with needs similar to mine? 
>>> 
>>> Will you provide specific strategies and product recommendations that I can implement on my own if I choose? 
>>> 
>>> How is implementation handled? 
>> 
>> Learning from Others' Mistakes
> 
> Chapter 19: Using a Computer to Manage Your Money
>
>> Surveying Software and Websites
>>
>>> Adding up financial software benefits
>>> 
>>> Surfing hazards online
>> 
>> Accomplishing Money Tasks on Your Computer
>>
>>> Paying your bills and tracking your money
>>> 
>>> Planning for retirement
>>> 
>>> Preparing your taxes
>>> 
>>> Researching investments
>>> 
>>> Trading online
>>> 
>>> Reading and searching periodicals
>>> 
>>> Buying life insurance
>>> 
>>> Preparing legal documents
> 
> Chapter 20: On Air and in Print
>
>> Observing the Mass Media
>>
>>> Alarming or informing us? 
>>> 
>>> Teaching questionable values
>>> 
>>> Worshipping prognosticating pundits
>> 
>> Rating Radio and Television Financial Programs
>> 
>> Finding the Best Websites
>> 
>> Navigating Newspapers and Magazines
>> 
>> Betting on Books
>>
>>> Understanding the book publishing business
>>> 
>>> Books at the head of their class

Part VI: The Part of Tens

> Chapter 21: Survival Guide for Ten Life Changes
>
>> Starting Out: Your First Job
>> 
>> Changing Jobs or Careers
>> 
>> Getting Married
>> 
>> Buying a Home
>> 
>> Having Children
>> 
>> Starting a Small Business
>> 
>> Caring for Aging Parents
>> 
>> Divorcing
>> 
>> Receiving a Windfall
>> 
>> Retiring
> 
> Chapter 22: Ten Tactics to Thwart Identity Theft and Fraud
>
>> Save Phone Discussions for Friends Only
>> 
>> Never Respond to E-Mails Soliciting Information
>> 
>> Review Your Monthly Financial Statements
>> 
>> Secure All Receipts
>> 
>> Close Unnecessary Credit Accounts
>> 
>> Regularly Review Your Credit Reports
>> 
>> Freeze Your Credit Reports
>> 
>> Keep Personal Info Off Your Checks
>> 
>> Protect Your Computer and Files
>> 
>> Protect Your Mail
> 
> Glossary
> 
> Cheat Sheet
Introduction

You're probably not a personal finance expert, for good reason.  Personal Finance 101 isn't typically offered in our schools — not in high school and not even in the best colleges and graduate programs.  It should be. 

However, even if you got some financial education and acquired some financial knowledge over the years, you're likely a busy person who doesn't have enough hours in the day to get things done.  Thus, you want to know how to diagnose your financial ­situation efficiently (and painlessly) to determine what you should do next.  Unfortunately, after figuring out which financial strategies make sense for you, choosing specific financial products in the marketplace is often overwhelming.  You have literally thousands of investment, insurance, and loan options to choose from.  Talk about information overload! 

To further complicate matters, you probably hear about most products through advertising that can be misleading, if not downright false.  Of course, some ethical and outstanding firms advertise, but so do those that are more interested in converting your hard-earned income and savings into their profits.  And they may not be here tomorrow when you need them. 

Perhaps you've ventured online and been attracted to the promise of "free" advice.  Unfortunately, discerning the expertise and background (and even identity) of those behind various blogs and websites is nearly impossible.  And, as I discuss in this book, conflicts of interest (many of which aren't disclosed) abound online. 

Despite the development of new media and new financial products and services, folks keep making the same common financial mistakes — procrastinating and lack of planning, wasteful spending, falling prey to financial salespeople and pitches, failing to do sufficient research before making important financial decisions, and so on.  This book can keep you from falling into the same traps and get you going on the best paths. 

As unfair as it may seem, numerous pitfalls await you when you seek help for your financial problems.  The world is filled with biased and bad financial advice.  As a former practicing financial counselor and now as a writer, I constantly see and hear about the consequences of poor advice.  All too often, financial advice ignores the big picture and focuses narrowly on investing.  Because money is not an end in itself but a part of your whole life, this book helps connect your financial goals and challenges to the rest of your life.  You need a broad understanding of personal finance that includes all areas of your financial life: spending, taxes, saving and investing, insurance, and planning for major goals like education, buying a home, and retirement. 

Even if you understand the financial basics, thinking about your finances in a holistic way can be difficult.  Sometimes you're too close to the situation to be objective.  Your finances may reflect the history of your life more than they reflect a comprehensive plan for your future. 

You want to know the best places to go for your circumstances, so this book contains specific, tried-and-proven recommendations.  I also suggest where to turn next if you need more information and help. 

About This Book

You selected wisely in picking up a copy of Personal Finance For Dummies, 7th Edition!  Over two million copies of prior editions of this book are in print, and as you can see from the quotes in the front of this edition, readers and reviewers alike have been pleased.  This book also previously earned the prestigious Benjamin Franklin Award for best book of the year in business. 

However, I never rest on my laurels.  So the book you hold in your hands reflects more hard work and brings you the freshest material for addressing your personal financial quandaries.  Here are some of the major updates you may notice as you peruse the pages of this book:

  Updated coverage of the best ways to reduce, minimize the cost of, and eliminate consumer debt

  Expanded information regarding smart ways to use credit and qualify for the best loan terms, as well as how to understand — and improve — your credit scores

  A complete discussion on making the most of Internet resources, including smart shopping online, the dangers of "free" money websites, and investing online

  Coverage of new and revised tax laws, pending and likely future tax law changes, and how to best take advantage of them

  The latest information on what's going on with government assistance programs, Social Security, and Medicare and what it means in terms of how you should prepare for and live in retirement

  Updated investment recommendations — especially in the areas of exchange-traded funds, mutual funds, and real estate

  Revised recommendations for where to get the best insurance deals, the impact of federal health insurance legislation, and expanded coverage on preparing for natural disasters

  Expanded and updated coverage of how to use and make sense of the news and financial resources (especially online resources)

Aside from being packed with updated information, another great feature of this book is that you can read it from cover to cover if you want, or you can read each chapter and part without having to read what comes before, which is useful if you have better things to do with your free time.  Handy cross-references direct you to other places in the book for more details on a particular subject. 

Conventions Used in This Book

To help you navigate the waters of this book, I've set up a few conventions:

  I use italics for emphasis and to highlight new words or terms that I define. 

  I use boldface text to indicate the action part of numbered steps and to highlight key words or phrases in bulleted lists. 

  I put all web addresses in `monofont` for easy identification. 

What You Can Skip or Skim

I've written this book so you can find information easily and easily understand what you find.  And although I'd like to believe that you want to pore over every last word between the two yellow and black covers, I actually make it easy for you to identify "skippable" material.  This information is the stuff that, although interesting, isn't essential for you to know:

  Text in sidebars: The sidebars are the shaded boxes that appear here and there.  They include helpful information and observations but aren't necessary reading. 

  Anything with a Technical Stuff icon attached: This information is interesting but not critical to your understanding of the topic at hand. 

Foolish Assumptions

In writing this book, I made some assumptions about you, dear reader:

  You want expert advice about important financial topics — such as paying off and reducing the cost of debt, planning for major goals, making wise investments — and you want answers quickly. 

  Perhaps you want a crash course in personal finance and are looking for a book you can read cover-to-cover to help solidify major financial concepts and get you thinking about your finances in a more comprehensive way. 

This book is basic enough to help novices get their arms around thorny financial issues.  But advanced readers will be challenged, as well, to think about their finances in a new way and identify areas for improvement. 

How This Book Is Organized

This book is organized into six parts, with each covering a major area of your personal finances.  The chapters within each part cover specific topics in detail.  Here's a summary of what you can find in each part. 

Part I: Assessing Your Financial Fitness and Setting Goals

This part explains how to diagnose your current financial health and explores common reasons for any missing links in your personal finance knowledge.  We all have dreams and goals, so in this part, I also encourage you to think about your financial (and personal) aspirations and figure out how much you should be saving if you want to retire someday or accomplish other important goals. 

Part II: Spending Less, Saving More

Most people don't have gobs of extra cash.  Therefore, this part shows you how to figure out where all your dollars are going and tells you how to reduce your spending.  Chapter 5 is devoted to helping you get out from under the burden of high-interest consumer debt (such as credit card debt).  I also provide specifics for reducing your tax burden. 

Part III: Building Wealth through Investing

Earning and saving money are hard work, so you should be careful when it comes to investing what you've worked so hard to save (or waited so long to inherit!).  In this part, I assist you with picking investments wisely and help you understand investment risks, returns, and much more.  I explain all the major — and best — investment options.  I recommend specific strategies and investments to use both inside and outside of tax-sheltered retirement accounts.  I also discuss buying, selling, and investing in real estate, as well as other wealth-building investments. 

Part IV: Insurance: Protecting What You Have

Insurance is an important part of your financial life.  Unfortunately, for most people, insurance is a thoroughly overwhelming and dreadfully boring subject.  But perhaps I can pique your interest in this esoteric topic by telling you that you're probably paying more than you should for insurance and that you probably don't have the right coverage for your situation.  This part tells you all you ever wanted to know (okay, fine — all you never wanted to know but probably should know anyway) about how to buy the right insurance at the best price. 

Part V: Where to Go for More Help

As you build your financial knowledge, more questions and issues may arise.  In this part, I discuss where to go and what to avoid when you seek financial information and advice.  I also discuss hiring a financial planner as well as investigating resources in print, on the air, and online. 

Part VI: The Part of Tens

The chapters in this part can help you manage major life changes and protect yourself from the increasingly common problem of identity theft.  You also can find a glossary in this part.  The world of money is filled with jargon, so you'll be happy to know that this book includes a comprehensive glossary of financial terms that are often tossed around but seldom explained. 

Icons Used in This Book

The icons in this book help you find particular kinds of information that may be of use to you. 

  This nerdy-looking guy appears beside discussions that aren't critical if you just want to understand basic concepts and get answers to your financial questions.  You can safely ignore these sections, but reading them can help deepen and enhance your personal financial knowledge. 

  This target flags strategy recommendations for making the most of your money. 

  This icon highlights the best financial products in the areas of investments, insurance, and so on.  These products can help you implement my strategy recommendations. 

  This icon points out information that you'll definitely want to remember. 

  This icon marks things to avoid and points out common mistakes people make when managing their finances. 

  This icon alerts you to scams and scoundrels who prey on the unsuspecting. 

  This icon tells you when you should consider doing some additional research.  I explain what to look for and what to look out for. 

Where to Go from Here

This book is organized so you can go wherever you want to find complete information.  Want advice on investing strategies, for example?  Go to Part III for that.  You can check out the table of contents to find broad categories of information and a chapter-by-chapter rundown of what this book offers, or you can look up a specific topic in the index. 

If you're not sure where you want to go, you may want to turn a few pages and start at the beginning with Part I. It gives you all the basic info you need to assess your financial situation and points to places where you can find more detailed information for improving it. 
Part I

Assessing Your Financial Fitness and Setting Goals

In this part . . . 

I discuss the concepts that underlie sensible personal financial management.  You find out why you didn't know all these concepts before now (and whom to blame).  Here, you undergo a (gentle) financial physical exam to diagnose your current fiscal health, and I show you how to identify where your hard-earned dollars are going.  I also cover understanding and improving your credit report and scores and how to plan for and accomplish your financial goals. 
Chapter 1

Improving Your Financial Literacy

In This Chapter

  Looking at what your parents and others taught you about money

  Questioning reliability and objectivity

  Overcoming real and imagined barriers to financial success

A recent Center for Economic and Entrepreneurial Literacy (CEEL) financial literacy survey showed that Americans lack basic math and personal finance skills.  The national survey, conducted just before the holiday shopping season, found that an overwhelming number of Americans are unable to answer basic financial literacy questions.  For example, the survey results revealed the following:

  Sixty-five percent answered incorrectly when asked how many reindeer would remain if Santa had to lay off 25 percent of his eight reindeer because of the bad economy. 

  Seventy-five percent of people thought that it would take 15 years or less to pay off $5,000 in Christmas presents if they made the minimum payment on their credit card.  In reality, it would take 46 years to pay off those holiday expenses! 

  One in three people didn't know how much money a person would be spending on gifts if they spent 1 percent of their $50,000-per-year salary. 

Sixteen percent of respondents admitted that they didn't expect to have their holiday debt paid off by the following March.  I was tickled to see in CEEL's press release its antidote to dealing with gaps in personal financial knowledge: "Santa would be well advised to leave Personal Finance For Dummies in stockings across the country," said James Bowers, CEEL's managing director. " Many Americans don't even have the basic math skills required to balance their checkbooks; forget about understanding complicated mortgages or credit-card statements." 

Unfortunately, most Americans don't know how to manage their personal finances because they were never taught how to do so.  Their parents may have avoided discussing money in front of them, and most high schools and colleges lack courses that teach this vital, lifelong-needed skill. 

  Some people are fortunate enough to learn the financial keys to success at home, from knowledgeable friends, and from the best expert-written books like this one.  Others either never discover important personal finance concepts, or they learn them the hard way — by making lots of costly mistakes.  People who lack knowledge make more mistakes, and the more financial errors you commit, the more money passes through your hands and out of your life.  In addition to the enormous financial costs, you experience the emotional toll of not feeling in control of your finances.  Increased stress and anxiety go hand in hand with not mastering your money. 

This chapter examines where people learn about finances and helps you decide whether your current knowledge is helping you or holding you back.  You can find out how to improve your financial literacy and take responsibility for your finances, putting you in charge and reducing your anxiety about money.  After all, you have more important things to worry about, like what's for dinner. 

Talking Money at Home

I was fortunate — my parents taught me a lot of things that have been invaluable throughout my life, and among those things were sound principles for earning, spending, and saving money.  My parents had to know how to do these things, because they were raising a family of three children on (usually) one modest income.  They knew the importance of making the most of what you have and of passing that vital skill on to your kids. 

However, my parents' financial knowledge did have some gaps.  I observed firsthand the struggles my father endured handling some retirement money after being laid off from a job when I was in middle school.  In subsequent years, this situation propelled me to learn about investing to help myself, my family, and others. 

  In many families money is a taboo subject — parents don't level with their kids about the limitations, realities, and details of their budgets.  Some parents I talk with believe that dealing with money is an adult issue and that children should be insulated from it so that they can enjoy being kids.  In many families, kids hear about money only when disagreements and financial crises bubble to the surface.  Thus begins the harmful cycle of children having negative associations with money and financial management. 

In other cases, parents with the best of intentions pass on their bad money-management habits.  You may have learned from a parent, for example, to buy things to cheer yourself up.  Or you may have witnessed a family member maniacally chasing get-rich-quick business and investment ideas.  Now I'm not saying that you shouldn't listen to your parents.  But in the area of personal finance, as in any other area, poor family advice and modeling can be problematic. 

Think about where your parents learned about money management and then consider whether they had the time, energy, or inclination to research choices before making their decisions.  For example, if they didn't do enough research or had faulty information, your parents may mistakenly have thought that banks were the best places for investing money or that buying stocks was like going to Las Vegas. ( You can find the best places to invest your money in Part III of this book.) 

Personal finance at school

In schools, the main problem with personal finance education is the lack of classes, not that kids already know the information or that the skills are too complex for children to understand. 

Nancy Donovan teaches personal finance to her fifth-grade math class as a way to illustrate how math can be used in the real world. " Students choose a career, find jobs, and figure out what their taxes and take-home paychecks will be.  They also have to rent apartments and figure out a monthly budget," says Donovan. " Students like it, and parents have commented to me how surprised they are by how much financial knowledge their kids can handle."  Donovan also has her students invest $10,000 (play money) and then track the investments' performance. 

Urging schools to teach the basics of personal finance is just common sense.  Children need to be taught how to manage a household budget, the importance of saving money for future goals, and the consequences of overspending.  Unfortunately, few schools offer classes like Donovan's.  In most cases, the financial basics aren't taught at all. 

In the minority of schools that do offer a course remotely related to personal finance, the class is typically in economics (and an elective at that). " Archaic theory is being taught, and it doesn't do anything for the students as far as preparing them for the real world," says one high school principal I know.  Having taken more than my fair share of economics courses in college, I understand the principal's concerns. 

Some people argue that teaching children financial basics is the parents' job.  However, this well-meant sentiment is what we're relying on now, and for all too many, it isn't working.  In some families, financial illiteracy is passed on from generation to generation. 

Education takes place in the home, on the streets, and in the schools.  Therefore, schools must bear some responsibility for teaching this skill.  However, if you're raising children, remember that no one cares as much as you do or has as much ability to teach the important life skill of personal money management. 

In still other cases, the parents had the right approach, but the kids do the opposite out of rebellion.  For example, if your parents spent money carefully and thoughtfully and at times made you feel denied, you may tend to do the opposite, buying yourself gifts the moment any extra money comes your way. 

Although you can't change what the educational system and your parents did or didn't teach you about personal finances, you now have the ability to find out what you need to know to manage your finances. 

  If you have children of your own, I'm sure you agree that kids really are amazing.  Don't underestimate their potential or send them out into the world without the skills they need to be productive and happy adults.  Buy them some good financial books when they head off to college or begin their first job. 

Identifying Unreliable Sources of Information

Most folks know that they're not financial geniuses.  So they set out to take control of their money matters by reading about personal finance or consulting a financial advisor. 

But reading and seeking advice to find out how to manage your money can be dangerous if you're a novice.  Misinformation can come from popular and seemingly reliable information sources, as I explain in the following sections. ( Because the pitfalls are numerous and the challenges significant when choosing an advisor, I devote Chapter 18 to the financial planning business and tell you what you need to know to avoid being fooled.) 

Understanding the dangers of free financial content online

In addition to being able to quickly access what we want, the other major attraction of the Internet is the abundance of seemingly free websites providing piles of free content.  Appearances, however, can be greatly deceiving. 

While there are exceptions to any rule, the fact of the matter is that the vast majority of websites purporting to provide a seemingly never-ending array of "free" content are rife with conflicts of interest and quality problems due to the following:

  Advertising: Any publication that accepts advertising has a potential conflict of interest because it may not want to publish articles that would upset its advertisers.  Such a mindset, however, can stand in the way of telling consumers the unvarnished truth about various products and services.  For example, auto leasing companies aren't very interested in advertising someplace that publishes articles highlighting the negatives of leasing. ( Check out the section "Publishers pandering to advertisers" later in this chapter for more on the power of advertising to influence the financial information you encounter online, on TV, and elsewhere.) 

  Advertorials: Too many website owners are unwilling or unable to pay real writers for quality content and instead publish articles that are provided and written by advertisers.  These pieces of "content" are known as advertorials and, in the worst cases, aren't even clearly labeled as advertisements, which is precisely what they are. 

  Affiliate relationships: Many companies now pay "referral fees" to websites that bring in new customers.  Here's how that practice causes major conflicts of interest.  On a financial website, you read a glowing review of a particular financial product or service.  And, the site provides a helpful link to the website of the provider of that product or service.  Unbeknownst to you, when you click on that link and buy something, the seller kicks money back to the "affiliate" who reeled you in.  At a minimum, such relationships should be clearly disclosed and detailed in any review. 

  Insufficient editorial oversight: At most established, quality print publications, there are usually several layers of editors who oversee the publication and all of its articles.  This structure helps ensure the accuracy of what gets into print (although bias, such as political bias, isn't necessarily controlled).  Unfortunately, the shoestring budget on which many websites operate precludes these quality control checks and balances.  Thus, sites operated by non-experts proffering advice place you at great risk. 

  Lack of accountability: In part because of a lack of editorial oversight, there's also often a lack of accountability for advice given online.  This situation is especially problematic on the numerous sites that are run without disclosure of who is actually in charge of the site and/or who is writing the articles.  Although such anonymity may be helpful to the site and its content providers, it's certainly not in your best interests because it prevents you from checking out the background, qualifications, and track record of the providers. 

Recognizing fake financial gurus

Before you take financial advice from anyone, examine her background, including professional work experience and education credentials.  This is true whether you're getting advice from an advisor, writer, talk show host, or TV financial reporter. 

If you can't easily find such information, that's usually a red flag.  People with something to hide or a lack of something redeeming to say about themselves usually don't promote their background. 

Of course, just because someone seems to have a relatively impressive-sounding background doesn't mean that she has your best interests in mind or has honestly presented her qualifications.  Forbes magazine journalist William P. Barrett presented a sobering review of financial author Suze Orman's stated credentials and qualifications:

"Besides books and other royalties, Orman's earned income has come mainly from selling insurance — which gets much more attention in her book than do stocks or bonds. . . .  The jacket of her video says she has '18 years of experience at major Wall Street institutions.'  In fact, she has 7." 

When the Forbes piece came out, Orman's publicist tried to discredit it and made it sound as if the magazine had falsely criticized Orman.  In response, the San Francisco Chronicle, which is the nearest major newspaper to Orman's hometown, picked up on the Forbes piece and ran a story of its own — written by Mark Veverka in his "Street Smarts" column — which substantiated the Forbes story. 

Veverka went through the Forbes piece point by point and gave Orman's company and the public relations firm numerous opportunities to provide information contrary to the piece, but they did not.  Here's some of what Veverka recounts from his contact with them:

"If you want your side told, you have to return reporters' telephone calls.  But alas, no callback. 

". . .  Orman's publicist said a written response to the Forbes piece and the 'Street Smarts' column would be sent by facsimile to the Chronicle. . . .  However, no fax was ever sent.  They blew me off.  Twice. 

"In what was becoming an extraordinary effort to be fair, I placed more telephone calls over several days to Orman Financial and the publicist, asking for either an interview with Orman or an official response.  If Orman didn't fudge about her years on Wall Street or didn't let her commodity-trading adviser license lapse, surely we could straighten all of this out, right? 

"Still, no answer.  Nada . . .  I called yet again.  Finally, literally on deadline, a woman who identified herself as Orman's 'consultant' called me to talk 'off the record' about the column.  What she ended up doing was bashing the Forbes piece and my column but not for publication.  More importantly, she offered no official retort to allegations made by veteran Forbes writer William Barrett.  I have to say, it was an incredibly unprofessional attempt at spinning.  And I've been spun by the worst of them." 

You can't always accept stated credentials and qualifications at face value, because some people lie (witness the billions lost to hedge fund Ponzi-scheme-man Bernie Madoff, who was brought down in 2008).  You can't sniff out liars by the way they look, their resume, their gender, or their age.  You can, however, increase your chances of being tipped off by being skeptical (and by regularly reading the "Guru Watch" section of my website at `www.erictyson.com`). 

  You can see a number of hucksters for what they are by using common sense in reviewing some of their outrageous claims.  Some sources of advice, such as Wade Cook's investment seminars, lure you in by promising outrageous returns.  The stock market has generated average annual returns of about 10 percent over the long term.  However, Cook, a former taxi driver, promoted his seminars as an "alive, hands-on, do the deals, two-day intense course in making huge returns in the stock market.  If you aren't getting 20 percent per month, or 300-percent annualized returns on your investments, you need to be there." ( I guess I do, as does every investment manager and individual investor I know!) 

Cook's get-rich-quick seminars, which cost more than $6,000, were so successful at attracting people that his company went public in the late 1990s and generated annual revenues of more than $100 million.  Cook's "techniques" included trading in and out of stocks and options after short holding periods of weeks, days, or even hours.  His trading strategies can best be described as techniques that are based upon technical analysis — that is, charting a stock's price movements and volume history, and then making predictions based on those charts. 

  The perils of following an approach that advocates short-term trading with the allure of high profits are numerous:

  You'll rack up enormous brokerage commissions. 

  On occasions where your short-term trades produce a profit, you'll pay high ordinary income tax rates rather than the far lower capital gains rate for investments held more than 12 months. 

  You won't make big profits — quite the reverse.  If you stick with this approach, you'll underperform the market averages. 

  You'll make yourself a nervous wreck.  This type of trading is gambling, not investing.  Get sucked up in it, and you'll lose more than money — you may also lose the love and respect of your family and friends. 

If Cook's followers were able to indeed earn the 300-percent annual returns his seminars claimed to help you achieve, any investor starting with just $10,000 would vault to the top of the list of the world's wealthiest people (ahead of Bill Gates and Warren Buffett) in just 11 years! 

How some gurus become popular

You may be wondering how Wade Cook became so popular despite the obvious flaws in his advice (see the section "Recognizing fake financial gurus" for the goods on Cook).  He promoted his seminars through infomercials and other advertising, including radio ads on respected news stations.  The high stock market returns of the 1990s brought greed back into fashion. ( My experience has been that you see more of this greed near market tops.) 

The attorneys general of numerous states sued Cook's company and sought millions of dollars in consumer refunds.  The suits alleged that the company lied about its investment track record (not a big surprise — this company claimed that you'd make 300 percent per year in stocks!). 

Cook's company settled the blizzard of state and Federal Trade Commission (FTC) lawsuits against his firm by agreeing to accurately disclose its trading record in future promotions and give refunds to customers who were misled by past inflated return claims. ( That didn't stop Cook, however, from getting into more legal hot water — he's currently serving a seven-year prison term for failing to pay millions in personal income taxes.) 

According to a news report by Bloomberg News, Cook's firm disclosed that it lost a whopping 89 percent of its own money trading during one year in which the stock market fared well.  As Deb Bortner, director of the Washington State Securities Division and president of the North American Securities Administrators Association, observed, "Either Wade is unable to follow his own system, which he claims is simple to follow, or the system doesn't work." 

Don't assume that someone with something to sell, who is getting good press and running lots of ads, will take care of you.  That "guru" may just be good at press relations and self-promotion.  Certainly, talk shows and the media at large can and do provide useful information on a variety of topics, but bad eggs sometimes turn up.  These bad eggs may not always smell bad upfront.  In fact, they may hoodwink people for years before finally being exposed.  Please review Part V for the details on resources you can trust and those that could cause you to go bust! 

Publishers pandering to advertisers

  Thousands of publications and media outlets — newspapers, magazines, websites, radio, TV, and so on — dole out personal financial advice and perspectives.  Although many of these "service providers" collect revenue from subscribers, virtually all are dependent — in some cases, fully dependent (especially the Internet, radio, and TV) — on advertising dollars.  Although advertising is a necessary part of capitalism, advertisers can taint and, in some cases, dictate the content of what you read, listen to, and view. 

Be sure to consider how dependent a publication or media outlet is on advertising.  I find that "free" publications, radio, and TV are the ones that most often create conflicts of interest by pandering to advertisers. ( All three derive all their revenue from advertising.) 

Much of what's on the Internet is advertiser-driven, as well.  Many of the investing sites on the Internet offer advice about individual stocks.  Interestingly, such sites derive much of their revenue from online brokerage firms seeking to recruit customers who are foolish enough to believe that selecting their own stocks is the best way to invest. ( See Part III for more information about your investment options.) 

As you read various publications, watch TV, or listen to the radio, note how consumer-oriented these media are.  Do you get the feeling that they're looking out for your interests?  For example, if lots of auto manufacturers advertise, does the media outlet ever tell you how to save money when shopping for a car or the importance of buying a car within your means?  Or are they primarily creating an advertiser-friendly broadcast or publication? 

Jumping over Real and Imaginary Hurdles to Financial Success

Perhaps you know that you should live within your means, buy and hold sound investments for the long term, and secure proper insurance coverage; however, you can't bring yourself to do these things.  Everyone knows how difficult it is to break habits that have been practiced for many years.  The temptation to spend money lurks everywhere you turn.  Ads show attractive and popular people enjoying the fruits of their labors — a new car, an exotic vacation, and a lavish home. 

Maybe you felt deprived by your tightwad parents as a youngster, or maybe you're bored with life and you like the adventure of buying new things.  If only you could hit it big on one or two investments, you think, you could get rich quick and do what you really want with your life.  As for disasters and catastrophes, well, those things happen to other people, not to you.  Besides, you'll probably have advance warning of pending problems, so you can prepare accordingly, right? 

Your emotions and temptations can get the better of you.  Certainly, part of successfully managing your finances involves coming to terms with your shortcomings and the consequences of your behaviors.  If you don't, you may end up enslaved to a dead-end job so you can keep feeding your spending addiction.  Or you may spend more time with your investments than you do with your family and friends.  Or unexpected events may leave you reeling financially; disasters and catastrophes can happen to anyone at any time. 

Discovering what (or who) is holding you back

A variety of personal and emotional hurdles can get in the way of making the best financial moves.  As I discuss earlier in this chapter, a lack of financial knowledge (which stems from a lack of personal financial education) can stand in the way of making good decisions. 

But I've seen some people caught in the psychological trap of blaming something else for their financial problems.  For example, some people believe that adult problems can be traced back to childhood and how they were raised. 

I don't want to disregard the negative impact particular backgrounds can have on some people's tendency to make the wrong choices during their lives.  Exploring your personal history can certainly yield clues to what makes you tick.  That said, adults make choices and engage in behaviors that affect themselves as well as others.  They shouldn't blame their parents for their own inability to plan for their financial futures, live within their means, and make sound investments. 

Some people also tend to blame their financial shortcomings on not earning more income.  Such people believe that if only they earned more, their financial (and personal) problems would melt away.  My experience working and speaking with people from diverse economic backgrounds has taught me that achieving financial success — and more importantly, personal happiness — has virtually nothing to do with how much income a person makes but rather with what she makes of what she has.  I know financially wealthy people who are emotionally poor even though they have all the material goods they want.  Likewise, I know people who are quite happy, content, and emotionally wealthy even though they're struggling financially. 

Americans — even those who have not had an "easy" life — ought to be able to come up with numerous things to be happy about and grateful for: a family who loves them; friends who laugh at their stupid jokes; the freedom to catch a movie or play or to read a good book; a great singing voice, sense of humor, or a full head of hair. 

Developing good financial habits

After you understand the basic concepts and know where to buy the best financial products when you need them, you'll soon see that managing personal finances well is not much more difficult than other things you do regularly, like tying your shoelaces and getting to work each day. 

  Regardless of your income, you can make your dollars stretch further if you practice good financial habits and avoid mistakes.  In fact, the lower your income, the more important it is that you make the most of your income and savings (because you don't have the luxury of falling back on your next fat paycheck to bail you out). 

More and more industries are subject to global competition, so you need to be on your financial toes now more than ever.  Job security is waning; layoffs and retraining for new jobs are increasing.  Putting in 30 years for one company and retiring with the gold watch and lifetime pension are becoming as rare as never having problems with your computer. 

Speaking of company pensions, odds are increasing that you work for an employer that has you save toward your own retirement instead of providing a pension for you.  Not only do you need to save the money, you must also decide how to invest it.  Chapter 11 can help you get a handle on investing in retirement accounts. 

Personal finance involves much more than managing and investing money.  It also includes making all the pieces of your financial life fit together; it means lifting yourself out of financial illiteracy.  Like planning a vacation, managing your personal finances means forming a plan for making the best use of your limited time and dollars. 

  Intelligent personal financial strategies have little to do with your gender, ethnicity, or marital status.  All people need to manage their finances wisely.  Some aspects of financial management become more or less important at different points in your life, but for the most part, the principles remain the same for everyone. 

Knowing the right answers isn't enough.  You have to practice good financial habits just as you practice other good habits, such as brushing your teeth.  Don't be overwhelmed.  As you read this book, make a short list of your financial marching orders and then start working away.  Throughout this book, I highlight ways you can overcome temptations and keep control of your money rather than let your emotions and money rule you. ( I discuss common financial problems in Chapter 2.) 

  What you do with your money is a quite personal and confidential matter.  In this book, I try to provide guidance that can keep you in sound financial health.  You don't have to take it all — pick what works best for you and understand the pros and cons of your options.  But from this day forward, please don't make the easily avoidable mistakes or overlook the sound strategies that I discuss throughout this book. 

Throughout your journey, I hope to challenge and even change the way you think about money and about making important personal financial decisions — and sometimes even about the meaning of life.  No, I'm not a philosopher, but I do know that money — for better but more often for worse — is connected to many other parts of our lives. 
Chapter 2

Measuring Your Financial Health

In This Chapter

  Tallying your assets, liabilities, and your (financial) net worth

  Requesting (and fixing) your credit reports

  Making sense of your credit score

  Understanding bad debt, good debt, and too much debt

  Calculating your rate of savings

  Assessing your investment and insurance know-how

How financially healthy are you?  When was the last time you took stock of your overall financial situation, including reviewing your spending, savings, future goals, and insurance?  If you're like most people, you've either never done this exercise or you did so too long ago. 

This chapter guides you through a financial physical to help you detect problems with your current financial health.  But don't dwell on your "problems."  View them for what they are — opportunities to improve your financial situation.  In fact, the more areas you can identify that stand to benefit from improvement, the greater the potential you may have to build real wealth and accomplish your financial and personal goals. 

Avoiding Common Money Mistakes

Financial problems, like many medical problems, are best detected early (clean living doesn't hurt, either).  Here are the common personal financial problems I've seen in my work as a financial counselor:

  Not planning: Most of us procrastinate.  That's why we have deadlines (like April 15) — and deadline extensions (need another six months to get that tax return done?).  Unfortunately, you may have no explicit deadlines with your personal finances.  You can allow your credit-card debt to accumulate, or you can leave your savings sitting in lousy investments for years.  You can pay higher taxes, leave gaps in your retirement and insurance coverage, and overpay for financial products.  Of course, planning your finances isn't as much fun as planning a vacation, but doing the former can help you take more of the latter.  See Chapter 4 for details on setting financial goals. 

  Overspending: Simple arithmetic helps you determine that savings is the difference between what you earn and what you spend (assuming that you're not spending more than you're earning!).  To increase your savings, you either have to work more, increase your earning power through education or job advancement, get to know a wealthy family who wants to leave its fortune to you, or spend less.  For most people, especially over the short-term, the thrifty approach is the key to building savings and wealth. ( Check out Chapter 3 for a primer on figuring out where your money goes; Chapter 6 gives advice for reducing your spending.) 

  Buying with consumer credit: Even with the benefit of today's low interest rates, carrying a balance month-to-month on your credit card or buying a car on credit means that even more of your future earnings are going to be earmarked for debt repayment.  Buying on credit encourages you to spend more than you can really afford.  Chapter 5 discusses debt and credit problems. 

  Delaying saving for retirement: Most folks say that they want to retire by their mid-60s or sooner.  But in order to accomplish this goal, they need to save a reasonable chunk (around 10 percent) of their incomes starting sooner rather than later.  The longer you wait to start saving for retirement, the harder reaching your goal will be.  And you'll pay much more in taxes to boot if you don't take advantage of the tax benefits of investing through particular retirement accounts.  For information on planning for retirement, see Chapters 4 and 11. 

  Falling prey to financial sales pitches: Steer clear of people who pressure you to make decisions, promise you high investment returns, and lack the proper training and experience to help you.  Great deals that can't wait for a little reflection or a second opinion are often disasters waiting to happen.  A sucker may be born every minute, but a slick salesperson is pitching something every second!  For important investment concepts and what kinds of investments to avoid, turn to Chapter 8. 

  Not doing your homework: To get the best deal, shop around, read reviews, and get advice from objective third parties.  You also need to check references and track records so that you don't hire incompetent, self-serving, or fraudulent financial advisors. ( For more on hiring financial planners, see Chapter 18.)  But with all the different financial products available, making informed financial decisions has become an overwhelming task.  I do a lot of the homework for you with the recommendations in this book.  I also explain what additional research you need to do and how to do it. 

  Making decisions based on emotion: You're most vulnerable to making the wrong moves financially after a major life change (a job loss or divorce, for example) or when you feel pressure.  Maybe your investments plunged in value.  Or perhaps a recent divorce has you fearing that you won't be able to afford to retire when you planned, so you pour thousands of dollars into some newfangled financial product.  Take your time and keep your emotions out of the picture.  In Chapter 21, I discuss how to approach major life changes and determine what changes you may need to make to your financial picture. 

  Not separating the wheat from the chaff: In any field in which you're not an expert, you run the danger of following the advice of someone you think is an expert but really isn't.  This book shows you how to separate the financial fluff from the financial facts. ( Flip to Chapter 19 for information on how to evaluate financial advice online and Chapter 20 for how to evaluate financial coverage in the mass media.)  You are the person who is best able to manage your personal finances.  Educate and trust yourself! 

  Exposing yourself to catastrophic risk: You're vulnerable if you and your family don't have insurance to pay for financially devastating losses.  People without a savings reserve and support network can end up homeless.  Many people lack sufficient insurance coverage to replace their income.  Don't wait for a tragedy to strike to find out whether you have the right insurance coverage.  Check out Part IV for more on insurance. 

  Focusing too much on money: Placing too much emphasis on making and saving money can warp your perspective on what's important in life.  Money is not the first — or even second — priority in happy people's lives.  Your health, relationships with family and friends, career satisfaction, and fulfilling interests are more significant. 

  Money problems can be fixed over time with changes in your behavior.  That's what the rest of this book is all about. 

Determining Your Financial Net Worth

Your financial net worth is an important barometer of your monetary health.  Your net worth indicates your capacity to accomplish major financial goals, such as buying a home, retiring, and withstanding unexpected expenses or loss of income. 

Your net worth is your financial assets minus your financial liabilities:

`Financial Assets – Financial Liabilities = Net Worth`

The following sections explain how to determine those numbers. 

Adding up your financial assets

A financial asset is real money or an investment you can convert into your favorite currency that you can use to buy things now or in the future.  Financial assets generally include the money you have in bank accounts, stocks, bonds, and mutual-fund accounts (see Part III, which deals with investments).  Money that you have in retirement accounts (including those with your employer) and the value of any businesses or real estate that you own are also counted. 

  I generally recommend that you exclude your personal residence when figuring your financial assets.  Include your home only if you expect to sell it someday or otherwise live off the money you now have tied up in it (perhaps by taking out a reverse mortgage, which I discuss in Chapter 14).  If you plan on eventually tapping into the equity (the difference between the market value and any debt owed on the property), add that portion of the equity that you expect to use to your list of assets. 

Assets can also include your future expected Social Security benefits and pension payments (if your employer has such a plan).  These assets are usually quoted in dollars per month rather than as a lump sum value.  In Table 2-1, I explain how to account for these monthly benefits when tallying your financial assets. 

  Consumer items — such as your car, clothing, stereo, and so forth — do not count as financial assets.  I know that adding these things to your assets makes your assets look larger (and some financial software and publications encourage you to list these items as assets), but you can't live off them unless you sell them. 

Subtracting your financial liabilities

To arrive at your financial net worth, you must subtract your financial liabilities from your assets.  Liabilities include loans and debts outstanding, such as credit-card and auto-loan debts.  When figuring your liabilities, include money you borrowed from family and friends — unless you're not expected to pay it back! 

Include mortgage debt on your home as a liability only if you include the value of your home in your asset list.  Be sure to also include debt owed on other real estate — no matter what (because you count the value of investment real estate as an asset). 

Crunching your numbers

Table 2-1 provides a place for you to figure your financial assets.  Go ahead and write in the spaces provided, unless you plan to lend this book to someone and don't want to put your money situation on display.  Note: See Table 4-1 in Chapter 4 to estimate your Social Security benefits. 

Now comes the potentially depressing part — figuring out your debts and loans in Table 2-2. 

Now you can subtract your liabilities from your assets to figure your net worth in Table 2-3. 

Interpreting your net worth results

Your net worth is important and useful only to you and your unique situation and goals.  What seems like a lot of money to a person with a simple lifestyle may seem like a pittance to a person with high expectations and a desire for an opulent lifestyle. 

In Chapter 4, you can crunch numbers to determine your financial status more precisely for goals such as retirement planning.  I also discuss saving toward other important goals in that chapter.  In the meantime, if your net worth (excluding expected monthly retirement benefits such as those from Social Security and pensions) is negative or less than half your annual income, take notice.  If you're in your 20s and you're just starting to work, a low net worth is less concerning and not unusual.  Focus on turning this number positive over the next several years.  However, if you're in your 30s or older, consider this a wake-up call to aggressively address your financial situation. 

Getting rid of your debts — the highest-interest rate ones first — is the most important thing.  Then you want to build a safety reserve equal to three to six months of living expenses.  Your overall plan should involve getting out of debt (Chapter 5), reducing your spending (Chapter 6), and developing tax-wise ways to save and invest your future earnings (Part III). 

Examining Your Credit Score and Reports

You may not know it (or care), but you probably have a personal credit report and a credit score.  Lenders examine your credit report and score before granting you a loan or credit line.  This section highlights what you need to know about your credit score and reports, including how to obtain them and how to improve them. 

Understanding what your credit data includes and means

A credit report contains information such as

  Personal identifying information: Includes your name, address, Social Security number, and so on

  Record of credit accounts: Details when each account was opened, the latest balance, your payment history, and so on

  Bankruptcy filings: Indicates whether you've filed bankruptcy in recent years

  Inquiries: Lists who has pulled your credit report because you applied for credit

Your credit score, which is not the same as your credit report, is a three-digit score based on the report.  Lenders use your credit score as a predictor of your likelihood of defaulting on repaying your borrowings.  As such, your credit score has a major impact on whether a lender is willing to extend you a particular loan and at what interest rate. 

FICO, developed by Fair Isaac and Company, is the leading credit score in the industry.  FICO scores range from a low of 300 to a high of 850.  Most scores fall in the 600s and 700s.  As with college entrance examinations, higher scores are better. ( In recent years, the major credit bureaus — Equifax, Experian, and TransUnion — have developed their own credit scoring systems, but many lenders still use FICO the most.) 

The higher your credit score, the lower your predicted likelihood of defaulting on a loan (see Figure 2-1).  The "rate of credit delinquency" refers to the percentage of consumers who will become 90 days late or later in repaying a creditor within the next two years.  As you can see in the chart, consumers with low credit scores have dramatically higher rates of falling behind on their loans.  Thus, low credit scorers are considered much riskier borrowers, and fewer lenders are willing to offer them a given loan; those who do offer loans charge relatively high interest rates. 

**Figure 2-1:** Lenders use credit scores to estimate how likely people are to default on a loan. 

Source: Fair Isaac Corporation

The median FICO score is around 720.  You generally qualify for the best lending rates if your credit score is in the mid-700s or higher. 

Obtaining your credit reports and score

Given the importance of your personal credit report, you may be pleased to know that you're entitled to receive a free copy of your credit report annually from each of the three credit bureaus (Equifax, Experian, and TransUnion). 

If you visit `www.annualcreditreport.com`, you can view and print copies of your credit report information from each of the three credit agencies online (alternatively, call 877-322-8228 to have your reports mailed to you).  After entering some personal data at the website, check the box indicating that you want to obtain all three credit reports, because each report may have slightly different information.  You'll then be directed to one of the three bureaus, and after you finish verifying that you are who you claim to be at that site, you can easily navigate back to `www.annualcreditreport.com` so you can continue to the next agency's site. 

When you receive your reports, the best first step is to examine them for possible mistakes (see the upcoming section "Getting credit report errors corrected" to find out how to fix problems in your reports).  Several years ago when I did that myself, I found minor errors on two of the three reports.  It took me several minutes to correct one of the errors (by submitting a request to that credit reporting agency's website), and it took about half an hour to get the other mistake fixed (a small doctor's bill was erroneously listed as unpaid and in collections). 

You may be surprised to find that your credit reports do not include your credit score.  The reason for this is quite simple: The 2003 law mandating that the three credit agencies provide a free credit report annually to each U.S. citizen who requests a copy did not mandate that they provide the credit score.  Thus, if you want to obtain your credit score, it's going to cost you. 

  You can request your credit score from Fair Isaac, but you'll get whacked $15.95 for every request (that can set you back nearly $50 to see your FICO score for all three credit bureaus).  Save your money.  If you want to purchase your credit score, you can do so for less by ordering it from the individual credit bureaus when you obtain your credit report(s) via `www.annual creditreport.com` — Equifax and Experian, for example, charge just $7.95 to obtain your current credit score. 

  If you do spring for your current credit score, be clear about what you're buying.  You may not realize that you're agreeing to some sort of ongoing credit monitoring service for, say, $50 to $100+ per year, an expenditure I don't feel is worthwhile. 

Improving your credit reports and score

Instead of simply throwing money into buying your credit scores or paying for some ongoing monitoring service to which you may not pay attention, take an interest in improving your credit standing and score.  Working to boost your credit rating is especially worthwhile if you know that your credit report contains detrimental information. 

Here are the most important actions that you can take to boost your attractiveness to lenders:

  Get all three of your credit reports, and be sure each is accurate.  Correct errors (as I explain in the next section) and be especially sure to get accounts removed if they aren't yours and they show late payments or are in collection. 

  Ask to have any late or missed payments that are more than seven years old removed.  Ditto for a bankruptcy that occurred more than ten years ago. 

  Pay all your bills on time.  To ensure on-time payments, sign up for automatic bill payment, a service that most companies (like phone and utility providers) offer. 

  Be loyal if it doesn't cost you.  The older your open loan accounts are, the better your credit rating will be.  Closing old accounts and opening a bunch of new ones generally lowers your credit score.  But don't be loyal if it costs you!  For example, if you can refinance your mortgage and save some money, by all means do so.  The same logic applies if you're carrying credit-card debt at a high interest rate and want to transfer that balance to a lower-rate card.  If your current credit-card provider refuses to match a lower rate you find elsewhere, move your balance and save yourself some money (see Chapter 5 for details). 

  Limit your debt and debt accounts.  The more loans, especially consumer loans, that you hold and the higher the balances, the lower your credit score will be. 

  Work to pay down consumer revolving debt (such as credit-card debt).  Turn to Chapters 5 and 6 for suggestions. 

Getting credit report errors corrected

If you obtain your credit report and find a blemish on it that you don't recognize as being your mistake or fault, do not assume that the information is correct.  Credit reporting bureaus and the creditors who report credit information to these bureaus often make errors. 

You hope and expect that, if a credit bureau has negative and incorrect information in your credit report and you bring the mistake to their attention, they will graciously and expeditiously fix the error.  If you believe that, you're the world's greatest optimist; perhaps you also think you won't have to wait in line at the Department of Motor Vehicles or the post office! 

Odds are, you're going to have to fill out a form on a website, make some phone calls, or write a letter or two to fix the problems on your credit report.  Here's how to correct most errors that aren't your fault:

  If the credit problem is someone else's: A surprising number of personal credit report glitches are the result of someone else's negative information getting on your credit report.  If the bad information on your report is completely foreign-looking to you, contact the credit bureau (by phone or online) and explain that you need more information because you don't recognize the creditor. 

  If the creditor made a mistake: Creditors make mistakes, too.  You need to write or call the creditor to get it to correct the erroneous information that it sent to the credit bureau.  Phoning first usually works best. ( The credit bureau should be able to tell you how to reach the creditor if you don't know how.)  If necessary, follow up with a letter. 

  Whether you speak with a credit bureau or an actual lender, make note of your conversations.  If representatives say that they can fix the problem, get their names, e-mail addresses, and phone extensions, and follow up with them if they don't deliver as promised.  If you're ensnared in bureaucratic red tape, escalate the situation by speaking with a department manager.  By law, bureaus are required to respond to a request to fix a credit error within 30 days — hold the bureau accountable! 

Telling your side of the story

With a minor credit infraction, some lenders may simply ask for an explanation.  Years ago, I had a credit report blemish that was the result of being away for several weeks and missing the payment due date for a couple of small bills.  When my proposed mortgage lender saw my late payments, the lender asked for a simple written explanation. 

You and a creditor may not see eye to eye on a problem, and the creditor may refuse to budge.  If that's the case, credit bureaus are required by law to allow you to add a 100-word explanation to your credit file. 

Sidestepping "credit repair" firms

Online and in newspapers and magazines, you may see ads for credit repair companies that claim to fix your credit report problems.  In the worst cases I've seen, these firms charge outrageous amounts of money and don't come close to fulfilling their marketing hype. 

If you have legitimate glitches on your credit report, credit repair firms can't make the glitches disappear.  Hope springs eternal, however — some people would like to believe that their credit problems can be fixed. 

  If your problems are fixable, you can fix them yourself; you don't need to pay a company big bucks to do it. 

Knowing the Difference between Bad Debt and Good Debt

Why do you borrow money?  Usually, you borrow money because you don't have enough to buy something you want or need — like a college education.  A four-year college education can easily cost $100,000, $150,000, or more.  Not too many people have that kind of spare cash.  So borrowing money to finance part of that cost enables you to buy the education. 

How about a new car?  A trip to your friendly local car dealer shows you that a new set of wheels will set you back $20,000+.  Although more people may have the money to pay for that than, say, the college education, what if you don't?  Should you finance the car the way you finance the education? 

  The auto dealers and bankers who are eager to make you an auto loan say that you deserve and can afford to drive a nice, new car, and they tell you to borrow away (or lease, which I don't love either — please see Chapter 6).  I just say, "No!  No!  No!"  Why do I disagree with the auto dealers and lenders?  For starters, I'm not trying to sell you a car or loan from which I derive a profit!  More importantly, there's a big difference between borrowing for something that represents a long-term investment and borrowing for short-term consumption. 

If you spend, say, $1,500 on a vacation, the money is gone.  Poof!  You may have fond memories and photos, but you have nothing of financial value to show for it. " But," you say, "vacations replenish my soul and make me more productive when I return . . .  the vacation more than pays for itself!" 

I'm not saying that you shouldn't take a vacation.  By all means, take one, two, three, or as many as you can afford yearly.  But the point is to take what you can afford.  If you have to borrow money in the form of an outstanding balance on your credit card for many months in order to take the vacation, you can't afford it. 

Consuming your way to bad debt

I coined the term bad debt to refer to debt incurred for consumption, because such debt is harmful to your long-term financial health. ( I used this term back in the early 1990s when the first edition of this book was published, and I'm flattered that others have since used the same terminology.) 

You'll be able to take many more vacations during your lifetime if you save the cash in advance.  If you get into the habit of borrowing and paying all the associated interest for vacations, cars, clothing, and other consumer items, you'll spend more of your future income paying back the debt and interest, leaving you with less money for your other goals. 

The relatively high interest rates that banks and other lenders charge for bad (consumer) debt is one of the reasons you're less able to save money when using such debt.  Not only does money borrowed through credit cards, auto loans, and other types of consumer loans carry a relatively high interest rate, but it also isn't tax-deductible. 

  I'm not saying that you should never borrow money and that all debt is bad.  Good debt, such as that used to buy real estate and small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible.  If well managed, these investments may also increase in value.  Borrowing to pay for educational expenses can also make sense.  Education is generally a good long-term investment because it can increase your earning potential.  And student loan interest is tax-deductible subject to certain limitations (see Chapter 7). 

Recognizing bad debt overload

Calculating how much debt you have relative to your annual income is a useful way to size up your debt load.  Ignore, for now, good debt — the loans you may owe on real estate, a business, an education, and so on (I get to that in the next section).  I'm focusing on bad debt, the higher-interest debt used to buy items that depreciate in value. 

To calculate your bad debt danger ratio, divide your bad debt by your annual income.  For example, suppose you earn $40,000 per year.  Between your credit cards and an auto loan, you have $20,000 of debt.  In this case, your bad debt represents 50 percent of your annual income. 

` bad debt `

` annual income = bad debt danger ratio`

The financially healthy amount of bad debt is zero.  While enjoying the convenience of credit cards, never buy anything with your card that you can't afford to pay off in full when the bill comes at the end of the month.  Not everyone agrees with me.  One major U.S. credit-card company says — in its "educational" materials, which it "donates" to schools to teach students about supposedly sound financial management — that carrying consumer debt amounting to 10 to 20 percent of your annual income is just fine. 

  When your bad debt danger ratio starts to push beyond 25 percent, it can spell real trouble.  Such high levels of high-interest consumer debt on credit cards and auto loans grow like cancer.  The growth of the debt can snowball and get out of control unless something significant intervenes.  If you have consumer debt beyond 25 percent of your annual income, see Chapter 5 to find out how to get out of debt. 

How much good debt is acceptable?  The answer varies.  The key question is: Are you able to save sufficiently to accomplish your goals?  In the "Analyzing Your Savings" section later in this chapter, I help you figure out how much you're actually saving, and in Chapter 4, I help you determine how much you need to save to accomplish your goals. ( See Chapter 14 to find out how much mortgage debt is appropriate to take on when buying a home.) 

  Borrow money only for investments (good debt) — for purchasing things that retain and hopefully increase in value over the long term, such as an education, real estate, or your own business.  Don't borrow money for consumption (bad debt) — for spending on things that decrease in value and eventually become financially worthless, such as cars, clothing, vacations, and so on. 

The lure of easy credit

Many years ago, I worked as a management consultant and did a lot of work with companies in the financial services industry, including some of the major credit-card companies.  Their game then, as it is now, was to push cards into the hands of as many people as possible who have a tendency and propensity to carry debt month to month at high interest rates.  Their direct marketing campaigns are quite effective.  Ditto for the auto manufacturers who successfully entice many people who can't really afford to spend $20,000, $30,000, or more on a brand-new car to buy new autos financed with an auto loan or lease. 

And just as alcohol and cigarette makers target young people with their advertising, credit-card companies are recruiting and grooming the next generation of overspenders on college campuses.  Unbelievably, our highest institutions of learning receive large fees from credit-card companies for allowing them to promote their cards on campuses! 

As widely available as credit is today, so, too, are suggestions for how to spend it.  We're bombarded with ads 24/7 on radio, TV, websites, cellphones, PDAs, the sides of buses and trains and the tops of taxicabs, people's clothing, and cars.  You couldn't go a day without advertising if you wanted to — you're surrounded! 

Assessing good debt: Can you get too much? 

As with good food, you can get too much of a good thing, including good debt!  When you incur debt for investment purposes — to buy real estate, for small business, even your education — you hope to see a positive return on your invested dollars. 

But some real-estate investments don't work out.  Some small businesses crash and burn, and some educational degrees and programs don't help in the way that some people hope that they will. 

There's no magic formula for determining when you have too much "good debt."  In extreme cases, I've seen entrepreneurs, for example, borrow up to their eyeballs to get a business off the ground.  Sometimes this works, and they end up financially rewarded, but in most cases, it doesn't. 

Here are three important questions to ponder and discuss with your loved ones about the seemingly "good debt" you're taking on:

  Are you and your loved ones able to sleep well at night and function well during the day, free from great worry about how you're going to meet next month's expenses? 

  Are the likely rewards worth the risk that the borrowing entails? 

  Are you and your loved ones financially able to save what you'd like to work toward your goals (see Chapter 4)? 

If you answer "no" to these questions, see the debt-reduction strategies in Chapter 5 for more information. 

Playing the credit-card float

Given what I have to say about the vagaries of consumer debt, you may think that I'm always against using credit cards.  Actually, I have credit cards, and I use them — but I pay my balance in full each month.  Besides the convenience credit cards offer me — in not having to carry around extra cash and checks — I receive another benefit: I have free use of the bank's money until the time the bill is due. ( Some cards offer other benefits, such as frequent flyer miles, and I have one of those types of cards too.  Also, purchases made on credit cards may be contested if the sellers of products or services don't stand behind what they sell.) 

When you charge on a credit card that does not have an outstanding balance carried over from the prior month, you typically have several weeks (known as the grace period) from the date of the charge to the time when you must pay your bill.  This is called playing the float.  Had you paid for this purchase by cash or check, you would have had to shell out the money sooner. 

  If you have difficulty saving money and plastic tends to break your budget, forget the float game.  You're better off not using credit cards.  The same applies to those who pay their bills in full but spend more because it's so easy to do so with a piece of plastic. ( For information on alternatives to using credit cards, see Chapter 5.) 

Analyzing Your Savings

How much money have you actually saved in the past year?  By that I mean the amount of new money you've added to your nest egg, stash, or whatever you like to call it. 

Most people don't know or have only a vague idea of the rate at which they're saving money.  The answer may sober, terrify, or pleasantly surprise you.  In order to calculate your savings over the past year, you need to calculate your net worth as of today and as of one year ago. 

The amount you actually saved over the past year is equal to the change in your net worth over the past year — in other words, your net worth today minus your net worth from one year ago.  I know it may be a pain to find statements showing what your investments were worth a year ago, but bear with me: It's a useful exercise. 

If you own your home, ignore this in the calculations. ( However, you can consider the extra payments you make to pay off your mortgage principal faster as new savings.)  And don't include personal property and consumer goods, such as your car, computer, clothing, and so on, with your assets. ( See the earlier section "Determining Your Financial Net Worth" if you need more help with this task.) 

When you have your net worth figures from both years, plug them into Step 1 of Table 2-4.  If you're anticipating the exercise and are already subtracting your net worth of a year ago from what it is today in order to determine your rate of savings, your instincts are correct, but the exercise isn't quite that simple.  You need to do a few more calculations in Step 2 of Table 2-4.  Why?  Well, counting the appreciation of the investments you've owned over the past year as savings wouldn't be fair.  Suppose you bought 100 shares of a stock a year ago at $17 per share, and now the value is at $34 per share.  Your investment increased in value by $1,700 during the past year.  Although you'd be the envy of your friends at the next party if you casually mentioned your investments, the $1,700 of increased value is not really savings.  Instead, it represents appreciation on your investments, so you must remove this appreciation from the calculations. ( Just so you know, I'm not unfairly penalizing you for your shrewd investments — you also get to add back the decline in value of your less-successful investments.) 

  If all this calculating gives you a headache, you get stuck, or you just hate crunching numbers, try the intuitive, seat-of-the-pants approach: Save a regular portion of your monthly income.  You can save it in a separate savings or retirement account. 

How much do you save in a typical month?  Get out the statements for accounts you contribute to or save money in monthly.  It doesn't matter if you're saving money in a retirement account that you can't access — money is money. 

Note: If you save, say, $200 per month for a few months, and then you spend it all on auto repairs, you're not really saving.  If you contributed $5,000 to an individual retirement account (IRA), for example, but you depleted money that you had from long ago (in other words, money that wasn't saved during the past year), don't count the $5,000 IRA contribution as new savings. 

Save at least 5 to 10 percent of your annual income for longer-term financial goals such as retirement (Chapter 4 helps you to fine-tune your savings goals).  If you're not saving that much, be sure to read Chapter 6 to find out how to reduce your spending and increase your savings. 

Evaluating Your Investment Knowledge

Congratulations!  If you've stuck with me from the beginning of this chapter, you've completed the hardest part of your financial physical.  The physical is much easier from here! 

Regardless of how much or how little money you have invested in banks, mutual funds, or other types of accounts, you want to invest your money in the wisest way possible.  Knowing the rights and wrongs of investing is vital to your long-term financial well-being.  Few people have so much extra money that they can afford major or frequent investing mistakes. 

Answering "yes" or "no" to the following questions can help you determine how much time you need to spend with my Investing Crash Course in Part III, which focuses on investing.  Note: The more "no" answers you reluctantly scribble, the more you need to find out about investing, and the faster you should turn to Part III. 

_____ Do you understand the investments you currently hold? 

_____ Is the money that you'd need to tap in the event of a short-term emergency in an investment where the principal does not fluctuate in value? 

_____ Do you know what marginal income-tax bracket (combined federal and state) you're in, and do you factor that in when choosing investments? 

_____ For money outside of retirement accounts, do you understand how these investments produce income and gains and whether these types of investments make the most sense from the standpoint of your tax situation? 

_____ Do you have your money in different, diversified investments that aren't dependent on one or a few securities or one type of investment (that is, bonds, stocks, real estate, and so on)? 

_____ Is the money that you're going to need for a major expenditure in the next few years invested in conservative investments rather than in riskier investments such as stocks or pork bellies? 

_____ Is the money that you have earmarked for longer-term purposes (more than five years) invested to produce returns that are likely to stay ahead of inflation? 

_____ If you currently invest in or plan to invest in individual stocks, do you understand how to evaluate a stock, including reviewing the company's balance sheet, income statement, competitive position, price-earnings ratio versus its peer group, and so on? 

_____ If you work with a financial advisor, do you understand what that person is recommending that you do, are you comfortable with those actions and that advisor, and is that person compensated in a way that minimizes potential conflicts of interest in the strategies and investments he recommends? 

  Making and saving money are not guarantees of financial success; rather, they're prerequisites.  If you don't know how to choose sound investments that meet your needs, you'll likely end up throwing money away, which leads to the same end result as never having earned and saved it in the first place.  Worse still, you won't be able to derive any enjoyment from spending the lost money on things that you perhaps need or want.  Turn to Part III to discover the best ways to invest; otherwise, you may wind up spinning your wheels working and saving. 

Assessing Your Insurance Savvy

In this section, you have to deal with the prickly subject of protecting your assets and yourself with insurance.  The following questions help you get started.  Answer "yes" or "no" for each question. 

_____ Do you understand the individual coverages, protection types, and amounts of each insurance policy you have? 

_____ Does your current insurance protection make sense given your current financial situation (as opposed to your situation when you bought the policies)? 

_____ If you wouldn't be able to make it financially without your income, do you have adequate long-term disability insurance coverage? 

_____ If you have family members who are dependent on your continued income, do you have adequate life insurance coverage to replace your income if you die? 

_____ Do you know when it makes sense to buy insurance through discount brokers, fee-for-service advisors, and companies that sell directly to the public (bypassing agents) and when it doesn't? 

_____ Do you carry enough liability insurance on your home, car (including umbrella/excess liability), and business to protect all your assets? 

_____ Have you recently (in the last year or two) shopped around for the best price on your insurance policies? 

_____ Do you know whether your insurance companies have good track records when it comes to paying claims and keeping customers satisfied? 

That wasn't so bad, was it?  If you answered "no" more than once or twice, don't feel bad — nine out of ten people make significant mistakes when buying insurance.  Find your insurance salvation in Part IV.  If you answered "yes" to all the preceding questions, you can spare yourself from reading Part IV, but bear in mind that many people need as much help in this area as they do in other aspects of personal finance. 
Chapter 3

Managing Where Your Money Goes

In This Chapter

  Understanding why people overspend

  Assessing your spending

  Tracking your expenses via "free" websites

As a financial counselor, I've worked with people who have small incomes, people who have six-figure and even seven-figure incomes, and everyone in between.  At every income level, people fall into one of the following three categories:

  People who spend more than they earn (accumulating debt)

  People who spend all that they earn (saving nothing)

  People who save 2, 5, 10, or even 20 percent (or more!) 

I've seen $40,000 earners who save 20 percent of their income ($8,000), $80,000 earners who save just 5 percent ($4,000), and people earning well into six figures annually who save nothing or accumulate debt. 

Suppose that you currently earn $50,000 per year and spend all of it.  You may wonder, "How can I save money?"  Good question!  Rather than knock yourself out at a second job, you may want to try living below your income — in other words, spending less than you earn.  Consider that for every discontented person earning and spending $50,000 per year, someone else is out there making do on $45,000. 

A great many people live on less than you make.  If you spend as they do, you can save and invest the difference.  In this chapter, I examine why people overspend and help you look at your own spending habits.  When you know where your money goes, you can find ways to spend less and save more (see Chapter 6) so that someday, you, too, can live richly and achieve your life's goals. 

Examining Overspending

If you're like most people, you must live within your means in order to accomplish your financial goals.  Doing so requires spending less than you earn and then investing your savings intelligently (unless you plan on winning the lottery or receiving a large inheritance).  To put yourself in a position that allows you to start saving, take a close look at your spending habits. 

Many folks earn just enough to make ends meet.  And some can't even do that; they simply spend more than they make.  The result of such spending habits is, of course, an accumulation of debt. 

Most of the influences in society encourage you to spend.  Think about it: More often than not, you're referred to as a consumer in the media and in the hallowed halls of U.S. government.  You're not referred to as a person, a citizen, or a human being.  This section looks at some of the adversaries you're up against as you attempt to control your spending. 

Having access to credit

As you probably already know, spending money is easy.  Thanks to innovations like ATMs, credit cards, PayPal, and so on, your money is always available, 24/7. 

Sometimes it may seem as though lenders are trying to give away money by making credit so easily available.  But this free money is a dangerous illusion.  Credit is most perilous when you make consumption purchases you can't afford in the first place.  When it comes to consumer debt (credit cards, auto loans, and the like), lenders aren't giving away anything except the misfortune of getting in over your head, racking up high interest charges, and delaying your progress toward your financial and personal goals. 

Misusing credit cards

The modern-day bank credit card was invented by Bank of America near the end of the baby boom.  The credit industry has been booming along with the boomers ever since. 

If you pay your bill in full every month, credit cards offer a convenient way to buy things with an interest-free, short-term loan.  But if you carry your debt over from month to month at high interest rates, credit cards encourage you to live beyond your means.  Credit cards make it easy and tempting to spend money that you don't have. 

  You'll never pay off your credit-card debt if you keep charging on your card and make only the minimum monthly payments.  Interest continues to pile up on your outstanding debt.  Paying only the minimum monthly payment can lead to your carrying high-interest debt on your card for decades (not just months or years)! 

Some credit cards are now trying to sell cardholders "insurance" at a cost of 10 percent annually to pay the minimum payments due on credit-card balances for those months that the debtor is unable to pay because of some life transition event (such as a job layoff).  One such card normally charges a 13-percent annual interest rate on credit-card balances, so with the insurance charges, the annual interest rate is 23 percent! 

  If you have a knack for charging up a storm and spending more than you should with those little pieces of plastic, only one solution exists: Get rid of your credit cards.  Put scissors to the plastic.  Go cold turkey.  You can function without them. ( See Chapter 5 for details on how to live without credit cards.) 

Taking out car loans

Walking onto a car lot and going home with a new car that you could never afford if you had to pay cash is easy.  The dealer gets you thinking in terms of monthly payments that sound small when compared to what that four-wheeler is really gonna cost you.  Auto loans are easy for just about anyone to get (except maybe a recently paroled felon). 

Suppose you're tired of driving around in your old clunker.  The car is battle-scarred and boring, and you don't like being seen in it.  Plus, the car is likely to need more repairs in the months ahead.  So off you go to your friendly local car dealer. 

You start looking around at all the shiny, new cars, and then — like the feeling you experience when spotting a water fountain on a scorching hot day — there it is: your new car.  It's sleek and clean, and has air conditioning, a stereo, and power everything.  Before you can read the fine print on the sticker page on the side window, the salesperson moseys on up next to you.  He gets you talking about how nice the car is, the weather, or anything but the sticker price of that car. 

"How," you begin to think to yourself, "can this guy afford to spend time with me without knowing if I can afford this thing?"  After a test drive and more talk about the car, the weather, and your love life (or lack thereof) comes your moment of truth.  The salesperson, it seems, doesn't care about how much money you have.  Whether you have lots of money or very little doesn't matter.  The car is only $399 a month! 

"That price isn't bad," you think.  Heck, you were expecting to hear that the car would cost you at least 25 grand.  Before you know it, the dealer runs a credit report on you and has you sign a few papers, and minutes later you're driving home with your new car. 

  The dealer wants you to think in terms of monthly payments because the cost sounds so cheap: $399 for a car.  But, of course, that's $399 per month for many, many months.  You're gonna be payin' forever — after all, you just bought a car that cost a huge chunk of your yearly take-home income. 

But it gets worse.  What does the total sticker price come to when interest charges are added in? ( Even if interest charges are low, you may still be buying a car with a sticker price you can't afford.)  And what about the cost of insurance, registration, and maintenance over the seven or so years that you'll own the car?  Now you're probably up to more than a year's worth of your income.  Ouch! ( See Chapter 6 for information on how to spend what you can afford on a car.) 

Bending to outside influences and agendas

You go out with some friends to dinner, a sporting event, or a show.  Try to remember the last time one of you said, "Let's go someplace (or do something) less costly.  I can't afford to spend this much."  On the one hand, you don't want to be a stick in the mud.  But on the other hand, some of your friends have more money than you do — and the ones who don't may be running up debt fast. 

Some people just have to see the latest hit movie, wear the latest designer clothes, or get the newest smartphone or tablet device.  They don't want to feel left out or behind the times. 

When was the last time you heard someone say that she decided to forego a purchase because she was saving for retirement or a home purchase?  It doesn't happen often, does it?  Just dealing with the here-and-now and forgetting your long-term needs and goals is tempting.  This mindset leads people to toil away for too many years in jobs they dislike. 

Living for today has its virtues: Tomorrow may not come.  But odds are good that it will.  Will you still feel the same way about today's spending decisions tomorrow?  Or will you feel guilty that you again failed to stick to your goals? 

Your spending habits should be driven by your desires and plans, not those of others.  If you haven't set any goals yet, you may not know how much you should be saving.  Chapter 4 helps you kick-start the planning and saving process. 

Spending to feel good

Life is full of stress, obligations, and demands. " I work hard," you say, "and darn it, I deserve to indulge!"  Especially after your boss took the credit for your last great idea or blamed you for her last major screwup.  So you buy something expensive or go to a fancy restaurant.  Feel better?  You won't when the bill arrives.  And the more you spend, the less you save, and the longer you'll be stuck working for jerks like your boss! 

Just as people can become addicted to alcohol, tobacco, television, and the Internet, some people also become addicted to the high they get from spending.  Researchers can identify a number of psychological causes for a spending addiction, with some relating to how your parents handled money and spending. ( And you thought you'd identified all the problems you can blame on Mom and Dad!) 

  If your spending and debt problems are chronic, or even if you'd simply like to be a better consumer and saver, see Chapter 5 for more information. 

Analyzing Your Spending

Brushing your teeth, eating a diverse diet including plenty of fruits and vegetables, and exercising regularly are good habits.  Spending less than you earn and saving enough to meet your future financial objectives are the financial equivalents of these habits. 

Despite relatively high incomes compared with the rest of the world, some Americans have a hard time saving a good percentage of their incomes.  Why?  Often it's because they spend too much — sometimes far more than necessary. 

  The first step to saving more of the income that you work so hard for is to figure out where that income typically gets spent.  The spending analysis in the next section helps you determine where your cash is flowing.  Do the spending analysis if any of the following apply to you:

  You aren't saving enough money to meet your financial goals. ( If you're not sure whether this is the case, please see Chapter 4.) 

  You feel as though your spending is out of control, or you don't really know where all your income goes. 

  You're anticipating a significant life change (for example, marriage, leaving your job to start a business, having children, retiring, and so on). 

If you're already a good saver, you may not need to complete the spending analysis.  After you save enough to accomplish your goals, I don't see as much value in continually tracking your spending.  You've already established the good habit — saving.  Tracking exactly where you spend your money month after month is not the good habit. ( You may still benefit from perusing my smarter spending recommendations in Chapter 6.) 

The immediate goal of a spending analysis is to figure out where you typically spend your money.  The long-range goal is to establish a good habit: maintaining a regular, automatic savings routine. 

Notice the first four letters in the word analysis. ( You may never have noticed what they spell, but I feel the need to bring it to your attention.)  Knowing where your money is going each month is useful, and making changes in your spending behavior and cutting out the fat so you can save more money and meet your financial goals is terrific.  However, you may make yourself and those around you miserable if you're anal about documenting precisely where you spend every single dollar and cent. 

  Saving what you need to achieve your goals is what matters most. 

Tracking spending the low-tech way

Analyzing your spending is a little bit like being a detective.  Your goal is to reconstruct the crime of spending.  You probably have some major clues at your fingertips or somewhere on the desk or computer where you handle your finances. 

  Unless you keep meticulous records that detail every dollar you spend, you won't have perfect information.  Don't sweat it!  A number of sources can enable you to detail where you've been spending your money.  To get started, get out/access your

  Recent pay stubs

  Tax returns

  Online banking/bill payment record

  Log of checks paid and monthly debit card transactions

  Credit and charge card bills

Ideally, you want to assemble the documents needed to track 12 months of spending.  But if your spending patterns don't fluctuate greatly from month to month (or if your dog ate some of the old bills), you can reduce your data gathering to one six-month period, or to every second or third month for the past year.  If you take a major vacation or spend a large amount on gifts during certain months of the year, make sure that you include these months in your analysis.  Also account for insurance or other financial payments that you may choose not to pay monthly and instead pay quarterly, semiannually, or annually. 

  Purchases made with cash are the hardest to track because they don't leave a paper trail.  Over the course of a week or perhaps even a month, you could keep a record of everything you buy with cash.  Tracking cash can be an enlightening exercise, but it can also be a hassle.  If you're lazy like I sometimes am or you lack the time and patience, try estimating.  Think about a typical week or month — how often do you buy things with cash?  For example, if you eat lunch out four days a week, paying around $6 per meal, that's about $100 a month.  You may also want to try adding up all the cash withdrawals from your checking account statement and then working backwards to try to remember where you spent the cash. 

Separate your expenditures into as many useful and detailed categories as possible.  Table 3-1 gives you a suggested format; you can tailor it to fit your needs.  Remember, if you lump too much of your spending into broad, meaningless categories like "Other," you'll end up right back where you started — wondering where all the money went. ( Note: When completing the tax section in Table 3-1, report the total tax you paid for the year as tabulated on your annual income tax return — and take the total Social Security and Medicare taxes paid from your end-of-year pay stub — rather than the tax withheld or paid during the year.) 

Tracking your spending on "free" websites and your PC

Software programs and websites can assist you with paying bills and tracking your spending.  The main advantage of using software or websites is that you can continually track your spending as long as you keep entering the information.  Software packages and websites can even help speed up the check-writing process (after you figure out how to use them, which isn't always an easy thing to do). 

But you don't need a computer and fancy software to pay your bills and figure out where you're spending money.  Many people I know stop entering data after a few months.  If tracking your spending is what you're after, you need to enter information from the bills you pay by check and the expenses you pay by credit card and cash.  Like home exercise equipment and exotic kitchen appliances, such software often ends up in the consumer graveyard. 

Plenty of folks have trouble saving money and reducing their spending.  Thus, it's no surprise that in the increasingly crowded universe of free websites, plenty are devoted to supposedly helping you to reduce your spending. 

More of these sites keep springing up, but among those you may have heard of and stumbled upon are Geezeo, Mint, and Yodlee.  I've kicked the tires and checked out these sites, and frankly, I have mixed to negative feelings about them.  The biggest problem that I have with these "free" sites is that they're loaded with advertising and/or have "affiliate" relationships with companies.  This simply means that the site gets paid if you click on a link to one of their recommended service providers and buy what they are selling. 

This compensation, of course, creates an enormous conflict of interest and thoroughly taints any recommendation made by "free" sites that profit from affiliate referrals.  For starters, they have no incentive or reason to recommend companies that won't pay them an affiliate fee.  And, there's little — if any — screening of companies for quality, service levels, and other criteria important to you as a consumer. 

Also, be forewarned that after registering you as a site user, the first thing most of these sites want you to do is connect directly to your financial institutions (banks, brokerages, investment companies) and download your investment account and spending data.  If your intuition tells you this may not be a good idea, trust your instincts.  Yes, there are security concerns, but those pale in comparison to privacy concerns and apprehension about the endless pitching to you of products and services. 

Another problem I have with these websites is the incredibly simplistic calculators that they have.  One that purports to help with retirement planning doesn't allow users to choose a retirement age younger than 62 and has no provisions for part-time work.  When it asks about your assets, it makes no distinction between equity in your home and financial assets (stocks, bonds, mutual funds, and so on).  Finally, these sites generally offer no phone support, so if you encounter a problem using them, you're relegated to ping-ponging e-mails in the hope of getting your questions answered. 

I noticed over time that many "free" financial websites were singing the praises of the software "You Need A Budget" (YNAB).  I test-drove the product (which is like a slimmed-down version of Quicken) and found it to be a decent, but not exceptional, product.  My research uncovered the fact that the makers of YNAB pay a whopping 35 percent commission to website affiliates who pitch to users and direct them to buy the product.  The owner of a website flogging YNAB pockets about $21 to $24.50 of the software's sales price ($60 to $70 a whack) for each customer it refers who buys a copy.  Does that taint a site's recommendation of YNAB?  Of course it does. 

  Paper, pencil, and a calculator work just fine for tracking your spending.  For those of you who want to try computerizing your bill payments and expense tracking, I recommend the best software packages and discuss websites in detail in Chapter 19. 

Don't waste time on financial administration

Tom is the model of financial organization.  His financial documents are neatly organized into color-coded folders.  Every month, he reviews all his spending information on his computer.  He even carries a notebook to detail his cash spending so that every penny is accounted for.  Tom also balances his checkbook "to make sure that everything is in order."  He can't remember the last time his bank made a mistake, but he knows someone who once found a $50 error. 

If you spend seven hours per month balancing your checkbook and detailing all your spending (as Tom does), you may be wasting about two weeks' worth of time per year — the equivalent of two-thirds of your vacation time if you take three weeks annually. 

Suppose that, every other year, you're "lucky" enough to find a $100 error the bank made in its favor.  If you spend just three hours per month tracking your spending and balancing your checkbook to discover this glitch, you're spending 72 hours over two years to find a $100 mistake.  Your hourly pay: a wafer-thin $1.39 per hour. ( Note: If you make significant-sized deposits or withdrawals, make sure that you capture them on your statement.) 

To add insult to injury, you may not have the desire and energy to do the more important stuff after working a full week and doing all your financial and other chores.  Your big personal financial picture — establishing goals, choosing wise investments, securing proper insurance coverage — may continue to be shoved to the back burner.  As a result, you may lose thousands of dollars annually.  Over the course of your adult life, this amount can translate into tens or even hundreds of thousands of lost dollars. 

Tom, for example, doesn't know how much he should be saving to meet his retirement goals.  He doesn't review his employer's benefit materials, so he doesn't understand his insurance and retirement plan options.  He knows that he pays a lot in taxes, but he isn't sure how to reduce his taxes. 

You want to make the most of your money.  Unless you truly enjoy dealing with dollars and cents, you need to prioritize the money activities you work on.  Time is limited, and life is short.  Working harder on financial administration doesn't earn you bonus points.  The more time you spend dealing with your personal finances, the less time you have available to gab with friends, watch a good movie, read a good novel, and do other things you really enjoy. 

Don't get me wrong — nothing is inherently wrong with balancing your checkbook.  In fact, if you regularly bounce checks because you don't know how low your balance is, the exercise may save you a lot in returned check fees.  However, if you keep enough money in your checking account so that you don't have to worry about the balance reaching $0 or if you have overdraft protection, balancing your checkbook is probably a waste of time, even if your hourly wages aren't lofty.  I haven't balanced mine in years (but please don't tell my bank — it might start making some "mistakes" and siphoning money out). 

If you're busy, consider ways to reduce the amount of time you spend on mundane financial tasks like bill paying.  Many companies, for example, allow you to pay your monthly bills electronically via your bank checking account or your credit card. ( Don't use this option unless you pay your credit-card bill in full each month.)  The fewer bills you have to pay, the fewer separate checks and envelopes you must process each month.  That translates into more free time and fewer paper cuts! 
Chapter 4

Establishing and Achieving Goals

In This Chapter

  Defining what matters most to you

  Setting and prioritizing your financial goals

  Saving for unexpected expenses, a real-estate purchase, a small business, or educational needs

  Estimating what you need for retirement and making up for lost time

In my work as a financial counselor, I always asked new clients what their short- and long-term personal and financial goals were.  Most people reported that reflecting on this question was incredibly valuable, because they hadn't considered it for a long time — if ever. 

In this chapter, I help you dream about what you want to get out of life.  Although my expertise is in personal finance, I wouldn't be doing my job if I didn't get you to consider your nonfinancial goals and how money fits into the rest of your life goals.  So before I jump into how to establish and save toward common financial goals, I discuss how to think about making and saving money, as well as how to best fit your financial goals into the rest of your life. 

Creating Your Own Definition of "Wealth"

Peruse any major financial magazine, newspaper, or website and you'll quickly see our culture's obsession with financial wealth.  The more money financial executives, movie stars, or professional athletes have, the more publicity and attention they seem to get.  In fact, many publications go as far as ranking those people who earn the most or have amassed the greatest wealth! 

I can tell you from my decades of work as a personal financial advisor and writer and interacting with folks from varied backgrounds that there's surprisingly little correlation between financial wealth and emotional wealth.  That's why in your pursuit of financial wealth and security, you should always remember the emotional side.  The following sections can help you gain some perspective. 

Acknowledging what money can't buy

Recall the handful of best moments in your life.  Odds are these times don't include the time you bought a car or found a designer sweater that you liked.  The old saying is true: The most enjoyable and precious things of value in your life can't be bought. 

The following statement should go without saying, but I must say it, because too many people act as if it isn't so: Money can't buy happiness.  It's tempting to think that if you could only make 20 percent more or twice as much money, you'd be happier because you'd have more money to travel, eat out, and buy that new car you've been eyeing, right?  Not so.  A great deal of thoughtful research suggests that little relationship exists between money and happiness. 

"Wealth is like health: Although its absence can breed misery, having it is no guarantee of happiness," says psychology professor Dr. David G. Myers, who has written and researched happiness across cultures for decades.  Despite myriad technological gadgets and communication devices, cheap air travel, microwaves, personal computers, voice mail, and all the other stuff that's supposed to make life easier and more enjoyable, Americans aren't any happier than they were four decades ago, according to research conducted by the National Opinion Research Center.  These results occur even though incomes, after being adjusted for inflation, have more than doubled during that time. 

Managing the balancing act

Believe it or not, some people save too much.  In my counseling practice, I saw plenty of people who fell into that category.  If making and saving money are good things, then the more the better, right?  Well, take the admittedly extreme case of Anne Scheiber, who, on a modest income, started saving at a young age, allowing her money to compound in wealth-building investments such as stocks over many years.  As a result, she was able to amass $20 million before she passed away at the age of 101. 

What's your relationship to money? 

Over the years in my work as a financial counselor, I've come to find that how a person relates to and feels about money has a great impact on how good he is at managing his money and making important financial decisions.  For example, knowing that you have a net worth of negative $13,200 because of credit-card debt is useful, but it's probably not enough information for you to do something constructive about your problem.  A logical next step would be to examine your current spending and take steps to reduce your debt load. 

Although I cover practical solutions to common financial quandaries later in this book, I also discuss the more touchy-feely side of money.  For example, some people who continually rack up consumer debt have a spending addiction.  Other people who jump in and out of investments and follow them like a hawk have psychological obstacles that prevent them from holding on to investments. 

And then you have those somewhat philosophical and psychological issues relating to money and the meaning of life.  Saving more money and increasing your net worth aren't always the best approaches.  In my work, I've come across numerous people who attach too much significance to personal wealth accumulation and neglect important human relationships in their pursuit of more money.  Some retirees have a hard time loosening the purse strings and actually spending some of the money they worked so hard to save for their golden years. 

Balancing your financial goals with other important life goals is key to your happiness.  What's the point, for example, of staying in a well-paying, admired profession if you don't care for the work and you're mainly doing it for the financial rewards?  Life is too short and precious for you to squander away your days. 

So as you read through the various chapters and sections of this book, please consider your higher life goals and purposes.  What are your nonfinancial priorities (family, friends, causes), and how can you best accomplish your goals with the financial resources you do have? 

Scheiber lived in a cramped studio apartment and never used her investments.  She didn't even use the interest or dividends — she lived solely on her Social Security benefits and a small pension from her employer.  Scheiber was extreme in her frugality and obsessed with her savings.  As reported by James Glassman in The Washington Post, "She had few friends . . .  she was an unhappy person, totally consumed by her securities accounts and her money."  Most people, myself included, wouldn't choose to live and save the way that Scheiber did. 

Even those who are saving for an ultimate goal can become consumed by their saving habits.  I see some people pursuing higher-paying jobs and pinching pennies in order to retire early.  But sometimes they make too many personal sacrifices today while chasing after some vision of their lives tomorrow.  Others get consumed by work and then don't understand why their family and friends feel neglected — or don't even notice that they do. 

Another problem with seeking to amass wealth is that tomorrow may not come.  Even if all goes according to plan, will you know how to be happy when you're not working if you spend your entire life making money?  More importantly, who will be around to share your leisure time?  One of the costs of an intense career is time spent away from friends and family.  You may realize your goal of retiring early, but you may be putting off too much living today in expectation of living tomorrow.  As Charles D'Orleans said in 1465, "It's very well to be thrifty, but don't amass a hoard of regrets." 

Of course, at the other extreme are spendthrifts who live only for today.  A friend of mine once said, "I'm not into delayed gratification." " Shop 'til you drop" seems to be the motto of this personality type. " Why save when I might not be here tomorrow?"  reasons this type of person. 

The danger of this approach is that tomorrow may come after all, and most people don't want to spend all their tomorrows working for a living.  The earlier neglect of saving, however, may make it necessary for you to work when you're older.  And if for some reason you can't work and you have little money to live on, much less live enjoyably, the situation can be tragic.  The only difference between a person without any savings or access to credit and some homeless people is a few months of unemployment. 

Making and saving money are like eating food.  If you don't eat enough, you may suffer.  If you eat too much, the overage may go to waste or make you overweight.  The right amount, perhaps with some extra to spare, affords you a healthy, balanced, peaceful existence.  Money should be treated with respect and acknowledged for what it is — a means to an end and a precious resource that shouldn't be thoughtlessly squandered and wasted. 

  As Dr. David Myers, whom I introduce earlier in this chapter, says: "Satisfaction isn't so much getting what you want as wanting what you have.  There are two ways to be rich: One is to have great wealth; the other is to have few wants."  Find ways to make the most of the money that does pass through your hands, and never lose sight of all that is far more important than money. 

Prioritizing Your Savings Goals

Most people I know have financial goals.  The rest of this chapter discusses the most common financial goals and how to work toward them.  See whether any of the following reflect your ambitions:

  Owning your home: Renting and dealing with landlords can be a financial and emotional drag, so most folks want to buy into the American dream and own some real estate — the most basic of which is your own home. ( Despite the slide in property prices in the late 2000s, real estate has a pretty solid track record as a long-term investment.) 

  Making major purchases: Most folks need to plan ahead for major purchases such as a car, living room furniture, vacation trips, and so on. 

  Retiring: No, retiring doesn't imply sitting on a rocking chair watching the world go by while hoping that some long-lost friend, your son's or daughter's family, or the neighborhood dog comes by to visit.  Retiring is a catchall term for discontinuing full-time work or perhaps not even working for pay at all. 

  Educating the kids: All those diaper changes, late-night feedings, and trips to the zoo aren't enough to get Junior out of your house and into the real world as a productive, self-sufficient adult.  You may want to help your children get a college education.  Unfortunately, that can cost a truckload of dough. 

  Owning your own business: Many employees want to take on the challenges and rewards that come with being the boss.  The primary reason that most people continue just to dream is that they lack the money to leave their primary job.  Although many businesses don't require gobs of start-up cash, almost all require that you withstand a substantial reduction in your income during the early years. 

Because everyone is different, you can have goals (other than those in the preceding list) that are unique to your own situation.  Accomplishing such goals almost always requires saving money.  As one of my favorite Chinese proverbs says, "Do not wait until you are thirsty to dig a well," so don't wait to save money until you're ready to accomplish a personal or financial goal! 

Knowing what's most important to you

Unless you earn really big bucks or have a large family inheritance to fall back on, your personal and financial desires will probably outstrip your resources.  Thus, you must prioritize your goals. 

One of the biggest mistakes I see people make is rushing into a financial decision without considering what's really important to them.  Because many people get caught up in the responsibilities of their daily lives, they often don't have time for reflection. 

  As a result of my experience counseling and teaching people about better personal financial management, I can tell you that the folks who accomplish their goals aren't necessarily smarter or higher-income earners than those who don't.  People who identify their goals and then work toward them, which often requires changing some habits, are the ones who accomplish their goals. 

Valuing retirement accounts

Where possible, try to save and invest in accounts that offer you a tax advantage, which is precisely what retirement accounts offer you.  These accounts — known by such enlightening acronyms and names as 401(k), 403(b), SEP-IRAs, Keoghs, and so on — offer tax breaks to people of all economic means.  Consider the following advantages to investing in retirement accounts:

  Contributions are usually tax-deductible.  By putting money in a retirement account, not only do you plan wisely for your future, but you also get an immediate financial reward: lower taxes, which mean more money available for saving and investing.  Retirement account contributions generally aren't taxed at either the federal or state income tax level until withdrawal (but they're still subject to Social Security and Medicare taxes when earned).  If you're paying, say, 35 percent between federal and state taxes (see Chapter 7 to determine your tax bracket), a $5,000 contribution to a retirement account lowers your taxes by $1,750. 

  In some company retirement accounts, companies match a portion of your own contributions.  Thus, in addition to tax breaks, you get free extra money courtesy of your employer! 

  Returns on your investment compound over time without taxation.  After you put money into a retirement account, any interest, dividends, and appreciation add to your account without being taxed.  Of course, there's no such thing as a free lunch — these accounts don't allow for complete tax avoidance.  Yet you can get a really great lunch at a discount: You get to defer taxes on all the accumulating gains and profits until you withdraw the money down the road.  Thus, more money is working for you over a longer period of time. ( The newer Roth IRA that I discuss in Chapter 11 offers no upfront tax breaks but does allow future tax-free withdrawal of investment earnings.) 

  The tax rates on stock dividends and long-term capital gains (investments held more than one year) are lower than the tax rates levied on ordinary income (such as that earned through working).  This fact makes some people think that investing through retirement accounts may not be worthwhile because all investment earnings are taxed at the relatively high ordinary income tax rates when money is withdrawn from retirement accounts.  I'll cut to the chase: The vast majority of people are better off contributing to retirement accounts (please see Chapter 7 for more details). 

Avoiding retirement account early withdrawal penalties

You can find ways to avoid the early withdrawal penalties that the tax authorities normally apply.  Suppose you read this book at a young age, develop sound financial habits early, and save enough to retire before age 591⁄2.  In this case, you can take money out of your retirement account without triggering penalties (which are normally 10 percent of the amount withdrawn for federal income tax plus whatever your state levies). 

The IRS allows you to withdraw money before 591⁄2 if you do so in equal, annual installments based on your life expectancy. ( You generally must do such distributions for at least five years or until age 591⁄2, whichever is later.)  The IRS (this is slightly chilling) even has a little table that allows you to look up your life expectancy. 

You can now also make penalty-free withdrawals from individual retirement accounts for a first-time home purchase (up to $10,000) or higher educational expenses for you, your spouse, your children, or your grandchildren.  The other conditions under which you can make penalty-free early withdrawals from retirement accounts are not as enjoyable: If you have major medical expenses (exceeding 7.5 percent of your income) or a disability, you may be exempt from the penalties under certain conditions. ( You will still owe ordinary income tax on withdrawals.) 

If you get into a financial pinch while you're still employed, be aware that some company retirement plans allow you to borrow against your balance.  This tactic is like loaning money to yourself — the interest payments go back into your account. 

If you lose your job and withdraw retirement account money simply because you need it to live on, the penalties do apply.  However, if you're not working and you're earning so little income that you need to tap your retirement account, you surely fall into a low tax bracket.  The lower income taxes you pay (when compared to the taxes you would have paid on that money had you not sheltered it in a retirement account in the first place) should make up for most or all of the penalty. 

Dealing with competing goals

Unless you enjoy paying higher taxes, why would you save money outside of retirement accounts, which shelter your money from taxation?  The reason is that some financial goals are not easily achieved by saving in retirement accounts.  Also, retirement accounts have caps on the amount you can contribute annually. 

If you're accumulating money for a down payment on a home or to start or buy a business, for example, you'll probably need to save that money outside of a retirement account.  Why?  Because if you withdraw funds from retirement accounts before age 591⁄2 and you're not retired, not only do you have to pay income taxes on the withdrawals, but you also generally have to pay early withdrawal penalties — 10 percent of the withdrawn amount in federal tax plus whatever your state charges. ( See the sidebar "Avoiding retirement account early withdrawal penalties" for exceptions to this rule.) 

Because you're constrained by your financial resources, you need to prioritize your goals.  Before funding your retirement accounts and racking up those tax breaks, read on to consider your other goals. 

Building Emergency Reserves

Because you don't know what the future holds, preparing for the unexpected is financially wise.  Even if you're the lucky sort who sometimes finds $5 bills on street corners, you can't control the sometimes chaotic world in which we live. 

Conventional wisdom says that you should have approximately six months of living expenses put away for an emergency.  This particular amount may or may not be right for you, because it depends, of course, on how expensive the emergency is.  Why six months, anyway?  And where should you put it? 

  How much of an emergency stash you need depends on your situation.  I recommend saving the following emergency amounts under differing circumstances (in Chapter 12, I recommend preferred places to invest this money):

  Three months' living expenses: Choose this option if you have other accounts, such as a 401(k), or family members and close friends whom you can tap for a short-term loan.  This minimalist approach makes sense when you're trying to maximize investments elsewhere (for example, in retirement accounts) or you have stable sources of income (employment or otherwise). 

  Six months' living expenses: This amount is appropriate if you don't have other places to turn for a loan or you have some instability in your employment situation or source of income. 

  Up to one year's living expenses: Set aside this much if your income fluctuates wildly from year to year or if your profession involves a high risk of job loss, finding another job could take you a long time, and you don't have other places to turn for a loan. 

  In the event that your only current source of emergency funds is a high-interest credit card, first save at least three months' worth of living expenses in an accessible account before funding a retirement account or saving for other goals. 

Saving to Buy a Home or Business

When you're starting out financially, deciding whether to save money to buy a home or to put money into a retirement account presents a dilemma.  In the long run, owning your own home is a wise financial move.  On the other hand, saving sooner for retirement makes achieving your goals easier. 

Presuming both goals are important to you, save toward both buying a home and for retirement.  If you're eager to own a home, you can throw all your savings toward achieving that goal and temporarily put your retirement savings on hold.  Save for both purposes simultaneously if you're not in a rush. 

  You may be able to have the best of both worlds if you work for an employer that allows borrowing against retirement account balances.  You can save money in the retirement account and then borrow against it for the down payment of a home.  Be extra careful, though.  Retirement account loans typically must be paid back within a set number of years (check with your employer) or immediately if you quit or lose your job.  As I mention earlier in this chapter, you're also allowed to make penalty-free withdrawals of up to $10,000 from individual retirement accounts toward a first-time home purchase. 

When saving money for starting or buying a business, most people encounter the same dilemma they face when deciding to save to buy a house: If you fund your retirement accounts to the exclusion of earmarking money for your small-business dreams, your entrepreneurial aspirations may never become a reality.  Generally, I advocate hedging your bets by saving money in your tax-sheltered retirement accounts as well as toward your business venture.  As I discuss in Part III, an investment in your own small business can produce great rewards, so you may feel comfortable focusing your savings on your own business. 

Funding Kids' Educational Expenses

  Wanting to provide for your children's future is perfectly natural, but doing so before you've saved adequately toward your own goals can be a major financial mistake.  The college financial-aid system effectively penalizes you for saving money outside of retirement accounts and penalizes you even more if the money's invested in the child's name. 

This concept may sound selfish, but you need to take care of your future first.  Take advantage of saving through your tax-sheltered retirement accounts before you set aside money in custodial savings accounts for your kids.  This practice isn't selfish: Do you really want to have to leech off your kids when you're old and frail because you didn't save any money for yourself? ( See Chapter 13 for a complete explanation of how to save for educational expenses.) 

Saving for Big Purchases

If you want to buy a car, a canoe, and a plane ticket to Thailand, do not, I repeat, do not buy such things with consumer credit (that is, carry debt month-to-month to finance the purchase on a credit card or auto loan).  As I explain in Chapter 5, cars, boats, vacations, and the like are consumer items, not wealth-building investments, such as real estate or small businesses.  A car begins to depreciate the moment you drive it off the sales lot.  A plane ticket is worthless the moment you arrive back home. ( I know your memories will be priceless, but they won't pay the bills.) 

  Don't deny yourself gratification; just learn how to delay it.  Get into the habit of saving for your larger consumer purchases to avoid paying for them over time with high-interest consumer credit.  When saving up for a consumer purchase such as a car, a money-market account or short-term bond fund (see Chapter 12) is a good place to store your short-term savings. 

Paying for high-interest consumer debt can cripple your ability not only to save for long-term goals but also to make major purchases in the future.  Interest on consumer debt is exorbitantly expensive — upwards of 20 percent on credit cards.  When contemplating the purchase of a consumer item on credit, add up the total interest you'd end up paying on your debt and call it the price of instant gratification. 

Preparing for Retirement

Many people toil away at work, dreaming about a future in which they can stop the daily commute and grind; get out from under that daily deluge of voice mails, e-mails, and other never-ending technological intrusions; and do what they want, when they want.  People often assume that this magical day will arrive either on their next true day off or when they retire or win the lottery — whichever comes first. 

I've never cared much for the term retire, which seems to imply idleness or the end of usefulness to society.  But if retirement means not having to work at a job (especially one you don't enjoy) and having financial flexibility and independence, then I'm all for it. 

Many folks aspire to retire sooner rather than later.  But this idea has some obvious problems.  First, you set yourself up for disappointment.  If you want to retire by your mid-60s (when Social Security kicks in), you need to save enough money to support yourself for 20 to 30 years, maybe longer.  Two to three decades is a long time to live off your savings.  You're going to need a good-sized chunk of money — more than most people realize. 

The earlier you hope to retire, the more money you need to set aside and the sooner you have to start saving — unless you plan to work part-time in retirement to earn more income!  See Chapter 11 for more details about how to save for retirement. 

  Many of the people I speak to say that they do want to retire, and most say "the sooner, the better."  Yet more than half of Americans between the ages of 18 and 34, and a quarter of those ages 35 to 54, have not begun to save for retirement.  When I asked one of my middle-aged counseling clients, who had saved little for retirement, when he would like to retire, he deadpanned, "Sometime before I die."  If you're in this group (and even if you're not), determine where you stand financially regarding retirement.  If you're like most working people, you need to increase your savings rate for retirement. 

Figuring out what you need for retirement

If you hope to someday reduce the time you spend working or cease working altogether, you'll need sufficient savings to support yourself.  Many people — particularly young people and those who don't work well with numbers — underestimate the amount of money needed to retire.  To figure out how much you should save per month to achieve your retirement goals, you need to crunch a few numbers. ( Don't worry — this number-crunching is usually easier than doing your taxes.) 

Don't neglect nonfinancial preparations for retirement

Investing your money is just one (and not even the most important) aspect of preparing for your retirement.  In order to enjoy the lifestyle that your retirement savings will provide you, you need to invest energy into other areas of your life as well:

  Few things are more important than your health.  Without your health, enjoying the good things in life can be hard.  Unfortunately, many people aren't motivated to care about their health until after they discover problems.  By then, it may be too late. 

Although exercising regularly, eating a balanced and nutritious diet, and avoiding substance abuse can't guarantee you a healthful future, these good habits go a long way toward preventing many of the most common causes of death and debilitating disease.  Regular medical exams also are important in detecting problems early. 

  In addition to your physical health, be sure to invest in your psychological health.  People live longer and have happier and healthier lives when they have a circle of family and friends around them for support. 

Unfortunately, many people become more isolated and lose regular contact with business associates, friends, and family members as they grow older. 

Happy retirees tend to stay active, getting involved in volunteer organizations and new social circles.  They may travel to see old friends or younger relatives who may be too busy to visit them. 

Treat retirement life like a bubbly, inviting hot tub set at 102 degrees.  You want to ease yourself in nice and slow; jumping in hastily can take most of the pleasantness out of the experience.  Abruptly leaving your job without a plan for spending all that free time is an invitation to boredom and depression.  Everyone needs a sense of purpose and a sense of routine.  Establishing hobbies, volunteer work, or a sideline business while gradually cutting back your regular work schedule can be a terrific way to ease into retirement. 

Luckily for you, you don't have to start cold.  Studies show how people typically spend money before and during retirement.  Most people need about 70 to 80 percent of their pre-retirement income throughout retirement to maintain their standard of living.  For example, if your household earns $50,000 per year before retirement, you're likely to need $35,000 to $40,000 (70 to 80 percent of $50,000) per year during retirement to live the way you're accustomed to living.  The 70 to 80 percent is an average.  Some people may need more simply because they have more time on their hands to spend their money.  Others adjust their standard of living and live on less. 

  So how do you figure out what you're going to need?  The following three profiles provide a rough estimate of the percentage of your pre-retirement income you're going to need during retirement.  Pick the one that most accurately describes your situation.  If you fall between two descriptions, pick a percentage in between those two. 

To maintain your standard of living in retirement, you may need about:

  65 percent of your pre-retirement income if you

• Save a large amount (15 percent or more) of your annual earnings

• Are a high-income earner

• Will own your home free of debt by the time you retire

• Do not anticipate leading a lifestyle in retirement that reflects your current high income

If you're an especially high-income earner who lives well beneath your means, you may be able to do just fine with even less than 65 percent.  Pick an annual dollar amount or percentage of your current income that will allow the kind of retirement lifestyle you desire. 

  75 percent of your pre-retirement income if you

• Save a reasonable amount (5 to 14 percent) of your annual earnings

• Will still have some mortgage debt or a modest rent to pay by the time you retire

• Anticipate having a standard of living in retirement that's comparable to what you have today

  85 percent of your pre-retirement income if you

• Save little or none of your annual earnings (less than 5 percent)

• Will have a relatively significant mortgage payment or sizeable rent to pay in retirement

• Anticipate wanting or needing to maintain your current lifestyle throughout retirement

Of course, you can use a more precise approach to figure out how much you need per year in retirement.  Be forewarned, though, that using a more-personalized method is far more time-consuming, and because you're making projections into an uncertain future, it may not be any more accurate than the simple method I explain here.  If you're data-oriented, you may feel comfortable tackling this method: Figure out where you're spending your money today (worksheets are available in Chapter 3) and then work up some projections for your expected spending needs in retirement (the information in Chapter 19 may help you, as well). 

Understanding retirement building blocks

Did you play with Lego blocks or Tinkertoys when you were a child?  You start by building a foundation on the ground, and then you build up.  Before you know it, you're creating bridges, castles, and animal figures.  Although preparing financially for retirement isn't exactly like playing with blocks, the concept is the same: You need a basic foundation so that your necessary retirement reserves can grow. 

If you've been working steadily, you may already have a good foundation, even if you haven't been actively saving toward retirement.  In the pages ahead, I walk you through the probable components of your future retirement income and show you how to figure how much you should be saving to reach particular retirement goals. 

Counting on Social Security

According to polls, nearly half of American adults under the age of 35, and more than a third of those between the ages of 35 and 49, think that Social Security benefits will not be available by the time they retire. 

Contrary to widespread skepticism, Social Security should be available when you retire, no matter how old you are today.  In fact, Social Security is one of the sacred cow political programs.  Imagine what would happen to the group of politicians who voted to greatly curtail benefits! ( Congress may make some reductions in benefits, probably for the highest income earners, at some point due to the federal debt problems.) 

If you think that you can never retire because you don't have any money saved, I'm happy to inform you that you're probably wrong.  You likely have some Social Security.  But Social Security generally isn't enough to live on comfortably. 

  Social Security is intended to provide you with a subsistence level of retirement income for the basic necessities: food, shelter, and clothing.  Social Security is not intended to be your sole source of income.  Some of the elderly are quite dependent upon Social Security: It's the only source of income for 22 percent of the elderly, and two out of three Social Security recipients derive at least half of their total retirement income from their Social Security retirement check.  Few working people can maintain their current lifestyles into retirement without supplementing Social Security with personal savings and company retirement plans. 

How much work makes me eligible? 

To be eligible to collect Social Security benefits, you need to have worked a minimum number of calendar quarters.  If you were born after 1928, you need 40 quarters of work credits to qualify for Social Security retirement benefits. 

If, for some reason, you work only the first half of a year or only during the summer months, don't despair.  You don't need to work part of every quarter to get a quarter's credit.  You get credits based on the income you earn during the year.  As of this writing, you get the full four quarters credited to your account if you earn $4,520 or more in a year. ( Prior to 1978, workers got one quarter's credit for each actual calendar quarter in which they earned $50.)  To get 40 quarters of coverage, you basically need to work (at least portions of) ten years. 

  To get credits, your income must be reported and you must pay taxes on it (including Social Security tax).  In other words, you and those you employ encounter problems when you neglect to declare income or you pay people under the table: You may be cheating yourself, or others, out of valuable benefits. 

How much will I get from Social Security? 

The average monthly benefit Social Security pays out to retirees is about $1,180.  The higher your employment earnings have been on average, the more you can expect to receive.  If you're married and one of you doesn't work for pay, the nonworking spouse collects 50 percent of what the working spouse collects.  Working spouses are eligible for either individual benefits or half of their spouse's benefits — whichever amount is greater. 

  To get a more precise handle on your Social Security benefits, call the Social Security Administration at 800-772-1213 and ask for Form 7004, which allows you to receive a record of your reported earnings and an estimate of your Social Security benefits. ( You can also visit the Social Security Administration website at `www.ssa.gov`.)  Check your earnings record, because occasional errors do arise and — surprise — they usually aren't in your favor. 

Planning your personal savings/investment strategy

Money you're saving toward retirement can include money under the mattress as well as money in a retirement account such as an individual retirement account (IRA), 401(k), or similar plan (see Chapter 11).  You may also earmark investments in nonretirement accounts for your retirement. 

Equity (the difference between the market value less any mortgage balances owed) in rental real estate can be counted toward your retirement as well.  Deciding whether to include the equity in your primary residence (your home) is trickier.  If you don't want to count on using this money in retirement, don't include it when you tally your stash.  You may want to count a portion of your home equity in your total assets for retirement.  Many people sell their homes when they retire and move to a lower-cost area, move closer to family, or downsize to a more manageable size home.  And increasing numbers of older retirees are tapping their homes' equity through reverse mortgages (see Chapter 14 for information on mortgages). 

More Social Security details

When the Social Security system was created in the 1930s, its designers underestimated how long people would live in retirement.  Thanks to scientific advances and improved medical care, life expectancies have risen substantially since that time.  As a result, many recent retirees get back far more than they paid into the system. 

The age at which you can start collecting full benefits has increased, and it may increase again.  In the "good old days" (prior to changes made in Social Security regulations in 1983), you could collect full Social Security payments at age 65, assuming you were eligible.  Under current rules, if you were born before 1938, you're still eligible to collect full Social Security benefits at age 65.  If you were born after 1959, you have to wait until age 67 for full benefits.  If you were born between 1938 and 1959, full benefits are payable to you at age 66 (plus or minus some number of months, depending on the year you were born). 

These regulations may seem unfair, but they're necessary for updating the system to fit with the realities of increased longevity, large federal budget deficits, and aging baby boomers.  Without changes, the Social Security system could collapse, because it would be fed by a relatively small number of workers while supporting large numbers of retirees. 

In addition to paying for retirement-income checks for retirees, your Social Security taxes also help fund disability insurance for you, survivor income insurance for your financial dependents, and Medicare (the health insurance program for retirees). 

The amount of Social Security benefits you receive in retirement depends on your average earnings during your working years.  Don't worry about the fact that you probably earned a lot less many years ago.  The Social Security benefits calculations increase your older earnings to account for the lower cost of living and wages in prior years. 

Making the most of pensions

Pension plans are a benefit offered by some employers — mostly larger organizations and government agencies.  Even if your current employer doesn't offer a pension, you may have earned pension benefits through a previous job. 

The plans I'm referring to are known as defined-benefit plans.  With these plans, you qualify for a monthly benefit amount to be paid to you in retirement based on your years of service for a specific employer. 

Although each company's plan differs, all plans calculate and pay benefits based on a formula.  A typical formula may credit you with 1.5 percent of your salary for each year of service (full-time employment).  For example, if you work ten years, you earn a monthly retirement benefit worth 15 percent of your monthly salary. 

  Pension benefits can be quite valuable.  In the better plans, employers put away the equivalent of 5 to 10 percent of your salary to pay your future pension.  This money is in addition to your salary — you never see it in your paycheck, and it isn't taxed.  The employer puts this money away in an account for your retirement. 

To qualify for pension benefits, you don't have to stay with an employer long enough to receive the 25-year gold watch.  Under current government regulations, employees must be fully vested (entitled to receive full benefits based on years of service upon reaching retirement age) after five years of full-time service. 

Defined-benefit pension plans are becoming rarer for two major reasons:

  They're costly for employers to maintain.  Many employees don't understand how these plans work and why they're so valuable, so companies don't get mileage out of their pension expenditures — employees don't see the money, so they don't appreciate the company's generosity. 

  Most of the new jobs being generated in the U.S. economy are with small companies that typically don't offer these types of plans. 

More employers offer plans like 401(k)s, in which employees elect to save money out of their own paychecks.  Known as defined-contribution plans, these plans allow you to save toward your retirement at your own expense rather than at your employer's expense. ( To encourage participation in defined-contribution plans, some employers "match" a portion of their employees' contributions.)  More of the burden and responsibility of investing for retirement falls on your shoulders with 401(k) and similar plans, so understanding how these plans work is important.  Most people are ill-equipped to know how much to save and how to invest the money.  The retirement planning worksheet in the next section can help you get started with figuring out the amount you need to save. ( Part III shows you how to invest.) 

Crunching numbers for your retirement

Now that you've toured the components of your future retirement income, take a shot at tallying where you stand in terms of retirement preparations.  Don't be afraid to do this exercise — it's not difficult, and you may find that you're not in such bad shape.  I even explain how to catch up if you find that you're behind in saving for retirement. 

Note: The following worksheet (Table 4-1) and the Growth Multiplier (Table 4-2) assume that you're going to retire at age 66 and that your investments will produce an annual rate of return that is 4 percent higher than the rate of inflation. ( For example, if inflation averages 3 percent, this table assumes that you will earn 7 percent per year on your investments.) 

  To get a more precise handle on where you stand in terms of retirement planning (especially if you'd like to retire earlier than your mid-60s), call T. Rowe Price at 800-638-5660 and ask for the company's retirement planning booklets.  You can also turn to Chapter 19, where I recommend retirement planning software and websites that can ease your number-crunching burdens. 

Table 4-2 Growth Multiplier

Your Current Age | Growth Multiplier | Savings Factor

---|---|---

26 | 4.8 | 0.001

28 | 4.4 | 0.001

30 | 4.1 | 0.001

32 | 3.8 | 0.001

34 | 3.5 | 0.001

36 | 3.2 | 0.001

38 | 3.0 | 0.002

40 | 2.8 | 0.002

42 | 2.6 | 0.002

44 | 2.4 | 0.002

46 | 2.2 | 0.003

48 | 2.0 | 0.003

50 | 1.9 | 0.004

52 | 1.7 | 0.005

54 | 1.6 | 0.006

56 | 1.5 | 0.007

58 | 1.4 | 0.009

60 | 1.3 | 0.013

62 | 1.2 | 0.020

64 | 1.1 | 0.041

Making up for lost time

If the amount you need to save per month to reach your retirement goals seems daunting, all is not lost.  Remember: Winners never quit, and quitters never win.  Here are my top recommendations for making up for lost time:

  Question your spending.  You have two ways to boost your savings: Earn more money or cut your spending (or do both).  Most people don't spend their money nearly as thoughtfully as they earn it.  See Chapter 6 for suggestions and strategies for reducing your spending. 

  Be more realistic about your retirement age.  If you extend the age at which you plan to retire, you get a double benefit: You earn and save money for more years, and you spend your nest egg over fewer years.  Of course, if your job is making you crazy, this option may not be too appealing.  Try to find work that makes you happy, and consider working, at least part-time, during your "early" retirement years. 

  Use your home equity.  The prospect of tapping the cash in your home can be troubling.  After getting together the down payment, you probably worked for many years to pay off that sucker.  You're delighted not to have to mail a mortgage payment to the bank anymore.  But what's the use of owning a house free of mortgage debt when you lack sufficient retirement reserves?  All the money that's tied up in the house can be used to help increase your standard of living in retirement. 

You have a number of ways to tap your home's equity.  You can sell your home and either move to a lower-cost property or rent an apartment.  Current tax laws allow you to realize up to $250,000 in tax-free profit from the sale of your house ($500,000 if you're married).  Another option is a reverse mortgage, in which you get a monthly income check as you build a loan balance against the value of your home.  The loan is paid when your home is finally sold. ( See Chapter 14 for more information about reverse mortgages.) 

  Get your investments growing.  The faster the rate at which your money grows and compounds, the less you need to save each year to reach your goals. ( Make sure, however, that you're not reckless; don't take huge risks in the hopes of big returns.)  Earning just a few extra percentage points per year on your investments can dramatically slash the amount you need to save.  The younger you are, the more powerful the effect of compounding interest.  For example, if you're in your mid-30s and your investments appreciate 6 percent per year (rather than 4 percent) faster than the rate of inflation, the amount you need to save each month to reach your retirement goals drops by about 40 percent! ( See Part III for more on investing.) 

  Turn a hobby into supplemental retirement income.  Even if you earn a living in the same career over many decades, you have skills that are portable and can be put to profitable use.  Pick something you enjoy and are good at, develop a business plan, and get smart about how to market your services and wares (check out the latest edition of Small Business For Dummies from Wiley, which I co-wrote with veteran entrepreneur Jim Schell).  Remember, as people get busier, more specialized services are created to support their hectic lives.  A demand for quality, homemade goods of all varieties also exists.  Be creative!  You never know — you may wind up profiled in a business publication! 

  Invest to gain tax-free and other free money.  By investing in a tax-wise fashion, you can boost the effective rate of return on your investments without taking on additional risk. 

In addition to the tax benefits you gain from funding most types of retirement accounts in this chapter (see the earlier section, "Valuing retirement accounts"), some employers offer free matching money.  Also, the government now offers tax credits (see Chapter 7) for low and moderate income earners who utilize retirement accounts. 

As for money outside of tax-sheltered retirement accounts, if you're in a relatively high tax bracket, you may earn more by investing in tax-free investments and other vehicles that minimize highly taxed distributions. 

  Think about inheritances.  Although you should never count on an inheritance to support your retirement, you may inherit money someday.  If you want to see what impact an inheritance has on your retirement calculations, add a conservative estimate of the amount you expect to inherit to your current total savings in Table 4-1. 
Part II

Spending Less, Saving More

In this part . . . 

I detail numerous ways to make your dollars go toward building up your savings rather than toward wasteful spending.  Are you buried in debt with little to show for it?  Well, it's never too late to start digging out.  Here you find out how to reduce your debt burden.  I also devote an entire chapter to discussing taxes and how to legally minimize them. 
Chapter 5

Dealing with Debt

In This Chapter

  Using your savings to lower your debt

  Getting out of debt when you don't have savings

  Understanding the pros and cons of filing bankruptcy

  Halting your spending and staying out of debt

Accumulating bad debt (consumer debt) by buying things like new living room furniture or a new car that you really can't afford is like living on a diet of sugar and caffeine: a quick fix with little nutritional value.  Borrowing on your credit card to afford an extravagant vacation is detrimental to your long-term financial health. 

When debt is used for investing in your future, I call it good debt (see Chapter 2).  Borrowing money to pay for an education, to buy real estate, or to invest in a small business is like eating fruits and vegetables for their vitamins.  That's not to say that you can't get yourself into trouble when using good debt.  Just as you can gorge yourself on too much "good food," you can develop financial indigestion from too much good debt. 

In this chapter, I mainly help you battle the pervasive problem of consumer debt.  Getting rid of your bad debts may be even more difficult than giving up the junk foods you love.  But in the long run, you'll be glad you did; you'll be financially healthier and emotionally happier.  And after you get rid of your high-cost consumer debts, make sure you practice the best way to avoid future credit problems: Don't borrow with bad debt. 

Before you decide which debt reduction strategies make sense for you, you must first consider your overall financial situation (see Chapter 2) and assess your alternatives. ( I discuss strategies for reducing your current spending — which help you free up more cash to pay down your debts — in the next chapter.) 

Using Savings to Reduce Your Consumer Debt

Many people build a mental brick wall between their savings and investment accounts and their consumer debt accounts.  By failing to view their finances holistically, they simply fall into the habit of looking at these accounts individually.  The thought of putting a door in that big brick wall doesn't occur to them.  This section helps you see how your savings can be used to lower your consumer debt. 

Understanding how you gain

If you have the savings to pay off consumer debt, like high-interest credit-card and auto loans, consider doing so. ( Make sure you pay off the loans with the highest interest rates first.)  Sure, you diminish your savings, but you also reduce your debts.  Although your savings and investments may be earning decent returns, the interest you're paying on your consumer debts is likely higher. 

  Paying off consumer loans on a credit card at, say, 12 percent is like finding an investment with a guaranteed return of 12 percent — tax-free.  You would actually need to find an investment that yielded even more — around 18 percent — to net 12 percent after paying taxes in order to justify not paying off your 12-percent loans.  The higher your tax bracket (see Chapter 7), the higher the return you need on your investments to justify keeping high-interest consumer debt. 

Even if you think that you're an investing genius and you can earn more on your investments, swallow your ego and pay down your consumer debts anyway.  In order to chase that higher potential return from investments, you need to take substantial risk.  You may earn more investing in that hot stock tip or that bargain real estate, but more than likely, you won't. 

  If you use your savings to pay down consumer debts, be careful to leave yourself enough of an emergency cushion. ( In Chapter 4, I tell you how to determine how large of an emergency reserve you should have.)  You want to be in a position to withstand an unexpected large expense or temporary loss of income.  On the other hand, if you use savings to pay down credit-card debt, you can run your credit-card balances back up in a financial pinch (unless your card gets canceled), or you can turn to a family member or wealthy friend for a low-interest loan. 

Discovering money to pay down consumer debts

Have you ever reached into the pocket of an old winter parka and found a rolled-up $20 bill you forgot you had?  Stumbling across some forgotten funds is always a pleasant experience.  But before you root through all your closets in search of stray cash to help you pay down that nagging credit-card debt, check out some of these financial jacket pockets you may have overlooked:

    Borrow against your cash value life insurance policy.  If a life insurance agent ever lured you into buying a policy, she probably sold you a cash value policy because it pays high commissions to insurance agents.  Or perhaps your parents bought one of these policies for you when you were a child.  Borrow against the cash value to pay down your debts. ( Note: You may want to consider discontinuing your cash value policy altogether and simply withdraw the cash balance — see Chapter 16 for details.) 

  Sell investments held outside of retirement accounts.  Maybe you have some shares of stock or a Treasury bond gathering dust in your safety deposit box.  Consider cashing in these investments to pay down your consumer loans.  Just be sure to consider the tax consequences of selling these investments.  If possible, sell only those investments that won't generate a big tax bill. 

  Tap the equity in your home.  If you're a homeowner, you may be able to tap in to your home's equity, which is the difference between the property's market value and the outstanding loan balance.  You can generally borrow against real estate at a lower interest rate and get a tax deduction.  However, you must take care to ensure that you don't overborrow on your home and risk losing it to foreclosure. 

  Borrow against your employer's retirement account.  Check with your employer's benefits department to see whether you can borrow against your retirement account balance.  The interest rate is usually reasonable.  Be careful, though — if you leave or lose your job, you may have to repay the loan within only 60 days.  Also recognize that you'll miss out on investment returns on the money borrowed. 

  Lean on friends and family.  They know you, love you, realize your shortcomings, and probably won't be as cold-hearted as some bankers.  Money borrowed from family members can have strings attached, of course.  Treating the obligation seriously is important.  To avoid misunderstandings, write up a simple agreement listing the terms and conditions of the loan.  Unless your family members are like the worst bankers I know, you'll probably get a fair interest rate, and your family will have the satisfaction of helping you out — just don't forget to pay them back. 

Decreasing Debt When You Lack Savings

If you lack savings to throw at your consumer debts, not surprisingly, you have some work to do.  If you're currently spending all your income (and more!),  you need to figure out how you can decrease your spending (see Chapter 6 for lots of great ideas) and/or increase your income.  In the meantime, you need to slow the growth of your debt. 

Reducing your credit card's interest rate

Different credit cards charge different interest rates.  So why pay 14, 16, or 18 percent (or more) when you can pay less?  The credit-card business is highly competitive.  Until you get your debt paid off, slow the growth of your debt by reducing the interest rate you're paying.  Here are sound ways to do that:

  Apply for a lower-rate credit card.  If you're earning a decent income, you're not too burdened with debt, and you have a clean credit record, qualifying for lower-rate cards is relatively painless.  Some persistence (and cleanup work) may be required if you have income and debt problems or nicks in your credit report.  After you're approved for a new, lower-interest-rate card, you can simply transfer your outstanding balance from your higher-rate card. 

CardTrak.com's website (`www.cardtrak.com`) has a credit-card locator tool that you may find useful.  CreditCards.com's website (`www.creditcards.com`) carries similar information on low-interest-rate and no-annual-fee cards (among others, including secured cards). 

  Call the bank(s) that issued your current high-interest-rate credit card(s) and say that you want to cancel your card(s) because you found a competitor that offers no annual fee and a lower interest rate.  Your bank may choose to match the terms of the "competitor" rather than lose you as a customer.  But be careful with this strategy and consider just paying off or transferring the balance.  Canceling the credit card, especially if it's one you've had for a number of years, may lower your credit score. 

  While you're paying down your credit-card balance(s), stop making new charges on cards that have outstanding balances.  Many people don't realize that interest starts to accumulate immediately when they carry a balance.  You have no grace period — the 20 or so days you normally have to pay your balance in full without incurring interest charges — if you carry a credit-card balance from month to month. 

Understanding all credit-card terms and conditions

  Avoid getting lured into applying for a credit card that hypes an extremely low interest rate.  One such card advertised a 1.9-percent rate, but you had to dig into the fine print for the rest of the story. 

First, any card that offers such a low interest rate will honor that rate only for a short period of time — in this case, six months.  After six months, the interest rate skyrocketed to nearly 15 percent. 

But wait, there's more: Make just one late payment or exceed your credit limit, and the company raises your interest rate to 19.8 percent (or even 24, 29 percent, or more) and slaps you with a $29 fee for each such infraction (some banks charge $39).  If you want a cash advance on your card, you get socked with a fee equal to 3 percent of the amount advanced. ( Some banks have even advertised 0-percent interest rates — although that rate generally has applied only to balances transferred from another card, and such cards have been subject to all of the other vagaries discussed in this section.) 

Now, I'm not saying that everyone should avoid this type of card.  Such a card may make sense for you if you want to transfer an outstanding balance and then pay off that balance within a matter of months and cancel the card to avoid getting socked with the card's high fees. 

  If you hunt around for a low-interest-rate credit card, be sure to check out all the terms and conditions.  Start by reviewing the uniform rates and terms disclosure, which details the myriad fees and conditions (especially how much your interest rate can increase for missed or late payments).  Also, be sure that you understand how the future interest rate is determined on cards that charge variable interest rates. 

Cutting up your credit cards

  If you have a tendency to live beyond your means by buying on credit, get rid of the culprit — the credit card.  To kick the habit, a smoker needs to toss all the cigarettes, and an alcoholic needs to get rid of all the booze.  Cut up all your credit cards and call the card issuers to cancel your accounts.  And when you buy consumer items such as cars and furniture, do not apply for E-Z credit. 

The world worked fine back in the years B.C. (Before Credit).  Think about it: Just a couple generations ago, credit cards didn't even exist.  People paid with cash and checks — imagine that!  You can function without buying anything on a credit card.  In certain cases, you may need a card as collateral — such as when renting a car.  When you bring back the rental car, however, you can pay with cash or a check.  Leave the card at home in the back of your sock drawer or freezer, and pull (or thaw) it out only for the occasional car rental. 

If you can trust yourself, keep a separate credit card only for new purchases that you know you can absolutely pay in full each month.  No one needs three, five, or ten credit cards!  You can live with one (and actually none), given the wide acceptance of most cards. 

Retailers such as department stores and gas stations just love to issue cards.  Not only do these cards charge outrageously high interest rates, but they're also not widely accepted like Visa and MasterCard.  Virtually all retailers accept Visa and MasterCard.  More credit lines mean more temptation to spend what you can't afford. 

If you decide to keep one widely accepted credit card instead of getting rid of them all, be careful.  You may be tempted to let debt accumulate and roll over for a month or two, starting up the whole horrible process of running up your consumer debt again.  Rather than keeping one credit card, consider getting a debit card. 

Discovering debit cards: The best of both worlds

Credit cards are the main reason today's consumers are buying more than they can afford.  So logic says that one way you can keep your spending in check is to stop using your credit cards.  But in a society that's used to the widely accepted Visa and MasterCard plastic for purchases, changing habits is hard.  And you may be legitimately concerned that carrying your checkbook or cash can be a hassle or can be costly if you're mugged. 

  Debit cards truly offer the best of both worlds.  The beauty of the debit card is that it offers you the convenience of making purchases with a piece of plastic without the temptation or ability to run up credit-card debt.  Debit cards keep you from spending money you don't have and help you live within your means. 

A debit card looks just like a credit card with either the Visa or MasterCard logo.  The big difference between debit cards and credit cards is that, as with checks, debit card purchase amounts are deducted electronically from your checking account within days. ( Bank ATM cards are also debit cards; however, if they lack a Visa or MasterCard logo, they're accepted by far fewer merchants.) 

  If you switch to a debit card and you keep your checking account balance low and don't ordinarily balance your checkbook, you may need to start balancing it.  Otherwise, you may face unnecessary bounced check charges. 

Here are some other differences between debit and credit cards:

  If you pay your credit-card bill in full and on time each month, your credit card gives you free use of the money you owe until it's time to pay the bill.  Debit cards take the money out of your checking account almost immediately. 

  Credit cards make it easier for you to dispute charges for problematic merchandise through the issuing bank.  Most banks allow you to dispute charges for up to 60 days after purchase and will credit the disputed amount to your account pending resolution.  Most debit cards offer a much shorter window, typically less than one week, for making disputes. 

Because moving your checking account can be a hassle, see whether your current bank offers Visa or MasterCard debit cards.  If your bank doesn't offer one, shop among the major banks in your area, which are likely to offer the cards.  Because such cards come with checking accounts, make sure that you do some comparison shopping among the different account features and fees. 

  A number of investment firms offer Visa or MasterCard debit cards with their asset management accounts.  Not only can these investment firm "checking accounts" help you break the credit-card overspending habit, but they may also get you thinking about saving and investing your money.  One drawback of these accounts is that most of them require fairly hefty minimum initial investment amounts — typically $5,000 to $10,000.  Among brokerages with competitive investment offerings and prices are TD Ameritrade (phone 800-934-4448; website `www.tdameritrade.com`), Vanguard (phone 800-992-8327; website `www.vanguard.com`), and Muriel Siebert (phone 800-872-0711; website `www.siebertnet.com`). 

What if your debit card is lost or stolen? 

Personal credit cards and debit cards offer you similar so-called "zero liability" if someone illegally uses your card.  If your debit card is lost or stolen and someone makes fraudulent charges on your debit card, you simply sign statements with your bank stating that the charges aren't yours.  You'll be reimbursed typically in a matter of days. 

However, cards designated and listed as business (commercial) cards may not have the same zero liability as consumer cards.  Generally speaking, banks view businesses as riskier and more prone to internal fraud.  Suppose, for example, that your business issued debit cards to its employees and one of them gave it to a friend to use and then said the card was lost and those purchases were fraudulent. 

Therefore, I recommend getting a separate consumer debit card for your small business (simply keep your name, not the business's, on the account) or use a bank that offers the same protections on their business debit cards as on their consumer debit cards.  Otherwise, you could get socked with a hefty bill that you don't deserve. 

Turning to Credit Counseling Agencies

Prior to the passage of the 2005 bankruptcy laws discussed later in this chapter, each year hundreds of thousands of debt-burdened consumers sought "counseling" from credit counseling service offices.  Now, more than a million people annually get the required counseling.  Unfortunately, some people find that the service doesn't always work the way it's pitched. 

Beware biased advice at credit counseling agencies

Leona Davis, whose family racked up significant debt due largely to unexpected medical expenses and a reduction in her income, found herself in trouble with too much debt.  So she turned to one of the large, nationally promoted credit counseling services, which she heard about through its advertising and marketing materials. 

The credit counseling agency Davis went to markets itself as a "nonprofit community service."  Davis, like many others I know, found that the "service" was not objective.  After her experience, Davis feels that a more appropriate name for the organization she worked with would be the Credit Card Collection Agency. 

Unbeknownst to Davis and most of the other people who use supposed credit counseling agencies is the fact that the vast majority of their funding comes from the fees that creditors pay them.  Most credit counseling agencies collect fees on a commission basis — just as collection agencies do!  Their strategy is to place those who come in for help on their "debt management program."  Under this program, counselees like Davis agree to pay a certain amount per month to the agency, which in turn parcels out the money to the various creditors. 

Because of Davis's tremendous outstanding consumer debt (it exceeded her annual income), her repayment plan was doomed to failure.  Davis managed to make 10 months' worth of payments, largely because she raided a retirement account for $28,000.  Had Davis filed bankruptcy (which she ultimately needed to do), she would've been able to keep her retirement money.  But Davis's counselor never discussed the bankruptcy option. " I received no counseling," says Davis. " Real counselors take the time to understand your situation and offer options.  I was offered one solution: a forced payment plan." 

Others who have consulted various credit counseling agencies, including one of my research assistants who, undercover, visited an office to seek advice, confirm that some agencies use a cookie-cutter approach to dealing with debt.  Such agencies typically recommend that debtors go on a repayment plan that has the consumer pay, say, 3 percent of each outstanding loan balance to the agency, which in turn pays the money to creditors. 

Unable to keep up with the enormous monthly payments, Davis finally turned to an attorney and filed for bankruptcy — but not before she had unnecessarily lost thousands of dollars because of the biased recommendations. 

Although credit counseling agencies' promotional materials and counselors aren't shy about highlighting the drawbacks to bankruptcy, counselors are reluctant to discuss the negative impact of signing up for a debt payment plan.  Davis's counselor never told her that restructuring her credit-card payments would tarnish her credit reports and scores.  The counselor my researcher met with also neglected to mention this important fact.  When asked, the counselor was evasive about the debt "management" program's impact on his credit report. 

  If you're considering bankruptcy or are otherwise unable to meet your current debt obligations, first be sure to read the rest of this chapter.  Second, interview any counseling agency you may be considering working with.  Remember that you're the customer and you should do your homework first and be in control.  Don't allow anyone or any agency to make you feel that they're in a position of power simply because of your financial troubles. 

Ask questions and avoid debt management programs

Probably the most important question to ask a counseling agency is whether it offers debt management programs (DMPs), whereby you're put on a repayment plan with your creditors and the agency gets a monthly fee for handling the payments.  You do not want to work with an agency offering DMPs because of conflicts of interest.  An agency can't offer objective advice about all your options for dealing with debt, including bankruptcy, if it has a financial incentive to put you on a DMP. 

  Two good agencies that don't offer DMPs are the Institute for Financial Literacy (phone 866-662-4932; website `www.financiallit.org`) and Hummingbird Credit Counseling (phone 800-645-4959; website `www.hummingbirdcreditcounseling.org`). 

  Here are some additional questions that the Federal Trade Commission suggests you ask prospective counseling agencies you may hire:

  What are your fees?  Are there setup and/or monthly fees?  Get a specific price quote in writing. 

  What if I can't afford to pay your fees or make contributions?  If an organization won't help you because you can't afford to pay, look elsewhere for help. 

  Will I have a formal written agreement or contract with you?  Don't sign anything without reading it first.  Make sure all verbal promises are in writing. 

  Are you licensed to offer your services in my state?  You should work only with a licensed agency. 

  What are the qualifications of your counselors?  Are they accredited or certified by an outside organization?  If so, by whom?  If not, how are they trained?  Try to use an organization whose counselors are trained by a nonaffiliated party. 

  What assurance do I have that information about me (including my address, phone number, and financial information) will be kept confidential and secure?  A reputable agency can provide you with a clearly written privacy policy. 

  How are your employees compensated?  Are they paid more if I sign up for certain services, if I pay a fee, or if I make a contribution to your organization?  Employees who work on an incentive basis are less likely to have your best interests in mind than those who earn a straight salary that isn't influenced by your choices. 

Filing Bankruptcy

For consumers in over their heads, the realization that their monthly income is increasingly exceeded by their bill payments is usually a traumatic one.  In many cases, years can pass before people consider drastic measures like filing bankruptcy.  Both financial and emotional issues come into play in one of the most difficult and painful, yet potentially beneficial, decisions. 

When Helen, a mother of two and a sales representative, contacted a bankruptcy attorney, her total credit-card debt equaled her annual gross income.  As a result of her crushing debt load, she couldn't meet her minimum monthly credit-card payments.  Rent and food gobbled up most of her earnings.  What little was left over went to the squeakiest wheel. 

Creditors were breathing down Helen's back. " I started getting calls from collection departments at home and work — it was embarrassing," she said.  Helen's case is typical in that credit-card debt was the prime cause of her bankruptcy. 

As the debt load grew (partly exacerbated by the high interest rates on the cards), more and more purchases got charged — from the kids' clothing to repairs for the car.  Finally, after running out of cash, she had to take a large cash advance on her credit cards to pay for rent and food. 

Despite trying to work out lower monthly payments to keep everyone happy, most of the banks to which Helen owed money were inflexible. " When I asked one bank's Visa department if it preferred that I declare bankruptcy because it was unwilling to lower my monthly payment, the representative said yes," Helen says.  After running out of options, Helen filed personal bankruptcy. 

Understanding bankruptcy benefits

Annually, more than 1 million American households (that's about 1 in every 100 households) file personal bankruptcy.  Given the economic problems in the late 2000s, you may be surprised to hear that far more folks — more than 2 million — filed for personal bankruptcy in 2005.  The reason for the spike in filings in the mid-2000s was the crush of people encouraged to file by attorneys and other advisors before the new bankruptcy laws took effect in late 2005. 

  With bankruptcy, certain types of debts can be completely eliminated or discharged.  Debts that typically can be discharged include credit-card, medical, auto, utilities, and rent. 

What you can keep if you file bankruptcy

In every state, you can retain certain property and assets when you file for bankruptcy.  You may be surprised to discover that in some states, you can keep your home regardless of its value!  Most states, though, allow you to protect a certain amount of home equity. 

Additionally, you're allowed to retain some other types and amounts of personal property and assets.  For example, most states allow you to retain household furnishings, clothing, pensions, and money in retirement accounts.  So don't empty your retirement accounts or sell off personal possessions to pay debts unless you're absolutely sure that you won't be filing bankruptcy. 

Debts that may not be canceled generally include child support, alimony, student loans, taxes, and court-ordered damages (for example, drunk driving settlements).  Helen, the subject of the preceding section, was an ideal candidate for bankruptcy because her debts (credit cards) were dischargeable.  Helen also met another important criterion — her level of high-interest consumer debt relative to her annual income was high (100 percent).  When this ratio (discussed in Chapter 2) exceeds 25 percent, filing bankruptcy may be your best option. 

Eliminating your debt also allows you to start working toward your financial goals.  Depending on the amount of debt you have outstanding relative to your income, you may need a decade or more to pay it all off.  In Helen's case, at the age of 48, she had no money saved for retirement, and she was increasingly unable to spend money on her children. 

Filing bankruptcy offers not only financial benefits but emotional benefits, as well. " I was horrified at filing, but it is good to be rid of the debts and collection calls — I should have filed six months earlier.  I was constantly worried.  When I saw homeless families come to the soup kitchen where I sometimes volunteer, I thought that someday that could be me and my kids," says Helen. 

Coming to terms with bankruptcy drawbacks

Filing bankruptcy, needless to say, has a number of drawbacks.  First, bankruptcy appears on your credit report for up to ten years, so you'll have difficulty obtaining credit, especially in the years immediately following your filing.  However, if you already have problems on your credit report (because of late payments or a failure to pay previous debts), the damage has already been done.  And without savings, you're probably not going to be making major purchases (such as a home) in the next several years anyway. 

  If you do file bankruptcy, getting credit in the future is still possible.  You may be able to obtain a secured credit card, which requires you to deposit money in a bank account equal to the credit limit on your credit card.  Of course, you'll be better off without the temptation of any credit cards and better served with a debit card.  Also, know that if you can hold down a stable job, most creditors will be willing to give you loans within a few years of your filing bankruptcy.  Almost all lenders ignore bankruptcy after five to seven years. 

Another drawback of bankruptcy is that it costs money, and those expenses have jumped higher due to the requirements from the 2005 bankruptcy law (more on that in a moment).  I know this expense seems terribly unfair.  You're already in financial trouble — that's why you're filing bankruptcy!  Court filing and legal fees can easily exceed $1,000, especially in higher cost-of-living areas. 

And finally, most people find that filing bankruptcy causes emotional stress.  Admitting that your personal income can't keep pace with your debt obligations is painful.  Although filing bankruptcy clears the decks of debt and gives you a fresh financial start, feeling a profound sense of failure (and sometimes shame) is common.  Despite the increasing incidence of bankruptcy, bankruptcy filers are reluctant to talk about it with others, including family and friends. 

Another part of the emotional side of filing bankruptcy is that you must open your personal financial affairs to court scrutiny and court control during the several months it takes to administer a bankruptcy.  A court-appointed bankruptcy trustee oversees your case and tries to recover as much of your property as possible to satisfy the creditors — those to whom you owe money. 

Some people also feel that they're shirking responsibility by filing for bankruptcy.  One client I worked with should have filed, but she couldn't bring herself to do it.  She said, "I spent that money, and it's my responsibility to pay it back." 

  Most banks make gobs and gobs of money from their credit-card businesses.  As a former consultant who worked in the industry, I can tell you that credit cards are one of the most profitable lines of business for banks.  Now you know why your mailbox is always filled with solicitations for more cards. 

So if you file for bankruptcy, don't feel bad about not paying back the bank.  The nice merchants from whom you bought the merchandise have already been paid.  Charge-offs — the banker's term for taking the loss on debt that you discharge through bankruptcy — are the banker's cost, which is another reason why the interest rate is so high on credit cards and why borrowing on them is a bad idea. 

Deciphering the bankruptcy laws

In 2005, a new bankruptcy law went into effect — the Bankruptcy Abuse and Prevention Act of 2005.  As you may be able to tell from the bill's name, major creditors, such as credit-card companies, lobbied heavily for new laws.  Although they didn't get everything they wanted, they got a lot, which — not surprisingly — doesn't benefit those folks in dire financial condition contemplating bankruptcy.  Don't despair, though; help and information can overcome the worst provisions of this new law.  Here are the major new elements of the personal bankruptcy laws:

  Required counseling: Before filing for bankruptcy, individuals are now mandated to complete credit counseling, the purpose of which is to explore your options for dealing with debt, including (but not limited to) bankruptcy and developing a debt repayment plan. 

  Historically, many supposed "counseling" agencies have provided highly biased advice.  Be sure to read the "Turning to Credit Counseling Agencies" section to find out what conflicts of interest agencies have and to get advice on how to pick a top-notch agency. 

To actually have debts discharged through bankruptcy, the new law requires a second type of counseling called "Debtor Education."  All credit counseling and debtor education must be completed by an approved organization on the U.S. Trustee's website (`www.justice.gov/ust`).  Click on the link Credit Counseling & Debtor Education in the Consumer Information section. 

  Means testing: Some high-income earners now may be precluded from filing the form of bankruptcy that actually discharges debts (called Chapter 7) and instead be forced to use the form of bankruptcy that involves a repayment plan (called Chapter 13). 

Recognizing that folks living in higher cost-of-living areas tend to have higher incomes, the new law does allow for differences in income by making adjustments based upon your state of residence and family size.  The expense side of the equation is considered as well, and allowances are determined by county and metropolitan area.  I won't bore you with the details and required calculations here.  Few potential filers are affected by this new provision.  For more information, click on the Means Testing Information link in the Bankruptcy Reform section on the U.S. Trustee's website (`www.justice.gov/ust`). 

  Increased requirements placed on filers and attorneys: The means testing alone has created a good deal of additional work for bankruptcy filers, work generally done by attorneys.  Filers, including lawyers, must also now attest to the accuracy of submitted information, which has attorneys doing more verification work.  Thus, it's no surprise that when the new bankruptcy laws were passed, legal fees increased significantly — jumps of 30 to 40 percent were common. 

  New rules for people who recently moved: Individual states have their own provisions for how much personal property and home equity you can keep.  Prior to the passage of the 2005 laws, in some cases, shortly before filing bankruptcy, people actually moved to a state that allowed them to keep more.  Under the new law, you must live in the state for at least two years before filing bankruptcy in that state and using that state's personal property exemptions.  To use a given state's homestead exemption, which dictates how much home equity you may protect, you must have lived in that state for at least 40 months. 

Choosing between Chapter 7 and 13

You can file one of two forms of personal bankruptcy: Chapter 7 or Chapter 13.  Here are the essentials regarding each type:

  Chapter 7 allows you to discharge, or cancel, certain debts.  This form of bankruptcy makes the most sense when you have significant debts that you're legally allowed to cancel. ( See "Understanding bankruptcy benefits," earlier in this chapter, for details on which debts can be canceled, or discharged.) 

  Chapter 13 comes up with a repayment schedule that requires you to pay your debts over several years.  Chapter 13 stays on your credit record (just like Chapter 7), but it doesn't eliminate debt, so its value is limited — usually to dealing with debts like taxes that can't be discharged through bankruptcy.  Chapter 13 can keep creditors at bay until you work out a repayment schedule in the courts. 

Seeking bankruptcy advice

  If you want to find out more about the pros, cons, and details of filing for bankruptcy, pick up a copy of The New Bankruptcy: Will It Work for You?  by attorney Stephen R. Elias (Nolo Press).  If you're comfortable with your decision to file and you think you can complete the paperwork, check out How to File for Chapter 7 Bankruptcy, by attorneys Elias, Albin Renauer, and Robin Leonard (Nolo Press), which comes with all the necessary filing forms. 

Hiring a paralegal typing service to prepare the forms, which can be a cost-effective way to get help with the process if you don't need heavy-duty legal advice, is an intermediate approach.  To find a paralegal typing service in your area, check your local yellow pages under "Paralegals." 

Stopping the Spending/Consumer Debt Cycle

Regardless of how you deal with paying off your debt, you're in real danger of falling back into old habits.  Backsliding happens not only to people who file bankruptcy but also to those who use savings or home equity to eliminate their debt.  This section speaks to that risk and tells you what to do about it. 

Resisting the credit temptation

Getting out of debt can be challenging, but I have confidence that you can do it with this book by your side.  In addition to the ideas I discuss earlier in this chapter (such as eliminating all your credit cards and getting a debit card), the following list provides some additional tactics you can use to limit the influence credit cards hold over your life. ( If you're concerned about the impact that any of these tactics may have on your credit rating, please see Chapter 2.) 

    Reduce your credit limit.  If you choose not to take my advice and get rid of all your credit cards or secure a debit card, be sure to keep a lid on your credit-card's credit limit (the maximum balance allowed on your card).  You don't have to accept the increase just because your bank keeps raising your credit limit to reward you for being such a profitable customer.  Call your credit-card service's toll-free phone number and lower your credit limit to a level you're comfortable with. 

  Replace your credit card with a charge card.  A charge card (such as the American Express Card) requires you to pay your balance in full each billing period.  You have no credit line or interest charges.  Of course, spending more than you can afford to pay when the bill comes due is possible.  But you'll be much less likely to overspend if you know you have to pay in full monthly. 

  Never buy anything on credit that depreciates in value.  Meals out, cars, clothing, and shoes all depreciate in value.  Don't buy these things on credit.  Borrow money only for sound investments — education, real estate, or your own business, for example. 

  Think in terms of total cost.  Everything sounds cheaper in terms of monthly payments — that's how salespeople entice you into buying things you can't afford.  Take a calculator along, if necessary, to tally up the sticker price, interest charges, and upkeep.  The total cost will scare you.  It should. 

  Stop the junk mail avalanche.  Look at your daily mail — I bet half of it is solicitations and mail-order catalogs.  You can save some trees and time sorting junk mail by removing yourself from most mailing lists.  To remove your name from mailing lists, contact the Direct Marketing Association (you can register through its website at `www.dmachoice.org` or call 212-768-7277 between 9 a.m. and 2 p.m. Eastern Standard Time Monday through Friday). 

To remove your name from the major credit reporting agency lists that are used by credit-card solicitation companies, call 888-567-8688.  Also, tell any credit-card companies you keep cards with that you want your account marked to indicate that you don't want any of your personal information shared with telemarketing firms. 

  Limit what you can spend.  Go shopping with a small amount of cash and no plastic or checks.  That way, you can spend only what little cash you have with you! 

Identifying and treating a compulsion

No matter how hard they try to break the habit, some people become addicted to spending and accumulating debt.  It becomes a chronic problem that starts to interfere with other aspects of their lives and can lead to problems at work and with family and friends. 

Debtors Anonymous (DA) is a nonprofit organization that provides support (primarily through group meetings) to people trying to break their debt accumulation and spending habits.  DA is modeled after the 12-step Alcoholics Anonymous (AA) program. 

Like AA, Debtors Anonymous works with people from all walks of life and socioeconomic backgrounds.  You can find people who are financially on the edge, $100,000-plus income earners, and everybody in between at DA meetings.  Even former millionaires join the program. 

DA has a simple questionnaire that helps determine whether you're a problem debtor.  If you answer "yes" to at least 8 of the following 15 questions, you may be developing or already have a compulsive spending and debt accumulation habit:

  Are your debts making your home life unhappy? 

  Does the pressure of your debts distract you from your daily work? 

  Are your debts affecting your reputation? 

  Do your debts cause you to think less of yourself? 

  Have you ever given false information in order to obtain credit? 

  Have you ever made unrealistic promises to your creditors? 

  Does the pressure of your debts make you careless when it comes to the welfare of your family? 

  Do you ever fear that your employer, family, or friends will learn the extent of your total indebtedness? 

  When faced with a difficult financial situation, does the prospect of borrowing give you an inordinate feeling of relief? 

  Does the pressure of your debts cause you to have difficulty sleeping? 

  Has the pressure of your debts ever caused you to consider getting drunk? 

  Have you ever borrowed money without giving adequate consideration to the rate of interest you're required to pay? 

  Do you usually expect a negative response when you're subject to a credit investigation? 

  Have you ever developed a strict regimen for paying off your debts, only to break it under pressure? 

  Do you justify your debts by telling yourself that you are superior to the "other" people, and when you get your "break," you'll be out of debt? 

  To find a Debtors Anonymous (DA) support group in your area, check your local phone directory (in the "Business" section) or visit the DA website at `www.debtorsanonymous.org`.  You can write to DA's national headquarters for meeting locations in your area and a literature order form at the following address: Debtors Anonymous General Service Office, P.O. Box 920888, Needham, MA 02492-0009.  You can also contact the DA's national headquarters by phone at 781-453-2743. 
Chapter 6

Reducing Your Spending

In This Chapter

  Getting the most for your money

  Increasing your savings

  Controlling and cutting costs

Telling people how and where to spend their money is a risky undertaking, because most people like to spend money and hate to be told what to do.  So, in this chapter I detail numerous strategies that I have seen work for other people.  The final decision for what to cut rests solely on you.  Only you can decide what's important to you and what's dispensable (should you cut out your weekly poker games or cut back on your shoe collection?) 

With these recommendations, I assume that you value your time.  Therefore, I don't tell you to scrimp and save by doing things like cutting open a tube of toothpaste so that you can use every last bit of it.  And I don't tell you to have your spouse do your ironing to reduce your dry-cleaning bills — no point in having extra money in the bank if your significant other walks out on you! 

The fact that you're busy all the time may be part of the reason you spend money as you do.  Therefore, the recommendations in this chapter focus on methods that produce significant savings but don't involve a lot of time.  In other words, these strategies provide bang for the buck. 

Unlocking the Keys to Successful Spending

For most people, spending money is a whole lot easier and more fun than earning it.  Far be it from me to tell you to stop having fun and turn into a penny-pinching, stay-at-home miser.  Of course you can spend money.  But there's a world of difference between spending money carelessly and spending money wisely. 

If you spend too much and spend unwisely, you put pressure on your income and your future need to continue working.  Savings dwindle, debts may accumulate, and you can't achieve your financial (and perhaps personal) goals. 

If you dive into details too quickly, you may miss the big picture.  So before I jump into the specific areas where you can trim your budget, I give you my four overall keys to successful spending.  These four principles run through my recommendations in this chapter:

  Living within your means

  Finding the best values

  Cutting excess spending

  Rejecting consumer credit

Living within your means

Spending too much is a relative problem.  Two people can each spend $40,000 per year yet still have drastically different financial circumstances.  How?  Suppose that one of them earns $50,000 annually, while the other makes $35,000.  The $50,000 income earner saves $10,000 each year.  The $35,000 wage earner, on the other hand, accumulates $5,000 of new debt (or spends that amount from prior savings).  So, spend within your means.  If you do nothing else in this chapter, please be sure to do this! 

  Don't let the spending habits of others dictate yours.  Certain people — and you know who they are — bring out the big spender in you.  Do something else with them besides shopping and spending.  If you can't find any other activity to share with them, try shopping with limited cash and no credit cards.  That way, you can't overspend on impulse. 

How much you can safely spend while working toward your financial goals depends on what your goals are and where you are financially.  Save first for your goals and then live on what's left over.  Chapter 4 assists you with figuring how much you should be saving and what you can afford to spend while still accomplishing your financial goals. 

Looking for the best values

You can find high quality and low cost in the same product.  Conversely, paying a high price is no guarantee that you're getting high quality.  Cars are a good example.  Whether you're buying a subcompact, a sports car, or a luxury four-door sedan, some cars are more fuel-efficient and cheaper to maintain than rivals that carry the same sticker price. 

When you evaluate the cost of a product or service, think in terms of total, long-term costs.  Suppose that you're comparing the purchase of two used cars: the Solid Sedan, which costs $11,995, and the Clunker Convertible, which weighs in at $9,995.  On the surface, the convertible appears to be cheaper.  However, the price that you pay for a car is but a small portion of what that car ultimately costs you.  If the convertible is costly to operate, maintain, and insure over the years, it could end up costing you much more than the sedan would.  Sometimes, paying more upfront for a higher-quality product or service ends up saving you money in the long run. 

  People who sell particular products and services may initially appear to have your best interests at heart when they steer you toward something that isn't costly.  However, you may be in for a rude awakening when you discover the ongoing service, maintenance, and other fees you face in the years ahead.  Salespeople are generally trained to pitch you a lower-cost product if you indicate that's what you're after. 

Don't waste money on brand names

  You don't want to compromise on quality, especially in the areas where quality is important to you.  But you also don't want to be duped into believing that brand-name products are better or worth a substantially higher price.  Be suspicious of companies that spend gobs on image-oriented advertising.  Why?  Because heavy advertising costs many dollars, and as a consumer of those companies' products and services, you pay for all that advertising. 

All successful companies advertise their products.  Advertising is cost-effective and good business if it brings in enough new business.  But you need to consider the products and services and the claims that companies make.  In grocery stores, for example, you can often find name brands and store brands for the same product sitting in close proximity to one another.  Upon reading the label, you can see that the products may in fact be identical and the only difference between the two products is that the name brand product costs more (because of the branding and associated advertising and marketing). 

Branding is used in many fields to sell overpriced, mediocre products and services to consumers.  Does a cola beverage really taste better if it's "the real thing" or "the choice of a new generation"?  Consider all the silly labels and fluffy marketing of beers.  Blind taste-testing demonstrates little if any difference between the more expensive brand-name products and the cheaper, less heavily advertised ones. 

Now, if you can't live without your Coca-Cola or Samuel Adams beer, and you think that these products are head and shoulders above the rest, drink them to your heart's content.  But question the importance of the name and image of the products you buy.  Companies spend a lot of money creating and cultivating an image, which has zero impact on how their products taste or perform. 

Tread carefully online

Online shopping has grown in popularity for some good reasons.  It's reasonably fast and convenient, and you can quickly research different products and services before buying.  But there are clear downsides to online shopping.  In your rush, you may make unwise purchases.  This slip-up may happen in part because so many reviews online are biased.  Also, be careful when ordering from newer, smaller sites that may not stand behind what they sell. ( See the next section for more shopping advice.) 

Getting your money back

  Take a look around your home for items you never use.  Odds are you have some (maybe even many).  Returning such items to where you bought them can be cathartic; it also reduces your home's clutter and puts more money in your pocket. 

Also, think about the last several times you bought a product or service and didn't get what was promised.  What did you do about it?  Most people do nothing and let the derelict company off the hook.  Why?  Here are some common explanations for this type of behavior:

  Low standards: Consumers have come to expect shoddy service and merchandise because of the common lousy experiences they've had. 

  Conflict avoidance: Most people shun confrontation.  It makes them tense and anxious, and it churns their stomachs. 

  Hassle aversion: Most companies don't make it easy for complainers to get their money back or obtain satisfaction.  To get restitution from some companies, you need the tenacity and determination of a pit bull. 

  You can increase your odds of getting what you expect for your money by doing business with companies that

  Have fair return policies: Don't purchase any product or service until you understand the company's return policy.  Be especially wary of buying from companies that charge hefty "restocking" fees for returned merchandise or simply don't allow returns at all.  Reputable companies offer full refunds and don't make you take store credit (although taking credit is fine if you're sure that you'll use it soon and that the company will still be around). 

  Can provide good references: Suppose that you're going to install a fence on your property, and, as a result, you're going to be speaking with fencing contractors for the first time.  You can sift out many inferior firms by asking each contractor that you interview for at least three references from people in your local area who have had a fence installed in the past year or two. 

  Are committed to the type of product or service they provide: Suppose that your chosen fencing contractor does a great job, and now that you're in the market for new gutters on your home, the contractor says that he does gutters, too.  Although the path of least resistance would be to simply hire the same contractor for your gutters, you should inquire about how many gutters the contractor has installed and also interview some other firms that specialize in such work.  Because your fencing contractor may have done only a handful of gutter jobs, he may not know as much about that type of work. 

  Following these guidelines can greatly diminish your chances of having unhappy outcomes with products or services you buy.  And here's another important tip: Whenever possible and as long as you can pay the balance in full when due, buy with a credit card if your credit's in good standing.  Doing so enables you to dispute a charge within 60 days and gives you leverage for getting your money back. 

Recognizing the Better Business Bureau's conflicts of interest

The Better Business Bureau (BBB) states that its mission is "to promote and foster the highest ethical relationship between businesses and the public."  The reality of the typical consumer's experience of dealing with the BBB doesn't live up to the BBB's marketing.  BBBs are nonprofits and are not agencies of any governmental body. 

"It's a business trade organization, and each local BBB is basically independent, like a franchise," says John Bear, an author of consumer advocacy books, including Send This Jerk the Bedbug Letter: How Companies, Politicians, and the Mass Media Handle Complaints & How to Be a More Effective Complainer (Ten Speed Press). " By and large, when somebody has a problem with a company and they fill out a complaint form with the BBB, if the company is a member of the BBB, there's ample evidence that consumers often end up not being satisfied.  The BBB protects their members." 

Particularly problematic among the BBB's pro-business practices are the company reports the BBB keeps on file.  The BBB often considers a legitimate complaint satisfactorily resolved even when you're quite unhappy and the company is clearly not working to satisfy the problems for which it's responsible. 

Bear also cites examples of some truly troubling BBB episodes.  In one case, he says that a diploma mill (a company that sells degrees but provides little, if any, education) in Louisiana was a member of the local BBB. " When complaints started coming in," says Bear, "the BBB's response was always that the company met their standards and that the complaints were resolved.  The reality was that the complaints weren't satisfactorily resolved, and it took about two years until complaints reached into the hundreds for the BBB to finally cancel the diploma mill's membership and give out a bland statement about complaints.  Two months later, the FBI raided the company.  Millions of consumers' dollars were lost because the BBB didn't do its job." 

In another case, the president of a South Florida BBB (the fifth largest in the country, according to Bear) was ultimately imprisoned for taking bribes from companies in exchange for maintaining favorable reports on file. 

If you find that you're unable to make progress when trying to get compensation for a lousy product or service, here's what I recommend you do:

    Document: Taking notes whenever you talk to someone at a company can help you validate your case down the road, should problems develop.  Obviously, the bigger the purchase and the more you have at stake, the more carefully you should document what you've been promised.  In many cases, though, you probably won't start carefully noting each conversation until a conflict develops.  Keep copies of companies' marketing literature, because such documents often make promises or claims that companies fail to live up to in practice. 

  Escalate: Some frontline employees either aren't capable of resolving disputes or lack the authority to do so.  No matter what the cause, speak with a department supervisor and continue escalating from there.  If you're still not making progress, lodge a complaint to whatever state regulatory agency (if any) oversees such companies.  Tell your friends and colleagues not to do business with the company (and let the company know that you're doing this until your complaint is resolved to your satisfaction).  Also consider contacting a consumer help group — these groups are typically sponsored by broadcast or print media in metropolitan areas.  They can be helpful in resolving disputes or shining adverse publicity on disreputable companies or products. 

  Litigate: If all else fails, consider taking the matter to small claims court if the company continues to be unresponsive. ( Depending on the amount of money at stake, this tactic may be worth your time.)  The maximum dollar limit that you may recover varies by state, but you're usually limited to a few thousand dollars.  For larger amounts than those allowed in small claims court in your state, you can, of course, hire an attorney and pursue the traditional legal channels — although you may end up throwing away more of your time and money.  Mediation and arbitration are generally a better option than following through on a lawsuit. 

Eliminating the fat from your spending

If you want to reduce your overall spending by, say, 10 percent, you can just cut all of your current expenditures by 10 percent.  Or, you can reach your 10-percent goal by cutting some categories a lot and others not at all.  You need to set priorities and make choices about where you want and don't want to spend your money. 

  What you spend your money on is sometimes a matter of habit rather than a matter of what you really want or value.  For example, some people shop at whatever stores are close to them.  But eliminating fat doesn't necessarily mean cutting back on your purchases: You can save money by buying in bulk.  Some stores specialize in selling larger packages or quantities of a product at a lower price because they save money on the packaging and handling.  If you're single, shop with a friend and split the bulk purchases. 

Turning your back on consumer credit

As I discuss in Chapters 3 and 5, buying items that depreciate — such as cars, clothing, and vacations — on credit is hazardous to your long-term financial health.  Buy only what you can afford today.  If you'll be forced to carry a debt for months or years on end, you can't really afford what you're buying on credit today. 

  Without a doubt, renting-to-own is the most expensive way to buy.  Here's how it works: You see a huge ad blaring "$12.95 for a DVD player!"  Well, the ad has a big hitch: That's $12.95 per week, for many weeks.  When all is said and done (and paid), buying a $100 DVD player through a rent-to-own store costs a typical buyer more than $375!  Welcome to the world of rent-to-own stores, which offer cash-poor consumers the ability to lease consumer items and, at the end of the lease, an option to buy. 

If you think that paying an 18-percent interest rate on a credit card is expensive, consider this: The effective interest rate charged on many rent-to-own purchases exceeds 100 percent; in some cases, it may be 200 percent or more!  Renting-to-own makes buying on a credit card look like a great deal.  I'm not sharing this information to encourage you to buy on credit cards but to point out what a rip-off renting-to-own is.  Such stores prey on cashless consumers who either can't get credit cards or don't understand how expensive renting-to-own really is.  Forget the instant gratification and save a set amount each week until you can afford what you want. 

  Consumer credit is expensive, and it reinforces a bad financial habit: spending more than you can afford. 

Budgeting to Boost Your Savings

When most people hear the word budgeting, they think unpleasant thoughts — like those associated with dieting — and rightfully so.  But budgeting can help you move from knowing how much you spend on various things to successfully reducing your spending. 

The first step in the process of budgeting, or planning your future spending, is to analyze where your current spending is going (refer to Chapter 3).  After you do that, calculate how much more you'd like to save each month.  Then comes the hard part: deciding where to make cuts in your spending. 

Suppose that you're currently not saving any of your monthly income and you want to save 10 percent for retirement.  If you can save and invest through a tax-sheltered retirement account — for example, a 401(k) or 403(b), or a SEP-IRA or Keogh — you don't actually need to cut your spending by 10 percent to reach a savings goal of 10 percent (of your gross income).  When you contribute money to a tax-deductible retirement account, you reduce your federal and state taxes.  If you're a moderate-income-earner paying, say, 30 percent in federal and state taxes on your marginal income, you actually need to reduce your spending by only 7 percent to save 10 percent.  The other 3 percent of the savings comes from the lowering of your taxes. ( The higher your tax bracket, the less you need to cut your spending to reach a particular savings goal.) 

So to boost your savings rate to 10 percent, go through your current spending category by category until you come up with enough proposed cuts to reduce your spending by 7 percent.  Make your cuts in the areas that will be the least painful and where you're getting the least value from your current level of spending. ( If you don't have access to a tax-deductible retirement account, budgeting still involves the same process of assessment and making cuts in various spending categories, but your cuts need to add up to the entire amount you want to save, in this example, 10 percent rather than 7 percent.) 

Another method of budgeting involves starting completely from scratch rather than examining your current expenses and making cuts from that starting point.  Ask yourself how much you'd like to spend on different categories.  The advantage of this approach is that it doesn't allow your current spending levels to constrain your thinking.  You'll likely be amazed at the discrepancies between what you think you should be spending and what you actually are spending in certain categories. 

Reducing Your Spending

As you read through the following strategies for reducing your spending, please keep in mind that some of these strategies will make sense for you and some of them won't.  Start your spending reduction plan with the strategies that come easily.  Work your way through them.  Keep a list of the options that are more challenging for you — ones that may require more of a sacrifice but may be workable if necessary to achieve your spending and savings goals. 

No matter which of the ideas in this chapter you choose, rest assured that keeping your budget lean and mean pays enormous dividends.  After you implement a spending reduction strategy, you'll reap the benefits for years to come.  Take a look at Figure 6-1: For every $1,000 that you shave from your annual spending (that's just $83 per month), check out how much more money you'll have down the road. ( This chart assumes that you invest your newfound savings in a tax-deferred retirement account, you average 8-percent-per-year returns on your investments, and you're in a combined federal and state tax bracket of 35 percent — see Chapter 7 for information on tax brackets.) 

**Figure 6-1:** Reducing your spending can yield large investment sums. 

Managing food costs

Not eating is one way to reduce food expenditures; however, this method tends to make you weak and dizzy, so it's probably not a viable long-term strategy.  The following culinary cutbacks can keep you on your feet — perhaps even improve your health — and help you save money. 

Eating out frugally

Eating meals out and getting takeout can be timesavers, but they rack up big bills if done too often and too lavishly.  Eating out is a luxury — think of it as hiring someone to shop, cook, and clean up for you.  Of course, some people either hate to cook or don't have the time, space, or energy to do much in the kitchen.  If this sounds like you, choose restaurants carefully and order from the menu selectively.  Here are a couple of tips for eating out:

  Avoid beverages, especially alcohol.  Most restaurants make big profits on beverages.  Drink water instead. ( Water is healthy, and it reduces the likelihood that you'll want a nap after a big meal.) 

  Order vegetarian.  Vegetarian dishes generally cost less than meat-based entrees (and they're generally better for you). 

I don't want to be a killjoy.  I'm not saying that you should live on bread and water.  You can have dessert — heck, have some wine, too, for special occasions!  Just try not to eat dessert with every meal.  Try eating appetizers and dessert at home, where they're a lot less expensive. 

  Also, if you aren't skilled in the kitchen, consider learning how to cook.  Folks who eat out a lot do so in part because they don't really know how to cook.  Take a course and read some good books on the topic. 

Eating healthy at home without spending a fortune

As evidenced by the preponderance of diet and weight-loss books on health book bestseller lists — and the growth of the natural and organic grocery stores like Whole Foods and Trader Joe's — Americans are trying to eat healthier.  Concerned about all the pesticides, antibiotics, and hormones that end up in the food supply, organic food purchases are growing at a fast rate. 

Problem is, financially speaking, better quality food, especially organic foods, can cost more, sometimes much more — but not always.  A number of studies I've seen demonstrate that highly processed foods, which are less nutritious and worse for your health, can be as costly as or even more expensive than fresh, so-called whole foods.  The key to not overspending on fresher, healthier, and organic foods is to be flexible when you're at the grocery store.  Buy more of what is seasonal and therefore currently less expensive, stock up on sale items that aren't perishable, and buy more at stores like Trader Joe's (go to their website at `www.traderjoes.com` or call 800-SHOPTJS [800-746-7857]) that have competitive pricing.  Local food co-ops, which source food locally, are another great source for competitively priced food and sometimes pay dividends annually to members. 

  According to various studies, spending the money to buy organic food makes the most sense when buying the following foods:

  Produce: Apples, bell peppers, celery, cherries, hot peppers, imported grapes, nectarines, peaches, pears, potatoes, red raspberries, spinach, and strawberries have historically been found to carry the greatest amount of pesticides, even after washing. 

  Meat, poultry, eggs, and dairy: By going organic, you avoid supplemental hormones and antibiotics.  You also greatly reduce the risk of exposure to the agent believed to cause mad cow disease, and you minimize your exposure to other potential toxins in nonorganic feed. 

  Baby food: Baby food is typically loaded with condensed fruits and vegetables, which thus contain concentrated pesticide residues.  Also, children's small and developing bodies are especially vulnerable to toxins. 

One area where many folks are wasting money is in buying bottled water.  Although tap water often does leave something to be desired, bottled water is typically not as pure as some folks think.  You can save hundreds of dollars annually and drink cleaner water by installing a water filtration system at home and improving your tap (or well) water. ( For more information, see my website, `www.erictyson.com`.) 

Joining a wholesale superstore

  Superstores such as Costco and Sam's Club enable you to buy groceries in bulk at wholesale prices.  And contrary to popular perception, you don't have to buy 1,000 rolls of toilet paper at once — just 24. 

I've performed price comparisons between wholesale superstores and retail grocery stores and found that wholesalers charge about 30 percent less for the exact same stuff — all without the hassle of clipping coupons or hunting for the store that has the best price on paper towels this month! ( At these discount prices, you only need to buy about $150 per year to recoup Costco and Sam's Club's membership fees, which start at $50 and $40 per year, respectively.)  In addition to saving you lots of money, buying in bulk requires fewer shopping trips.  You'll have more supplies around your humble abode, so you'll have less need to eat out (which is costly) or make trips (which wastes time and gasoline) to the local grocer, who may be really nice but charges the most. 

  Perishables run the risk of living up to their name, so only buy what you can reasonably use.  Repackage bulk packs into smaller quantities and store them in the freezer if possible.  If you're single, shop with a friend and split the order.  Also, be careful when you shop at the warehouse clubs — you may be tempted to buy things you don't really need.  These stores carry all sorts of items, including the newest TVs, computers, furniture, clothing, complete sets of baseball cards, and giant canisters of biscotti — so wallet and waistline beware!  Try not to make impulse purchases, and be especially careful when you have kids in tow. 

To find a superstore near you, check your local phone directory.  You can also find a Costco store near you by visiting the Costco website at `www.costco.com` or calling 800-774-2678.  Sam's Club is on the Internet at `www.samsclub.com`. 

Saving on shelter

Housing and all the costs associated with it (utilities, furniture, appliances, and if you're a homeowner, maintenance, repairs and home insurance) can gobble a large chunk of your monthly income.  I'm not suggesting that you live in an igloo or teepee (though they're probably less costly), but people often overlook opportunities to save money in this category. 

Reducing rental costs

Rent can take up a sizable chunk of your monthly take-home pay.  Many people consider rent to be a fixed and inflexible part of their expenses, but it's not.  Here's what you can do to cut down your rental costs:

    Move to a lower-cost rental.  Of course, a lower-cost rental may not be as nice — it may be smaller, lack a private parking spot, or be located in a less popular area.  Remember that the less you spend renting, the more you can save toward buying your own place.  Just be sure to factor in all the costs of a new location, including the possible higher commuting costs. 

  Share a rental.  Living alone has some benefits, but financially speaking, it's a luxury.  If you rent a larger place with roommates, your rental costs will go way down, and you'll get more home for your rental dollars.  You have to be in a sharing mood, though.  Roommates can be a hassle at times, but they can also be a plus — you get to meet all sorts of new people, and you have someone else to blame when the kitchen's a mess. 

  Negotiate your rental increases.  Every year, like clockwork, your landlord bumps up your rent by a certain percentage.  If your local rental market is soft or your living quarters are deteriorating, stand up for yourself!  You have more leverage and power than you probably realize.  A smart landlord doesn't want to lose good tenants who pay rent on time.  Filling vacancies takes time and money.  State your case: You've been a responsible tenant, and your research shows comparable rentals going for less.  Crying "poor" may help, too.  At the very least, if you can't stave off the rent increase, maybe you can wrangle some improvements to the place. 

  Buy rather than rent.  Purchasing your own place may seem costly but in the long run, owning is cheaper than renting, and you have something to show for it in the end. ( Actually, the late 2000s decline in home prices coupled with low interest rates have made housing the most affordable it has been in decades and even less costly than renting in some areas.)  If you purchase real estate with a 30-year fixed-rate mortgage, your mortgage payment (which is your biggest ownership expense) remains constant.  Only your property taxes, maintenance, and insurance costs are exposed to the vagaries of inflation.  As a renter, your entire monthly housing cost can rise with increases in the cost of living (unless you're the beneficiary of a rent-controlled apartment).  See Chapter 14 to find out the smart way to buy real estate. 

Reducing homeowner expenses

As every homeowner knows, houses suck up money.  You should be especially careful to watch your money in this area of your budget. 

    Know what you can afford.  Whether you're on the verge of buying your first home or trading up to a more costly property, crunch some realistic numbers before you commit.  Calculate how much you can afford to spend monthly on a home.  Do the exercises in Chapter 3, on where you're spending your money, and Chapter 4, on saving for retirement, to help you calculate the amount you can afford. 

Although real estate can be a good long-term investment, you can end up pouring a large portion of your discretionary dollars into your home.  In addition to decorating and remodeling, some people feel the need to trade up to a bigger home every few years.  Of course, after they're in their new home, the remodeling and renovation cycle simply begins again, which costs even more money.  Most home renovations or remodels will never recoup anything close to what they cost.  In addition, a major remodel may result in higher property taxes, as well as higher homeowner's insurance costs.  Appreciate what you have, and remember that homes are for living in, not museums for display.  If you have children, why waste a lot of money on expensive furnishings that take up valuable space and require you to constantly nag your kids to tread carefully?  And don't covet — the world will always have people with bigger houses and more toys than you. 

  Rent out a room.  Because selling your home to buy a less expensive place can be a big hassle, consider taking in a tenant (or charge those adult "children" still living at home!)  to reduce your housing expenses.  Check out the renter thoroughly: Get references, run a credit report, and talk about ground rules and expectations before sharing your space.  Don't forget to check with your insurance company to see whether your homeowner's policy needs adjustments to cover potential liability from renting. 

  Refinance your mortgage.  This step may seem like common sense, but surprisingly, many people don't keep up-to-date on mortgage rates.  If interest rates are lower than they were when you obtained your current mortgage, you may be able to save money by refinancing (see Chapter 14 for more information). 

  Appeal your property-tax assessment.  If you bought your property when housing prices were higher in your area than they are now, you may be able to save money by appealing your assessment.  Also, if you live in an area where your assessment is based on how the local assessor valued the property (rather than what you paid for your home), your home may be overassessed.  Check with your local assessor's office for the appeals procedure you need to follow.  An appraiser's recent evaluation of your property may help — you may already have one if you refinanced your mortgage recently.  Also, review how the assessor valued your property compared with similar ones nearby — mistakes happen. 

  Reduce utility costs.  Sometimes you have to spend money to save money.  Old refrigerators, for example, can waste a lot of electricity.  Insulate to save on heating and air-conditioning bills.  Install water flow regulators in shower heads.  When planting your yard, don't select water-guzzling plants, and keep your lawn area reasonable.  Even if you don't live in an area susceptible to droughts, why waste water (which isn't free) unnecessarily?  Recycle — recycling means less garbage, which translates into lower trash bills (because you won't be charged for using larger garbage containers) and benefits the environment by reducing landfill. 

Cutting transportation costs

America is a car-driven society.  In most other countries, cars are a luxury.  If more people in the United States thought of cars as a luxury, Americans might have far fewer financial problems (and accidents).  Not only do cars pollute the air and clog the highways, but they also cost you a bundle. 

Purchasing a quality car and using it wisely can reduce the cost of car ownership.  Using alternative modes of transportation can also help you save. 

Contrary to advertising slogans, cars aren't built to last; manufacturers don't want you to stick with the same car forever.  New models are constantly introduced with new features and styling changes.  But, getting a new set of wheels every few years is an expensive luxury.  Don't try to keep up with the Joneses as they show off their new cars every year — for all you know, they're running themselves into financial ruin trying to impress others.  Let your neighbors admire you for your thriftiness and wisdom instead. 

Research before you buy a car

When you buy a car, you don't just pay the initial sticker price: You also have to pay for gas, insurance, tolls, registration fees, maintenance, and repairs.  You may also owe sales and/or personal property taxes.  Don't compare simply sticker prices; think about the total, long-term costs of car ownership and see whether they fit into your budget while still allowing you to save toward your goals. 

Speaking of total costs, remember that you're also trusting your life to the car.  With about 33,000 Americans killed in auto accidents annually (about one-third of which are caused by drunk drivers), safety should be an important consideration as well.  Air bags, for example, may save your life.  The National Highway Traffic Safety Administration's website (`www.safercar.gov`) has lots of crash test data, as well as information on other car safety issues. 

  IntelliChoice (website `www.intellichoice.com`) provides information about all categories of ownership costs, warranties, and dealer costs for new cars, which are rated based on total ownership costs.  Edmunds (website `www.edmunds.com`) provides more general information about different makes and models of both new and used cars.  Please be aware that these sites have advertising and may receive referral fees if you buy a car through a dealer their website refers you to.  Consumer Reports' annual car guide also has good information and data. 

Don't lease, don't borrow: Buy your car with cash

The main reason people end up spending more than they can afford on a car is that they finance the purchase.  As I discuss in Part I, you should avoid borrowing money for consumption purchases, especially for items that depreciate in value (like cars).  A car is most definitely not an investment. 

  Leasing is generally more expensive than borrowing money to buy a car.  Leasing is like a long-term car rental.  Everyone knows how well rental cars get treated — leased cars are treated just as well, which is one of the reasons leasing is so costly. 

"But I can't buy a new car with cash," you may be thinking.  Some people feel that it's unreasonable of me to expect them to use cash to buy a new car, but I'm trying to look out for your best long-term financial interests.  Please consider the following:

  If you lack sufficient cash to buy a new car, don't buy a new car!  Most of the world's population can't even afford a car, let alone a new one!  Buy a car that you can afford — which for most people is a used one. 

  Don't fall for the rationale that says buying a used car means lots of maintenance, repair expenses, and problems.  Do your homework and buy a good quality used car (see the preceding section, "Research before you buy a car."  That way, you can have the best of both worlds.  A good used car costs less to buy and, thanks to lower insurance costs (and possibly property taxes), less to operate. 

  You don't need a fancy car to impress people for business purposes.  Some people I know say that they absolutely must drive a nice, brand-spanking-new car to set the right impression for business purposes.  I'm not going to tell you how to manage your career, but I will ask you to consider that if clients and others see you driving an expensive new car, they may think that you spend money wastefully or that you're getting rich off of them! 

If you absolutely must finance a portion or all of your new car, and you are a homeowner, consider using a home equity line of credit.  Interest rates on these loans are low right now, and interest on amounts of up to $100,000 of debt is currently tax deductible. 

Replace high-cost cars

Maybe you realize by now that your car is too expensive to operate because of insurance, gas, and maintenance costs.  Or maybe you bought too much car — people who lease or borrow money for a car frequently buy a far more expensive car than they can realistically afford. 

  Sell your expensive car and get something more financially manageable.  The sooner you switch, the more money you'll save.  Getting rid of a car on a lease is a challenge, but it can be done.  I had a client who, when he lost his job and needed to slash expenses, convinced the dealer (by writing a letter to the owner) to take the leased car back. 

Keep cars to a minimum

For most households, maintaining two or more cars is an expensive extravagance.  Try to find ways to make do with fewer cars.  You can move beyond the confines of owning a car by either carpooling or riding buses or trains to work.  Some employers give incentives for taking public transit to work, and some cities and counties offer assistance for setting up vanpools or carpools along popular routes.  By leaving the driving to someone else, you can catch up on reading or just relax on the way to and from work.  You also help reduce pollution. 

When you're considering the cost of living in different areas, don't forget to factor in commuting costs.  One advantage of living close to work, or at least close to public transit systems, is that you may be able to make do with fewer cars (or no car at all) in your household. 

Buy commuter passes

  In many areas, you can purchase train, bus, or subway passes to help reduce the cost of commuting.  Many toll bridges also have booklets of tickets or passes that you can buy at a discount.  Electronic passes like E-Z Pass help you keep moving through toll plazas and eliminate sitting in toll collection lines that waste your time and gas.  Some areas even allow before-tax dollars to be withheld from your paycheck to buy commuter passes. 

Use regular unleaded gas

A number of studies have shown that "premium" gasoline isn't worth the extra expense.  But make sure that you buy gasoline that has the minimum octane rating recommended for your vehicle by consulting your owner's manual.  Paying more for higher-octane gasoline just wastes money.  Your car doesn't run better; you just pay more for gas.  Fill up your tank when you're on a shopping trip to the warehouse wholesalers (discussed earlier in this chapter).  These superstores are usually located in lower-cost areas, so the gas is often cheaper there, too.  Also, don't use credit cards to buy your gas if you have to pay a higher price to do so. 

Service your car regularly

Sure, servicing your car (for example, changing the oil every 5,000 miles) costs money, but it saves you dough in the long run by extending the operating life of your car.  Servicing your car also reduces the chance that your car will conk out in the middle of nowhere, which requires a hefty towing charge to a service station.  Stalling on the freeway during peak rush hour and having thousands of angry commuters stuck behind you is even worse. 

Lowering your energy costs

Escalating energy prices remind all of us how much we depend upon and use oil, electricity, and natural gas in our daily lives.  A number of terrific websites are packed with suggestions and tips for how to lower your energy costs.  Before I present those to you, however, here are the basics:

  Drive fuel-efficient cars.  If you're safety minded, you know how dangerous driving can be and aren't willing to risk your life driving a pint-size vehicle just to get 50 miles per gallon.  That said, you can drive safe cars (see the section, "Research before you buy a car") that are fuel-efficient. 

  Be thrifty at home.  Get all family members on the same page, without driving them crazy, to turn off lights they don't need.  Turn down the heat at night, which saves money and helps you sleep better, and turn it down when no one is home.  Hint: If people are walking around your home during the winter with shorts on instead of wearing sweaters, turn the heat down! 

  Service and maintain what you have.  Anything that uses energy — from your cars to your furnace — should be regularly serviced.  For instance, make sure you clean your filters. 

  Investigate energy efficiency before you buy.  This advice applies not only to appliances but also to an entire home.  Some builders are building energy efficiency into their new homes. 

  My favorite energy information and tip websites are the Database of State Incentives for Renewables & Efficiency (`www.dsireusa.org`) and the U.S. Department of Energy's Energy Efficiency and Renewable Energy (`www.energy``savers.gov`). 

Controlling clothing costs

Given the amount of money that some people spend on clothing and related accessories, I've come to believe that people in nudist colonies must be great savers!  But you probably live among the clothed mainstream of society, so here's a short list of economical ideas:

    Avoid clothing that requires dry-cleaning.  When you buy clothing, try to stick with cottons and machine-washable synthetics rather than wools or silks that require dry-cleaning.  Check labels before you buy clothing. 

  Don't chase the latest fashions.  Fashion designers and retailers are constantly working to tempt you to buy more.  Don't do it.  Ignore publications that pronounce this season's look.  In most cases, you simply don't need to buy racks of new clothes or an entire new wardrobe every year.  True fashion, as defined by what people wear, changes quite slowly.  In fact, the classics never go out of style.  If you want the effect of a new wardrobe every year, store last year's purchases away next year and then bring them out the year after.  Or rotate your clothing inventory every third year.  Set your own fashion standards.  Buy basic and buy classic — if you let fashion gurus be your guide, you'll end up with the biggest wardrobe in the poorhouse! 

  Minimize accessories.  Shoes, jewelry, handbags, and the like can gobble large amounts of money.  Again, how many of these accessory items do you really need?  The answer is probably very few, because each one should last many years. 

  Go to your closet or jewelry box and tally up the loot.  What else could you have done with all that cash?  Do you see things you regret buying or forgot you even had?  Don't make the same mistake again.  Have a garage sale if you have a lot of stuff that you don't want.  Return recent unused purchases to stores. 

Repaying your debt

In Chapter 5, I discuss strategies for reducing the cost of carrying consumer debt.  The best way to reduce the costs of such debt is to avoid it in the first place when you're making consumption purchases. 

  You can avoid consumer debt by eliminating your access to credit or by limiting your purchase of consumer items to what you can pay off each month.  Borrow only for long-term investments (see Chapter 2 for more information). 

Don't keep a credit card that charges you an annual fee, especially if you pay your balance in full each month.  Many no-fee credit cards exist — and some even offer you a benefit for using them:

    Discover Card (phone 800-347-2683; website [`www.discover.com`](http://www.discover.com)) rebates up to 1 percent of purchases in cash. 

  Armed Forces Benefit Association (AFBA) (phone 800-776-2265; website `www.afba.com`) offers no-fee cards that accumulate points toward rewards such as airline tickets, merchandise, gift cards, or cash back. 

  USAA Federal Savings (phone 800-922-9092; website `www.usaa.com`) offers no-fee cards for members of the military and their immediate relatives. 

Consider the cards in the preceding list only if you pay your balance in full each month, because no-fee cards typically don't offer the lowest interest rates for balances carried month-to-month.  The small rewards that you earn really won't do you much good if they're negated by interest charges. 

  If you have a credit card that charges an annual fee, try calling the company and saying that you want to cancel the card because you can get a competitor's card without an annual fee.  Many banks will agree to waive the fee on the spot.  Some require you to call back yearly to cancel the fee — a hassle that can be avoided by getting a true no-fee card. 

Some cards that charge an annual fee and offer credits toward the purchase of a specific item, such as a car or airline ticket, may be worth your while if you pay your bill in full each month and charge $10,000 or more annually.  Note: Be careful — you may be tempted to charge more on a card that rewards you for more purchases.  Spending more in order to rack up bonuses defeats the purpose of the credits. 

Indulging responsibly in fun and recreation

Having fun and taking time out for R and R can be money well spent.  But when it comes to fun and recreation, financial extravagance can wreck an otherwise good budget. 

Looking at low-cost entertainment

If you adjust your plans and expectations, entertainment doesn't have to cost a great deal of money.  Many movies, theaters, museums, and restaurants offer discount prices on certain days and/or at certain times. 

Cultivate some interests and hobbies that are free or low-cost.  Visiting with friends, hiking, reading, and playing sports can be good for your finances as well as your health. 

Vacationing for less

  For many people, vacations are a luxury.  For others, regular vacations are essential parts of their routine.  Regardless of how you recharge your batteries, remember that vacations aren't investments, so you shouldn't borrow through credit cards to finance your travels.  After all, how relaxed will you feel when you have to pay all those bills? 

Try taking shorter vacations that are closer to home.  Have you been to a state or national park recently?  Great places that you've always wanted to see but haven't visited for one reason or another are probably located within 200 miles of you.  Or you may want to just block out some time and do what family pets do: Relax around your home and enjoy some naps. 

If you do travel a long way to a popular destination, travel during the off-season for the best deals on airfares and hotels.  Keep an eye out for discounts and "bought-but-unable-to-use" tickets advertised in your local paper.  The Consumer Reports Travel newsletter and numerous websites, such as `www.priceline.com`, `www.expedia.com`, and `www.travelocity.com` can help you find low-cost travel options as well.  Senior citizens generally qualify for special fares at most airlines — ask the airline what programs it offers. 

Also, be sure to shop around, even when working with a travel agent.  Travel agents work on commission, so they may not work hard to find you the best deals.  Tour packages, when they meet your interests and needs, can also save you money.  If you have flexible travel plans, courier services can cut your travel costs significantly (but make sure that the company is reputable). 

Using thrift with gifts

Think about how you approach buying gifts throughout the year — especially during the holidays.  I know people who spend so much on their credit cards during the year-end holidays that it takes them until late spring or summer to pay their debts off!  Some people forget their thrifty shopping habits when gift-buying, perhaps because they don't like to feel cheap when buying a gift.  As with other purchases you make, paying careful attention to where and what you buy can save you significant dollars.  Don't make the mistake of equating the value of a gift with its dollar cost. 

Although I don't want to deny your loved ones gifts from the heart — or deny you the pleasure of giving them — spend wisely.  Homemade gifts are less costly to the giver and may be dearer to recipients.  Many children actually love durable, classic, basic toys.  If the TV commercials dictate your kids' desires, it may be time to toss the TV or set better rules for what the kids are allowed to watch.  Use TiVo or similar DVR services to record desired shows so you can zap through the ubiquitous commercials. 

And here's a good suggestion for getting rid of those old, unwanted gifts: One of the most entertaining holiday parties I've ever attended involved a white elephant gift exchange: Everyone brought a wrapped, unwanted gift from the past and exchanged it with someone else.  After the gifts were opened, trading was allowed. ( Just be sure not to bring a gift that was given to you by any of the exchange participants!)  Can't be bothered with this?  Consider donating unwanted items for a tax write-off if you itemize on Schedule A — see Chapter 7. 

Lowering your phone bills

Thanks to increased competition and technology, telephoning costs continue to fall.  If you haven't looked for lower rates in recent years, you're probably paying more than you need to for quality phone service.  Unfortunately, shopping among the many service providers is difficult.  Plans come with different restrictions, minimums, and bells and whistles. 

  You may have to switch companies to reduce your bill, but I find that many people can save significantly with their current phone company simply by getting onto a better calling plan.  So before you spend hours shopping around, contact your current local and long distance providers and ask them which of their calling plans offer the lowest cost for you based on the patterns of your calls. 

Cellphones are ubiquitous.  And although being able to make calls from wherever you are can be enormously convenient, you can spend a lot of money for service given the myriad of extra charges.  On the other hand, if you're able to take advantage of the free minutes many plans offer (on weekends, for example), a good cellphone service can save you money. 

The primary reason that some parents elect to provide a cellphone to their teenage children is for safety reasons and the ability to call home for a ride and so on.  Thus, you don't need all the costly bells and whistles.  A cellphone need only be set up to place and receive calls. 

In addition to downloads, text messaging, web surfing, and other services, kids (and adults) can find all sorts of entertaining ways to run up huge cellphone bills each month.  Also, I hear a lot of complaints from parents about kids talking or texting too much and going over their minute allowances, racking up large extra-usage charges. 

To deal with going over the minute allowance, you have a few options:

  Examine family plan options that don't limit minutes so strictly.  Shop around and make sure you sign up with the best calling plan and carrier given your typical usage.  Reputable carriers let you test out their services.  They also offer full refunds if you're not satisfied after a week or two of service. 

  Set and enforce limits.  If you provide a cellphone to a child, keep in mind that kids don't need to talk for hours. 

  Check out prepaid or no-contract plans.  Costs start as low as 10 cents per minute for calls, and you pay only for what you use.  If you typically use a few hundred minutes per month or less, you can save money with one of these plans.  Look at companies like Consumer Cellular or TracFone. 

Technology: Spending wisely

Americans today have e-mail, cellphones, iPhones, voice mail, BlackBerries, satellite TV, the Internet, and too many other ways to stay in touch and entertained 24/7.  Visit a store that sells electronics, and you'll find no end to new gadgets. 

Cellphones and kids can be a dangerous mix

Everywhere you look these days it seems as if every teen (and just as often, every adult) has a cellphone.  Cellphones are a great way for parents to keep in contact with their children, especially in emergencies.  Along with cellphones come important safety issues when teens get caught up in using cellphones.  Keep the following in mind:

  A number of studies have raised concerns about the impact of repeated cellphone usage on the brain and the possible linkage between brain tumors and usage of cellphones held near the side of one's head.  Getting teens who talk on the phone a lot to use earpieces connected to the cellphone is easier said than done. 

  A second health concern with cellphone usage is the common occurrence of older teens operating their phones while driving.  Horrible accidents have happened not only with teens fiddling with their phones while placing and receiving calls but also while typing out text messages.  Increasing numbers of states have implemented laws requiring cellphone users to have hands-free devices and have laws banning texting while driving. 

Although I enjoy choices and convenience as much as the next person, I also see the detrimental impact these technologies have on people's lives.  As it is, most families struggle to find quality time together given their work obligations, long school days, and various other activities.  At home, all these technology choices and options compete for attention and often pull families apart.  The cost for all these services and gadgets adds up, leading to continued enslavement to your career.  Err on the side of keeping your life simple.  Doing so costs less, reduces stress, and allows more time for the things that really do matter in life. 

  The worst way to shop for electronics and technology-based products is to wander around stores selling lots of these goods while a salesperson pitches you things.  These folks are trained in what buttons to push to get you to whip out your Visa card and be on your way with things you don't know how you ever could've lived without.  Educate yourself (check out Consumer Reports and CNET's website at `www.cnet.com`) and determine what you really need instead of going to a store and being seduced by a salesperson. 

Curtailing personal care costs

You have to take care of yourself, but as with anything else, you can find ways to do it that are expensive, and you can find ways that save you money.  Try this money-saving advice:

    Hair care: Going bald is one way to save money in this category.  I'm working on this one myself.  In the meantime, if you have hair to be trimmed, a number of no-frills, low-cost, hair-cutting joints can do the job.  Supercuts is one of the larger hair-care chains.  You may insist that your stylist is the only one who can manage your hair the way you like it.  At the prices charged by some of the trendy hair places, you have to really adore what they do to justify the cost.  Consider going periodically to a no-frills stylist for maintenance after getting a fabulous cut at a more expensive place.  If you're daring, you can try getting your hair cut at a local training school. 

For parents of young children, buying a simple-to-use home haircutting electric shaver (such as Wahl's) can be a great time- and money-saver — no more agonizing trips with little ones to have their hair cut by a "stranger."  The kit pays for itself after just two haircuts! 

  Other personal-care services: As long as I'm on the subject of outward beauty, I have to say that, in my personal opinion, the billions spent annually on cosmetics are largely a waste of money (not to mention all the wasted time spent applying and removing them).  Women look fine without makeup. ( In most cases, they look better.)  And having regular facials, pedicures, and manicures can add up quickly. 

  Health club expenses: Money spent on exercise is almost always money well spent.  But you don't have to belong to a trendy club to receive the benefits of exercise.  Local schools, colleges, and universities often have tennis courts, running tracks, swimming pools, basketball courts, and exercise rooms, and they may provide instruction as well.  Community centers offer fitness programs and classes, too.  Metropolitan areas that have lots of health clubs undoubtedly have the widest range of options and prices.  Note: When figuring the cost of membership, be sure to factor in the cost of travel to and from the club, as well as any parking costs (and the realistic likelihood of going there regularly to work out). 

Don't forget that healthy exercise can be done indoors or out, free of charge.  Isn't hiking in the park more fun than pedaling away on a stationary bike, anyway?  You may want to buy some basic gym equipment for use at home.  Be careful, though: Lots of rowing machines and weights languish in a closet after their first week at home. 

Paring down professional expenses

Accountants, lawyers, and financial advisors can be worth their expense if they're good.  But be wary of professionals who create or perpetuate work and have conflicts of interest with their recommendations. 

Make sure that you get organized before meeting with professionals for tax, legal, or financial advice.  Do some background research to evaluate their strengths and biases.  Set goals and estimate fees in advance so you know what you're getting yourself into. 

Computer and printed resources (see Chapters 19 and 20) can be useful, low-cost alternatives and supplements to hiring professionals. 

Managing medical expenses

The cost of healthcare is going up fast.  Your health insurance — if you have health insurance, that is — probably covers most of your healthcare needs. ( Chapter 16 explains how to shop for health insurance.)  But many plans require you to pay for certain expenses out of your own pocket. 

  Medical care and supplies are like any other services and products — prices and quality vary.  And medicine in the United States, like any other profession, is a business.  A conflict of interest exists whenever the person recommending treatment benefits financially from providing that treatment.  Many studies have documented some of the unnecessary surgeries and medical procedures that have resulted from this conflict of interest. 

Remember to shop around when seeking health insurance.  Don't take any one physician's advice as gospel.  Always get a second opinion for any major surgery.  Most health insurance plans, out of economic self-interest, require a second opinion, anyway. 

Therapy can be useful and even lifesaving.  Have a frank talk with your therapist about how much total time and money you can expect to spend and what kind of results you can expect to receive.  As with any professional service, a competent therapist gives you a straight answer if he's looking out for your psychological and financial well-being. 

  Alternative medicine (holistic, for example) is gaining attention because of its focus on preventive care and the treatment of the whole body or person.  Although alternative medicine can be dangerous if you're in critical condition, alternative treatment for many forms of chronic pain or disease may be worth investigating.  Alternative medicine may lead to better and lower-cost healthcare. 

  If you have to take certain drugs on an ongoing basis and pay for them out-of-pocket, ordering through a mail-order company can bring down your costs and help make refilling your prescriptions more convenient.  Ask your health plan provider for more information about this option. 

Examine your employer's benefit plans.  Take advantage of being able to put away a portion of your income before taxes to pay for out-of-pocket healthcare expenses.  Make sure that you pay close attention to the "use it or lose it" provisions of each plan. ( Uncover more about health savings accounts in Chapter 16.) 

Eliminating costly addictions

Human beings are creatures of habit.  Everybody has habits they wish they didn't have, and breaking those habits can be very difficult.  Costly habits are the worst.  The following tidbits may nudge you in the right direction toward breaking your own financially-draining habits. 

    Kick the smoking habit.  Check with local hospitals for smoking-cessation programs.  The American Lung Association (check your local phone directory) also offers Freedom from Smoking clinics around the country.  The National Cancer Institute (phone 800-422-6237 or 800-4CANCER; website [`www.cancer.gov/`](http://www.cancer.gov/)) and the Office on Smoking and Health at the Centers for Disease Control (phone 800-784-8669 or 800-QUIT NOW; website [`www.cdc.gov/tobacco/osh/`](http://www.cdc.gov/tobacco/osh/)) offer free information online and in guides that contain effective methods for stopping smoking. 

  Stop abusing alcohol and other drugs.  The National Clearinghouse for Alcohol and Drug Information (phone 800-729-6686) can refer you to local treatment programs such as Alcoholics Anonymous.  It also provides pamphlets and other literature about the various types of substance abuse.  The National Substance Abuse Information and Treatment Hotline (phone 800-662-4357 or 800-662-HELP) can refer you to local drug treatment programs.  It provides literature as well. 

  Don't gamble.  The house always comes out ahead in the long run.  Why do you think so many governments run lotteries?  Because governments make money on people who gamble, that's why.  Casinos, horse and dog racetracks, and other gambling establishments are sure long-term losers for you.  So, too, is the short-term trading of stocks, which isn't investing but gambling.  Getting hooked on the dream of winning is easy.  And sure, occasionally you win a little bit (just enough to keep you coming back).  Every now and then, a few folks win a lot.  But your hard-earned capital mostly winds up in the pockets of the casino owners. 

If you gamble just for entertainment, take only what you can afford to lose.  Gamblers Anonymous (phone 213-386-8789; website `www.gamblers``anonymous.org`) helps those for whom gambling has become an addiction. 

Keeping an eye on insurance premiums

Insurance is a vast minefield.  In Part IV, I explain the different types of coverage, suggest what to buy and avoid, and detail how to save on policies.  The following list explains the most common ways people waste money on insurance:

    Keeping low deductibles.  The deductible is the amount of a loss that must come out of your pocket.  For example, if you have an auto insurance policy with a $100 collision deductible and you get into an accident, you pay for the first $100 of damage, and your insurance company picks up the rest.  Low deductibles, however, translate into much higher premiums for you.  In the long run, you save money with a higher deductible, even when factoring in the potential for greater out-of-pocket costs to you when you do have a claim.  Insurance should protect you from economic disaster.  Don't get carried away with a really high deductible, which can cause financial hardship if you have a claim and lack savings. 

If you have a lot of claims, you won't come out ahead with lower deductibles, because your insurance premiums will escalate.  Plus, low deductibles mean more claim forms to file for small losses (creating more hassle).  Filing an insurance claim usually isn't an enjoyable or quick experience. 

  Covering small potential losses.  You shouldn't buy insurance for anything that won't be a financial catastrophe if you have to pay for it out of your own pocket.  Although the postal service isn't perfect, insuring inexpensive gifts sent in the mail isn't worth the price.  Buying dental or home warranty plans, which also cover relatively small potential expenditures, doesn't make financial sense for the same reason.  And if no one's dependent on your income, you don't need life insurance either. ( Who will be around to collect when you're gone?) 

  Failing to shop around.  Rates vary tremendously from insurer to insurer.  In Part IV, I recommend the best companies to call for quotes and other cost-saving strategies. 

Trimming your taxes

Taxes are probably one of your largest — if not the largest — expenditures. ( So why is it last here?  Read on to find out.) 

Retirement savings plans are one of the best and simplest ways to reduce your tax burden. ( I explain more about retirement savings plans in Chapter 11.)  Unfortunately, most people can't take full advantage of these plans because they spend everything they make.  So not only do they have less savings, but they also pay higher income taxes — a double whammy. 

I've attended many presentations where a fast-talking investment guy in an expensive suit lectures about the importance of saving for retirement and explains how to invest your savings.  Yet details and tips about finding the money to save (the hard part for most people) are left to the imagination. 

  In order to take advantage of the tax savings that come through retirement savings plans, you must first spend less than you earn.  Only then can you afford to contribute to these plans.  That's why the majority of this chapter is about strategies to reduce your spending. 

Reduced sales tax is another benefit of spending less and saving more.  When you buy most consumer products, you pay sales tax.  Therefore, when you spend less money and save more in retirement accounts, you reduce your income and sales taxes. ( See Chapter 7 for detailed tax-reduction strategies.) 
Chapter 7

Trimming Your Taxes

In This Chapter

  Getting the lowdown on taxes and tax rates

  Lowering your employment and investment income taxes

  Tapping into education tax breaks

  Finding helpful tax resources

  Making an audit as painless as possible

You pay a lot of money in taxes — probably more than you realize.  Few people know just how much they pay in taxes each year.  Most people remember whether they received a refund or owed money on their return.  But when you file your tax return, all you're doing is settling up with tax authorities over the amount of taxes you paid during the year versus the total tax that you owe based on your income and deductions. 

Understanding the Taxes You Pay

Some people feel lucky when they get a refund, but all a refund really indicates is that you overpaid in taxes during the year.  You should have had this money in your own account all along.  If you're consistently getting big refunds, you need to pay less tax throughout the year. ( Fill out a W-4 to determine how much you should be paying in taxes throughout the year.  You can obtain a W-4 through your employer's payroll department.  If you're self-employed, you can obtain Form 1040-ES by calling the IRS at 800-TAX-FORM 800-829-3676] or visiting its website at [`www.irs.gov`.  The IRS website also has a helpful withholding calculator at `www.irs.gov/individuals/article/0,,id=96196,00.html`.) 

  Instead of focusing on whether you're going to get a refund when you complete your annual tax return, concentrate on the total taxes you pay, which I discuss in the following section. 

Focusing on your total taxes

To find out the total taxes you pay, you need to get out your federal and state tax returns.  On each of those returns is a line that shows the total tax you owed for the year: This is Line 61 on the most recent federal 1040 returns.  If you add up the totals from your federal and state tax returns, you'll probably see one of your largest expenses. 

The goal of this chapter is to help you legally and permanently reduce your total taxes.  Understanding the tax system is the key to reducing your tax burden — if you don't, you'll surely pay more taxes than necessary.  Your tax ignorance can lead to mistakes, which can be costly if the IRS and state government catch your underpayment errors.  With the proliferation of computerized information and data tracking, discovering mistakes has never been easier. 

The tax system, like other public policy, is built around incentives to encourage desirable behavior and activity.  For example, saving for retirement is considered desirable because it encourages people to prepare for a time in their lives when they may be less able or interested in working so much and when they may have additional healthcare expenses.  Therefore, the government offers all sorts of tax perks, which I discuss later in this chapter, to encourage people to save in retirement accounts. 

Not all people follow the path the government encourages — after all, it's a free country.  However, the fewer desirable activities you engage in, the more you pay in taxes.  If you understand the options, you can choose the ones that meet your needs as you approach different stages of your financial life. 

Recognizing the importance of your marginal tax rate

When it comes to taxes, not all income is treated equally.  This fact is far from self-evident.  If you work for an employer and earn a constant salary during the course of a year, a steady and equal amount of federal and state taxes is deducted from each paycheck.  Thus, it appears as though all that earned income is being taxed equally. 

In reality, however, you pay less tax on your first dollars of earnings and more tax on your last dollars of earnings.  For example, if you're single and your taxable income (see the next section) totals $45,000 during 2012, you pay federal tax at the rate of 10 percent on the first $8,700 of taxable income, 15 percent on income between $8,700 and $35,350, and 25 percent on income from $35,350 up to $45,000. 

Table 7-1 gives federal tax rates for singles and married households filing jointly. 

Table 7-1 2012 Federal Income Tax Brackets and Rates

Singles Taxable Income | Married-Filing-Jointly Taxable Income | Federal Tax Rate (Bracket)

---|---|---

$0–$8,700 | $0–$17,400 | 10%

$8,700–$35,350 | $17,400–$70,700 | 15%

$35,350–$85,650 | $70,700–$142,700 | 25%

$85,650–$178,650 | $142,700–$217,450 | 28%

$178,650–$388,350 | $217,450–$388,350 | 33%

More than $388,350 | More than $388,350 | 35%

  Your marginal tax rate is the rate of tax you pay on your last, or so-called highest, dollars of income.  In the example of a single person with taxable income of $45,000, that person's federal marginal tax rate is 25 percent.  In other words, she effectively pays 25-percent federal tax on her last dollars of income — those dollars in excess of $35,350. 

Marginal tax rates are a powerful concept.  Your marginal tax rate allows you to quickly calculate the additional taxes you'd have to pay on additional income.  Conversely, you can enjoy quantifying the amount of taxes you save by reducing your taxable income, either by decreasing your income or by increasing your deductions. 

As you're probably already painfully aware, you pay not only federal income taxes but also state income taxes — that is, unless you live in one of the handful of states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming) that have no state income tax.  Note: Some states, such as New Hampshire and Tennessee, don't tax employment income but do tax other income, such as investment income. 

Your total marginal rate includes your federal and state tax rates (not to mention local income tax rates in the municipalities that have them). 

  You can look up your state tax rate in your current state income tax preparation booklet. 

Defining taxable income

Taxable income is the amount of income on which you actually pay income taxes. ( In the sections that follow, I explain strategies for reducing your taxable income.)  The following reasons explain why you don't pay taxes on your total income:

  Not all income is taxable.  For example, you pay federal tax on the interest you earn on a bank savings account but not on the interest you earn from municipal bonds.  As I discuss later in this chapter, some income, such as from stock dividends and long-term capital gains, is taxed at lower rates. 

  You get to subtract deductions from your income.  Some deductions are available just for being a living, breathing human being.  In 2012, single people get an automatic $5,950 standard deduction, and married couples filing jointly get $11,900. ( People over age 65 and those who are blind get a slightly higher deduction.)  Other expenses, such as mortgage interest and property taxes, are deductible in the event that these so-called itemized deductions exceed the standard deductions.  When you contribute to qualified retirement plans, you also effectively get a deduction. 

Being mindful of the second tax system: Alternative minimum tax

You may find this hard to believe, but a second tax system actually exists (as if the first tax system weren't already complicated enough).  This second system may raise your taxes even higher than they would normally be. 

Over the years, as the government grew hungry for more revenue, taxpayers who slashed their taxes by claiming lots of deductions or exclusions from taxable income came under greater scrutiny.  So the government created a second tax system — the alternative minimum tax (AMT) — to ensure that those with high deductions or exclusions pay at least a certain percentage of taxes on their incomes. 

  If you have a lot of deductions or exclusions from state income taxes, real-estate taxes, certain types of mortgage interest, and passive investments (for example, rental real estate), you may fall prey to AMT.  You may also get tripped up by AMT if you exercise certain types of stock options or if you have a high amount of capital gains relative to your other ordinary income. 

AMT restricts you from claiming certain deductions and requires you to add back in income that is normally tax-free (like certain municipal-bond interest).  So you have to figure your tax under the AMT system and under the other system and then pay whichever amount is higher. 

Watching for tax reform

In the aftermath of the 2012 Presidential and Congressional elections, there is likely to be some significant tax reform unless control of Congress remains divided.  There has been much talk and discussion of tax reform, but the two political parties can't reach agreement. 

Republicans generally don't want anyone's tax rates to increase and they demand that the federal budget deficit be reduced through spending cuts and by fostering faster economic growth through tax policy that encourages investment.  Democrats, meanwhile, prefer raising taxes on the highest income earners while doing more minimal spending cuts. ( Please visit my website, `www.erictyson.com`, for updates on important pending tax law changes.) 

Trimming Employment Income Taxes

You're supposed to pay taxes on income you earn from work.  Countless illegal ways are available to reduce your employment income — for example, not reporting it — but if you use them, you can very well end up paying a heap of penalties and extra interest charges on top of the taxes you owe.  And you may even get tossed in jail.  Because I don't want you to serve jail time or lose even more money by paying unnecessary penalties and interest, this section focuses on the legal ways to reduce your taxes. 

Contributing to retirement plans

A retirement plan is one of the few relatively painless and authorized ways to reduce your taxable employment income.  Besides reducing your taxes, retirement plans help you build up a nest egg so that you don't have to work for the rest of your life. 

You can exclude money from your taxable income by tucking it away in employer-based retirement plans, such as 401(k) or 403(b) accounts, or self-employed retirement plans, such as SEP-IRAs or Keoghs.  If your combined federal and state marginal tax rate is, say, 33 percent and you contribute $1,000 to one of these plans, you reduce your federal and state taxes by $330.  Do you like the sound of that?  How about this: Contribute another $1,000, and your taxes drop another $330 (as long as you're still in the same marginal tax rate).  And when your money is inside a retirement account, it can compound and grow without taxation. 

  Many people miss this great opportunity to reduce their taxes because they spend all (or too much) of their current employment income and, therefore, have nothing (or little) left to put into a retirement account.  If you're in this predicament, you need to reduce your spending before you can contribute money to a retirement plan. ( Chapter 6 explains how to decrease your spending.) 

If your employer doesn't offer the option of saving money through a retirement plan, lobby the benefits and human resources departments.  If they resist, you may want to add this to your list of reasons for considering another employer.  Many employers offer this valuable benefit, but some don't.  Some company decision-makers either don't understand the value of these accounts or feel that they're too costly to set up and administer. 

If your employer doesn't offer a retirement savings plan, individual retirement account (IRA) contributions may or may not be tax-deductible, depending on your circumstances.  You should first maximize contributions to the previously mentioned tax-deductible accounts.  Chapter 11 can help you determine whether you should contribute to an IRA, what type you should contribute to, and whether your IRA contributions are tax-deductible. 

  Married couples filing jointly with adjusted gross incomes (AGIs) of less than $57,500 and single taxpayers with an AGI of less than $28,750 can earn a new tax credit (claimed on Form 8880) for retirement account contributions. ( For info on how the AGI is calculated, see "Deducting miscellaneous expenses.")  Unlike a deduction, a tax credit directly reduces your tax bill by the amount of the credit.  This credit, which is detailed in Table 7-2, is a percentage of the first $2,000 contributed (or $4,000 on a joint return).  The credit is not available to those under the age of 18, full-time students, or people who are claimed as dependents on someone else's tax return. 

Table 7-2 Special Tax Credit for Retirement Plan Contributions

Singles Adjusted Gross Income | Married-Filing-Jointly Adjusted Gross Income | Tax Credit for Retirement Account Contributions

---|---|---

$0–$17,250 | $0–$34,500 | 50%

$17,250–$18,750 | $34,500­–$37,500 | 20%

$18,750–$28,750 | $37,500–$57,500 | 10%

Shifting some income

  Income shifting, which has nothing to do with money laundering, is a more esoteric tax-reduction technique that's an option only to those who can control when they receive their income. 

For example, suppose your employer tells you in late December that you're eligible for a bonus.  You're offered the option to receive your bonus in either December or January.  If you're pretty certain that you'll be in a higher tax bracket next year, you should choose to receive your bonus in December. 

Or, suppose you run your own business and you think that you'll be in a lower tax bracket next year.  Perhaps you plan to take time off to be with a newborn or take an extended trip.  You can send out some invoices later in the year so that your customers won't pay you until January, which falls in the next tax year. 

Increasing Your Deductions

Deductions are amounts you subtract from your adjusted gross income before calculating the tax you owe.  To make things more complicated, the IRS gives you two methods for determining your total deductions.  The good news is that you get to pick the method that leads to greater deductions — and hence, lower taxes.  This section explains your options. 

Choosing standard or itemized deductions

The first method for figuring deductions requires no thinking or calculating.  If you have a relatively uncomplicated financial life, taking the so-called standard deduction is generally the better option. 

Single folks qualify for a $5,950 standard deduction, and married couples filing jointly get an $11,900 standard deduction in 2012.  If you're 65 or older, or blind, you get a slightly higher standard deduction. 

Itemizing your deductions on your tax return is the other method for determining your allowable deductions.  This method is definitely more of a hassle, but if you can tally up more than the standard amounts noted in the preceding section, itemizing will save you money.  Use Schedule A of IRS Form 1040 to sum up your itemized deductions. 

  Even if you take the standard deduction, take the time to peruse all the line items on Schedule A to familiarize yourself with the many legal itemized deductions.  Figure out what's possible to deduct so you can make more-informed financial decisions year-round. 

Organizing your deductions

Locating Form 1098 and all the other scraps of paper you need when completing your tax return can be a hassle.  Setting up a filing system can be a big timesaver:

  Folder or shoe box: If you have a simple financial life (that is, you haven't saved receipts throughout the year), you can confine your filing to January and February.  During those months, you receive tax summary statements on wages paid by your employer (Form W-2), investment income (Form 1099), and home mortgage interest (Form 1098) in the mail.  Label the shoe box or folder with something easy to remember ("2012 Taxes" is a logical choice) and dump these papers and your tax booklet into it.  When you're ready to crunch numbers, you'll have everything you need to complete the form. 

  Accordion-type file: Organizing the bills you pay into individual folders during the entire year is a more thorough approach.  This method is essential if you own your own business and need to tabulate your expenditures for office supplies each year.  No one is going to send you a form totaling your office expenditures for the year — you're on your own. 

  Software: Software programs can help organize your tax information during the year and save you time and accounting fees come tax-preparation time.  See Chapter 19 for more information about tax and financial software. 

The following sections explain commonly overlooked deductions and deduction strategies.  Some are listed on Schedule A, and others appear on Form 1040. 

Shifting or bunching deductions

When you total your itemized deductions on Schedule A and the sum is lower than the standard deduction, you should take the standard deduction.  This total is worth checking each year, because you may have more deductions in some years, and itemizing may make sense. 

Because you can control when you pay particular expenses that are eligible for itemizing, you can shift or bunch more of them into the select years where you have enough deductions to take advantage of itemizing.  Suppose, for example, that you're using the standard deduction this year because you don't have many itemized deductions.  Late in the year, though, you become certain that you're going to buy a home next year.  With mortgage interest and property taxes to write off, you also know that you can itemize next year.  If you typically make more charitable contributions in December because of the barrage of solicitations you receive when you're in the giving mood, you may want to write the checks in January rather than in December. 

  When you're sure that you're not going to have enough deductions in the current year to itemize, try to shift as many expenses as you can into the next tax year. 

Purchasing real estate

When you buy a home, you can claim two big ongoing expenses of home ownership as deductions on Schedule A: your property taxes and the interest on your mortgage.  You're allowed to claim mortgage interest deductions for a primary residence (where you actually live) and on a second home for mortgage debt totaling $1 million (and a home equity loan of up to $100,000).  There's no limit on property tax deductions. 

In order to buy real estate, you need to first collect a down payment, which requires maintaining a lid on your spending.  See Part I for help with prioritizing and achieving important financial goals.  Check out Chapter 14 for more on investing in real estate. 

Trading consumer debt for mortgage debt

When you own real estate, you haven't borrowed the maximum, and you've run up high-interest consumer debt, you may be able to trade one debt for another.  You may be able to save on interest charges by refinancing your mortgage or taking out a home equity loan and pulling out extra cash to pay off your credit card, auto loan, or other costly credit lines.  You can usually borrow at a lower interest rate for a mortgage and get a tax deduction as a bonus, which lowers the effective borrowing cost further.  Consumer debt, such as that on auto loans and credit cards, isn't tax-deductible. 

  This strategy involves some danger.  Borrowing against the equity in your home can be an addictive habit.  I've seen cases where people run up significant consumer debt three or four times and then refinance their home the same number of times over the years to bail themselves out. 

An appreciating home creates the illusion that excess spending isn't really costing you.  But debt is debt, and all borrowed money has to be repaid.  In the long run, you wind up with greater mortgage debt, and paying it off takes a bigger bite out of your monthly income.  Refinancing and establishing home equity lines cost you more in terms of loan application fees and other charges (points, appraisals, credit reports, and so on). 

At a minimum, the continued expansion of your mortgage debt handicaps your ability to work toward other financial goals.  In the worst case, easy access to borrowing encourages bad spending habits that can lead to bankruptcy or foreclosure on your debt-ridden home. 

Contributing to charities

You can deduct contributions to charities if you itemize your deductions.  Consider the following possibilities:

  Most people know that when they write a check for $50 to their favorite church or college, they can deduct it.  Note: Make sure that you get a receipt for contributions of $250 or more. 

  Many taxpayers overlook the fact that you can deduct expenses for work you do with charitable organizations.  For example, when you go to a soup kitchen to help prepare and serve meals, you can deduct your transportation costs.  Keep track of your driving mileage and other commuting expenses. 

  You can deduct the fair market value (which can be determined by looking at the price of similar merchandise in thrift stores) of donations of clothing, household appliances, furniture, and other goods to charities. ( Some charities will drive to your home to pick up the stuff.)  Find out whether organizations such as the Salvation Army, Goodwill, or others are interested in your donation.  Just make sure that you keep some documentation — write up an itemized list and get it signed by the charity.  Take pictures of your more valuable donations. 

  You can even donate securities and other investments to charity.  In fact, donating an appreciated investment gives you a tax deduction for the full market value of the investment and eliminates your need to pay tax on the (unrealized) profit. 

Remembering auto registration fees and state insurance

  If you don't currently itemize, you may be surprised to discover that your state income taxes can be itemized.  When you pay a fee to the state to register and license your car, you can itemize a portion of the expenditure as a deduction (on Schedule A, Line 7, "Personal Property Taxes").  The IRS allows you to deduct the part of the fee that relates to the value of your car.  The state organization that collects the fee should be able to tell you what portion of the fee is deductible. ( Some states detail on the invoice what portion of the fee is tax-deductible.) 

Several states have state disability insurance funds.  If you pay into these funds (check your W-2), you can deduct your payments as state and local income taxes on Line 5 of Schedule A. You may also claim a deduction on this line for payments you make into your state's unemployment compensation fund. 

Deducting miscellaneous expenses

  A number of so-called miscellaneous expenses are deductible on Schedule A. Most of these expenses relate to your job or career and the management of your finances:

  Educational expenses: You may be able to deduct the cost of tuition, books, and travel to and from classes if your education is related to your career.  Specifically, you can deduct these expenses if your course work improves your work skills.  Courses required by law or your employer to maintain your position are deductible.  Continuing education classes for professionals may also be deductible.  Note: Educational expenses that lead to your moving into a new field or career are not deductible. 

  Job searches and career counseling: After you obtain your first job, you may deduct legitimate costs related to finding another job within your field.  You can even deduct the cost of courses and trips for new job interviews — even if you don't change jobs.  And if you hire a career counselor to help you, you can deduct that cost as well. 

  Expenses related to your job that aren't reimbursed: When you pay for your own subscriptions to trade journals to keep up with your field or buy a new desk and chair to ease back pain, you can deduct these costs.  If your job requires you to wear special clothes or a uniform (for example, you're an EMT), you can write off the cost of purchasing and cleaning these clothes, as long as they aren't suitable for wearing outside of work.  When you buy a computer for use outside the office at your own expense, you may be able to deduct the cost if the computer is for the convenience of your employer, is a condition of your employment, and is used more than half the time for business.  Union dues and membership fees for professional organizations are also deductible. 

  Investment and tax-related expenses: Investment and tax-advisor fees are deductible when paid from taxable accounts (although fees associated with tax-exempt investments, such as municipal bonds, are not), as are subscription costs for investment-related publications.  Accounting fees for preparing your tax return or conducting tax planning during the year are deductible; legal fees related to your taxes are also deductible.  If you purchase a home computer to track your investments or prepare your taxes, you can deduct that expense, too. 

When you deduct miscellaneous expenses, you get to deduct only the amount that exceeds 2 percent of your AGI (adjusted gross income).  AGI is your total wage, interest, dividend, and all other income minus retirement account contributions, self-employed health insurance, alimony paid, and losses from investments. 

Deducting self-employment expenses

  When you're self-employed, you can deduct a multitude of expenses from your income before calculating the tax you owe.  If you buy a computer or office furniture, you can deduct those expenses. ( Sometimes they need to be gradually deducted, or depreciated, over time.)  Salaries for your employees, office supplies, rent or mortgage interest for your office space, and phone/communications expenses are also generally deductible. 

Many self-employed folks don't take all the deductions they're eligible for.  In some cases, people simply aren't aware of the wonderful world of deductions.  Others are worried that large deductions will increase the risk of an audit.  Spend some time finding out more about tax deductions; you'll be convinced that taking full advantage of your eligible deductions makes sense and saves you money. 

The following are common mistakes made by people who are their own bosses:

  Being an island unto yourself.  When you're self-employed, going it alone is usually a mistake when it comes to taxes.  You must educate yourself to make the tax laws work for rather than against you.  Hiring tax help is well worth your while. ( See "Professional hired help," later in this chapter, for information on hiring tax advisors.) 

  Making administrative tax screwups.  As a self-employed individual, you're responsible for the correct and timely filing of all taxes owed on your income and employment taxes on your employees.  You need to make estimated tax payments on a quarterly basis.  And if you have employees, you also need to withhold taxes from each paycheck they receive and make timely payments to the IRS and the appropriate state authorities.  In addition to federal and state income tax, you also need to withhold and send in Social Security and any other state or locally mandated payroll taxes. 

To pay taxes on your income, use Form 1040-ES.  This form, along with instructions, can be obtained from the IRS (phone 800-829-3676 or go online to `www.irs.gov`).  The form comes complete with an estimated tax worksheet and the four payment coupons you need to send in with your quarterly tax payments.  If you want to find the rules for withholding and submitting taxes from employees' paychecks, ask the IRS for Form 941 and Form 940, which is for unemployment insurance.  And unless you're lucky enough to live in a state with no income taxes, you need to call for your state's estimated income tax package.  Another alternative is to hire a payroll firm, such as Paychex, to do all this drudgery for you.  Scrutinize and negotiate the expenses. 

  Failing to document expenses.  When you pay with cash, following the paper trail for all the money you spent can be hard for you to do (and for the IRS, in the event you're ever audited).  At the end of the year, how are you going to remember how much you spent for parking or client meals if you fail to keep a record?  How will you survive an IRS audit without proper documentation? 

  Debit cards are accepted most places and provide a convenient paper trail. ( Be careful about getting a debit card in your business's name, because some banks don't offer protection against fraudulent use of business debit cards.)  Otherwise, you need a system or written record of your daily petty cash purchases.  Most pocket calendars or daily organizers include ledgers that allow you to track these small purchases.  If you aren't that organized, at least get receipts for cash transactions and write on each receipt what the purchase was for.  Then stash the receipts in a file folder in your desk or keep the receipts in envelopes labeled with the month and year. 

  Failing to fund a retirement plan.  You should be saving money toward retirement anyway, and you can't beat the tax break.  People who are self-employed are allowed to save a substantial portion of their net income on an annual basis.  To find out more about SEP-IRAs, Keoghs, and other retirement plans, see Chapter 11. 

  Failing to use numbers to help manage business.  If you're a small-business owner who doesn't track her income, expenses, staff performance, and customer data on a regular basis, your tax return may be the one and only time during the year when you take a financial snapshot of your business.  After you go through all the time, trouble, and expense to file your tax return, make sure you reap the rewards of all your work; use those numbers to help analyze and manage your business. 

  Some bookkeepers and tax preparers can provide you with management information reports on your business from the tax data they compile for you.  Just ask!  See "Software and websites," later in this chapter, for my recommendations. 

  Failing to pay family help.  If your children, spouse, or other relatives help with some aspect of your business, consider paying them for the work.  Besides showing them that you value their work, this practice may reduce your family's tax liability.  For example, children are usually in a lower tax bracket.  By shifting some of your income to family members, you not only cut your tax bill, but can also make them eligible for attractive savings options like IRAs. 

Reducing Investment Income Taxes

The distributions and profits on investments that you hold outside of tax-sheltered retirement accounts are exposed to taxation when you receive them.  Interest, dividends, and capital gains (profits from the sale of an investment at a price that's higher than the purchase price) are all taxed. 

Although this section explains some of the best methods for reducing the taxes on investments exposed to taxation, Chapter 12 discusses how and where to invest money held outside of tax-sheltered retirement accounts such as IRAs and 401(k) plans. 

Investing in tax-free money- market funds and bonds

When you're in a high enough tax bracket, you may find that you come out ahead with tax-free investments.  Tax-free investments pay investment income, which is exempt from federal tax, state tax, or both. ( See Part III for details.) 

Tax-free investments normally yield less than comparable investments that produce taxable income.  But because of the difference in taxes, the earnings from tax-free investments can end up being greater than what you're left with from taxable investments. 

Tax-free money-market funds can be a better alternative to bank savings accounts (where interest is subject to taxation).  Likewise, tax-free bonds are intended to be longer-term investments that pay tax-free interest, so they may be a better investment option for you than bank certificates of deposit, Treasury bills and bonds, and other investments that produce taxable income. ( See Chapter 12 for specifics on which tax-free investments may be right for your situation.) 

Selecting other tax-friendly investments

Too often, when selecting investments, people mistakenly focus on past rates of return.  Everyone knows that the past is no guarantee of the future.  But choosing an investment with a reportedly high rate of return without considering tax consequences is an even worse mistake.  What you get to keep — after taxes — is what matters in the long run. 

For example, when comparing two similar funds, most people prefer a fund that averages returns of 14 percent per year to one that earns 12 percent per year.  But what if the 14-percent-per-year fund, because of greater taxable distributions, causes you to pay a lot more in taxes?  What if, after factoring in taxes, the 14-percent-per-year fund nets just 9 percent, while the 12-percent-per-year fund nets an effective 10-percent return?  In such a case, you'd be unwise to choose a fund solely on the basis of the higher (pre-tax) reported rate of return. 

I call investments that appreciate in value and don't distribute much in the way of highly taxed income tax-friendly. ( Some in the investment business use the term tax-efficient.)  See Chapter 10 for more information on tax-friendly stocks and stock mutual funds. 

Real estate is one of the few areas with privileged status in the tax code.  In addition to deductions allowed for mortgage interest and property taxes, you can depreciate rental property to reduce your taxable income.  Depreciation is a special tax deduction allowed for the gradual wear and tear on rental real estate.  When you sell investment real estate, you may be eligible to conduct a tax-free exchange into a replacement rental property.  See Chapter 14 for a crash course in real estate. 

Making your profits long-term

As I discuss in Part III, when you buy growth investments such as stocks and real estate, you should do so for the long-term — ideally ten or more years.  The tax system rewards your patience with lower tax rates on your profits. 

  When you're able to hold on to an investment (outside of a retirement account) such as a stock, bond, or mutual fund for more than one year, you get a tax break if you sell that investment at a profit.  Specifically, your profit is taxed under the lower capital gains tax rate schedule.  If you're in the 25-percent-or-higher federal income tax bracket, you pay just 15 percent of your long-term capital gains' profit in federal taxes. ( The same lower tax rate applies to stock dividends.)  If you're in the 10- or 15-percent federal income tax brackets, the long-term capital gains tax rate is 0 percent. 

In 2013, higher income taxpayers (with total taxable income above $200,000 for singles; $250,000 for marrieds filing jointly), will be subject to a 3.8-percent-higher tax on their investment income (for example, interest, dividends, and capital gains) to help pay for Obamacare.  The Bush tax cuts are also set to expire then, causing the current 15-percent tax rate on long-term capital gains for higher income investors to increase back to 20 percent.  This increase combined with the new 3.8-percent tax from the health care bill produces a top long-term capital gains rate of nearly 24 percent — a significant increase from the current 15-percent level.  Stay tuned because the outcome of the 2012 elections will have a major impact on what happens in this area. 

Does funding retirement accounts still make sense? 

Historically, taking advantage of opportunities to direct money into retirement accounts gives you two possible tax benefits.  First, your contributions to the retirement account may be immediately tax-deductible (see Chapter 11 for details).  Second, the returns on the investments in the retirement accounts aren't generally taxed until withdrawal. 

In the preceding section, I mention a tax break for long-term capital gains and on stock dividends.  This break, unfortunately, applies only to investments held outside of retirement accounts.  If you realize a long-term capital gain or receive stock dividends inside a retirement account, those investment returns are taxed, upon withdrawal, at the relatively higher ordinary income tax rates.  Thus, some people argue that you shouldn't fund retirement accounts.  In most cases, the people making those arguments have a vested interest. 

One good reason not to fund a retirement account is having a specific goal, such as saving to purchase a home or start a business, that necessitates having access to your money.  Not funding a retirement account may make sense in only two atypical situations:

  You're temporarily in a very low tax bracket.  This circumstance can come about if, for example, you lose your job for an extended period of time or are in school.  In these cases, you're unlikely to have lots of spare money to contribute to a retirement account anyway!  If you have some employment income, consider the Roth IRA (see Chapter 11). 

  You have too much money socked away already.  If you have a large net worth inside retirement accounts, which could get hit by estate taxes (see Chapter 17), continuing to fund your retirement may be counterproductive. 

Enlisting Education Tax Breaks

The government offers plenty of tax reduction opportunities for those with educational expenses.  Knowing that you don't want to read the dreadful tax code, here's a summary of key provisions you should know about for yourself and your kids if you have them:

  Tax deductions for college expenses: You may take up to a $4,000 tax deduction on IRS Form 1040 for college costs as long as your modified adjusted gross income (AGI) is less than or equal to $65,000 for single taxpayers and $130,000 for married couples filing jointly. ( Note: You may take a $2,000 tax deduction if your AGI is between $65,000 and $80,000 for single taxpayers and between $130,000 and $160,000 for married couples filing jointly.) 

  Tax-free investment earnings in special accounts: Money invested in Education Savings Accounts (ESAs) and in Section 529 plans is sheltered from taxation and is not taxed upon withdrawal as long as the money is used to pay for eligible education expenses.  Subject to eligibility requirements, you may contribute up to $2,000 annually to ESAs; 529 plans allow you to sock away $200,000+.  Please be aware, however, that funding such accounts may harm your potential financial aid.  See Chapter 13 for details on these accounts. 

  Tax credits: The American Opportunity (AO) credit and Lifetime Learning (LL) credit provide tax relief to low- and moderate-income earners facing education costs.  The AO credit may be up to $2,500 per student per year of undergraduate education, while the LL credit may be up to $2,000 per taxpayer.  Each student may take only one of these credits per tax year, and they are subject to income limitations.  And in a year in which a credit is taken, you may neither withdraw money from an ESA or 529 plan nor take a tax deduction for your college expenses. 

Please be sure to read Chapter 13 for the best ways and strategies to pay for educational expenses. 

Getting Help from Tax Resources

There are all sorts of ways to prepare your tax return.  Which approach makes sense for you depends on the complexity of your situation and your knowledge of taxes. 

Regardless of which approach you use, you should be taking financial steps during the year to reduce your taxes.  By the time you actually file your return in the following year, it's often too late for you to take advantage of many tax-reduction strategies. 

Obtaining IRS assistance

If you have a simple, straightforward tax return, filing it on your own using only the IRS instructions is fine.  This approach is as cheap as you can get.  The main costs are time, patience, photocopying expenses (you should always keep a copy for your files), and postage for mailing the completed tax return. 

  IRS publications don't have Tip or Warning icons.  And the IRS has been known to give wrong information from time to time.  When you call the IRS with a question, be sure to take notes about your conversation to protect yourself in the event of an audit.  Date your notes and include the name and identification number of the tax employee you talked to, the questions you asked, and the employee's responses.  File your notes in a folder with a copy of your completed return. 

  In addition to the standard instructions that come with your tax return, the IRS offers some free (actually, paid for with your tax dollars) and sometimes useful booklets.  Publication 17, Your Federal Income Tax, is designed for individual tax-return preparation.  Publication 334, Tax Guide for Small Businesses, is for (you guessed it) small-business tax-return preparation.  These publications are more comprehensive than the basic IRS instructions.  Call 800-829-3676 to request these booklets or visit the IRS website at `www.irs.gov`. 

Consulting preparation and advice guides

  Books about tax preparation and tax planning that highlight common problem areas and are written in clear, simple English are invaluable.  They supplement the official instructions not only by helping you complete your return correctly but also by showing you how to save as much money as possible. 

Utilizing software and websites

  If you have access to a computer, good tax-preparation software can be helpful.  TaxCut and TurboTax are programs that I have reviewed and rated as the best.  If you go the software route, I highly recommend having a good tax advice book by your side. 

For you web surfers, the Internal Revenue Service website (`www.irs.gov`) is among the better Internet tax sites, believe it or not. 

Hiring professional help

Competent tax preparers and advisors can save you money — sometimes more than enough to pay their fees — by identifying tax-reduction strategies you may overlook.  They can also help reduce the likelihood of an audit, which can be triggered by blunders.  Mediocre and lousy tax preparers, on the other hand, may make mistakes and be unaware of sound ways to reduce your tax bill. 

Tax practitioners come with varying backgrounds, training, and credentials.  The four main types of tax practitioners are preparers, enrolled agents (EAs), certified public accountants (CPAs), and tax attorneys.  The more training and specialization a tax practitioner has (and the more affluent her clients), the higher her hourly fee usually is.  Fees and competence vary greatly.  If you hire a tax advisor and you're not sure of the quality of the work performed or the soundness of the advice, try getting a second opinion. 

Preparers

Preparers generally have the least amount of training of all the tax practitioners, and a greater proportion of them work part-time.  As with financial planners, no national regulations apply to preparers, and no licensing is required. 

Preparers are appealing because they're relatively inexpensive — they can do most basic returns for around $100 or so.  The drawback of using a preparer is that you may hire someone who doesn't know much more than you do. 

  Preparers make the most sense for folks who have relatively simple financial lives, who are budget-minded, and who hate doing their own taxes.  If you're not good about hanging on to receipts or you don't want to keep your own files with background details about your taxes, you should definitely shop around for a tax preparer who's committed to the business.  You may need all that stuff someday for an audit, and many tax preparers keep and organize their clients' documentation rather than return everything each year.  Also, going with a firm that's open year-round may be a safer option (some small shops are open only during tax season) in case tax questions or problems arise. 

Enrolled agents (EAs)

A person must pass IRS scrutiny in order to be called an enrolled agent.  This license allows the agent to represent you before the IRS in the event of an audit.  Continuing education is also required; an EA's training is generally longer and more sophisticated than that of a typical preparer. 

Enrolled agents' fees tend to fall between those of a preparer and a CPA (see the next section).  Returns that require a few of the more common schedules (such as Schedule A for deductions and Schedule D for capital gains and losses) shouldn't cost more than $200 to $300 to prepare. 

  EAs are best for people who have moderately complex returns and don't necessarily need complicated tax-planning advice throughout the year (although some EAs provide this service as well).  You can get names and telephone numbers of EAs in your area by contacting the National Association of Enrolled Agents (NAEA).  You can call the NAEA at 202-822-6232 or visit its website at `www.naea.org`. 

Certified public accountants (CPAs)

Certified public accountants go through significant training and examination before receiving the CPA credential.  In order to maintain this designation, a CPA must also complete a fair number of continuing education classes every year. 

CPA fees vary tremendously.  Most charge $100+ per hour, but CPAs at large companies and in high-cost-of-living areas tend to charge somewhat more. 

  If you're self-employed and/or you file lots of other schedules, you may want to hire a CPA.  But you don't need to do so year after year.  If your situation grows complex one year and then stabilizes, consider getting help for the perplexing year and then using preparation guides, software, or a lower-cost preparer or enrolled agent in the future. 

Tax attorneys

Tax attorneys deal with complicated tax problems and issues that usually have some legal angle.  Unless you're a super-high-income earner with a complex financial life, hiring a tax attorney to prepare your annual return is prohibitively expensive.  In fact, many tax attorneys don't prepare returns, but they may offer tax preparation as an ancillary service through others in their office. 

Because of their level of specialization and training, tax attorneys tend to have the highest hourly billing rates — $200 to $300+ per hour is not unusual. 

Dealing with an Audit

On a list of real-life nightmares, most people would rank tax audits right up there with root canals, rectal exams, and court appearances.  Many people are traumatized by audits because they feel like they're on trial and being accused of a crime.  Take a deep breath and don't panic. 

You may be getting audited simply because someone at the IRS or a business that reports tax information on you made an error regarding the data on your return.  In the vast majority of cases, the IRS conducts its audit by corresponding with you through the mail. 

Audits that require you to schlep to the local IRS office are the most feared type of audit.  In these cases, about 20 percent of such audited returns are left unchanged by the audit — in other words, the taxpayer doesn't end up owing more money.  In fact, if you're the lucky sort, you may be one of the 5 percent of folks who actually gets a refund because the audit finds a mistake in your favor! 

Unfortunately, you'll most likely be one of the roughly 75 percent of audit survivors who end up owing more tax money.  The amount of additional tax that you owe in interest and penalties hinges on how your audit goes. 

Getting your act together

Preparing for an audit is sort of like preparing for a test at school.  The IRS lets you know which sections of your tax return it wants to examine. 

The first decision you face when you get an audit notice is whether to handle it yourself or hire a tax advisor to represent you.  Hiring representation may help you save time, stress, and money. 

  If you normally prepare your own return and you're comfortable with your understanding of the areas being audited, handle the audit yourself.  When the amount of tax money in question is small compared to the fee you'd pay the tax advisor to represent you, self-representation is probably your best option.  However, if you're likely to turn into a babbling, intimidated fool and you're unsure of how to present your situation, hire a tax advisor to represent you. ( See "Hiring professional help," earlier in this chapter, for information about whom to hire.) 

If you decide to handle the audit yourself, get your act together sooner rather than later.  Don't wait until the night before to start gathering receipts and other documentation.  You may need to contact others to get copies of documents you can't find. 

You need to document and be ready to speak only about the areas the audit notice says are being investigated.  Organize the various documents and receipts into folders.  You want to make it as easy as possible for the auditor to review your materials.  Don't show up, dump shopping bags full of receipts and paperwork on the auditor's desk, and say, "Here it is — you figure it out." 

  Whatever you do, don't ignore your audit request letter.  The IRS is the ultimate bill-collection agency.  And if you end up owing more money (the unhappy result of most audits), the sooner you pay, the less interest and penalties you'll owe. 

Surviving the day of reckoning

Two people with identical situations can walk into an audit and come out with very different results.  The loser can end up owing much more in taxes and have the audit expanded to include other parts of the return.  The winner can end up owing no additional tax or even owing less. 

  Here's how to be a winner in your tax audit:

  Treat the auditor as a human being.  This advice may be obvious, but it isn't practiced by taxpayers very often.  You may be resentful or angry about being audited.  You may be tempted to gnash your teeth and tell the auditor how unfair it is that an honest taxpayer like you had to spend hours getting ready for this ordeal.  You may feel like ranting and raving about how the government wastes too much of your tax money, or how the party in power is out to get you.  Bite your tongue. 

Believe it or not, most auditors are decent people just trying to do their jobs.  They're well aware that taxpayers don't like seeing them.  Don't suck up, either — just relax and be yourself.  Behave as you would around a boss you like — with respect and congeniality. 

  Stick to the knitting.  Your audit is for discussing only the sections of your tax return that are in question.  The more you talk about other areas or things that you're doing, the more likely the auditor is to probe into other items.  Don't bring documentation for parts of your return that aren't being audited.  Besides creating more work for yourself, you may be opening up a can of worms that doesn't need to be opened.  Should the auditor inquire about areas that aren't covered by the audit notice, politely say that you're not prepared to discuss those other issues and that another meeting should be scheduled. 

  Don't argue when you disagree.  State your case.  When the auditor wants to disallow a deduction or otherwise increase the taxes you owe and you disagree, state once why you don't agree with her assessment.  If the auditor won't budge, don't get into a knock-down, drag-out confrontation.  She may not want to lose face and is inclined to find additional tax money — that's the auditor's job. 

  When necessary, you can plead your case with several people who work above your auditor.  If this method fails and you still feel wronged, you can take your case to tax court. 

  Don't be intimidated.  Most auditors are not tax geniuses.  The work is stressful — being in a job where people dislike seeing you isn't easy.  Turnover is quite high.  Thus, many auditors are fairly young, just-out-of-school types who majored in something like English, history, or sociology.  They may know less about tax and financial matters than you do.  The basic IRS tax boot camp that auditors go through doesn't come close to covering all the technical details and nuances in the tax code.  So you may not be at such a disadvantage in your tax knowledge after all, especially if you work with a tax advisor (most tax advisors know more about the tax system than the average IRS auditor). 
Part III

Building Wealth through Investing

In this part . . . 

I lay out the principles of investing and show you how to choose your investments wisely.  Earning and saving are hard work, so you need to be careful where you invest the fruits of your labor.  This part is where you find out the real story about stocks, bonds, and mutual funds; the differences between investing in retirement and nonretirement accounts; how to invest for college; and how to buy a home and invest in other real estate. 
Chapter 8

Considering Important Investment Concepts

In This Chapter

  Determining your investment goals

  Evaluating returns and risks

  Keeping your eggs in more than one basket: Asset allocation

  Distinguishing the best investment firms from the rest

Making wise investments need not be complicated.  However, many investors get bogged down in the morass of the thousands of investment choices out there and the often-conflicting perspectives on how to invest.  This chapter helps you grasp the important "bigger picture" issues that can help you ensure that your investment plan meshes with your needs and the realities of the investment marketplace. 

Establishing Your Goals

  Before you select a specific investment, first determine your investment needs and goals.  Why are you saving money — what are you going to use it for?  You don't need to earmark every dollar, but you should set some major objectives.  Establishing objectives is important because the expected use of the money helps you determine how long to invest it.  And that, in turn, helps you determine which investments to choose. 

The risk level of your investments should factor in your time frame and your comfort level.  Investing in high-risk vehicles doesn't make sense if you'll need to spend the funds within the next few years or if you'll have to spend all your profits on stress-induced medical bills.  For example, suppose you've been accumulating money for a down payment on a home you want to buy in a few years.  You can't afford much risk with that money because you're going to need it sooner rather than later.  Putting that money in the stock market, then, is foolish.  As I discuss later in this chapter, the stock market can drop a lot in a year or over several years.  So stocks are probably too risky a place to invest money you plan to use soon. 

Perhaps you're saving toward a longer-term goal, such as retirement, that's 20 or 30 years away.  In this case, you're in a position to make riskier investments, because your holdings have more time to bounce back from temporary losses or setbacks.  You may want to consider investing in growth investments, such as stocks, within a retirement account that you leave alone for 20 years or longer.  You can tolerate year-to-year volatility in the market — you have time on your side.  If you haven't yet done so, take a tour through Chapter 4, which helps you contemplate and set your financial goals. 

Understanding the Primary Investments

For a moment, forget all the buzzwords, jargon, and product names you've heard tossed around in the investment world — in many cases, they're only meant to obscure what an investment really is and to hide the hefty fees and commissions. 

Imagine a world with only two investment flavors — think of chocolate and vanilla ice cream (or low-fat frozen yogurt for you health-minded folks).  The investment world is really just as simple.  You have only two major investment choices: You can be a lender or an owner. 

Looking at lending investments

You're a lender when you invest your money in a bank certificate of deposit (CD), a treasury bill, or a bond issued by a company like Exxon Mobil, for example.  In each case, you lend your money to an organization — a bank, the federal government, or Exxon Mobil.  You're paid an agreed-upon rate of interest for lending your money.  The organization also promises to have your original investment (the principal) returned to you on a specific date. 

Getting paid all the interest in addition to your original investment (as promised) is the best that can happen with a lending investment.  Given that the investment landscape is littered with carcasses of failed investments, this is not a result to take for granted. 

The worst that can happen with a lending investment is that you don't get everything you're promised.  Promises can be broken under extenuating circumstances.  When a company goes bankrupt, for example, you can lose all or part of your original investment. 

  Another risk associated with lending investments is that even if you get what you were promised, the ravages of inflation may reduce the purchasing power of your money.  Also, the value of a bond may drop below what you paid for it if interest rates rise or the quality/risk of the issuing company declines. 

Table 8-1 shows the reduction in the purchasing power of your money at varying rates of inflation after just ten years. 

Table 8-1 Reduction in Purchasing Power Due to Inflation

Inflation Rate | Reduction in Purchasing Power after Ten Years

---|---

6 percent | –44 percent

8 percent | –54 percent

10 percent | –61 percent

Some investors make the common mistake of thinking that they're diversifying their long-term investment money by buying several bonds, some CDs, and an annuity.  The problem, however, is that all these investments pay a relatively low fixed rate of return that's exposed to the vagaries of inflation. 

  A final drawback to lending investments is that you don't share in the success of the organization to which you lend your money.  If the company doubles or triples in size and profits, your principal and interest rate don't double or triple in size along with it; they stay the same.  Of course, such success does ensure that you'll get your promised interest and principal. 

Exploring ownership investments

You're an owner when you invest your money in an asset, such as a company or real estate, that has the ability to generate earnings or profits.  Suppose that you own 100 shares of Verizon Communications stock.  With billions of shares of stock outstanding, Verizon is a mighty big company — your 100 shares represent a tiny piece of it.  What do you get for your small slice of Verizon?  As a stockholder, although you don't get free calling, you do share in the profits of the company in the form of annual dividends and an increase (you hope) in the stock price if the company grows and becomes more profitable.  Of course, you receive these benefits if things are going well.  If Verizon's business declines, your stock may be worth less (or even worthless!). 

Real estate is another one of my favorite financially rewarding and time-honored ownership investments.  Real estate can produce profits when it's rented out for more than the expense of owning the property or sold at a price higher than what you paid for it.  I know numerous successful real-estate investors (myself included) who have earned excellent long-term profits. 

The value of real estate depends not only on the particulars of the individual property but also on the health and performance of the local economy.  When companies in the community are growing and more jobs are being produced at higher wages, real estate often does well.  When local employers are laying people off and excess housing is sitting vacant because of previous overbuilding, rent and property values fall, as they did in the late 2000s. 

Finally, many Americans have also built substantial wealth through small business.  According to Forbes magazine, more of the United States' (and the world's) wealthiest individuals have built their wealth through their stake in small businesses than through any other vehicle.  Small business is the engine that drives much of the country's economic growth.  You can participate in small business in a variety of ways.  You can start your own business, buy and operate an existing business, or simply invest in promising small businesses.  In the chapters ahead, I explain each of these major investment types in detail. 

Shunning Gambling Instruments and Behaviors

Although investing is often risky, it's not gambling.  Gambling is putting your money into schemes that are sure to lose you money over time.  That's not to say that everyone loses or that you lose every time you gamble.  However, the deck is stacked against you.  The house wins most of the time. 

  Horse-racing tracks, gambling casinos, and lotteries are set up to pay out 50 to 60 cents on the dollar.  The rest goes to profits and covering the costs of those businesses — don't forget that these are businesses.  Sure, your chosen horse may win a race or two, but in the long run, you're almost guaranteed to lose about 40 to 50 percent of what you bet.  Would you put your money in an "investment" where your expected return was negative 40 percent? 

Forsaking futures, options, and other derivatives

Futures, options, and commodity futures are derivatives, or financial investments whose value is derived from the performance of another security, such as a stock or bond. 

Suppose you hear a radio ad from the firm Fleecem, Cheatem, and Leavem advocating that you buy heating oil futures because of conflicts in the Middle East and the upcoming rise in heating oil usage due to the cold-weather months.  You call the firm and are impressed by the smooth-talking vice president.  His logic makes sense, and he spends a lot of time with little ol' you, so you send him a check for $10,000. 

Buying futures isn't much different from blowing $10,000 at the craps tables in Las Vegas.  Futures prices depend on short-term, highly volatile price movements.  As with gambling, you occasionally win when the market moves the right way at the right time.  But in the long run, you're gonna lose.  In fact, you can lose it all. 

Options are as risky as futures.  With options, you're betting on the short-term movements of a specific security.  If you have inside information (such as knowing in advance when a major corporate development is going to occur), you can get rich.  But insider trading is illegal and will land you in jail. 

Honest brokers who help their clients invest in stocks, bonds, and mutual funds tell them the truth about commodities, futures, and options.  A former broker I know who worked for various major brokerage firms for 12 years told me, "I had just one client who made money in options, futures, or commodities, but the only reason he came out ahead was because he was forced to pull money out to close on a home purchase just when he happened to be ahead.  The commissions were great for me, but there's no way a customer will make money in them."  Remember these words if you're tempted to gamble with futures, options, and the like. 

Futures and options are not always used for speculation and gambling.  Some sophisticated professional investors use them to hedge, or actually reduce the risk of, their broad investment holdings.  When futures and options are used in this fashion, things don't often work out the way that the pros hoped.  You, the individual investor, should steer clear of futures and options. 

Ditching day trading

  Day trading — which is the rapid buying and selling of securities online — is a newer and equally foolish vehicle for individual investors to pursue.  This is speculation and gambling, not investing.  Placing trades via the Internet is far cheaper than the older methods of trading (such as telephoning a broker), but the more you trade, the more trading costs eat into your investment capital. 

Frequent trading also increases your tax bill as profits realized over short periods of time are taxed at your highest possible tax rate (see Chapter 7).  You can certainly make some profits when day trading.  However, over an extended period of time, you'll inevitably underperform the broad market averages.  In those rare instances where you may do a little better than the market averages, the profits are rarely worth the time and personal sacrifices that you, your family, and your friendships endure. 

Understanding Investment Returns

The previous sections describe the difference between ownership and lending investments, and they help you distinguish gambling and speculation from investing. " That's all well and good," you say, "but how do I choose which type of investments to put my money into?  How much can I make, and what are the risks?" 

Good questions.  I'll start with the returns you might make.  I say "might" because I'm looking at history, and history is a record of the past.  Using history to predict the future — especially the near future — is dangerous.  History may repeat itself, but not always in exactly the same fashion and not necessarily when you expect it to. 

During this past century, ownership investments such as stocks and investment real estate returned around 9 percent per year, handily beating lending investments such as bonds (around 5 percent) and savings accounts (roughly 4 percent) in the investment performance race.  Inflation has averaged 3 percent per year. 

If you already know that the stock market can be risky, you may be wondering why investing in stocks is worth the anxiety and potential losses.  Why bother for a few extra percent per year?  Well, over many years, a few extra percent per year can really magnify the growth of your money (see Table 8-2).  The more years you have to invest, the greater the difference a few percent makes in your returns. 

Table 8-2 The Difference a Few Percent Makes

At This Rate of Return on $10,000 Invested | You'll Have This Much in 25 Years | You'll Have This Much in 40 Years

---|---|---

4% (savings account) | $26,658 | $48,010

5% (bond) | $33,863 | $70,400

9% (stocks and investment real estate) | $86,231 | $314,094

  Investing is not a spectator sport.  You can't earn good returns on stocks and real estate if you keep your money in cash on the sidelines.  If you invest in growth investments such as stocks and real estate, don't chase one new investment after another trying to beat the market average returns.  The biggest value comes from being in the market, not from beating it. 

Sizing Investment Risks

Many investors have a simplistic understanding of what risk means and how to apply it to their investment decisions.  For example, when compared to the yo-yo motions of the stock market, a bank savings account may seem like a less risky place to put your money.  Over the long term, however, the stock market usually beats the rate of inflation, while the interest rate on a savings account does not, especially when factoring in taxes.  Thus, if you're saving your money for a long-term goal like retirement, a savings account can be a "riskier" place to put your money. 

  Before you invest, ask yourself these questions:

  What am I saving and investing this money for?  In other words, what's my goal? 

  What is my timeline for this investment?  When will I use this money? 

  What is the historical volatility of the investment I'm considering?  Does that suit my comfort level and timeline for this investment? 

After you answer these questions, you'll have a better understanding of risk and you'll be able to match your savings goals to their most appropriate investment vehicles.  In Chapter 4, I help you consider your savings goals and timeline.  I address investment risk and returns in the sections that follow. 

Comparing the risks of stocks and bonds

Given the relatively higher historic returns I mention for ownership investments in the previous section, some people think that they should put all their money in stocks and real estate.  So what's the catch? 

  The risk with ownership investments is the short-term fluctuations in their value.  During the last century, stocks declined, on average, by more than 10 percent once every five years.  Drops in stock prices of more than 20 percent occurred, on average, once every ten years.  Real-estate prices suffer similar periodic setbacks. 

Therefore, in order to earn those generous long-term returns from ownership investments like stocks and real estate, you must be willing to tolerate volatility.  You absolutely should not put all your money in the stock or real-estate market.  Investing your emergency money or money you expect to use within the next five years in such volatile investments is not a good idea. 

The shorter the time period that you have for holding your money in an investment, the less likely growth-oriented investments like stocks are to beat out lending-type investments like bonds.  Table 8-3 illustrates the historical relationship between stock and bond returns based on number of years held. 

Table 8-3 Stocks versus Bonds

Number of Years Investment Held | Likelihood of Stocks Beating Bonds

---|---

1 | 60%

5 | 70%

10 | 80%

20 | 91%

30 | 99%

Some types of bonds have higher yields than others, but the risk-reward relationship remains intact (see Chapter 9 for more on bonds).  A bond generally pays you a higher rate of interest when it has a

  Lower credit rating: To compensate for the higher risk of default and the higher likelihood of losing your investment

  Longer-term maturity: To compensate for the risk that you'll be unhappy with the bond's set interest rate if the market level of interest rates moves up

Focusing on the risks you can control

I always asked students in my personal finance class that I used to teach at the University of California to write down what they'd like to learn.  Here's what one student had to say: "I want to learn what to invest my money in now, as the stock market is overvalued and interest rates are about to go up, so bonds are dicey and banks give lousy interest — HELP!" 

This student recognized the risk of price fluctuations in her investments, but she also seemed to believe, like too many people, that you can predict what's going to happen.  How did she know that the stock market was overvalued, and why hadn't the rest of the world figured it out?  How did she know that interest rates were about to go up, and why hadn't the rest of the world figured that out, either? 

  When you invest in stocks and other growth-oriented investments, you must accept the volatility of these investments.  That said, you can take several actions, which I discuss in this chapter and the remainder of Part III, to greatly reduce your risk when investing in these higher potential return investments.  Invest the money that you have earmarked for the longer term in these vehicles.  Minimize the risk of these investments through diversification.  Don't buy just one or two stocks; buy a number of stocks.  Later in this chapter, I discuss what you need to know about diversification. 

Discovering low-risk, high- return investments

Despite what professors teach in the nation's leading business and finance graduate-school programs, low-risk investments that almost certainly lead to high returns are available.  I can think of at least four such investments:

    Paying off consumer debt.  If you're paying 10-, 14-, or 18-percent interest or more on an outstanding credit card or other consumer loan, pay it off before investing.  To get a comparable return through other investment vehicles (after the government takes its share of your profits), you'd have to start a new career as a loan shark.  If, between federal and state taxes, you're in a 33-percent tax bracket and you're paying 14-percent interest on consumer debt, you need to annually earn a whopping pretax return of 21 percent on your investments to justify not paying off the debt.  Good luck! 

When your only source of funds for paying off debt is a small emergency reserve equal to a few months' living expenses, paying off your debt may involve some risk.  Tap into your emergency reserves only if you have a backup source — for example, the ability to borrow from a willing family member or against a retirement account balance. 

  Investing in your health.  Eat healthy, exercise, and relax. 

  Investing in friends and family.  Invest time and effort in improving your relationships with loved ones. 

  Investing in personal and career development.  Pick up a new hobby, improve your communication skills, or read widely.  Take an adult education course or go back to school for a degree.  Your investment will most likely lead to greater happiness and perhaps even higher paychecks. 

Diversifying Your Investments

Diversification is one of the most powerful investment concepts.  It refers to saving your eggs (or investments) in different baskets.  Diversification requires you to place your money in different investments with returns that are not completely correlated, which is a fancy way of saying that when some of your investments are down in value, odds are that others are up in value. 

  To decrease the chances of all your investments getting clobbered at the same time, you must put your money in different types of investments, such as bonds, stocks, real estate, and small business. ( I cover all these investments and more in Chapter 9.)  You can further diversify your investments by investing in domestic as well as international markets. 

Within a given class of investments, such as stocks, investing in different types of that class (such as different types of stocks) that perform well under various economic conditions is important.  For this reason, mutual funds, which are diversified portfolios of securities such as stocks or bonds, are a highly useful investment vehicle.  When you buy into a mutual fund, your money is pooled with the money of many others and invested in a vast array of stocks or bonds. 

You can look at the benefits of diversification in two ways:

  Diversification reduces the volatility in the value of your whole portfolio.  In other words, your portfolio can achieve the same rate of return that a single investment can provide with less fluctuation in value. 

  Diversification allows you to obtain a higher rate of return for a given level of risk. 

Keep in mind that no one, no matter whom he works for or what credentials he has, can guarantee returns on an investment.  You can do good research and get lucky, but no one is free from the risk of losing money.  Diversification allows you to hedge the risk of your investments.  See Figures 8-1, 8-2, and 8-3 to get an idea of how diversifying can reduce your risk. ( The figures in these charts are adjusted for inflation.)  Notice that different investments did better during different economic environments and time periods. 

**Figure 8-1:** Value of $10,000 invested from 1928 to 1937. 

**Figure 8-2:** Value of $10,000 invested from 1947 to 1956. 

**Figure 8-3:** Value of $10,000 invested from 1972 to 1980. 

Recent decades have shown fluctuations as well.  In the 1990s, stocks appreciated greatly, and bonds did pretty well, too, while gold and silver did poorly.  In the 2000s, stocks treaded water (except those in emerging markets) while bonds and precious metals did well.  Because the future can't be predicted, diversifying your money into different investments is safer. 

Spreading the wealth: Asset allocation

Asset allocation refers to how you spread your investing dollars among different investment options (stocks, bonds, money-market accounts, and so on).  Before you can intelligently decide how to allocate your assets, you need to ponder a number of issues, including your present financial situation, your goals and priorities, and the pros and cons of various investment options. 

Although stocks and real estate offer attractive long-term returns, they can sometimes suffer significant declines.  Thus, these investments are not suitable for money that you think you may want or need to use within, say, the next five years. 

  Money-market and shorter-term bond investments are good places to keep money that you expect to use soon.  Everyone should have a reserve of money — about three to six months' worth of living expenses in a money-market fund — that's accessible in an emergency.  Shorter-term bonds or bond mutual funds can serve as a higher-yielding, secondary emergency cushion. ( Refer to Chapter 4 for more on emergency reserves.) 

  Bonds can also be useful for some longer-term investing for diversification purposes.  For example, when investing for retirement, placing a portion of your money in bonds helps buffer stock market declines.  The remaining chapters in Part III detail your various investment options and explain how to select those that best meet your needs. 

Allocating money for the long term

Investing money for retirement is a classic long-term goal that most people have.  Your current age and the number of years until you retire are the biggest factors to consider when allocating money for long-term purposes.  The younger you are and the more years you have before retirement, the more comfortable you can afford to be with growth-oriented (and more volatile) investments, such as stocks and investment real estate. 

  One useful guideline for dividing or allocating your money between longer-term-oriented growth investments, such as stocks, and more-conservative lending investments, such as bonds, is to subtract your age from 110 (or 120 if you want to be aggressive; 100 to be more conservative) and invest the resulting percentage in stocks.  You then invest the remaining amount in bonds. 

For example, if you're 30 years old, you invest from 70 (100 – 30) to 90 (120 – 30) percent in stocks.  You invest the remaining 10 to 30 percent in bonds. 

Table 8-4 lists some guidelines for allocating long-term money based upon your age and the level of risk you desire. 

Table 8-4 Allocating Long-Term Money

Your Investment Attitude | Bond Allocation (%) | Stock Allocation (%)

---|---|---

Play it safer | = Age | = 100 – age

Middle-of-the-road | = Age – 10 | = 110 – age

Aggressive | = Age – 20 | = 120 – age

For example, if you're the conservative sort who doesn't like a lot of risk but recognizes the value of striving for some growth and making your money work harder, you're a middle-of-the-road type.  Using Table 8-4, if you're 40 years old, you may consider putting 30 percent (40 – 10) in bonds and 70 percent (110 – 40) in stocks. 

In most employer retirement plans, mutual funds are the typical investment vehicle.  If your employer's retirement plan includes more than one stock mutual fund as an option, you may want to try discerning which options are best by using the criteria I discuss in Chapter 10.  In the event that all your retirement plan's stock fund options are good, you can simply divide your stock allocation among the choices. 

  When one or more of the choices is an international stock fund, consider allocating a percentage of your stock fund money to overseas investments: at least 20 percent for play-it-safe investors, 25 to 35 percent for middle-of-the-road investors, and as much as 35 to 50 percent for aggressive investors. 

If the 40-year-old middle-of-the-roader from the previous example is investing 70 percent in stocks, about 25 to 35 percent of the stock fund investments (which works out to be about 18 to 24 percent of the total) can be invested in international stock funds. 

Historically, most employees haven't had to make their own investing decisions with retirement money.  Pension plans, in which the company directs the investments, were more common in previous years.  It's interesting to note that in a typical pension plan, companies choose to allocate the majority of money to stocks (about 60 percent), with a bit less placed in bonds (about 35 percent) and other investments.  For more information on investing in retirement accounts, see Chapter 11. 

Sticking with your allocations: Don't trade

Your goals and desire to take risk should drive the allocation of your investment dollars.  As you get older, gradually scaling back on the riskiness (and therefore growth potential) of your portfolio generally makes sense. 

Don't tinker with your portfolio daily, weekly, monthly, or even annually. ( Every two to three years or so, you may want to rebalance your holdings to get your mix to a desired asset allocation, as discussed in the preceding section.)  Don't engage in trading with the hopes of buying into a hot investment and selling your losers.  Jumping onto a "winner" and dumping a "loser" may provide some short-term psychological comfort, but in the long-term, such an investment strategy often produces below-average returns. 

  When an investment gets front-page coverage and everyone is talking about its stunning rise, it's definitely time to take a reality check.  The higher the value of an investment rises, the greater the danger that it's overpriced.  Its next move may be downward.  Don't follow the herd. 

During the late 1990s, many technology (especially Internet) stocks had spectacular rises, thus attracting a lot of attention.  However, the fact that the U.S. economy is increasingly becoming technology-based doesn't mean that any price you pay for a technology stock is fine.  Some investors who neglected to do basic research and bought into the attention-grabbing, high-flying technology stocks lost 80 percent or more of their investments in the early 2000s — ouch! 

Conversely, when things look bleak (as when stocks in general suffered significant losses in the early 2000s and then again in the late 2000s), giving up hope is easy — who wants to be associated with a loser?  However, investors who forget about their overall asset allocation plan and panic and sell after a major decline miss out on a tremendous buying opportunity. 

Many people like buying everything from clothing to cars to ketchup on sale — yet whenever the stock market has a clearance sale, most investors stampede for the exits instead of snatching up great buys.  Demonstrate your courage; don't follow the herd. 

Investing lump sums via dollar-cost averaging

When you have a large chunk of cash to invest — whether you received it from an accumulation of funds over the years, the sale of some of your investments, an inheritance, or a recent windfall from work you've done — you may have a problem deciding what to do with it.  Many people, of course, would like to have your problem. ( You're not complaining, right?)  You want to invest your money, but you're a bit skittish — if not outright terrified — at the prospect of investing the lump of money all at once. 

  If the money is residing in a savings or money-market account, you may feel like it's wasting away.  You want to put it to work!  My first words of advice are "Don't rush."  Nothing is wrong with earning a small return in a money-market account. ( See Chapter 12 for my recommendations of the best money funds.)  Remember that a money-market fund beats the heck out of rushing into an investment in which you may lose 20 percent or more.  I sometimes get calls from people in a state of near panic.  Typically, these folks have CDs coming due, and they feel that they must decide exactly where they want to invest the money in the 48 hours before the CD matures. 

Keeping your investing wits during uncertain times

During times like the early 2000s and late 2000s, some investors abandon the stock market for good.  Although some people who get burned badly discover that they're not cut out for stock investing, everybody else should take stock of their investing approaches and adjust their practices and expectations. 

In the early 2000s, the stock market began falling — with some growth stocks, especially technology stocks, plunging like stocks do in a depression.  Layoffs mounted, and September 11 undermined consumer confidence.  Then the general public found out that some major companies — Enron, WorldCom, and Global Crossing — pulled the wool over investors' eyes with shady accounting techniques that artificially inflated earnings.  Concerns about further terrorist attacks, smallpox, and war with Iraq (and perhaps other nations) hung like dark clouds on the horizon. 

In the late 2000s, a global financial crisis, brought on by risky mortgage investments made by financial service companies, captured headlines and public attention.  Major financial firms went bankrupt while others required large capital injections from the government for their survival.  Most global stock markets plunged in value by the largest amounts since the Great Depression of the 1930s.  And the wars in Iraq and Afghanistan and associated spending lingered on and depressed the public's mood, adding to a widening U.S. budget deficit. 

I see many similarities between the early 2000s and the early 1970s, when a multitude of problems (that could not have been predicted) unfolded.  The early '70s saw record trade and budget deficits and inflation rearing its ugly head, in addition to the invasion of Cambodia, the Arab oil embargo, gas lines, and that period's Arab-Israeli conflict — the Yom Kippur War.  Vice President Spiro Agnew resigned over the exposure of his personal income tax evasion and acceptance of bribes while working in Maryland's government. 

Then news of Watergate broke, and Nixon's impeachment hearings began.  After flirting with the 1,000 level since 1966, the Dow Jones Industrial Average plunged below 600 after Nixon resigned in 1974.  Many investors soured on stocks and swore off the market forever.  That reaction was unfortunate because stocks are more than 20-fold higher today than they were back at their lows in 1974 (not even accounting for their dividends). 

Don't let a poor string of events sour you on stock investing.  History has repeatedly proven that continuing to buy stocks during down markets increases your long-term returns.  Throwing in the towel is the worst thing you can do in a slumping market.  And don't waste time trying to find a way to beat the system.  Buy and hold a diversified portfolio of stocks.  Remember that the financial markets reward investors for accepting risk and uncertainty. 

  Take a deep breath.  You have absolutely no reason to rush into an important decision.  Tell your friendly banker that when the CD matures, you want to put the proceeds into the bank's highest-yielding savings or money-market account.  That way, your money continues to earn interest while you buy yourself some breathing room. 

One approach to investing is called dollar-cost averaging (DCA).  With DCA, you invest your money in equal chunks on a regular basis — such as once a month — into a diversified group of investments.  For example, if you have $60,000 to invest, you can invest $2,500 per month until it's all invested, which takes a couple years.  The money awaiting future investment isn't lying fallow; you keep it in a money-market account so it can earn a bit of interest while waiting its turn. 

The attraction of DCA is that it allows you to ease into riskier investments instead of jumping in all at once.  If the price of the investment drops after some of your initial purchases, you can buy some later at a lower price.  If you dump all your money into an investment all at once and then it drops like a stone, you'll be kicking yourself for not waiting. 

The flip side of DCA is that when your investment of choice appreciates in value, you may wish that you had invested your money faster.  Another drawback of DCA is that you may get cold feet as you continue to pour money into an investment that's dropping in value.  Many people who are attracted to DCA because they fear that they may buy before a price drop end up bailing out of what feels like a sinking ship. 

DCA can also cause headaches with your taxes when the time comes to sell investments held outside retirement accounts.  When you buy an investment at many different times and prices, the accounting becomes muddied as you sell blocks of the investment. 

  DCA is most valuable when the money you want to invest represents a large portion of your total assets and you can stick to a schedule.  Make DCA automatic so that you're less likely to chicken out if the investment falls after your initial purchases.  Most of the investment firms I recommend in the next few chapters provide automatic exchange services. 

Acknowledging Differences among Investment Firms

Thousands of firms sell investments and manage money.  Banks, mutual-fund companies, securities brokerage firms, and even insurance companies all vie for your dollars. 

Just to make matters more complicated, each industry plays in the others' backyards.  You can find mutual-fund companies that offer securities brokerage, insurance firms that are in the mutual-fund business, and mutual-fund companies that offer banklike accounts and services.  You may benefit from this competition and one-stop shopping convenience.  On the other hand, some firms are novices at particular businesses and count on folks shopping by brand-name recognition. 

Focusing on the best firms

  Make sure that you do business with a firm that

  Offers the best value investments in comparison to its competitors.  Value is the combination of performance (including service) and cost.  Given the level of risk that you're comfortable with, you want investments that offer higher rates of return, but you don't want to have to pay a small fortune for them.  Commissions, management fees, maintenance fees, and other charges can turn a high-performance investment into a mediocre or poor one. 

  Employs representatives who don't have an inherent self-interest in steering you into a particular type of investment.  This criterion has nothing to do with whether an investment firm hires polite, well-educated, or well-dressed people.  The most important factor is the way the company compensates its employees.  If the investment firm's personnel are paid on commission, pass on that firm.  Give preference to investing firms that don't tempt their employees to push one investment over another in order to generate more fees. 

No-load (commission-free) mutual-fund companies

Mutual funds are an ideal investment vehicle for most investors.  No-load mutual-fund companies are firms through which you can invest in mutual funds without paying sales commissions.  In other words, every dollar you invest goes to work in the mutual funds you choose — nothing is siphoned off to pay sales commissions.  See Chapter 10 for details on investing in mutual funds. 

Discount brokers

In one of the most beneficial changes for investors in the past century, the Securities and Exchange Commission (SEC) deregulated the retail brokerage industry on May 1, 1975.  Prior to this date, investors were charged fixed commissions when they bought or sold stocks, bonds, and other securities.  In other words, no matter which brokerage firm an investor did business with, the cost of the firm's services was set (and the level of commissions was high).  After the 1975 deregulation, brokerage firms could charge people whatever their little hearts desired. 

Competition inevitably resulted in more and better choices.  Many new brokerage firms (that didn't do business the old way) opened.  They were dubbed discount brokers because the fees they charged customers were substantially lower than what brokers charged under the old fixed-fee system. 

Even more important than saving customers money, discount brokers established a vastly improved compensation system that greatly reduced conflicts of interest.  Discount brokers generally pay the salaries of their brokers.  The term discount broker is actually not an enlightening one.  Certainly, this new breed of brokerage firm saves you lots of money when you invest; you can easily save 50 to 80 percent through the major discount brokers.  But these firms' investments are not "on sale" or "second-rate."  Discount brokers are simply brokers without major conflicts of interest.  Of course, like any other for-profit enterprise, they're in business to make money, but they're much less likely to steer you in the wrong direction for their own benefit. 

  Be wary of discount brokers selling load mutual funds. ( I discuss the reasons you should shun these brokers in Chapter 10.) 

Places to consider avoiding

The worst places to invest are those that charge you a lot, have mediocre- or poor-performing investments, and have major conflicts of interest.  The prime conflict of interest arises when investment firms pay their brokers commissions on the basis of what and how much they sell.  The result: The investment firms sell lots of stuff that pays fat commissions, and they churn, or cause a rapid turnover of, your account. ( Because each transaction has a fee, the more you buy and sell, the more money they make.) 

  Some folks who call themselves financial planners or financial consultants work on commission.  In addition to working at the bigger brokerage firms, many of them belong to so-called broker-dealer networks, which provide back-office support and investment products to sell.  When a person claiming to be a financial planner or advisor is part of a broker-dealer network, odds are quite high that you're dealing with an investment salesperson.  See Chapter 18 for more background on the financial-planning industry and questions to ask an advisor you're thinking about hiring. 

Commissions and their impact on human behavior

Investment products bring in widely varying commissions.  The products that bring in the highest commissions tend to be the ones that money-hungry brokers push the hardest. 

Table 8-5 lists the commissions that you pay — and that come out of your investment dollars — when you work with brokers, financial consultants, and financial planners who work on commission. 

Table 8-5 Investment Sales Commissions

Investment Type | Average Commission on a $20,000 Investment | Average Commission on a $100,000 Investment

---|---|---

Annuities | $1,400 | $7,000

Initial public offerings (new stock issue) | $1,000 | $5,000

Limited partnerships | $1,800 | $9,000

Load mutual funds | $1,200 | $5,000

Options and futures | $2,000+ | $10,000+

Besides the fact that you can never be sure that you're getting an unbiased recommendation from a salesperson working on commission, you're wasting money unnecessarily.  The best investments can be bought on a no-load (commission-free) basis. 

  When you're unsure about an investment product that's being pitched to you (and even when you are sure), ask for a copy of the prospectus.  In the first few pages, check out whether the investment includes a commission (also known as a load).  Although salespeople can hide behind obscure titles such as vice president or financial consultant, a prospectus must detail whether the investment carries a commission. 

Investment salespeople's conflicts of interest

Financial consultants (also known as stockbrokers), financial planners, and others who sell investment products can have enormous conflicts of interest when recommending strategies and specific investment products.  Commissions and other financial incentives can't help but skew the advice of even the most earnest and otherwise well-intentioned salespeople. 

  Numerous conflicts of interest can damage your investment portfolio.  The following are the most common conflicts to watch out for:

  Pushing higher-commission products: As I discuss earlier in this chapter, commissions on investment products vary tremendously.  Products like limited partnerships, commodities, options, and futures are at the worst end of the spectrum for you (and the best end of the spectrum for a salesperson).  Investments such as no-load mutual funds and Treasury bills that are 100-percent commission-free are at the best end of the spectrum for you (and, therefore, the worst end of the spectrum for a salesperson). 

Surprisingly, commission-based brokers and financial planners don't have to give you the prospectus (where commissions are detailed) before you buy a financial product that carries commissions (as with a load mutual fund).  In contrast, commission-free investment companies, such as no-load mutual-fund companies, must send a prospectus before taking a mutual-fund order.  Commission-based investment salespeople should also be required to provide a prospectus and disclose any commissions upfront and in writing before making a sale.  I suppose that if they were actually required to follow these guidelines, the result would be akin to politicians telling the truth — more people would choose to place their money (or their vote) elsewhere! 

  Recommending active trading: Investment salespeople often advise you to trade frequently into and out of different securities.  They usually base their advice on current news events or an analyst's comments on the security.  Sometimes these moves are valid, but more often they're not.  In extreme cases, brokers trade on a monthly basis.  By the end of the year, they've churned through your entire portfolio.  Needless to say, all these transactions cost you big money in trading fees. 

Diversified mutual funds (see Chapter 10) make more sense for most people.  You can invest in mutual funds free of sales commissions.  Besides saving money on commissions, you earn better long-term returns by having an expert money manager work for you. 

  Failing to recommend investing through retirement plans: If you're not taking advantage of retirement savings plans (see Chapter 11), you may be missing out on valuable tax benefits.  The initial contributions to most retirement plans are tax-deductible, and your money compounds without taxation over the years.  An investment salesperson is not likely to recommend that you contribute to your employer's retirement plan — a 401(k) for example.  Such contributions cut into the money you have available to invest with your friendly salesperson. 

If you're self-employed, salespeople are somewhat more likely to recommend that you fund a retirement plan because they can set up such plans for you.  You're better off setting up a retirement plan through a no-load mutual-fund company (see Chapters 10 and 11). 

  Pushing high-fee products: Many of the brokerage firms that used to sell investment products only on commission moved into fee-based investment management.  This change is an improvement for investors because it reduces some of the conflicts of interest caused by commissions. 

On the other hand, these brokers charge extraordinarily high fees, which are usually quoted as a percentage of assets under management on their managed-investment (or wrap) accounts (see the sidebar "Wrap (or managed) accounts" for more info). 

What to do when you're fleeced by a broker

You can't sue a broker just because you lose money on that person's investment recommendations.  However, if you have been the victim of one of the following cardinal financial sins, you may have some legal recourse:

  Misrepresentation and omission: If you were told, for example, that a particular investment guaranteed returns of 15 percent per year and then the investment ended up plunging in value by 50 percent, you were misled.  Misrepresentation can also be charged if you're sold an investment with hefty commissions after you were originally told that it was commission-free. 

  Unsuitable investments: Retirees who need access to their capital are often advised to invest in limited partnerships (or LPs, discussed in Chapter 9) for safe, high yields.  The yields on most LPs end up being anything but safe.  LP investors have also discovered how illiquid (or not readily converted into cash) their investments are — some can't be liquidated for up to ten years or more. 

  Churning: If your broker or financial planner is constantly trading your investments, odds are that his weekly commission check is benefiting at your expense. 

  Rogue elephant salespeople: When your planner or broker buys or sells without your approval or ignores your request to make a change, you may be able to collect for losses caused by these actions. 

Two major types of practitioners — securities lawyers and arbitration consultants — stand ready to help you recover your lost money.  You can find securities lawyers by looking under "Attorneys — Securities" in the Yellow Pages or calling your local bar association for referrals.  Arbitration consultants can be found in the phone book under "Arbitrators."  If you come up dry, try contacting business writers at a major newspaper in your area or at your favorite personal finance magazine.  These sources may be able to give you names and numbers of folks they know. 

Most lawyers and consultants work on a contingency-fee basis — they get a percentage (about 20 to 40 percent) of the amount collected.  They also often ask for an upfront fee, ranging from several hundred to several thousand dollars, to help them cover their expenses and time.  If they take your case and lose, they generally keep the upfront money.  Securities lawyers are usually a more expensive option. 

You may want to go to arbitration — in fact, you may have agreed to do just that (probably without realizing it) when you set up an account to work with the broker or planner.  Arbitration is usually much quicker, cheaper, and easier than going to court.  You can even choose to represent yourself.  Both sides present their case, typically to a panel of three arbitrators.  The arbitrators then make a decision that neither side can squabble over or appeal.  If you decide to prepare for arbitration by yourself, the nonprofit American Arbitration Association can send you a package of background materials to help with your case.  Check your phone directory for a local branch, or contact the association's headquarters (1633 Broadway, 10th Floor, New York, NY 10019; phone 212-716-5800; website `www.adr.org`). 

Valuing brokerage research

Brokerage firms and the brokers who work for them frequently argue that their research is better.  With their insights and recommendations, they say, you'll do better and "beat the market averages." 

Wall Street analysts are often overly optimistic when it comes to predicting corporate profits.  If analysts were simply inaccurate or bad estimators, you'd expect that they'd sometimes underestimate and, at other times, overestimate companies' earnings.  The discrepancy identifies yet another conflict of interest among many of the brokerage firms. 

Brokerage firm analysts are reluctant to write a negative report about a company because the firms these analysts work for also solicit companies to issue new stock to the public.  What better way to show businesses your potential for selling shares to the public at a high price than by showing how much you believe in certain companies and writing glowing reports about their future prospects? 

Seeing through Experts Who Predict the Future

Believing that you can increase your investment returns by following the prognostications of certain gurus is a common mistake that some investors make, especially during more trying and uncertain times.  Many people may want to believe that some experts can predict the future of the investment world and keep them out of harm's way.  Believing in gurus makes it easier to accept the risk you know you're taking when trying to make your money grow.  The sage predictions that you read in an investment newsletter or hear from an "expert" who is repeatedly quoted in financial publications make you feel protected — sort of like Linus and his security blanket. 

Investment newsletter subscribers and guru followers would be better off buying a warm blanket instead — it has a lot more value and costs a whole lot less!  No one can predict the future.  If they could, they'd be so busy investing their own money and getting rich that they wouldn't have the time and desire to share their secrets with you. 

Investment newsletters

Many investment newsletters purport to time the markets, telling you exactly the right time to get into and out of certain stocks or mutual funds (or the financial markets in general).  Such an approach is doomed to failure in the long run.  By failure, I mean that this approach won't beat the tried-and-true strategy of buying and holding. 

I see people paying hundreds of dollars annually to subscribe to all sorts of market-timing and stock-picking newsletters.  One client of mine, an attorney, subscribed to several newsletters.  When I asked him why, he said that their marketing materials claimed that if you followed their advice, you would make a 20-percent-per-year return on your money.  But in the four years that he'd followed their advice, he'd actually lost money, despite appreciating financial markets overall. 

Before I ever consider subscribing to any investment newsletter, I examine its historic track record through avenues such as Hulbert Financial Digest.  The investment newsletter's marketing materials typically hype the supposed returns that the publication's recommendations have produced.  Sadly, newsletters seem to be able to make lots of bogus claims without suffering the timely wrath of securities regulators. 

  Don't get predictive advice from newsletters.  If newsletter writers were so smart about the future of financial markets, they'd be making lots more money as money managers.  The only types of investment newsletters and periodicals that you should consider subscribing to are those that offer research and information rather than predictions.  I discuss the investment newsletters that fit the bill in the subsequent investment chapters.  My website, `www.erictyson.com`, provides excerpts and updates from the best newsletters to which I subscribe and read.  Also check out the "Guru Watch" section of my site in which I evaluate commonly quoted gurus. 

Investment gurus

Investment gurus come and go.  Some of them get their 15 minutes of fame on the basis of one or two successful predictions that someone in the press remembers (and makes famous). 

During the financial crisis of 2008 and 2009, all sorts of pundits were coming out of the woodwork claiming that they had predicted what was unfolding.  Chief among them was an economist named Nouriel Roubini, whom few people had previously heard of.  Many news services credited Roubini for supposedly predicting the recession.  My research uncovered that Roubini had indeed predicted a recession.  The only problem, however, is that Roubini predicted a recession in 2004, 2005, 2006, and 2007.  So he was wrong for four long years in a row.  In 2008, his prediction of a recession finally came true. 

Wrap (or managed) accounts

Wrap accounts (also called managed accounts) are all the rage among commission-based brokerage firms.  These accounts go by a variety of names, but they're all similar in that they charge a fixed percentage of the assets under management to invest your money through money managers. 

Wrap accounts can be poor investments because their management expenses may be extraordinarily high — up to 3 percent per year (some even higher) of assets under management.  Remember that in the long haul, stocks can return about 10 percent per year before taxes.  So if you're paying 3 percent per year to have your money managed in stocks, 30 percent of your return (before taxes) is siphoned off.  But don't forget — because the government sure won't — that you pay a good chunk of money in taxes on your 10 percent return as well.  So the 3 percent wrap actually ends up depleting 40 to 50 percent of your after-tax profits! 

The best no-load (commission-free) mutual funds offer investors access to the nation's best investment managers for a fraction of the cost of wrap accounts.  You can invest in dozens of top-performing funds for an annual expense of 1 percent per year or less.  Some of the best fund companies offer excellent funds for a cost as low as 0.2 to 0.5 percent (see Chapter 10). 

You may be told, in the marketing of wrap accounts, that you're getting access to investment managers who don't normally take money from small-fry investors like you.  Not a single study shows that the performance of money managers has anything to do with the minimum account they handle.  Besides, no-load mutual funds hire many of the same managers who work at other money management firms.  You also may be told that you'll earn a higher rate of return, so the extra cost is worth it. " You could have earned 18 to 25 percent per year," they say, "had you invested with the 'Star of Yesterday' investment management company."  The key word here is had.  History is history.  Many of yesterday's winners become tomorrow's losers or mediocre performers. 

You also need to remember that, unlike mutual funds, wrap account performance records may include unaudited marketing hype.  Showing only the performance of selected accounts — those that performed the best — is the most common ploy. 

When the stock market dropped sharply and the recession worsened in late 2008, Roubini maintained a breakneck schedule with the news media.  So he made even more predictions.  For example, in late October, Roubini predicted that ". . .  hundreds of hedge funds are poised to fail as frantic investors rush to redeem their assets and force managers into a fire sale of assets. . . .  We've reached a situation of sheer panic.  Don't be surprised if policymakers need to close down markets for a week or two in coming days."  This prediction sounded absurd to me at the time, which prompted me to write an article warning folks not to blindly follow Roubini's advice.  This prediction was indeed absurd and, of course, never happened.  Roubini was wrong. 

In January 2009, Roubini predicted oil prices would stay below $40 per barrel for all of 2009.  It didn't take long for that prediction to be proven wrong: Oil jumped above $50 per barrel by April and $70 by June. 

When the Dow Jones Industrial Average fell to 6,500 in early 2009, Roubini said the market was likely to fall much further, and he described any rally from that level as a "sucker's rally."  Those people who panicked and sold in early 2009 because of Roubini's dire prediction were soon disappointed again as the stock market rebounded sharply. 

The sad part about hyped articles with hyped predictions is that they cause some individual investors to panic and do the wrong thing — selling good assets like stocks at depressed prices.  The media shouldn't irresponsibly publicize hyped predictions, especially without clearly and accurately disclosing the predictor's track record.  Don't fall victim to such hype. 

  Commentators and experts who publish predictive commentaries and newsletters and who are interviewed in the media can't predict the future.  Ignore the predictions and speculations of self-proclaimed gurus and investment soothsayers.  The few people who have a slight leg up on everyone else aren't going to share their investment secrets — they're too busy investing their own money!  If you have to believe in something to offset your fears, believe in good information and proven investment managers.  And don't forget the value of optimism, faith, and hope — regardless of what or whom you believe in! 

Leaving You with Some Final Advice

I cover a lot of ground in this chapter.  In the remaining chapters in this part, I detail different investment choices and accounts and how to build a champion portfolio!  Before you move on, here are several other issues to keep in mind as you make important investing choices:

  Don't invest based on sales solicitations.  Companies that advertise and solicit prospective customers aggressively with tactics such as telemarketing offer some of the worst financial products with the highest fees.  All companies have to do some promotion, but the companies with the best investment offerings don't have to use the hard-sell approach; they get plenty of new business through the word-of-mouth recommendations of satisfied customers. 

  Don't invest in what you don't understand.  When you don't understand an investment, odds are good that it won't be right for you.  Slick-tongued brokers (who may call themselves financial consultants, advisors, or planners) who earn commissions based on what they sell can talk you into inappropriate investments.  Before you invest in anything, you need to know its track record, its true costs, and how liquid (easily convertible to cash) it is. 

  Minimize fees.  Avoid investments that carry high sales commissions and management expenses (usually disclosed in a prospectus).  Virtually all investments today can be purchased without a salesperson.  Besides paying unnecessary commissions, the bigger danger in investing through a salesperson is that you may be directed to a path that's not in your best interests.  Management fees create a real drag on investment returns.  Not surprisingly, higher-fee investments, on average, perform worse than alternatives with lower fees.  High ongoing management fees often go toward lavish offices, glossy brochures, and skyscraper salaries, or toward propping up small, inefficient operations.  Do you want your hard-earned dollars to support either of these types of businesses? 

  Pay attention to tax consequences.  Even if you never become an investment expert, you're smart enough to know that the more money you pay in taxes, the less you have for investing and playing with.  See Chapter 11 for info on how retirement accounts can help boost your investment returns.  For investments outside retirement accounts, you need to match the types of investments to your tax situation (see Chapter 12). 
Chapter 9

Understanding Your Investment Choices

In This Chapter

  Playing it "safe": Bank and money-market accounts and bonds

  Growing your wealth: Stocks, real estate, and small business

  Eyeballing oddball investments: Precious metals, annuities, and collectibles

Which vehicle you choose for your investment journey depends on where you're going, how fast you want to get there, and what risks you're willing to take.  If you haven't yet read Chapter 8, you may want to do so now.  In it, I cover a number of investment concepts, such as the difference between lending and ownership investments, which will enhance your ability to choose among the common investment vehicles I discuss in this chapter. 

Slow and Steady Investments

Everyone should have some money in stable, safe investment vehicles, including money that you've earmarked for your short-term bills, both expected and unexpected.  Likewise, if you're saving money for a home purchase within the next few years, you certainly don't want to risk that money on the roller coaster of the stock market. 

The investment options that follow are appropriate for money you don't want to put at great risk. 

Transaction/checking accounts

Transaction/checking accounts are best used for depositing your monthly income and paying for your expenditures.  If you want to have unlimited check-writing privileges and access to your money with an ATM card, checking accounts at local banks are often your best bet. 

  Here's how not to be taken by banks:

  Consider small banks and credit unions.  You may get a better checking account deal at a credit union or a smaller bank.  Because you can easily obtain cash through ATM outlets in supermarkets and other retail stores, you may not need to do business with Big City Bank, which has ATMs and branch offices at every intersection.  Whatever institution you use, make sure your deposits are fully insured by the FDIC or NCUA. 

  Shop around.  Some banks don't require you to maintain a minimum balance to avoid a monthly service charge when you direct-deposit your paychecks.  Make sure that you shop around for accounts that don't ding you $1.50 here for the use of an ATM and $12 there for a low balance. 

  Limit the amount you keep in checking.  Keep only enough money in the account for your monthly bill payment needs.  If you consistently keep more than a few thousand dollars in a checking account, get the excess out.  You can earn more in a savings or money-market account, which I describe in the following section.  And, if you're a high roller, be sure to limit the total amount you invest at any one institution to avoid exceeding insurance limits. 

  Don't do your checking through the bank.  Some folks (myself included) don't have a bank checking account.  Discount brokerage accounts offer unlimited check-writing within a money-market fund. ( See Chapter 10 for recommended firms; also see my discussion in Chapter 19 about paying your bills via your computer and through other automatic means.) 

Savings accounts and money-market funds

Savings accounts are available through banks; money-market funds are available through mutual-fund companies.  Savings accounts and money-market funds are nearly identical, except that money-market funds generally pay a better rate of interest.  The interest rate paid to you, also known as the yield, fluctuates over time, depending on the level of interest rates in the overall economy. ( Note that some banks offer money-market accounts, which are basically like savings accounts and shouldn't be confused with money-market mutual funds.) 

The federal government backs bank savings accounts with Federal Deposit Insurance Corporation (FDIC) insurance.  Money-market funds are not insured.  But don't give preference to a bank account just because your investment (principal) is insured.  In fact, your preference should lean toward money-market funds, because the better ones are higher-yielding than the better bank savings accounts.  And money-market funds offer check-writing and other easy ways to access your money (for more on money funds, please see Chapter 10). 

Money-market funds have several advantages over bank savings accounts:

  The best money-market funds have higher yields. 

  If you're in a higher tax bracket, you may net more after factoring in taxes using tax-free money-market funds.  No savings account pays tax-free interest. 

  Most money-market funds come with free check-writing privileges. ( The only stipulation is that each check must be written for a minimum amount — $250 is common.) 

As with money you put into bank savings accounts, money-market funds are suitable for money that you can't afford to see dwindle in value. 

Bonds

When you invest in a bond, you effectively lend your money to an organization.  When a bond is issued, it includes a specified maturity date at which time the principal will be repaid.  Bonds are also issued at a particular interest rate, or what's known as a coupon.  This rate is fixed on most bonds.  So, for example, if you buy a five-year, 6-percent bond issued by Home Depot, you're lending your money to Home Depot for five years at an interest rate of 6 percent per year. ( Bond interest is usually paid in two equal, semi-annual installments.) 

The value of a bond generally moves opposite of the directional change in interest rates.  For example, if you're holding a bond issued at 6 percent and rates increase to 8 percent for comparable, newly issued bonds, your 6-percent bond will decrease in value. ( Why would anyone want to buy your bond at the price you paid if it yields just 6 percent and 8 percent can be obtained elsewhere?) 

Some bonds are tied to variable interest rates.  For example, you can buy bonds that are adjustable-rate mortgages, on which the interest rate can fluctuate.  As an investor, you're actually lending your money to a mortgage borrower — indirectly, you're the banker making a loan to someone buying a home. 

The overused certificate of deposit

A certificate of deposit (CD) is another type of bond that's issued by a bank.  With a CD, as with a real bond, you agree to lend your money to an organization (in this case, a bank) for a predetermined number of months or years.  Generally, the longer you agree to lock up your money, the higher the interest rate you receive. 

With CDs, you pay a penalty for early withdrawal.  If you want your money back before the end of the CD's term, you get whacked with the loss of a number of months' worth of interest.  CDs also don't tend to pay very competitive interest rates.  You can usually beat the interest rate on shorter-term CDs (those that mature within a year or so) with the best money-market mutual funds, which offer complete liquidity without any penalty. 

Bonds differ from one another in the following major ways:

  The type of institution to which you're lending your money: With municipal bonds, you lend your money to the state or local government or agency; with Treasuries, you lend your money to the federal government; with GNMAs (Ginnie Maes), you lend your money to a mortgage holder (and the federal government backs the bond); with corporate bonds, you lend your money to a corporation. 

  The credit quality of the borrower to whom you lend your money: Credit quality refers to the probability that the borrower will pay you the interest and return your principal as agreed. 

  The length of maturity of the bond: Short-term bonds mature within a few years, intermediate bonds within 3 to 10 years, and long-term bonds within 30 years.  Longer-term bonds generally pay higher yields but fluctuate more with changes in interest rates. 

  Bonds are rated by major credit-rating agencies for their safety, usually on a scale where AAA is the highest possible rating.  For example, high-grade corporate bonds (AAA or AA) are considered the safest (that is, most likely to pay you back).  Next in safety are general bonds (A or BBB), which are still safe but just a little less so.  Junk bonds rated BB or B are actually not all that junky; they're just lower in quality and have a slight (1 or 2 percent) probability of default over long periods of time.  Junk bonds with even lower ratings — such as C or lower — carry higher default rates. 

Some bonds are callable, which means that the bond's issuer can decide to pay you back earlier than the previously agreed-upon date.  This event usually occurs when interest rates fall and the lender wants to issue new, lower-interest-rate bonds to replace the higher-rate, outstanding bonds.  To compensate you for early repayment, the lender typically gives you a small premium over what the bond is currently valued at. 

Building Wealth with Ownership Vehicles

The three best legal ways to build wealth are to invest in stocks, real estate, and small business.  I've found this to be true from observing many clients and other investors and from my own personal experiences.  Check out the following sections for more details about these three options. 

Socking your money away in stocks

Stocks, which represent shares of ownership in a company, are the most common ownership investment vehicle.  When companies go public, they issue shares of stock that people like you and me can purchase on the major stock exchanges, such as the New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation system), or on the over-the-counter market. 

As the economy grows and companies grow with it, earning greater profits, stock prices (and dividend payouts on those stocks) generally follow suit.  Stock prices and dividends don't move in lockstep with earnings, but over the years, the relationship is pretty close.  In fact, the price/earnings ratio — which measures the level of stock prices relative to (or divided by) company earnings — of U.S. stocks has averaged approximately 15 (although it has tended to be higher during periods of low inflation).  A price-earnings ratio of 15 simply means that stock prices per share, on average, are selling at about 15 times those companies' earnings per share. 

Companies that issue stock (called publicly held companies) include automobile manufacturers, computer software producers, fast-food restaurants, hotels, publishers, supermarkets, wineries, and everything in between! ( You can also invest overseas — see the "International stocks" sidebar.)  By contrast, some companies are privately held, which means that they've elected to have senior management and a small number of affluent investors own their stock.  Privately held companies' stocks do not trade on a stock exchange, so folks like you and me can't buy stock in such firms. 

International stocks

Not only can you invest in company stocks that trade on the U.S. stock exchanges, but you can also invest in stocks overseas.  Why would you want to invest in international stocks? 

I can give you several reasons.  First, many investing opportunities exist overseas.  If you look at the total value of all stocks outstanding worldwide, the value of foreign stocks now exceeds the value of U.S. stocks.  Another reason for investing in international stocks is that when you confine your investing to U.S. securities, you miss a world of opportunities, not only because of business growth available in other countries but also because you get the opportunity to diversify your portfolio even further.  International securities markets don't move in tandem with U.S. markets.  During various U.S. stock market drops, some international stock markets drop less, while others actually rise in value. 

Some people hesitate to invest in overseas securities out of concern that overseas investing hurts the U.S. economy and contributes to a loss of American jobs.  I have some counterarguments.  First, if you don't profit from the growth of economies overseas, someone else will.  If there's money to be made, Americans may as well be there to participate.  Profits from a foreign company are distributed to all stockholders, no matter where they live.  Dividends and stock price appreciation know no national boundaries. 

Also, recognize that you already live in a global economy.  Making a distinction between U.S. and non-U.S. companies is no longer appropriate.  Many companies that are headquartered in the United States also have overseas operations.  Some U.S. firms derive a large portion of their revenue from their international divisions.  Conversely, many firms based overseas also have U.S. operations.  An increasing number of companies are worldwide operations. 

  Companies differ in what industry or line of business they're in and also in size.  In the financial press, you often hear companies referred to by their market capitalization, which is the value of their outstanding stock (the number of total shares multiplied by the market price per share).  When describing the sizes of companies, Wall Street has done away with such practical adjectives as big and small and replaced them with expressions like large cap and small cap (where cap stands for capitalization).  Such is the language of financial geekiness. 

  Investing in the stock market involves occasional setbacks and difficult moments (just like raising children or going mountain climbing), but the overall journey is almost certainly worth the effort.  Over the past two centuries, the U.S. stock market has produced an annual average rate of return of about 10 percent.  However, the market, as measured by the Dow Jones Industrial Average, fell more than 20 percent during 16 different periods in the 20th century.  On average, these periods of decline lasted less than two years.  So if you can withstand a temporary setback over a few years, the stock market is a proven place to invest for long-term growth. 

You can invest in stocks by making your own selection of individual stocks or by letting a mutual (or exchange-traded) fund (discussed in Chapter 10) do it for you. 

Discovering the relative advantages of mutual funds

  Efficiently managed mutual funds offer investors of both modest and substantial means low-cost access to high-quality money managers.  Mutual funds span the spectrum of risk and potential returns, from nonfluctuating money-market funds (which are similar to savings accounts) to bond funds (which generally pay higher yields than money-market funds but fluctuate with changes in interest rates) to stock funds (which offer the greatest potential for appreciation but also the greatest short-term volatility). 

Investing in individual securities should be done only by those who really enjoy doing it and are aware of and willing to accept the risks in doing so.  Mutual funds and exchange-traded funds (see the next section), if properly selected, are a low-cost, quality way to hire professional money managers.  Over the long haul, you're highly unlikely to beat full-time professional managers who are investing in securities of the same type and at the same risk level.  Chapter 10 is devoted to mutual funds. 

Understanding exchange-traded funds, hedge funds, and managed accounts

Mutual funds aren't the only game in town when it comes to hiring a professional money manager.  Three additional options you may hear about include

  Exchange-traded funds (ETFs): These funds are the most similar to mutual funds except that they trade on a major stock exchange and, unlike mutual funds, can be bought and sold during the trading day.  The best ETFs have low fees and, like an index fund (see Chapter 10), invest to track the performance of a stock market index. 

  Hedge funds: These privately managed funds are for wealthier investors and are generally riskier (some even go bankrupt) than a typical mutual fund.  The fees can be steep — typically 20 percent of the hedge fund's annual returns as well as an annual management fee of 1 percent or so.  They're also generally illiquid — there are usually lock-up periods, and it can still be difficult to get your money back out later when needed.  I generally don't recommend them. 

  Managed accounts: The major brokerage firms, which employ brokers on commission, offer access to private money managers.  In reality, this option isn't really different from getting access to fund managers via mutual funds, but you'll generally pay a much higher fee, which reduces this option's attractiveness. 

Investing in individual stocks

My experience is that plenty of people choose to invest in individual securities because they think that they're smarter or luckier than the rest.  I don't know you personally, but it's safe to say that in the long run, your investment choices are highly unlikely to outperform those of the best full-time investment professionals and index funds. 

When I was a financial counselor, I noticed a distinct difference between the sexes on this issue.  Perhaps because of the differences in how people are raised, testosterone levels, or whatever, men tend to have more of a problem swallowing their egos and admitting that they're better off not selecting their own individual securities.  Maybe the desire to be a stock picker is genetically linked to not wanting to ask for directions! 

  Investing in individual stocks entails numerous drawbacks and pitfalls:

  You need to spend a significant amount of time doing research.  When you're considering the purchase of an individual security, you need to know a lot about the company in which you're thinking about investing.  Relevant questions to ask about the company include:

• What products or services does it sell? 

• What are its prospects for future growth and profitability? 

• How much debt does the company have? 

You need to do your homework not only before you make your initial investment but also on an ongoing basis for as long as you hold the investment.  Research takes your valuable free time and sometimes costs money. 

  Your emotions will probably get in your way.  Analyzing financial statements, corporate strategy, and competitive position requires great intellect and insight.  However, those skills aren't nearly enough.  Will you have the stomach to hold on after what you thought was a sure-win stock plunges 50 percent?  Will you have the courage to dump such a stock if your new research suggests that the plummet is the beginning of the end rather than just a big bump in the road?  When your money is on the line, emotions often kick in and undermine your ability to make sound long-term decisions.  Few people have the psychological constitution to handle and outfox the financial markets. 

  You're less likely to diversify.  Unless you have tens of thousands of dollars to invest in different stocks, you probably can't cost-effectively afford to develop a diversified portfolio.  For example, when you're investing in stocks, you should hold companies in different industries, different companies within an industry, and so on.  By not diversifying, you unnecessarily add to your risk. 

  You'll face accounting and bookkeeping hassles.  When you invest in individual securities outside retirement accounts, every time you sell a specific security, you must report that transaction on your tax return.  Even if you pay someone else to complete your tax return, you still have the hassle of keeping track of statements and receipts. 

  Of course, you may find some people (with a vested interest) who try to convince you that picking your own stocks and managing your own portfolio of stocks is easy and more profitable than investing in, say, a mutual fund.  In my experience, such stock-picking cheerleaders fall into at least one of the following categories:

  Newsletter writers: Whether in print, on television, or on a website, some pundits pitch the notion that professional money managers are just overpaid buffoons and that you can handily trounce the pros with little of your time by simply putting your money into the pundits' stock picks.  Of course, what these self-anointed gurus are really selling is either an ongoing newsletter (which can run upwards of several hundred dollars per year) or your required daily visitation of their advertising-stuffed websites.  How else will you be able to keep up with their announced buy-and-sell recommendations?  These supposed experts want you to be dependent on continually following their advice. ( I discuss investment newsletters in Chapter 8 and websites in Chapter 19.) 

  Book authors: Go into any bookstore with a decent-sized investing section and you'll find plenty of books claiming that they can teach you a stock-picking strategy for beating the system.  Never mind the fact that the author has no independently audited track record demonstrating her success!  The book publisher of at least one investment group was successfully sued over hyping and distorting the group's actual investment success. 

  Stockbrokers: Some brokers steer you toward individual stocks for several reasons that benefit the broker and not you.  First, as I discuss in Chapter 8, the high-commission brokerage firms can make handsome profits for themselves by getting you to buy stocks.  Secondly, brokers can use changes in the company's situation to encourage you to then sell and buy different stocks, generating even more commissions.  Lastly, as with newsletter writers, this whole process forces you to be dependent on the broker, leaving you broker! 

  Researching individual stocks can be more than a full-time job, and if you choose to take this path, remember that you'll be competing against the professionals who do so on a full-time basis.  If you derive pleasure from picking and following your own stocks, or you want an independent opinion of some stocks you currently own, useful research reports are available from Value Line (call 800-833-0046 or visit `www.valueline.com`).  I also recommend that you limit your individual stock picking to no more than 20 percent of your overall investments. 

Individual stock dividend reinvestment plans

Many corporations allow existing shareholders to reinvest their dividends (their share in company profits) in more shares of stock without paying brokerage commissions.  In some cases, companies allow you to make additional cash purchases of more shares of stock, also commission-free. 

In order to qualify, you must first generally buy some shares of stock through a broker (although some companies allow the initial purchases to be made directly from them).  Ideally, you should purchase these initial shares through a discount broker to keep your commission burden as low as possible. 

Some investment associations also have plans that allow you to buy one or just a few shares to get started.  You typically need to complete a lot of paperwork to invest in a number of different companies' stock.  Life is too short to bother with these plans for this reason alone. 

Finally, even with those companies that do sell stock directly without charging an explicit commission like a brokerage firm, you pay plenty of other fees.  Many plans charge an upfront enrollment fee, fees for reinvesting dividends, and a fee when you want to sell. 

Generating wealth with real estate

Over the generations, real-estate owners and investors have enjoyed rates of return comparable to those produced by the stock market, thus making real estate another time-tested method for building wealth.  However, like stocks, real estate goes through good and bad performance periods.  Most people who make money investing in real estate do so because they invest over many years and do their homework when they buy to ensure that they purchase good property at an attractive price. 

  Buying your own home is the best place to start investing in real estate.  The equity (the difference between the market value of the home and the loan owed on it) in your home that builds over the years can become a significant part of your net worth.  Among other things, you can tap this equity to help finance other important personal goals, such as retirement, college, and starting or buying a business.  Moreover, throughout your adult life, owning a home should be less expensive than renting a comparable home.  See Chapter 14 for the best ways to buy and finance real estate. 

Real estate: Not your ordinary investment

Real estate differs from most other investments in several respects.  Here's what makes real estate unique as an investment:

  You can live in it.  You can't live in a stock, bond, or mutual fund (although I suppose you could glue together a substantial fortress with all the paper these companies fill your mailbox with each year).  Real estate is the only investment you can use (by living in it or renting it out) to produce income. 

  Land is in limited supply.  The percentage of the Earth occupied by land is relatively constant.  And because humans like to reproduce, the demand for land and housing continues to grow.  Consider the areas that have the most expensive real-estate prices in the world — Hong Kong, Tokyo, Hawaii, San Francisco, and Manhattan.  In these densely populated areas, virtually no new land is available for building new housing. 

  Zoning shapes potential value.  Local government regulates the zoning of property, and zoning determines what a property can be used for.  In most communities these days, local zoning boards are against big growth.  This position bodes well for future real-estate values.  Also know that in some cases, a particular property may not have been developed to its full potential.  If you can figure out how to develop the property, you can reap large profits. 

  You don't need a lot of cash upfront.  Real estate is also different from other investments because you can borrow a lot of money to buy it — up to 80 to 90 percent or more of the value of the property.  This borrowing is known as exercising leverage: With only a small investment of 10 to 20 percent down, you're able to purchase and own a much larger investment.  When the value of your real estate goes up, you make money on your investment and on all the money you borrowed. ( In case you're curious, you can leverage nonretirement-account stock and bond investments through margin borrowing.  However, you have to make a much larger "down payment" — about double to triple the percentage you need to buy real estate.) 

For example, suppose that you plunk down $20,000 to purchase a property for $100,000.  If the property appreciates to $120,000, you make a profit of $20,000 (on paper) on your investment of just $20,000.  In other words, you make a 100-percent return on your investment.  But leverage cuts both ways.  If your $100,000 property decreases in value to $80,000, you actually lose (on paper) 100 percent of your original $20,000 investment, even though the property value drops only 20 percent. 

  You can discover hidden value.  In an efficient market, the price of an investment accurately reflects its true worth.  Some investment markets are more efficient than others because of the large number of transactions and easily accessible information.  Real-estate markets can be inefficient at times.  Information is not always easy to come by, and you may find an ultramotivated or uninformed seller.  If you're willing to do some homework, you may be able to purchase a property below its fair market value (perhaps by as much as 10 to 20 percent). 

Comparing real estate and stocks

Real estate and stocks have historically produced comparable returns.  Deciding between the two depends less on the performance of the markets than on you and your situation.  Consider the following major issues when deciding which investment may be better for you:

  The first and most important question to ask yourself is whether you're cut out to handle the responsibilities that come with being a landlord.  Real estate is a time-intensive investment (property managers can help, but their cost takes a sizable chunk of your rental income).  Investing in stocks can be time-intensive as well, but it doesn't have to be if you use professionally managed mutual funds and exchange-traded funds (see Chapter 10). 

  An often-overlooked drawback to investing in real estate is that you earn no tax benefits while you're accumulating your down payment.  Retirement accounts such as 401(k)s, SEP-IRAs, Keoghs, and so on (see Chapter 11) give you an immediate tax deduction as you contribute money to them.  If you haven't exhausted your contributions to these accounts, consider doing so before chasing after investment real estate. 

  Ask yourself which investments you have a better understanding of.  Some folks feel uncomfortable with stocks and mutual funds because they don't understand them.  If you have a better handle on what makes real estate tick, you have a good reason to consider investing in it. 

  Figure out what will make you happy.  Some people enjoy the challenge that comes with managing and improving rental property; it can be a bit like running a small business.  If you're good at it and you have some good fortune, you can make money and derive endless hours of enjoyment. 

Although few will admit it, some real-estate investors get an ego rush from a tangible display of their wealth.  Sufferers of this "edifice complex" (think Donald Trump) can't obtain similar pleasure from a stock portfolio detailed on a piece of paper (although others have been known to boast of their stock-picking prowess). 

Just as with any other investment, real estate has its drawbacks.  For starters, buying or selling a property generally takes time and significant cost.  When you're renting property, you discover firsthand the occasional headaches of being a landlord.  And especially in the early years of rental property ownership, the property's expenses may exceed the rental income, producing a net cash drain. 

The best real-estate investment options

Although real estate is unique in some ways, it's also like other types of investments in that prices are driven by supply and demand.  You can invest in homes or small apartment buildings and then rent them out.  In the long run, investment-property buyers hope that their rental income and the value of their properties will increase faster than their expenses. 

When selecting real estate for investment purposes, remember that local economic growth is the fuel for housing demand.  In addition to a vibrant and diverse job base, you want to look for limited supplies of both existing housing and land on which to build.  When you identify potential properties in which you may want to invest, run the numbers to understand the cash demands of owning the property and the likely profitability.  See Chapter 14 for help determining the costs of real-estate ownership. 

When you want to invest directly in real estate, residential housing — such as single-family homes or small multi-unit buildings — may be an attractive investment.  Buying properties close to home offers the advantage of allowing you to more easily monitor and manage what's going on.  The downside is that your investments will be less diversified — more of them will be dependent on the local economy. 

  If you don't want to be a landlord — one of the biggest drawbacks of investment real estate — consider investing in real estate through real-estate investment trusts (REITs).  REITs are diversified real-estate investment companies that purchase and manage rental real estate for investors.  A typical REIT invests in one or two types of property, such as shopping centers, apartments, and other rental buildings.  You can invest in REITs either by purchasing them directly on the major stock exchanges or by investing in a real-estate mutual fund (see Chapter 10) that invests in numerous REITs. 

The worst real-estate investments

  Not all real-estate investments are good; some aren't even real investments.  The bad ones are characterized by burdensome costs and problematic economic fundamentals:

  Limited partnerships: Avoid limited partnerships (LPs) sold through brokers and financial consultants.  LPs are inferior investment vehicles.  They're so burdened with high sales commissions and ongoing management fees that deplete your investment that you can do better elsewhere.  The investment salesperson who sells you such an investment stands to earn a commission of up to 10 percent or more — so only 90 cents of each dollar gets invested.  Each year, LPs typically siphon off another several percent for management and other expenses.  Most partnerships have little or no incentive to control costs.  In fact, they have a conflict of interest that forces them to charge more to enrich the managing partners. 

Unlike a mutual fund, you can't vote with your dollars.  If the partnership is poorly run and expensive, you're stuck.  LPs are illiquid (not readily convertible into cash without a substantial loss).  You can't access your money until the partnership is liquidated, typically seven to ten years after you buy in. 

Many of the yields on LPs have turned out to be bogus.  In some cases, partnerships prop up their yields by paying back investors' principals (without telling them, of course).  As for returns — well — historically too many LPs have been turkeys.  The only thing limited about a limited partnership is its ability to make you money. 

  Time shares: Time shares are another nearly certain money loser.  With a time share, you buy a week or two of ownership, or usage, of a particular unit (usually a condominium in a resort location) per year.  If, for example, you pay $8,000 for a week (in addition to ongoing maintenance fees), you're paying the equivalent of more than $400,000 for the whole unit, when a comparable unit nearby may sell for only $150,000.  The extra markup pays the salespeople's commissions, administrative expenses, and profits for the time-share development company. 

People usually get enticed into buying a time share when they're enjoying a vacation someplace.  They're easy prey for salespeople who want to sell them a souvenir of the trip.  The "cheese in the mousetrap" is an offer of something free (for example, a free night's stay in a unit) for attending the sales presentation. 

If you can't live without a time share, consider buying a used one.  Many previous buyers, who more than likely have lost a good chunk of money, are trying to dump their shares (which should tell you something).  In this case, you may be able to buy a time share at a fair price.  But why commit yourself to taking a vacation in the same location and building at the same time each year?  Many time shares let you trade your weeks for other times and other places; however, doing so is a hassle — you're charged an extra fee, and your choices are usually limited to time slots that other people don't want (that's why they're trading them!). 

  Second homes: The weekend getaway is a sometimes romantic notion and an extended part of the so-called American dream.  When your vacation home is not in use, you may be able to rent it out and earn some income to help defray the expense of keeping it up.  However, most second-home owners seldom rent out their property — they typically do so 10 percent or less of the time.  As a result, second homes are usually money drains, not investments. 

The supposed tax benefits are part of the attraction of a second home.  Even when you qualify for some or all of them, tax benefits only partially reduce the cost of owning a property.  In some cases, the second home is such a cash drain that it prevents its owners from contributing to and taking advantage of tax-deductible retirement savings plans. 

If you aren't going to rent out a second home most of the time, ask yourself whether you can afford such a luxury.  Can you accomplish your other financial goals — saving for retirement, paying for the home in which you live, and so on — with this added expense?  Keeping a second home is more of a consumption than an investment decision.  Few people can afford more than one home. 

Investing in small business (and your career)

  Small business is the leading investment through which folks have built the greatest wealth.  You can invest in small business by starting one yourself (and thus finding yourself the best boss you've probably ever had), buying an existing business, or investing in someone else's small business.  Even if small business doesn't interest you, hopefully your own job does, so I present some tips on making the most of your career. 

Launching your own enterprise

When you have self-discipline and a product or service you can sell, starting your own business can be both profitable and fulfilling.  Consider first what skills and expertise you possess that you can use in your business.  You don't need a "eureka"-type idea or invention to start a small business.  Millions of people operate successful businesses that are hardly unique, such as dry cleaners, restaurants, tax preparation firms, and so on. 

  Begin exploring your idea by first developing a written business plan.  Such a plan should detail your product or service, how you're going to market it, your potential customers and competitors, and the economics of the business, including the start-up costs. 

Of all the small-business investment options, starting your own business involves the most work.  Although you can do this work on a part-time basis in the beginning, most people end up running their business full-time — it's your new job, career, or whatever you want to call it. 

I've been running my own business for most of my working years, and I wouldn't trade that experience for the corporate life.  That's not to say that running my own business doesn't have its drawbacks and down moments.  But in my experience counseling small-business owners, I've seen many people of varied backgrounds, interests, and skills succeed and be happy with running their own businesses. 

In most people's eyes, starting a new business is the riskiest of all small-business investment options.  But if you're going into a business that uses your skills and expertise, the risk isn't nearly as great as you may think.  Many businesses can be started with little cash by leveraging your existing skills and expertise.  You can build a valuable company and job if you have the time to devote.  As long as you check out the competition and offer a valued service at a reasonable cost, the principal risk with your business comes from not doing a good job marketing what you have to offer.  If you can market your skills and have a plan to get through the inevitable economic down cycles that affect every business, you're home free. 

  As long as you're thinking about the risks of starting a business, consider the risks of staying in a job you don't enjoy or that doesn't challenge or fulfill you.  If you never take the plunge, you may regret that you didn't pursue your dreams. 

Buying an existing business

If you don't have a specific product or service you want to sell but you're skilled at managing and improving the operations of a company, buying a small business may be for you.  Finding and buying a good small business takes much time and patience, so be willing to devote at least several months to the search.  You may also need to enlist financial and legal advisors to help inspect the company, look over its financial statements, and hammer out a contract. 

Although you don't have to go through the riskier start-up period if you buy a small business, you'll likely need more capital to buy an established enterprise.  You'll also need to be able to deal with stickier personnel and management issues.  The history of the organization and the way things work will predate your ownership of the business.  If you don't like making hard decisions, firing people who don't fit with your plans, and coercing people into changing the way they do things, buying an existing business likely isn't for you. 

  Some people perceive buying an existing business as being safer than starting a new one.  Buying someone else's business may actually be riskier.  You're likely to shell out far more money upfront, in the form of a down payment, to buy an existing business.  If you don't have the ability to run the business and it does poorly, you have more to lose financially.  In addition, the business may be for sale for a reason — it may not be very profitable, it may be in decline, or it may generally be a pain in the neck to operate. 

Good businesses don't come cheap.  If the business is a success, the current owner has already removed the start-up risk from the business, so the price of the business should be at a premium to reflect this lack of risk.  When you have the capital to buy an established business and you have the skills to run it, consider going this route. 

Investing in someone else's small business

Are you someone who likes the idea of profiting from successful small businesses but doesn't want the day-to-day headaches of being responsible for managing the enterprise?  Then investing in someone else's small business may be for you.  Although this route may seem easier, few people are actually cut out to be investors in other people's businesses.  The reason: Finding and analyzing opportunities isn't easy. 

Are you astute at evaluating corporate financial statements and business strategies?  Investing in a small, privately held company has much in common with investing in a publicly traded firm (as is the case when you buy stock), but it also has a few differences.  One difference is that private firms aren't required to produce comprehensive, audited financial statements that adhere to certain accounting principles.  Thus, you have a greater risk of not having sufficient or accurate information when evaluating a small, private firm. 

Another difference is that unearthing private, small-business investing opportunities is harder.  The best private companies who are seeking investors generally don't advertise.  Instead, they find prospective investors through networking with people such as business advisors.  You can increase your chances of finding private companies to invest in by speaking with tax, legal, and financial advisors who work with small businesses.  You can also find interesting opportunities through your own contacts or experience within a given industry. 

  Don't consider investing in someone else's business unless you can afford to lose all of what you're investing.  Also, you should have sufficient assets so that what you're investing in small, privately held companies represents only a small portion (20 percent or less) of your total financial assets. 

Investing in your career

In my work with financial counseling clients over the years and from observing friends and colleagues, I've witnessed plenty of people succeed working for employers.  So I don't want to leave you with the impression that financial success equates with starting, buying, or investing in someone else's small business. 

You can and should invest in your career.  Some time-tested, proven ways to do that include

  Networking: Some people wait to network until they've been laid off or are really hungry to change jobs.  Take an interest in what others do for a living and you'll learn and grow from the experience, even if you choose to stay with your current employer or in your chosen field. 

  Making sure you keep learning: Whether it's reading quality books or other publications or taking some night courses, find ways to build on your knowledge base. 

  Considering the risk in the status quo: Many folks are resistant to change and get anxious thinking about what could go wrong when taking a new risk.  I know when I was ready to walk away from a six-figure consulting job with a prestigious firm and open my own financial counseling firm, a number of my relatives and friends thought I had lost my marbles.  I'm glad I didn't listen to their fears and worries! 

Off the Beaten Path: Investment Odds and Ends

The investments that I discuss in this section sometimes belong on their own planet (because they're not an ownership or lending vehicle).  Here are the basics on these other common, but odd, investments. 

Precious metals

Gold and silver have been used by many civilizations as currency or a medium of exchange.  One advantage of precious metals as a currency is that they can't be debased by the government.  With paper currency, such as U.S. dollars, the government can simply print more.  This process can lead to the devaluation of a currency and inflation. 

Holdings of gold and silver can provide a so-called hedge against inflation.  In the late 1970s and early 1980s, inflation rose dramatically in the United States.  This largely unexpected rise in inflation depressed stocks and bonds.  Gold and silver, however, rose tremendously in value — in fact, more than 500 percent (even after adjusting for inflation) from 1972 to 1980 (see Chapter 8).  Such periods are unusual.  Precious metals produced decent returns in the 2000s.  Over many decades, precious metals tend to be lousy investments.  Their rate of return tends to keep up with the rate of inflation but not surpass it. 

  When you want to invest in precious metals as an inflation hedge, your best option is to do so through mutual funds (see Chapter 10).  Don't purchase precious metals futures.  They're not investments; they're short-term gambles on which way gold or silver prices may head over a short period of time.  I also recommend staying away from firms and shops that sell coins and bullion (not the soup, but bars of gold or silver).  Even if you can find a legitimate firm (not an easy task), the cost of storing and insuring gold and silver is quite costly.  You won't get good value for your money — markups can be substantial. 

Annuities

Annuities are a peculiar type of insurance and investment product.  They're a sort of savings-type account with slightly higher yields, and they're backed by insurance companies. 

As with other types of retirement accounts, money placed in an annuity compounds without taxation until it's withdrawn.  However, unlike most other types of retirement accounts, such as 401(k)s, SEP-IRAs, and Keoghs, you don't receive upfront tax breaks on contributions you make to an annuity.  Ongoing investment expenses also tend to be much higher than in retirement plan accounts.  Therefore, consider an annuity generally only after you fully fund tax-deductible retirement accounts.  There's one other possible personal use for annuities: Those nearing or in retirement with limited resources can insure against the risk of outliving their assets by buying an annuity and annuitizing it — again, at a cost, so proceed carefully. ( For more help on deciding whether to invest in an annuity, see Chapter 12.) 

Collectibles

The collectibles category is a catchall for antiques, art, autographs, baseball cards, clocks, coins, comic books, diamonds, dolls, gems, photographs, rare books, rugs, stamps, vintage wine, and writing utensils — in other words, any material object that, through some kind of human manipulation, has become more valuable to certain humans. 

  Notwithstanding the few people who discover on the Antiques Roadshow that they own an antique of significant value, collectibles are generally lousy investment vehicles.  Dealer markups are enormous, maintenance and protection costs are draining, research is time-consuming, and people's tastes are quite fickle.  All this for returns that, after you factor in the huge markups, rarely keep up with inflation.  Furthermore, investment gains you do earn on collectibles are currently taxed at a higher federal tax rate (28 percent) than capital gains on stocks, real estate, and small business (15 percent) held for a year or more. 

  Buy collectibles for your love of the object, not for financial gain.  Treat collecting as a hobby rather than as an investment.  When buying a collectible, try to avoid the big markups by cutting out the middlemen.  Buy directly from the artist or producer if you can. 
Chapter 10

Investing in Funds

In This Chapter

  Grasping the advantages of mutual funds and exchange-traded funds (ETFs)

  Checking out the different types of funds

  Choosing the best funds

  Evaluating your fund's performance

  Monitoring and selling your funds

When you invest in a mutual fund (or its close sibling — an exchange-traded fund that trades on a stock exchange), an investment company pools your money with the money of many other like-minded individuals and invests it in stocks, bonds, and other securities.  Think of it as a big investment club without the meetings!  When you invest through a typical mutual fund, several hundred million to billions of dollars are typically invested along with your money. 

If you're thinking of joining the club, read on to discover the benefits of investing in mutual funds and exchange-traded funds and the types of funds available (see Chapter 9 for a discussion of mutual-fund alternatives).  In this chapter, I advise you on analyzing and choosing your funds, explain how to track your investments, and help you decide when to sell. 

Understanding the Benefits of Mutual Funds and Exchange-Traded Funds

Mutual funds and exchange-traded funds (ETFs) rank right up there with microwave ovens, sticky notes, and plastic wrap as one of the best modern inventions.  To understand their success is to grasp how and why these funds can work for you.  Here are the benefits you receive when you invest in mutual funds and ETFs:

  Professional management: Mutual funds and ETFs are managed by a portfolio manager and research team whose full-time jobs are to screen the universe of investments for those that best meet the stated objectives of the fund.  These professionals call and visit companies, analyze companies' financial statements, and speak with companies' suppliers and customers.  In short, the team does more research and analysis than you could ever hope to do in your free time. 

Fund managers are typically graduates of the top business and finance schools in the country, where they learn the principles of portfolio management and securities valuation and selection.  The best fund managers typically have a decade of experience or more in analyzing and selecting investments, and many measure their experience in decades rather than years. 

  Low fees: The most efficiently managed stock mutual funds and ETFs cost less than 1 percent per year in fees (bond and money-market funds cost much less).  Because funds typically buy or sell tens of thousands of shares of a security at a time, the percentage of commissions these funds pay is far less than what you pay to buy or sell a few hundred shares on your own.  In addition, when you buy a no-load fund, you avoid paying sales commissions (known as loads) on your transactions.  I discuss these types of funds throughout this chapter.  You can buy an ETF for a low transaction fee through the best online brokers (see Chapter 19). 

  Diversification: Fund investing enables you to achieve a level of diversification that's difficult to reach without tens of thousands of dollars and a lot of time to invest.  If you go it alone, you should invest money in at least 8 to 12 different securities in different industries to ensure that your portfolio can withstand a downturn in one or more of the investments.  Proper diversification allows a mutual fund to receive the highest possible return at the lowest possible risk given its objectives.  The most unfortunate investors during major stock market downswings have been individuals who had all their money riding on only a few stocks that plunged in price by 90 percent or more. 

  Low cost of entry: Most mutual funds have low minimum-investment requirements, especially for retirement account investors. ( ETFs essentially have no minimum, although you don't want to do transactions involving small amounts because the brokerage fee takes up a larger percentage of your investment amount).  Even if you have a lot of money to invest, consider mutual funds for the low-cost, high-quality money-management services that they provide. 

  Audited performance records and expenses: In their prospectuses, all mutual funds are required to disclose historical data on returns, operating expenses, and other fees.  The U.S. Securities and Exchange Commission (SEC) and accounting firms check these disclosures for accuracy.  Also, several firms (such as Morningstar, Inc.) report hundreds of fund statistics, allowing comparisons of performance, risk, and many other factors. 

  Flexibility in risk level: Among the different funds, you can choose a level of risk that you're comfortable with and that meets your personal and financial goals.  If you want your money to grow over a long period of time, you may want to select funds that invest more heavily in stocks.  If you need current income and don't want investments that fluctuate in value as widely as stocks, you may choose more-conservative bond funds.  If you want to be sure that your invested principal doesn't drop in value (perhaps because you may need your money in the short term), you can select a money-market fund. 

Exploring Various Fund Types

  When fund companies package and market funds, the names they give their funds aren't always completely accurate or comprehensive.  For example, a stock fund may not be totally invested in stocks.  Twenty percent of it may be invested in bonds.  Don't assume that a fund invests exclusively in U.S. companies, either — it may invest in international firms, as well. 

Note: If you haven't yet read Chapters 8 and 9, which provide an overview of investment concepts and vehicles, doing so can enhance your understanding of the rest of this chapter. 

Money-market funds

Money-market funds are the safest type of mutual funds (although not insured or guaranteed) for people concerned about losing their invested dollars.  As with bank savings accounts, the value of your original investment does not fluctuate. ( For more background on the advantages of money funds, see Chapter 9.) 

These funds are closely regulated by the SEC.  Trillions of dollars of individuals' and institutions' money are invested in money-market funds.  General-purpose money-market funds invest in safe, short-term bank certificates of deposit, U.S. Treasuries, and corporate commercial paper (short-term debt), which is issued by the largest and most creditworthy companies. 

Since their origination in the early 1970s, money-market funds have been extremely safe.  The risk difference versus a bank account is nil.  Only twice have funds broken the buck (one by 6 percent, the other by 3 percent) and both funds were used by institutional investors.  Hundreds of trillions of dollars have flowed into and out of money funds over the decades without any retail investors losing principal. 

Money-market-fund investments can exist only in the most creditworthy securities and must have an average maturity of less than 120 days.  In the unlikely event that an investment in a money-market-fund's portfolio goes sour, the mutual-fund company that stands behind the money-market fund will almost certainly cover the loss. 

  If the lack of insurance on money-market funds still spooks you, select a money-market fund that invests exclusively in U.S. government securities, which are virtually risk-free because they're backed by the full strength and credit of the federal government (as is the FDIC insurance system).  These types of accounts typically pay less interest, although the interest is free of state income tax. 

Bond funds

Bonds are IOUs.  When you buy a newly issued bond, you typically lend your money to a corporation or government agency.  A bond fund is nothing more than a large group (pack, herd, gaggle, whatever) of bonds. 

Bond funds typically invest in bonds of similar maturity (the number of years that elapse before the borrower must pay back the money you lend).  The names of most bond funds include a word or two that provides clues about the average length of maturity of their bonds.  For example, a short-term bond fund typically concentrates its investments in bonds maturing in the next two to three years.  An intermediate-term fund generally holds bonds that come due within three to ten years.  The bonds in a long-term fund usually mature in more than ten years. 

In contrast to an individual bond that you buy and hold until it matures, a bond fund is always replacing bonds in its portfolio to maintain its average maturity objective.  Therefore, if you know that you absolutely, positively must have a certain principal amount back on a particular date, individual bonds may be more appropriate than a bond fund. 

Like money-market funds, bond funds can invest in tax-free bonds, which are appropriate for investing money you hold outside retirement accounts if you're in a reasonably high tax bracket. 

  Bond funds are useful when you want to live off dividend income or you don't want to put all your money in riskier investments such as stocks and real estate (perhaps because you plan to use the money soon).  Also, making small incremental investments in a bond fund is easier, as opposed to the cost of buying a single individual bond, which can be many thousands of dollars.  Bonds (especially municipal bonds) are among the most inefficient parts of the U.S. securities markets.  Most trade via bond "warehousers" in round lots of $1 million.  Most individuals can't easily determine the bonds' true value and pay steep markups or markdowns, all of which a larger institutional trader (like a mutual fund) can more easily avoid. 

Stock funds

Stock funds, as their name implies, invest in stocks.  These funds are often referred to as equity funds.  Equity — not to be confused with equity in real estate — is another word for stocks.  Stock funds are often categorized by the type of stocks they primarily invest in. 

Stock types are first defined by size of company (small, medium, or large).  The total market value (capitalization) of a company's outstanding stock determines its size.  Small-company stocks, for example, are usually defined as companies with total market capitalization of less than $1 billion.  Stocks are further categorized as growth or value stocks:

  Growth stocks represent companies that are experiencing rapidly expanding revenues and profits and typically have high stock prices relative to their current earnings or asset (book) values.  These companies tend to reinvest most of their earnings back into their infrastructure to fuel future expansion.  Thus, growth stocks typically pay low ­dividends. ( See the later "Dividends" section for more information.) 

  Value stocks are at the other end of the spectrum.  Value stock investors look for good buys.  They want to invest in stocks that are cheaply priced in relation to the profits per share and book value (assets less liabilities) of the company.  Value stocks are usually less volatile than growth stocks. 

These categories are combined in various ways to describe how a mutual fund invests its money.  One fund may focus on large-company growth stocks, while another fund may limit itself to small-company value stocks.  Funds are further classified by the geographical focus of their investments: U.S., international, worldwide, and so on (see the section "U.S., international, and global funds"). 

Balancing bonds and stocks: Hybrid funds

Hybrid funds invest in a mixture of different types of securities.  Most commonly, they invest in bonds and stocks.  These funds are usually less risky and volatile than funds that invest exclusively in stocks.  In an economic downturn, bonds usually hold up in value better than stocks do.  However, during good economic times when the stock market is booming, the bond portions of these funds tend to drag down their performance a bit. 

Hybrid mutual funds are typically known as balanced funds, which generally try to maintain a fairly constant percentage of investments in stocks and bonds, or asset allocation funds, which tend to adjust the mix of different investments according to the portfolio manager's expectations of the market.  Of course, exceptions do exist — some balanced funds make major shifts in their allocations, whereas some asset allocation funds maintain a relatively fixed mix. 

  Most funds that shift money around instead of staying put in good investments rarely beat the market averages over a number of years. 

There are also now increasing numbers of target-maturity funds (also known as target-date or retirement-date funds), which tend to decrease their risk (and stock allocation) over time.  Such funds appeal to investors who are approaching a particular future goal, such as retirement or a child's college education, and want their fund to automatically adjust as that date approaches. 

  Hybrid funds are a way to make fund investing simple.  They give you extensive diversification across a variety of investing options.  They also make it easier for stock-skittish investors to invest in stocks while avoiding the high volatility of pure stock funds. 

U.S., international, and global funds

Unless they have words like international, global, worldwide, or world in their names, most American-issued funds focus their investments in the United States.  But even funds without one of these terms attached may invest money internationally. 

  The only way to know for sure where a fund is currently invested (or where the fund may invest in the future) is to ask.  You can start by calling the toll-free number of the fund company you're interested in.  A fund's annual report (which often can be found on the fund company's website) also details where the fund is investing (the prospectus will also detail where the fund can be invested). 

Funds of funds

An increasing number of fund providers are responding to overwhelmed investors by offering a simplified way to construct a portfolio: a fund that diversifies across numerous other funds — or a fund of funds.  When a fund of funds is done right, it helps focus fund investors on the important big-picture issue of asset allocation — how much of your investment money you put into bonds versus stocks.  Although the best funds of funds appear to deliver a high-quality, diversified portfolio of funds in one fell swoop, funds of funds are not all created equal and not all are worthy of your investment dollars. 

The fund of funds idea isn't new.  In fact, the concept has been around for many years.  High fees gave the earlier funds of funds, run in the 1950s by the late Bernie Cornfeld, a bad name.  Cornfeld established a fund of funds outside the United States and tacked on many layers of fees.  Although the funds were profitable for his enterprise, duped investors suffered a continual drain of high fees.  The Cornfeld episode is an important reason why the SEC has been careful in approving new funds of funds. 

The newer funds of funds developed by the larger fund companies are investor friendly and ones that I recommend.  Vanguard's LifeStrategy, Fidelity's Freedom, and T. Rowe Price's Spectrum funds of funds add no extra fees for packaging together the individual funds.  Long-term performance of many of these is solid.  Annual operating fees on the underlying funds at Vanguard are less than 0.2 percent. 

When a fund has the term international or foreign in its name, it typically means that the fund invests anywhere in the world except the United States.  The term worldwide or global generally implies that a fund invests everywhere in the world, including the United States.  I generally recommend avoiding worldwide or global funds for two reasons.  First, thoroughly following the financial markets and companies is hard enough for a fund manager to do solely in the United States or a specific international market; following the markets and companies in both is even more difficult.  Second, most of these funds charge high operating expenses — often well in excess of 1 percent per year — which puts a drag on returns. 

Index funds

Index funds are funds that can be (and are, for the most part) managed by a computer.  An index fund's assets are invested to replicate an existing market index such as Standard & Poor's 500, an index of 500 large U.S. company stocks. 

Over long periods (ten years or more), index funds outperform about three-quarters of their peers!  How is that possible?  How can a computer making mindless, predictable decisions beat an intelligent, creative, MBA-endowed portfolio manager with a crack team of research analysts scouring the market for the best securities?  The answer is largely cost.  The computer doesn't demand a high salary or need a big corner office.  And index funds don't need a team of research analysts. 

Most active fund managers can't overcome the handicap of high operating expenses that pull down their funds' rates of return.  As I discuss later in this chapter, operating expenses include all the fees and profit that a mutual fund extracts from a fund's returns before the returns are paid to you.  For example, the average U.S. stock fund has an operating expense ratio of 1.4 percent per year.  So a U.S. stock index fund (or its peer exchange-traded fund, which is an index fund that trades on a stock exchange) with an expense ratio of just 0.1 to 0.2 percent per year has an advantage of 1.2 to 1.3 percent per year. 

Another not-so-inconsequential advantage of index funds is that they can't underperform the market.  Some funds do just that because of the burden of high fees and/or poor management.  For money invested outside retirement accounts, index funds have an added advantage: Lower taxable capital gains distributions are made to shareholders because less trading of securities is conducted and a more stable portfolio is maintained. 

Yes, index funds may seem downright boring.  When you invest in them, you give up the opportunity to brag to others about your shrewd investments that beat the market averages.  On the other hand, with a low-cost index fund, you have no chance of doing much worse than the market (which more than a few mutual-fund managers do). 

  Index funds and exchange-traded funds make sense for a portion of your investments, because beating the market is difficult for portfolio managers.  The Vanguard Group (phone 800-662-7447; website `www.vanguard.com`), headquartered in Valley Forge, Pennsylvania, is the largest and lowest-cost mutual-fund provider of these funds. 

Specialty (sector) funds

Specialty funds don't fit neatly into the previous categories.  These funds are often known as sector funds, because they tend to invest in securities in specific industries. 

  In most cases, you should avoid investing in specialty funds.  Investing in stocks of a single industry defeats one of the major purposes of investing in funds — diversification.  Another good reason to avoid specialty funds is that they tend to carry much higher expenses than other funds. 

Identifying socially responsible funds

Select funds label themselves socially responsible.  This term means different things to different people.  In most cases, though, it implies that the fund avoids investing in companies whose products or services harm people or the world at large — tobacco manufacturers, for example.  Because cigarettes and other tobacco products kill hundreds of thousands of people and add billions of dollars to healthcare costs, most socially responsible funds shun tobacco companies. 

Socially responsible investing presents challenges.  For example, your definition of social responsibility may not match the definition offered by the investment manager who's running a fund.  Another problem is that even if you can agree on what's socially irresponsible (such as selling tobacco products), funds aren't always as clean as you would think or hope.  Even though a fund avoids tobacco manufacturers, it may well invest in retailers that sell tobacco products.  Another drawback is that these funds tend to have higher-than-average costs, even when they take an indexing approach. 

If you want to consider a socially responsible fund, review the fund's recent annual report, which lists the specific investments the fund owns.  Also consider giving directly to charities (and getting a tax deduction) instead. 

  Specialty funds that invest in real estate or precious metals may make sense for a small portion (10 percent or less) of your investment portfolio.  These types of funds can help diversify your portfolio, because they can do better during times of higher inflation. 

Selecting the Best Funds

When you go camping in the wilderness, you can do a number of things to maximize your chances for happiness and success.  You can take maps and a GPS to keep you on course, food for nourishment, proper clothing to stay dry and warm, and some first-aid gear to treat minor injuries.  But regardless of how much advance preparation you do, you may have a problematic experience.  You may take the wrong trail, trip on a rock and break your ankle, or lose your food to a tenacious bear that comes romping through camp one night. 

And so it is with funds.  Although most fund investors are rewarded for their efforts, you get no guarantees.  You can, however, follow some simple, common-sense guidelines to help keep you on the trail and increase your odds of investment success and happiness.  The issues in the following sections are the main ones to consider. 

Reading prospectuses and annual reports

Fund companies produce information that can help you make decisions about fund investments.  Every fund is required to issue a prospectus.  This legal document is reviewed and audited by the SEC.  The most valuable information — the fund's investment objectives, costs, performance history, and primary risks — is summarized in the first few pages of the prospectus.  Make sure that you read this part.  Skip the rest, which is comprised mostly of tedious legal details. 

Funds also produce annual reports that discuss how the fund has been doing and provide details on the specific investments a fund holds.  If, for example, you want to know which countries an international fund invests in, you can find this information in the fund's annual report. 

Keeping costs low

The charges you pay to buy or sell a fund, as well as the fund's ongoing operating expenses, can have a big impact on the rate of return you earn on your investments.  Many novice investors pay too much attention to a fund's prior performance (in the case of stock funds) or to the fund's current yield (in the case of bond funds) and too little attention to fees.  Doing so is dangerous because a fund can inflate its return or yield in many (risky) ways.  And what worked yesterday may flop tomorrow. 

Fund costs are an important factor in the return you earn from a mutual fund.  Fees are deducted from your investment.  All other things being equal, high fees and other charges depress your returns.  What are a fund's fees, you ask?  Good question — read on to find the answers. 

Eliminating loads

Loads are upfront commissions paid to brokers who sell mutual funds.  Loads typically range from 3 percent to as high as 8.5 percent of your investment.  Sales loads have two problems:

  Sales loads are an extra cost that drags down your investment returns.  Because commissions are paid to the salesperson and not to the fund manager, the manager of a load fund doesn't work any harder and isn't any more qualified than a manager of a no-load fund.  Common sense suggests, and studies confirm, that load funds perform worse, on average, than no-loads when factoring in the load because the load charge is subtracted from your payment before your payment is invested. 

    The power of self-interest can bias your broker's advice.  Although this issue is rarely discussed, it's even more problematic than the issue of sales loads.  Brokers who work for a commission are interested in selling you commission-based investment products; therefore, their best interests often conflict with your best interests. 

Although you may be mired in high-interest debt or underfunding your retirement plan, salespeople almost never advise you to pay off your credit cards or put more money into your 401(k).  To get you to buy, they tend to exaggerate the potential benefits and obscure the risks and drawbacks of what they sell.  They don't take the time to educate investors.  I've seen too many people purchase investment products through brokers without understanding what they're buying, how much risk they're taking, and how these investments will affect their overall financial lives. 

  Invest in no-load (commission-free) funds.  The only way to be sure that a fund is truly no-load is to look at the prospectus for the fund.  Only there, in black and white and without marketing hype, must the truth be told about sales charges and other fund fees.  When you want investing advice, hire a financial advisor on a fee-for-service basis (see Chapter 18), which should cost less and minimize potential conflicts of interest. 

Decreasing operating expenses

All funds charge ongoing fees.  The fees pay for the operational costs of running the fund — employees' salaries, marketing, servicing the toll-free phone lines, printing and mailing published materials, computers for tracking investments and account balances, accounting fees, and so on.  Despite being labeled "expenses," the profit a fund company earns for running the fund is added to the tab, as well. 

The fund's operating expenses are quoted as an annual percentage of your investment and are essentially invisible to you, because they're deducted before you're paid any return.  The expenses are charged on a daily basis, so you don't need to worry about trying to get out of a fund before these fees are deducted.  You can find a fund's operating expenses in the fund's prospectus.  Look in the expenses section and find a line that says something like "Total Fund Operating Expenses."  You can also call the fund's toll-free number and ask a representative. 

  Within a given sector of funds (for example, money-market, short-term bond, or international stock), funds with low annual operating fees can more easily produce higher total returns for you.  Although expenses matter on all funds, some types of funds are more sensitive to high expenses than others.  Expenses are critical on money-market funds and very important on bond funds.  Fund managers already have a hard time beating the averages in these markets; with higher expenses added on, beating the averages is nearly impossible. 

With stock funds, expenses are a less important (but still significant) factor in a fund's performance.  Don't forget that, over time, stocks average returns of about 10 percent per year.  So if one stock fund charges 1 percent more in operating expenses than another fund, you're already giving up an extra 10 percent of your expected returns. 

Some people argue that investing in stock funds that charge high expenses may be justified if those funds generate higher rates of return.  However, evidence doesn't show that these stock funds actually generate higher returns.  In fact, funds with higher operating expenses tend to produce lower rates of return.  This trend makes sense, because operating expenses are deducted from the returns a fund generates. ( One additional cost not included in a fund's expense ratio is trading costs.  The SEC is now requiring funds to report these costs in their annual reports.) 

  Stick with funds that maintain low total operating expenses and don't charge loads (commissions).  Both types of fees come out of your pocket and reduce your rate of return.  You have no reason to pay a lot for the best funds. ( In Chapters 11 and 12, I provide some specific fund recommendations as well as sample portfolios for investors in different situations.) 

Evaluating historic performance

A fund's performance, or historic rate of return, is another factor to weigh when selecting a fund.  As all funds are supposed to tell you, past performance is no guarantee of future results.  An analysis of historic fund performance proves that some of yesterday's stars turn into tomorrow's skid-row bums. 

Many former high-return funds achieved their results by taking on high risk.  Funds that assume higher risk should produce higher rates of return.  But high-risk funds usually decline in price faster during major market declines.  Thus, in order for a fund to be considered a best fund, it must consistently deliver a favorable rate of return given the degree of risk it takes. 

  When assessing an individual fund, compare its performance and volatility over an extended period of time (five or ten years will do) to a relevant market index.  For example, compare funds that focus on investing in large U.S. companies to the Standard & Poor's 500 Index.  Compare funds that invest in U.S. stocks of all sizes to the Wilshire 5000 Index.  Indexes also exist for bonds, foreign stock markets, and almost any other type of security you can imagine. 

Assessing fund manager and fund family reputations

Much is made of who manages a specific mutual fund.  As Peter Lynch, the retired and famous former manager of the Fidelity Magellan fund, said, "The financial press made us Wall Street types into celebrities, a notoriety that was largely undeserved.  Stock stars were treated as rock stars. . . ." 

  Although the individual fund manager is important, no fund manager is an island.  The resources and capabilities of the parent company are equally important.  Different companies have different capabilities and levels of expertise in relation to the different types of funds.  When you're considering a particular fund — for example, the Barnum & Barney High-Flying Foreign Stock fund — examine the performance history and fees not only of that fund but also of similar foreign stock funds at the Barnum & Barney company.  If Barnum's other foreign stock funds have done poorly, or Barnum & Barney offers no other such funds because it's focused on its circus business, those are strikes against its High-Flying fund.  Also be aware that "star" fund managers tend to be associated with higher-expense funds to help pay their rock-star salaries. ( And star managers tend to leave or get hired away after three to five years of stellar performance, so you may not be getting the manager who created that good past performance in the first place.  Index and asset class funds that use a team approach avoid this issue.) 

Rating tax friendliness

Investors often overlook tax implications when selecting funds for nonretirement accounts.  Numerous funds effectively reduce their shareholders' returns because of their tendency to produce more taxable distributions — that is, capital gains (especially short-term gains, which are taxed at the highest federal income tax rate) and dividends. ( See the "Dividends" and "Capital gains" sections later in this chapter.) 

Fund capital-gains distributions have an impact on an investor's after-tax rate of return.  All mutual-fund managers buy and sell stocks over the course of a year.  Whenever a fund manager sells securities, any gain or loss from those securities must be distributed to fund shareholders.  Securities sold at a loss can offset securities sold at a profit.  When a fund manager has a tendency to cash in more winners than losers, investors in the fund receive taxable gains.  So, even though some funds can lay claim to producing higher total returns, after you factor in taxes, they actually may not produce higher total returns. 

Choosing funds that minimize capital-gains distributions helps you defer taxes on your profits.  By allowing your capital to continue compounding as it would in a retirement account, you receive a higher total return.  When you're a long-term investor, you benefit most from choosing funds that minimize capital-gains distributions.  The more years that appreciation can compound without being taxed, the greater the value to you as the investor. 

  If you're purchasing shares in funds outside tax-sheltered retirement accounts, consider the time of year when making your purchases.  December is the most common month in which funds make capital-gains distributions.  When making purchases late in the year, ask if and when the fund may make a significant capital-gains distribution.  Consider delaying purchases in such funds until after the distribution date. 

Determining your needs and goals

Selecting the best funds for you requires an understanding of your investment goals and risk tolerance.  What may be a good fund for your next-door neighbor may not necessarily be a good fund for you.  You have a unique financial profile. 

  If you've already determined your needs and goals — terrific!  If you haven't, refer to Chapter 4.  Understanding yourself is a good part of the battle.  But don't shortchange yourself by not being educated about the investment you're considering.  If you don't understand what you're investing in and how much risk you're taking, stay out of the game. 

Deciphering Your Fund's Performance

  You can't simply calculate your return by comparing the share price of the fund today to the share price you originally paid.  Why not?  Because funds make distributions (of dividends and capital gains), which, when reinvested, give you more shares of the fund. 

Distributions create an accounting problem, because they reduce the share price of a fund. ( Otherwise, you could make a profit from the distribution by buying into a fund just before a distribution is made.)  Therefore, over time, following just the share price of your fund doesn't tell you how much money you've made or lost. 

  The only way to figure out exactly how much you've made or lost on your investment is to compare the total value of your holdings in the fund today with the total dollar amount you originally invested.  If you invested chunks of money at various points in time and you want to factor in the timing of your various investments, this exercise becomes complicated. ( Check out my investment software recommendations in Chapter 19 if you want your computer to help you crunch the numbers.) 

The total return of a fund is the percentage change of your investment over a specified period.  For example, a fund may tell you that in 2011, its total return was 15 percent.  Therefore, if you invested $10,000 in the fund on the last day of 2010, your investment would be worth $11,500 at the end of 2011.  To find out a fund's total return, you can call the fund company's toll-free number, visit the company's website, or read the fund's annual report. 

The following three components make up your total return on a fund:

  Dividends (includes interest paid by money-market or bond funds)

  Capital gains distributions

  Share price changes

In short, you calculate a fund's total return as follows:

`Dividends + Capital Gains Distributions + Share Price Changes = Total Return`

The following sections discuss each of these components in more detail. 

Dividends

Dividends are income paid by investments.  Both bond funds and stocks can pay dividends.  Bond fund dividends (the interest paid by the individual bonds in a fund) tend to be higher (as a percentage of the amount you have invested in a fund).  When a dividend distribution is made, you can receive it as cash (which is good if you need money to live on) or reinvest it into more shares in the fund.  In either case, the share price of the fund drops to offset the payout.  So if you're hoping to strike it rich by buying into a bunch of funds just before their dividends are paid, don't bother.  You'll just end up paying more in income taxes. 

If you hold your mutual fund outside a retirement account, the dividend distributions are taxable income (unless they come from a tax-free municipal bond fund).  Dividends are taxable whether or not you reinvest them as additional shares in the fund.  Stock dividends are taxed at a low rate — 0 percent for those in the federal 10- and 15-percent tax brackets and 15 percent for everyone in the higher federal tax brackets. ( Tax reform may be coming in 2013, so stay tuned to `www.erictyson.com` for up-to-date information on tax law changes affecting your investments.) 

Capital gains

When a mutual-fund manager sells a security in the fund, net gains realized from that sale (the difference from the purchase price) must be distributed to you as a capital gain.  Typically, funds make one annual capital gains distribution in December, but distributions can be paid multiple times per year. 

As with a dividend distribution, you can receive your capital-gains distribution as cash or as more shares in the fund.  In either case, the share price of the fund drops to offset the distribution. 

For funds held outside retirement accounts, your capital-gains distribution is taxable.  As with dividends, capital gains are taxable whether or not you reinvest them in additional shares in the fund.  Capital-gains distributions can be partly comprised of short-term and long-term gains.  As I discuss in Chapter 7, profits realized on securities sold after more than a one-year holding period are taxed at the lower long-term capital gains rate.  Short-term gains are taxed at the ordinary income tax rate. 

  If you want to avoid making an investment in a fund that is about to make a capital-gains distribution, check with the fund to determine when capital gains are distributed.  Capital-gains distributions increase your current-year tax liability for investments made outside of retirement accounts. ( I discuss this concept in more detail in Chapter 12.) 

Share price changes

You also make money with a fund when the share price increases.  This occurrence is just like investing in a stock or piece of real estate.  If the mutual fund is worth more today than it was when you bought it, you've made a profit (on paper, at least).  In order to realize or lock in this profit, you need to sell your shares in the fund. 

Evaluating and Selling Your Funds

  How closely you follow your funds is up to you, depending on what makes you happy and comfortable.  I don't recommend tracking the share prices of your funds (or other investments, for that matter) on a daily basis; it's time-consuming and nerve-racking, and it can make you lose sight of the long-term picture.  When you track your investments too closely, you're more likely to panic when times get tough.  And with investments held outside of retirement accounts, every time you sell an investment at a profit, you get hit with taxes. 

  A monthly or quarterly check-in is more than frequent enough for following your funds.  Many publications carry total return numbers over varying periods so you can determine the exact rate of return you're earning. 

Trying to time and trade the markets so that you buy at lows and sell at highs rarely works.  Yet an entire industry of investment newsletters, hotlines, online services, and the like purport to be able to tell you when to buy and sell.  Don't waste your time and money on such predictive nonsense. ( See Chapter 8 for more info about gurus and newsletters.) 

Consider selling a fund only when it no longer meets the criteria mentioned in "Selecting the Best Funds," earlier in this chapter.  If a fund underperforms its peers for at least a two-year period, or if a fund jacks up its management fees, it may be a good time to sell.  But if you do your homework and buy good funds from good fund companies, you shouldn't have to do much trading. 

  Finding and investing in good funds isn't rocket science.  Chapters 11 and 12 recommend some specific funds using the criteria discussed earlier in this chapter.  If you're still not satiated, pick up a copy of the latest edition of my book Mutual Funds For Dummies (Wiley) and visit my website at `www.erictyson.com` for more details on the best exchange-traded funds and mutual funds. 
Chapter 11

Investing in Retirement Accounts

In This Chapter

  Deciding among retirement accounts

  Determining how to allocate money in retirement accounts

  Moving your retirement account to a new firm

This chapter helps you make sense of the various retirement account options and decide how to invest money you currently hold inside — or plan to contribute to — retirement accounts. ( To see how much money you should be saving toward retirement, see Chapter 4.) 

Looking at Types of Retirement Accounts

Retirement accounts offer numerous benefits.  In most cases, your contributions to retirement accounts are tax-deductible.  The contribution limits increased significantly in the earlier part of the first decade of the 2000s.  And when you place your money inside the retirement account, it compounds without taxation until you withdraw it. ( Some accounts, such as the newer Roth IRA, even allow for tax-free withdrawal of investment earnings.)  If you're not a high-income earner, you may be eligible for a new, special tax credit for making retirement account contributions — please refer to Table 7-2 in Chapter 7.  The following sections detail the types of retirement accounts and explain how to determine whether you're eligible and how to make the best use of them. 

Employer-sponsored plans

Your employer sets up this type of retirement plan and usually provides a limited selection of investment options.  All you have to do is contribute and choose how to spread your money among the menu of investment choices. 

401(k) plans

For-profit companies offer 401(k) plans.  The silly name comes from the section of the tax code that establishes and regulates these plans.  A 401(k) generally allows you to save up to $17,000 per year (for 2012), usually through payroll deductions.  If you're age 50 or older, you can stash away even more — $22,500 (for 2012).  Your employer's plan may have lower limits, though.  Your contributions to a 401(k) are excluded from your reported income and thus are generally free from federal and state income taxes (although they are subject to Social Security and Medicare taxes).  Future year limits will increase in $500 increments to keep pace with inflation. ( Some employers are offering a Roth 401(k) option, which doesn't offer an up-front tax deduction but does enable you to put away more money to compound without taxation.  Also, withdrawals after age 591⁄2 are tax-free as long as you've had the account for at least five years.) 

Some employers don't allow you to contribute to a 401(k) plan until you work for them for a full year.  Others allow you to start contributing right away.  Some employers also match a portion of your contributions.  They may, for example, match half of your first 6 percent of contributions; so in addition to saving a lot of taxes, you get a bonus from the company. 

  If you're a high-income earner and you contribute such a significant percentage of each paycheck that you hit the plan maximum before the end of the year, you may lose out on some matching money.  You may be better off spreading your contributions over the full calendar year.  Check with your company's benefits department for your plan's specifics. 

Smaller companies (those with fewer than 100 employees) can offer 401(k) plans, too.  If your company is interested in this option, contact some of the leading mutual fund organizations and discount brokerage firms that I discuss in Chapter 12 and in the section "Allocating money in plans you design," later in this chapter. 

403(b) plans

Nonprofit organizations offer 403(b) plans to their employees.  As with 401(k)s, your contributions to these plans are excluded from federal and state income taxes. ( Some employers are offering a Roth 403(b) option: There are no up-front tax breaks on contributions, but investment earnings compound without taxation and withdrawals past age 591⁄2 aren't taxed as long as you've had the account for five years.)  The 403(b) plans are often called tax-sheltered annuities, the name for insurance company investments that satisfy the requirements for 403(b) plans.  For the benefit of 403(b) retirement plan participants, no-load (commission-free) mutual funds can be used in 403(b) plans. ( See Chapter 10 for more on mutual funds.) 

Nonprofit employees are allowed to annually contribute up to $17,000 of their salary ($22,500 if age 50 or older) for tax year 2012. ( Future year limits will increase with the cost of living in $500 increments.)  Employees who have 15 or more years of service may be allowed to contribute beyond the standard limits.  Ask your employee benefits department or the investment provider for the 403(b) plan about eligibility requirements and the details of your personal contribution limit. 

  If you work for a nonprofit or public-sector organization that doesn't offer this benefit, lobby for it.  Nonprofit organizations have no excuse not to offer a 403(b) plan to their employees.  Unlike a 401(k), this type of plan requires virtually no out-of-pocket expenses from the employer.  The only requirement is that the organization must deduct the appropriate contribution from employees' paychecks and send the money to the investment company handling the 403(b) plan. 

Can your employer steal your retirement plan money? 

The short answer, unfortunately, is yes.  However, the vast majority of employees, particularly those who work for larger and more established companies, need not worry. 

Some companies that administer 401(k) plans have been cited by the U.S. Labor Department for being too slow in putting money that employees had deferred from their paychecks into employee 401(k) investment accounts.  In the worst cases, companies diverted employees' 401(k) money to pay corporate bills.  Many business owners who engaged in such practices used 401(k) money as a short-term emergency fund. 

In cases where companies failed and funds were diverted from employee 401(k) accounts, the funds were lost.  In situations where the employer delayed placing the money into the employees' 401(k) accounts, employees simply lost out on earning returns on their investments during the period.  When your contributions are in your 401(k) account, they're financially and legally separate from your employer.  Thus, your funds are still protected even if your employer goes bankrupt. 

The Labor Department requires employers to contribute employee retirement contributions to their proper accounts as soon as they can reasonably be segregated from the employer's general assets, but not later than the 15th business day of the month immediately after the month in which the contributions were either withheld or received by the employer.  In addition to keeping tabs on your employer to ensure that money withheld from your paycheck is contributed into your account within this time frame, you should also periodically check your 401(k) statement to make sure that your contributions are being invested as you instructed. 

When compared to insurance company annuities, no-load (no sales charge) mutual funds are superior investment vehicles on several fronts:

  Mutual fund companies have a longer and more successful investment track record than do insurance companies, many of which have only recently entered the mutual fund arena. 

  Insurance annuities charge higher annual operating expenses, often two to three times those of efficiently managed no-load mutual funds.  These high expenses reduce your returns. 

  Insurance company insolvency (bankruptcy) can risk the safety of your investment in an annuity, whereas the value of a mutual fund depends only on the value of the securities in the fund. ( If a mutual fund company fails, your securities investments aren't lost because they're held separately from the assets of the fund company itself.) 

  Insurance annuities come with significant charges for early surrender; 403(b) plans with mutual funds don't include these charges. 

With some 403(b) plans, you may borrow against your fund balance without penalty.  If this capability is important to you, check with your employer to see whether the company plan allows loans.  Although many insurance annuities advertise borrowing as an advantage, it can also be a drawback, because it may encourage you to raid your retirement money. 

  As long as your employer allows it, you may want to open a 403(b) account at the investment companies I suggest in the section "Allocating money in plans you design," later in this chapter. 

457 plans

Some nonprofit organizations and state and local governments offer 457 plans.  Like 403(b) or 401(k) plans, 457 plans offer participants the ability to contribute money from their paychecks on a pretax basis and thus save on federal and state taxes. 

  Money that you contribute to a tax-exempt organization's 457 plan is not separate from the organization's finances.  Thus, if the nonprofit goes belly up — a rare but not impossible occurrence in the nonprofit world — your retirement funds could be in jeopardy. 

Don't consider contributing to a 457 plan until you exhaust contributions to your 403(b).  The 2012 tax year contribution limits for a 457 plan are $17,000 per year ($22,500 if age 50 or older).  Future year limits will increase with inflation in $500 increments. 

Self-employed plans

When you work for yourself, you don't have an employer to do the legwork necessary for setting up a retirement plan.  You need to take the initiative.  Although setting up a retirement account on your own requires more work, you can select and design a plan that meets your needs.  Self-employment retirement savings plans often allow you to put more money away on a tax-deductible basis than do employers' plans. 

When you have employees, you're required to provide coverage for them under these plans with contributions comparable to the company owners' (as a percentage of salary). 

Some part-time (fewer than 1,000 hours per year) and newer (those with less than a few years of service) employees may be excluded.  Many small-business owners either don't know about this requirement or choose to ignore it; they set up plans for themselves but fail to cover their employees. 

  The danger is that the IRS and state tax authorities may discover small-business owners' negligence, sock them with big penalties, and disqualify their prior contributions.  Remember: Self-employed people and small businesses get their tax returns audited at a relatively high rate. 

  To get the most from contributions as an employer, consider the following advice:

  Educate your employees about the value of retirement savings plans.  You want them to understand, but more importantly, you want them to appreciate your investment. 

  Select a Keogh plan (see "Keoghs," later in this chapter) that requires employees to stay a certain number of years before they vest fully in their contributions.  Reward long-term contributors to your company's success. 

  Consider offering a 401(k) or SIMPLE (Savings Incentive Match Plan for Employees) if you have more than ten employees. ( For more information on the SIMPLE, see the Department of Labor's website at `www.dol.gov/ebsa/publications/simple.html`.) 

Making retirement contributions doesn't have to increase your personnel costs.  In the long run, you build the contributions you make for your employees into their total compensation package — which includes salary and benefits such as health insurance. 

Don't be duped into a "private pension plan"

Employers who don't want to make retirement plan contributions on behalf of their employees are bait for insurance salespeople selling so-called "private pension plans."  Basically, these plans are cash value life insurance policies that combine life insurance protection with a savings-type account. ( See Chapter 16 for more details.) 

The selling hook of these plans is that you can save money for yourself, but you don't need to contribute money on your employees' behalf (as you must with self-employed retirement plans).  And your contributions compound without taxation over the years. 

Sound too good to be true?  Well, life insurance salespeople who earn hefty commissions from selling cash value life policies won't tell you about the big negatives of these plans.  Unlike contributions to true retirement savings plans such as SEP-IRAs and Keoghs, you derive no upfront tax deduction.  Your long-term investment returns will be quite mediocre, especially due to these plans' high and hidden fees. 

Also, if you don't need life insurance protection, the cost of such coverage is wasted when you save through these plans. 

SEP-IRAs

SEP-IRA (Simplified Employee Pension Individual Retirement Account) plans require little paperwork to set up.  SEP-IRAs allow you to sock away 20 percent of your self-employment income (business revenue minus deductions), up to a maximum of $50,000 (for tax year 2012).  Future contribution limits will rise with inflation in $1,000 increments. 

Each year, you decide the amount you want to contribute — with no minimums.  Your contributions to a SEP-IRA are deducted from your taxable income, saving you big-time on federal and state taxes.  As with other retirement plans, your money compounds without taxation until you withdraw it. 

Keoghs

Setting up and administering Keogh plans requires a bit more paperwork than SEP-IRAs.  The historic appeal of certain types of Keoghs was that they allowed you to put away a greater amount of your self-employment income (revenue less your deductions).  However, Keogh plans now have the same contribution limits (20 percent of net self-employment income up to $50,000 per year) that SEP-IRA plans have. ( This is the 2012 tax year limit; future limits will increase with inflation in $1,000 increments.) 

A combined Keogh and individual 401(k) plan offers an advantage for self-employeds.  The advantage is that self-employeds can reach the max contribution to the plan ($50,000) with lower income than they can with just the Keough or SEP-IRA alone (again, because 100 percent of income up to $17,000 — not just 20 percent — is allowed for the 401(k) portion). 

Keogh plans still hold some unique appeal for business owners who seek to maximize their own personal retirement plan contributions relative to those made for employees.  All types of Keogh plans allow vesting schedules, which require employees to remain with the company a number of years before they earn the right to their full retirement account balances. 

Keogh plans also allow for Social Security integration.  Without going into all the gory tax details, integration effectively allows those in the company who are high-income earners (usually the owners) to receive larger-percentage contributions for their accounts than the less-highly-compensated employees.  The logic behind this idea is that Social Security benefits top out when you earn more than $110,100 (for 2012).  Social Security integration allows you to make up for this ceiling. 

Individual Retirement Accounts (IRAs)

Anyone with employment income can contribute to an Individual Retirement Account (IRA).  You may contribute up to $5,000 each year — $6,000 if you're age 50 or older.  If you earn less than these contribution limits, you can contribute up to the amount you earn.  This rule has an exception if you're a nonworking spouse: As long as the working spouse earns at least $10,000 in income, the nonworking spouse can put up to $5,000 per year into a so-called spousal IRA; likewise, the working spouse can put up to $5,000 into his or her own IRA.  Another exception to earning employment income makes you eligible to contribute to an IRA: receiving alimony. 

Your contributions to an IRA may or may not be tax-deductible.  For tax year 2012, if you're single and your adjusted gross income is $58,000 or less for the year, you can deduct your full IRA contribution.  If you're married and file your taxes jointly, you're entitled to a full IRA deduction if your AGI (adjusted gross income) is $92,000 per year or less.  If you make more than these amounts, you can take a full IRA deduction if and only if you're not an active participant in any other retirement plan.  The only way to know for certain whether you're an active participant is to look at your W-2 Form — that smallish (4-x-81⁄2-inch) document your employer sends you early in the year to file with your tax returns.  An "X" mark in a little box in Section 13 on that form indicates that you're an active participant in an employer retirement plan. 

If your adjusted gross income is higher than the previously mentioned amounts by less than $10,000 for singles ($20,000 for married couples filing jointly), you're eligible for a partial IRA deduction, even if you're an active participant in another plan.  The IRS 1040 instruction booklet comes with a worksheet that allows you to do the calculations for your situation. 

  If you can't deduct your contribution to a standard IRA, consider making a contribution to a newer type of IRA called the Roth IRA.  With the Roth IRA, the contribution is not deductible (you're contributing after-tax dollars), but earnings inside the account are shielded from tax; and unlike a standard IRA, qualified withdrawals from the account, including investment earnings, are free from income tax.  Single taxpayers with an AGI less than $110,000, and joint filers with an AGI less than $173,000 can contribute up to $5,000 per year to a Roth IRA ($6,000 for those age 50 and older), provided that they have at least that amount in earned income. ( Reduced contributions are allowed for taxpayers with AGIs above these amounts up to $125,000 for single taxpayers and $183,000 for married taxpayers filing jointly.) 

To make a qualified (tax-free) withdrawal, you must be at least 591⁄2 and have held the account for at least five years.  An exception to the age rule is made for first-time home buyers, who can withdraw up to $10,000 toward the down payment on a principal residence. 

Annuities: An odd investment

Annuities are peculiar investment products.  They're contracts that are backed by an insurance company.  If you, the annuity holder (investor), die during the so-called accumulation phase (that is, prior to receiving payments from the annuity), your designated beneficiary is guaranteed to receive the amount of your contribution.  In this sense, annuities look a bit like life insurance. 

Annuities, like IRAs, allow your capital to grow and compound without taxation.  You defer taxes until withdrawal.  Annuities carry the same penalties for withdrawal prior to age 591⁄2 as do other retirement accounts. 

Unlike an IRA, which has an annual contribution limit, you can deposit as much as you want into an annuity in any year — even a million dollars or more if you have it!  As with a so-called nondeductible IRA, you get no upfront tax deduction for your contributions. 

  Contributing to an annuity may make sense if

  You have exhausted contributions to employer-sponsored and self-employed plans.  Your contributions to these retirement accounts are tax-deductible, while annuity contributions are not. 

  You have made the maximum contribution possible to an IRA, even if it's not tax-deductible.  Annuities carry higher fees (which reduce your investment returns) because of the insurance that comes with them; IRA investments offer you slightly better returns.  Roth IRAs also allow for tax-free withdrawal of investment earnings. 

  You expect to leave the money compounding in the annuity for at least 15 years.  It typically takes this long for the benefits of tax-deferred compounding to outweigh the higher annuity fees and treatment of all withdrawn annuity earnings at the higher ordinary income tax rates.  If you're close to or are actually in retirement, tax-friendly investments made outside of retirement accounts are preferable. 

For details about other investment options and the best places to purchase annuities, see Chapter 12, where I discuss investing money outside of retirement accounts. 

Allocating Your Money in Retirement Plans

With good reason, people are concerned about placing their retirement account money in investments that can decline in value.  You may feel that you're gambling with dollars intended for the security of your golden years. 

Most working folks need to make their money work hard in order for it to grow fast enough to provide this security.  This need involves taking some risk; you have no way around it.  Luckily, if you have 15 to 20 years or more before you need to draw on the bulk of your retirement account assets, time is on your side.  As long as the value of your investments has time to recover, what's the big deal if some of your investments drop a bit over a year or two?  The more years you have before you're going to retire, the greater your ability to take risk. 

  Think of your retirement accounts as part of your overall plan to generate retirement income.  Then allocate different types of investments between your tax-deferred retirement accounts and other taxable investment accounts to get the maximum benefit of tax deferral.  This section helps you determine how to distribute your money in retirement plans.  Chapter 8 can help you decide how to divide your money among different nonretirement investment options based on your time frame and risk tolerance. 

Inappropriate retirement account investments

Some investments for retirement accounts simply don't make sense.  Investments that produce income that is tax-free either at the federal or state level don't generally make much sense inside retirement accounts.  Because tax-free securities generally yield less than their taxable counterparts, you're essentially giving away free yield when you invest in such securities inside retirement accounts. 

Investing in municipal bonds inside a retirement account is a big no-no, and the better investment firms won't let you make this mistake.  Municipals are free from federal taxation (and state tax, too, if you buy such a bond issued in your state).  As such, they yield significantly less than an equivalent bond that pays fully taxable dividends. 

Lots of people make the mistake (albeit a smaller one) of investing in Treasuries — that is, U.S. Treasury bills, notes, or bonds — inside retirement accounts.  When you buy Treasuries, you get the safety net of a government guarantee, but you also get a bond that produces interest free of state tax.  Fully taxable bonds yield more than state-tax-free Treasuries.  And the safety of Treasuries can be replicated in other bonds. 

Although annuities are retirement vehicles, as noted earlier in this chapter, they have no place inside retirement accounts.  Annuities allow your investment dollars to compound without taxation.  In comparison to other investments that don't allow such tax deferral, annuities carry much higher annual operating expenses, which depress your returns. 

Purchasing an annuity inside an IRA, 401(k), or other type of retirement account is like wearing a belt and suspenders together.  Either you have a peculiar sense of style, or you're spending too much time worrying about your pants falling down.  In my experience, many people who mistakenly invest in annuities inside retirement accounts have been misled by investment salespeople. 

Limited partnerships (LPs) are treacherous, high-commission, high-cost (and hence low-return) investments sold through investment salespeople.  Part of their supposed allure, however, is the tax benefits they generate.  But when you buy and hold a limited partnership in a retirement account, you lose the ability to take advantage of many of the tax deductions.  The illiquidity of LPs may also mean that you can't make required retirement account withdrawals when needed.  These are just some of the many reasons to avoid investing in limited partnerships. ( For more reasons, see Chapter 9.) 

Prioritizing retirement contributions

  When you have access to various retirement accounts, prioritize which account you're going to use first by determining how much each gives you in return.  Your first contributions should be to employer-based plans that match your contributions.  After that, contribute to any other employer or self-employed plans that allow tax-deductible contributions.  After you contribute as much as possible to these tax-deductible plans (or if you don't have access to such plans), contribute to an IRA.  If you max out on contributions to an IRA or you don't have this choice because you lack employment income, consider an annuity (see "Annuities: An odd investment," earlier in this chapter). 

Setting up a retirement account

Investments and account types are different issues.  People sometimes get confused when discussing the investments they make in retirement accounts — especially people who have a retirement account, such as an IRA, at a bank.  They don't realize that you can have your IRA at a variety of financial institutions (for example, a mutual fund company or brokerage firm).  At each financial institution, you can choose among the firm's investment options for putting your IRA money to work. 

  No-load, or commission-free, mutual funds and discount brokerage firms are your best bets for establishing a retirement account.  For more specifics, see my recommendations throughout the remainder of this chapter. 

Allocating money when your employer selects the investment options

In some company-sponsored plans, such as 401(k)s, you're typically limited to the predetermined investment options your employer offers.  In the following sections, I discuss common investment options for 401(k) plans in order of increasing risk and, hence, likely return.  Then I follow with examples for how to allocate your money across the different types of common employer retirement plan options. 

Money market/savings accounts

For regular contributions that come out of your paycheck, the money-market or savings account option makes little sense.  Some people who are skittish about the stock and bond markets are attracted to money-market and savings accounts because they can't drop in value.  However, the returns are low — so low that you have a great risk that your investment will not stay ahead of, or even keep up with, inflation and taxes (which are due upon withdrawal of your money from the retirement account). 

Don't be tempted to use a money-market fund as a parking place until the time that you think stocks and bonds are cheap.  In the long run, you won't be doing yourself any favors.  As I discuss in Chapter 8, timing your investments to attempt to catch the lows and avoid the peaks isn't possible. 

  You may need to keep money in the money-market investment option if you utilize the borrowing feature that some retirement plans allow.  Check with your employee benefits department for more details.  After you retire, you may also want to use a money-market account to hold money you expect to withdraw and spend within a year or so. 

Bond mutual funds

Bond mutual funds (which I describe in Chapter 10) invest in a mixture of typically high-quality bonds.  Bonds pay a higher rate of interest or dividends than money funds.  Depending on whether your plan's option is a short-term, intermediate-term, or long-term fund (maybe you have more than one type), the bond fund's current yield is probably a percent or two higher than the money-market fund's yield. ( Note: During certain time periods, such as the late 2000s, the yield difference may be more whereas during other time periods, such as the mid-2000s, it may be less.) 

Bond funds carry higher yields than money-market funds, but they also carry greater risk, because their value can fall if interest rates increase.  However, bonds tend to be more stable in value over the shorter term (such as a few years) than stocks. 

  Aggressive, younger investors should keep a minimum amount of money in bond funds.  Older folks who want to invest conservatively can place more money in bonds (see the asset allocation discussion in Chapter 8). 

Guaranteed-investment contracts (GICs)

Guaranteed-investment contracts (GICs) are backed by an insurance company, and they typically quote you a rate of return projected one or a few years forward.  Thus, you don't have the uncertainty that you normally face with bond or stock investments (unless, of course, the insurance company fails). 

The attraction of these investments is that your account value doesn't fluctuate (at least, not that you can see).  Insurers normally invest your money mostly in bonds and maybe a bit in stocks.  The difference between what these investments generate for the insurer and what they pay in interest to GIC investors is profit to the insurer.  A GIC's yield is usually comparable to that of a bond fund. 

  For people who hit the eject button the moment that a bond fund slides a bit in value, GICs are soothing to the nerves.  And they're certainly higher yielding than a money-market or savings account. 

Like bonds, however, GICs don't give you the opportunity for much long-term growth above the rate of inflation.  Over the long haul, you can expect to earn a better return in a mixture of bond and stock investments.  In GICs, you pay for the peace of mind of a guaranteed return with lower long-term returns. 

GICs also have another minor drawback: Insurance companies, unlike mutual funds, can and do fail, putting GIC investment dollars at risk.  Some employers' retirement plans have been burned by insurance company failures. 

Balanced mutual funds

Balanced mutual funds invest primarily in a mixture of stocks and bonds.  This one-stop-shopping concept makes investing easier and smoothes out fluctuations in the value of your investments — funds investing exclusively in stocks or in bonds make for a rougher ride.  These funds are solid options and, in fact, can be used for a significant portion of your retirement plan contributions.  See Chapter 10 to find out more about balanced funds. 

Stock mutual funds

Stock mutual funds invest in stocks, which often provide greater long-term growth potential but also wider fluctuations in value from year to year.  Some companies offer a number of different stock funds, including funds that invest overseas.  Unless you plan to borrow against your funds to purchase a home (if your plan allows), you should have a healthy helping of stock funds.  See Chapter 10 for an explanation of the different types of stock funds as well as for details on how to evaluate a stock fund. 

Stock in the company you work for

  Some companies offer employees the option of investing in the company's stock.  I generally advocate avoiding this option for the simple reason that your future income and other employee benefits are already riding on the success of the company.  If the company hits the skids, you may lose your job and your benefits.  You certainly don't want the value of your retirement account to depend on the same factors. 

In the early 2000s, you may have heard all the hubbub about companies such as Enron going under and employees losing piles of money in their retirement savings plans.  Enron's bankruptcy in and of itself shouldn't have caused direct problems in Enron's 401(k) plan.  The problem was that Enron required employees to hold substantial amounts of Enron company stock.  Thus, when the company tanked, employees lost their jobs and their retirement savings balances. 

Thanks to the Employee Retirement Income Security Act (ERISA), companies are no longer allowed to force employees to hold retirement plan money in company stock.  Specifically, ERISA rules require companies to offer prudent and adequately diversified investments within their retirement savings plans.  Investing in the employer's stock can be offered, but investing in the stock must be strictly optional, and it must be one of numerous investment options offered to employees. 

If you think that your company has its act together and the stock is a good buy, investing a portion of your retirement account is fine — but no more than 25 percent.  Now, if your company is on the verge of hitting it big and the stock is soon to soar, you'll of course be kicking yourself for not putting more of your money into the company's stock.  But when you place a big bet on your company's stock, be prepared to suffer the consequences if the stock tanks.  Don't forget that lots of smart investors track companies' prospects, so odds are that the current value of your company's stock is reasonably fair. 

  Some employers offer employees an additional option to buy company stock outside a tax-deferred retirement plan at a discount, sometimes as much as 15 percent, when compared to its current market value.  If your company offers a discount on its stock, take advantage of it.  When you sell the stock, you'll usually be able to lock in a decent profit over your purchase price. 

Some asset allocation examples

Using the methodology that I outline in Chapter 8 for allocating money, Table 11-1 shows a couple examples of how people in different employer plans may choose to allocate their 401(k) investments among the plan's investment options. 

Please note that making allocation decisions is not a science.  Use the formulas in Chapter 8 as a guideline. 

Allocating money in plans you design

With self-employed plans (SEP-IRAs and Keoghs), certain 403(b) plans for nonprofit employees, and IRAs, you may select the investment options as well as the allocation of money among them.  In the sections that follow, I give some specific recipes that you may find useful for investing at some of the premier investment companies. 

To establish your retirement account at one of these firms, simply pick up your telephone, dial the company's toll-free number, and ask the representative to mail you an account application for the type of account (for example, SEP-IRA, 403(b), and so on) you want to set up.  You can also have the company mail you background information on specific mutual funds.  Furthermore, many investment firms provide downloadable account applications on their websites, and some allow you to complete the application online. 

Note: In the examples, I make recommendations for a conservative portfolio and an aggressive portfolio for each firm.  I use the terms conservative and aggressive in a relative sense.  Because some of the funds I recommend don't maintain fixed percentages of their different types of investments, the actual percentage of stocks and bonds that you end up with may vary slightly from the targeted percentages.  Don't sweat it. 

  Where you have more than one fund choice, you can pick one or split the suggested percentage among them.  If you don't have enough money today to divvy up your portfolio as I suggest, you can achieve the desired split over time as you add more money to your retirement accounts. 

Vanguard

Vanguard (phone 877-662-7447; website `www.vanguard.com`) is a mutual fund powerhouse, and it also operates a discount brokerage division.  It's the largest no-load fund company, and it consistently has the lowest operating expenses in the business.  Historically, Vanguard's funds have shown excellent performance when compared to those of the company's peers, especially among conservatively managed bond and stock funds. 

A conservative portfolio with 50 percent stocks, 50 percent bonds

  If you don't want to risk too much, try this:

  Vanguard Total Bond Market Index — 25 percent

  Vanguard Star (balanced fund of funds) — 60 percent

  Vanguard International Value and/or Vanguard Total International Stock Index — 15 percent

An aggressive portfolio with 80 percent stocks, 20 percent bonds

  If you want to be aggressive, try this:

  Vanguard Star (fund of funds) — 50 percent

  Vanguard Total Stock Market Index — 30 percent

  Vanguard International Value and/or Vanguard Total International Stock Index — 20 percent

Should I use more than one investment firm? 

The firms I recommend in this chapter offer a large-enough variety of investment options, managed by different fund managers, that you can feel comfortable concentrating your money at one firm.  Your investments themselves aren't at risk based on the financial health of the fund company itself.  Discovering the nuances and choices of just one firm rather than several and having fewer administrative hassles are the advantages of a focused approach. 

If you like the idea of spreading your money around, you may want to invest through a number of different firms using a discount brokerage account (see Chapter 8).  You can diversify across different mutual fund companies through one brokerage firm.  However, you'll pay small transaction fees on some of your purchases and sales of funds. 

Or you can place 100 percent in Vanguard LifeStrategy Growth (fund of funds).  Note that this portfolio places less money overseas than the preceding example. 

Fidelity

Fidelity Investments (phone 800-343-3548; website `www.fidelity.com`) is the largest provider of mutual funds in terms of total assets, and it operates a discount brokerage division.  However, some Fidelity funds assess sales charges (no such funds are recommended in the sections that follow). 

A conservative portfolio with 50 percent stocks, 50 percent bonds

  If you want to maintain a conservative portfolio, try this:

  Fidelity Puritan (balanced fund) — 50 percent

  Dodge & Cox Balanced — 50 percent

An aggressive portfolio with 80 percent stocks, 20 percent bonds

  If you want to maintain an aggressive portfolio, try this:

  Fidelity Puritan (balanced fund) — 35 percent

  Sequoia — 25 percent

  Fidelity Low-Priced Stock — 20 percent

  Vanguard Total International Stock Index and/or Litman Gregory Masters' International — 20 percent

Discount brokers

As I discuss in Chapter 8, a discount brokerage account can allow you centralized, one-stop shopping and the ability to hold mutual funds from a variety of leading fund companies.  Some funds are available without transaction fees, although most of the better funds require you to pay a small transaction fee when you buy funds through a discount broker.  The reason: The discounter is a middleman between you and the fund companies.  You have to weigh the convenience of being able to buy and hold funds from multiple fund companies in a single account versus the lower cost of buying funds directly from their providers.  A $25 to $30 transaction fee can gobble a sizeable chunk of what you have to invest, especially if you're investing smaller amounts. 

Among brokerage firms or brokerage divisions of mutual fund companies, for breadth of fund offerings and competitive pricing, I like TD Ameritrade (phone 800-454-9272; website `www.tdameritrade.com`), T. Rowe Price (phone 800-225-5132; website `www.troweprice.com`), and Vanguard (phone 877-662-7447; website `www.vanguard.com`). 

A conservative portfolio with 50 percent stocks, 50 percent bonds

  If you want to set up a conservative portfolio, try this:

  Vanguard Short-Term Investment-Grade — 20 percent

  Harbor Bond and/or Dodge & Cox Income — 20 percent

  Dodge & Cox Balanced — 20 percent

  T. Rowe Price Spectrum Growth (global stock fund of funds) — 30 percent

  Litman Gregory Masters' International and/or Tweedy Browne Global Value — 10 percent

An aggressive portfolio with 80 percent stocks, 20 percent bonds

  If you want to set up an aggressive portfolio, try this:

  Harbor Bond and/or Vanguard Total Bond Market Index — 20 percent

  Vanguard Total Stock Market Index and/or Dodge & Cox Stock and/or Sequoia — 50 percent

  Litman Gregory Masters' International and/or Vanguard International Growth and/or Vanguard Total International Stock — 30 percent

Transferring Retirement Accounts

With the exception of plans maintained by your current employer that limit your investment options, such as most 401(k)s, you can move your money held in an SEP-IRA, Keogh, IRA, and many 403(b) plans (also known as tax-sheltered annuities) or 401(k) plans you hold at former employers, to almost any major investment firm.  Moving the money is pretty simple: If you can fill out a couple of short forms and send them back in a postage-paid envelope, you can transfer an account.  The investment firm to which you're transferring your account does the rest. 

Transferring accounts you control

Here's a step-by-step list of what you need to do to transfer a retirement account to another investment firm.  Even if you're working with a financial advisor, you should be aware of this process (called a direct trustee-to-trustee transfer) to ensure that no hanky-panky takes place on the advisor's part and to ensure that the transfer is not taxable. 

1.  Decide where you want to move the account. 

I recommend several investment companies in this chapter, along with some sample portfolios within those firms.  You may also want to consult the latest editions of some of my other books, including Mutual Funds For Dummies and Investing For Dummies (Wiley) and visit my website at `www.erictyson.com`. 

2.  Obtain an account application and asset transfer form. 

Call the toll-free number of the firm you're transferring the money to and ask for an account application and asset transfer form for the type of account you're transferring — for example, SEP-IRA, Keogh, IRA, 403(b), or 401(k).  You can also visit the firm's website, but for this type of request, I think most people find it easier to speak directly to someone. 

  Ask for the form for the same type of account you currently have at the company from which you're transferring the money.  You can determine the account type by looking at a recent account statement — the account type should appear near the top of the form or in the section with your name and address.  If you can't figure out the account type on a cryptic statement, call the firm where the account is currently held and ask a representative to tell you what kind of account you have. 

  Never, ever sign over assets such as checks and security certificates to a financial advisor, no matter how trustworthy and honest she may seem.  The advisor could bolt with them quicker than you can say "Bonnie and Clyde."  Transfers should not be completed this way.  Besides, you'll find it easier to handle the transfer by following the information in this section. 

3.  Figure out which securities you want to transfer and which need to be liquidated. 

Transferring existing investments in your account to a new investment firm can sometimes be a little sticky.  Transferring such assets as cash (money-market funds) or securities that trade on any of the major stock exchanges is not a problem. 

  If you own publicly traded securities, transferring them as is (also known as transferring them in kind) to your new investment firm is better, especially if the firm offers discount brokerage services.  You can then sell your securities through that firm more cheaply. 

If you own mutual funds unique to the institution you're leaving, check with your new firm to see whether it can accept them.  If not, you need to contact the firm that currently holds them to sell them. 

Certificates of deposit are tricky to transfer.  Ideally, you should send in the transfer forms several weeks or so before the CDs mature — few people do this.  If the CD matures soon, call the bank and tell it that when the CD matures, you would like the funds to be invested in a savings or money-market account that you can access without penalty when your transfer request lands in the bank's mailbox. 

4.  Complete and mail the account application and asset transfer form. 

Completing these for your new investment firm opens your new account and authorizes the transfer. 

  Don't take possession of the money in your retirement account when moving it over to the new firm.  The tax authorities impose huge penalties if you perform a transfer incorrectly.  Let the company to which you're transferring the money do the transfer for you.  If you have questions or problems, the firm(s) to which you're transferring your account has armies of capable employees waiting to help you.  Remember, these firms know that you're transferring your money to them, so they should roll out the red carpet. 

5.  Let the firm from which you're transferring the money know that you're doing so. ( This step is optional.) 

If the place you're transferring the money from doesn't assign a specific person to your account, you can definitely skip this step.  When you're moving your investments from a brokerage firm where you dealt with a particular broker, deciding whether to follow this step can be more difficult. 

Most people feel obligated to let their representative know that they're moving their money.  In my experience, calling the person with the "bad news" is usually a mistake.  Brokers or others who have a direct financial stake in your decision to move your money will try to sell you on staying.  Some may try to make you feel guilty for leaving, and some may even try to bully you. 

  Writing a letter may seem like the coward's way out, but writing usually makes leaving your broker easier for both of you.  You can polish what you have to say, and you don't put the broker on the defensive.  Although I don't want to encourage lying, not telling the whole truth may be an even better idea.  Excuses, such as that you have a family member in the investment business who will manage your money for free, may help you avoid an uncomfortable confrontation. 

Then again, telling an investment firm that its charges are too high or that it misrepresented and sold you a bunch of lousy investments may help the firm improve in the future.  Don't fret too much — do what's best for you and what you're comfortable with.  Brokers are not your friends.  Even though the broker may know your kids' names, your favorite hobbies, and your birthday, you have a business relationship with him. 

Transferring your existing assets typically takes two to four weeks to complete.  If the transfer is not completed within one month, get in touch with your new investment firm to determine the problem.  If your old company isn't cooperating, call a manager there to help get the ball rolling. 

The unfortunate reality is that an investment firm will cheerfully set up a new account to accept your money on a moment's notice, but it will drag its feet, sometimes for months, when the time comes to relinquish your money.  To light a fire under the behinds of the folks at the investment firm, tell a manager at the old firm that you're going to send letters to the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) if it doesn't complete your transfer within the next week. 

Moving money from an employer's plan

  When you leave a job, particularly if you're retiring or being laid off after many years of service, money-hungry brokers and financial planners probably will be on you like a pack of bears on a tree leaking sweet honey.  If you seek financial help, tread carefully — Chapter 18 helps you avoid the pitfalls of hiring such assistance. 

When you leave a job, you're confronted with a slightly different transfer challenge: moving money from an employer plan into one of your own retirement accounts. ( As long as your employer allows it, typically if the account has a value that exceeds about $3,500, you may be able to leave your money in your old employer's plan.  Evaluate the quality of the investment choices using the information I provide in this part of the book.)  Typically, employer retirement plan money can be rolled over into your own IRA.  Check with your employer's benefits department or a tax advisor for details. 

  Federal tax law requires employers to withhold, as a tax, 20 percent of any retirement account disbursements to plan participants.  So if you personally take possession of your retirement account money in order to transfer it to an IRA, you must wait until you file your annual tax return to be reimbursed by the government for this 20-percent withholding.  This withholding creates a problem, because if you don't replace the 20-percent withholding into the rollover IRA and deposit the entire rollover within 60 days in the new account, the IRS treats the shortfall as an early distribution subject to income tax and penalties. 

  Never take personal possession of money from your employer's retirement plan.  To avoid the 20-percent tax withholding and a lot of other hassles, simply inform your employer of where you want your money to be sent.  Prior to doing so, establish an appropriate account (an IRA, for example) at the investment firm you intend to use.  Then tell your employer's benefits department where you'd like your retirement money transferred.  You can send your employer a copy of your account statement, which contains the investment firm's mailing address and your account number. 
Chapter 12

Investing in Taxable Accounts

In This Chapter

  Taking advantage of overlooked, attractive investment options

  Factoring taxes into your investment decisions

  Bolstering your emergency reserves

  Looking at longer-term investments

In this chapter, I discuss investment options for money held outside retirement accounts, and I include some sample portfolio recommendations. ( Chapter 11 reviews investments for money inside retirement accounts.)  This distinction may seem somewhat odd — it's not one that's made in most financial books and articles.  However, thinking of these two types of investment accounts differently can be useful because

  Investments held outside retirement accounts are subject to taxation.  You have a whole range of different investment options to consider when taxes come into play. 

  Money held outside retirement accounts is more likely to be used sooner than funds held inside retirement accounts.  Why?  Because you'll generally have to pay far more in income taxes to access money inside rather than outside retirement accounts. ( And, you may be subject to penalties if you need to make early withdrawals from retirement accounts.) 

  Funds inside retirement accounts have their own nuances.  For example, when you invest through your employer's retirement plan, your investment options are usually limited to a handful of choices.  And special rules govern transfer of your retirement account balances. 

Getting Started

Suppose that you have some money sitting in a bank savings account or money-market mutual fund, earning a pitiful amount of interest, and you want to invest it more profitably.  You need to remember two things about investing this type of money:

  Earning a little is better than losing 20 to 50 percent or more.  Just talk to anyone who bought a lousy investment.  Be patient.  Educate yourself before you invest. 

  To earn a higher rate of return, you must be willing to take more risk.  In order to earn a better rate of return, you need to consider investments that fluctuate in value — of course, the value can drop as well as rise. 

You approach the vast sea of investment options and start stringing up your rod to go fishing.  You hear stories of people catching big ones — cashing in big on stocks or real estate that they bought years ago.  Even if you don't have delusions of grandeur, you'd at least like your money to grow faster than the cost of living. 

But before you cast your investment line, consider the following often overlooked ways to put your money to work and earn higher returns without much risk.  These options may not be as exciting as hunting the big fish out there, but they can easily improve your financial health. 

Paying off high-interest debt

  Many folks have credit card or other consumer debt that costs more than 10 percent per year in interest.  Paying off this debt with savings is like putting your money in an investment with a guaranteed return that's equal to the rate you're paying on the debt. 

For example, if you have credit card debt outstanding at 14-percent interest, paying off that loan is the same as putting your money to work in an investment with a sure 14-percent annual return.  Remember that the interest on consumer debt is not tax-deductible, so you actually need to earn more than 14 percent investing your money elsewhere in order to net 14 percent after paying taxes. ( See Chapter 5 for more details if you're still not convinced.) 

Paying off some of or your entire mortgage may make sense, too.  This financial move isn't as clear as erasing consumer debt, because the mortgage interest rate is lower than it is on consumer debt and is usually tax-deductible. ( See Chapter 14 for more details on this strategy.) 

Taking advantage of tax breaks

  Make sure that you take advantage of the tax benefits offered on retirement accounts.  If you work for a company that offers a retirement savings plan such as a 401(k), fund it at the highest level you can manage.  If you earn self-employment income, consider SEP-IRAs and Keoghs. ( I discuss retirement-plan options in Chapter 11.) 

If you need to save money outside retirement accounts for shorter-term goals (for example, to buy a car or a home, or to start or buy a small business), then by all means, do so.  This chapter can assist you with thinking through investing money in taxable accounts (nonretirement accounts exposed to taxation). 

Understanding Taxes on Your Investments

When you invest money outside of a retirement account, investment distributions — such as interest, dividends, and capital gains — are subject to current taxation.  Too many folks (and too many of their financial advisors) ignore the tax impact of their investment strategies.  You need to pay attention to the tax implications of your investment decisions before you invest your money. 

Consider a person in a combined 40-percent tax bracket (federal plus state taxes) who keeps extra cash in a taxable bond paying 5-percent interest.  If he pays 40 percent of his interest earnings in taxes, he ends up keeping just 3 percent.  With a similar but tax-free bond, he could easily earn more than this amount, completely free of federal and/or state taxes. ( Make sure you do an apples-to-apples comparison: Both the taxable and tax-free bonds must be of similar risk, which means that they should have the same credit rating/risk of default and mature in about the same number of years.) 

Another mistake some people make is investing in securities that produce tax-free income when they're not in a high enough tax bracket to benefit.  Now consider a person in a combined 20-percent tax bracket who's investing in securities that produce tax-free income.  Suppose he invests in a tax-free investment that yields 4.5 percent.  A comparable taxable investment is yielding 7 percent.  If he had instead invested in the taxable investment at a 7-percent yield, the after-tax yield would have been 5.6 percent.  Thus, he's losing out on yield by being in the tax-free investment, even though he may feel happy in it because the yield isn't taxed. 

  To decide between comparable taxable and tax-free investments, you need to know your marginal tax bracket (the tax rate you pay on an extra dollar of taxable income) and the rates of interest or yield on each investment. ( Check out Table 7-1 in Chapter 7 to see what federal income tax bracket you're in.) 

Fortifying Your Emergency Reserves

In Chapter 4, I explain the importance of keeping sufficient money in an emergency reserve account.  From such an account, you need two things:

  Accessibility: When you need to get your hands on the money for an emergency, you want to be able to do so quickly and without penalty. 

  Highest possible return: You want to get the highest rate of return possible without risking your principal.  This factor doesn't mean that you should simply pick the money-market or savings option with the highest yield, because other issues, such as taxes, are a consideration.  What good is earning a slightly higher yield if you pay a lot more in taxes? 

The following sections give you information on investments that are suitable for emergency reserves. 

Bank and credit union accounts

When you have a few thousand dollars or less, your best and easiest path is to keep this excess savings in a local bank or credit union.  Look first to the institution where you keep your checking account. 

  Keeping this stash of money in your checking account, rather than in a separate savings account, makes financial sense if the extra money helps you avoid monthly service charges when your balance occasionally dips below the minimum.  Compare the service charges on your checking account with the interest earnings from a savings account. 

For example, suppose you're keeping $4,000 in a savings account to earn 1 percent interest versus earning no interest on your checking account money.  Over the course of a year, you earn $40 in interest on that savings account.  If you incur a $9 per month service charge on your checking account, you pay $108 per year.  So keeping your extra $4,000 in a checking account may be better if it keeps you above a minimum balance and erases that monthly service charge. ( However, if you're more likely to spend the extra money in your checking account, keeping it in a separate savings account where you won't be tempted to spend it may be better.) 

Money-market mutual funds

Money-market funds, a type of mutual fund (see Chapter 10), are just like bank savings accounts — but better, in most cases.  The best money-market funds pay higher yields than bank savings accounts and allow check-writing.  And if you're in a high tax bracket, you can select a tax-free money-market fund, which pays interest that's free from federal and/or state tax — a feature you can't get with a bank savings account. 

  The yield on a money-market fund is an important consideration.  The operating expenses deducted before payment of dividends is the single biggest determinant of yield.  All other things being equal (which they usually are with different money-market funds), lower operating expenses translate into higher yields for you.  With interest rates as low as they are these days, seeking out money funds with the lowest operating expenses is now more vital than ever. 

Doing most or all of your fund shopping (money-market and otherwise) at one good fund company can reduce the clutter in your investing life.  Chasing after a slightly higher yield offered by another company sometimes isn't worth the extra paperwork and administrative hassle.  On the other hand, there's no reason why you can't invest in funds at multiple firms (as long as you don't mind the extra paperwork), using each for its relative strengths. 

Most mutual fund companies don't have many local branch offices, so you may have to open and maintain your money-market mutual fund through the fund's toll-free phone line, website, or the mail.  Distance has its advantages.  Because you can conduct business by mail, the Internet, and the phone, you don't need to go schlepping into a local branch office to make deposits and withdrawals.  I'm happy to report that I haven't visited a bank office in many years. 

  Despite the distance between you and your mutual fund company, your money is still accessible via check-writing, and you can also have money wired to your local bank on any business day.  Don't fret about a deposit being lost in the mail; it rarely happens, and no one can legally cash a check made payable to you, anyway.  Just be sure to endorse the check with the notation "for deposit only" under your signature. 

Watch out for "sales"

  Beware of money-market mutual funds that have a "sale" by temporarily waiving (sometimes called absorbing) operating expenses, which lets a fund boost its yield.  These sales rarely last long; the operating expenses come back and deflate that too-good-to-be-true yield like a nail in a bike tire.  Some fund companies run sales because they know that a major portion of the fund buyers who are lured in won't bother leaving when they jack up operating expenses. 

You're better off sticking with funds that maintain "everyday low operating expenses" to get the highest long-term yield.  I recommend such funds in the next section.  However, if you want to move your money to companies having specials and then move it back out when the special is over, be my guest.  If you have lots of money and don't mind paperwork, it may be worth the bother. 

Recommended money-market mutual funds

  In this section, I recommend good money-market mutual funds.  As you peruse this list, remember that the money-market fund that works best for you depends on your tax situation.  Throughout the list, I try to guide you to funds that generally make sense for people in particular tax brackets. 

  Money-market funds that pay taxable dividends are appropriate when you're not in a high tax bracket.  Some of my favorites include

• Fidelity Cash Reserves (phone 800-343-3548; website `www.fidelity.com`)

• USAA Money Market (phone 800-531-8722; website `www.usaa.com`)

• Vanguard Prime Money Market (phone 877-662-7447; website `www.vanguard.com`)

  U.S. Treasury money-market funds are appropriate if you prefer a money fund that invests in U.S. Treasuries, which have the safety of government backing, or if you're in a high state tax bracket (5 percent or higher) but not in a high federal tax bracket.  Vanguard (phone 877-662-7447; website `www.vanguard.com`) offers the Vanguard Admiral Treasury Money Market fund. 

  State-focused tax-free money-market funds are appropriate when you're in high federal and state tax brackets.  Fidelity (phone 800-343-3548; website `www.fidelity.com`), USAA (phone 800-531-8722; website `www.usaa.com`) and Vanguard (phone 877-662-7447; website `www.vanguard.com`) offer the best selection. 

Residents of many states won't find attractive state-specific money-market funds or won't find any at all.  In some cases, no options exist.  In other cases, the funds available for that particular state have such high annual operating expenses, and therefore such low yields, that you're better off in one of the more competitively run federal-tax-free-only funds that I note in the next Bullet1. 

  Federal-tax-free-only money-market funds (the dividends on these are state taxable) are appropriate when you're in a high federal but not state bracket, or if you live in a state that doesn't have competitive state- and federal-tax-free funds available.  Here are a few to choose from:

• Vanguard Tax-Exempt Money Market (phone 877-662-7447; website `www.vanguard.com`)

• Fidelity AMT Tax-Free Money Market and Tax-Free Money Market (phone 800-343-3548; website `www.fidelity.com`)

• T. Rowe Price Summit Municipal Money Market and Tax-Exempt Money Market (phone 800-225-5132; website `www.troweprice.com`)

• USAA Tax-Exempt Money Market (phone 800-531-8722; website `www.usaa.com`)

Investing for the Longer Term (A Few Years or More)

Important note: This section (together with its recommended investments) assumes that you have a sufficient emergency reserve stashed away and are taking advantage of tax-deductible retirement account contributions. ( Please see Chapter 4 for more on these goals.) 

Asset allocation refers to the process of figuring out what portion of your wealth to invest in different types of investments.  You often (and most appropriately) practice asset allocation with retirement accounts, because this money is earmarked for the long term.  Ideally, more of your saving and investing should be conducted through tax-sheltered retirement accounts.  These accounts generally offer the best way to lower your long-term tax burden (see Chapter 11 for details). 

If you plan to invest outside retirement accounts, asset allocation for these accounts depends on how comfortable you are with risk.  But your choice of investments should also be suited to how much time you have until you plan to use the money.  That's not because you won't be able to sell these investments on short notice if necessary (in most cases, you can).  Investing money in a more volatile investment is simply riskier if you need to liquidate it in the short term. 

For example, suppose that you're saving money for a down payment on a house and are about one to two years away from having enough to make your foray into the real-estate market.  If you had put this "home" money into the U.S. stock market near the beginning of one of the stock market's 20- to 50-percent corrections (such as what happened in the early 2000s and then again in the late 2000s), you'd have been mighty unhappy.  You would have seen a substantial portion of your money vanish in short order and would've seen your home ownership dreams put on hold. 

Defining your time horizons

The different investment options in the remainder of this chapter are organized by time frame.  All the recommended investment funds that follow assume that you have at least a several-year time frame, and they're all no-load (commission-free) mutual funds.  Mutual funds can be sold on any business day, usually with a simple phone call.  Funds come with all different levels of risk, so you can choose funds that match your time frame and desire to take risk. ( Chapter 10 discusses all the basics of mutual funds.) 

The recommended investments are also organized by your tax situation. ( If you don't know your current tax bracket, be sure to review Chapter 7.)  Following are summaries of the different time frames associated with each type of fund:

  Short-term investments: These investments are suitable for a period of a few years — perhaps you're saving money for a home or some other major purchase in the near future.  When investing for the short-term, look for liquidity and stability — features that rule out real estate and stocks.  Recommended investments include shorter-term bond funds, which are higher-yielding alternatives to money-market funds.  If interest rates increase, these funds drop slightly in value — a couple percent or so (unless rates rise tremendously).  I also discuss Treasury bonds and certificates of deposit (CDs) later in this chapter. 

  Intermediate-term investments: These investments are appropriate for more than a few years but less than ten years.  Investments that fit the bill are intermediate-term bonds and well-diversified hybrid funds (which include some stocks as well as bonds). 

  Long-term investments: If you have a decade or more for investing your money, you can consider potentially higher-return (and therefore riskier) investments.  Stocks, real estate, and other growth-oriented investments can earn the most money if you're comfortable with the risk involved.  See Chapter 8 for information on investing the portion that you intend to hold for the long term. 

Bonds and bond funds

  Bond funds that pay taxable dividends are generally appropriate when you're not in a high tax bracket.  Here are some of my favorites:

  Short-term: Vanguard Short-Term Investment-Grade (phone 877-662-7447; website `www.vanguard.com`)

  Intermediate-term: Dodge & Cox Income (phone 800-621-3979; website `www.dodgeandcox.com`); Harbor Bond (phone 800-422-1050; website `www.harborfunds.com`); Vanguard Total Bond Market Index (phone 877-662-7447; website `www.vanguard.com`)

  Long-term: Vanguard Long-Term Investment-Grade (phone 877-662-7447; website `www.vanguard.com`)

The following sections discuss other bond funds, as well as the individual bonds you can buy through Treasury Direct. 

U.S. Treasury bond funds

  U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing), or when you're in a high state tax bracket (5 percent or higher) but not a high federal tax bracket.  For good Treasury bond funds, look no further than the Vanguard Group, which offers short-, intermediate-, and long-term U.S. Treasury funds with a low 0.25-percent operating expense ratio.  With a $50,000 minimum, Vanguard's Admiral series of U.S. Treasury funds offers even higher yields thanks to an even lower expense ratio of 0.10 percent. 

Buying Treasuries from the Federal Reserve Bank

  If you want an even cheaper method of investing in Treasury bonds than you can get through the thrifty Vanguard Treasury funds, try this: Purchase Treasuries directly from the Federal Reserve Bank.  To open an account through the Treasury Direct program, call 800-722-2678, or visit its website at `www.treasurydirect.gov`. 

You do sacrifice a bit of liquidity, however, when purchasing Treasury bonds directly from the government.  You can sell your bonds prior to maturity; however, you'll have to go through the hassle of having your Treasury bond(s) transferred to a brokerage account and you'll pay brokerage fees to sell them.  If you want daily access to your money, buy a recommended Vanguard fund and pay the company's low management fee. 

State- and federal-tax-free bond funds

  State- and federal-tax-free bond funds are appropriate when you're in high federal and state (5 percent or higher) tax brackets.  Vanguard (phone 877-662-7447; website `www.vanguard.com`) has the best selection of state-specific tax-free bond funds.  USAA (phone 800-531-8722; website `www.usaa.com`) and, to a lesser extent, Fidelity (phone 800-343-3548; website `www.fidelity.com`) offer some of the better state-specific bond funds.  Fidelity does have higher balance ($10,000) requirements. 

Federal-tax-free-only bond funds

Federal-tax-free-only bond funds (the dividends on them are state-taxable) are appropriate when you're in a high federal bracket but a low state bracket (less than 5 percent) or when you live in a state that doesn't have state- and federal-tax-free funds available.  Vanguard (phone 877-662-7447; website `www.vanguard.com`) offers the best selection of federal-tax-free bond funds. 

Inflation-indexed Treasury bonds

Like a handful of other nations, the U.S. Treasury now offers inflation-indexed government bonds.  Because a portion of these Treasury bonds' return is pegged to the rate of inflation, the bonds offer investors a safer type of Treasury bond investment option. 

To understand the relative advantages of an inflation-indexed bond, take a brief look at the relationship between inflation and a normal bond.  When an investor purchases a normal bond, he's committing himself to a fixed yield over a set period of time — for example, a bond that matures in ten years and pays 5 percent interest.  However, changes in the cost of living (inflation) aren't fixed, so they're difficult to predict. 

Suppose that an investor put $10,000 into a regular bond in the 1970s.  During the life of his bond, he would've unhappily watched inflation escalate.  During the time he held the bond, and by the time his bond matured, he would've witnessed the erosion of the purchasing power of his $500 of annual interest and $10,000 of returned principal. 

Enter the inflation-indexed Treasury bond.  Suppose that you have $10,000 to invest and you buy a ten-year, inflation-indexed bond that pays you a real rate of return (the return above and beyond the rate of inflation) of, say, 2 percent (or $200).  This portion of your return is paid out in interest.  The other portion of your return is from the inflation adjustment to the principal you invested.  The inflation portion of the return gets put back into the principal.  So if inflation were running at about 2 percent, as it has in recent years, your $10,000 of principal would be indexed upwards after one year to $10,200.  In the second year of holding this bond, the 2 percent real return of interest ($204), would be paid on the increased ($10,200) principal base. 

If inflation skyrocketed and was running at, say, 8 percent rather than 2 percent per year, your principal balance would grow 8 percent per year, and you'd still get your 2 percent real rate of return on top of that.  Thus, an inflation-indexed Treasury bond investor doesn't see the purchasing power of his invested principal or annual interest earnings eroded by unexpected inflation. 

The inflation-indexed Treasuries can be a good investment for conservative bond investors who are worried about inflation, as well as taxpayers who want to hold the government accountable for increases in inflation.  The downside: Inflation-indexed bonds can yield slightly lower returns, because they're less risky compared to regular Treasury bonds. 

Certificates of deposit (CDs)

For generations, bank CDs have been a popular investment for folks with some extra cash that isn't needed in the near future.  With a CD, you generally get a higher rate of return than you get on a bank savings account.  And unlike with bond funds, your principal doesn't fluctuate in value. 

Compared to bonds, however, CDs have a couple drawbacks:

  Inaccessibility: In a CD, your money isn't accessible unless you cough up a fairly big penalty — typically six months' interest.  With a no-load (commission-free) bond fund, you can access your money without penalty — whether you need some or all of your money next week, next month, or next year. 

  Taxability: CDs come in only one tax flavor — taxable.  Bonds, on the other hand, come in tax-free (federal and/or state) and taxable flavors.  So if you're a higher-tax-bracket investor, bonds offer you a tax-friendly option that CDs can't. 

  In the long run, you can expect to earn more — perhaps 1 to 2 percent more per year — and have better access to your money in bond funds than in CDs.  Bond funds make particular sense when you're in a higher tax bracket and you'd benefit from tax-free income on your investments.  If you're not in a high tax bracket and you have a bad day whenever your bond fund takes a dip in value, consider CDs.  Just make sure that you shop around to get the best interest rate. 

One final piece of advice: Don't buy CDs simply for the FDIC (Federal Deposit Insurance Corporation) insurance.  Much is made, particularly by bankers, of the FDIC government insurance that comes with bank CDs.  The lack of this insurance on high-quality bonds shouldn't be a big concern for you.  High-quality bonds rarely default; even if a fund were to hold a bond that defaulted, that bond would probably represent only a tiny fraction (less than 1 percent) of the value of the fund, having little overall impact. 

Besides, the FDIC itself is no Rock of Gibraltar.  Banks have failed and will ­continue to fail.  Yes, you are insured if you have less than $250,000 in a bank.  However, if the bank crashes, you may have to wait a long time and settle for less interest than you thought you were getting.  You're not immune from harm, FDIC or no FDIC. 

  If the government backing you receive through FDIC insurance allows you to sleep better, you can invest in Treasuries (see "Bonds and bond funds" earlier in this chapter), which are government-backed bonds. 

Stocks and stock funds

Stocks have stood the test of time for building wealth. ( In Chapter 9, I discuss picking individual stocks versus investing through stock mutual funds.)  Remember that when you invest in stocks in taxable (nonretirement) accounts, all the distributions on those stocks, such as dividends and capital gains, are taxable.  Stock dividends and long-term capital gains do benefit from lower tax rates (the maximum 15 percent). 

Some stock-picking advocates argue that you should shun stock funds due to tax considerations.  I disagree.  You can avoid stock funds that generate a lot of short-term capital gains, which are taxed at the relatively high ordinary income tax rates.  Additionally, increasing numbers of fund companies offer tax-friendly stock funds, which are appropriate if you don't want current income or you're in a high federal tax bracket and seek to minimize receiving taxable distributions on your funds.  Vanguard (phone 877-662-7447; website `www.vanguard.com`) offers the best menu of tax-managed stock funds.  Alternatively, you can invest in a wider variety of diversified stock funds inside an annuity (see the following section).  Also consider some of the stock funds I recommend in Chapter 11. 

Annuities

As I discuss in Chapter 11, annuities are accounts that are partly insurance but mostly investment.  Consider contributing to an annuity only after you exhaust contributions to all your available retirement accounts.  Because annuities carry higher annual operating expenses than comparable mutual funds, you should consider them only if you plan to leave your money invested, preferably for 15 years or more.  Even if you leave your money invested for that long, the tax-friendly funds discussed in the previous sections of this chapter can allow your money to grow without excessive annual taxation. 

The best annuities can be purchased from no-load (commission-free) mutual fund companies — specifically Vanguard (phone 877-662-7447; website `www. ``vanguard.com`), Fidelity (phone 800-343-3548; website `www.fidelity.com`), and T. Rowe Price (phone 800-225-5132; website `www.troweprice.com`). 

Real estate

Real estate can be a financially and psychologically rewarding investment.  It can also be a money pit and a real headache if you buy the wrong property or get a "tenant from hell." ( I discuss the investment particulars of real estate in Chapter 9 and the nuts and bolts of buying real estate in Chapter 14.) 

Small-business investments

Investing in your own business or someone else's established small business can be a high-risk but potentially high-return investment.  The best options are those you understand well.  See Chapter 9 for more information about small-business investments. 
Chapter 13

Investing for Educational Expenses

In This Chapter

  Understanding the financial aid system

  Examining the right and wrong ways to save for college

  Figuring out how much you need to save

  Finding ways to pay for college when the time comes

  Exploring educational investment options

If you're like most parents (or potential future parents), just turning to this chapter makes you anxious.  Such trepidation is understandable.  According to much of what you read about educational expenses (particularly college expenses), if costs keep rising at the current rate, you'll soon have to spend upwards of $250,000 dollars to give your youngster a quality college education. ( And, if you add in graduate school, you could be pushing $400,000 to $500,000.) 

Whether you're about to begin a regular college investment plan or you've already started saving, your emotions may lead you astray.  The hype about educational costs may scare you into taking a financially detrimental path.  However, quality education for your child doesn't have to — and probably won't — cost you as much as those gargantuan projections suggest.  In this chapter, I explain the inner workings of the financial aid system, help you gauge how much money you'll need, and discuss educational investment options so that you can keep a cool head (and some money in your pocket) when all is said and done. 

Figuring Out How the Financial Aid System Works

Your child shouldn't choose to apply to a college on the basis of whether you think you can afford it.  Except for the affluent, who have plenty of cash available to pay for the full cost of college, everyone else should apply for financial aid.  More than a few parents who don't think that they qualify for financial aid are pleasantly surprised to find that their children have access to loans as well as grants, which don't have to be repaid. ( And your ability to pay often isn't a consideration when scholarship committees hand out money — see "Tips for getting loans, grants, and scholarships," later in this chapter, for info on scholarships.) 

Completing the Free Application for Federal Student Aid (FAFSA), which is available from any high school or college, is the first step in the financial aid process. ( Internet users can fill out the form online at `www.fafsa.ed.gov`.)  As its name implies, you pay nothing for submitting this application other than the time to complete the paperwork.  Some private colleges also require that you complete the Financial Aid Form (FAF), which asks for more information than the FAFSA.  Some schools also supplement the FAFSA with PROFILE forms; these forms are mainly used by costly private schools to differentiate need among financial aid applicants. 

States have their own financial aid programs, so apply to these programs as well if your child plans to attend an in-state college.  You and your child can check with your local high school or college financial aid office to get the necessary forms.  Some colleges also require submission of supplementary forms directly to them. 

The data you supply through student aid forms is run through a financial needs analysis, a standard methodology approved by the U.S. Congress.  The needs analysis considers a number of factors, such as your income and assets, age and need for retirement income, number of dependents, number of family members in college, and unusual financial circumstances, which you explain on the application. 

  The financial needs analysis calculates how much money you, as the parent(s), and your child, as the student, are expected to contribute toward educational expenses.  Even if the needs analysis determines that you don't qualify for needs-based financial aid, you may still have access to loans that are not based on need if you go through the financial aid application process.  So make sure that you apply for financial aid! 

Treatment of retirement accounts

Under the current financial needs analysis, the value of your retirement plans is not considered an asset.  By contrast, money that you save outside retirement accounts, especially money in the child's name, is counted as an asset and reduces financial aid eligibility. 

  Therefore, forgoing contributions to your retirement savings plans in order to save money in a taxable account for Junior's college fund doesn't make sense.  When you do, you pay higher taxes both on your current income and on the interest and growth of the college fund money.  In addition to paying higher taxes, you're expected to contribute more to your child's educational expenses. 

Let me stress the need to get an early start on saving for retirement.  Most retirement accounts limit how much you can contribute each year.  See Chapter 11 for more on saving for your golden years. 

Treatment of money in the kids' names

  If you plan to apply for financial aid, save money in your name rather than in your children's names (such as via custodial accounts).  Colleges expect a much greater percentage of the money in your children's names (20 percent) to be used annually for college costs than the money in your name (about 6 percent). 

However, if you're affluent enough to foot your child's college bill without outside help, investing in your kid's name can save you some money in taxes.  Read on. 

Traditional custodial accounts

Parents control a custodial account until the child reaches either the age of 18 or 21, depending upon the state in which you reside.  Prior to your child's reaching age 18, the first $950 of interest and dividend income is tax-free; the next $950 is taxed at 10 percent.  Any income above $1,900 is taxed at the parents' marginal tax rate.  Upon reaching age 18 (or age 24 if your offspring are still full-time students), all income generated by investments in your child's name is taxed at your child's rate, which is presumably a lower tax rate. 

Education Savings Accounts

  The newer Education Savings Account (ESA) is another option that, like a traditional custodial account, generally makes the most sense for affluent parents who don't expect to apply for or need any type of financial aid.  As with regular custodial accounts, parents who have their kids apply for financial aid will be penalized by college financial aid offices for having ESA balances. 

Subject to eligibility requirements, you can put up to $2,000 per child per year into an ESA.  Single taxpayers with adjusted gross incomes (AGIs) of $110,000 or more and couples with AGIs of $220,000 or more may not contribute to an ESA (although another individual, such as a grandparent, may make the contribution to the child's account).  Although the contribution is not tax-deductible, the future investment earnings compound without taxation.  Upon withdrawal, the investment earnings are not taxed (unlike a traditional retirement account) as long as the money is used for qualified education expenses.  These expenses can include pre-college expenses as well, such as private K–12 school expenses. 

Section 529, state-sponsored college savings plans

Section 529 plans (named after Internal Revenue Code Section 529 and also known as qualified state tuition plans) are among the newest educational savings plans.  A parent or grandparent can generally put more than $200,000 per beneficiary into one of these plans.  Up to $65,000 per donor or $130,000 per married couple may be placed in a child's college savings account immediately, and this amount counts for the next five years' worth of $13,000 annual tax-free gifts per donor allowed under current gifting laws. ( Money contributed to the account is not considered part of the donor's taxable estate.  However, if the donor gives $65,000 and then dies before five years are up, a proportionate amount of that gift will be charged back to the donor's estate.) 

The attraction of the Section 529 plans is that money inside the plans compounds without tax, and if it's used to pay for college tuition, room and board, and other related qualifying higher-education (post-secondary) expenses, the investment earnings and appreciation can be withdrawn tax-free.  You can generally invest in any state plan to pay college expenses in any state, regardless of where you live. 

In addition to paying college costs, the money in Section 529 plans may be used for graduate school expenses.  Some states provide additional tax benefits on contributions to their state-sanctioned plan. 

Unlike the money in a custodial account, with which a child may do as she pleases when she reaches either the age of 18 or 21 (the age varies by state), these state tuition plans must be used for higher-education expenses.  However, most state plans do allow you to change the beneficiary.  You can also take the money out of the plan if you change your mind. ( You will, however, owe tax on the withdrawn earnings plus a penalty — typically 10 percent.) 

  A big potential drawback of the Section 529 plans — especially for families hoping for some financial aid — is that college financial aid offices treat assets in these plans as parental nonretirement assets.  Even worse, the assets can be considered as belonging to an older child (independent young adult) who no longer reports parental financial information for financial aid purposes. 

With some plans, you can't control how the money is invested, although this may be a positive.  The further your child is from college age, the more aggressive the investment mix.  As your child approaches college age, the investment mix is tilted to more conservative investments.  The best plans offer both individually selected investments and age-based options. 

Some state plans have high investment management fees, and some plans don't allow transfers to other plans.  Avoid such plans. 

Please also be aware that a future Congress could change the tax laws affecting these plans, diminishing the tax breaks or increasing the penalties for nonqualified withdrawals. 

  Clearly, these plans have both pros and cons.  They generally make the most sense for affluent parents (or grandparents) who don't expect their children to qualify for financial aid.  Do a lot of research and homework before investing in any plan.  Check out the investment track record, allocations, and fees of each plan, as well as restrictions on transferring to other plans or changing beneficiaries. ( See my website at `www.erictyson.com` for more information on these plans.) 

Treatment of home equity and other assets

Your family's assets may include equity in real estate and businesses that you own.  Although the federal financial aid analysis no longer counts equity in your primary residence as an asset, many private (independent) schools continue to ask parents for this information when making their own financial aid determinations.  Therefore, paying down your home mortgage more quickly instead of funding retirement accounts can harm you financially: You may end up with less financial aid and a higher tax bill. 

Strategizing to Pay for Educational Expenses

Now I get more specific about what college may cost your kids and how you're going to pay for it.  I don't have just one solution, because how you help pay for your child's college costs depends on your own unique situation and personal philosophy.  However, in most cases, you may have to borrow some money, even if you have some available cash that can be directed to pay the college bills as you receive them. 

  Ask yourself what the best way is to "help" pay for college and what you want/expect in the way of contribution(s) by your children.  Even parents who can afford to pay the entire costs often require their children to contribute something meaningful in terms of costs — whether from savings over summer work, loans, and so on.  This strategy increases the chances of the kids having more focus via some "skin in the game," and helps ensure that they don't walk away after four or five years with a degree but no direction or purpose. 

Estimating college costs

College can cost a lot.  The total costs — including tuition, fees, books, supplies, room, board, and transportation — vary substantially from school to school.  The total average annual cost is running around $41,000 per year at private colleges and around $20,200 at public colleges and universities (at the in-state rate).  The more expensive schools can cost up to one-third more.  Ouch! 

Is all this expense worth it?  Although many critics of higher education claim that the cost of a college education shouldn't be rising faster than inflation and that costs can, and should, be contained, denying the value of going to college is hard.  Whether you're considering a local community college, your state's university, or a selective Ivy League institution, investing in education is usually worth the effort and the cost. 

An investment is an outlay of money for an expected profit.  Unlike a car, which depreciates in value, an investment in education generally yields monetary, social, and intellectual profits.  A car is more tangible in the short term, but an investment in education (even if it means borrowing money) gives you more bang for your buck in the long run. 

Colleges are now finding themselves subject to the same types of competition that companies confront.  As a result, some colleges are clamping down on rising costs.  As with any other product or service purchase, it pays to shop around.  You can find good values — colleges that offer competitive pricing and provide a quality education.  Although you don't want your son or daughter to choose a college simply because it costs less, you also shouldn't allow a college choice without any consideration of cost. 

Setting realistic savings goals

If you have money left over after taking advantage of retirement accounts, by all means, try to save for your children's college costs.  You should save in your name unless you know that you aren't going to apply for financial aid, including those loans that are available regardless of your economic ­situation. 

Be realistic about what you can afford for college expenses given your other financial goals, especially saving for retirement (see Chapter 4).  Being able to personally pay 100 percent of the cost of a college education, especially at a four-year private college, is a luxury of the affluent.  If you're not a high-income earner, consider trying to save enough to pay a third or, at most, half of the cost.  You can make up the balance through loans, your child's employment before and during college, and the like. 

Use Table 13-1 to help get a handle on how much you should be saving for college. 

Tips for getting loans, grants, and scholarships

A host of financial aid programs, including a number of loan programs, allow you to borrow at reasonable interest rates.  Federal government educational loans have variable interest rates — which means that the interest rate you're charged floats, or varies, with the overall level of interest rates.  Most programs add a few percent to the current interest rates on three-month to one-year Treasury bills.  Thus, current rates on educational loans are in the vicinity of rates charged on fixed-rate mortgages.  The rates are also capped so that the interest rate on your student loan can never exceed several percent more than the initial rate on the loan. 

  A number of loan programs, such as unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), are available even when your family is not deemed financially needy.  Only subsidized Stafford Loans, on which the federal government pays the interest that accumulates while the student is still in school, are limited to students deemed financially needy. 

Most loan programs limit the amount that you can borrow per year, as well as the total you can borrow for a student's educational career.  If you need more money than your limits allow, PLUS loans can fill the gap: Parents can borrow the full amount needed after other financial aid is factored in.  The only obstacle is that you must go through a credit qualification process.  Unlike privately funded college loans, you can't qualify for a federal loan if you have negative credit (recent bankruptcy, more than three debts over three months past due, and so on).  For more information from the federal government about these student loan programs, call the Federal Student Aid Information Center at 800-433-3243 or visit its website at `studentaid.ed.gov`. 

If you're a homeowner, you may be able to borrow against the equity (market value less the outstanding mortgage loan) in your property.  This option is useful because you can borrow against your home at a reasonable interest rate, and the interest is generally tax-deductible on up to $100,000 borrowed.  Some company retirement plans — for example, 401(k)s — allow borrowing as well. 

Parents are allowed to make penalty-free withdrawals from individual retirement accounts if the funds are used for college expenses.  Although you won't be charged an early-withdrawal penalty, the IRS (and most states) will treat the amount withdrawn as taxable income.  On top of that, the financial aid office will look at your beefed-up income and assume that you don't need as much financial aid.  Because of these negative ramifications, funding college costs in this fashion should only be done as an absolute last resort. 

  In addition to loans, a number of grant programs are available through schools, the government, and independent sources.  You can apply for federal government grants via the FAFSA (see "Figuring Out How the Financial Aid System Works," earlier in this chapter).  Grants available through state government programs may require a separate application.  Specific colleges and other private organizations (including employers, banks, credit unions, and community groups) also offer grants and scholarships. 

One of the most important aspects of getting financial aid is choosing to apply, even if you're not sure whether you qualify.  You may be able to lower your expected contribution by reducing your qualifying assets. ( For more information on how those in charge of handing out financial aid evaluate how much of the bill you can foot, see "Figuring Out How the Financial Aid System Works.") 

Many scholarships and grants don't require any extra work on your part — simply apply for financial aid through colleges.  Other aid programs need seeking out — check directories and databases at your local library, your child's school counseling department, and college financial aid offices.  You can also contact local organizations, churches, employers, and so on.  You have a better chance of getting scholarship money through these avenues. 

  Your child can work and save money during high school and college.  In fact, if your child qualifies for financial aid, she is expected to contribute a certain amount to education costs from savings and employment during the school year or summer breaks.  Besides giving your child a stake in her own future, this training encourages sound personal financial management. 

Investing Educational Funds

Financial companies pour billions of dollars into advertising for investment and insurance products that they claim are best for making your money grow for your children.  Don't get sucked in by these ads. 

What makes for good and bad investments in general applies to investments for educational expenses, too.  Stick with basic, proven, lower-cost investments. ( Chapter 9 explains what you generally need to look for and beware of.)  The following sections focus on considerations specific to college funding. 

Good investments: No-load mutual funds and exchange-traded funds

As I discuss in Chapter 10, the professional management and efficiency of the best no-load mutual funds and exchange-traded funds makes them a tough investment to beat.  Chapters 11 and 12 provide recommendations for investing money in funds both inside and outside tax-sheltered retirement accounts. 

  Gearing the investments to the time frame involved until your children will need to use the money is the most important issue with funds.  The closer your child gets to attending college and using the money saved, the more conservatively the money should be invested. 

Bad investments

  Life insurance policies that have cash values are among the most oversold investments for funding college costs.  Here's the usual pitch: "Because you need life insurance to protect your family, why not buy a policy that you can borrow against to pay for college?" 

One reason you shouldn't invest in this type of policy to fund college costs is that you're better off contributing to retirement accounts that give you an immediate tax deduction that saving through life insurance doesn't offer.  Because life insurance that comes with a cash value is more expensive (largely due to the higher commissions these policies pay out to agents who sell them), parents are more likely to make a second mistake — not buying enough coverage.  If you need and want life insurance, you're better off buying lower-cost term life insurance (see Chapter 16). 

Another poor investment for college expenses is one that fails to keep you ahead of inflation, such as savings or money market accounts.  You need your money to grow so that you can afford educational costs down the road. 

  Prepaid tuition plans should generally be avoided.  A few states have developed plans that allow you to pay college costs at a specific school (calculated for the age of your child).  The allure of these plans is that by paying today, you eliminate the worry of not being able to afford rising costs in the future. 

This logic doesn't work for several reasons.  First, odds are quite high that you don't have the money today to pay in advance.  Second, putting money into such plans reduces your eligibility for financial aid dollar for dollar.  If you have that kind of extra dough around, you're better off using it for other purposes.  You can invest your own money — that's what the school's going to do with it, anyway. 

Besides, how do you know which college your child will want to attend and how long it may take her to finish?  Coercing your child into the school you've already paid for is a sure ticket to long-term problems in your relationship. 

Overlooked investments

Too often, I see parents knocking themselves out to make more money so that they can afford to buy a bigger home, purchase more expensive cars, take costly vacations, and send their kids to more expensive (and therefore supposedly better) private schools and colleges.  Sometimes families want to send younger children to costly elementary schools, too.  Families stretch themselves with outrageous mortgages or complicated living arrangements so that they can get into neighborhoods with top-rated public schools or send their kids to expensive private elementary schools. 

The best school in the world for your child is you and your home.  The reason many people I know (including my siblings and I) were able to attend some of the top educational institutions in this country is that concerned parents worked hard, not just at their jobs, but at spending time with the kids when they were growing up.  Rather than working to make more money (with the best intentions of buying educational games or trips, or sending the kids to better schools), try focusing more attention on your kids.  In my humble opinion, you can do more for your kids by spending more time with them. 

I see parents scratching their heads about their child's lack of academic interest and achievement — they blame the school, TV, video games, or society at large.  These factors may contribute to the problem, but education begins in the home.  Schools can't do it alone. 

  Living within your means not only allows you to save more of your income but also frees up more of your time for raising and educating your children.  Don't underestimate the value of spending more time with your kids and giving them your attention. 
Chapter 14

Investing in Real Estate: Your Home and Beyond

In This Chapter

  Choosing between buying and renting

  Determining how to finance your real-estate purchase

  Finding a great property

  Working successfully with real-estate agents

  Negotiating your best deal

  Handling money issues after you buy

Buying a home or investing in real estate can be financially and psychologically rewarding.  On the other hand, owning real estate can be a real pain in the posterior, because purchasing and maintaining property can be quite costly, time-consuming, and emotionally draining.  Perhaps you're looking to escape your rented apartment and buy your first home.  Or maybe you're interested in becoming a local real-estate investing tycoon.  In either case, you can learn many lessons from real-estate buyers who've traveled before you. 

Note: Although this chapter focuses primarily on real estate in which you're going to live — otherwise known by those in the trade as owner-occupied property — much of what this chapter covers is relevant to real-estate investors. ( For additional information on buying investment real estate — property that you rent out to others — see Chapter 9.) 

Deciding Whether to Buy or Rent

You may be tired of moving from rental to rental.  Perhaps your landlord doesn't adequately keep up the place, or you have to ask permission to hang a picture on the wall.  You may desire the financial security and rewards that seem to come with home ownership.  Or maybe you just want a place to call your own. 

Any one of these reasons is good enough to want to buy a home.  But before you commit to buy, you should take stock of your life and your financial health so you can decide whether you still want to buy a home and how much you can really afford to spend.  You need to ask yourself some bigger questions. 

Assessing your timeline

  From a financial standpoint, you really shouldn't buy a place unless you can anticipate being there for at least three years (preferably five or more).  Buying and selling a property entails a lot of expenses, including the cost of getting a mortgage (points, application, and appraisal fees), inspection expenses, moving costs, real-estate agents' commissions, and title insurance.  To cover these transaction costs plus the additional costs of ownership, a property needs to appreciate about 15 percent. 

If you need or want to move in a couple years, counting on 15 percent appreciation is risky.  If you're fortunate and you happen to buy before a sharp upturn in housing prices, you may get it.  If you're unlucky, you'll probably lose money on the deal. 

Some people are willing to invest in real estate even when they don't expect to live in it for long and are open to turning their home into a rental.  Doing so can work well financially in the long haul, but don't underestimate the responsibilities that come with being a landlord.  Also, most people need to sell their current home in order to tap all the cash that they have in it so that they can buy the next one. 

Determining what you can afford

Although buying and owning your own home can be a wise financial move in the long run, it's a major purchase that can send shock waves through the rest of your personal finances.  You'll probably have to take out a 15- to 30-year mortgage to finance your purchase.  The home you buy will need maintenance over the years.  Owning a home is a bit like running a marathon: Just as you should be in good physical shape to successfully run a marathon, you should be in good financial health when you buy a home. 

  I've seen too many people fall in love with a home and make a rushed decision without taking a hard look at the financial ramifications.  Take stock of your overall financial health (especially where you stand in terms of retirement planning), before you buy property and agree to a particular mortgage.  Don't let the financial burdens of a home control your financial future. 

Don't trust a lender when he tells you what you can "afford" according to some formulas the bank uses to figure out what kind of a credit risk you are.  To determine how much a potential home buyer can borrow, lenders look primarily at annual income; they pay no attention to some major aspects of a borrower's overall financial situation.  Even if you don't have money tucked away into retirement savings, or you have several children to clothe, feed, and help put through college, you still qualify for the same size loan as other people with the same income (assuming equal outstanding debts).  Only you can figure out how much you can afford, because only you know what your other financial goals are and how important they are to you. 

  Here are some important financial questions that no lender will ask or care about but that you should ask yourself before buying a home:

  Are you saving enough money monthly to reach your retirement goals? 

  How much do you spend (and want to continue spending) on fun things such as travel and entertainment? 

  How willing are you to budget your expenses in order to meet your monthly mortgage payments and other housing expenses? 

  How much of your children's expected college educational expenses do you want to be able to pay for? 

The other chapters in this book can help you answer these important questions.  Chapter 4, in particular, helps you think through saving for important financial goals. 

  Since the first edition of this book was published nearly two decades ago, I have warned that many homeowners run into financial trouble because they don't know their spending needs and priorities or how to budget for them.  For this reason, a surprisingly large percentage — some studies say about half — of people who borrow additional money against their home equity use the funds to pay consumer debts. 

Calculating how much you can borrow

Mortgage lenders want to know your ability to repay the money you borrow.  So you have to pass a few tests that calculate the maximum amount the lender is willing to lend you.  For a home in which you'll reside, lenders total up your monthly housing expenses.  They define your housing costs as

`mortgage payment + property taxes + insurance`

Lenders typically limit the amount they'll loan so that your total housing costs are no more than 35 percent of your monthly gross (before taxes) income for the housing expense. ( If you're self-employed, take your net income from the bottom line of your federal tax form Schedule C and divide by 12 to get your monthly gross income.) 

Lenders also consider your other debts when deciding how much to lend you.  These other debts diminish the funds available to pay your housing expenses.  Lenders add the amount you need to pay down your other consumer debts (for example, auto loans and credit cards) to your monthly housing expense.  The monthly total costs of these debt payments plus your housing costs typically cannot exceed 40 percent. 

One general rule says that you can borrow up to three times (or two and one-half times) your annual income when buying a home.  But this rule is a really rough estimate.  The maximum that a mortgage lender will loan you depends on interest rates.  If rates fall, the monthly payment on a mortgage of a given size also drops.  Thus, lower interest rates make real estate more affordable. 

Table 14-1 gives you an estimate of the maximum amount you may be eligible to borrow.  Multiply your gross annual income by the number in the second column to determine the approximate maximum you may be able to borrow.  For example, if you're getting a mortgage with a rate around 7 percent and your annual income is $50,000, multiply 3.5 by $50,000 to get $175,000 — the approximate maximum mortgage allowed. 

Table 14-1 The Approximate Maximum You Can Borrow

When Mortgage Rates Are | Multiply Your Gross Annual Income* by This Figure

---|---

3% | 5.0

4% | 4.6

5% | 4.2

6% | 3.8

7% | 3.5

8% | 3.2

9% | 2.9

10% | 2.7

11% | 2.5

*If you're self-employed, this is your net business income (before taxes). 

Comparing owning versus renting costs

The cost of owning a home is an important financial consideration for many renters.  Some people assume that owning costs more.  In fact, owning a home doesn't have to cost a truckload of money; it may even cost less than renting, especially with the decline in home prices in the late 2000s in many parts of the country. 

On the surface, buying a place seems a lot more expensive than renting.  You're probably comparing your monthly rent (measured in hundreds of dollars to more than $1,000, depending on where you live) to the purchase price of a property, which is usually a much larger number — perhaps $150,000 to $500,000 or more.  When you consider a home purchase, you're forced to think about your housing expenses in one huge chunk rather than in small monthly installments (like a rent check). 

Tallying up the costs of owning a place can be a useful and not-too-complicated exercise.  To make a fair comparison between ownership and rental costs, you need to figure what it will cost on a monthly basis to buy a place you desire versus what it will cost to rent a comparable place.  The worksheet in Table 14-2 enables you to do such a comparison.  Note: In the interest of reducing the number of variables, all this "figuring" assumes a fixed-rate mortgage, not an adjustable-rate mortgage. ( For more info on mortgages, see "Financing Your Home," later in this chapter.) 

  Also, I ignore what economists call the opportunity cost of owning.  In other words, when you buy, the money you put into your home can't be invested elsewhere, and the foregone investment return on that money, say some economists, should be considered a cost of owning a home.  I choose to ignore this concept because I don't agree with this line of thinking.  When you buy a home, you're investing your money in real estate, which historically has offered solid returns over the decades (see Chapter 8).  And second, I have you ignore opportunity cost because it greatly complicates the analysis. 

Table 14-2 Monthly Expenses: Renting versus Owning

Figure Out This ($ per Month) | Write It Here

---|---

1.  Monthly mortgage payment (see "Mortgage") | $

2.  Plus monthly property taxes (see "Property taxes") | \+ $

3.  Equals total monthly mortgage plus property taxes | = $

4.  Your income tax rate (refer to Table 7-1 in Chapter 7) | %

5.  Minus tax benefits (line 3 multiplied by line 4) | – $

6.  Equals after-tax cost of mortgage and property taxes (subtract line 5 from line 3) | = $

7.  Plus insurance ($30 to $150/mo.,  depending on property value) | \+ $

8.  Plus maintenance (1% of property cost divided by 12 months) | \+ $

9.  Equals total cost of owning (add lines 6, 7, and 8) | = $

Now compare line 9 in Table 14-2 with the monthly rent on a comparable place to see which costs more — owning or renting. 

Mortgage

To determine the monthly payment on your mortgage, simply multiply the relevant number (or multiplier) from Table 14-3 by the size of your mortgage expressed in thousands of dollars (divided by 1,000).  For example, if you're taking out a $100,000, 30-year mortgage at 6.5 percent, you multiply 100 by 6.32 for a $632 monthly payment. 

Table 14-3 Your Monthly Mortgage Payment Multiplier

Interest Rate | 15-Year Mortgage Multiplier | 30-Year Mortgage Multiplier

---|---|---

3.0% | 6.91 | 4.22

3.5% | 7.15 | 4.49

4.0% | 7.40 | 4.77

4.5% | 7.65 | 5.07

5.0% | 7.91 | 5.37

5.5% | 8.17 | 5.68

6.0% | 8.44 | 6.00

6.5% | 8.71 | 6.32

7.0% | 8.99 | 6.65

7.5% | 9.27 | 6.99

8.0% | 9.56 | 7.34

8.5% | 9.85 | 7.69

9.0% | 10.14 | 8.05

9.5% | 10.44 | 8.41

10.0% | 10.75 | 8.78

Property taxes

You can ask a real-estate person, mortgage lender, or your local assessor's office what your annual property tax bill would be for a house of similar value to the one you're considering buying (the average is about 1.5 percent of your property's value).  Divide this amount by 12 to arrive at your monthly property tax bill. 

Tax savings in home ownership

  Generally speaking, mortgage interest and property tax payments for your home are tax-deductible on Schedule A of IRS Form 1040 (see Chapter 7).  Here's a shortcut that works quite well in determining your tax savings in home ownership: Multiply your federal tax rate (see Table 7-1 in Chapter 7) by the total amount of your property taxes and mortgage payment. ( Technically speaking, not all of your mortgage payment is tax-deductible — only the portion of the mortgage payment that goes toward interest.  In the early years of your mortgage, nearly all of your payment goes toward interest.  On the other hand, you may earn state tax benefits from your deductible mortgage interest and property taxes.) 

If you want to more accurately determine how home ownership may affect your tax situation, get out your tax return and try plugging in some reasonable numbers to estimate how your taxes will change.  You can also speak with a tax advisor. 

Considering the long-term costs of renting

When you crunch the numbers to find out what owning rather than renting a comparable place may cost you on a monthly basis, you may discover that owning isn't as expensive as you thought.  Or you may find that owning costs more than renting.  This discovery may tempt you to think that, financially speaking, renting is cheaper than owning. 

  Be careful not to jump to conclusions.  Remember that you're looking at the cost of owning versus renting today.  What about 5, 10, 20, or 30 years from now?  As an owner, your biggest monthly expense — the mortgage payment — doesn't increase (assuming that you buy your home with a fixed-rate mortgage).  Your property taxes, homeowner's insurance, and maintenance expenses — which are generally far less than your mortgage payment — will increase over time with the cost of living. 

When you rent, however, your entire monthly rent is subject to the vagaries of inflation.  Living in a rent-controlled unit, where the annual increase allowed in your rent is capped, is the exception to this rule.  Rent control does not eliminate price hikes; it just limits them. 

Suppose you're comparing the costs of owning a home that costs $240,000 to renting that same home for $1,200 a month.  Table 14-4 compares the cost per month of owning the home (after factoring in tax benefits) to your rental costs over 30 years.  This comparison assumes that you take out a mortgage loan equal to 80 percent of the cost of the property at a fixed rate of 7 percent and that the rate of inflation of your homeowner's insurance, property taxes, maintenance, and rent is 4 percent per year.  I further assume that you're in a moderate, combined 35 percent federal and state tax bracket. 

Table 14-4 Cost of Owning versus Renting over 30 Years

Year | Ownership Cost per Month | Rental Cost per Month

---|---|---

1 | $1,380 | $1,200

5 | $1,470 | $1,410

10 | $1,620 | $1,710

20 | $2,040 | $2,535

30 | $2,700 | $3,750

As you can see in Table 14-4, in the first few years, owning a home costs a little more than renting it.  In the long run, however, owning is less expensive, because more of your rental expenses increase with inflation.  And don't forget that as a homeowner you're building equity in your property; that equity will be quite substantial by the time you have your mortgage paid off. 

Recognizing advantages to renting

Although owning a home and investing in real estate generally pay off handsomely over the long-term, to be fair and balanced, I must say that renting has its advantages.  Some of the financially successful renters I've seen include people who pay low rent, either because they've made housing sacrifices or they live in a rent-controlled building.  If you're consistently able to save 10 percent or more of your earnings, you're probably well on your way to achieving your future financial goals. 

As a renter, you can avoid worrying about or being responsible for fixing up the property — that's your landlord's responsibility.  You also have more financial and psychological flexibility as a renter.  If you want to move, you can generally do so a lot easier as a renter than you can as a homeowner. 

Having a lot of your money tied up in your home is another challenge that you don't face when renting over the long haul.  Some people enter their retirement years with a substantial portion of their wealth in their homes.  As a renter, you can have all your money in financial assets that you can tap in to more easily.  Homeowners who have a major chunk of equity tied up in a home at retirement can downsize to a less costly property to free up cash and/or take out a reverse mortgage (which I discuss later in this chapter) on their home equity. 

Financing Your Home

After you look at your financial health, figure out your timeline, and compare renting costs to owning costs, you need to confront the tough task of taking on debt to buy a home (unless you're independently wealthy).  A mortgage loan from a bank or other source makes up the difference between the cash you intend to put into the purchase and the agreed-upon selling price of the real estate.  This section reviews the different options you have for financing your home. 

Understanding the two major types of mortgages

Like many other financial products, you have more mortgages to choose from than you could ever possibly investigate.  The differences can be important or trivial, expensive or not.  Two major types of mortgages exist — those with a fixed interest rate and those with a variable or adjustable rate. 

  Fixed-rate mortgages, which are usually issued for a 15- or 30-year period, have interest rates that never, ever change.  The interest rate you pay the first month is the same rate you pay the last month (and every month in between).  Because the interest rate stays the same, your monthly mortgage payment amount doesn't change.  With a fixed-rate mortgage, your monthly mortgage expense is certain. 

Fixed-rate loans are not risk-free, however.  If interest rates fall significantly after you obtain your mortgage, you face the danger of being stuck with your higher-cost mortgage if you're unable to refinance (see "Refinancing your mortgage," later in this chapter).  You can be turned down for a refinance because of deterioration in your financial situation or a decline in the value of your property.  Even if you're eligible to refinance, you may have to spend significant time and money to complete the process. 

  Adjustable-rate mortgages (ARMs) carry an interest rate that varies over time.  With an adjustable-rate mortgage, you can start with one interest rate and then have different rates for every year (or possibly every month) during a 30-year mortgage.  Thus, the size of your monthly payment fluctuates.  Because a mortgage payment makes an unusually large dent in most homeowners' checkbooks anyway, signing up for an ARM without understanding its risks is dangerous. 

The attraction of ARMs is the potential interest savings.  For the first few years of an adjustable loan, the interest rate is typically lower than it is on a comparable fixed-rate loan.  After that, the relative cost depends on the overall trends in interest rates.  When interest rates drop, stay level, or rise just a little, you probably continue to pay less for your adjustable mortgage.  On the other hand, when rates rise more than a percent or two and then stay elevated, the adjustable loan can cost you more than a fixed-rate loan. 

Choosing between fixed- and adjustable-rate mortgages

You need to weigh the pros and cons of each mortgage type and decide what's best for your situation before you go out to purchase a piece of real estate or refinance a loan.  In the real world, most people ignore this advice.  The excitement of purchasing a home tends to cloud one's judgment.  My experience has been that few people look at their entire financial picture before making major real-estate decisions.  If you're one of them, you may end up with a mortgage that could someday seriously overshadow the delight you take in your little English herb garden out back. 

Consider the issues I discuss in this section before you decide which kind of mortgage — fixed or adjustable — is right for you. 

How willing and able are you to take on financial risk? 

  Take stock of how much risk you can handle with the size of your monthly mortgage payment.  You can't afford much risk, for example, if your job and income are unstable and you need to borrow a lot.  I define a lot as "close to the maximum a bank is willing to lend you."  A lot can also mean that you have no slack in your monthly budget — in other words you're not regularly saving money.  If you're in this situation, stick with a fixed-rate loan. 

Don't take an adjustable loan simply because the initially lower interest rates allow you to afford the property you want to buy (unless you're absolutely certain that your income will rise to meet future payment increases).  Try setting your sights on a property that you can afford with a fixed-rate mortgage. 

If interest rates rise, a mushrooming adjustable mortgage payment may test the lower limits of your checking account balance.  When you don't have emergency savings you can tap to make the higher payments, how can you afford the monthly payments — much less all the other expenses of home ownership? 

And don't forget to factor in reasonably predictable future expenses that may affect your ability to make payments.  For example, are you planning to start a family soon?  If so, your income may fall while your expenses rise (as they surely will). 

  If you can't afford the highest allowed payment on an adjustable-rate mortgage, don't take it.  You shouldn't accept the chance that the interest rate may not rise that high — it might, and then you could lose your home!  Ask your lender to calculate the highest possible maximum monthly payment on your loan.  That's the payment you'd face if the interest rate on your loan were to go to the highest level allowed (the lifetime cap). 

You need to also consider your stress level.  If you have to start following interest rate movements, it's probably not worth gambling on rates.  On the other hand, maybe you're in a position to take the financial risks that come with an adjustable-rate mortgage.  An adjustable loan places much of the risk of fluctuating rates on you (most adjustables, however, limit, or cap, the rise in the interest rate allowed on your loan).  In return for your accepting some interest-rate risk, lenders cut you a deal — an adjustable mortgage's interest rate starts lower and stays lower if the overall level of interest rates doesn't rise substantially.  Even if rates go up, they'll probably come back down over the life of your loan.  So if you can stick with your adjustable for better and for worse, you may still come out ahead over the long term.  Typical caps are 2 percent per year and 6 percent over the life of the loan. 

  You may feel financially secure in choosing an adjustable loan if you have a hefty financial cushion accessible in the event that rates go up, you take out a smaller loan than you're qualified for, or you're saving more than 10 percent of your income. 

How long do you plan to keep the mortgage? 

A mortgage lender takes extra risk when committing to a fixed interest rate for 15 to 30 years.  Lenders don't know what may happen in the intervening years, so they charge you a premium for their risk. 

  The savings on most adjustables is usually guaranteed in the first two or three years, because an adjustable-rate mortgage starts at a lower interest rate than a fixed one.  If rates rise, you can end up giving back or losing the savings you achieve in the early years of the mortgage.  In most cases, if you aren't going to keep your mortgage more than five to seven years, you're probably paying unnecessary interest costs to carry a fixed-rate mortgage. 

Another mortgage option is a hybrid loan, which combines features of both the fixed- and adjustable-rate mortgages.  For example, the initial rate may hold constant for a number of years — three to five years is common — and then adjust once a year or every six months thereafter.  These hybrid loans may make sense for you if you foresee a high probability of keeping your loan seven to ten years or less but want some stability in your monthly payments.  The longer the initial rate stays locked in, the higher the rate. 

Shopping for fixed-rate mortgages

Of the two major types of mortgages I discuss earlier in this chapter, fixed-rate loans are generally easier to shop for and compare.  The following sections cover what you need to know when shopping for fixed-rate mortgages. 

Trading off interest rates and points

The interest rate is the annual amount a lender charges you for borrowing its money.  The interest rate on a fixed-rate loan should always be quoted with the points on the loan. 

Points are upfront fees paid to your lender when you close on your loan.  Points are actually percentages: One point is equal to 1 percent of the loan amount.  So when a lender tells you that 1.5 points are on a quoted loan, you pay 1.5 percent of the amount you borrow as points.  On a $100,000 loan, for example, 1.5 points cost you $1,500.  Points are actually prepaid interest, so they're tax deductible like the interest portion of regular monthly mortgage payments. 

Home equity loans

Home equity loans, or home equity lines of credit (HELOCs) can be a useful source of financing to help buy or improve a home.  HELOCs are second mortgages and best used by someone who already owns a home and wants to simply tap some of that equity without affecting the existing first mortgage (perhaps because of its attractive interest rate). 

HELOCs of up to $100,000 are generally tax deductible.  Once established, most HELOCs allow you to tap in to your credit line as you need or want to so you can use the money for many purposes, including a home remodel, college expenses for your kids, or as an emergency source of funds. 

HELOCs have their downsides.  The biggest negative in my experience is that they encourage homeowners to view their homes as piggy banks from which they can keep borrowing.  The interest rate on a HELOC can increase instantaneously.  Also beware that lenders can generally cancel your HELOC at their discretion, for example, if the value of your home falls too much or your credit score deteriorates. 

For more complete and detailed information on HELOCs and all other home loans, please consult Mortgages For Dummies (Wiley), which I coauthored with Ray Brown. 

If one lender offers 30-year mortgages at 5.75 percent and another lender offers them at 6 percent, the 6-percent loan isn't necessarily worse.  You also need to consider how many points each lender charges. 

  The interest rate and points on a fixed-rate loan go together and move in opposite directions.  If you're willing to pay more points on a given loan, the lender will often reduce the interest rate.  Paying more in upfront points may save you a lot of money in interest, because the interest rate on your loan determines your payments over a long, long time — 15 to 30 years.  If you pay fewer points, your interest rate increases.  Paying less in points may appeal to you if you don't have much cash for closing on your loan. 

Suppose Lender X quotes you 5.75 percent on a 30-year fixed-rate loan and charges one point (1 percent).  Lender Y, who quotes 6 percent, doesn't charge any points.  Which is better?  The answer depends mostly on how long you plan to keep the loan. 

The 5.75-percent loan is 0.25 percent less than the 6-percent loan.  Year in and year out, the 5.75-percent loan saves you 0.25 percent.  But because you have to pay 1 percent (one point) upfront on the 5.75-percent loan, it takes about four years to earn back the savings to cover the cost of that point.  So if you expect to keep the loan less than four years, go with the 6-percent option. 

  To perform an apples-to-apples comparison of mortgages from different lenders, get interest rate quotes at the same point level for each mortgage.  For example, ask each lender for the interest rate on a loan for which you pay one point. 

Be wary of lenders who advertise no-point loans as though they're offering something for nothing.  Remember, if a loan has no points, it's guaranteed to have a higher interest rate.  That's not to say that the loan is better or worse than comparable loans from other lenders.  But don't get sucked in by a no-points sales pitch.  Most lenders who spend big bucks advertising these types of loans rarely have the best deals. 

Understanding other lender fees

In addition to charging you points and the ongoing interest rate, lenders tack on all sorts of other upfront fees when processing your loan.  You need to know the total of all lender fees so that you can compare different mortgages and determine how much completing your home purchase is going to cost you. 

Lenders can nickel and dime you with a number of fees other than points.  Actually, you pay more than nickels and dimes — $300 here and $50 there add up in a hurry!  Here are the main culprits:

  Application and processing fees: Most lenders charge several hundred dollars to complete your paperwork and process it through their underwriting (loan evaluation) department.  The justification for this fee is that if your loan is rejected or you decide not to take it, the lender needs to cover the costs.  Some lenders return this fee to you upon closing if you go with their loan (after you're approved). 

  Credit report: Many lenders charge a modest fee (about $50 to $75) for obtaining a copy of your credit report.  This report tells the lender whether you've paid other loans you've taken in a timely manner.  If you have problems on your credit report, clean them up before you apply (see "Increasing your approval chances," later in this chapter; also check out Chapter 2 for info on checking your credit report). 

  Appraisal: The property for which you're borrowing money needs to be valued.  If you default on your mortgage, your lender doesn't want to get stuck with a property worth less than you owe.  For most residential properties, the appraisal cost is typically several hundred dollars. 

  Title and escrow charges: These not-so-inconsequential costs are discussed in the section, "Remembering title insurance and escrow fees," later in this chapter. 

  Get a written itemization of charges from all lenders you are seriously considering so that you can more readily compare different lenders' mortgages and so you have no surprises when you close on your loan.  And to minimize your chances of throwing money away on a loan for which you may not qualify, ask the lender whether you may not be approved for some reason.  Be sure to disclose any problems you're aware of that are on your credit report or with the property. 

  Some lenders offer loans without points or other lender charges.  If lenders don't charge points or other fees, they have to make up the difference by charging a higher interest rate on your loan.  Consider such loans only if you lack cash for closing or if you're planning to use the loan for just a few years. 

Shunning balloon loans

  Be wary of balloon loans.  They look like fixed-rate loans, but they really aren't.  With a balloon loan, the large remaining loan balance becomes fully due at a predetermined time — typically within three to ten years.  Balloon loans are dangerous because you may not be able to refinance into a new loan to pay off the balloon loan when it comes due.  What if you lose your job or your income drops?  What if the value of your property drops and the appraisal comes in too low to qualify you for a new loan?  What if interest rates rise and you can't qualify for a new loan at the higher rate?  Taking a balloon loan is a high-risk maneuver that can backfire. 

Don't take a balloon loan unless all the following conditions apply:

  You really, really want a certain property. 

  The balloon loan is your only financing option. 

  You're positive that you're going to be able to refinance or pay off the loan entirely when the balloon loan comes due. 

If you take a balloon loan, get one that allows for as much time as possible before coming due. 

Inspecting adjustable-rate mortgages (ARMs)

Although sorting through myriad fixed-rate mortgage options is enough to give most people a headache, comparing the bells and whistles of ARMs can give you a mortgage migraine.  Caps, indexes, margins, and adjustment periods — you can spend weeks figuring it all out.  If you're clueless about personal finances — or just think that you are — shopping for adjustable mortgages scores a 9.9 degree of difficulty on the financial frustration scale. 

Unfortunately, you have to wade through a number of details to understand and compare one adjustable to another.  Bear with me.  And remember throughout this discussion that calculating exactly which ARM is going to cost you the least is impossible, because the cost depends on so many variables.  Selecting an ARM has a lot in common with selecting a home: You have to make trade-offs and compromises based on what's important to you. 

Understanding the start rate

Just as the name implies, the start rate is the interest rate your ARM starts with.  Don't judge a loan by this rate.  You won't be paying this attractively low rate for long.  The interest rate will rise as soon as the terms of the mortgage allow. 

Start rates are probably one of the least important items to focus on when comparing adjustable loans. ( You'd never know this from the way some lenders advertise them — you see ads with the start rate in 3-inch bold type and everything else in microscopic footnotes!) 

Beware of prepayment penalties

Avoid loans with prepayment penalties.  You pay this charge, usually 2 to 3 percent of the loan amount, when you pay off your loan before you're supposed to. 

Prepayment penalties don't typically apply when you pay off a loan because you sell the property.  But if you refinance such a loan in order to take advantage of lower interest rates, you almost always get hit by the prepayment penalties if the loan calls for such penalties. 

The only way to know whether a loan has a prepayment penalty is to ask.  If the answer is yes, find yourself another mortgage. 

  The formula (which includes index and margin) and rate caps are far more important for determining what a mortgage will cost you in the long run.  Some people have labeled the start rate a teaser rate, because the initial rate on your loan is set artificially low to entice you.  In other words, even if the market level of interest rates doesn't change, your adjustable is destined to increase — 1 to 2 percent is common. 

Determining the future interest rate

You'd never (I hope) agree to a loan if your lender's whim and fancy determined your future interest rate.  You need to know exactly how a lender figures out how much your interest rate is going to increase.  All adjustables are based on the following formula, which specifies how the future interest rate on your loan is set:

`index + margin = interest rate`

Indexes are often (but not always) widely quoted in the financial press, and the specific one used on a given adjustable loan is chosen by the lender.  The six-month Treasury bill rate is an example of an index that's used on some mortgages. 

The margin is the amount added to the index to determine the interest rate you pay on your mortgage.  Most loans have margins of around 2.5 percent. 

So, for example, the interest rate of a mortgage could be driven by the following ­formula:

`six-month Treasury bill rate + 2.5 percent = mortgage interest rate`

In this situation, if six-month Treasuries are yielding 3 percent, the interest rate on your loan should be 5.5 percent.  This figure is known as the fully indexed rate.  If this loan starts at a 4.0-percent rate and the rate on six-month Treasuries stays the same, your loan should eventually increase to 5.5 percent. 

  The margin on a loan is hugely important.  When you're comparing two loans that are tied to the same index and are otherwise equivalent, the loan with the lower margin is better.  The margin determines the interest rate for every year you hold the mortgage. 

Avoid negative amortization and interest-only loans if you're stretching

As you make mortgage payments over time, the loan balance you still owe is gradually reduced — this process is known as amortizing the loan.  The reverse of this process — increasing your loan balance — is called negative amortization. 

Negative amortization is allowed by some ARMs.  Your outstanding loan balance can grow even though you're continuing to make mortgage payments when your mortgage payment is less than it really should be. 

Some loans cap the increase of your monthly payment, but not the interest rate.  The size of your mortgage payment may not reflect all the interest you owe on your loan.  So rather than paying off the interest and some of your loan balance (or principal) every month, you're paying off some, but not all, of the interest you owe.  Thus, the extra unpaid interest you still owe is added to your outstanding debt. 

Using negative amortization is like paying only the minimum payment required on a credit card bill.  You keep racking up greater interest charges on the balance as long as you make only the artificially low payment.  Doing so defeats the whole purpose of borrowing an amount that fits your overall financial goals.  And you may never get your mortgage paid off!  Even worse, the increased interest you start to accrue on the unpaid interest added to your mortgage balance may not be tax deductible, because it doesn't qualify as interest incurred as part of the original purchase (what the IRS calls the acquisition debt.) 

In prior editions of this book published in the early to mid-2000s, I warned that another type of potentially concerning loan, the interest-only mortgage, was being promoted heavily in higher cost housing markets that stretch buyers' budgets.  In the early years of an interest-only loan, the monthly payment is kept lower because only interest is being paid; no payment is going to reduce the loan balance.  What many folks don't realize is that at a set number of years into the mortgage (for instance, three, five, or seven), principal payments kick in as well, which dramatically increases the monthly payment. 

Avoid negative-amortization mortgages.  The only way to know for certain whether a loan includes negative amortization is to ask.  Some lenders aren't forthcoming about telling you.  You'll find it more frequently on loans that lenders consider risky.  If you're having trouble finding lenders who are willing to deal with your financial situation, be especially careful. 

Tread carefully with interest-only mortgages.  Do not consider interest-only loans if you're stretching to be able to afford a home, and consider one only if you understand how they work and can afford the inevitable jump in payments. 

Indexes differ mainly in how rapidly they respond to changes in interest rates.  Following are the more common indexes:

  Treasury bills (T-bills): These indexes are based on government IOUs (Treasury bills), and a whole lot of them are out there.  Most adjustables are tied to the interest rate on 6-month or 12-month T-bills. 

  Certificates of deposit (CDs): Certificates of deposit are interest-bearing bank investments that lock you in for a specific period of time.  ARMs are usually tied to the average interest rate banks are paying on six-month CDs.  Like T-bills, CDs tend to respond quickly to changes in the market level of interest rates.  Unlike T-bills, CD rates tend to move up a bit more slowly when rates rise and come down faster when rates decline. 

  11th District Cost of Funds: This index tends to be among the slower-moving indexes.  ARMs tied to 11th District Cost of Funds tend to start out at a higher interest rate. ( The 11th District Cost of Funds Index is the weighted average of the cost of borrowings to member banking institutions of the Federal Home Loan Bank of San Francisco, the 11th District).  A slower-moving index has the advantage of moving up less quickly when rates are on the rise.  On the other hand, you need to be patient to realize the benefit of falling interest rates. 

Adjustment period or frequency

Every so often, the mortgage-rate formula is applied to recalculate the interest rate on an adjustable-rate loan.  Some loans adjust monthly.  Others adjust every 6 or 12 months. 

In advance of each rate change, the lender should send you a notice telling you what your new rate is.  All things being equal, the less frequently your loan adjusts, the less financial uncertainty you have in your life.  Less-frequent adjustments usually coincide with a loan starting at a higher interest rate. 

Understanding rate caps

  When the initial interest rate expires, the interest rate fluctuates based on the formula of the loan.  Almost all adjustables come with rate caps.  The adjustment cap limits the maximum rate change (up or down) allowed at each adjustment.  On most loans that adjust every six months, the adjustment cap is 1 percent. 

Loans that adjust more than once per year often limit the maximum rate change allowed over the entire year as well.  On most such loans, the annual rate cap is 2 percent. 

  Almost all adjustables come with lifetime caps, which limit the highest rate allowed over the entire life of the loan.  ARMs often have lifetime caps that are 5 to 6 percent higher than the start rate (though higher lifetime caps are increasingly common during the current low-interest-rate period).  Before taking an adjustable, figure out the maximum possible payment at the lifetime cap to be sure that you can handle it. 

Other ARM fees

Just as with fixed-rate mortgages, ARMs can carry all sorts of additional lender-levied charges.  See the section "Understanding other lender fees," earlier in this chapter, for details. 

Avoiding the down-payment blues

You can generally qualify for the most favorable mortgage terms by making a down payment of at least 20 percent of the purchase price of the property. 

In addition to saving money on interest, you can avoid the added cost of private mortgage insurance (PMI) by putting down this much. ( To protect against losing money in the event you default on your loan, lenders usually require PMI, which costs several hundred dollars per year on a typical mortgage.) 

  Many people don't have the equivalent of 20 percent or more of the purchase price of a home to avoid paying private mortgage insurance.  Here are a number of solutions for coming up with that 20 percent faster or buying with less money down:

  Go on a spending diet.  Take a tour through Chapter 6 to find strategies for cutting back on your spending. 

  Consider lower-priced properties.  Smaller properties and ones that need some work can help reduce the purchase price and, therefore, the required down payment. 

  Find partners.  You can often get more home for your money when you buy a building in partnership with one, two, or a few people.  Prepare a legal contract to specify what's going to happen if a partner wants out, divorces, or passes away. 

  Seek reduced down-payment financing.  Some lenders will offer you a mortgage even though you may be able to put down only 10 percent (and perhaps even less) of the purchase price (typically at the cost of a much higher interest rate).  You must have solid credit to qualify for such loans, and you generally have to obtain and pay for the extra expense of private mortgage insurance (PMI), which protects the lender if you default on the loan.  When the property value rises enough or you pay down the mortgage enough to have 20-percent equity in the property, you can drop the PMI.  You have to apply to your lender to have the PMI dropped; it doesn't happen automatically. 

Some property owners or developers may also be willing to finance your purchase with 10 percent or less down.  You can't be as picky about properties, because not as many are available under these terms — many need work or haven't been sold yet for other reasons. 

  Get assistance from family.  If your relatives have money dozing away in a savings or CD account, they may be willing to lend (or even give) you the down payment.  You can pay them an interest rate higher than the rate they're currently earning but lower than what you'd pay to borrow from a bank — a win/win situation for both of you.  Lenders generally ask whether any portion of the down payment is borrowed and will reduce the maximum amount they're willing to loan you accordingly. 

For more home-buying strategies, get a copy of the latest edition of Home Buying For Dummies (Wiley), which I coauthored with real-estate guru Ray Brown. 

Comparing 15-year and 30-year mortgages

Many people don't have a choice between 15- and 30-year mortgages.  To afford the monthly payments on their desired home, they need to spread the loan payments over a longer period of time, and a 30-year mortgage is the answer.  A 15-year mortgage has higher monthly payments because you pay it off faster, meaning you pay off a larger amount of the loan balance each month and thus build equity in your home quicker.  With fixed-rate mortgages at 6 percent, a 15-year mortgage comes with payments that are about 35 percent higher than those for a 30-year mortgage. 

Even if you can afford these higher payments, taking the 15-year option isn't necessarily better.  The money for making extra payments doesn't come out of thin air.  You may have better uses (which I discuss later in this section) for your excess funds. 

And if you opt for a 30-year mortgage, you maintain the flexibility to pay it off faster (except in those rare cases where you have to pay a prepayment penalty).  By making additional payments on a 30-year mortgage, you can create your own 15-year mortgage.  But if the need arises, you can fall back to making only the payments required on your 30-year schedule. 

  Locking yourself into higher monthly payments with a 15-year mortgage comes with a risk.  If money gets too tight in the future, you can fall behind in your mortgage payments.  You may be able to refinance your way out of the predicament, but you can't count on it.  If your finances worsen or your property declines in value, you may have trouble qualifying for a refinance. 

Suppose you qualify for a 15-year mortgage and you're financially comfortable with the higher payments; the appeal of paying off your mortgage 15 years sooner is enticing.  Besides, the interest rate is lower — generally up to 1⁄2 percent lower — on a 15-year mortgage.  So if you can afford the higher payments on the 15-year mortgage, you'd be silly not to take it, right?  Not so fast.  You're really asking whether you should pay off your mortgage slowly or more quickly.  And the answer isn't simple — it depends.  Don't spend hours crunching numbers; you can make this decision by considering some qualitative issues. 

  First, think about alternative uses for the extra money you'd be throwing into paying down the mortgage.  What's best for you depends on your overall financial situation and what else you can do with the money.  If you would end up blowing the extra money at the racetrack or on an expensive car, pay down the mortgage.  That's a no-brainer. 

But suppose you take the extra $100 or $200 per month that you were planning to add to your mortgage payment and contribute it to a retirement account instead.  This step may make financial sense.  Why?  Because contributions to 401(k)s, SEP-IRAs, Keoghs, and other types of retirement accounts (discussed in Chapter 11) are tax-deductible. 

When you add an extra $200 to your mortgage payment to pay off your mortgage faster, you receive no tax benefits.  When you dump that $200 into a retirement account, you get to subtract that $200 from the income on which you pay taxes.  If you're paying 35 percent in federal and state income taxes, you shave $70 (that's $200 multiplied by 35 percent) off your tax bill. 

In most cases, you get to deduct your mortgage interest on your tax return.  So if you're paying 6 percent interest, your mortgage may really cost you only around 4 percent after you factor in the tax benefits.  If you think you can do better (remember to consider the taxes on investment returns) by investing elsewhere (stocks, investment real estate, and so on), go for it.  Investments such as stocks and real estate have generated better returns over the long haul.  These investments carry risk, though, and they're not guaranteed to produce any return. 

  If you're uncomfortable investing and you'd otherwise leave the extra money sitting in a money market fund or savings account, you're better off paying down the mortgage.  When you pay down the mortgage, you invest your money in a sure thing with a modest return.  In fact, it's equivalent to buying a risk-free bond that pays you a pretax interest rate equal to whatever your mortgage interest rate is. 

With pre-college-age kids at home, you have an even better reason to fund retirement accounts before you consider paying down your mortgage quickly.  Retirement account balances are generally not counted as an asset when determining financial aid for college expenses.  By contrast, many schools still count equity in your home (the difference between its market value and your loan balance) as an asset.  Your reward for paying down your mortgage balance may be less financial aid! ( See Chapter 13 for more details about financing educational expenses.) 

  Paying down your mortgage faster, especially when you have children, is rarely a good financial decision if you haven't exhausted contributions to your retirement accounts.  Save in your retirement accounts first and get the tax benefits. 

Finding the best lender

As with other financial purchases, you can save a lot of money by shopping around.  It doesn't matter whether you shop around on your own or hire someone to help you.  Just do it! 

On a 30-year, $180,000 mortgage, for example, getting a mortgage that costs 0.5 percent less per year saves you about $20,000 in interest over the life of the loan (given current interest rate levels).  That's enough to buy a decent car!  On second thought, save it! 

Shopping for a lender on your own

In most areas, you can find many mortgage lenders.  Although having a large number of lenders to choose from is good for competition, it also makes shopping a chore. 

Large banks whose names you recognize from their advertising usually don't offer the best rates.  Make sure that you check out some of the smaller lending institutions in your area.  Also, check out mortgage bankers, who, unlike banks, only do mortgages.  The better mortgage bankers offer some of the most competitive rates. 

Real-estate agents can also refer you to lenders with whom they've previously done business.  These lenders may not necessarily offer the most competitive rates — the agent simply may have done business with them in the past. 

  Web-surfers can head on over to E-Loan (`www.eloan.com`), Bankrate (`www.bankrate.com`), and Realtor.com (`www.realtor.com`).  HSH Associates (phone 800-873-2837; website `www.hsh.com`) publishes mortgage information for each of the 50 states.  For $10, the company will send you a list of dozens of lenders' rate quotes.  You need to be a real data junkie to wade through these multipage reports full of numbers and abbreviations, though. 

You can also look in the real-estate section of one of the larger Sunday newspapers (and associated websites) in your area for charts of selected lender interest rates.  These tables are by no means comprehensive or reflective of the best rates available.  In fact, many of them are sent to newspapers for free by firms that distribute mortgage information to mortgage brokers.  Use the tables as a starting point by calling the lenders who list the best rates. 

  One tactic that works well, especially in refinance situations, is to gather the best quotes from various sources, and then check with your current banking relationship last.  Ask them to match or beat your best offer (waive or discount some fees, discount the interest rate, and so on).  If you're a good client and they want to keep your business (or expand what they already have with you), they may give you the best deal. 

Hiring a mortgage broker

Insurance agents peddle insurance, real-estate agents sell real estate, and mortgage brokers deal in mortgages.  They buy mortgages at wholesale from lenders and then mark them up to retail before selling them to you.  The mortgage brokers get their income from the difference, or spread, in the form of a commission.  The terms of the loan obtained through a broker are generally the same as the terms you obtain from the lender directly. 

  Mortgage brokers get paid a percentage of the loan amount — typically 0.5 to 1 percent.  This commission is negotiable, especially on larger loans that are more lucrative.  Ask a mortgage broker what his cut is.  Many people don't ask for this information, so some brokers may act taken aback when you inquire.  Remember, it's your money! 

The chief advantage of using a mortgage broker is that the broker can shop among lenders to get you a good deal.  If you're too busy or disinterested to shop around for a good deal on a mortgage, a competent mortgage broker can probably save you money.  A broker can also help you through the tedious process of filling out all those horrible documents lenders demand before giving you a loan.  And if you have credit problems or an unusual property you're financing, a broker may be able to match you up with a hard-to-find lender who's willing to offer you a mortgage. 

  When evaluating a mortgage broker, be on guard for those who are lazy and don't continually shop the market looking for the best mortgage lenders.  Some brokers place their business with the same lenders all the time, and those lenders don't necessarily offer the best rates.  Also watch out for salespeople who earn big commissions pushing certain loan programs that aren't in your best interests.  These brokers aren't interested in taking the time to understand your needs and discuss your options.  Thoroughly check a broker's references before doing business. 

Even if you plan to shop on your own, talking to a mortgage broker may still be worthwhile.  At the very least, you can compare what you find with what brokers say they can get for you.  Just be careful.  Some brokers tell you what you want to hear and then aren't able to deliver when the time comes. 

  When a loan broker quotes you a really good deal, ask who the lender is. ( Most brokers refuse to reveal this information until you pay the few hundred dollars to cover the appraisal and credit report.)  You can check with the actual lender to verify the interest rate and points the broker quotes you and make sure that you're eligible for the loan. 

Increasing your approval chances

A lender can take several weeks to complete your property appraisal and an evaluation of your loan package.  When many people are trying to refinance their loans, typically after a large drop in interest rates, the process may even take upwards of six weeks.  When you're under contract to buy a property, having your loan denied after waiting several weeks can mean that you lose the property as well as the money you spent applying for the loan and having the property inspected.  Some property sellers may be willing to give you an extension, but others won't. 

  Here's how to increase your chances of having your mortgage approved:

  Get your finances in shape before you shop.  You won't have a good handle on what you can afford to spend on a home until you whip your personal finances into shape.  Do so before you begin to make offers on properties.  This book can help you.  If you have consumer debt, eliminate it — the more credit card, auto loan, and other consumer debt you rack up, the less mortgage you qualify for.  In addition to the high interest rate and the fact that it encourages you to live beyond your means, you now have a third reason to get rid of consumer debt.  Hang onto the dream of owning a home, and plug away at paying off consumer debts. 

  Clear up credit report problems.  Get a copy of your credit report before you apply for a mortgage.  Chapter 2 explains how to obtain a free copy, as well as correct any mistakes or clear up blemishes. 

  Get preapproved or prequalified.  When you get prequalified, a lender speaks with you about your financial situation and then calculates the maximum amount he's willing to lend you based on what you tell him.  Preapproval is much more in-depth and includes a lender's review of your financial statements.  Don't waste your time and money getting preapproved if you're not really ready to buy. 

  Be upfront about problems.  Late payments, missed payments, or debts that you never bothered to pay can come back to haunt you.  The best defense against loan rejection is to avoid it in the first place.  You can sometimes head off potential rejection by disclosing to your lender anything that may cause a problem before you apply for the loan.  That way, you have more time to correct problems and find alternate solutions.  Mortgage brokers (see the preceding section) can also help you shop for lenders who are willing to offer you a loan despite credit problems. 

  Work around low/unstable income.  When you've been changing jobs or you're self-employed, your recent economic history may be as unstable as a country undergoing a regime change.  Making a larger down payment is one way around this problem.  You may try getting a cosigner, such as a relative or good friend.  As long as he isn't borrowed up to his eyeballs, he can help you qualify for a larger loan than you can get on your own.  Be sure that all parties understand the terms of the agreement, including who's responsible for monthly payments! 

  Consider a backup loan.  You certainly should shop among different lenders, and you may want to apply to more than one for a mortgage.  Although applying for a second loan means additional fees and work, it can increase your chances of getting a mortgage if you're attempting to buy a difficult-to-finance property or if your financial situation makes some lenders leery.  Be sure to disclose to each lender what you're doing — the second lender to pull your credit report will see that another lender has already done so. 

Finding the Right Property

Shopping for a home can be fun.  You get to peek inside other people's closets.  But for most people, finding the right house at the right price can take a lot of time.  When you're buying with partners or a spouse (or children, if you choose to share the decision-making with them), finding the right place can also entail a lot of compromise.  A good agent (or several who specialize in different areas) can help with the legwork.  The following sections cover the main things you need to consider when shopping for a home to call your own. 

Condo, town house, co-op, or detached home? 

Some people's image of a home is a single-family dwelling — a stand-alone house with a lawn and white picket fence.  In some areas, however — particularly in higher-cost neighborhoods — you find condominiums (you own the unit and a share of everything else), town homes (attached or row houses), and cooperatives, also known as co-ops (you own a share of the entire building).  The allure of such higher-density housing is that it's generally less expensive.  In some cases, you don't have to worry about some of the general maintenance, because the owner's association (which you pay for, directly or indirectly) takes care of it. 

  If you don't have the time, energy, or desire to keep up a property, shared housing may make sense for you.  You generally get more living space for your dollars, and it may also provide you with more security than a stand-alone home. 

As investments, however, single-family homes generally do better in the long run.  Shared housing is easier to build and thus overbuild; on the other hand, single-family houses are harder to put up because more land is required.  And most people, when they can afford it, still prefer a stand-alone home. 

With that being said, you should remember that a rising tide raises all boats.  In a good real-estate market, all types of housing appreciate, although single-family homes tend to do better.  Shared housing values tend to increase the most in densely populated urban areas with little available land for new building. 

  From an investment return perspective, if you can afford a smaller single- family home instead of a larger shared-housing unit, buy the single-family home.  Be especially wary of buying shared housing in suburban areas with lots of developable land. 

Casting a broad net

You may have an idea about the type of property and location you're interested in or think you can afford before you start your search.  You may think, for example, that you can only afford a condominium in the neighborhood you're interested in.  But if you take the time to check out other communities, you may be surprised to find one that meets most of your needs and also has affordable single-family homes.  You'd never know about this community if you were to narrow your search too quickly. 

Even if you've lived in an area for a while and you think you know it well, look at different types of properties in a number of communities before you narrow your search.  Be open-minded and figure out which of your many criteria for a home you really care about. 

Finding out actual sale prices

Don't look at just a few of the homes listed at a particular price and then get depressed because they're all dogs or you can't afford what you really want.  Before you decide to renew your apartment lease, remember that properties often sell for less than the price at which they're listed. 

  Find out what the places you look at eventually sell for.  Doing so gives you a better sense of what places are really worth and what properties you may be able to afford.  Ask the agent or owner who sold the property what the sale price was, or contact the town's assessors' office for information on how to obtain property sale price information. 

Researching the area

  Even (and especially) if you fall in love with a house at first sight, go back to the neighborhood at various times of the day and on different days of the week.  Travel to and from your prospective new home during commute hours to see how long your commute will really take.  Knock on some doors and meet your potential neighbors.  You may discover, for example, that a flock of chickens lives in the backyard next door or that the street and basements frequently flood. 

Go visit the schools.  Don't rely on statistics about test scores.  Talk to parents and teachers.  What's really going on at the school?  Even if you don't have kids, the quality of the local school has direct bearing on the value of your property.  Is crime a problem?  Call the local police department.  Will future development be allowed?  If so, what type?  Talk to the planning department.  What are your property taxes going to be?  Is the property located in an area susceptible to major risks, such as floods, mudslides, fires, or earthquakes?  Consider these issues even if they're not important to you, because they can affect the resale value of your property.  Make sure that you know what you're getting yourself into before you buy. 

Working with Real-Estate Agents

When you buy (or sell) a home, you'll probably work with a real-estate agent.  Real-estate agents earn their living on commission.  As such, their incentives can be at odds with what's best for you.  Real-estate agents usually don't hide the fact that they get a cut of the deal.  Property buyers and sellers generally understand the real-estate commission system.  I credit the real-estate profession for calling its practitioners "agents" instead of coming up with some silly obfuscating title such as "housing consultants." 

A top-notch real-estate agent can be a significant help when you purchase or sell a property.  On the other hand, a mediocre, incompetent, or greedy agent can be a real liability.  The following sections help you sort the best from the rest. 

Recognizing conflicts of interest

  Real-estate agents, because they work on commission, face numerous conflicts of interest.  Some agents may not even recognize the conflicts in what they're doing.  The following list presents the most common conflicts of interest that you need to watch out for:

  Because agents work on commission, it costs them when they spend time with you and you don't buy or sell.  They want you to complete a deal, and they want that deal as soon as possible — otherwise, they don't get paid.  Don't expect an agent to give you objective advice about what you should do given your overall financial situation.  Examine your overall financial situation before you decide to begin working with an agent. 

  Because real-estate agents get a percentage of the sales price of a property, they have a built-in incentive to encourage you to spend more.  Adjustable-rate mortgages (see "Financing Your Home," earlier in this chapter) allow you to spend more, because the interest rate starts at a lower level than that of a fixed-rate mortgage.  Thus, real-estate agents are far more likely to encourage you to take an adjustable.  But adjustables are a lot riskier — you need to understand these drawbacks before signing up for one. 

  Agents often receive a higher commission when they sell listings that belong to other agents in their office.  Beware.  Sometimes the same agent represents both the property seller and the property buyer in the transaction — a real problem.  Agents who hold open houses for sale may try to sell to an unrepresented buyer they meet at the open house.  There's no way one person can represent the best interests of both sides. 

  Because agents work on commission and get paid a percentage of the sales price of the property, many aren't interested in working with you if you can't or simply don't want to spend a lot.  Some agents may reluctantly take you on as a customer and then give you little attention and time.  Before you hire an agent, check references to make sure that he works well with buyers like you. 

  Real-estate agents typically work a specific territory.  As a result, they usually can't objectively tell you the pros and cons of the surrounding regions.  Most won't admit that you may be better able to meet your needs by looking in another area where they don't normally work.  Before you settle on an agent (or an area), spend time figuring out the pros and cons of different territories on your own.  If you want to seriously look in more than one area, find agents who specialize in each area. 

  Some agents may refer you to a more expensive lender who has the virtue of high approval rates.  If you don't get approved for a mortgage loan, your entire real-estate deal may unravel.  Be sure to shop around — you can probably get a loan more cheaply.  Be especially wary of agents who refer you to mortgage lenders and mortgage brokers who pay agents referral fees.  Such payments clearly bias a real-estate agent's "advice." 

  Agents may encourage you to use a particular inspector with a reputation of being "easy" — meaning he may not "find" all the house's defects.  Home inspectors are supposed to be objective third parties who are hired by prospective buyers to evaluate the condition of a property.  Remember, it's in the agent's best interest to seal the deal, and the discovery of problems may sidetrack those efforts. 

  Under pressure to get a house listed for sale, some agents agree to be accomplices and avoid disclosing known defects or problems with the property.  In most cover-up cases, it seems, the seller doesn't explicitly ask an agent to help cover up a problem; the agent just looks the other way or avoids telling the whole truth.  Never buy a home without having a home inspector look it over from top to bottom. 

Looking for the right qualities in real-estate agents

When you hire a real-estate agent, you want to find someone who's competent and with whom you can get along.  Working with an agent costs a lot of money (which is built into the price of houses' sold and generally deducted from the seller's proceeds) — so make sure that you get your money's worth. 

  Interview several agents.  Check references.  Ask agents for the names and phone numbers of at least three clients they've worked with in the past six months (in the geographical area in which you're looking).  Look for the following traits in any agent you work with:

  Full-time employment: Some agents work in real estate as a second or even third job.  Information in this field changes constantly.  The best agents work at it full-time so that they can stay on top of the market. 

  Experience: Hiring someone with experience doesn't necessarily mean looking for an agent who's been kicking around for decades.  Many of the best agents come into the field from other occupations, such as business or teaching.  Some sales, marketing, negotiation, and communication skills can certainly be picked up in other fields, but experience in buying and selling real estate does count. 

  Honesty and integrity: If your agent doesn't level with you about what a neighborhood or particular property is really like, you suffer the consequences. 

  Interpersonal skills: An agent has to be able to get along not only with you but also with a whole host of other people who are typically involved in a real-estate deal: other agents, property sellers, inspectors, mortgage lenders, and so on. 

  Negotiation skills: Is your agent going to exhaust all avenues to negotiate the best deal possible for you?  Be sure to ask the agent's references how well the agent negotiated for them. 

  High-quality standards: Sloppy work can lead to big legal or logistical problems down the road.  If an agent neglects to recommend thorough and complete inspections, for example, you may be stuck with undiscovered problems after the deal is done. 

  Agents sometimes market themselves as top producers, which means that they sell a relatively large volume of real estate.  This title doesn't count for much for you, the buyer.  It may be a red flag for an agent who focuses on completing as many deals as possible.  When you're buying a home, you need an agent who has the following additional traits:

  Patience: You need an agent who's patient and willing to allow you the necessary time it takes to get educated and make the best decision for yourself. 

  Local market and community knowledge: When you're looking to buy a home in an area in which you're not currently living, an informed agent can have a big impact on your decision. 

  Financing knowledge: As a buyer (especially a first-time buyer or someone with credit problems), you should look for an agent who knows which lenders can best handle your type of situation. 

  Buying real estate requires somewhat different skills than selling real estate.  Few agents can do both equally well.  No law or rule says that you must use the same agent when you sell a property as you do when you buy a property. 

Buyer's agents/brokers

Increasing numbers of agents are marketing themselves as buyer's agents/brokers.  Supposedly, these folks represent your interests as a property buyer exclusively.  Legally speaking, buyer's agents may sign a contract saying that they represent your — and only your — interests.  Before this enlightened era, all agents contractually worked for the property seller.  The title "buyer's agent" is one of those things that sounds better than it really is.  Agents who represent you as buyer's brokers still get paid only when you buy.  And they still get a commission as a percentage of the purchase price.  So they still have an incentive to sell you a piece of real estate; and the more expensive it is, the more commission they make. 

Putting Your Deal Together

After you do your homework on your personal finances, discover how to choose a mortgage, and research neighborhoods and home prices, you'll hopefully be ready to close in on your goal.  Eventually you'll find a home you want to buy.  Before you make that first offer, though, you need to understand the importance of negotiations, inspections, and the other elements of a real-estate deal. 

Negotiating 101

  When you work with an agent, the agent usually handles the negotiation process.  But you need to have a plan and strategy in mind; otherwise, you may end up overpaying for your home.  Here are some recommendations for getting a good deal:

  Never fall in love with a property.  If you have money to burn and can't imagine life without the home you just discovered, pay what you will.  Otherwise, remind yourself that other good properties are out there.  Having a backup property in mind can help. 

  Find out about the property and owner before you make your offer.  How long has the property been on the market?  What are its flaws?  Why is the owner selling?  The more you understand about the property and the seller's motivations, the better able you'll be to draft an offer that meets both parties' needs. 

  Get comparable sales data to support your price.  Too often, home buyers and their agents pick a number out of the air when making an offer.  But if the offer has no substance behind it, the seller will hardly be persuaded to lower his asking price.  Pointing to recent and comparable home sales to justify your offer price strengthens your case. 

  Remember that price is only one of several negotiable items.  Sometimes sellers get fixated on selling their homes for a certain amount.  Perhaps they want to get at least what they paid for it years ago.  You may be able to get a seller to pay for certain repairs or improvements, to pay some of your closing costs, or to offer you an attractive loan without the extra loan fees that a bank would charge.  Likewise, the real-estate agent's commission is negotiable. 

Inspecting before you buy

When you buy a home, you may be making one of the biggest (if not the biggest) purchases of your life.  Unless you build homes and do contracting work, you probably have no idea what you're getting yourself into when it comes to furnaces and termites. 

  Spend the time and money to locate and hire good inspectors and other experts to evaluate the major systems and potential problem areas of the home.  Areas that you want to check include

  Overall condition of the property

  Electrical, heating, and plumbing systems

  Foundation

  Roof

  Pest control and dry rot

  Seismic/slide/flood risk

Inspection fees often pay for themselves.  When problems that you weren't aware of are uncovered, the inspection reports give you the information you need to go back and ask the property seller to fix the problems or reduce the purchase price of the property to compensate you for correcting the deficiencies yourself. 

As with other professionals whose services you retain, interview several inspection companies.  Ask which systems they inspect and how detailed a report they're going to prepare for you (ask for a sample copy).  Request names and phone numbers of three people who have used their service within the past six months. 

  Never accept a seller's inspection report as your only source of information.  When a seller hires an inspector, he may hire someone who won't be as diligent and critical of the property.  What if the inspector is a buddy of the seller or his agent?  By all means, review the seller's inspection reports if available, but get your own as well. 

And here's one more inspection for you to do: The day before you close on the purchase, do a brief walk-through of the property.  Make sure that everything is still in good order and that all the fixtures, appliances, curtains, and other items that were to be left per the contract are still there.  Sometimes sellers (and their movers) "forget" what they're supposed to leave or try to test your powers of observation. 

Remembering title insurance and escrow fees

Mortgage lenders require title insurance to protect against someone else claiming legal title to your property.  This claim can happen, for example, when a husband and wife split up and the one who remains in the home decides to sell and take off with the money.  If both spouses are listed as owners on the title, the spouse who sells the property (possibly by forging the other's signature) has no legal right to do so.  Both you and the lender can get stuck holding the bag if you buy the home that the one spouse of this divided couple is selling.  But title insurance acts as the salvation for you and your lender.  Title insurance protects you against the risk that the spouse whose name was forged will come back and reclaim rights to the home after it's sold. 

If you're in the enviable position of paying cash for a property, you should still buy title insurance, even though a mortgage lender won't prod you to do so.  You need to protect your investment. 

Escrow charges pay for neutral third-party services to ensure that the instructions of the purchase contract or refinance are fulfilled and that everyone gets paid. 

Many people don't seem to understand that title insurance and escrow fees vary from company to company.  As a result, they don't bother to comparison shop; they simply use the company that their real-estate agent or mortgage lender suggests. 

  When you call around for title insurance and escrow fee quotes, make sure that you understand all the fees.  Many companies tack on all sorts of charges for things such as courier fees and express mail.  If you find a company with lower prices and want to use it, ask for an itemization in writing so that you don't have any surprises.  Real-estate agents and mortgage lenders can be a good starting point for referrals because they usually have a broader perspective on the cost and service quality of different companies.  Call other companies as well.  Agents and lenders may be biased toward a company simply because they're in the habit of using it or they've referred clients to it before. 

After You Buy

After you buy a home, you'll make a number of important decisions over the months and years ahead.  This section discusses the key issues you need to deal with as a homeowner and tells what you need to know to make the best decision for each of them. 

Refinancing your mortgage

Three reasons motivate people to refinance, or obtain a new mortgage to replace an old one.  One is obvious: to save money because interest rates have dropped.  Refinancing can also be a way to raise capital for some other purpose.  You can use refinancing to get out of one type of loan and into another.  The following sections can help you decide on the best option in each case. 

Spending money to save money

  If your current loan has a higher rate of interest than comparable new loans, you may be able to save money by refinancing.  Because refinancing costs money, whether you can save enough to justify the cost is open to question.  If you can recover the expenses of the refinance within a few years, go for it.  If recovering the costs will take longer, refinancing may still make sense if you anticipate keeping the property and mortgage that long. 

Be wary of mortgage lenders or brokers who tout how soon your refinance will pay for itself; they usually oversimplify their calculations.  For example, if the refinance costs you $2,000 to complete (for appraisals, loan fees and points, title insurance, and so on) and reduces your monthly payment by $100, lenders or brokers typically say that it's going to take 20 months for you to recoup the refinance costs.  This estimate isn't accurate, however, because you lose some tax write-offs if your mortgage interest rate and payment are reduced.  You can't simply look at the reduced amount of your monthly payment. ( Mortgage lenders like to look at it, however, because it makes refinancing more attractive.)  And your new mortgage will be reset to a different term than the number of years remaining on your old one. 

If you want a better estimate of your likely cost savings but don't want to spend hours crunching numbers, take your tax rate — for example, 27 percent — and reduce your monthly payment savings on the refinance by this amount (see Chapter 7).  Continuing with the example in the preceding paragraph, if your monthly payment drops by $100, you're really saving about $73 a month after factoring in the lost tax benefits.  So it takes about 28 months ($2,000 divided by $73) — not 20 — to recoup the refinance costs. 

Note that not all refinances cost big money.  So-called no-cost refinances or no-point loans minimize your out-of-pocket expenses, but as I discuss earlier in this chapter, they may not be your best long-term options.  Such loans usually come with higher interest rates. 

Using money for another purpose

Refinancing to pull out cash from your home for some other purpose can make good financial sense because under most circumstances, mortgage interest is tax-deductible.  Paying off other higher-interest consumer debt — such as on credit cards or on an auto loan — is a common reason for borrowing against a home.  The interest on consumer debt is not tax-deductible and is generally at a much higher interest rate than what mortgages charge you. 

  If you're starting a business, consider borrowing against your home to finance the launch of your business.  You can usually do so at a lower cost than with a business loan. 

You need to find out whether a lender is willing to lend you more money against the equity in your home (which is the difference between the market value of your house and the loan balance).  You can use Table 14-1, earlier in this chapter, to estimate the maximum loan for which you may qualify. 

Changing loans

You may want to refinance even though you aren't forced to raise cash or you're able to save money.  Perhaps you're not comfortable with your current loan — holders of adjustable-rate mortgages often face this problem.  You may find out that a fluctuating mortgage payment makes you anxious and wreaks havoc on your budget. 

Paying money to go from an adjustable to a fixed rate is a lot like buying insurance.  The cost of the refinance is "insuring" you a level mortgage payment.  Consider this option only if you want peace of mind and you plan to stay with the property for a number of years. 

Sometimes jumping from one adjustable to another makes sense.  Suppose that you can lower the maximum lifetime interest rate cap and the refinance won't cost much.  Your new loan should have a lower initial interest rate than the one you're paying on your current loan.  Even if you don't save megabucks, the peace of mind of a lower ceiling can make refinancing worth your while. 

Mortgage life insurance

Shortly after you buy a home or close on a mortgage, you start getting mail from all kinds of organizations that keep track of publicly available information about mortgages.  Most of these organizations want to sell you something, and they don't tend to beat around the bush. " What will your dependents do if you meet with an untimely demise and they're left with a gargantuan mortgage?"  these organizations ask.  In fact, this is a good financial-planning question.  If your family is dependent on your income, can it survive financially if you pass away? 

  Don't waste your money on mortgage life insurance.  You may need life insurance to provide for your family and help meet large obligations such as mortgage payments or educational expenses for your children, but mortgage life insurance is typically grossly overpriced. ( Check out the life insurance section in Chapter 16 for advice about term life insurance.)  Consider mortgage life insurance only if you have a health problem and the mortgage life insurer doesn't require a physical examination.  Be sure to compare it with term life options. 

Is a reverse mortgage a good idea? 

An increasing number of homeowners are finding, particularly in their later years of retirement, that they lack cash.  The home in which they live is usually their largest asset.  Unlike other investments, such as bank accounts, bonds, or stocks, a home does not provide any income to the owner unless he decides to rent out a room or two. 

A reverse mortgage allows a homeowner who is low on cash to tap home equity.  For an elderly homeowner, using home equity can be a difficult thing to do psychologically.  Most people work hard to pay a mortgage month after month, year after year, until it's finally all paid off.  What a feat and what a relief after all those years! 

Taking out a reverse mortgage reverses this process.  Each month, the reverse mortgage lender sends you a check that you can spend on food, clothing, travel, or whatever you want.  The money you receive each month is really a loan from the bank against the value of your home, which makes the monthly check free from taxation.  A reverse mortgage also allows you to stay in your home and use its equity to supplement your monthly income. 

The main drawback of a reverse mortgage is that it can diminish the estate that you may want to pass on to your heirs or use for some other purpose.  Also, some loans require repayment within a certain number of years.  The fees and the effective interest rate you're charged to borrow the money can be quite high. 

Because some loans require the lender to make monthly payments to you as long as you live in the home, lenders assume that you'll live many years in your home so that they won't lose money when making these loans.  If you end up keeping the loan for only a few years because you move, for example, the cost of the loan is extremely high. 

  You may be able to create a reverse mortgage with your relatives.  This technique can work if you have family members who are financially able to provide you with monthly income in exchange for ownership of the home when you pass away. 

You have other alternatives to tapping the equity in your home.  Simply selling your home and buying a less expensive property (or renting) is one option.  Under current tax laws, qualifying house sellers can exclude a sizable portion of their profits from capital gains tax: up to $250,000 for single taxpayers and $500,000 for married couples. 

Selling your house

The day may come when you want to sell your house.  If you're going to sell, make sure you can afford to buy the next home you desire.  Be especially careful if you're a trade-up buyer — that is, if you're going to buy an even more expensive home.  All the affordability issues discussed at the beginning of this chapter apply.  You also need to consider the following issues. 

Selling through an agent

When you're selling a property, you want an agent who can get the job done efficiently and sell your house for as much as possible.  As a seller, you need to seek an agent who has marketing and sales expertise and is willing to put in the time and money necessary to sell your house.  Don't necessarily be impressed by an agent who works for a large company.  What matters more is what the agent will do to market your property. 

When you list your house for sale, the contract you sign with the listing agent includes specification of the commission to be paid if the agent is successful in selling your house.  In most areas of the country, agents usually ask for a 6-percent commission.  In an area that has lower-cost housing, they may ask for 7 percent. 

Remember that commissions are always negotiable.  Because the commission is a percentage, you have a much greater possibility of getting a lower commission on a higher-priced house.  If an agent makes 6 percent selling both a $200,000 house and a $100,000 house, the agent makes twice as much on the $200,000 house.  Yet selling the higher-priced house does not take twice as much work. ( Selling a $400,000 house certainly doesn't take four times the effort of selling a $100,000 house.) 

  If you're selling a higher-priced home (above $250,000), you have no reason to pay more than a 5-percent commission.  For expensive properties ($500,000 and up), a 4-percent commission may be reasonable.  You may find, however, that your ability to negotiate a lower commission is greatest when an offer is on the table.  Because you don't want to give other agents (working with buyers) a reason not to sell your house, have your listing agent cut his take rather than reduce the commission that you advertise you're willing to pay to an agent who brings you a buyer. 

In terms of the length of the listing sales agreement you make with an agent, three months is reasonable.  When you give an agent a listing that's too long (6 to 12 months) in duration, the agent may simply toss your listing into the multiple listing book and expend little effort to sell your property.  Practically speaking, if your home hasn't sold, you can fire your agent whenever you want, regardless of the length of the listing agreement.  However, a shorter listing may be more motivating for your agent. 

Selling without a real-estate agent

You may be tempted to sell without an agent so that you can save the commission that's deducted from your house's sale price.  If you have the time, energy, and marketing experience and you can take the time to properly value your home, you can sell your house without an agent and possibly save some money. 

The major problem with attempting to sell your house on your own is that agents who are working with buyers don't generally look for or show their clients properties that are for sale by owner.  Besides saving you time, a good agent can help ensure that you're not sued for failing to disclose the known defects of your property.  If you decide to sell your house on your own, make sure you have access to a legal advisor who can review the contracts.  Whether you sell through an agent or not, be sure to read the latest edition of House Selling For Dummies (Wiley), which I co-wrote with real-estate expert Ray Brown. 

Should you keep your home until prices go up? 

Many homeowners are tempted to hold on to their properties (when they need to move) if the property is worth less than when they bought it or if the real-estate market is soft.  Renting out your property probably isn't worth the hassle, and holding on to it probably isn't worth the financial gamble.  If you need to move, you're better off, in most cases, selling your house. 

  You may reason that, in a few years (during which you'd rent the property), the real-estate storm clouds will clear, and you'll be able to sell your property at a much higher price.  Here are three risks associated with this line of thinking:

  You can't know whether property prices in the next few years are going to rebound, stay the same, or drop even further.  A property generally needs to appreciate at least a few percent per year just to make up for all the costs of holding and maintaining it. 

  You may be unprepared for legal issues and dealings with your tenants.  If you've never been a landlord, don't underestimate the hassle and headaches associated with this job. 

  If you convert your home into a rental property in the meantime and it appreciates in value, you're going to pay capital gains tax on your profit when you sell it (and the taxable profit will be higher if you have taken tax deductions for depreciation during the rental period).  This capital gains tax wipes out much of the advantage of having held on to the property until prices recovered. ( If you want to be a long-term rental property owner, you can do a tax-free exchange into another rental property when you sell.) 

However, if you would realize little cash from selling and you lack other money for the down payment to purchase your next property, you have good reason for holding on to a home that has dropped in value. 

Should you keep your home as investment property after you move? 

  Converting your home into rental property is worth considering if you need or want to move.  Don't consider doing so unless it really is a long-term proposition (ten years or more).  As discussed in the preceding section, selling rental property has tax consequences. 

If you want to convert your home into an investment property, you have an advantage over someone who's looking to buy an investment property, because you already own your home.  Locating and buying investment property takes time and money.  You also know what you have with your current home.  If you go out and purchase a property to rent, you're starting from scratch. 

If your property is in good condition, consider what damage renters may do to it; few renters will take care of your home the way that you would.  Also consider whether you're cut out to be a landlord.  For more information, see the section on real estate as an investment in Chapter 9. 
Part IV

Insurance: Protecting What You Have

In this part . . . 

Just because insurance is boring doesn't mean you can ignore it!  I show you how to obtain the right kind of insurance to shield you from the brunt of unexpected major expenses and protect your assets and future earnings.  I also reveal which types of insurance you do and do not need, explain what to include and what not to include in your policies, and tell you how much of which things you should insure.  Plus, I help you face other creepy but important stuff such as wills, probate, and estate planning. 
Chapter 15

Insurance: Getting What You Need at the Best Price

In This Chapter

  Buying the right insurance at the best price

  Overcoming roadblocks to getting the coverage you need

  Getting your claim money when you've suffered a loss

Unless you work in the industry, you may find insurance to be a dreadfully boring topic.  Most people associate insurance with disease, death, and disaster and would rather do just about anything other than review their policies or spend money on insurance.  But because you won't want to deal with money hassles when you're coping with catastrophes — illness, disability, death, fires, floods, earthquakes, and so on — you should secure insurance well before you need it. 

Insurance is probably the most misunderstood and least monitored area of personal finance.  Studies show that more than 90 percent of Americans purchase and carry the wrong types and amounts of insurance coverage.  My own experience as a financial counselor confirms this statistic.  Most people are overwhelmed by all the jargon in sales and policy statements.  Thus, they pay more than necessary for their policies and fail to get coverage through the best companies. 

In this chapter, I tell you how to determine what kinds of insurance you need, explain what you can do if you're denied coverage, and give you advice on getting your claims paid.  Later chapters discuss types of insurance in detail, including insurance on people (Chapter 16) and possessions (Chapter 17). 

Discovering My Three Laws of Buying Insurance

I know your patience and interest in finding out about insurance is surely limited, so in this section I boil the subject down to three fairly simple but powerful concepts that can easily save you big bucks.  And while you're saving money, you can still get the quality coverage you need in order to avoid a financial catastrophe. 

Law I: Insure for the big stuff; don't sweat the small stuff

Imagine, for a moment, that you're offered a chance to buy insurance that reimburses you for the cost of your cellphone if you lose or damage it.  Because most cellphones don't cost much, I don't think you'd buy that insurance. ( This coverage really does exist, and about 20 percent of mobile phone owners plunk down about $50 to $150 annually to insure their phones.) 

What if you could buy insurance that would pay for the cost of a restaurant meal if you got food poisoning?  Even if you were splurging at a fancy restaurant, you wouldn't have a lot of money at stake, so you'd probably decline that coverage as well. 

  The point of insurance is to protect against losses that would be financially catastrophic to you, not to smooth out the bumps of everyday life.  The preceding example about restaurant insurance is silly, but some people buy equally foolish policies without knowing it.  In the following sections, I tell you how to get the most appropriate insurance coverage for your money.  I start off with the "biggies" that are worth your money, and then I work down to some insurance options that are less worthy of your dollars. 

Buy insurance to cover financial catastrophes

  You want to insure against what could be a huge financial loss for you or your dependents.  The price of insurance isn't cheap, but it's relatively small in comparison to the potential total loss from a financial catastrophe. 

The beauty of insurance is that it spreads risks over millions of other people.  If your home were to burn to the ground, paying the rebuilding cost out of your own pocket probably would be a financial catastrophe.  If you have insurance, the premiums paid by you and all the other homeowners collectively can easily pay the bills. 

Think for a moment about what your most valuable assets are.  Also consider potential large expenses.  Perhaps they include the following:

  Future income: During your working years, your most valuable asset is probably your future earnings.  If you were disabled and unable to work, what would you live on?  Long-term disability insurance exists to help you handle this type of situation.  If you have a family that's financially dependent on your earnings, how would your family manage if you died?  Life insurance can fill the monetary void left by your death. 

  Business: If you're a business owner, what would happen if you were sued for hundreds of thousands of dollars or a million dollars or more for negligence in some work that you messed up?  Liability insurance can protect you. 

  Health: In this age of soaring medical costs, you can easily rack up a $100,000 hospital bill in short order.  Major medical health insurance helps pay such expenses.  And yet, a surprising number of people don't carry any health insurance — particularly those who work in small businesses. ( See Chapter 16 for more on health insurance.) 

Psychologically, buying insurance coverage for the little things that are more likely to occur is tempting.  You don't want to feel like you're wasting your insurance dollars.  You want to get some of your money back, darn it!  You're more likely to get into a fender bender with your car or have a package lost in the mail than you are to lose your home to fire or suffer a long-term disability.  But if the fender bender costs $500 (which you end up paying out of your pocket because you took my advice to take a high deductible; see the next section) or the postal service loses your package worth $50 or $100, you won't be facing a financial disaster. 

On the other hand, if you lose your ability to earn an income because of a disability, or if you're sued for $1 million and you're not insured against such catastrophes, not only will you be extremely unhappy, but you'll also face financial ruin. " Yes, but what are the odds," I hear people rationalize, "that I'll suffer a long-term disability or that I'll be sued for $1 million?"  I agree that the odds are quite low, but the risk is there.  The problem is that you just don't know what, or when, bad luck may befall you. 

And don't make the mistake of thinking that you can figure the odds better than the insurance companies can.  The insurance companies predict the probability of your making a claim, large or small, with a great deal of accuracy.  They employ armies of number-crunching actuaries to calculate the odds that bad things will happen and the frequency of current policyholders' making particular types of claims.  The companies then price their policies accordingly. 

  So buying (or not buying) insurance based on your perception of the likelihood of needing the coverage is foolish.  Insurance companies aren't stupid; in fact, they're ruthlessly smart!  When insurance companies price policies, they look at a number of factors to determine the likelihood of your filing a claim.  Take the example of auto insurance.  Who do you think will pay more for auto insurance — a single male who's age 20, lives the fast life in a high-crime city, drives a macho, turbo sports car, and has received two speeding tickets in the past year?  Or a couple in their 40s, living in a low-crime area, driving a four-door sedan, and having a clean driving record? 

Take the highest deductible you can afford

Most insurance policies have deductibles — the maximum amount you must pay in the event of a loss, before your insurance coverage kicks in and begins paying out.  On many policies, such as auto and homeowner's/renter's coverage, most folks opt for a $100 to $250 deductible. 

  Here are some benefits of taking a higher deductible:

  You save premium dollars.  Year in and year out, you can enjoy the lower cost of an insurance policy with a high deductible.  You may be able to shave 15 to 20 percent off the cost of your policy.  Suppose, for example, that you can reduce the cost of your policy by $150 per year by raising your deductible from $250 to $1,000.  That $750 worth of coverage is costing you $150 per year.  Thus, you'd need to have a claim of $1,000 or more every five years — highly unlikely — to come out ahead.  If you're that accident-prone, guess what?  The insurance company will raise your premiums. 

  You don't have the hassles of filing small claims.  If you have a $300 loss on a policy with a $100 deductible, you need to file a claim to get your $200 (the amount you're covered for after your deductible).  Filing an insurance claim can be an aggravating experience that takes hours of time.  In some cases, you may even have your claim denied after jumping through all the necessary hoops.  Getting your due may require prolonged haggling. 

When you have low deductibles, you may file more claims (although this doesn't necessarily mean that you'll get more money).  After filing more claims, you may be "rewarded" with higher premiums — in addition to the headache you get from preparing all those blasted forms!  Filing more claims may even cause cancellation of your coverage! 

Avoid small-potato policies

A good insurance policy can seem expensive.  A policy that doesn't cost much, on the other hand, can fool you into thinking that you're getting something for next to nothing.  Policies that cost little also cover little — they're priced low because they don't cover large potential losses. 

  Following are examples of common "small-potato" insurance policies that are generally a waste of your hard-earned dollars.  As you read through this list, you may find examples of policies that you bought and that you feel paid for themselves.  I can hear you saying, "But I collected on that policy you're telling me not to buy!"  Sure, getting "reimbursed" for the hassle of having something go wrong is comforting.  But consider all such policies that you bought or may buy over the course of your life.  You're not going to come out ahead in the aggregate — if you did, insurance companies would lose money!  These policies aren't worth the cost relative to the small potential benefit.  On average, insurance companies pay out just 60 cents in benefits on every dollar collected.  Many of the following policies pay back even less — around 20 cents in benefits (claims) for every insurance premium dollar spent:

  Extended warranty and repair plans: Isn't it ironic that right after the salesperson persuades you to buy a television, computer, or car — in part by saying how reliable the product is — she tries to convince you to spend more money to insure against the failure of the item?  If the product is so good, why do you need such insurance? 

Extended warranty and repair plans are expensive and unnecessary insurance policies.  Product manufacturers' warranties typically cover any problems that occur in the first year or even several years.  After that, paying for a repair out of your own pocket isn't a financial catastrophe. ( Some credit-card issuers automatically double the manufacturer's warranty without additional charge on items purchased with their card.  However, the cards that do this typically are higher-cost premium cards, so this is no free lunch — you're paying for this protection in terms of higher fees.) 

  Home warranty plans: If your real-estate agent or the seller of a home wants to pay the cost of a home warranty plan for you, turning down the offer would be ungracious. ( As Grandma would say, you shouldn't look a gift horse in the mouth.)  But don't buy this type of plan for yourself.  In addition to requiring some sort of fee (around $50 to $100), home warranty plans limit how much they'll pay for problems. 

Your money is best spent hiring a competent inspector to uncover problems and fix them before you purchase the home.  If you buy a house, you should expect to spend money on repairs and maintenance; don't waste money purchasing insurance for such expenses. 

  Dental insurance: If your employer pays for dental insurance, take advantage of it.  But don't pay for this coverage on your own.  Dental insurance generally covers a couple teeth cleanings each year and limits payments for more expensive work. 

  Credit life and credit disability policies: Credit life policies pay a small benefit if you die with an outstanding loan.  Credit disability policies pay a small monthly income in the event of a disability.  Banks and their credit-card divisions usually sell these policies.  Some companies sell insurance to pay off your credit-card bill in the event of your death or disability, or to cover minimum monthly payments for a temporary period during specified life transition events (such as loss of a job, divorce, and so on). 

The cost of such insurance seems low, but that's because the potential benefits are relatively small.  In fact, given what little insurance you're buying, these policies are expensive.  If you need life or disability insurance, purchase it.  But get enough coverage, and buy it in a separate, cost-effective policy (see Chapter 16 for more details). 

  If you're in poor health and you can buy these insurance policies without a medical evaluation, you represent an exception to the "don't buy it" rule.  In this case, these policies may be the only ones to which you have access — another reason these policies are expensive.  If you're in good health, you're paying for the people with poor health who can enroll without a medical examination and who undoubtedly file more claims. 

  Daily hospitalization insurance: Hospitalization insurance policies that pay a certain amount per day, such as $100, prey on people's fears of running up big hospital bills.  Health care is expensive — there's no doubt about that. 

But what you really need is a comprehensive (major medical) health insurance policy.  One day in the hospital can lead to thousands, even tens of thousands, of dollars in charges, so that $100-per-day policy may pay for less than an hour of your 24-hour day!  Daily hospitalization policies don't cover the big-ticket expenses.  If you lack a comprehensive health insurance policy, make sure you get one (see Chapter 16)! 

  Insuring packages in the mail: You buy a $40 gift for a friend, and when you go to the post office to ship it, the friendly postal clerk asks whether you want to insure it.  For a few bucks, you think, "Why not?"  The U.S. Postal Service may have a bad reputation for many reasons, but it rarely loses or damages things.  Go spend your money on something else — or better yet, invest it. 

  Contact lens insurance: The things that people in this country come up with to waste money on just astound me.  Contact lens insurance really does exist!  The money goes to replace your contacts if you lose or tear them.  Lenses are cheap.  Don't waste your money on this kind of insurance. 

  Little stuff riders: Many policies that are worth buying, such as auto and disability insurance, can have all sorts of riders added on.  These riders are extra bells and whistles that insurance agents and companies like to sell because of the high profit margin they provide (for them).  On auto insurance policies, for example, you can buy a rider for a few bucks per year that pays you $25 each time your car needs to be towed.  Having your vehicle towed isn't going to bankrupt you, so it isn't worth insuring against. 

Likewise, small insurance policies that are sold as add-ons to bigger insurance policies are usually unnecessary and overpriced.  For example, you can buy some disability insurance policies with a small amount of life insurance added on.  If you need life insurance, purchasing a sufficient amount in a separate policy is less costly. 

Law II: Buy broad coverage

Purchasing coverage that's too narrow is another major mistake people make when buying insurance.  Such policies often seem like cheap ways to put your fears to rest.  For example, instead of buying life insurance, some folks buy flight insurance at an airport self-service kiosk.  They seem to worry more about their mortality when getting on an airplane than they do when getting into a car.  If they die on the flight, their beneficiaries collect.  But should they die the next day in an auto accident or get some dreaded disease — which is statistically far more likely than going down in a jumbo jet — the beneficiaries get nothing from flight insurance.  Buy life insurance (broad coverage to protect your loved ones financially in the event of your death no matter how you die), not flight insurance (narrow coverage). 

  The medical equivalent of flight insurance is cancer insurance.  Older people, who are fearful of having their life savings depleted by a long battle with this dreaded disease, are easy prey for this narrow insurance.  If you get cancer, cancer insurance pays the bills.  But what if you get heart disease, diabetes, or some other disease?  Cancer insurance won't pay these costs.  Purchase major medical coverage, not cancer insurance. 

Recognizing fears

Fears, such as getting cancer, are natural and inescapable.  Although you may not have control over the emotions that your fears invoke, you must often ignore those emotions in order to make rational insurance decisions.  In other words, getting shaky in the knees and sweaty in the palms when boarding an airplane is okay, but letting your fear of flying cause you to make poor insurance decisions is not okay, especially when those decisions affect the financial security of your loved ones. 

Preparing for natural disasters — insurance and otherwise

In the chapters following this one, in which I discuss specific types of insurance such as disability insurance and homeowner's insurance, I highlight the fact that you'll find it nearly impossible to get coverage that includes every possibility of catastrophe.  For example, when purchasing homeowner's coverage, you find that losses from floods and earthquakes are excluded.  You can secure such coverage in separate policies, which you should do if you live in an area subject to such risks (see more on this in Chapter 17).  Many people don't understand these risks, and insurers don't always educate customers about such gaping holes in their policies. 

Examining misperceptions of risks

How high do you think your risks are for expiring prematurely if you're exposed to toxic wastes or pesticides, or if you live in a dangerous area that has a high murder rate?  Well, actually, these risks are quite small when compared to the risks you subject yourself to when you get behind the wheel of a car or light up yet another cigarette. 

Reporter John Stossel was kind enough to share with me the results of a study done for him by physicist Bernard Cohen.  In the study, Cohen compared different risks.  Cohen's study showed that people's riskiest behaviors are smoking and driving.  Smoking whacks an average of seven years off a person's life, whereas driving a car results in a bit more than half a year of life lost, on average.  Toxic waste shaves an average of one week off an American's life span. 

Unfortunately, you can't buy a formal insurance policy to protect yourself against all of life's great dangers and risks.  But that doesn't mean that you must face these dangers as a helpless victim; simple changes in behavior can help you improve your security. 

Personal health habits are a good example of the types of behavior you can change.  If you're overweight and you eat unhealthy, highly processed foods, drink alcohol excessively, and don't exercise, you're asking for trouble, especially during post-middle age.  Engage in these habits, and you dramatically increase your risk of heart disease and cancer. 

You can buy all the types of traditional insurance that I recommend in this book and still not be well protected for the simple reason that you're overlooking uninsurable risks.  However, not being able to buy formal insurance to protect against some dangers doesn't mean that you can't drastically reduce your exposure to such risks by modifying your behavior.  For example, you can't buy an auto insurance policy that protects your personal safety against drunk drivers, who are responsible for about 11,000 American deaths annually.  However, you can choose to drive a safe car, practice safe driving habits, and minimize driving on the roads during the late evening hours and on major holidays when drinking is prevalent (such as New Year's Eve, July 4th, and so on). 

In addition to filling those voids, also think about and plan for the nonfinancial issues that inevitably arise in a catastrophe.  For example, make sure you have

  A meeting place for you and your loved ones if you're separated during a disaster (and an out-of-area person to serve as a common point of contact). 

  An escape plan in the event that your area is hit with flooding or some other natural disaster (tornado, hurricane, earthquake, fire, or mudslide)

  The security of having taken steps to make your home safer in the event of an earthquake or fire (for instance, securing shelving and heavy objects from falling and tipping, and installing smoke detectors and fire extinguishers)

  A plan for what you'll do for food, clothing, and shelter should your home become uninhabitable

You get the idea.  Although you can't possibly predict what's going to happen and when, you can find out about the risks of your area.  In addition to buying the broadest possible coverage, you should also make contingency plans for disasters. 

Law III: Shop around and buy direct

Whether you're looking at auto, home, life, disability, or other types of coverage, some companies may charge double or triple the rates that other companies charge for the same coverage.  Insurers that charge the higher rates may not be better about paying claims, however.  You may even end up with the worst of both possible worlds — high prices and lousy service. 

Most insurance is sold through agents and brokers who earn commissions based on what they sell.  The commissions, of course, can bias what they recommend. 

Not surprisingly, policies that pay agents the biggest commissions also tend to be more costly.  In fact, insurance companies compete for the attention of agents by offering bigger commissions.  When I browse publications targeted to insurance agents, I often see ads in which the largest text is the commission percentage offered to agents who sell the advertiser's products. 

Besides the attraction of policies that pay higher commissions, agents also get hooked, financially speaking, on companies whose policies they sell frequently.  After an agent sells a certain amount of a company's insurance policies, she is rewarded with higher commission percentages (and other perks) on any future sales.  Just as airlines bribe frequent fliers with mileage bonuses, insurers bribe agents with fatter commissions and awards such as trips and costly goods. 

Shopping around is a challenge not only because most insurance is sold by agents working on commission, but also because insurers set their rates in mysterious ways.  Every company has a different way of analyzing how much of a risk you are; one company may offer low rates to me but not to you, and vice versa. 

Despite the obstacles, several strategies exist for obtaining low-cost, high-quality policies.  The following sections offer smart ways to shop for insurance. ( Chapters 16 and 17 recommend how and where to get the best deals on specific types of policies.) 

Choosing financially stable insurers

In addition to the price of the policy and the insurer's reputation and track record for paying claims, an insurer's financial health is important to consider when choosing a company.  If you faithfully pay your premium dollars year after year, you're going to be upset if the insurer goes bankrupt right before you have a major claim. 

Insurance companies can fail just like any other company, and dozens do in a typical year.  A number of organizations evaluate and rate, with some sort of letter grade, the financial viability and stability of insurance companies.  The major rating agencies include A. M. Best, Fitch, Moody's, Standard & Poor's, and Weiss. 

The rating agencies' letter-grade system works just the way it does in high school: A is better than B or C. Each company uses a different scale.  Some companies have AAA as their highest rating, and then AA, A, BBB, BB, and so on.  Others use A+, A, A–, B+, B, B–, and so on. 

Just as getting more than one medical opinion is a good idea, getting two or three financial ratings can give you a better sense of the safety of an insurance company.  Stick with companies that are in the top two — or, at worst, three — levels on the different rating scales. 

You can obtain current rating information about insurance companies, free of charge, by asking your agent for a listing of the current ratings.  If you're interested in a policy sold without the involvement of an agent, you can request the current ratings from the insurer itself. 

Although the financial health of an insurance company is important, it's not as big a deal as some insurers (usually those with the highest ratings) and agents make it out to be.  Just as financially unhealthy banks are taken over and merged into viable ones, sickly insurers usually follow a similar path under the direction of state insurance regulators. 

With most insurance company failures, claims still get paid.  The people who had money invested in life insurance or annuities with the failed insurer are the ones who usually lose out.  Even then, you typically get back 80 to 90 cents on the dollar of your account value with the insurer, but you may have to wait years to get it. 

Looking at employer and other group plans

When you buy insurance as part of a larger group, you generally get a lower price because of the purchasing power of the group.  Most of the health and disability policies that you can access through your employer are less costly than equivalent coverage you can buy on your own. 

  Likewise, many occupations have professional associations through which you may be able to obtain lower-cost policies.  Not all associations offer better deals on insurance — compare their policy features and costs with other options. 

Life insurance is an exception to the rule that states that group policies offer better value than individual policies.  Group life insurance plans usually aren't cheaper than the best life insurance policies that you can buy individually.  However, group policies may have the attraction of convenience (ease of enrollment and avoidance of lengthy sales pitches from life insurance salespeople).  Group life insurance policies that allow you to enroll without a medical evaluation are usually more expensive, because such plans attract more people with health problems who can't get coverage on their own.  If you're in good health, you should definitely shop around for life insurance (see Chapter 16 to find out how). 

  Insurance agents who want to sell you an individual policy can come up with 101 reasons why buying from them is preferable to buying through your employer or some other group.  In most cases, agents' arguments for buying an individual policy from them include self-serving hype. 

One valid issue that agents raise is that if you leave your job, you'll lose your group coverage.  Sometimes that may be true.  For example, if you know that you're going to be leaving your job to become self-employed, securing an individual disability policy before you leave your job makes sense.  However, your employer's health insurer may allow you to buy an individual policy when you leave. 

In Chapter16, I explain what you need in the policies you're looking for so that you can determine whether a group plan meets your needs.  In most cases, group plans, especially through an employer, offer good benefits.  So as long as the group policy is cheaper than a comparable individual policy, you'll save money overall buying through the group plan. 

Buying insurance without paying sales commissions

Buying policies from the increasing number of companies that are selling their policies directly to the public without the insurance agent and the agent's commission is your best bet for getting a good insurance value.  Just as you can purchase no-load mutual funds directly from an investment company without paying any sales commission (see Chapter 10), you also can buy no-load insurance.  Be sure to read Chapters 16 and 17 for more specifics on how to buy insurance directly from insurance companies. 

Annuities, investment/insurance products traditionally sold through insurance agents, are also now available directly to the customer, without commission.  Simply contact some of the leading no-load mutual fund companies (see Chapter 11). 

The straight scoop on commissions

The commission paid to an insurance agent is never disclosed through any of the documents or materials that you receive when buying insurance.  The only way you can know what the commission is and how it compares with other policies is to ask the agent.  Nothing is wrong or impolite about asking.  After all, your money pays the commission.  You need to know whether a particular policy is being pitched harder because of its higher commission. 

Commissions are typically paid as a percentage of the first year's premium on the insurance policy. ( Many policies pay smaller commissions on subsequent years' premiums.)  With life and disability insurance policies, for example, a 50-percent commission on the first year's premium is not unusual.  With life insurance policies that have a cash value, commissions of 80 to 100 percent of your first year's premium are possible.  Commissions on health insurance are lower but generally not as low as commissions on auto and homeowner's insurance. 

Dealing with Insurance Problems

When you seek out insurance or have insurance policies, sooner or later you're bound to hit a roadblock.  Although insurance problems can be among the more frustrating in life, in the following sections, I explain how to successfully deal with the more common obstacles. 

Knowing what to do if you're denied coverage

Just as you can be turned down when you apply for a loan, you can also be turned down when applying for insurance.  With medical, life, or disability insurance, a company may reject you if you have an existing medical problem (a preexisting condition) and are therefore more likely to file a claim.  When it comes to insuring assets such as a home, you may have difficulty getting coverage if the property is deemed to be in a high-risk area. 

  Here are some strategies to employ if you're denied coverage:

  Ask the insurer why you were denied.  Perhaps the company made a mistake or misinterpreted some information that you provided in your application.  If you're denied coverage because of a medical condition, find out what information the company has on you and determine whether it's accurate. 

  Request a copy of your medical information file.  Just as you have a credit report file that details your use (and misuse) of credit, you also have a medical information report.  Once per year, you can request a free copy of your medical information file (which typically highlights only the more significant problems over the past seven years, not your entire medical file or history) by calling 866-692-6901 or visiting the website at `www.mib.com` (click on the link on the homepage for "Consumers").  If you find a mistake on your report, you have the right to request that it be fixed.  However, the burden is on you to prove that the information in your file is incorrect.  Proving that your file contains errors can be a major hassle — you may even need to contact physicians you saw in the past, because their medical records may be the source of the incorrect information. 

  Shop other companies.  Just because one company denies you coverage, that doesn't mean all insurance companies will do the same.  Some insurers better understand certain medical conditions and are more comfortable accepting applicants with those conditions.  While most insurers charge higher rates to people with blemished medical histories than they do to people with perfect health records, some companies penalize them less than others.  An agent who sells policies from multiple insurers, called an independent agent, can be helpful, because she can shop among a number of different companies. 

  Find out about state high-risk pools.  A number of states act as the insurer of last resort and provide basic insurance for those who can't get it from insurance companies.  The Health Insurance Resource Center website at `www.healthinsurance.org/risk_pools` provides links to all state health coverage high-risk pool websites.  Alternatively, you can check with your state department of insurance (see the "Government" section of your local white pages) for high-risk pools for other types of insurance, such as property coverage. 

  Check for coverage availability before you buy.  If you're considering buying a home, for example, and you can't get coverage, the insurance companies are trying to tell you something.  What they're effectively saying is "We think that property is so high-risk, we're not willing to insure it even if you pay a high premium." 

Getting your due on claims

In the event that you suffer a loss and file an insurance claim, you naturally hope that your insurance company will cheerfully and expeditiously pay your claims.  Given all the money that you shelled out for coverage and all the hoops you jumped through to get approved for coverage in the first place, that's a reasonable expectation. 

Insurance companies may refuse to pay you what you think they owe you for many reasons, however.  In some cases, your claim may not be covered under the terms of the policy.  At a minimum, the insurer wants documentation and proof of your loss.  Other people who have come before you have been known to cheat, so insurers won't simply take your word, no matter how honest and ethical you are. 

Some insurers view paying claims as an adversarial situation and take a "negotiate tough" stance.  Thinking that all insurance companies are going to pay you a fair and reasonable amount even if you don't make your voice heard is a mistake. 

The tips that I discuss in this section can help you ensure that you get paid what your policy entitles you to. 

Documenting your assets and case

  When you're insuring assets, such as your home and its contents, having a record of what you own can be helpful if you need to file a claim.  The best defense is a good offense.  If you keep records of valuables and can document their cost, you should be in good shape. 

A video is the most efficient record for documenting your assets, but a handwritten list detailing your possessions works, too.  Just remember to keep this record someplace away from your home — if your home burns to the ground, you'll lose your documentation, too! 

If you're robbed or are the victim of an accident, get the names, addresses, and phone numbers of witnesses.  Take pictures of property damage and solicit estimates for the cost of repairing or replacing whatever has been lost or damaged.  File police reports when appropriate, if for no other reason than to bolster your documentation for the insurance claim. 

Preparing your case

Filing a claim should be viewed the same way as preparing for a court trial or an IRS audit.  Any information you provide verbally or in writing can and will be used against you to deny your claim.  First, you should understand whether your policy covers your claim (this is why getting the broadest ­possible coverage helps).  Unfortunately, the only way to find out whether the policy covers your claim is to read it.  Policies are hard to read because they use legal language in non-user-friendly ways. 

  A possible alternative to reading your policy is to call the claims department and, without providing your name (and using caller ID blocking on your phone if you're calling from home), ask a representative whether a particular loss (such as the one that you just suffered) is covered under its policy.  You have no need to lie to the company, but you don't have to tell the representative who you are and that you're about to file a claim, either.  Your call is so you can understand what your policy covers.  However, some companies aren't willing to provide detailed information unless a specific case is cited. 

After you initiate the claims process, keep records of all conversations and copies of all the documents you give to the insurer's claims department.  If you have problems down the road, this "evidence" may bail you out. 

For property damage, get at least a couple of reputable contractors' estimates.  Demonstrate to the insurance company that you're trying to shop for a low price, but don't agree to use a low-cost contractor without knowing that she can do quality work. 

Approaching your claim as a negotiation

To get what you're owed on an insurance claim, you must approach most claims' filings for what they are — a negotiation with a party that's often uncooperative.  And the bigger the claim, the more your insurer will play the part of adversary. 

A number of years ago, when I filed a homeowner's insurance claim after a major rain and wind storm significantly damaged my backyard fence, I was greeted on a weekday by a perky, smiley adjuster.  When the adjuster entered my yard and started to peruse the damage, her demeanor changed dramatically.  She had a combative, hard-bargainer type attitude that I last witnessed when I worked on some labor-management negotiations during my days as a consultant. 

The adjuster stood on my back porch, a good distance away from the fences that had been blown over by wind and crushed by two large trees, and said that my insurer preferred to repair damaged fences rather than replace them. " With your deductible of $1,000, I doubt this will be worth filing a claim for," she said. 

The fence that had blown over, she reasoned, could have new posts set in concrete.  Because we had already begun to clean up some of the damage for safety reasons, I presented to her some pictures of what the yard looked like right after the storm; she refused to take them.  She took some measurements and said that she'd have her settlement check to us in a couple of days.  The settlement she faxed was for $1,119 — nowhere near what it would cost me to fix the damage that was done. 

Practicing persistency

When you take an insurance company's first offer and don't fight for what you're due, you may be leaving a lot of money on the table.  To make my long fence-repair story somewhat shorter, after five rounds of haggling with the adjusters, supervisors, and finally managers, I was awarded payment to replace the fences and clean up most of the damage.  Even though all the ­contractors I contacted recommended that the work be done this way, the insurance adjuster discredited their recommendations by saying, "Contractors try to jack up the price and recommended work once they know an insurer is involved." 

My final total settlement came to $4,888, more than $3,700 higher than the insurer's first offer.  Interestingly, my insurer backed off its preference for repairing the fence when the contractor's estimates for doing that work exceeded the cost of a new fence. 

I was disappointed with the behavior of that insurance company.  I know from conversations with others that my homeowner's insurance company (at that time) was not unusual in its adversarial strategy, especially with larger claims.  And to think that this insurer at the time had one of the better track records for paying claims! 

Enlisting support

If you're doing your homework and you're not making progress with the insurer's adjuster, ask to speak with supervisors and managers.  This is the strategy I used to get the additional $3,700 needed to get things back to where they were before the storm. 

The agent who sold you the policy may be helpful in preparing and filing the claim.  A good agent can help increase your chances of getting paid — and getting paid sooner.  If you're having difficulty with a claim for a policy obtained through your employer or other group, speak with the benefits department or a person responsible for interacting with the insurer.  These folks have a lot of clout, because the agent and/or insurer doesn't want to lose the entire account. 

  If you're having problems getting a fair settlement from the insurer of a policy you bought on your own, try contacting the state department of insurance.  You can find the phone number in the "Government" section of the white pages of your phone book or possibly in your insurance policy, or you can peruse the list at the National Association of Insurance Commissioners website at `www.naic.org` (click on the link for "States and Jurisdictions" on its home page to find links to department of insurance websites for each state). 

When insurers (and government) move slowly

In 2005, when two hurricanes caused unprecedented damage and loss along the Gulf Coast, I received many complaints from folks in that region.  Typical is the following note I received from a New Orleans family in December 2005, more than three months after hurricane Katrina:

"We had substantial damage to our home in New Orleans due to hurricane Katrina.  We had roof damage on August 29th and three feet of water August 31st.  Our flood insurance is through an insurance company acting as an agent for FEMA's program.  Our adjuster has still not turned in the necessary paperwork for our claim.  Our home insurer made no allowance for proper removal and disposal of asbestos shingles and we have gotten just $2,000 for living expenses out of the $21,000 we're now owed.  We have just gotten a first partial payment ($40,000 out of $160,000) on the flood insurance, but it was made out to the wrong mortgage company so we had to send the check back. 

"It is shocking that it has gone on this long.  It has been all over the papers about the delay of some flood insurance payments being due to FEMA not having adequate money in the till.  There's no doubt the insurers are overwhelmed, but why is this taking so long?  I called the Louisiana Department of Insurance and was told that insurers normally have 30 days for claims according to the insurance department (who has said they can have 45 days in this case).  It's been over 60 days since the adjuster came out to our home." 

Stories like this make me disappointed and mad.  There's simply no excuse for large insurance companies who are in the business of insuring for such events not to bring the proper resources to bear to make timely payments.  The fact that they did not do so for Gulf Coast victims is even more reprehensible given the widespread problems in that area.  In addition to home losses, many people also had job losses to deal with and could ill afford to be without money.  Large insurers that have written flood policies for which FEMA temporarily lacks money should pay their policyholders.  Although the federal government and FEMA officials should be taken to task for allowing FEMA's accounts to run dry, customer-service-oriented insurers can step up and advance money that they know will soon be coming from FEMA. 

In situations like this, if you do your homework and you're not making progress with the insurer's adjuster, ask to speak with supervisors and managers.  If you're having problems getting a fair and timely settlement from the insurer, try contacting your state's department of insurance.  This person who wrote me was from Louisiana, where the state department of insurance had more than 1,600 hurricane-related complaints in the first three months after hurricane Katrina.  To my surprise when I spoke with them, the department's Director of Public Information told me that no insurance companies had been fined and penalized for delaying payments.  It's no wonder these companies weren't getting on the stick! 

Hiring a public adjuster who, for a percentage of the payment (typically 5 to 10 percent), can negotiate with insurers on your behalf is another option. 

When all else fails and you have a major claim at stake, try contacting an attorney who specializes in insurance matters.  You can find these specialists in the yellow pages under "Attorneys — Insurance Law."  Expect to pay $100+ per hour.  Look for a lawyer who's willing to negotiate on your behalf, help draft letters, and perform other necessary tasks on an hourly basis without filing a lawsuit.  Your state department of insurance, the local bar association, or other legal, accounting, or financial practitioners also may be able to refer you to someone. 
Chapter 16

Insurance on You: Life, Disability, and Health

In This Chapter

  Looking into life insurance

  Debating disability insurance

  Selecting the best health insurance

During your working years, multiplying your typical annual income by the number of years you plan to continue working produces a pretty big number.  That dollar amount equals what is probably your most valuable asset — your ability to earn an income.  You need to protect this asset by purchasing some insurance on you. 

This chapter explains the ins and outs of buying insurance to protect your income: life insurance in case of death, and disability insurance in case of an accident or severe medical condition that prevents you from working.  I tell you what coverage you should have, where to look for it, and what to avoid. 

In addition to protecting your income, you also need to insure against financially catastrophic expenses.  I'm not talking about January's credit-card bill — you're on your own with that one.  I'm talking about the type of bills that are racked up from a major surgery and a multi-week stay in the hospital.  To protect yourself from potentially astronomical medical bills, you need to have comprehensive health insurance. 

Providing for Your Loved Ones: Life Insurance

You generally need life insurance only when other people depend on your income.  The following folks don't need life insurance to protect their incomes:

  Single people with no children

  Working couples who could maintain a lifestyle acceptable to them on one of their incomes

  Independently wealthy people who don't need to work

  Retired people who are living off their retirement nest egg

  Minor children (are you financially dependent upon your children?) 

If others are either fully or partly dependent on your paycheck (usually a spouse and/or child), you need life insurance, especially if you have major financial commitments such as a mortgage or years of child-rearing ahead.  You may also want to consider life insurance if an extended family member is currently or likely to be dependent on your future income. 

Determining how much life insurance to buy

Determining how much life insurance to buy is as much a subjective decision as it is a quantitative decision.  I've seen some worksheets that are incredibly long and tedious (some are worse than your tax returns).  There's no need to get fancy.  If you're like me, your eyes start to glaze over if you have to complete 20-plus lines of calculations.  Figuring out how much life insurance you need doesn't have to be that complicated. 

The main purpose of life insurance is to provide a lump sum payment to replace the deceased person's income.  Ask yourself how many years of income you want to replace.  Table 16-1 provides a simple way to figure how much life insurance to consider purchasing.  To replace a certain number of years' worth of income, simply multiply the appropriate number in the table by your annual after-tax income. 

Table 16-1 Life Insurance Calculation

Years of Income to Replace | Multiply Annual After-Tax Income* By

---|---

5 | 4.5

10 | 8.5

20 | 15

30 | 20

*Roughly determine your annual after-tax income in one of two ways: Get out last year's tax return (and Form W-2) and subtract the federal, state, and Social Security taxes you paid from your gross employment income; or multiply your gross income by 80 percent if you're a low-income earner, 70 percent if you're a moderate-income earner, or 60 percent if you're a high-income earner. 

Another way to determine the amount of life insurance to buy is to think about how much would be needed to pay for major debts or expenditures, such as your mortgage, other loans, and college for your children.  For example, suppose you want your spouse to have enough of a life insurance death benefit to pay off your mortgage and half of your children's college education.  Simply add your mortgage amount to half of your children's estimated college costs (see Chapter 13 for approximate numbers) and then buy that amount of life insurance. 

Social Security, if you're covered, can provide survivors benefits to your spouse and children.  However, if your surviving spouse is working and earning even a modest amount of money, he or she is going to get few, if any, survivors benefits.  Prior to reaching Social Security's "full retirement age" (see Chapter 4), your survivors benefits get reduced by $1 for every $2 you earn above $14,640 (in 2012). 

This income threshold is higher if you reach full retirement age during the year.  For example, the Social Security benefits for those reaching full retirement age during 2012 are reduced by $1 for each $3 they earn above $38,880 until the month in which they reach full retirement age.  Beginning the month you reach your full retirement age, there's no limit on your earnings if you're collecting survivors benefits. 

If either you or your spouse anticipates earning a low enough income to qualify for survivors benefits, you may want to factor your Social Security survivors benefits into how much life insurance to buy.  Contact the Social Security Administration by phone at 800-772-1213 or visit its website at `www.ssa.gov` to estimate your benefits. 

Examining "other" life insurance

Contemplating the possibility of your untimely demise is surely depressing.  You'll likely feel some peace of mind when purchasing a life insurance policy to provide for your dependents.  However, I suggest you take things a step further.  Suppose you (or your spouse) pass away.  Do you think that simply buying a life insurance policy will be sufficient "help" for the loved ones you leave behind?  Surely your contribution to your household involves far more than being a breadwinner. 

Do you have a will?  See Chapter 17 for more details on wills and other estate-planning documents.  Make sure that all your important financial documents — investment account statements, insurance policies, employee benefits materials, small-business accounting records, and so on — are kept in one place (such as a file drawer) that your loved ones know about.  You may also want to consider providing a list of key contacts — such as who you recommend calling (or what you recommend reading) in the event of legal, financial, or tax quandaries. 

So, in addition to trying to provide financially for your dependents, you also need to take some time to reflect on what else you can do to help point them in the right direction on matters you normally handle.  With most couples, it's natural for one spouse to take more responsibility for money management.  That's fine; just make sure to talk about what's being done so that in the event that the responsible spouse dies, the surviving person knows how to jump into the driver's seat. 

If you have kids (and even if you don't), you may want to give some thought to sentimental leave-behinds for your loved ones.  These leave-behinds can be something like a short note telling them how much they meant to you and what you'd like them to remember about you. 

The Social Security Administration can tell you how much your survivors would receive per month in the event of your death.  You should factor this benefit into the amount of life insurance that you calculate in Table 16-1.  For example, suppose your annual after-tax income is $25,000 and Social Security provides a survivors benefit of $10,000 annually.  Therefore, for the purposes of Table 16-1, you should determine the amount of life insurance needed to replace $15,000 annually ($25,000 – $10,000), not $25,000. 

Comparing term life insurance to cash value life insurance

I'm going to tell you how you can save hours of time and thousands of dollars.  Ready?  Buy term life insurance. ( An exception is if you have a high net worth — several million bucks or more — in which case you may want to consider other options.  See the estate-planning section in Chapter 17.)  If you've already figured out how much life insurance to purchase and this is all the advice you need, you can jump to the "Buying term insurance" section that follows. 

If you want the details behind my recommendation for term insurance, the following information is for you.  Or maybe you've heard (and have already fallen prey to) the sales pitches from life insurance agents, most of whom love selling cash value life insurance because of its huge commissions. 

Despite the variety of names that life insurance marketing departments have cooked up for policies, life insurance comes in two basic flavors:

  Term insurance: This insurance is pure life insurance.  You pay an annual premium for which you receive a particular amount of life insurance coverage.  If you, the insured person, pass away, your beneficiaries collect; otherwise, the premium is gone, but you're grateful to be alive! 

  Cash value insurance: All other life insurance policies (whole, universal, variable, and so on) combine life insurance with a supposed savings feature.  Not only do your premiums pay for life insurance, but some of your dollars are also credited to an account that grows in value over time, assuming you keep paying your premiums.  On the surface, this type of insurance sounds potentially attractive.  People don't like to feel that their premium dollars are getting tossed away. 

  But cash value insurance has a big catch.  For the same amount of coverage (for example, for $100,000 of life insurance benefits), cash value policies cost you about eight times (800 percent) more than comparable term policies. 

Insurance salespeople know the buttons to push to interest you in buying the wrong kind of life insurance.  In the following sections, I give you some of the typical arguments they make for purchasing cash value polices, followed by my perspective on each one. 

"Cash value policies are all paid up after X years.  You don't want to be paying life insurance premiums for the rest of your life, do you?" 

Agents who pitch cash value life insurance present projections that imply that after the first ten or so years of paying your premiums, you don't need to pay more premiums to keep the life insurance in force.  The only reason you may be able to stop paying premiums is because you poured a lot of extra money into the policy in the early years.  Remember that cash value life insurance costs about eight times as much as term insurance. 

Imagine that you're currently paying $500 a year for auto insurance and that an insurance company comes along and offers you a policy for $4,000 per year.  The representative tells you that after ten years, you can stop paying and still keep your same coverage.  I'm sure that you wouldn't fall for this sales tactic, but many people do when they buy cash value life insurance. 

You also need to be wary of the projections, because they often include unrealistic and lofty assumptions about the investment return that your cash balance can earn.  When you stop paying into a cash value policy, the cost of each year's life insurance is deducted from the remaining cash value.  If the rate of return on the cash balance is not sufficient to pay the insurance cost, the cash balance declines, and eventually you receive notices saying that your policy needs more funding to keep the life insurance in force. 

"You won't be able to afford term insurance when you're older." 

As you get older, the cost of term insurance increases because the risk of dying rises.  But life insurance is not something you need all your life!  It's ­typically bought in a person's younger years when financial commitments and obligations outweigh financial assets.  Twenty or thirty years later, the reverse should be true — if you use the principles in this book! 

When you retire, you don't need life insurance to protect your employment income, because there isn't any to protect!  You may need life insurance when you're raising a family and/or you have a substantial mortgage to pay off, but by the time you retire, the kids should be out on their own (you hope!),  and the mortgage should be paid down. 

In the meantime, term insurance saves you a tremendous amount of money.  For most people, it takes 20 to 30 years for the premium they're paying on a term insurance policy to finally catch up to (equal) the premium they've been paying all along on a comparable amount of cash value life insurance. 

"You can borrow against the cash value at a low interest rate." 

Such a deal!  It's your money in the policy, remember?  If you deposited money in a savings or money market account, how would you like to pay for the privilege of borrowing your own money back?  Borrowing on your cash value policy is potentially dangerous: You increase the chances that the policy will lapse — leaving you with nothing to show for your premiums. 

"Your cash value grows tax-deferred." 

Ah, a glimmer of truth at last.  The cash value portion of your policy grows without taxation until you withdraw it, but if you want tax-deferral of your investment balances, you should first take advantage of funding 401(k)s, 403(b)s, SEP-IRAs, and Keoghs.  Such accounts give you an immediate tax deduction for your current contributions in addition to growth without taxation until withdrawal. 

The money you pay into a cash value life policy gives you no upfront tax deductions.  If you exhaust the tax-deductible plans, consider a Roth IRA and then variable annuities, which provide access to better investment options and tax-deferred compounding of your investment dollars.  Roth IRAs have the added bonus of tax-free withdrawal of your investment earnings. ( See Chapter 11 for details on retirement accounts.) 

  Life insurance tends to be a mediocre investment at best.  The insurance company generally quotes you an interest rate for the first year; after that, the company changes the rate annually.  If you don't like the future interest rates, you can be penalized for quitting the policy.  Would you ever invest your money in a bank account that quoted an interest rate for the first year and then penalized you for moving your money within the next seven to ten years? 

"Cash value policies are forced savings." 

Many agents argue that a cash value plan is better than nothing — at least it's forcing you to save.  This line of thinking is silly because so many people drop cash value life insurance policies after just a few years of paying into them.  You can accomplish "forced savings" without using life insurance.  Any of the retirement savings accounts mentioned in Chapter 11 can be set up for automatic monthly transfers.  Employers offering such a plan can deduct contributions from your paycheck — and they don't take a commission!  You can also set up monthly electronic transfers from your bank checking account to contribute to mutual funds (see Chapter 10). 

"Life insurance is not part of your taxable estate." 

If the ownership of a life insurance policy is properly structured, the death benefit is free of estate taxes.  This part of the sales pitch is about the only sound reasoning that exists for buying cash value life insurance.  Under current federal laws, you can pass on $5 million free of federal estate taxes.  But even if you have that large of a nest egg, you have numerous other ways to reduce your taxable estate (see Chapter 17). 

Making your decision

Insurance salespeople aggressively push cash value policies because of the high commissions that insurance companies pay them.  Commissions on cash value life insurance range from 50 to 100 percent of your first year's premium.  An insurance salesperson, therefore, can make eight to ten times more money (yes, you read that right) selling you a cash value policy than he can selling you term insurance. 

Ultimately, when you purchase cash value life insurance, you pay the high commissions that are built into these policies.  As you can see in the policy's cash value table, you don't get back any of the money that you dump into the policy if you quit the policy in the first few years.  The insurance company can't afford to give you any of your money back in those early years because so much of it has been paid to the selling agent as commission.  That's why these policies explicitly penalize you for withdrawing your cash balance within the first seven to ten years. 

Because of the high cost of cash value policies relative to the cost of term, you're more likely to buy less life insurance coverage than you need — that's the sad part of the insurance industry's pushing of this stuff.  The vast majority of life insurance buyers need more protection than they can afford to buy with cash value coverage. 

Cash value life insurance is the most oversold insurance and financial product in the history of the financial services industry.  Cash value life insurance makes sense for a small percentage of people, such as small-business owners who own a business worth at least several million dollars and don't want their heirs to be forced to sell their business to pay estate taxes in the event of their death. ( See "Considering the purchase of cash value life insurance," later in this chapter.) 

Purchase low-cost term insurance and do your investing separately.  Life insurance is rarely a permanent need; over time, you can reduce the amount of term insurance you carry as your financial obligations lessen and you accumulate more assets. 

Buying term insurance

Term insurance policies have several features from which to choose.  I cover the important elements of term insurance in this section so you can make an informed decision about purchasing it. 

Selecting how often your premium adjusts

Term insurance can be purchased so that your premium adjusts (increases) annually or after 5, 10, 15, or 20 years.  The less frequently your premium adjusts, the higher the initial premium and its incremental increases will be. ( Remember, as you get older, the risk of dying increases, so the cost of your insurance goes up.) 

The advantage of a premium that locks in for, say, 15 years is that you have the security of knowing how much you'll be paying annually for the next 15 years.  You also don't need to go through medical evaluations as frequently to qualify for the lowest rate possible.  The disadvantage of a policy with a long-term rate lock is that you pay more in the early years than you do on a policy that adjusts more frequently.  In addition, you may want to change the amount of insurance you carry as your circumstances change.  Thus, you may throw money away when you dump a policy with a long-term premium guarantee before its rate is set to change. 

Policies that adjust the premium every five to ten years offer a happy medium between price and predictability. 

Ensuring guaranteed renewability

Guaranteed renewability, which is standard practice on the better policies, assures that the policy can't be canceled because of poor health.  Don't buy a life insurance policy without this feature unless you expect that your life insurance needs will disappear when the policy is up for renewal. 

Deciding where to buy term insurance

A number of sound ways to obtain high-quality, low-cost term insurance are available.  You may choose to buy through a local agent because you know him or prefer to buy from someone close to home.  However, you should invest a few minutes of your time getting quotes from one or two of the following sources to get a sense of what's available in the insurance market.  Gaining familiarity with the market can prevent an agent from selling you an overpriced, high-commission policy. 

Here are some sources for high-quality, low-cost term insurance:

  USAA: This company sells low-cost term insurance directly to the public.  Contact USAA by phone at 800-531-8722 or visit `www.usaa.com/inet/pages/insurance_life_main`. 

  Insurance agency quotation services: These services provide proposals from the highest-rated, lowest-cost companies available.  Like other agencies, the services receive a commission if you buy a policy from them, which you're under no obligation to do.  They ask questions such as your date of birth, whether you smoke, some basic health questions, and how much coverage you want.  Services that are worth considering include

• AccuQuote: Phone 800-442-9899; website `www.accuquote.com`

• ReliaQuote: Phone 800-940-3002; website `www.reliaquote.com`

• Term4Sale: Phone 888-798-3488; website `www.term4sale.com` (this company doesn't sell life insurance but can refer you to agents who do)

See Chapter 19 for information on how to use your computer when making life insurance decisions. 

Considering the purchase of cash value life insurance

  Don't expect to get objective information from anyone who sells cash value life insurance.  Beware of insurance salespeople masquerading under the guise of self-anointed titles, such as estate-planning specialists or financial planners. 

As I discuss earlier in the chapter, purchasing cash value life insurance may make sense if you expect to have an estate-tax "problem."  However, cash value life insurance is just one of many ways to reduce your estate taxes (see the section on estate planning in Chapter 17). 

Among the best places to shop for cash value life insurance policies are

  USAA: Phone 800-531-8722; website `www.usaa.com/inet/pages/insurance_life_main`

  Ameritas Direct: Phone 800-555-4655; website `www.ameritasdirect.com`

  If you want to obtain some cash value life insurance, tread carefully with local insurance agents.  Most agents aren't as interested in educating as they are in selling.  Besides, the best cash value policies can be obtained commission-free when you buy them from the sources I provide in the preceding list.  The money saved on commissions (which can easily be thousands of dollars) is reflected in a much higher cash value for you. 

Getting rid of cash value life insurance

If you were snookered into buying a cash value life insurance policy and you want to part ways with it, go ahead and do so.  But don't cancel the coverage until you first secure new term coverage.  When you need life insurance, you don't want to have a period when you're not covered (Murphy's Law says that's when disaster will strike). 

Ending a cash value life insurance policy has tax consequences.  You generally must pay federal income tax on the amount you receive in excess of the premiums you paid over the life of the policy.  Because some life insurance policies feature tax-deferred retirement savings, you may incur a 10-percent federal income tax penalty on earnings withdrawn before age 591⁄2, just as you would with an IRA.  Before withdrawing the cash balance in your life insurance policy, consider checking with the insurer or a tax advisor to clarify what the tax consequences may be. 

  You can avoid federal income tax early withdrawal penalties and sidestep taxation on accumulated interest in a life insurance policy by doing a tax-free exchange (also known as a section 1035 exchange) into a no-load (commission-free) variable annuity.  The no-load mutual fund company through which you buy the annuity takes care of transferring your existing balance. ( See Chapter 12 for more information about annuities.) 

Preparing for the Unpredictable: Disability Insurance

As with life insurance, the purpose of disability insurance is to protect your income.  The only difference is that with disability insurance, you're protecting the income for yourself (and perhaps also your dependents).  If you're completely disabled, you still have living expenses, but you probably can't earn employment income. 

I'm referring to long-term disabilities.  If you throw out your back while reliving your athletic glory days and you wind up in bed for a couple weeks, it likely won't be a financial disaster.  But, what if you were disabled in such a way that you couldn't work for several years?  This section helps you figure out whether you need disability insurance, how much to get, and where to find it. 

Deciding whether you need coverage

Most large employers offer disability insurance to their employees.  Many small-company employees and all self-employed people are left to fend for themselves without disability coverage.  Being without disability insurance is a risky proposition, especially if, like most working people, you need your employment income to live on. 

If you're married and your spouse earns a large enough income that you can make do without yours, consider skipping disability coverage.  The same is true if you've already accumulated enough money for your future years (in other words, you're financially independent).  Keep in mind, though, that your expenses may go up if you become disabled and require specialized care. 

For most people, dismissing the need for disability coverage is easy.  The odds of suffering a long-term disability seem so remote — and they are.  But if you suffer bad luck, disability coverage can relieve you (and possibly your family) of a major financial burden. 

Most disabilities are caused by medical problems, such as arthritis, heart conditions, hypertension, and back/spine or hip/leg impairments.  Some of these ailments occur with advancing age, but more than one-third of all disabilities are suffered by people under the age of 45.  The vast majority of these medical problems cannot be predicted in advance, particularly those caused by random accidents. 

  If you think you have good disability coverage through government programs, you'd better think again:

  Social Security disability: Social Security pays long-term benefits only if you're not able to perform any substantial, gainful activity for more than a year or if your disability is expected to result in death.  Furthermore, Social Security disability payments are quite low because they're intended to provide only for basic, subsistence-level living expenses. 

  Workers' compensation: Workers' compensation (if you have such coverage through your employer) pays you benefits if you're injured on the job, but it doesn't pay any benefits if you get disabled away from your job.  You need coverage that pays regardless of where and how you're disabled. 

  State disability programs: Some states have disability insurance programs, but the coverage is typically bare bones.  State programs are also generally not a good value because of the cost for the small amount of coverage they provide.  Benefits are paid over a short period of time (rarely more than a year). 

Determining how much disability insurance you need

You need enough disability coverage to provide you with sufficient income to live on until other financial resources become available.  If you don't have much saved in the way of financial assets and you want to continue with the lifestyle supported by your current income if you suffer a disability, get disability coverage to replace your entire monthly take-home (after-tax) pay. 

The benefits you purchase on a disability policy are quoted as the dollars per month you receive if disabled.  So if your job provides you with a $3,000-per-month income after payment of taxes, seek a policy that provides a $3,000-per-month benefit. 

If you pay for your disability insurance, the benefits are tax-free (but hopefully you won't ever have to collect them).  If your employer picks up the tab, your benefits are taxable, so you need a larger benefit amount. 

In addition to the monthly coverage amount, you also need to select the duration for which you want a policy to pay you benefits.  You need a policy that pays benefits until you reach an age at which you become financially self-sufficient.  For most people, that's around age 65, when their Social Security benefits kick in.  If you anticipate needing your employment income past your mid-60s, you may want to obtain disability coverage that pays you until a later age. 

On the other hand, if you crunch some numbers (see Chapter 3) and you expect to be financially independent by age 55, shop for a policy that pays benefits up to that age — it'll cost you less than one that pays benefits to you until age 65.  If you're within five years of being financially independent or able to retire, five-year disability policies are available, too.  You may also consider such short-term policies when you're sure that someone (for example, a family member) can support you financially over the long-term. 

Identifying other features you need in disability insurance

Disability insurance policies have many confusing features.  Here's what to look for — and look out for — when purchasing disability insurance:

  Definition of disability: An own-occupation disability policy provides benefit payments if you can't perform the work you normally do.  Some policies pay you only if you're unable to perform a job for which you are reasonably trained.  Other policies revert to this definition after a few years of being own-occupation.  Own-occupation policies are the most expensive because there's a greater chance that the insurer will have to pay you.  The extra cost may not be worth it unless you're in a high-income or specialized occupation and you'd have to take a significant pay cut to do something else (and you wouldn't be happy about a reduced income and the required lifestyle changes). 

  Noncancelable and guaranteed renewable: These features ensure that your policy can't be canceled because of your falling into poor health.  With policies that require periodic physical exams, you can lose your coverage just when you're most likely to need it. 

  Waiting period: This is the "deductible" on disability insurance — the time between the onset of your disability and the time you begin collecting benefits.  As with other types of insurance, you should take the highest deductible (longest waiting period) that your financial circumstances allow.  The waiting period significantly reduces the cost of the insurance and eliminates the hassle of filing a claim for a short-term disability.  The minimum waiting period on most policies is 30 days.  The maximum waiting period can be up to one to two years.  Try a waiting period of three to six months if you have sufficient emergency reserves. 

  Residual benefits: This option pays you a partial benefit if you have a disability that prevents you from working full-time. 

  Cost-of-living adjustments (COLAs): This feature automatically increases your benefit payment by a set percentage annually or in accordance with changes in inflation.  The advantage of a COLA is that it retains the purchasing power of your benefits.  A modest COLA, such as 3 to 4 percent, is worth having. 

  Future insurability: A clause that many agents encourage you to buy, future insurability allows you to buy additional coverage regardless of health.  For most people, paying for the privilege of buying more coverage later is not worth it if the income you earn today fairly reflects your likely long-term earnings (except for cost-of-living increases).  You may benefit from the future insurability option if your income is artificially low now and you're confident that it will rise significantly in the future. ( For example, you just got out of medical school and you're ­earning a low salary while being enslaved as a resident.) 

  Insurer's financial stability: As I discuss in Chapter 15, you should choose insurers that'll be here tomorrow to pay your claim.  But don't get too hung up on the stability of the company; benefits are paid even if the insurer fails, because the state or another insurer will almost always bail out the unstable insurer. 

Deciding where to buy disability insurance

The place to buy disability insurance with the best value is through your employer or professional association.  Unless these groups have done a lousy job shopping for coverage, group plans offer a better value than disability insurance you can purchase on your own.  Just make sure that the group plan meets the specifications discussed in the preceding section, especially any limitations of benefit amounts or stricter qualification terms, which are found on some group plans. 

  Don't trust an insurance agent to be enthusiastic about the quality of a disability policy your employer or other group is offering.  Agents have a conflict of interest when they criticize these options, because they won't make a commission if you buy through a group. 

If you don't have access to a group policy, check with your agent or a company you already do business with.  But tread carefully when purchasing disability insurance through an agent.  Some agents try to load down your policy with all sorts of extra bells and whistles to pump up the premium along with their commission. 

  If you buy disability insurance through an agent, consider list billing, where you sign up with several other people for coverage at the same time and are invoiced together for your coverage.  It can knock up to 15 percent off an insurer's standard prices.  Ask your insurance agent how list billing works. 

Getting the Care You Need: Health Insurance

Almost everyone needs health insurance, but not everyone has it.  Some people who can afford health insurance choose not to buy it because they believe that they're healthy and they're not going to need it.  Others who opt not to buy health insurance figure that if they ever really need healthcare, they'll get it even if they can't pay.  To a large extent, they're right.  People without health insurance generally put off getting routine care, which can lead to small problems turning into bigger and costlier ones. 

Choosing the best health plan

Before Medicare (the government-run insurance program for the elderly) kicks in at age 65+, odds are that you'll obtain your health insurance through your employer.  Be thankful if you do.  Employer-provided coverage eliminates the headache of having to shop for coverage, and it's usually cheaper than coverage you buy on your own. 

Whether you have options through your employer or you have to hunt for a plan on your own, the following sections cover the major issues to consider when selecting among the health insurance offerings in the marketplace. 

Major medical coverage

You need a plan that covers the big potential expenses: hospitalization, physician, and ancillary charges, such as X-rays and laboratory work.  If you're a woman and you think that you may want to have children, make sure that your plan has maternity benefits. 

Choice of healthcare providers

Plans that allow you to use any healthcare provider you want are becoming less common and more expensive in most areas.  Health maintenance organizations (HMOs) and preferred provider organizations (PPOs) are the main plans that restrict your choices.  They keep costs down because they negotiate lower rates with selected providers. 

HMOs and PPOs are more similar than they are different.  The main difference is that PPOs still pay the majority of your expenses if you use a provider outside their approved list.  If you use a provider outside the approved list with an HMO, you typically aren't covered at all. 

If you have your heart set on particular physicians or hospitals, find out which health insurance plans they accept as payment.  Ask yourself whether the extra cost of an open-choice plan is worth being able to use their services if they're not part of a restricted-choice plan.  Also be aware that some plans allow you to go outside their network of providers as long as you pay a bigger portion of the incurred medical costs.  If you're interested in being able to use alternative types of providers, such as acupuncturists, find out whether the plans you're considering cover these services. 

Don't let stories of how hard it is to get an appointment with a doctor or other logistical hassles deter you from going with an HMO or PPO plan.  These things can happen in plans with open choice, too.  The idea that doctors who can't get patients on their own are the only ones who sign up with restricted-choice plans is a myth.  Although HMO and PPO plans do offer fewer choices when it comes to providers, surveys show that customer satisfaction with these plans is as high as it is for plans that offer more choices. 

Lifetime maximum benefits

Health insurance plans specify the maximum total benefits they'll pay over the course of time you're insured by their plan.  Although a million dollars may be more money than you could ever imagine being spent on your healthcare, it's the minimum acceptable level of total benefits.  With the cost of healthcare today, you can quickly blow through that if you develop major health problems.  Ideally, choose a plan that has no maximum or that has a maximum of at least 5 million dollars. 

Deductibles and co-payments

  To reduce your health insurance premiums, choose a plan with the highest deductible and co-payment you can afford.  As with other insurance policies, the more you're willing to share in the payment of your claims, the less you have to pay in premiums.  Most policies have annual deductible options (such as $250, $500, $1,000, and so on) as well as co-payment options, which are typically 20 percent or so. 

When choosing a co-payment percentage, don't let your imagination run wild and unnecessarily scare you.  A 20-percent co-payment doesn't mean that you have to come up with $20,000 for a $100,000 claim.  Insurance plans generally set a maximum out-of-pocket limit on your annual co-payments (such as $1,000, $2,000, and so on); the insurer covers 100 percent of any medical expenses that go over that cap. 

  For insurance provided by your employer, consider plans with low out-of-pocket expenses if you know that you have health problems.  Because you're part of a group, the insurer won't increase your individual rates just because you're filing more claims. 

Saving on taxes when spending on healthcare

If you expect to have out-of-pocket medical expenses, find out whether your employer offers a flexible spending or healthcare reimbursement account.  These accounts enable you to pay for uncovered medical expenses with pretax dollars.  If, for example, you're in a combined 35-percent federal and state income tax bracket, these accounts allow you to pay for necessary healthcare at a 35-percent discount.  These accounts can also be used to pay for vision and dental care. 

Be forewarned of the major stumbling blocks you face when saving through medical reimbursement accounts.  First, you need to elect to save money from your paycheck prior to the beginning of each plan year.  The only exception is at the time of a "life change," such as a family member's death, marriage, spouse's job change, divorce, or the birth of a child.  You also need to use the money within the year you save it, because these accounts contain a "use it or lose it" feature. 

Health savings accounts (HSAs) are another option, especially for the self-employed and people who work for smaller firms.  To qualify, you must have a high-deductible (at least $1,200 for individuals; $2,400 for families) health insurance policy; then you can put money earmarked for medical expenses into an investment account that offers the tax benefits — deductible contributions and tax-deferred compounding — of a retirement account (see Chapter 4).  And unlike a flexible spending account, you don't have to deplete the HSA by the end of the year: Money can compound tax-deferred inside the HSA for years.  Begin to investigate an HSA through insurers offering health plans you're interested in or with the company you currently have coverage through (also see my website, `www.erictyson.com`, for the latest information on the best HSA plans). 

You may also be able to save on taxes if you have a substantial amount of healthcare expenditures in a year.  You can deduct medical and dental expenses as an itemized deduction on Schedule A to the extent that they exceed 7.5 percent of your adjusted gross income (refer to Chapter 7).  Unless you're a low-income earner, you need to have substantial expenses, usually caused by an accident or major illness, to take advantage of this tax break. 

Most HMO plans don't have deductible and co-payment options.  Most just charge a set amount — such as $25 — for a physician's office visit. 

Guaranteed renewability

You want a health insurance plan that keeps renewing your coverage without you having to prove continued good health.  If good health could be guaranteed, you wouldn't need health insurance in the first place. 

Buying health insurance

You can buy many health plans through agents, and you can also buy some directly from the insurer.  When health insurance is sold both ways, buying through an agent usually doesn't cost more. 

If you're self-employed or you work for a small employer that doesn't offer health insurance as a benefit, get proposals from the larger and older health insurers in your area.  Larger plans can negotiate better rates from providers, and older plans are more likely to be here tomorrow. 

Many insurers operate in a bunch of different insurance businesses.  You want those that are the biggest in the health insurance arena and are committed to that business.  Nationally, Blue Cross, Blue Shield, Kaiser Permanente, Aetna, UnitedHealth Group, CIGNA, Assurant, Golden Rule, and Anthem are among the older and bigger health insurers.  If your coverage is canceled, you may have to search for coverage that allows an existing medical problem.  Other health insurers won't want to insure you. ( Find out whether your state department of insurance offers a plan for people unable to get coverage.) 

Also check with professional or other associations that you belong to, because plans offered by these groups sometimes offer decent benefits at a competitive price due to the purchasing power clout that they possess.  A competent independent insurance agent who specializes in health insurance can help you find insurers who are willing to offer you coverage. 

Health insurance agents have a conflict of interest that's common to all financial salespeople working on commission: The higher the premium plan they sell you, the bigger the commission they earn.  So an agent may try to steer you into higher-cost plans and avoid suggesting some of the strategies I discuss in the preceding section for reducing your cost of coverage. ( Good agents can help guide you to the best plans that cover preexisting conditions and offer the lowest costs for your medications.  Be sure to provide them with this information and compare options carefully.) 

Dealing with insurance denial

When you try to enroll in a particular health insurance plan, you may be turned down because of current or previous health problems.  Your medical information file (the medical equivalent of a credit report) may contain information explaining why you were turned down. ( See Chapter 15 for more about medical information files.) 

If you have a so-called preexisting condition (current or prior medical problems), you have several options to pursue when trying to secure health ­insurance:

  Try health insurance plans that don't discriminate.  A few plans — typically Blue Cross, Blue Shield, and some HMO plans, such as Kaiser Permanente — will sometimes take you regardless of your condition. 

  Find a job with an employer whose health insurer doesn't require a medical exam.  This shouldn't be your only reason for seeking new employment, but it can be an important factor.  If you're married, you may also be able to get into an employer group plan if your spouse takes a new job. 

  Find out whether your state offers a plan.  A number of states maintain "high-risk" pools that insure people who have preexisting conditions and are unable to find coverage elsewhere (see Chapter 15 for how to find out which states offer such plans).  If your state doesn't offer one of these plans, I suppose that, in a drastic situation, you could move to a nearby state that does. 

Understanding Obamacare

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act.  Together, these two laws enacted comprehensive health care reform in the United States. 

This is mammoth legislation comprising thousands of pages of rule and regulations, the constitutionality of which is going to be evaluated by the U.S. Supreme Court, likely before the 2012 election.  Also, depending upon the outcome of the 2012 elections, much — if not all — of Obamacare may be repealed.  In the meantime, this section highlights the most important portions of the legislation that you need to understand. 

Dealing with medical claims headaches

If you sign up for a health plan that has deductibles and co-payments, make sure that you review the benefits statements your insurer sends you.  Errors often pop up on these statements and during the claims filing process.  Not surprisingly, the errors are usually at your expense. 

Make sure that your insurer has kept accurate track of your contributions toward meeting your plan's annual deductible and maximum out-of-pocket charges.  Also, don't pay any healthcare providers who send you bills until you receive proper notification from the insurance company detailing what you are obligated to pay those providers according to the terms of your plan.  Because most insurance companies have negotiated discounted fee schedules with healthcare providers, the amount that a provider bills you is often higher than the amount they're legally due as per the terms of their contract with your insurer.  Your insurer's benefits statement should detail the approved and negotiated rate once the claim is processed.  And don't let providers try to bully you into paying them the difference between what they billed you for and what the insurer says they are due.  Providers are due only the discounted fees they agreed to with your insurer. 

Haggling with your health insurer is a real pain, and it usually happens after you rack up significant medical expenses and may still not be feeling well.  But if you don't stay on top of your insurer, you can end up paying thousands of dollars in overpayments.  If you're overwhelmed with an avalanche of claims and benefits statements, you may want to consider using a health insurance claims processing service.  You can get a referral to firms that engage in this line of work by visiting the Alliance of Claims Assistance Professionals website at `www.claims.org`. 

Effective in 2011, employer group health plans

  Must offer coverage to adult children up to age 26 who are not eligible for coverage under another employer's health plan (this latter requirement is dropped effective 2014).  The coverage is not taxable to the employee or dependent. 

  May not impose lifetime limits. 

  May not impose preexisting condition exclusions on children under age 19. 

  Must provide preventive care without cost sharing, and must cover certain child preventive care services as recommended by government.  This rule applies only to new group health plans. 

In 2013, higher income taxpayers will get hit with higher tax rates on their investments as well as higher Medicare tax rates to help pay for Obamacare.  Taxpayers with total taxable income above $200,000 (for a single return) or $250,000 (for a joint return) from any source will be subject to a 3.8 percent tax on the lesser of the following:

  Their net investment income (for example, interest, dividends, and capital gains)

  The amount, if any, by which their modified adjusted gross income exceeds the dollar thresholds

Taxpayers with earned income above $200,000 (for a single return) or $250,000 (for a joint return) will be subject to an additional 0.9 percent Medicare tax (in other words, rising from 1.45 percent to 2.35 percent) on wages in excess of those amounts.  Employers will not be required to match the payment of this incremental increase, which is applicable only to the employee. 

Also in 2013, individual taxpayers seeking to claim an itemized income tax deduction for medical expenses will be able to deduct only the portion of such expenses in excess of 10 percent of their adjusted gross income, up from the current level of 7.5 percent of income. ( This change is deferred to 2017 for those people age 65 and over.) 

In 2014, the following additional provisions of Obamacare kick in:

  Employer "pay or play" responsibility begins.  Employers must offer minimum essential coverage to full-time employees or make nondeductible payments to government. 

  Group health plans must remove all annual dollar limits on participants' benefit payments. 

  Group health plans must limit cost-sharing and deductibles to levels that don't exceed those applicable to a health-savings-account-eligible, high-deductible health plan. ( Such plans currently have a $1,200 individual and $2,400 family minimum deductible.) 

  Group health plans must remove all preexisting condition exclusions on all participants. 

  Group health plans may not have waiting periods of longer than 90 days. 

Looking at retiree medical care insurance

Medicare, the government-run health insurance plan for the elderly, is a multi-part major medical plan.  Enrollment in Part A (hospital expenses) is automatic.  Part B, which covers physician expenses and other charges, including home healthcare coverage; Part C, supplemental Medicare coverage (sold through private insurers); and Part D, for prescription drugs (provided through private insurers), are optional.  Supplemental insurance policies, also known as Medigap coverage, may be of interest to you if you want help paying for the costs that Medicare doesn't pay. 

Closing Medicare's gaps

Medigap coverage generally pays the deductibles and co-payments that Medicare charges.  For the first 60 days of hospitalization, you pay $1,156 total out of your own pocket.  If you have an unusually long hospital stay, you pay $289 per day for the 61st through the 90th day, $578 per day for the 91st through the 150th day, and all costs beyond 150 days.  Clearly, if you stay in a hospital for many months, your out-of-pocket expenses can escalate; however, the longest hospitalizations tend not to last for many months.  Also note that Medicare's hospitalization benefits refresh when you're out of the hospital for 60 consecutive days. 

If you're unable to pay for the deductibles and co-payments because your income is low, making a long hospital stay a financial catastrophe for you, Medicaid (the state-run medical insurance program for low-income people) may help pay your bills.  Alternatively, Medigap insurance can help close the gap. 

Check with your physician(s) to see if he charges a fee higher than the one listed on Medicare's fee schedule.  If your physician does charge a higher fee, you may want to consider going to another physician if you can't afford the fee or if you want to save some money. ( But don't drop your current doctor before finding another who accepts Medicare and you as a patient.  Many doctors are not accepting Medicare patients.)  Medicare often pays only 80 percent of the physician charges that the program allows on its fee schedule. 

The biggest reason that elderly people consider extra health insurance is that Medicare pays only for the first 100 days in a skilled nursing facility.  Anything over that is your responsibility.  Unfortunately, Medigap policies don't address this issue, either. 

Long-term care insurance

Insurance agents who are eager to earn a hefty commission will often tell you that long-term care (LTC) insurance is the solution to your concerns about an extended stay in a nursing home.  Don't get your hopes up.  Policies are complicated and filled with all sorts of exclusions and limitations.  On top of all that, they're expensive, too. 

The decision to purchase LTC insurance is a trade-off.  Do you want to pay thousands of dollars annually, beginning at age 60, to guard against the possibility of a long-term stay in a nursing home?  If you live into or past your mid-80s, you can end up paying $100,000 or more on an LTC policy (not to mention the lost investment earnings on these insurance premiums). 

People who end up in a nursing home for years on end may come out ahead financially when buying LTC insurance.  The majority of people who stay in a nursing home are there for less than a year, though, because they either pass away or move out.  Medicare pays for the bulk of the cost of the first 100 days in a nursing home as long as certain conditions are satisfied.  Medicare pays for all basic services (telephone, television, and private room charges excluded) for the first 20 days and then requires a co-payment of $144.50 per day for the next 80 days.  First, the nursing-home stay must follow hospitalization within 30 days, and the nursing-home stay must be for the same medical condition that caused the hospitalization.  When you're discharged from the nursing home, you can qualify for an additional 100-day benefit period as long as you haven't been hospitalized or in a nursing home in the 60 days prior to your readmission. 

If you have relatives or a spouse who will likely care for you in the event of a major illness, you definitely should not waste your money on nursing-home insurance.  You can also bypass this coverage if you have and don't mind using retirement assets to help pay nursing-home costs. 

Even if you do deplete your assets, remember that you have a backup: Medicaid (state-provided medical insurance) can pick up the cost if you can't.  However, be aware of a number of potential drawbacks to getting coverage for nursing-home stays under Medicaid:

  Medicaid patients are at the bottom of the priority list.  Most nursing homes are interested in the bottom line, so the patients who bring in the least revenue — namely Medicaid patients — get the lowest priority on nursing-home waiting lists. 

  Some nursing homes don't take Medicaid patients.  Check with your preferred nursing homes in your area to see whether they accept Medicaid. 

  The states may squeeze Medicaid further.  Deciding which medical conditions warrant coverage is up to your state.  With the budget noose tightening, some states are disallowing certain types of coverage (for example, mental problems for elderly people who are otherwise in good physical health). 

If you're concerned about having your stash of money wiped out by an extended nursing-home stay and you have a strong desire to pass money to your family or a favorite charity, you can start giving your money away while you're still healthy. ( If you're already in poor health, legal experts can strategize to preserve your assets and keep them from being used to pay nursing-home costs.) 

  Consider buying nursing-home insurance if you want to retain and protect your assets and it gives you peace of mind to know that a long-term nursing-home stay is covered.  But do some comparison shopping, and make sure that you buy a policy that pays benefits for the long term.  A year's worth (or even a few years' worth) of benefits won't protect your assets if your stay lasts longer.  Also be sure to get a policy that adjusts the daily benefit amount for increases in the cost of living.  Get a policy that covers care in your home or other settings if you don't need to be in a high-cost nursing home, and make sure that it doesn't require prior hospitalization for benefits to kick in.  To keep premiums down, also consider a longer exclusion or waiting period — three to six months or a year before coverage starts. 

You may also want to consider retirement communities if you're willing to live as a younger retiree in such a setting.  After paying an entrance fee, you pay a monthly fee, which usually covers your rent, care, and meals.  Make sure that any such facility you're considering guarantees care for life and preferably has a continuum of care levels available.  Also verify that it accepts Medicaid in case you deplete your assets. 

Making sense of Medicare's prescription drug program

As if there weren't enough confusing government programs, Uncle Sam had to create yet another that began in 2006 — the Medicare (Part D) prescription drug plan.  Here are some key facts you need to know about these somewhat complicated plans, which are offered through private insurers:

  Plans make the most sense for those who expect to spend more than $5,000 annually on prescription drugs. 

  If you choose not to enroll when you're first eligible and then later enroll, you'll be charged a penalty equal to 1 percent of the national average Part D premium for each month that has elapsed since you were first eligible to participate.  You will pay this penalty for as long as you're in the plan. 

  If you're on the fence about enrolling, consider starting with a low-premium plan that then gives you the right to transfer into a higher-cost and better-coverage plan without paying the late enrollment penalty. 

  Visit `www.medicare.gov` for helpful information on drug plans and how to select one.  For example, click on the Formulary (drug) Finder to identify specific insurer plans that cover your current medications or your anticipated future medications.  AARP's website, `www.aarp.org`, also has plenty of information and resources to find out more about these confusing plans. 
Chapter 17

Covering Your Assets

In This Chapter

  Checking out homeowner's/renter's insurance

  Considering automobile insurance

  Understanding umbrella insurance

  Ensuring your estate is handled as you want

In Chapter 16, I discuss the importance of protecting your future income from disability, death, or large, unexpected medical expenses.  But you also have to insure major assets that you've acquired in the past: your home, your car, and your personal property.  You need to protect these assets for two reasons:

  Your assets are valuable.  If you were to suffer a loss, replacing the assets with money out of your own pocket could be a financial catastrophe. 

  A lawsuit can drain your finances.  Should someone be injured or killed in your home or because of your car, a lawsuit could be financially devastating. 

In this chapter, I explain why, how, and for how much to insure your home, personal property, and vehicle.  I also discuss excess liability insurance and how to determine where your money will go in the event of your death. 

Insuring Where You Live

When you buy a home with a mortgage, most lenders require you to purchase homeowner's insurance.  But even if they don't, you're wise to do so, because your home and the personal property within it are worth a great deal and would cost a bundle to replace. 

As a renter, damage to the building in which you live is not your immediate financial concern, but you still have personal property you may want to insure.  You also have the possibility (albeit remote) that you'll be sued by someone who's injured in your rental. 

When shopping for a homeowner's or renter's policy, consider the important features that I cover in the following sections. 

Dwelling coverage: The cost to rebuild

How much would you have to spend to rebuild your home if it were completely destroyed, for example, in a fire?  The cost to rebuild should be based on the size (square footage) of your home.  Neither the purchase price nor the size of your mortgage should determine how much dwelling coverage you need. 

If you're a renter, rejoice that you don't need dwelling coverage.  If you're a condominium owner, find out whether the insurance the condo association bought for the entire building is sufficient. 

Be sure that your homeowner's policy includes a guaranteed replacement cost provision.  This useful feature ensures that the insurance company will rebuild the home even if the cost of construction is more than the policy coverage.  If the insurance company underestimates your dwelling coverage, it has to make up the difference. 

Unfortunately, insurers define guaranteed replacement cost differently.  While some companies pay for the full replacement cost of the home, no matter how much it ends up costing, most insurers set limits.  For example, some insurers may pay up to only 25 percent more than the dwelling coverage on your policy.  Ask your insurer how it defines guaranteed replacement cost. 

If you have an older property that doesn't meet current building standards, consider buying a rider (supplemental coverage to your main insurance policy) that pays for code upgrades.  This rider covers the cost of rebuilding your home, in the event of a loss, to comply with current building codes that may be more stringent than the ones in place when your home was built.  Ask your insurance company what your basic policy does and doesn't cover.  Some companies include a certain amount (for example, 10 percent of your dwelling coverage) for code upgrades in the base policy. 

Personal property coverage: For your things

On your homeowner's policy, the amount of personal property coverage is typically derived from the amount of dwelling coverage you carry.  Generally, you get personal property coverage that's equal to 50 to 75 percent of the dwelling coverage.  This amount is usually more than enough. 

Regarding riders to cover jewelry, computers, furs, and other somewhat costly items that may not be fully covered by typical homeowner's policies, ask yourself whether the out-of-pocket expense from the loss of such items would constitute a financial catastrophe.  Unless you have more than several thousand dollars worth of jewelry or computer equipment, skip such riders. 

Some policies come with replacement cost guarantees that pay you the cost to replace an item.  This payment can be considerably more than what the used item was worth before it was damaged or stolen.  When this feature is not part of the standard policy sold by your insurer, you may want to purchase it as a rider, if available. 

As a renter or condominium owner, you need to choose a dollar amount for the personal property you want covered.  Tally it up instead of guessing — the total cost of replacing all your personal property may surprise you. 

  Make a list of your belongings — or even better, take pictures or make a video — with an estimate of what they're worth.  Keep this list updated; you'll need it if you have to file a claim.  Retaining receipts for major purchases may also help your case.  No matter how you document your belongings, don't forget to keep the documentation somewhere besides your home — otherwise, it could be destroyed along with the rest of your house in a fire or other disaster. 

Liability insurance: Coverage for when others are harmed

Liability insurance protects you financially against lawsuits that may arise if someone gets injured on your property, including wounds inflicted by the family pit bull or terrible tabby. ( Of course, you should keep Bruno restrained when guests visit — even your cranky in-laws.)  At a minimum, get enough liability insurance to cover your financial assets — covering two times your assets is better.  Buying extra coverage is inexpensive and well worth the cost. 

The probability of being sued is low, but if you are sued and lose, you could end up owing big bucks.  If you have substantial assets to protect, you may want to consider an umbrella, or excess liability, policy. ( See "Protecting against Mega-Liability: Umbrella Insurance," later in this chapter.) 

Liability protection is one of the side benefits of purchasing a renter's policy — you protect your personal property as well as insure against lawsuits. ( But don't be reckless with your banana peels even if you get liability insurance!) 

Flood and earthquake insurance: Protection from Mother Nature

You should purchase the broadest possible coverage when buying any type of insurance (see Chapter 15).  The problem with homeowner's insurance is that it's not comprehensive enough — it doesn't typically cover losses due to earthquakes and floods.  You must buy such disaster coverage separately. 

If an earthquake or flood were to strike your area and destroy your home, you'd be out tens (if not hundreds) of thousands of dollars without proper coverage.  Yet many people don't carry these important coverages, often as a result of some common misconceptions:

  "Not in my neighborhood."  Many people mistakenly believe that earthquakes occur only in California.  I wish this were true for those of you who live in the other 49 states, but it's not.  In fact, one of the strongest earthquakes in the United States occurred in the Midwest, and known (though less active) fault lines lie along the East Coast.  The cost of earthquake coverage is based on insurance companies' assessment of the risk of your area and property type.  You shouldn't decide whether to buy insurance based on how small you think the risk is.  The risk is already built in to the price. 

An estimated 20,000 communities around the country face potential flood damage.  Like earthquakes, floods are not a covered risk in standard homeowner's policies, so you need to purchase a flood insurance rider.  Check with your current homeowner's insurer or with the insurers recommended in this chapter.  The federal government flood insurance program (phone 888-379-9531; website `www.floodsmart.gov`) provides background information on flood insurance policies. 

  "The government will bail me out."  The vast majority of government financial assistance is obtained through low-interest loans.  Loans, unfortunately, need to be repaid, and that money comes out of your pocket. 

  "In a major disaster, insurers would go bankrupt anyway."  This is highly unlikely given the reserves insurers are required to keep and the fact that the insurance companies reinsure — that is, they buy insurance to back up the policies they write.  Also, state regulatory agencies facilitate the merging of faltering insurers into strong entities. 

People who have little equity in their property and are willing to walk away from their property and mortgage in the event of a major quake or flood may consider not buying earthquake or flood coverage.  Keep in mind that walking away damages your credit report, because you're essentially defaulting on your loan. 

  You may be able to pay for much of the cost of earthquake or flood insurance by raising the deductibles (discussed in the next section) on the main part of your homeowner's/renter's insurance and other insurance policies (such as auto insurance).  You can more easily afford the smaller claims, not the big ones.  If you think flood or earthquake insurance is expensive, compare those costs with the expenditures you would incur to completely replace your home and personal property.  Buy this insurance if you live in an area that has a chance of being affected by these catastrophes.  To help keep the cost of earthquake insurance down, consider taking a 10 percent deductible.  Most insurers offer deductibles of 5 or 10 percent of the cost to rebuild your home.  Ten percent of the rebuilding cost is a good chunk of money.  But losing the other 90 percent is what you want to insure against. 

Deductibles: Your cost with a claim

As I discuss in Chapter 15, the point of insurance is to protect against catastrophic losses, not the little losses.  By taking the highest deductibles you're comfortable with, you save on insurance premiums year after year, and you don't have to go through the hassle of filing small claims. 

Special discounts

  You may qualify for special discounts on your policy.  Companies and agents that sell homeowner's and renter's insurance don't always check to see whether you're eligible for discounts.  After all, the more you spend on policy premiums, the more money they make!  If your property has a security system, you're older, or you have other policies with the same insurer, you may qualify for a lower rate.  Remember to ask. 

Also, be aware that insurers use your credit score as a factor in setting some of your insurance rates.  They do this because their studies have shown that folks who have higher credit scores tend to have fewer accidents and insurance claims.  See Chapter 2 for how to assess and improve your credit reports and scores. 

Buying homeowner's or renter's insurance

Each insurance company prices its homeowner's and renter's policies based on its own criteria.  So the lowest-cost company for your friend's property may not be the lowest-cost company for you.  You have to shop around at several companies to find the best rates.  The following list features companies that historically offer lower-cost policies for most people and have decent track records regarding customer satisfaction and the payment of claims:

  Amica: Although Amica does have good customer satisfaction, its prices are high in some areas.  You can contact the company by calling 800-242-6422 or checking out the company's website at `www.amica.com`. 

  Erie Insurance: This company does business primarily in the Midwest and Mid-Atlantic.  Check your local phone directory for agents, call 800-458-0811 for a referral to a local agent, or visit the company's website at `www.erieinsurance.com`. 

  GEICO: You can contact the company by calling 800-841-2946 or visit `www.geico.com`. 

  Liberty Mutual: Check your local phone directory for agents or go to `www.libertymutual.com`. 

  Nationwide Mutual: Check your local phone directory for agents or see `www.nationwide.com`. 

  State Farm: Check your local phone directory for agents or visit `www.statefarm.com`. 

  USAA: This company provides insurance for members of the military and their families.  Call the company at 800-531-8722 (or visit its website at `www.usaa.com`) to see whether you qualify. 

Don't worry that some of these companies require you to call a toll-free number for a price quote.  This process saves you money, because these insurers don't have to pay commissions to local agents hawking their policies.  These companies have local claims representatives to help you if and when you have a claim. 

A number of the companies mentioned in the preceding list sell other types of insurance (for example, life insurance) that aren't as competitively priced.  Be sure to check out the relevant sections in this part of the book for the best places to buy these other types of coverage if you need them. 

Some state insurance departments conduct surveys of insurers' prices and tabulate complaints received.  Look up your state's department of insurance phone number in the government section of your local phone directory or visit the National Association of Insurance Commissioners' website at `www.naic.org/state_web_map.htm` to find links to each state's department of insurance site. 

Auto Insurance 101

Over the course of your life, you may spend tens of thousands of dollars on auto insurance.  Much of the money people spend on auto insurance is not spent where it's needed most.  In other cases, the money is simply wasted.  Look for the following important features when searching for an auto insurance policy. 

Bodily injury/property damage liability

As with homeowner's liability insurance, auto liability insurance provides insurance against lawsuits.  Accidents happen, especially with a car.  Make sure that you have enough bodily injury liability insurance, which pays for harm done to others, to cover your assets. ( Coverage of double your assets is preferable.) 

If you're just beginning to accumulate assets, don't mistakenly assume that you don't need liability protection.  Many states require a minimum amount — insurers should be able to fill you in on the details for your state.  Also, don't forget that your future earnings, which are an asset, can be garnished in a lawsuit. 

Property damage liability insurance covers damage done by your car to other people's cars or property.  The amount of property damage liability coverage in an auto insurance policy is usually determined as a consequence of the bodily injury liability amount selected.  Coverage of $50,000 is a good minimum to start with. 

Coping with teen drivers

If you have a teenage driver in your household, you're going to be spending a lot more on auto insurance (in addition to worrying a lot more).  As soon as you decide to allow your teenager to drive, you can take a number of steps to avoid spending all your take-home pay on auto insurance bills:

  Make sure that your teen does well in school.  Some insurers offer discounts if your child is a strong academic achiever and has successfully completed a driver's education class (which is not required). 

  Get price quotes from several insurers to see how adding your teen driver to your policy affects the cost. 

  Have your teenager share in the costs of using the car.  If you pay all the insurance, gas, and maintenance bills, your teenager won't value the privilege of using your "free" car. 

Of course, teen driving involves more than just keeping your insurance bills to a minimum.  Auto accidents are the number-one cause of death for teens.  For more on driving responsibly, see the sidebar later in this chapter titled "Driving safely: Overlooked auto insurance." 

Uninsured or underinsured motorist liability

When you're in an accident with another motorist and she doesn't carry her own liability protection (or doesn't carry enough), uninsured or underinsured motorist liability coverage allows you to collect for lost wages, medical expenses, and pain and suffering incurred in the accident. 

If you already have comprehensive health and long-term disability insurance, uninsured or underinsured motorist liability coverage is largely redundant.  However, if you drop this coverage, you do give up the ability to sue for general pain and suffering and to insure passengers in your car who may lack adequate medical and disability coverage. 

To provide a death benefit to those financially dependent on you in the event of a fatal auto accident, buy term life insurance (see Chapter 16). 

Deductibles

To minimize your auto insurance premiums and eliminate the need to file small claims, take the highest deductibles you're comfortable with. ( Most people should consider a $500 to $1,000 deductible.)  On an auto policy, two deductibles exist: collision and comprehensive.  Collision applies to claims arising from collisions. ( Note that if you have collision coverage on your own policy, you can generally bypass collision coverage when you rent a car.)  Comprehensive applies to other claims for damages not caused by collision (for example, a window broken by vandals). 

As your car ages and loses its value, you can eventually eliminate your comprehensive and collision coverages altogether.  The point at which you do this is up to you.  Insurers won't pay more than the book value of your car, regardless of what it costs to repair or replace it.  Remember that the purpose of insurance is to compensate you for losses that are financially catastrophic to you.  For some people, this amount may be as high as $5,000 or more — others may choose $1,000 as their threshold point. 

Special discounts

You may be eligible for special discounts on auto insurance.  Don't forget to tell your agent or insurer if your car has a security alarm, air bags, or anti-lock brakes.  If you're older or you have other policies or cars insured with the same insurer, you may also qualify for discounts.  And make sure that you're given appropriate "good driver" discounts if you've been accident- and ticket-free in recent years. 

And here's another idea: Before you buy your next car, call insurers and ask for insurance quotes for the different models you're considering.  The cost of insuring a car should factor into your decision of which car you buy, because the insurance costs represent a major portion of your car's ongoing operating expenses. 

Little-stuff coverage to skip

Auto insurers have dreamed up all sorts of riders, such as towing and rental car reimbursement.  On the surface, these riders appear to be inexpensive.  But they're expensive given the little amount you'd collect from a claim and the hassle of filing. 

Riders that waive the deductible under certain circumstances make no sense, either.  The point of the deductible is to reduce your policy cost and eliminate the hassle of filing small claims. 

Medical payments coverage typically pays a few thousand dollars for medical expenses.  If you and your passengers carry major medical insurance coverage, this rider isn't really necessary.  Besides, a few thousand dollars of medical coverage doesn't protect you against catastrophic expenses. 

Driving safely: Overlooked auto insurance

Tragic events (murders, fires, hurricanes, plane crashes, and so on) are well-covered by the media, but the number of deaths that make the front pages of our newspapers pales in comparison to the more than 30,000 people who die on America's roads every year.  I'm not suggesting that the national media should start reporting every automobile fatality.  Even 24 hours of daily CNN coverage probably couldn't keep up with all the accidents on our roads.  But the real story with auto fatalities lies not in the who, what, and where of specific accidents but in the why.  When we ask the why question, we see how many of them are preventable. 

No matter what kind of car you drive, you can and should drive safely.  Stay within the speed limits and don't drive while intoxicated or tired or in adverse weather conditions.  Wear your seat belt — a U.S. Department of Transportation study found that 60 percent of auto passengers killed were not wearing their seat belts.  And don't try to talk or text on your cellphone and write notes on a pad of paper attached to your dashboard while balancing your coffee cup between your legs! 

You can also greatly reduce your risk of dying in an accident by driving a safe car.  You don't need to spend buckets of money to get a car with desirable safety features.  For a list of the safest cars along with links for more information, visit my website: `www.erictyson.com`. 

Buying auto insurance

You can use the homeowner's insurers list I present earlier in this chapter to obtain quotes for auto insurance.  In addition, you can contact Progressive by calling 800-776-4737 or visiting its website at `www.progressive.com`. 

Protecting against Mega-Liability: Umbrella Insurance

Umbrella insurance (which is also referred to as excess liability insurance) is liability insurance that's added on top of the liability protection on your home and car(s).  If, for example, you have $700,000 in assets, you can buy a $1 million umbrella liability policy to add to the $300,000 liability insurance that you have on your home and car.  Expect to pay a couple hundred dollars — a small cost for big protection.  Each year, thousands of people suffer lawsuits of more than $1 million related to their cars and homes. 

Diversification: Investment insurance

Insurance companies don't sell policies that protect the value of your investments, but you can shield your portfolio from many of the dangers of a fickle market through diversification. 

If all your money is invested in bank accounts or bonds, you're exposed to the risks of inflation, which can erode your money's purchasing power.  Conversely, if the bulk of your money is invested in one high-risk stock, your financial future could go up in smoke if that stock explodes. 

Chapter 9 discusses the benefits of diversification and tells you how to assemble a portfolio of investments that do well under different conditions. 

Umbrella insurance is generally sold in increments of $1 million.  So how do you decide how much you need if you have a lot of assets?  You should have at least enough liability insurance to protect your assets and preferably enough to cover twice the value of those assets.  To purchase umbrella insurance, start by contacting your existing homeowner's or auto insurance company. 

Planning Your Estate

Estate planning is the process of determining what will happen to your assets after you die.  Considering your mortality in the context of insurance may seem a bit odd.  But the time and cost of various estate-planning maneuvers is really nothing more than buying insurance: You're ensuring that, after you die, everything will be taken care of as you wish, and taxes will be minimized.  Thinking about estate planning in this way can help you better evaluate whether certain options make sense at particular points in your life. 

Depending upon your circumstances, you may eventually want to contact an attorney who specializes in estate-planning matters.  However, educating yourself first about the different options is worth your time.  More than a few attorneys have their own agendas about what you should do, so be careful.  And most of the estate-planning strategies that you're likely to benefit from don't require hiring an attorney. 

Wills, living wills, and medical powers of attorney

When you have children who are minors (dependents), a will is a necessity.  The will names the guardian to whom you entrust your children if both you and your spouse die.  Should you and your spouse both die without a will (called intestate), the state (courts and social-service agencies) decides who will raise your children.  Therefore, even if you can't decide at this time who you want to raise your children, you should at least appoint a trusted guardian who can decide for you. 

Having a will makes good sense even if you don't have kids, because it gives instructions on how to handle and distribute all your worldly possessions.  If you die without a will, your state decides how to distribute your money and other property, according to state law.  Therefore, your friends, distant relatives, and favorite charities will probably receive nothing.  Without any living relatives, your money may go to the state government! 

Without a will, your heirs are legally powerless, and the state may appoint an administrator to supervise the distribution of your assets at a fee of around 5 percent of your estate.  A bond typically must also be posted at a cost of several hundred dollars. 

A living will and a medical power of attorney are useful additions to a standard will.  A living will (also known as an advanced healthcare directive) tells your doctor what, if any, life-support measures you prefer.  A medical (or healthcare) power of attorney grants authority to someone you trust to make decisions regarding your medical care options. 

The simplest and least costly way to prepare a will, a living will, and a medical power of attorney is to use the high-quality, user-friendly software packages that I recommend in Chapter 19.  Be sure to give copies of these documents to the guardians and executors named in the documents.  You don't need an attorney to make a legal will.  Most attorneys, in fact, prepare wills and living trusts using software packages!  What makes a will valid is that three people witness your signing it. 

  If preparing the will all by yourself seems overwhelming, you can (instead of hiring an attorney) use a paralegal typing service to help you prepare the documents.  These services generally charge 50 percent or less of what an attorney charges. 

Avoiding probate through living trusts

Because of the United States's quirky legal system, even if you have a will, some or all of your assets must go through a court process known as probate.  Probate is the legal process for administering and implementing the directions in a will.  Property and assets that are owned in joint tenancy or inside retirement accounts, such as IRAs or 401(k)s, generally pass to heirs without having to go through probate.  However, passing through probate is necessary for most other assets. 

A living trust effectively transfers assets into a trust.  As the trustee, you control those assets, and you can revoke the trust whenever you desire.  The advantage of a living trust is that upon your death, assets can pass directly to your beneficiaries without going through probate.  Probate can be a lengthy, expensive hassle for your heirs — with legal fees tallying 5 percent or more of the value of the estate.  In addition, your assets become a matter of public record as a result of probate. 

Living trusts are likely to be of greatest value to people who meet one or more of the following criteria (the more that apply, the more value trusts have):

  Age 60 or older

  Single

  Assets worth more than $100,000 that must pass through probate (including real estate, nonretirement accounts, and small businesses)

  Real property held in other states

As with a will, you do not need an attorney to establish a legal and valid living trust. ( See my software recommendations in Chapter 19 and consider the paralegal services that I mention in the preceding section on wills.)  Attorney fees for establishing a living trust can range from hundreds to thousands of dollars.  Hiring an attorney is of greatest value to people with large estates (see the next section) who don't have the time, desire, and expertise to maximize the value derived from estate planning.  Also consult with an attorney if you have nonstandard wishes to be carried out, such as special-needs beneficiaries or extra control measures you want applied to assets after incapacity or death. 

Note: Living trusts keep assets out of probate but have nothing to do with minimizing estate or inheritance taxes. 

Reducing estate taxes

Under current tax laws, an individual can pass $5 million to beneficiaries without having to pay federal estate taxes. 

Whether you should be concerned about possible estate taxes depends on several issues.  How much of your assets you're going to use up during your life is the first and most important issue you need to consider.  This amount depends on how much your assets grow over time, as well as how rapidly you spend money.  During retirement, you'll (hopefully) be utilizing at least some of your money. 

I've seen too many affluent individuals, especially in their retirements, worry about estate taxes on their assets.  If your intention is to leave your money to your children, grandchildren, or a charity, why not start giving while you're still alive so you can enjoy the act?  You can give $13,000 annually to each of your beneficiaries, tax-free.  By giving away money, you reduce your estate and, therefore, the estate taxes owed on it.  Any appreciation on the value of the gift between the date of the gift and your date of death is also out of your estate and not subject to estate taxes. 

In addition to gifting, a number of trusts allow you to minimize estate taxes.  For example, if you're married, both you and your spouse can each pass up to $5 million to your heirs (for a total of $10 million) free of federal estate taxes.  You can accomplish this by establishing a bypass trust.  Upon the death of the first spouse, assets held in his or her name go into the bypass trust, effectively removing those assets from the remaining spouse's taxable estate. 

Cash value life insurance is another estate-planning tool.  Unfortunately, it's a tool that's overused or, I should say, oversold.  People who sell cash value insurance — that is, insurance salespeople and others masquerading as financial planners — too often advocate life insurance as the one and only way to reduce estate taxes.  Other methods for reducing estate taxes are usually superior, because they don't require wasting money on life insurance. 

Small-business owners whose businesses are worth several million dollars or more may want to consider cash value life insurance under specialized ­circumstances.  If you lack the necessary additional assets to pay expected estate taxes and you don't want your beneficiaries to be forced to sell the business, you can buy cash value life insurance to pay expected estate taxes.  To find out more about how to reduce your estate (and other) taxes, visit my website at `www.erictyson.com`. 
Part V

Where to Go for More Help

In this part . . . 

I help you sift through the morass of financial resources competing for your attention and dollars.  Many people who call themselves financial planners claim to be able to make you rich, but I show you how you may end up poorer if you don't choose an advisor wisely.  I also cover software and Internet resources and name the best of the bunch and the pitfalls of financial websites.  Finally, I discuss how to benefit from the financial coverage in print and on the air, as well as how to sidestep the sometimes-problematic advice in these media. 
Chapter 18

Working with Financial Planners

In This Chapter

  Checking out your choices for managing your finances

  Determining whether you need help from a financial planner

  Searching for a stellar financial advisor

  Interviewing financial planners before you hire them

Hiring a competent and ethical financial planner or advisor to help you make and implement financial decisions can be money well spent.  But if you pick a poor advisor or someone who really isn't a financial planner but a salesperson in disguise, your financial situation can get worse instead of better.  So before I talk about the different types of help for hire, I discuss the options you have for directing the management of your personal finances. 

Surveying Your Financial Management Options

Everyone has three basic choices for managing money: You can do nothing, you can do it yourself, or you can hire someone to help you.  This section lays out these three options in more detail. 

Doing nothing

The do-nothing approach has a large following (and you thought you were alone!).  People who fall into this category may be leading exciting, interesting lives and are therefore too busy to attend to something as mundane as dealing with their personal finances.  Or they may be leading mundane existences but are too busy fantasizing about more-appealing ways to spend their time. 

  The dangers of doing nothing are many.  Putting off saving for retirement or ignoring your buildup of debt eventually comes back to haunt you.  If you don't carry adequate insurance, accidents can be devastating.  Fires, earthquakes, flooding, and hurricanes show how precarious living in paradise actually is. 

If you've been following the do-nothing approach all your life, you're now officially promoted out of it!  You bought this book to find out more about personal finance and make changes in your money matters, right?  So take control and keep reading! 

Doing it yourself

The do-it-yourselfers learn enough about financial topics to make informed decisions on their own.  Doing anything yourself, of course, requires you to invest some time in learning the basic concepts and keeping up with changes.  The idea that you're going to spend endless hours on your finances if you direct them yourself is a myth.  The hardest part of managing money for most people is catching up on things that they should have done previously.  After you get things in order, which you can easily do with this book as your companion, you shouldn't have to spend more than an hour or two working on your personal finances every few months (unless a major issue, like a real estate purchase, comes up). 

  Some people in the financial advisory business like to make what they do seem so complicated that they compare it to brain surgery!  Their argument goes, "You wouldn't perform brain surgery on yourself, so why would you manage your money yourself?"  Well, to this I say, "Personal financial management ain't brain surgery — not even close."  You can manage on your own.  In fact, you can do a better job than most advisors.  Why?  Because you're not subject to their conflicts of interest, and you care the most about your money. 

Hiring financial help

Realizing that you need to hire someone to help you make and implement financial decisions can be a valuable insight.  Spending a few hours and several hundred dollars to hire a competent professional can be money well spent, even if you have a modest income or assets.  But you need to know what your money is buying.  Financial planners or advisors make money in three ways:

  They earn commissions based on the sales of financial products. 

  They charge a percentage of the assets they invest on your behalf. 

  They charge by the hour (this can also be done through fixed-fee arrangements). 

The following sections help you differentiate among the three main types of financial planners. 

Commission-based "planners"

  Commission-based planners aren't really planners, advisors, or counselors at all — they're salespeople.  Many stockbrokers and insurance brokers are now called financial consultants or financial service representatives in order to glamorize the profession and obscure how they're compensated.  Ditto for insurance salespeople calling themselves estate planning specialists. 

A stockbroker referring to himself as a financial consultant is like a Honda dealer calling himself a transportation consultant.  A Honda dealer is a salesperson who makes a living selling Hondas — period.  He's definitely not going to tell you nice things about Ford, Chrysler, or Toyota cars — unless, of course, he happens to sell those, too.  He also has no interest in educating you about money-saving public-transit possibilities! 

Salespeople and brokers masquerading as planners can have an enormous self-interest when they push certain products, particularly those products that pay generous commissions.  Getting paid on commission tends to skew their recommendations toward certain strategies (such as buying investment or life-insurance products) and to cause them to ignore or downplay other aspects of your finances.  For example, they'll gladly sell you an investment rather than persuade you to pay off your high-interest debts or save and invest through your employer's retirement plan, thereby reducing your taxes. 

Table 18-1 gives you an idea of the commissions that a financial planner/salesperson can earn by selling particular financial products. 

Table 18-1 Financial Product Commissions

Product | Commission

---|---

Life Insurance ($250,000, age 45):

|

Term life | $125 to $500

Universal/whole life | $1,000 to $2,500

Disability Insurance:

|

$4,000/month benefit, age 35 | $400 to $1,500

Investments ($20,000):

|

Mutual funds | $800 to $1,700

Limited partnerships | $1,400 to $2,000

Annuities | $1,000 to $2,000

Percentage-of-assets-under-management advisors

A financial advisor who charges a percentage of the assets that are being managed or invested is generally a better choice than a commission-based planner.  This compensation system removes the incentive to sell you products with high commissions and initiate lots of transactions (to generate more of those commissions). 

  The fee-based system is an improvement over product-pushers working on commission, but it has flaws, too.  Suppose that you're trying to decide whether to invest in stocks, bonds, or real estate.  A planner who earns his living managing your money likely won't recommend real estate because that will deplete your investment capital.  The planner also won't recommend paying down your mortgage for the same reason — he'll claim that you can earn more investing your money (with his help, of course) than it'll cost you to borrow. 

Fee-based planners are also only interested in managing the money of those who have already accumulated a fair amount of it — which rules out most people.  Many have minimums of $250,000, $500,000, or more. 

Hourly-based advisors

Your best bet for professional help with your personal finances is an advisor who charges for his time.  Because he doesn't sell any financial products, his objectivity is maintained.  He doesn't perform money management, so he can help you make comprehensive financial decisions with loans, retirement planning, and the selection of good investments, including real estate, mutual funds, and small business. 

  Hiring someone incompetent is the primary risk you face when selecting an hourly-based planner.  So be sure to check references and find out enough about finances on your own to discern between good and bad financial advice.  Another risk comes from not clearly defining the work to be done and the approximate total cost of the planner's service before you begin, so consider getting these items in writing.  You should also review some of the other key questions that I outline in "Interviewing Financial Advisors: Asking the Right Questions," later in this chapter. 

An entirely different kind of drawback occurs when you don't follow through on your advisor's recommendations.  You pay for his work but don't act on it, so you don't capture its value.  If part of the reason you hired the planner in the first place was that you're too busy or not interested enough to make changes to your financial situation, look for this type of support in the services you buy from the planner. 

Some planners charge a fixed fee to whip up a financial plan for you.  Remember to ask how much of their time is involved in working with you so that you can assess the amount you're paying per hour. 

  If you just need someone to act as a sounding board for ideas or to recommend a specific strategy or product, you can hire an hourly-based planner for one or two sessions of advice.  You save money doing the legwork and implementation on your own.  Just make sure the planner is willing to give you specific advice so you can properly implement the strategy. 

Deciding Whether to Hire a Financial Planner

If you're like most people, you don't need to hire a financial planner, but you may benefit from hiring some help at certain times in your life.  Good reasons for hiring a financial planner can be similar to the reasons you may have for hiring someone to clean your home or do your taxes.  If you're too busy, you don't enjoy doing it, or you're terribly uncomfortable making decisions on your own, using a planner for a second opinion makes good sense.  And if you shy away from numbers and bristle at the thought of long division, a good planner can help you. 

How a good financial advisor can help

The following list gives you a rundown of some of the important ways a competent financial planner can assist you:

  Identifying problems and goals: Many otherwise intelligent people have a hard time being objective about their financial problems.  They may ignore their debts or have unrealistic goals and expectations given their financial situations and behaviors.  And many are so busy with other aspects of their lives that they never take the time to think about what their financial goals are.  A good financial planner can give you the objective perspective you need.  Surprisingly, some people are in a better financial position than they think they are in relation to their goals.  Good counselors really enjoy this aspect of their jobs — good news is easier and much more fun to deliver. 

  Identifying strategies for reaching your financial goals: Your mind may be a jumble of various plans, ideas, and concerns, along with a cobweb or two.  A good planner can help you sort out your thoughts and propose alternative strategies for you to consider as you work to accomplish your financial goals. 

  Setting priorities: You may be considering doing dozens of things to improve your financial situation, but making just a few key changes is likely to have the greatest value.  Identifying the changes that fit your overall situation and that won't keep you awake at night is equally important.  Good planners help you prioritize. 

  Saving research time and hassle: Even if you know which major financial decisions are most important to you, doing the research needed to make them can be time-consuming and frustrating if you don't know where to turn for good information and advice.  A good planner does research to match your needs to the best available strategies and products.  A good advisor can prevent you from making a bad decision based on poor or insufficient information. 

  Purchasing commission-free financial products: When you hire a planner who charges for his time, you can easily save hundreds or thousands of dollars by avoiding the cost of commissions in the financial products you buy.  Purchasing commission-free is especially valuable when you buy investments and insurance. 

  Providing an objective voice for major decisions: When you're trying to figure out when to retire, how much to spend on a home purchase, and where to invest your money, you're faced with some big decisions.  Getting swept up in the emotions of these issues can cloud your perspective.  A competent and sensitive advisor can help you cut through the confusion and provide you with sound counsel. 

  Helping you to just do it: Deciding what you need to do is not enough — you have to actually do it.  And although you can use a planner for advice and then make all the changes on your own, a good counselor can help you follow through with your plan.  After all, part of the reason you hired the advisor in the first place may be that you're too busy or uninterested to manage your finances. 

  Mediating: If you have a spouse or partner, financial decisions can produce real fireworks.  Although a financial counselor isn't a therapist, a good one can be sensitive to the different needs and concerns of each party and can try to find middle ground on the financial issues you're grappling with. 

  Making you money and allowing you peace of mind: The whole point of professional financial planning is to help you make the most of your money and plan for and attain your financial and personal goals.  In the process, the financial planner should show you how to enhance your investment returns; reduce your spending, taxes, and insurance costs; increase your savings; improve your catastrophic-insurance coverage; and achieve your financial-independence goals. 

Why advisors aren't for everyone

Finding a good financial planner isn't easy, so make sure you want to hire an advisor before you venture out in search of a competent one.  You should also consider your personality type before you decide to hire help.  My experience has been that some people (believe it or not) enjoy the research and number crunching.  If this sounds like you, or if you're not really comfortable taking advice, you may be better off doing your own homework and creating your own plan. 

  If you have a specific tax or legal matter, you may be better off hiring a good professional who specializes in that specific field rather than hiring a financial planner. 

Recognizing conflicts of interest

  All professions have conflicts of interest.  Some fields have more than others, and the financial-planning field is one of those fields.  Knowing where some of the land mines are located can certainly help.  Here, then, are the most common reasons that planners may not have 20/20 vision when giving financial directions. 

Selling and pushing products that pay commissions

If a financial planner isn't charging you a fee for his time, you can rest assured that he's earning commissions on the products he tries to sell you and thus needs a broker's license.  A person who sells financial products and then earns commissions from those products is a salesperson, not a financial planner.  Financial planning done well involves taking an objective, holistic look at your financial situation — something brokers are neither trained nor financially motivated to do. 

To make discerning a planner's agenda even harder, you can't assume that planners who charge fees for their time don't also earn commissions selling products.  This compensation double dipping is common. 

Selling products that provide a commission tends to skew a planner's recommendations.  Products that carry commissions result in fewer of your dollars going to the investments and insurance you buy.  Because a commission is earned only when a product is sold, such a product or service is inevitably more attractive in the planner's eyes than other options.  For example, consider the case of a planner who sells disability insurance that you can obtain at a lower cost through your employer or a group trade association (see Chapter 16).  He may overlook or criticize your most attractive option (buying through your employer) and focus on his most attractive option — selling you a higher-cost disability policy on which he derives a commission. 

"Financial planning" in banks

Many banks have "financial representatives" and "investment specialists" sitting in their branches, waiting to pounce on bank customers with big balances.  In many banks, these "financial planners" are simply brokers who are out to sell investments that pay them (and the bank) hefty sales commissions. 

Customers often have no idea that these bank reps are earning commissions and that those commissions are being siphoned out of customers' investment dollars.  Many customers are mistaken (partly due to the banks' and salespeople's poor disclosure) in believing that these investments, like bank savings accounts, are FDIC-insured and cannot lose value. 

  Another danger of trusting the recommendation of a commission-based planner is that he may steer you toward the products that have the biggest payback for him.  These products are among the worst for you because they siphon off even more of your money up-front to pay the commission.  They also tend to be among the costliest and riskiest financial products available. 

Planners who are commission-greedy may also try to churn your investments.  They encourage you to frequently buy and sell, attributing the need to changes in the economy or the companies you invested in.  More trading means more commissions for the broker. 

Taking a narrow view

  Because of the way they earn their money, many planners are biased in favor of certain strategies and products.  As a result, they typically don't keep your overall financial needs in mind.  For example, if you have a problem with accumulated consumer debts, some planners may never know (or care) because they're focused on selling you an investment product.  Likewise, a planner who sells a lot of life insurance tends to develop recommendations that require you to purchase it. 

Not recommending saving through your employer's retirement plan

Taking advantage of saving through your employer's retirement savings plan(s) is one of your best financial options.  Although this method of saving may not be as exciting as risking your money in cattle futures, it's not as dull as watching paint dry — and most importantly, it's tax-deductible.  Some planners are reluctant to recommend taking full advantage of this option: It doesn't leave much money for the purchase of their commission-laden investment products. 

Ignoring debts

Sometimes paying off outstanding loans — such as credit-card, auto, or even mortgage debts — is your best investment option.  But most financial planners don't recommend this strategy because paying down debts depletes the capital with which you could otherwise buy investments — the investments that the broker may be trying to sell you to earn a commission or that the advisor would like to manage for an ongoing fee. 

Not recommending real estate and small-business investments

Investing in real estate and small business, like paying off debts, takes money away from your investing elsewhere.  Most planners won't help with these choices.  They may even tell you tales of real-estate- and small-business-investing disasters to dissuade you. 

The value of real estate can go down just like any other investment.  But over the long haul, owning real estate makes good financial sense for most people.  With small business, the risks are higher, but so are the potential returns.  Don't let a financial planner convince you that these options are foolish — in fact, if you do your homework and know what you're doing, you can make higher rates of return investing in real estate and small business than you can in traditional securities such as stocks and bonds. 

That said, certain real-estate and small-business investments can be risky, inefficient, and illiquid — so caution by an advisor informed in these fields (and that's a key point) may be helpful.  See Part III to read more about your real-estate and small-business investment options. 

Selling ongoing money-management services

The vast majority of financial planners who don't work on commission make their money by managing your money for an ongoing fee percentage (typically 1 to 1.5 percent of your investment annually).  Although this fee removes the incentive to churn your account (frequently trade your investments) to run up more commissions, the service is something that you're unlikely to need. ( As I explain in Part III, you can hire professional money managers for less.) 

An ongoing fee percentage still creates a conflict of interest: The financial planner may tend to steer you away from beneficial financial strategies that reduce the asset pool from which he derives his percentage.  Financial strategies such as maximizing contributions to your employer's retirement savings plan, paying off debts like your mortgage, investing in real estate or small business, and so on may make the most sense for you.  Advisors who work on a percentage-of-assets-under-management basis may be biased against such strategies. 

Selling legal services

Some planners are in the business of drawing up trusts and providing other estate-planning services for their clients.  Although these and other legal documents may be right for you, legal matters are complex enough that the competence of someone who isn't a full-time legal specialist should be carefully scrutinized.  And lower-cost options may be available if your situation is not complicated. 

  If you need help determining whether you need these legal documents, do some additional reading or consult an advisor who won't actually perform the work.  If you do ultimately hire someone to perform estate-planning services for you, make sure you hire someone who specializes in estate planning and works at it full time.  See Chapter 17 to find out more about estate planning. 

Scaring you unnecessarily

Some planners put together nifty computer-generated projections that show you that you're going to need millions of dollars by the time you retire to maintain your standard of living or that college will cost hundreds of thousands of dollars by the time your 2-year-old is ready to go. 

Waking up a client to the realities of his financial situation is an important and difficult job for good financial planners.  But some planners take this task to an extreme, deliberately scaring you into buying what they're selling.  They paint a bleak picture and imply that you can fix your problems only if you do what they say.  Don't let them scare you; read this book and get your financial life in order. 

Creating dependency

  Many financial planners create dependency by making things seem so complicated that their clients feel as though they could never manage their finances on their own.  If your advisor is reluctant to tell you how you can educate yourself about personal money management, you probably have a self-perpetuating consultant.  Financial planning is hardly the only occupation guilty of this.  As author George Bernard Shaw said, "All professions are conspiracies against the laity." 

Finding a Good Financial Planner

Locating a good financial planner who is willing to work with the not-yet- rich-and-famous and who doesn't have conflicts of interest can feel like trying to find a needle in a haystack.  Personal referrals and associations are two methods that can serve as good starting points. 

Soliciting personal referrals

Getting a personal referral from a satisfied customer you trust is one of the best ways to find a good financial planner.  Obtaining a referral from an accountant or attorney whose judgment you've tested can help as well. ( Beware that such professionals in other fields may also do some financial planning and recommend themselves.) 

The best financial planners continue to build their practices through word of mouth.  Satisfied customers are a professional's best and least costly marketers.  However, you should never take a recommendation from anyone as gospel.  I don't care who is making the referral — even if it's your mother or the pope.  You must do your homework.  Ask the planner the questions I list in the upcoming section "Interviewing Financial Advisors: Asking the Right Questions."  I've seen people get into real trouble because of blindly accepting someone else's recommendation.  Remember that the person making the recommendation is (probably) not a financial expert.  He may be just as bewildered as you are. 

You may get referred to a planner or broker who returns the favor by sending business to the tax, legal, or real-estate person who referred you.  Hire professionals who make referrals to others based on their competence and ethics. 

Seeking advisors through associations

Associations of financial planners are more than happy to refer you to planners in your area.  But as I discuss earlier in this chapter, the major trade associations are composed of planners who sell products and work on commission. 

Here are two solid places to start searching for good financial planners:

    The National Association of Personal Financial Advisors: The NAPFA (phone 847-483-5400; website [`www.napfa.org`](http://www.napfa.org)) is made up of fee-only planners.  Its members are not supposed to earn commissions from products they sell or recommend.  However, most planners in this association earn their living by providing money-management services and charging a fee that is a percentage of assets under management.  And most have minimums, which can put them out of reach of the majority of people. 

  The American Institute of Certified Public Accountants: The AICPA (phone 888-777-7077; website `www.aicpa.org`) is the professional association of CPAs, and it can provide names of members who have completed the Institute's Personal Financial Specialist (PFS) program.  Many of the CPAs who have completed the PFS program provide financial advice on a fee basis.  Competent CPAs have the advantage of understanding the tax consequences of different choices, which are important components of any financial plan.  On the other hand, it can be hard for a professional to keep current in two broad fields. 

Warning signs in planners' cultivation techniques

The channel through which you hear of a planner may provide clues to the planner's integrity and way of doing business.  Beware of planners you find (or who find you) through these avenues:

  Cold calling: You've just come home after a hard day.  No sooner has your posterior hit the recliner to settle in for the night when the phone rings.  It's Joe the financial planner, and he wants to help you achieve all your financial dreams.  Cold calling (whereby the salesperson calls you, without an appointment) is the most inefficient way for a planner to get new clients.  Cold calling is intrusive, and it's typically used by aggressive salespeople who work on commission. 

Keep a log beside your telephone.  Record the date, time, name of the organization, and name of the caller every time you receive a cold call.  Politely but firmly tell cold callers to never call you again.  Then, if they do call you again, you can collect $500 in small claims court! 

  Adult education classes: Here's what often happens at the adult education classes that are offered at local universities: You pay a reasonable fee for the course.  You go to class giddy at the prospect of learning how to manage your finances.  And then the instructor ends up being a broker or financial planner hungry for clients.  He confuses more than he conveys.  He's short on specifics.  But he's more than happy to show you the way if you contact (and hire) him outside of class. 

The instructors for these courses are paid to teach.  They don't need to solicit clients in class, and, in fact, it's unethical for them to do so.  I should note, however, that part of the problem is that some universities take advantage of the fact that such "teachers" want to solicit business, setting the pay at a low level.  So never assume that someone who is teaching a financial-planning course at a local college is ethical, competent, or looking out for your best interests.  Although I may sound cynical, assume that these people are none of the above until they clearly prove otherwise. 

Ethical instructors who are there to teach do not solicit clients.  In fact, they may actively discourage students from hiring them.  Smart universities pay their instructors well and weed out those who are more interested in building up their client base than they are in teaching. 

  "Free" seminars: This is a case of "you get what you pay for."  Because you don't pay a fee to attend "free seminars" and the "teachers" don't get paid either, these events tend to be clear-cut sales pitches.  The "instructor" may share some information, but smart seminar leaders know that the goal of a successful seminar is to establish themselves as experts and to whet the prospects' appetites. 

Note: Be wary of seminars targeted at select groups, such as special seminars for people who have received retirement-plan distributions or seminars touting "Financial Planning for Women."  Financial planning is not specific to gender, ethnicity, or marital status. 

Don't assume that the financial planner giving a presentation at your employer's office is the right planner for you, either.  You may be surprised at how little some corporate benefits departments investigate the people they let in.  In most cases, planners are accepted simply because they don't charge.  One organization I'm familiar with gave preference to planners who, in addition to doing free presentations, also brought in a catered lunch!  Guess what — this preference attracted a lot of brokers who sell high-commission products. 

Interviewing Financial Advisors: Asking the Right Questions

Don't consider hiring a financial advisor until you read the rest of this book.  If you're not educated about personal finance, how can you possibly evaluate the competence of someone you may hire to help you make important financial decisions? 

I firmly believe that you are your own best financial advisor.  However, I know that some people don't want to make financial decisions without getting assistance.  Perhaps you're busy or simply can't stand making money decisions.  You need to recognize that you have a lot at stake when you hire a financial advisor.  Besides the cost of his services, which generally don't come cheap, you're placing a lot of trust in his recommendations.  The more you know, the better the advisor you can hire and the fewer services you need to buy. 

The following questions will help you get to the core of an advisor's competence and professional integrity.  Get answers to these questions before you decide to hire a financial advisor. 

What percentage of your income comes from clients' fees versus commissions? 

Asking this question first may save you the trouble and time of asking the next nine questions.  The right answer is "100 percent of my income comes from fees paid by clients."  Anything less than 100 percent means that the person you're speaking to is a salesperson with a vested interest in recommending certain strategies and products. 

Sadly, more than a few financial advisors don't tell the truth.  In an undercover investigation done by Money magazine, nearly one-third of self-proclaimed fee-only advisors turned out to be brokers who also sold investment and insurance products on a commission basis. 

How can you ferret these people out?  Advisors who provide investment advice and oversee at least $100 million must register with the U.S. Securities and Exchange Commission (SEC); otherwise, they generally must register with the state that they make their principal place of business.  They must file Form ADV, otherwise known as the Uniform Application for Investment Adviser Registration.  This lengthy document asks for the following specific information from investment advisors:

  A breakdown of where their income comes from

  Relationships and affiliations with other companies

  Education and employment history

  The types of securities the advisory firm recommends

  The advisor's fee schedule

In short, Form ADV provides — in black and white — answers to all the essential questions.  With a sales pitch over the phone or marketing materials sent in the mail, a planner is much more likely to gloss over or avoid certain issues.  Although some advisors fib on Form ADV, most advisors are more truthful on this form than they are in their own marketing.  You can ask the advisor to send you a copy of Form ADV.  You can also find out whether the advisor is registered and whether he has a track record of problems by calling the SEC at 800-732-0330 or by visiting its website at `www.adviserinfo.sec.gov`. 

Many states require the registration of financial advisors, so you should also contact the department that oversees advisors in your state.  Visit the North American Securities Administrators Association's website (`www.nasaa.org`) and click on the "Contact Your Regulator" link on the home page. 

What portion of client fees is for money management versus hourly planning? 

The answer to how the advisor is paid provides clues to whether he has an agenda to convince you to hire him to manage your money.  If you want objective and specific financial planning recommendations, give preference to advisors who derive their income from hourly fees.  Many counselors and advisors call themselves "fee-based," which usually means that they make their living managing money for a percentage. 

If you want a money manager, you can hire the best quite inexpensively through a mutual fund.  Or, if you have substantial assets, you can hire an established money manager (refer to Chapter 10). 

What is your hourly fee? 

The rates for financial advisors range from as low as $75 per hour up to several hundred dollars per hour.  If you shop around, you can find fine planners who charge around $100 to $150 per hour.  As you compare planners, remember that what matters is the total cost that you can expect to pay for the services you're seeking. 

Do you also perform tax or legal services? 

Be wary of someone who claims to be an expert beyond one area.  The tax, legal, and financial fields are vast in and of themselves, and they're difficult for even the best and brightest advisor to cover simultaneously. 

One exception is the accountant who also performs some basic financial planning by the hour.  Likewise, a good financial advisor should have a solid grounding in the basic tax and legal issues that relate to your personal finances.  Large firms may have specialists available in different areas. 

What work and educational experience qualifies you to be a financial planner? 

This question doesn't have one right answer.  Ideally, a planner should have experience in the business or financial services field.  Some say to look for planners with at least five or ten years of experience.  I've always wondered how planners earn a living their first five or ten years if folks won't hire them until they reach these benchmarks!  A planner should also be good with numbers, speak in plain English, and have good interpersonal skills. 

Education is sort of like food.  Too little leaves you hungry.  Too much can leave you feeling stuffed and uncomfortable.  And a small amount of high quality is better than a lot of low quality. 

Because investment decisions are a critical part of financial planning, take note of the fact that the most-common designations of educational training among professional money managers are MBA (master of business administration) and CFA (chartered financial analyst).  And some tax advisors who work on an hourly basis have the PFS (personal financial specialist) credential. 

Have you ever sold limited partnerships?  Options?  Futures?  Commodities?  Invested with Madoff? 

The correct answers here are no, no, no, no, and no.  If you don't know what these disasters are, refer to Chapter 9. ( Madoff ran a hedge fund that was actually a Ponzi scheme.)  You also need to be wary of any financial advisor who used to deal in these areas but now claims to have seen the light and reformed his ways. ( Some sophisticated advisors may use some of these instruments to hedge or reduce risk, but be sure you understand what they're doing and that you and the advisor fully understand all costs and potential risks.) 

Professionals with poor judgment may not repeat the same mistakes, but they're more likely to make some new ones at your expense.  My experience is that even advisors who have been "reformed" are unlikely to be working by the hour.  Most of them either work on commission or want to manage your money for a hefty fee. 

Do you carry liability (errors and omissions) insurance? 

Some counselors may be surprised by this question or think that you're a problem customer looking for a lawsuit.  On the other hand, accidents happen; that's why insurance exists.  So if the planner doesn't have liability insurance, he has missed one of the fundamental concepts of planning: Insure against risk.  Don't make the mistake of hiring him. 

You wouldn't (and shouldn't) let contractors into your home to do work without knowing that they have insurance to cover any mistakes they make.  Likewise, you should insist on hiring a planner who carries protection in case he makes a major mistake for which he is liable.  Make sure that he carries enough coverage given what he is helping you with. 

Can you provide references from clients with needs similar to mine? 

Take the time to talk to other people who have used the planner.  Ask what the planner did for them, and find out what the advisor's greatest strengths and weaknesses are.  You can find out a bit about the planner's track record and style.  And because you want to have as productive a relationship as possible with your planner, the more you find out about him, the easier it'll be for you to hit the ground running if you hire him. 

Some financial advisors offer a "complimentary" introductory consultation.  If an advisor offers a free consultation to allow you to check him out and it makes you feel more comfortable about hiring him, fair enough.  But be careful: Most free consultations end up being a big sales pitch for certain products or services the advisor offers. 

The fact that a planner doesn't offer a free consultation may be a good sign.  Counselors who are busy and who work strictly by the hour can't afford to burn an hour of their time for an in-person free session.  They also need to be careful of folks seeking free advice.  Such advisors usually are willing to spend some time on the phone answering background questions.  They should also be able to send background materials by mail and provide references. 

Will you provide specific strategies and product recommendations that I can implement on my own if I choose? 

This is an important question.  Some advisors may indicate that you can hire them by the hour.  But then they provide only generic advice without specifics.  Some planners even double dip — they charge an hourly fee initially to make you feel like you're not working with a salesperson, and then they try selling commission-based products.  Also be aware of advisors who say that you can choose to implement their recommendations on your own and then recommend financial products that carry commissions. 

How is implementation handled? 

Ideally, you should find an advisor who lets you choose whether you want to hire him to help with implementation after the recommendations have been presented to you.  If you know that you're going to follow through on the advice and you can do so without further discussions and questions, don't hire the planner to help you implement his recommendations. 

On the other hand, if you hire the counselor because you lack the time, desire, and/or expertise to manage your financial life in the first place, building implementation into the planning work makes good sense. 

Learning from Others' Mistakes

Over the many years that I've worked as a financial counselor and now fielding questions from readers, I hear too many problems that people encounter from hiring incompetent and unethical financial advisors.  To avoid repeating others' mistakes, please remember the following:

  You absolutely must do your homework before hiring any financial advisor.  Despite recommendations from others about a particular advisor, you can end up with bad advice from biased advisors. 

    Avoid conflicts of interest.  The financial planning and brokerage fields are minefields for consumers.  The fundamental problem is the enormous conflict of interest that is created when "advisors" sell products that earn them sales commissions.  Selling ongoing money management services creates a conflict of interest as well. 

  You are your own best advocate.  The more you know, and the more you understand that investing and other financial decisions needn't be complicated, the more you realize that you don't need to spend gobs of money (or any money at all) on financial planners and advisors.  When you look in the mirror, you see the person who has your best interests at heart and is your best financial advisor. 
Chapter 19

Using a Computer to Manage Your Money

In This Chapter

  Evaluating money management software and websites

  Performing financial tasks with your computer

Although a computer may be able to assist you with your personal finances, it simply represents one of many tools.  Computers are best for performing routine tasks (such as processing lots of bills or performing many calculations) quickly and for aiding you with research. 

This chapter gives you an overview of how to use software and cyberspace with your finances.  I tell you how to use this technology to pay your bills, prepare taxes, research investments, plan for retirement, trade securities, buy insurance, and plan your estate, and I suggest the best software and websites. 

Surveying Software and Websites

You can access two major repositories of personal finance information through your computer.  Although the lines are blurring between these two categories, they're roughly defined as software and the Internet:

  Software refers to computer programs that are either packaged in a box or DVD case or are available to be downloaded online.  Most of the mass-marketed financial software packages sell for under $100.  If you've ever used a word-processing program such as Word or WordPerfect or a spreadsheet program such as Excel, then you've used software. 

  The Internet is a vast ocean of information that you can generally access via a modem, cable modem, or DSL (digital subscriber line).  These devices allow your computer to talk with other computers.  To access the Internet, you need a web browser, which you can obtain through your Internet service provider (ISP).  Most of the financial stuff on the Internet is supplied by companies marketing their wares and, hence, is available for free.  Some sites sell their content for a fee. 

Adding up financial software benefits

Although the number of personal-finance software packages and websites is large and growing, quality is lagging behind quantity, especially among the free Internet sites.  The best software can

  Guide you to better organization and management of your personal finances

  Help you complete mundane tasks or complex calculations quickly and easily and provide basic advice in unfamiliar territory

  Make you feel in control of your financial life

Mediocre and bad software, on the other hand, can make you feel stupid or, at the very least, make you want to scream.  Lousy packages usually end up in the software graveyard. 

Having reviewed many of the packages available, I can assure you that if you're having a hard time with some of the programs out there (and sometimes even with the more useful programs), you're not at fault.  Too many packages assume that you already know things such as your tax rate, your mortgage options, and the difference between stock and bond mutual funds.  Much of what's out there is too technically oriented and isn't user-friendly.  Some of it is even flawed in its financial accuracy. 

A good software package, like a good tax or financial advisor, helps you better manage your finances.  It simply and concisely explains financial terminology, and it helps you make decisions by offering choices and recommendations, allowing you to "play" with alternatives before following a particular course of action.  With increasing regularity, financial software packages are being designed to perform more than one task or to address more than one area of personal finances.  But remember that no software package covers the whole range of issues in your financial life.  Later in this chapter, I recommend some of my favorite financial software. 

Surfing hazards online

Like the information you receive from any medium, you have to sift out the good from the bad when you surf the Internet.  If you blindly navigate the Internet and naively think that what's out there is useful "information," "research," or "objective advice," you're in for a rude awakening. 

Most personal-finance sites on the Internet are free, which — guess what — means that these sites are basically advertising or are dominated and driven by advertising.  If you're looking for material written by unbiased experts or writers, well, finding it on the web may seem like searching for the proverbial needle in the haystack because the vast majority of what's online is biased and uninformed. 

Considering the source so you can recognize bias

A report on the Internet published by a leading investment-banking firm provides a list of the "coolest finance" sites.  On the list is the website of a major bank.  Because it has been a long time since I was in junior high school, I'm not quite sure what "cool" means anymore.  If cool can be used to describe a well-organized and graphically pleasing website, then I guess I can say that the bank's site is cool. 

However, if you're looking for sound information and advice, then the bank's site is decidedly "uncool."  It steers you in a financial direction that benefits (not surprisingly) the bank and not you.  For example, in the real-estate section, users are asked to plug in their gross monthly income and down payment.  The information is then used to spit out the supposed amount that users can "afford" to spend on a home.  No mention is given to the other financial goals and concerns — such as saving for retirement — that affect one's ability to spend a particular amount of money on a home. 

Consider this advice in the lending area of the site: "When you don't have the cash on hand for important purchases, we can help you borrow what you need.  From a new car, to that vacation you've been longing for, to new kitchen appliances, you can make these dreams real now."  Click on a button at the bottom of this screen — and presto, you're on your way to racking up credit-card and auto debt.  Why bother practicing delayed gratification, living within your means, or buying something used if getting a loan is "easy" and comes with "special privileges"? 

Watching out for "sponsored" content

Sponsored content, a euphemism for advertising under the guise of editorial content (known in the print media as advertorials), is another big problem to watch out for on websites.  You may find a disclaimer or note, which is often buried in small print in an obscure part of the website, saying that an article is sponsored by (in other words, paid advertising by) the "author." 

A mutual-fund "education" site, for example, states that its "primary purpose is to provide viewers with an independent guide that contains information and articles they can't get anywhere else."  The content of the site suggests other­wise.  In the "Expert's Corner" section of the site, material is reprinted from a newsletter that advocates frequent trading in and out of mutual funds to try and guess and time market moves.  Turns out that the article is "sponsored by the featured expert": In other words, it's a paid advertisement. ( The track record of the newsletter's past recommendations, which isn't discussed on the site, is poor.) 

  Even more troubling is the increasing number of websites that fail to disclose (even cryptically) that their content comes from advertisers.  Print publications generally have a tradition of disclosing when an article is paid advertising, but in the Wild West online, many sites fail to make this important disclosure.  Mind you, I'm not saying that disclosure makes paid-for content okay — I'm simply stating that a lack of disclosure makes an already bad situation even worse. 

Also, beware of websites, especially those that are "free," that are making money in a clandestine way from two sources: companies whose products they praise and affiliates to whom they direct mouse clicks/web traffic.  In perusing the web, I noticed, for example, that many "free" financial websites were singing the praises of the software You Need A Budget (YNAB).  I test-drove the product (which is like a slimmed-down version of Quicken or Microsoft Money), and it's a decent but not exceptional product.  My research uncovered the fact that the makers of YNAB pay a whopping 35-percent commission to website affiliates who pitch and direct users to buy the product.  YNAB Pro is their most popular product and sells for $60, so a website flogging it for them pockets $21 for each copy it sells.  Does that taint a site's recommendation of YNAB?  Of course it does. 

Increasingly, companies are paying websites outright to simply mention and praise their products; doing so is incredibly sleazy even if it's disclosed, but to do so without disclosure is unethical.  Also beware of links to recommended product and service providers to do business with — more often than not, the referring website gets paid an affiliate fee.  Look for sites that post policies against receiving such referral fees from companies whose products and services they recommend. ( As an example, see the disclosure I use on my own site, `www.erictyson.com`.) 

Steering clear of biased financial-planning advice

I also suggest skipping the financial-planning advice offered by financial service companies that are out to sell you something.  Such companies can't take the necessary objective, holistic view required to render useful advice. 

For example, on one major investment company's website, you find a good deal of material on the firm's mutual funds.  The site's college-planning advice is off the mark because it urges parents to put money in a custodial account in the child's name.  Ignored is the fact that doing so will undermine your child's ability to qualify for financial aid (see Chapter 13), that your child will have control of the money at either age 18 or 21 depending upon your state, and that you're likely better off funding your employer's retirement plan.  If you did that, though, you couldn't set up a college savings-plan account at the fund company, which this area of the site prods you to do. 

Shunning short-term thinking

  Many financial websites provide real-time stock quotes as a hook to a site that is cluttered with advertising.  My experience working with individual investors is that the more short-term they think, the worse they do.  And checking your portfolio during the trading day certainly promotes short-term thinking. 

Another way that sites create an addictive environment for you to return to multiple times daily is to constantly provide news and other rapidly changing content.  Do you really need "Breaking News" updates that gasoline prices jumped 19 cents per gallon over the past two weeks or that Larry King is having a contest with a Hollywood celebrity on Twitter to see who can sign up more followers in the next week? 

Also, beware of tips offered around the electronic water cooler — message boards.  As in the real world, chatting with strangers and exchanging ideas are sometimes fine.  However, if you don't know the identity and competence of message-board posters or chat-room participants, why would you follow their financial advice or stock tips?  Getting ideas from various sources is okay, but educate yourself and do your homework before making personal financial decisions. 

  If you want to best manage your personal finances and find out more, remember that the old expression "You get what you pay for" contains a grain of truth.  Free information on the Internet, especially information provided by companies in the financial-services industry, is largely self-serving.  Stick with information providers who have proven themselves offline or who don't have anything to sell except objective information and advice. 

Accomplishing Money Tasks on Your Computer

In the remainder of this chapter, I detail important personal financial tasks that your computer can assist you with.  I also provide my recommendations for the best software and websites to help you accomplish these chores. 

Paying your bills and tracking your money

Plenty of folks have trouble saving money and reducing their spending.  Thus, it's no surprise that in the increasingly crowded universe of free websites, plenty are devoted to supposedly helping you to reduce your spending.  More of these sites keep springing up, but among those you may have heard of and stumbled upon are Geezeo, Mint, Wesabe, and Yodlee.  As you can already see, attracting attention online starts with having a quirky name! 

I've kicked the tires and checked out these sites and frankly have mixed to negative feelings about them.  The biggest problems I have with these sites are that they're loaded with advertising and/or have affiliate relationships with companies.  What does this mean?  The site gets paid if you click on a link to one of its recommended service providers and buy what it's selling. 

I will give credit to Mint for at least admitting in black and white that it is soliciting and receiving affiliate payments when it states on its site:

"How can Mint be free?  We give you personalized ideas on how to save money by showing you the best way to save among thousands of financial products.  If you decide to make a change that saves you some cash, we sometimes earn a small fee from the bank or company you switch to." 

This, of course, creates an enormous conflict of interest and thoroughly taints any recommendation made by Mint and similar sites that profit from affiliate referrals.  For starters, they have no incentive or reason to recommend companies that won't pay them an affiliate fee.  And, there's little — if any — screening of companies for quality service levels that are important to you as a consumer. 

Also, be forewarned that after registering you as a site user, the first thing most of these sites want you to do is connect directly to your financial institutions (banks, brokerages, investment companies) and download your investment account and spending data.  If your instincts tell you this might not be a good idea, you should trust your instincts.  Yes, there are security concerns, but those pale in comparison to privacy concerns and concerns about the endless pitching to you of products and services. 

Another problem that I have with these websites is the incredibly simplistic calculators that they have.  One that purported to help with retirement planning didn't allow users to choose a retirement age younger than 62 and had no provisions for part-time work.  When it asked about your assets, it made no distinction between equity in your home and financial assets (stocks, bonds, mutual funds, and so on).  Finally, if you encounter a problem using these sites, they generally offer no phone support, so you're relegated to ping-ponging e-mails in the hopes of getting your questions answered. 

  Quicken is a good software program that I've reviewed that helps with expense tracking and bill paying.  In addition to offering printed checks and electronic bill-payment, Quicken is a financial organizer.  The program allows you to list your investments and other assets, along with your loans and other financial liabilities.  Quicken automates the process of paying your bills, and it can track your check-writing and prepare reports that detail your spending by category so you can find the fat in your budget. ( For a complete discussion on how to track your spending, see Chapter 3.) 

In addition to the significant investment of time necessary to figure out how to use Quicken, another drawback is the cost of computer checks if you buy them from the software company.  You can chop those costs by ordering from other companies, such as Checks Tomorrow (website `www.checkstomorrow.com`). 

  You can avoid dealing with paper checks — written or printed — by signing up for online bill payment.  With such services, you save on checks, stamps, and envelopes.  These services are available to anyone with a checking account through an increasing number of banks, credit unions, and brokerage firms, as well as through Quicken.  Another option is to sign up through CheckFree's website: `www.mycheckfree.com`. 

Planning for retirement

Good retirement-planning software and online tools can help you plan for retirement by crunching the numbers for you.  But they can also teach you how particular changes — such as your investment returns, the rate of inflation, or your savings rate — can affect when and in what style you can retire.  The biggest time-saving aspect of retirement-planning software and websites is that they let you more quickly play with and see the consequences of changing the assumptions. 

Some of the major investment companies I profile in Part III of this book are sources for some high-quality, low-cost retirement-planning tools.  Here are some good ones to consider:

  T. Rowe Price's website (`www.troweprice.com`) has several tools that can help you determine where you stand in terms of reaching a given retirement goal.  T. Rowe Price (phone 800-225-5132) also offers some excellent workbooklets for helping you plan for retirement.  Expect some marketing of T. Rowe Price's mutual funds in its booklets and software. 

  Vanguard's website (`www.vanguard.com`) can help with figuring savings goals to reach retirement goals as well as with managing your budget and assets in retirement. 

Preparing your taxes

Good, properly-used tax-preparation software can save you time and money.  The best programs "interview" you to gather the necessary information and select the appropriate forms based on your responses.  Of course, you're still the one responsible for locating all the information needed to complete your return.  More-experienced taxpayers can bypass the interview and jump directly to the forms they know they need to complete.  These programs also help flag overlooked deductions and identify other tax-reducing strategies. 

  TurboTax and H&R Block at Home are among the better tax-preparation programs I've reviewed. 

In addition to the federal tax packages, tax-preparation programs are available for state income taxes, too.  Many state tax forms are fairly easy to complete because they're based on information from your federal form.  If your state tax forms are based on your federal form, you may want to skip buying the state income-tax preparation packages and prepare your state return by hand. 

If you're mainly looking for tax forms, you can get them at no charge in tax-preparation books or through the IRS's website (`www.irs.gov`). 

Researching investments

Instead of schlepping off to the library and fighting over the favorite investing reference manuals, ponying up hundreds of dollars to buy print versions for your own use, or slogging through voice-mail hell when you call government agencies, you can access a variety of materials on your computer.  You can also often pay for just what you need:

  The SEC: The Securities and Exchange Commission (SEC) allows unlimited, free access to its documents at `www.sec.gov`.  All public corporations, as well as mutual funds, file their reports with the agency.  Be aware, however, that navigating this site takes patience. 

  Morningstar: You can access Morningstar's individual stock and mutual fund reports at `www.morningstar.com`.  The reports are free, but they're watered-down versions of the company's comprehensive software and paper products.  If you want to buy Morningstar's unabridged fund reports online, you can do so for a fee. 

  Vanguard: Although I'm leery of financial service company "educational" materials because of bias and self-serving advice, some companies do a worthy job on these materials.  The investor-friendly, thrifty Vanguard Group of mutual funds has an online university on its website (`www.vanguard.com`), where investors can learn the basics of fund investing.  Additionally, investors in Vanguard's funds can access up-to-date personal account information through the site. 

Trading online

If you do your investing homework, trading securities online may save you money and perhaps some time.  For years, discount brokers (which I discuss in Chapter 8) were heralded as the low-cost source for trading.  Now, online bro­kers such as E*TRADE Financial (phone 800-387-2331; website `www.etrade.com`) and Scottrade (phone 800-619-7283; website `www.scottrade.com`) have set a new, lower-cost standard.  The major mutual fund companies, such as T. Rowe Price and Vanguard, also offer competitive online services. 

A number of the newer discount brokers have built their securities brokerage business around online trading.  By eliminating the overhead of branch offices and by accepting and processing trades by computer, online brokers keep their costs and brokerage charges to a minimum.  Cut-rate electronic brokerage firms are for people who want to direct their own financial affairs and don't want or need to work with a personal broker.  However, some of these brokers have limited products and services.  For example, some don't offer many of the best mutual funds.  And my own experience with reaching live people at some online brokers has been trying — I've had to wait on hold for more than ten minutes before a customer service representative answered the call. 

  Although online trading may save you on transaction costs, it can also encourage you to trade more than you should, resulting in higher total trading costs, lower investment returns, and higher income tax bills.  Following investments on a daily basis encourages you to think short-term.  Remember that the best investments are bought and held for the long haul (see Part III for more information). 

Reading and searching periodicals

Many business and financial publications are online, offering investors news and financial market data.  The Wall Street Journal provides an online, personalized edition of the paper (`http://online.wsj.com`) that allows you to tailor the content to meet your specific needs.  The cost is $21.62 per month. 

Leading business publications such as Forbes (`www.forbes.com`) and BusinessWeek (`www.bloombergbusinessweek.com`) put their current magazines' content on the Internet.  Some publications are charging for archived articles and for some current content for nonsubscribers to their print magazine.  Be careful to take what you read and hear in the mass media with many grains of salt (see Chapter 20 for more on mass media).  Much of the content revolves around tweaking people's anxieties and dwelling on the latest crises and fads. 

My website (`www.erictyson.com`) includes analysis of current news and highlights and summarizes the best content from many sources and sites, including leading newsletters. 

Buying life insurance

If loved ones are financially dependent on you, you probably know that you need some life insurance.  But add together the dread of life-insurance salespeople and a fear of death, and you have a recipe for procrastination.  Although your computer can't stave off the Grim Reaper, it can help you find a quality, low-cost policy that can be more than 80 percent less costly than the most expensive options, all without having you deal with high-pressure sales tactics. 

The best way to shop for term life insurance online is through one of the quotation services that I discuss in Chapter 16.  At each of these sites, you fill in your date of birth, whether you smoke, how much coverage you'd like, and for how long you'd like to lock in the initial premium.  When you're done filling in this information, a new web page pops up with a list of low-cost quotes (based on assumed good health) from highly rated (for financial stability) insurance companies. 

  Invariably, the quotes are ranked by how cheap they are.  Although cost is certainly an important factor, many of these services don't do as good of a job explaining other important factors to consider when doing your comparison shopping.  For example, the services sometimes don't cover the projected and maximum rates after the initial term has expired.  Be sure to ask about these other future rates before you agree to a specific policy. 

If you decide to buy a policy from one of the online agencies, you can fill out an online application form.  The quotation agency will then mail you a detailed description of the policy and insurer, along with your completed application.  In addition to having to deal with snail mail, you'll also have to deal with a medical technician, who will drop by your home to check on your health status . . .  at least until some computer genius figures out a way for you to give blood and urine samples online! 

Preparing legal documents

Just as you can prepare a tax return with the advice of a software program, you can also prepare common legal documents.  This type of software may save you from the often difficult task of finding a competent and affordable attorney. 

Using legal software is generally preferable to using fill-in-the-blank documents.  Software has the built-in virtues of directing and limiting your choices and preventing you from making common mistakes.  Quality software also incorporates the knowledge and insights of the legal eagles who developed the software.  And it can save you money. 

If your situation isn't unusual, legal software may work well for you.  As to the legality of documents that you create with legal software, remember that a will, for example, is made legal and valid by your witnesses; the fact that an attorney prepares the document is not what makes it legal. 

  An excellent package for preparing your own will is Quicken WillMaker Plus, which is published by Nolo, a name synonymous with high quality and user-friendliness in the legal publishing world.  In addition to allowing you to prepare wills, WillMaker can also help you prepare a living will and medical power of attorney document.  The software also allows you to create a living trust that serves to keep property out of probate in the event of your death (see Chapter 17).  Like wills, living trusts are fairly standard legal documents that you can properly create with the guidance of a top-notch software package.  The package advises you to seek professional guidance for your situation, if necessary. 
Chapter 20

On Air and in Print

In This Chapter

  Recognizing the impact of the media and pundits on investors

  Deciding whether to tune in radio and television investing coverage

  Surfing safely on the Internet

  Evaluating newspapers and magazines

  Finding the best investing books

We have too many options when it comes to finding radio and television news, websites, newspapers, magazines, and books that talk about money and purport to help you get rich.  Tuning out poor resources and focusing on the best ones are the real challenges. 

Because you probably don't consider yourself a financial expert, more often than not you won't know who to believe and listen to.  I help you solve that problem in this chapter. 

Observing the Mass Media

For better and for worse, America's mass media has a profound influence on our culture.  On the good side, news is widely disseminated these days.  So if a product is recalled or a dangerous virus breaks out in your area, you'll probably hear about it, perhaps more than you want to, through the media — or perhaps from tuned-in family members!  The downsides of the mass media are plenty, though. 

Alarming or informing us? 

In case you didn't already know, you've recently lived through the second Great Depression.  During the "financial crisis" of 2008-09, we were told over and over and over again how it was the worst economy and worst economic crisis since the Great Depression.  Endless parallels were drawn between the Great Depression of the 1930s and the recently slumping economy. 

For sure, we suffered a significant recession (economic downturn).  But some in the news media (and pundit class) went overboard in suggesting we were in the midst of another depression.  During the Great Depression of the 1930s, the unemployment rate hit 25 percent and remained in double digits for years on end.  Half of all homes ended up in foreclosure during that period.  Although job losses and home foreclosures mounted during the recent recession, they were nowhere near the Great Depression levels.  The recessions of the late 1970s and early 1980s were actually worse because of the pain and hardship caused by the 10+ percent inflation rate and interest rates of that period.  The unemployment rate was also above 10 percent in the early 1980s recession. 

The U.S. stock market suffered a steep decline during the recent recession and, in fact, the percentage decline in the widely followed Dow Jones Industrial Average was the worst since the 1930s.  Interestingly, the severity of the 2008-09 stock market decline was likely exacerbated by all the talk and fear of another Depression.  Various research polls taken during late 2008 found that more than 6 in 10 Americans believed we were about to enter another Great Depression.  Those who panicked and bailed out when the Dow sagged below 6,500 in early 2009 learned another hard lesson when the market surged back, as it always inevitably does after a significant sell-off. 

  Some news producers, in their quest for ratings and advertising dollars, try to be alarming to keep you tuned in and coming back for their "breaking news" updates.  The more you watch, the more unnerved you get over short-term, especially negative, events. 

Teaching questionable values

Daily doses of American mass media, including all the advertising that comes with them, essentially communicate the following messages to us:

  Your worth as a person is directly related to your physical appearance (including the quality of clothing and jewelry you wear) and your material possessions — cars, homes, electronics, and other gadgets. 

  The more money you make, the more "successful" you clearly are. 

  The more famous you are (especially as a movie or sports star), the more you're worth listening to and admiring. 

  Don't bother concerning yourself with the consequences before engaging in negative behavior. 

  Delaying gratification and making sacrifices are for boring losers. 

  Continually inundating yourself with poor messages can cause you to behave in a way that undermines your long-term happiness and financial success.  Don't support (by watching, listening, or reading) forms of media that don't reflect your values and morals. 

Worshipping prognosticating pundits

Quoting and interviewing experts are perhaps the only things that the media loves more than hyping short-term news events.  What's the economy going to do next quarter?  What's stock XYZ going to do next month?  What's the stock market going to do in the next few hours?  No, I'm not kidding about that last one — the stock market cable channel CNBC regularly interviews floor traders from the New York Stock Exchange during the trading day to get their opinions about what the market will do in hours before closing! 

  Prognosticating pundits keep many people tuned in because their advice is constantly changing (and is therefore entertaining and anxiety-producing), and they lead investors to believe that investments can be maneuvered in advance to outfox future financial market moves.  Common sense suggests, though, that no one has a working crystal ball, and if he did, he certainly wouldn't share such insights with the mass media for free. ( For more on experts who purport to predict the future, see Chapter 8.) 

Rating Radio and Television Financial Programs

Over the years, money issues have received increased coverage through the major media of television and radio.  Some topics gain more coverage in radio and TV because they help draw more advertising dollars (which follow what people are watching).  When you turn on the radio or TV, you don't pay a fee to tune in to a particular channel (with pay cable channels being an exception).  Advertising doesn't necessarily prevent a medium from delivering coverage that is objective and in your best interests, but it sure doesn't help foster this type of coverage either. 

For example, can you imagine a financial radio or TV correspondent saying:

"We've decided to stop providing financial market updates every five minutes because we've found it causes some investors to become addicted to tracking the short-term movements in the markets and to lose sight of the bigger picture.  We don't want to encourage people to make knee-jerk reactions to short-term events." 

Sound-bite-itis is another problem with both of these media.  Producers and network executives believe that if you go into too much detail, viewers and listeners will change the channel. 

Finding the Best Websites

Yes, the Internet is changing the world, but certainly not always for the better and not always in such a big way.  Consider the way we shop.  You can buy things online that you couldn't in the past.  Purchasing items online broadens the avenues through which you can spend money.  I see a big downside here: Overspending is easier to do when you surf the Internet a lot. 

  Some of the best websites allow you to more efficiently access information that may help you make important investing decisions.  However, this doesn't mean that your computer allows you to compete at the same level as professional money managers.  The best pros work at their craft full-time and have far more expertise and experience than the rest of us.  Some nonprofessionals have been fooled into believing that investing online makes them better investors.  My experience has been that people who spend time online every day dealing with investments tend to trade and react more to short-term events and have a harder time keeping the bigger picture and their long-term goals and needs in focus. 

If you know where to look, you can more easily access some types of information.  However, you often find a lot of garbage online — just as you do on other advertiser-dominated media like TV and radio.  In Chapter 19, I explain how to safely navigate online to find the best of what's out there. 

Navigating Newspapers and Magazines

Compared with radio and TV, print publications generally offer lengthier discussions of topics.  And in the more financially focused publications, the editors who work on articles generally have more background in the topics they write about.  Even within the better publications, I find a wide variety of quality.  So don't instantly believe what you read, even if you read a piece in a publication you like.  Here's how to get the most from financial periodicals:

    Read some back issues.  Go to your local library (or visit the publication's website) and read some issues that are at least one to two years old.  Although reading old issues may seem silly and pointless, it actually can be enlightening.  You can begin to get a taste of a publication's style, priorities, and philosophies as well as how their prior advice has worked out. 

  Look for solid information and perspective.  Headlines reveal a lot about how a publication perceives its role.  Publications with cover stories such as "10 hot stocks to buy now!"  and "Funds that will double your money in the next three years!"  are probably best avoided.  Look for articles that seek to educate with accuracy, not predict. 

  Note bylines.  As you read a given publication over time, you should begin to make note of the different writers.  After you get to know who the better writers are, you can skip over the ones you don't care for and spend your limited free time reading the best. 

  Don't react without planning.  Here's a common example of how not to use information and advice you glean from publications: I had a client who had some cash he wanted to invest.  He would read an article about investing in real-estate investment trusts and then go out the next week and buy several of them.  Then he'd see a mention of some technology stock funds and invest in some of those.  Eventually his portfolio was a mess of investments that reflected the history of what he had read rather than an orchestrated, well-thought-out investment portfolio. 

Betting on Books

Reading a good book is one of my favorite ways to get a crash course on a given financial topic.  Good books can go into depth on a topic in a way that simply isn't possible with other resources.  Books also aren't cluttered with advertising and the conflicts inherent therein. 

As with the other types of resources I discuss in this chapter, you definitely have to choose carefully — plenty of mediocrity and garbage is out there. 

Understanding the book publishing business

Book publishers are businesses first.  And like most businesses, their business practices vary.  Some have a reputation for care and quality; others just want to push a product out the door with maximum hype and minimum effort. 

For instance, you may think that book publishers check out an author before they sign him to write an entire book.  Well, you may be surprised to find out that some publishers don't do their homework.  What most publishers care about first is the marketability of a particular book and author.  Some authors are marketable because of their well-earned reputation for sound advice.  Others are marketable because of stellar promotional campaigns built on smoke and mirrors.  Even more troubling is that few publishers require advice guides to be technically reviewed for accuracy by an expert in the field other than the author, who sometimes is not an expert.  You, the reader, are expected to be your own technical reviewer.  But do you have the expertise to do that? ( Don't worry; this book has been checked for accuracy.) 

As an author and financial counselor, I know that financial ideas and strategies can differ considerably.  Different is not necessarily wrong.  When a technical reviewer looks at my text and tells me that a better way is out there, I take a second look.  I may even see things in a new way.  If I were the only expert to see my book before publication, I wouldn't benefit from this second expert opinion.  How do you know whether a book has been technically reviewed?  Check the credits page or the author's acknowledgments. 

Authors write books for many reasons other than to teach and educate.  The most common reason financial book authors write books is to further their own business interests.  That's not the best thing for you when you're trying to educate yourself and better manage your own finances.  For example, some investment newsletter sellers write investment books.  Rather than teach you how to make good investments, the authors make the investment world sound complicated so that you feel the need to subscribe to their ongoing newsletters. 

Books at the head of their class

  In addition to books that I've recommended at various places throughout this book, here's a list of some of my other favorite financial titles (please also see the book summaries I provide on my website, `www.erictyson.com`):

  A Random Walk Down Wall Street by Burton G. Malkiel (Norton)

  Built to Last: Successful Habits of Visionary Companies by Jim Collins and Jerry I. Porras (HarperCollins)

  Good to Great: Why Some Companies Make the Leap . . .  and Others Don't by Jim Collins (HarperCollins)

  Paying for College without Going Broke by Kalman A. Chany (Princeton Review)

  Don't Miss Out: The Ambitious Student's Guide to Financial Aid by Anna and Robert Leider (Octameron Associates)

  Nolo's legal titles

  And, not surprisingly, my For Dummies books on investing, mutual funds, taxes, home buying, house selling, mortgages, real estate investing, and small business (all published by Wiley)
Part VI

The Part of Tens

In this part . . . 

You find some fun and useful chapters that can help you with financial strategies for ten life changes and guide you with ten tips for avoiding identity theft and fraud.  Why "tens"?  Why not? 
Chapter 21

Survival Guide for Ten Life Changes

In This Chapter

  Handling the financial challenges that arise during life changes

  Minimizing money worries so you can focus on what matters most

Some of life's changes come unexpectedly, like earthquakes.  Others you can see coming when they're still far off, like a big storm moving in off the horizon.  Whether a life change is predictable or not, your ability to navigate successfully through its challenges and adjust quickly to new circumstances depends largely on your degree of preparedness. 

Perhaps you find my comparison of life changes to natural disasters to be a bit negative.  After all, some of the changes I discuss in this chapter should be occasions for joy.  But understand that what one defines as a "disaster" has everything to do with preparedness.  To the person who has stored no emergency rations in her basement, the big snowstorm that traps her in her home can lead to problems.  But to the prepared person with plenty of food and water, that same storm may mean a vacation from work and some relaxing days in the midst of a winter wonderland. 

First, here are some general tips that apply to all types of life changes:

  Stay in financial shape.  An athlete is best able to withstand physical adversities during competition by training and eating well in advance.  Likewise, the sounder your finances are to begin with, the better you'll be able to deal with life changes. 

  Changes require change.  Even if your financial house is in order, a major life change — starting a family, buying a home, starting a business, divorcing, retiring — should prompt you to review your personal financial strategies.  Life changes affect your income, spending, insurance needs, and ability to take financial risk. 

  Don't procrastinate.  With a major life change on the horizon, procrastination can be costly.  You (and your family) may overspend and accumulate high-cost debts, lack proper insurance coverage, or take other unnecessary risks.  Early preparation can save you from these pitfalls. 

  Manage stress and your emotions.  Life changes often are accompanied by stress and other emotional upheavals.  Don't make knee-jerk decisions during these changes.  Take the time to become fully informed and recognize and acknowledge your feelings.  Educating yourself is key.  You may want to hire experts to help (see Chapter 18), but don't abdicate decisions and responsibilities to advisors — the advisors may not have your best interests at heart or fully appreciate your needs. 

Here, then, are the major changes you may have to deal with at some point in your life.  I wish you more of the good changes than the bad. 

Starting Out: Your First Job

If you just graduated from college or some other program, or you're otherwise entering the workforce, your increased income and reduction in educational expenses are probably a welcome relief.  You'd think, then, that more young adults would be able to avoid financial trouble and challenges.  But they face these challenges largely because of poor financial habits picked up at home or from the world at large.  Here's how to get on the path to financial success:

  Don't use consumer credit.  The use and abuse of consumer credit can cause long-term financial pain and hardship.  To get off on the right financial foot, young workers need to shun the habit of making purchases on credit cards that they can't pay for in full when the bill arrives in the mail.  Here's the simple solution for running up outstanding credit-card balances: Don't carry a credit card.  If you need the convenience of making purchases with a piece of plastic, get a debit card (see Chapter 5). 

  Get in the habit of saving and investing.  Ideally, your savings should be directed into retirement accounts that offer tax benefits unless you want to accumulate down-payment money for a home or small-business purchase (see Chapter 4).  Thinking about a home purchase or retirement is usually not in the active thought patterns of first-time job seekers.  I'm often asked, "At what age should a person start saving?"  To me, that's similar to asking at what age you should start brushing your teeth.  Well, when you have teeth to brush!  So I say you should start saving and investing money from your first paycheck.  Try saving 5 percent of every paycheck and then eventually increase your saving to 10 percent.  If you're having trouble saving money, track your spending and make cutbacks as needed (refer to Chapters 3 and 6). 

  Get insured.  When you're young and healthy, imagining yourself feeling otherwise is hard.  Many twenty-somethings give little thought to the potential for healthcare expenses.  But because accidents and unexpected illnesses can strike at any age, forgoing coverage can be financially devastating.  When you're in your first full-time job with more-limited benefits, buying disability coverage, which replaces income lost due to a long-term disability, is also wise.  And as you begin to build your assets, consider making out a will so that your assets go where you want them to in the event of your untimely passing. 

  Continue your education.  After you get out in the workforce, you (like many other people) may realize how little you learned in formal schooling that can actually be used in the real world and, conversely, how much you need to learn that school never taught you.  Read, learn, and continue to grow.  Continuing education can help you advance in your career and enjoy the world around you. 

Changing Jobs or Careers

During your adult life, you'll almost surely change jobs — perhaps several times a decade.  I hope that most of the time you'll be changing by your own choice.  But let's face it: Job security is not what it used to be.  Downsizing has impacted even the most talented workers. 

Always be prepared for a job change.  No matter how happy you are in your current job, knowing that your world won't fall apart if you're not working tomorrow can give you an added sense of security and encourage openness to possibility.  Whether you're changing your job by choice or necessity, the following financial maneuvers can help ease the transition:

  Structure your finances to afford an income dip.  Spending less than you earn always makes good financial sense, but if you're approaching a possible job change, spending less is even more important, particularly if you're entering a new field or starting your own company and you expect a short-term income dip.  Many people view a lifestyle of thriftiness as restrictive, but ultimately those thrifty habits can give you more freedom to do what you want to do.  Be sure to keep an emergency reserve fund (see Chapter 8). 

If you lose your job, batten down the hatches.  You normally get little advance warning when you lose your job through no choice of your own.  It doesn't mean, however, that you can't do anything financially.  Evaluating and slashing your current level of spending may be necessary.  Everything should be fair game, from how much you spend on housing to how often you eat out to where you do your grocery shopping.  Avoid at all costs the temptation to maintain your level of spending by accumulating consumer debt. 

  Evaluate the total financial picture when relocating.  At some point in your career, you may have the option of relocating.  But don't call the moving company until you understand the financial consequences of such a move.  You can't simply compare salaries and benefits between the two jobs.  You also need to compare the cost of living between the two areas: housing, commuting, state income and property taxes, food, utilities, and all the other major expenditure categories that I cover in Chapter 3. 

  Track your job search expenses for tax purposes.  If you're seeking a new job in your current (or recently current) field of work, your job search expenses may be tax-deductible, even if you don't get a specific job you desire.  Remember, however, that if you're moving into a new career, your job search expenses are not tax-deductible. 

Getting Married

Ready to tie the knot with the one you love?  Congratulations — I hope that you'll have a long, healthy, and happy life together.  In addition to the emotional and moral commitments that you and your spouse will make to one another, you're probably going to be merging many of your financial decisions and resources.  Even if you're largely in agreement about your financial goals and strategies, managing as two is far different than managing as one.  Here's how to prepare:

  Take a compatibility test.  Many couples never talk about their goals and plans before marriage, and failing to do so breaks up way too many marriages.  Finances are just one of the many issues you need to discuss.  Ensuring that you know what you're getting yourself into is a good way to minimize your chances for heartache.  Ministers, priests, and rabbis sometimes offer premarital counseling to help bring issues and differences to the surface. 

  Discuss and set joint goals.  After you're married, you and your spouse should set aside time once a year, or every few years, to discuss personal and financial goals for the years ahead.  When you talk about where you want to go, you help ensure that you're both rowing your financial boat in unison. 

  Decide whether to keep finances separate or manage them jointly.  Philosophically, I like the idea of pooling your finances better.  After all, marriage is a partnership.  In some marriages, however, spouses may choose to keep some money separate so they don't feel the scrutiny of a spouse with different spending preferences.  Spouses who have been through divorce may choose to keep the assets they bring into the new marriage separate in order to protect their money in the event of another divorce.  As long as you're jointly accomplishing what you need to financially, some separation of money is okay.  But for the health of your marriage, don't hide money from one another, and if you're the higher-income spouse, don't assume power and control over your joint income. 

  Coordinate and maximize employer benefits.  If one or both of you have access to a package of employee benefits through an employer, understand how best to make use of those benefits.  Coordinating and using the best that each package has to offer is like getting a pay raise.  If you both have access to health insurance, compare which of you has better benefits.  Likewise, one of you may have a better retirement savings plan — one that matches and offers superior investment options.  Unless you can afford to save the maximum through both your plans, saving more in the better plan will increase your combined assets. ( Note: If you're concerned about what will happen if you save more in one of your retirement plans and then you divorce, in most states, the money is considered part of your joint assets to be divided equally.) 

  Discuss life and disability insurance needs.  If you and your spouse can make do without each other's income, you may not need any income-protecting insurance.  However, if you both depend on each other's incomes, or if one of you depends fully or partly on the other's income, you may each need long-term disability and term life insurance policies (refer to Chapter 16). 

  Update your wills.  When you marry, you should make or update your wills.  Having a will is potentially more valuable when you're married, especially if you want to leave money to others in addition to your spouse, or if you have children for whom you need to name a guardian.  See Chapter 17 for more on wills. 

  Reconsider beneficiaries on investment and life insurance.  With retirement accounts and life insurance policies, you name beneficiaries to whom the money or value in those accounts will go in the event of your passing.  When you marry, you'll probably want to rethink your beneficiaries. 

Buying a Home

Most Americans eventually buy a home.  You don't need to own a home to be a financial success, but home ownership certainly offers financial rewards.  Over the course of your adult life, the real estate you own is likely going to appreciate in value.  Additionally, you'll pay off your mortgage someday, which will greatly reduce your housing costs.  If you're thinking about buying a home, take these steps:

  Get your overall finances in order.  Before buying, analyze your current budget, your ability to afford debt, and your future financial goals.  Make sure your expected housing expenses allow you to save properly for retirement and other long- or short-term objectives.  Don't buy a home based on what lenders are willing to lend. 

  Determine whether now's the time.  Buying a house when you don't see yourself staying put three to five years rarely makes financial sense.  Buying and selling a home gobbles up a good deal of money in transaction costs — you'll be lucky to recoup all those costs even within a five-year period.  Also, if your income is likely to drop or you have other pressing goals, such as starting a business, you may want to wait to buy. 

For more about buying a home, be sure to read Chapter 14. 

Having Children

If you think that being a responsible adult, holding down a job, paying your bills on time, and preparing for your financial future are tough, wait 'til you add kids to the equation.  Most parents find that with children in the family, the already precious commodities of free time and money become even scarcer.  The sooner you discover how to manage your time and money, the better able you'll be to have a sane, happy, and financially successful life as a parent.  Here are some key things to do both before and after you begin your family:

  Set your priorities.  As with many other financial decisions, starting or expanding a family requires that you plan ahead.  Set your priorities and structure your finances and living situation accordingly.  Is having a bigger home in a particular community important, or would you rather feel less pressure to work hard, giving you more time to spend with your family?  Keep in mind that a less hectic work life not only gives you more free time but also often reduces your cost of living by decreasing meals out, dry-cleaning costs, day-care expenses, and so on. 

  Take a hard look at your budget.  Having kids requires you to increase your spending.  At a minimum, expenditures for food and clothing will increase.  But you're also likely to spend more on housing, insurance, day care, and education.  On top of that, if you want to play an active role in raising your children, working at a full-time job won't be possible.  So while you consider the added expenses, you may also need to factor in a decrease in income. 

No simple rules exist for estimating how kids will affect your household's income and expenses.  On the income side, figure out how much you want to cut back on work.  On the expense side, government statistics show that the average household with school-age children spends about 20 percent more than a household without children.  Going through your budget category by category and estimating how kids will change your spending is a more scientific approach. ( You can use the worksheets in Chapter 3.) 

  Boost insurance coverage before getting pregnant.  Make sure your health insurance plan offers maternity benefits. ( Ask about waiting periods that may exclude coverage for a pregnancy within the first year or so of the insurance.)  With disability insurance, pregnancy is considered a preexisting condition, so women should secure this coverage before getting pregnant.  And most families-to-be should buy life insurance.  Buying life insurance after the bundle of joy comes home from the hospital is a risky proposition — if one of the parents develops a health problem, he or she may be denied coverage.  You should also consider buying life insurance for a stay-at-home parent.  Even though the stay-at-home parent is not bringing in income, if he or she were to pass away, hiring assistance could cripple the family budget. 

  Check maternity leave with your employers.  Many of the larger employers offer some maternity leave for women and, in rare but thankfully increasing cases, for men.  Some employers offer paid leaves, while others may offer unpaid leaves.  Understand the options and the financial ramifications before you consider the leave and, ideally, before you get pregnant.  Also, check laws within your state for mandated maternity and paternity leave. 

  Update your will.  If you have a will, update it; if you don't have a will, make one now.  With children in the picture, you need to name a guardian who will be responsible for raising your children should you and your spouse both pass away. 

  Enroll the baby in your health plan.  After your baby is welcomed into this world, enroll him or her in your health insurance plan.  Most insurers give you about a month or so to enroll. 

  Understand child-care tax benefits.  For every one of your children with an official Social Security number, you get a $3,800 deduction on your income taxes (for tax year 2012).  So if you're in the 25 percent federal tax bracket, each child saves you $950 in federal taxes.  On top of that, you may be eligible for a $1,000 tax credit for each child under the age of 17.  That should certainly motivate you to apply for your kid's Social Security number! 

If you and your spouse both work and you have children under the age of 13, you can also claim a tax credit for child-care expenses.  Or you may work for an employer who offers a flexible benefit or spending plan.  These plans allow you to put away up to $5,000 per year on a pretax basis for child-care expenses.  For many parents, especially those in higher income tax brackets, these plans can save a lot in taxes.  Keep in mind, however, that if you use one of these plans, you can't claim the child-care tax credit.  Also, if you don't deplete the account every tax year, you forfeit any money left over. 

  Skip saving in custodial accounts.  One common concern is how to sock away enough money to pay for the ever-rising cost of a college education.  If you start saving money in your child's name in a so-called custodial account, however, you may harm your child's future ability to qualify for financial aid and miss out on the tax benefits that come with investing elsewhere (see Chapter 13). 

  Don't indulge the children.  Toys, art classes, music lessons, travel sports and associated lessons, field trips, and the like can rack up big bills, especially if you don't control your spending.  Some parents fail to set guidelines or limits when spending on children's programs.  Others mindlessly follow the examples set by the families of their children's peers.  Introspective parents have told me that they feel some insecurity about providing the best for their children.  The parents (and kids) who seem the happiest and most financially successful are the ones who clearly distinguish between material luxuries and family necessities. 

As children get older and become indoctrinated into the world of shopping, all sorts of other purchases come into play.  Consider giving your kids a weekly allowance and letting them discover how to spend and manage it.  And when they're old enough, having your kids get a part-time job can help teach financial responsibility. 

Starting a Small Business

Many people aspire to be their own bosses, but far fewer people actually leave their jobs in order to achieve that dream.  Giving up the apparent security of a job with benefits and a built-in network of co-workers is difficult for most people, both psychologically and financially.  Starting a small business is not for everyone, but don't let inertia stand in your way.  Here are some tips to help get you started and increase your chances for long-term success:

  Prepare to ditch your job.  To maximize your ability to save money, live as Spartan a lifestyle as you can while you're employed; you'll develop thrifty habits that'll help you weather the reduced income and increased expenditure period that come with most small-business start-ups.  You may also want to consider easing into your small business by working at it part-time in the beginning, with or without cutting back on your normal job. 

  Develop a business plan.  If you research and think through your business idea, not only will you reduce the likelihood of your business's failing and increase its success if it thrives, but you'll also feel more comfortable taking the entrepreneurial plunge.  A good business plan describes in detail the business idea, the marketplace you'll compete in, your marketing plans, and expected revenue and expenses. 

  Replace your insurance coverage.  Before you finally leave your job, get proper insurance.  With health insurance, employers allow you to continue your existing coverage (at your own expense) for 18 months.  Individuals with existing health problems are legally entitled to purchase an individual policy at the same price that a healthy individual pays.  With disability insurance, secure coverage before you leave your job so you have income to qualify for coverage.  If you have life insurance through your employer, obtain new individual coverage as soon as you know you're going to leave your job. ( See Chapter 16 for details.) 

  Establish a retirement savings plan.  After your business starts making a profit, consider establishing a retirement savings plan such as a SEP-IRA or Keogh.  As I explain in Chapter 11, such plans allow you to shelter up to 20 percent of your business income from federal and state taxation. 

Caring for Aging Parents

For many of us, there comes a time when we reverse roles with our parents and become the caregivers.  As your parents age, they may need help with a variety of issues and living tasks.  Although you probably won't have the time or ability to perform all these functions yourself, you may end up coordinating some service providers who will.  Here are key issues to consider when caring for aging parents:

  Get help where possible.  In most communities, a variety of nonprofit organizations offer information and counseling to families who are caring for elderly parents.  Numerous for-profit agencies can help with everything from simple cleaning and cooking, to health checks and medication monitoring, to assisted living and health advocacy.  You may be able to find your way to such resources through your state's department of insurance, as well as through recommendations from local hospitals and doctors.  You'll especially want to get assistance and information if your parents need some sort of home care, nursing home care, or assisted living arrangement. 

  Get involved in their health care.  Your aging parents may already have a lot on their minds, or they simply may not be able to coordinate and manage all the healthcare providers who are giving them medications and advice.  Try, as best as you can, to be their advocate.  Speak with their doctors so you can understand their current medical condition, the need for various medications, and how to help coordinate caregivers.  Visit home care providers and nursing homes, and speak with prospective care providers. 

  Understand tax breaks.  If you're financially supporting your parents, you may be eligible for a number of tax credits and deductions for elder care.  Some employers' flexible benefit plans allow you to put away money on a pretax basis to pay for the care of your parents.  Also explore the dependent care tax credit, which you can take on your federal income tax Form 1040.  And if you provide half or more of the support costs for your parents, you may be able to claim them as dependents on your tax return. 

  Discuss getting the estate in order.  Parents don't like thinking about their demise, and they may feel awkward discussing this issue with their children.  But opening a dialogue between you and your folks about such issues can be healthy in many ways.  Not only does discussing wills, living wills, living trusts, and estate planning strategies (see Chapter 17) make you aware of your folks' situation, but it can also improve their plans to both their benefit and yours. 

  Take some time off.  Caring for an aging parent, particularly one who is having health problems, can be time-consuming and emotionally draining.  Do your parents and yourself a favor by using some vacation time to help get things in order. 

Divorcing

In most marriages that are destined to split up, both parties usually recognize early warning signs.  Sometimes, however, one spouse may surprise the other with an unexpected request for divorce.  Whether the divorce is planned or unexpected, here are some important considerations when getting a divorce:

  Question the divorce.  Some say that divorcing in America is too easy, and I tend to agree.  Although some couples are indeed better off parting ways, others give up too easily, thinking that the grass is greener elsewhere, only to later discover that all lawns have weeds and crabgrass.  Just as with lawns that aren't watered and fertilized, relationships can wither without nurturing. 

Money and disagreements over money are certainly contributing factors in marital unhappiness.  Unfortunately, in some relationships, money is wielded as power by the spouse who earns more of it.  Try talking things over, perhaps with a marital counselor. 

  Separate your emotions from the financial issues.  Feelings of revenge may be common in some divorces, but they'll probably only help ensure that the attorneys get rich as you and your spouse butt heads.  If you really want a divorce, work at doing it efficiently and harmoniously so that you can get on with your lives and have more of your money to work with. 

  Detail resources and priorities.  Draw up a list of all the assets and liabilities that you and your spouse have.  Make sure you list all the financial facts, including investment account records and statements.  After you know the whole picture, begin to think about what is and isn't important to you financially and otherwise. 

  Educate yourself about personal finance and legal issues.  Divorce sometimes forces nonfinancially oriented spouses to get a crash course in personal finance at a difficult emotional time.  This book can help educate you financially.  Visit a bookstore and pick up a good legal guide or two about divorce. 

  Choose advisors carefully.  Odds are that you'll retain the services of one or more specialists to assist you with the myriad issues, negotiations, and concerns of your divorce.  Legal, tax, and financial advisors can help, but make sure you recognize their limitations and conflicts of interest.  The more complicated things become and the more you haggle with your spouse, the more attorneys, unfortunately, benefit financially.  Don't use your divorce attorney for financial or tax advice — your lawyer probably knows no more than you do in these areas.  Also, realize that you don't need an attorney to get divorced.  A variety of books and kits can help you.  As for choosing tax and financial advisors, if you think you need that type of help, see Chapters 7 and 18 for advice on how to find good advisors. 

  Analyze your spending.  Some divorcees find themselves financially squeezed in the early years following a divorce because two people living together in the same property can generally do so less expensively than two people living separately.  Analyzing your spending needs pre-divorce can help you adjust to a new budget and negotiate a fairer settlement with your spouse. 

  Review needed changes to your insurance.  If you're covered under your spouse's employer's insurance plan, make sure you get this coverage replaced (see Chapter 16).  If you or your children will still be financially dependent upon your spouse post-divorce, make sure that the divorce agreement mandates life insurance coverage.  You should also revise your will (see Chapter 17). 

  Revamp your retirement plan.  With changes to your income, expenses, assets, liabilities, and future needs, your retirement plan will surely need a post-divorce overhaul.  Refer to Chapter 4 for a reorientation. 

Receiving a Windfall

Whether through inheritance, stock options, small-business success, or lottery winnings, you may receive a financial windfall at some point in your life.  Like many people who are totally unprepared psychologically and organizationally for their sudden good fortune, you may find that a flood of money can create more problems than it solves.  Here are a few tips to help you make the most of your financial windfall:

  Educate yourself.  If you've never had to deal with significant wealth, I don't expect you to know how to handle it.  Don't pressure yourself to invest it as soon as possible.  Leaving the money where it is or stashing it in one of the higher-yielding money market funds I recommend in Chapter 12 is far better than jumping into investments that you don't understand and haven't researched. 

  Beware of the sharks.  You may begin to wonder whether someone has posted your net worth, address, and home telephone number in the local newspaper and on the Internet.  Brokers and financial advisors may flood you with marketing materials, telephone solicitations, and lunch date requests.  These folks pursue you for a reason: They want to convert your money into their income either by selling you investments and other financial products or by managing your money.  Stay away from the sharks, educate yourself, and take charge of your own financial moves.  Decide on your own terms whom to hire, and then seek them out. 

  Recognize the emotional side of coming into a lot of money.  One of the side effects of accumulating wealth quickly is that you may have feelings of guilt or otherwise be unhappy, especially if you expected money to solve your problems.  If you didn't invest in your relationship with your parents and after their passing, you regret how you interacted with them, getting a big inheritance from your folks may make you feel badly.  If you poured endless hours into a business venture that finally paid off, all that money in your investment accounts may leave you with a hollow feeling if you're divorced and you lost friends by neglecting your relationships. 

  Pay down debts.  People generally borrow money to buy things that they otherwise can't buy in one fell swoop.  Paying off your debts is one of the simplest and best investments you can make when you come into wealth. 

  Diversify.  If you want to protect your wealth, don't keep it all in one pot.  Mutual funds (see Chapter 10) are an ideally diversified, professionally managed investment vehicle to consider.  And if you want your money to continue growing, consider the wealth-building investments — stocks, real estate, and small-business options — that I discuss in Part III of this book. 

  Make use of the opportunity.  Most people work for a paycheck their whole lives so they can pay a never-ending stream of monthly bills.  Although I'm not advocating a hedonistic lifestyle, why not take some extra time to travel, spend time with your family, and enjoy the hobbies you've long been putting off?  How about trying a new career that you may find more fulfilling and that may make the world a better place?  And what about donating some to your favorite charities? 

Retiring

If you've spent the bulk of your adult life working, retiring can be a challenging transition.  Most Americans have an idealized vision of how wonderful retirement will be — no more irritating bosses and pressure of work deadlines; unlimited time to travel, play, and lead the good life.  Sounds good, huh?  Well, the reality for most Americans is different, especially for those who don't plan ahead (financially and otherwise).  Here are some tips to help you through retirement:

  Plan both financially and personally.  Planning your activities is even more important than planning financially.  If the focus during your working years is solely on your career and saving money, you may lack interests, friends, and the ability to know how to spend money when you retire. 

  Take stock of your resources.  Many people worry and wonder whether they have sufficient assets for cutting back on work or retiring completely, yet they don't crunch any numbers to see where they stand.  Ignorance may cause you to misunderstand how little or how much you really have for retirement when compared to what you need.  See Chapters 4 and 11 for help with retirement planning and investing. 

  Reevaluate your insurance needs.  When you have sufficient assets to retire, you don't need to retain insurance to protect your employment income any longer.  On the other hand, as your assets grow over the years, you may be underinsured with regards to liability insurance (refer to Chapter 17). 

  Evaluate healthcare/living options.  Medical expenses in your retirement years (particularly the cost of nursing home care) can be daunting.  Which course of action you take — supplemental insurance, buying into a retirement community, or not doing anything — depends on your financial and personal situation.  Early preparation increases your options; if you wait until you have major health problems, it may be too late to choose specific paths. ( See Chapter 16 for more details on healthcare options.) 

  Decide what to do with your retirement plan money.  If you have money in a retirement savings plan, your employer may offer you the option of leaving the money in the plan rather than rolling it over into your own retirement account.  Brokers and financial advisors clearly prefer that you do the latter because it means more money for them, but it can also give you many more (and perhaps better) investment choices to consider.  Read Part III of this book to find out about investing and evaluating the quality of your employer's retirement plan investment options. 

  Pick a pension option.  Selecting a pension option (a plan that pays a monthly benefit during retirement) is similar to choosing a good investment — each pension option carries different risks, benefits, and tax consequences.  Pensions are structured by actuaries, who base pension options on reasonable life expectancies.  The younger you are when you start collecting your pension, the less you get per month.  Check to see whether the amount of your monthly pension stops increasing past a certain age.  You obviously don't want to delay access to your pension benefits past that age, because you won't receive a reward for waiting any longer and you'll collect the benefit for fewer months. 

If you know that you have a health problem that shortens your life expectancy, you may benefit from drawing your pension sooner.  If you plan to continue working in some capacity and earning a decent income after retiring, waiting for higher pension benefits when you're in a lower tax bracket is probably wise. 

At one end of the spectrum, you have the risky single life option, which pays benefits until you pass away and then provides no benefits for your spouse thereafter.  This option maximizes your monthly take while you're alive.  Consider this option only if your spouse can do without this income.  The least risky option, and thus least financially rewarding while the pensioner is still living, is the 100-percent joint and survivor option, which pays your survivor the same amount that you received while still alive.  The other joint and survivor options fall somewhere between these two extremes and generally make sense for most couples who desire decent pensions early in retirement but want a reasonable amount to continue in the event that the pensioner dies first.  The 75-percent joint and survivor option is a popular choice, because it closely matches the lower expense needs of the lone surviving spouse at 75 percent of the expenses of the couple, and it provides higher payments than the 100-percent joint and survivor option while both spouses are alive. 

  Get your estate in order.  Confronting your mortality is never fun, but when you're considering retirement or you're already retired, getting your estate in order makes all the more sense.  Find out about wills and trusts that may benefit you and your heirs.  You may also want to consider giving monetary gifts now if you have more than you need. 
Chapter 22

Ten Tactics to Thwart Identity Theft and Fraud

In This Chapter

  Protecting your personal information

  Paying attention to activity in your accounts and credit history

Hucksters and thieves are often several steps ahead of law enforcement.  Eventually, some of the bad guys get caught, but many don't, and those who do get nabbed often go back to their unsavory ways after penalties and some jail time.  They may even be in your neighborhood or on your local Little League board. ( For an enlightening read, check out Dr. Martha Stout's book The Sociopath Next Door [Three Rivers Press].) 

Years ago when I lived on the West Coast, I got a call from my bank informing me that it had just discovered "concerning activity" on the joint checking account I held with my wife.  Specifically, what had happened was that a man with a bogus ID in my name had gone into five different Bank of America branches on the same day and withdrawn $80 from our checking account at each one.  After some detective work on my part, I discovered that someone had pilfered our personal banking information at my wife's employer's payroll office.  Fortunately, the bank made good on the money that it had allowed to be withdrawn by the Eric Tyson impostor. 

I had been the victim of identity theft.  In my situation, the crook had accessed one of my accounts; in other cases, the criminal activity may develop with someone opening an account (such as a credit card) using someone's stolen personal information.  Victims of identity theft can suffer trashed credit reports, reduced ability to qualify for loans and even jobs (with employers who check credit reports), out-of-pocket costs and losses, and dozens of hours of time to clean up the mess and clear their credit record and name. 

Unfortunately, identity theft is hardly the only way to be taken to the cleaners by crooks.  All sorts of scamsters hatch schemes to separate you from your money.  Please follow the ten tips in this chapter to keep yourself from falling prey and unnecessarily losing money. 

Save Phone Discussions for Friends Only

Never, ever give out personal information over the phone, especially when you aren't the one who initiated the call.  Suppose you get a call and the person on the other end of the line claims to be with a company you conduct business with (such as your credit-card company or bank).  Ask for the caller's name and number and call back the company's main number (which you look up) to be sure he is indeed with that company and has a legitimate business reason for contacting you. 

With caller ID on your phone line, you may be able to see what number a call is originating from, but more often than not, calls from business-registered phone numbers come up as "unavailable."  A major red flag: calling back the number that comes through on caller ID and discovering that the number is bogus (a nonworking number). 

Never Respond to E-Mails Soliciting Information

If you're an e-mail user, you may have seen or heard about official-looking e-mails sent from companies you know of and may do business with asking you to promptly visit their website to correct some sort of billing or account problem.  Crooks can generate a return/sender e-mail address that looks like it comes from a known institution but really does not.  This unscrupulous practice is known as phishing, and if you bite at the bait, visit the site, and provide the requested personal information, your reward is likely to be some sort of future identity-theft problem. 

To find out more about how to protect yourself from phishing scams, visit the website of the Anti-Phishing Working Group (APWG) at `www.antiphishing.org`. 

Review Your Monthly Financial Statements

Although financial institutions such as banks may call you if they notice unusual activity on one of your accounts, some people discover problematic account activity by simply reviewing their monthly credit-card, checking-account, and other statements. 

Do you need to balance bank account statements to the penny?  No, you don't.  I haven't for years (decades actually), and I don't have the time or patience for such minutiae.  The key is to review the line items on your statement to be sure that all the transactions were yours. 

Secure All Receipts

When you make a purchase, be sure to keep track of and secure receipts, especially those that contain your personal financial or account information.  You can keep these in an envelope in your home, for example.  Then cross-check them against your monthly statement. 

When you no longer need to retain your receipts, be sure to dispose of them in a way that prevents a thief, who may get into your garbage, from being able to decipher the information on them.  Rip up the receipts or, if you feel so inclined, buy a small paper shredder for your home and/or small business. 

Close Unnecessary Credit Accounts

Open your wallet and remove all the pieces of plastic within it that enable you to charge purchases.  The more credit cards and credit lines you have, the more likely you are to have problems with identity theft and fraud and the more likely you are to overspend and carry debt balances.  Also, reduce preapproved credit offers by contacting 888-5OPTOUT (888-567-8688) or visiting `www.optoutprescreen.com`. 

Unless you maintain a card for small business transactions, you really "need" only one piece of plastic with a VISA or MasterCard logo.  Give preference to a debit card if you have a history of accumulating credit-card-debt balances. 

Regularly Review Your Credit Reports

You may also be tipped off to shenanigans going on in your name when you review your credit report.  Some identity-theft victims have found out about credit accounts opened in their name by reviewing their credit reports. 

Because you're entitled to a free credit report from each of the three major credit agencies every year, I recommend reviewing your reports at least that often.  The reports generally contain the same information, so you can request and review one agency report every four months, which enables you to keep a closer eye on your reports and still obtain them without cost. 

I don't recommend spending the $100 or so annually for a so-called credit monitoring service that updates you when something happens on your credit reports.  If you're concerned about someone illegally applying for credit in your name, know that another option for you (in some states) to stay on top of things is to "freeze" your personal credit reports and scores (see the next tip). 

Freeze Your Credit Reports

To address the growing problem of identity theft, increasing numbers of states are passing credit freeze laws, which enable consumers to prevent access to their reports.  Many states enable consumers, typically for a nominal fee, to freeze their credit information. 

In some states, only identity-theft victims may freeze their reports.  The individual whose credit report is frozen is the only person who may grant access to the frozen credit report. 

Keep Personal Info Off Your Checks

Don't place personal information on checks.  Information that is useful to identity thieves — and that you should not put on your checks — includes your credit-card number, driver's license number, Social Security number, and so on.  I also encourage you to leave your home address off your preprinted checks when you order them.  Otherwise, every Tom, Dick, and Jane whose hands your check passes through knows exactly where you live. 

When writing a check to a merchant, question the need for adding personal information to the check (in fact, in numerous states, requesting and placing credit-card numbers on checks is against the law).  Use a debit card instead for such transactions and remember that your debit card doesn't advertise your home address and other financial account data, so there's no need to publicize it to the world on your checks. 

Protect Your Computer and Files

Especially if you keep personal and financial data on your computer, consider the following safeguards to protect your computer and the confidential information on it:

  Install a firewall. 

  Use virus protection software. 

  Password-protect access to your programs and files. 

Protect Your Mail

Some identity thieves have collected personal information by simply helping themselves to mail in home mailboxes.  Stealing mail is easy, especially if your mail is delivered to a curbside box. 

Consider using a locked mailbox or a post office box to protect your incoming mail from theft.  Consider having your investment and other important statements sent to you via e-mail, or simply access them online and eliminate mail delivery of the paper copies. 

Be careful with your outgoing mail as well, such as bills with checks attached.  Minimize your outgoing mail and save yourself hassles by signing up for automatic bill payment for as many bills as possible.  Drop the rest of your outgoing mail in a secure U.S. postal box, such as those you find at the post office. 
Glossary

adjustable-rate mortgage (ARM): A mortgage whose interest rate and monthly payments vary throughout its life.  ARMs typically start with an artificially low interest rate that gradually rises over time.  The interest rate is determined by a formula: margin (which is a fixed number) plus index (which varies).  Generally speaking, if the overall level of interest rates drops, as measured by a variety of different indexes, the interest rate of your ARM generally follows suit.  Similarly, if interest rates rise, so does your mortgage's interest rate and monthly payment.  Caps limit the amount that the interest rate can fluctuate.  Before you agree to an ARM, be certain that you can afford its highest possible payments. 

adjusted cost basis: For capital gains tax purposes, the adjusted cost basis is how the IRS determines your profit or loss when you sell an asset such as a home or a security.  For an investment such as a mutual fund or stock, your cost basis is what you originally invested plus any reinvested money.  For a home, you arrive at the adjusted cost basis by adding the original purchase price to the cost of any capital improvements (expenditures that increase your property's value and life expectancy). 

adjusted gross income (AGI): The sum of your taxable income (such as wages, salaries, and tips) and taxable interest less allowable adjustments (such as retirement account contributions and moving expenses).  AGI is calculated before subtracting your personal exemptions and itemized deductions, which are used to derive your taxable income. 

after-tax contributions: Some retirement plans allow you to contribute money that has already been taxed.  Such contributions are known as after-tax contributions. 

alternative minimum tax (AMT): The name given to a sort of shadow tax system that may cause you to pay a higher amount in federal income taxes than you otherwise would.  The AMT was designed to prevent higher income earners from lowering their tax bills too much through large deductions. 

annual percentage rate (APR): The figure that states the total yearly cost of a loan as expressed by the actual rate of interest paid.  The APR includes the base interest rate and any other add-on loan fees and costs.  The APR is thus inevitably higher than the rate of interest that the lender quotes. 

annuity: An investment that is a contract backed by an insurance company.  An annuity is frequently purchased for retirement purposes.  Its main benefit is that it allows your money to compound and grow without taxation until withdrawal.  Selling annuities is a lucrative source of income for insurance agents and financial planners who work on commission, so don't buy an annuity until you're sure it makes sense for your situation. 

asset allocation: When you invest your money, you need to decide how to proportion (allocate) it between risky, growth-oriented investments (such as stocks), whose values fluctuate, and more stable, income-producing investments (like bonds).  How soon you'll need the money and how tolerant you are of risk are two important determinants when deciding how to allocate your money. 

audit: An IRS examination of your financial records, generally at the IRS offices, to substantiate your tax return.  IRS audits are among life's worst experiences. 

bank prime rate: See prime rate. 

bankruptcy: Legal action that puts a halt to creditors' attempts to collect unpaid debts from you.  Of use to people who have a high proportion of consumer debt to annual income (25 percent or greater). 

bear market: A period (such as the early 2000s and late 2000s) when the stock market experiences a strong downward swing.  It is often accompanied by (and sometimes precedes) an economic recession.  Imagine a bear in hibernation, because this is what happens in a bear market: Investors hibernate, and the market falters.  During a bear market, the value of stocks can decrease significantly.  The market usually has to drop at least 20 percent from its peak before it is considered a bear market. 

beneficiaries: The people to whom you want to leave your assets (or in the case of life insurance or a pension plan, benefits) in the event of your death.  You denote beneficiaries for each of your retirement accounts. 

blue chip stock: The stock of the largest and most consistently profitable corporations.  This term comes from poker, where the most valuable chips are blue.  This list is unofficial and changes. 

bond: A loan investors make to a corporation or government.  Bonds generally pay a set amount of interest on a regular basis.  They're an appropriate investment vehicle for conservative investors who don't feel comfortable with the risk involved in investing in stocks and who want to receive a steady income.  All bonds have a maturity date when the bond issuer must pay back the bond at par (full) value to the bondholders (lenders).  Bonds should not be your primary long-term investment vehicle, because they produce little real growth on your original investment after inflation is factored in. 

bond rating: See Standard & Poor's (S&P) ratings and Moody's ratings. 

bond yield: A yield is quoted as an annual percentage rate of return that a bond will produce based on its current value if it makes its promised interest payments.  How much a bond will yield to an investor depends on three important factors: the stated interest rate paid by the bond, changes in the creditworthiness of the bond's issuer, and the maturity date of the bond.  The better the rating a bond receives, the less risk involved and, thus, the lower the yield.  As far as the maturity date is concerned, the longer you loan your money, the higher the risk (because it's more likely that rates will fluctuate) and the higher your yield generally will be. 

broker: A person who acts as an intermediary for the purchase or sale of investments.  When you buy a house, insurance, or stock, you're most likely to do so through a broker.  Most brokers are paid on commission, which creates a conflict of interest with their clients: The more the broker sells, the more he makes.  Some insurance companies let you buy their policies directly, and many mutual fund families bypass stockbrokers.  If you're going to work with a broker, a discount broker can help you save on commissions. 

bull market: A period (such as most of the 1990s and mid-2000s in the United States) when the stock market moves higher, usually accompanied and driven by a growing economy and increasing corporate profits. 

callable bond: A bond for which the lender can decide to pay the holder earlier than the previously agreed-upon final maturity date.  If interest rates are relatively high when a bond is issued, lenders may prefer to issue callable bonds because they have the flexibility to call back these bonds and issue new, lower-interest-rate bonds if interest rates decline.  Callable bonds are risky for investors, because if interest rates decrease, the bond holder will get his investment money returned early and may have to reinvest his money at a lower interest rate. 

capital gain: The profit from selling your stock at a higher price than the price for which it was purchased.  For example, if you buy 50 shares of Rocky and Bullwinkle stock at $20 per share and two years later you sell your shares when the price rises to $25 per share, your profit or capital gain is $5 per share, or $250.  If you hold this stock outside of a tax-sheltered retirement account, you'll owe federal tax on this profit when you sell the stock.  Many states also levy such a tax. 

capital gains distribution: Taxable distribution by a mutual fund or real-estate investment trust (REIT) created by securities that are sold within the fund or REIT at a profit.  These distributions may be either short-term (assets held a year or less) or long-term (assets held for more than one year). 

cash value insurance: A type of life insurance that's extremely popular with insurance salespeople because it commands a high commission.  In a cash value policy, you buy life insurance coverage but also get a savings-type account.  Unless you're looking for ways to limit your taxable estate (if you're extremely wealthy, for example), avoid cash value insurance.  The investment returns tend to be mediocre, and your contributions aren't tax-deductible. 

certificate of deposit (CD): A specific-term loan that you make to your banker.  The maturity date for CDs ranges from a month up to several years.  The interest paid on CDs is fully taxable, thus making CDs inappropriate for higher tax-bracket investors investing outside tax-sheltered retirement accounts. 

closed-end mutual fund: A mutual fund for which the exact number of shares that are going to be issued to investors is decided upfront.  After all the shares are sold, an investor seeking to invest in the closed-end fund can only do so by purchasing shares from an existing investor.  Shares of closed-end funds trade on the major stock exchanges and therefore sell at either a discount, if the sellers exceed the buyers, or at a premium, if demand exceeds supply. 

COBRA (Consolidated Omnibus Budget Reconciliation Act): Name of the federal legislation that requires health insurers and larger employers to continue to offer health insurance, at the employee's expense, for 18 months after coverage would otherwise end — for example, when an employee is laid off. 

commercial paper: A short-term debt or IOU issued by larger, stable companies to help make their businesses grow and prosper.  Credit-worthy companies can sell this debt security directly to large investors and thus bypass borrowing money from bankers.  Money-market funds invest in soon-to-mature commercial paper. 

commission: The percentage of the selling price of a house, stock, bond, or other investment that's paid to agents and brokers.  Because most agents and brokers are paid by commission, understanding how the commission can influence their behavior and recommendations is important for investors and home buyers.  Agents and brokers make money only when you make a purchase, and they make more money when you make a bigger purchase.  Choose an agent carefully and take your agent's advice with a grain of salt, because this conflict of interest can often set an agent's visions and goals at odds with your own. 

commodity: A raw material (gold, wheat, sugar, or gasoline, for example) traded on the futures market. 

common stock: Shares in a company that don't offer a guaranteed amount of dividend to investors; the amount of dividend distributions, if any, is at the discretion of company management.  Although common-stock investors may or may not make money through dividends, they hope that the stock price will appreciate as the company expands its operations and increases its profits.  Common stock tends to offer you a better return (profit) than other investments, such as bonds or preferred stock.  However, if the company falters, you may lose some or all of your original investment. 

comparable market analysis (CMA): A written analysis of similar houses currently being offered for sale and those that have recently sold.  Real estate agents usually complete CMAs. 

consumer debt: Debt on consumer items that depreciate in value over time.  Credit card balances and auto loans are examples of consumer debt.  This type of debt is bad for your financial health because it carries a high interest rate and encourages you to live beyond your means. 

Consumer Price Index (CPI): The Consumer Price Index reports price changes, on a monthly basis, in the cost of living for such items as food, housing, transportation, healthcare, entertainment, clothing, and other miscellaneous expenses.  The CPI is used to adjust government benefits, such as Social Security, and is used by many employers to determine cost-of-living increases in wages and pensions.  An increase in prices is also known as inflation. 

co-payment: The percentage of your medical bill that your health plan requires you to pay out of your own pocket with each medical visit or treatment, often even after you satisfy your annual deductible.  A typical co-payment is 20 percent. 

credit report: A report that details your credit history.  It's the main report that a lender uses to determine whether to give you a loan.  You may now obtain free copies of your credit reports annually. 

debit card: Although they may look like credit cards, debit cards are different in one important way: When you use a debit card, the cost of the purchase is deducted from your checking account.  Thus, a debit card gives you the convenience of a credit card without the danger of building up a mountain of consumer debt. 

deductible: You may be thinking that this is a new product from the Keebler elves.  Unfortunately, a deductible is actually much more mundane.  With insurance, the deductible is the amount you pay when you file a claim.  For example, say that your car sustains $800 of damage.  If your deductible is $500, the insurance covers $300, and you pay $500 out of your own pocket for the repairs.  The higher the deductible, the lower your insurance premiums and the less paperwork you expose yourself to when filing claims (because small losses that are less than the deductible don't require filing a claim).  Take the highest deductibles that you can afford when selecting insurance. 

deduction: An expense you may subtract from your income to lower your taxable income.  Examples include mortgage interest and property taxes (itemized deductions), and most retirement account contributions. 

derivative: An investment instrument whose value is derived from other securities.  For example, the value of an option to buy IBM stock is derived from the price of IBM's stock. 

disability insurance: Disability insurance replaces a portion of your employment income in the unlikely event that you suffer a disability that keeps you from working. 

discount broker: Unlike a full-service broker, a discount broker generally offers no investment advice and has employees who work on salary rather than on commission.  In addition to trading individual securities, most discount brokerage firms also offer no-load (commission-free) mutual funds. 

diversification: If you put all your money into one type of investment, you're potentially setting yourself up for a big shock.  If that investment collapses, so does your investment world.  By spreading (diversifying) your money among different investments — bonds, U.S. stocks, international stocks, real estate, and so on — you ensure yourself a better chance of investing success and fewer sleepless nights. 

dividend: The dividend is the income paid to investors holding an investment.  With stock, the dividend is a portion of a company's profits paid to its shareholders.  For example, if a company has an annual dividend of $2 per share and you own 100 shares, your total dividend is $200.  Usually, established and slower-growing companies pay dividends, while smaller and faster-growing companies reinvest their profits for growth.  For assets held outside retirement accounts, dividends (except from tax-free money-market and tax-free bond funds) are taxable. 

Dow Jones Industrial Average (DJIA): A widely followed stock market index comprised of 30 large, actively traded U.S. company stocks.  Senior editors at The Wall Street Journal select the stocks in the DJIA. 

down payment: The part of the purchase price for a house that the buyer pays in cash upfront and does not finance with a mortgage.  The larger the down payment, the smaller the mortgage amount and often the lower the interest rate.  You can usually get access to the best mortgage programs with a down payment of at least 20 percent of the home's purchase price. 

earthquake insurance: Although the West Coast is often associated with earthquakes, other areas are also quake prone.  An earthquake insurance rider (which usually comes with a deductible of 5 to 15 percent of the cost to rebuild the home) on a homeowner's policy pays to repair or rebuild your home if it is damaged in an earthquake.  If you live in an area with earthquake risk, consider earthquake insurance coverage! 

Emerging Markets Index: The Emerging Markets Index, which is published by Morgan Stanley, tracks stock markets in developing countries.  The main reason for investing in emerging markets is that these economies typically experience a higher rate of economic growth than developed markets.  However, the potential for higher returns is coupled with greater risk. 

equity: In the real-estate world, this term refers to the difference between the market value of your home and what you owe on it.  For example, if your home is worth $250,000, and you have an outstanding mortgage of $190,000, your equity is $60,000.  Equity is also a synonym for stock. 

estate: The value, at the time of your death, of your assets minus your loans and liabilities. 

estate planning: The process of deciding where and how your assets will be transferred when you die and structuring your assets during your lifetime so as to minimize likely estate taxes. 

Federal National Mortgage Association (FNMA): The FNMA (or Fannie Mae) is one of the best-known institutions in the secondary mortgage market.  Fannie Mae buys mortgages from banks and other mortgage-lending institutions and, in turn, sells them to investors.  These loan investments are considered safe because Fannie Mae buys mortgages only from companies that conform to its stringent mortgage regulations, and Fannie Mae guarantees the repayment of principal and interest on the loans that it sells.  FNMA, although it is a public company, also has an implicit federal government guarantee that was demonstrated in late 2008 during the financial crisis. 

financial assets: A property or investment (such as investment real estate or a stock, mutual fund, or bond) that is held primarily as an investment to generate a positive return over time. 

financial liabilities: Your outstanding loans and debts.  To determine your net worth, subtract your financial liabilities from your financial assets. 

financial planners (or advisors): A motley crew that professes an ability to direct your financial future.  Financial planners come with varying backgrounds and degrees: MBAs, Certified Financial Planners, and Certified Public Accountants, to name a few.  A useful way to distinguish among this mixed bag of nuts is to determine whether the planners are commission-, fee-, or hourly-based. 

fixed-rate mortgage: The granddaddy of all mortgages.  You lock into an interest rate (for example, 6 percent), and it never changes during the life (term) of your 15- or 30-year mortgage.  Your mortgage payment and interest rate will be the same amount each and every month.  If you become a cursing, frothing maniac when you miss your morning coffee or someone is five minutes late, then this mortgage may be for you! 

flood insurance: If there's a remote chance that your area may flood, having flood insurance, which reimburses rebuilding your home and replacing its contents in the event of a flood, is wise. 

401(k) plan: A type of retirement savings plan offered by many for-profit companies to their employees.  Your contributions compound without taxation over time and are usually exempt (yes!)  from federal and state income taxes until withdrawal. 

403(b) plan: Similar to a 401(k) plan but for employees of nonprofit organizations. 

full-service broker: A broker who gives advice and charges a high commission relative to discount brokers.  Because the brokers work on commission, they have a significant conflict of interest: namely, to advocate strategies that will benefit them financially. 

futures: An obligation to buy or sell a commodity or security on a specific day for a preset price.  When used by most individual investors, futures represent a short-term gamble on the short-term direction of the price of a commodity.  Companies and farmers use futures contracts to hedge their risks of changing prices. 

guaranteed-investment contracts (GICs): Insurance company investments that appeal to skittish investors.  GICs generally tell you one year in advance what your interest rate will be for the coming year.  Thus, you don't have to worry about fluctuations and losses in your investment value.  On the other hand, GICs offer you little upside, because the interest rate is comparable to what you may get on a short-term bank certificate of deposit. 

home equity: See equity. 

home equity loan: Technical jargon for what used to be called a second mortgage.  With this type of loan, you borrow against the equity in your house.  If used wisely, a home equity loan can help pay off high-interest consumer debt or be tapped for other short-term needs (such as a remodeling project).  In contrast with consumer debt, mortgage debt usually has a lower interest rate and is tax-deductible. 

homeowner's insurance: Dwelling coverage that covers the cost of rebuilding your house in the event of fire or other calamity.  The liability insurance portion of this policy protects you against lawsuits associated with your property.  Another essential element of homeowner's insurance is the personal property coverage, which pays to replace your damaged or stolen worldly possessions. 

index: 1) A security market index, such as the Standard & Poor's 500 Index, is a statistical composite that tracks the price level and performance of a basket of many securities, typically within a specific investment asset class.  Indexes exist for various stock and bond markets and are typically set at a round number, such as 100, at a particular point in time.  See also Dow Jones Industrial Average and Russell 2000.  2) The index can also refer to the measure of the overall level of interest rates that a lender uses as a reference to calculate the specific interest rate on an adjustable-rate loan.  The index plus the margin is the formula for determining the interest rate on an adjustable-rate mortgage. 

Individual Retirement Account (IRA): A retirement account into which anyone with sufficient employment income or alimony may contribute up to $5,000 per year ($6,000 if age 50 or older).  Based on your eligibility for other employer-based retirement programs and which type of IRA you select (regular or Roth), your contributions may be tax-deductible. 

inflation: The technical term for a general rise in prices in the economy.  Inflation usually occurs when too much money is in circulation and not enough goods and services are available to spend it on.  As a result of this excess money, prices rise.  A link is present between inflation and interest rates: If interest rates don't keep up with inflation, no one will invest in bonds issued by the government or corporations.  When the interest rates on bonds are high, it usually reflects a high rate of expected inflation that will eat away at your return. 

initial public offering (IPO): The first time a company offers stock to the investing public.  An IPO typically occurs when a company wants to expand more rapidly and seeks additional money to support its growth.  A number of studies have demonstrated that buying into IPOs in which the general public can participate produces subpar investment returns.  A high level of IPO activity may indicate a cresting stock market, as companies and their investment bankers rush to cash in on a "pricey" marketplace. ( IPO could stand for It's Probably Overpriced.) 

interest rate: The rate lenders charge you to use their money.  The higher the interest rate, the higher the risk entailed in the loan.  With bonds of a given maturity, a higher rate of interest means a lower quality of bond — one that's less likely to return your money. 

international stock markets: Stock markets outside of the United States account for a significant portion of the world stock market capitalization (value).  Some specific stock indices track international markets (see Morgan Stanley EAFE index and Emerging Markets Index).  International investing offers one way for you to diversify your portfolio and reduce your risk.  Some of the foreign countries with major stock exchanges outside the United States include Japan, Britain, France, Germany, and Canada. 

junk bond: A bond rated Ba (Moody's) or BB (Standard & Poor's) or lower.  Historically, these bonds have had a 1 to 2 percent chance of default, which is not exactly "junky."  Of course, the higher risk is accompanied by a higher interest rate. 

Keogh plan: A tax-deductible retirement savings plan available to self-employed individuals.  Certain Keoghs allow you to put up to 25 percent of your net self-employment income into the account. 

leverage: Financial leverage affords its users a disproportionate amount of financial power relative to the amount of their own cash invested.  In some circumstances, you can borrow up to 50 percent of a stock price and use all funds (both yours and those that you borrow) to make a purchase.  You repay this so-called margin loan when you sell the stock.  If the stock price rises, you make money on what you invested plus what you borrowed.  Although this money sounds attractive, remember that leverage cuts both ways — when prices decline, you lose money not only on your investment but also on the money you borrowed. 

limited partnership (LP): A private partnership, which is designed to limit the legal liability of the investors who participate, is often promoted in a way that promises high returns, but it generally limits one thing: your investment return.  Why?  Because it's burdened with high commissions and management fees.  Another problem is that it's typically not liquid for many years. 

load mutual fund: A mutual fund that includes a sales load, which is the commission paid to brokers who sell commission-based mutual funds.  The commission typically ranges from 4 to 8.5 percent.  This commission is deducted from your investment money, so it reduces your returns. 

marginal tax rate: The rate of income tax you pay on the last dollars you earn over the course of a year.  Why the complicated distinction?  Because not all income is treated equally: You pay less tax on your first dollars of your annual earnings and more tax on the last dollars of your annual income.  Knowing your marginal tax rate is helpful because it can help you analyze the tax implications of important personal financial decisions. 

market capitalization: The value of all the outstanding stock of a company.  Market capitalization is the quoted price per share of a stock multiplied by the number of shares outstanding.  Thus, if Rocky and Bullwinkle Corporation has 100 million shares of outstanding stock and the quoted price per share is $20, the company has a market capitalization of $2 billion (100 million × $20). 

Moody's ratings: Moody's rating service measures and rates the credit (default) risks of various bonds.  Moody's investigates the financial condition of a bond issuer.  Its ratings use the following grading system, which is expressed from highest to lowest: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. Higher ratings imply a lower risk but also mean that the interest rate will be lower. 

Morgan Stanley EAFE (Europe, Australia, Far East) index: The Morgan Stanley EAFE index tracks the performance of the more established countries' stock markets in Europe and Asia.  This index is important for international-minded investors who want to follow the performance of overseas stock investments. 

mortgage-backed bond (GNMAs and FNMAs): The Government National Mortgage Association (GNMA, or Ginnie Mae) specializes in mortgage-backed securities.  It passes the interest and principal payments of borrowers to investors.  When a homeowner makes a mortgage payment, GNMA deducts a small service charge and forwards the mortgage payments to its investors.  The payments are guaranteed in case a borrower fails to pay his mortgage.  The Federal National Mortgage Association (FNMA or Fannie Mae) is a publicly owned, government-sponsored corporation that purchases mortgages from lenders and resells them to investors.  FNMA mainly deals with mortgages backed by the Federal Housing Administration. 

mortgage broker: Mortgage brokers buy mortgages wholesale from lenders and then mark the mortgages up (typically from 0.5 to 1 percent) and sell them to borrowers.  A good mortgage broker is most helpful for people who don't want to shop around on their own for a mortgage or people who have blemishes on their credit reports. 

mortgage life insurance: Mortgage life insurance guarantees that the lender will receive its money in the event that you meet an untimely demise.  Many people may try to convince you that you need this insurance to protect your dependents and loved ones.  Mortgage life insurance is relatively expensive given the cost of the coverage provided.  If you need life insurance, buy low-cost, high-quality term life insurance instead. 

municipal bond: A loan for public projects, such as highways, parks, or cultural centers, that an investor makes to cities, towns, and states.  The tax-exempt status of their interest is what makes municipal bonds special: They're exempt from federal taxes and, if you reside in the state where the bond is issued, state taxes.  Because of that tax exclusion, municipal bonds are generally issued with interest rates that are lower than taxable corporate bonds of comparable credit quality.  Municipal bonds are most appropriate for people in high tax brackets who invest money outside of tax-sheltered retirement accounts. 

mutual fund: A portfolio of stocks, bonds, or other securities that is owned by numerous investors and managed by an investment company.  See also no-load mutual fund. 

National Association of Securities Dealers Automated Quotation (NASDAQ) system: An electronic network that allows brokers to trade from their offices all over the country.  With NASDAQ, brokers buy and sell shares using constantly updated prices that appear on their computer screens. 

negative amortization: Negative amortization occurs when your outstanding mortgage balance increases despite the fact that you're making the required monthly payments.  Negative amortization occurs with adjustable-rate mortgages that cap the increase in your monthly payment but do not cap the interest rate.  Therefore, your monthly payments don't cover all the interest that you actually owe.  Avoid loans with this "feature." 

net asset value (NAV): The dollar value of one share of a mutual fund.  For a no-load fund, the market price is its NAV.  For a load fund, the NAV is the "buy" price minus the commission. 

New York Stock Exchange (NYSE): The largest stock exchange in the world in terms of total volume and value of shares traded.  It lists companies that tend to be among the oldest, largest, and best-known companies. 

no-load mutual fund: A mutual fund that doesn't come with a commission payment attached to it.  Some funds claim to be no-load but simply hide their sales commissions as an ongoing sales charge; you can avoid these funds by educating yourself and reading the prospectuses carefully. 

open-end mutual fund: A mutual fund that issues as many shares as investors demand.  These open-end funds do not generally limit the number of investors or amount of money in the fund.  Some open-end funds have been known to close to new investors, but investors with existing shares can often still buy more shares from the company. 

option: The right to buy or sell a specific security (such as a stock) for a preset price during a specified period of time.  Options differ from futures in that with an option, you pay a premium fee upfront and you can either exercise the option or let it expire.  If the option expires worthless, you lose 100 percent of your original investment.  The use of options is best left to companies as hedging tools.  Investment managers may use options to reduce the risk in their investment portfolio.  As with futures, when most individual investors buy an option, they're doing so as a short-term gamble, not as an investment. 

pension: Pensions (also known as defined-benefit plans) are a benefit offered by some employers.  These plans generally pay you a monthly retirement income based on your years of service and former pay with the employer. 

performance: You traditionally judge an investment's performance by looking at the historic rate of return.  The longer the period over which these numbers are tallied, the more useful they are.  Considered alone, these numbers are practically meaningless.  You must also note how well a fund has performed in comparison to competitors with the same investment objectives.  Beware of advertisements that tout the high returns of a mutual fund, because they may not be looking at risk-adjusted performance, or they may be promoting performance over a short time period.  Keep in mind that high return statistics are usually coupled with high risk and that this year's star may turn out to be next year's crashing meteor. 

precertification: A condition for health insurance benefit coverage that requires a patient to get approval before being admitted to a hospital for nonemergency care. 

preferred stock: Preferred stock dividends must be paid before any dividends are paid to the common stock shareholders.  Although preferred stock reduces your risk as an investor (because of the more secure dividend and greater likelihood of getting your money back if the company fails), it also often limits your reward if the company expands and increases its profits. 

price/earnings (P/E) ratio: The current price of a stock divided by the current (or sometimes the projected) earnings per share of the issuing company.  This ratio is a widely used stock analysis statistic that helps an investor get an idea of how cheap or expensive a stock price is.  In general, a relatively high P/E ratio indicates that investors feel that the company's earnings are likely to grow quickly. 

prime rate: The rate of interest that major banks charge their most creditworthy corporate customers.  Why should you care?  Well, because the interest rates on various loans you may be interested in are often based on the prime rate.  And, guess what — you pay a higher interest rate than those big corporations! 

principal: No, I'm not talking about the big boss from elementary school who struck fear into the hearts of most 8-year-olds.  The principal is the amount you borrow for a loan.  If you borrow $100,000, your principal is $100,000.  Principal can also refer to the amount you originally placed in an investment. 

prospectus: Individual companies and mutual funds are required by the Securities and Exchange Commission to issue a prospectus.  For a company, the prospectus is a legal document presenting a detailed analysis of that company's financial history, its products and services, its management's background and experience, and the risks of investing in the company.  A mutual fund prospectus tells you about the fund's investment objectives, costs, risk, and performance history. 

real estate investment trust (REIT): Real estate investment trusts are like a mutual fund of real estate investments.  Such trusts invest in a collection of properties (from shopping centers to apartment buildings).  REITs trade on the major stock exchanges.  If you want to invest in real estate while avoiding the hassles inherent in owning property, real estate investment trusts may be the right choice for you. 

refinance: Refinance, or refi, is a fancy word for taking out a new mortgage loan (usually at a lower interest rate) to pay off an existing mortgage (generally at a higher interest rate).  Refinancing is not automatic, nor is it guaranteed.  Refinancing can also be a hassle and expensive.  Weigh the costs and benefits of refinancing carefully before proceeding. 

return on investment: The percentage of profit you make on an investment.  If you put $1,000 into an investment and then one year later it's worth $1,100, you make a profit of $100.  Your return on investment is the profit ($100) divided by the initial investment ($1,000) — in this case, 10 percent. 

reverse mortgage: A reverse mortgage enables elderly homeowners, typically those who are low on cash, to tap into their home's equity without selling their home or moving from it.  Specifically, a lending institution makes a check out to you each month, and you can use the check as you want.  This money is really a loan against the value of your home, so it's tax-free when you receive it.  The downside of these loans is that they deplete your equity in your estate, the fees and interest rates tend to be on the high side, and some require repayment within a certain number of years. 

Russell 2000: An index that tracks the returns of 2,000 small-company U.S. stocks.  Small-company stocks tend to be more volatile than large-company stocks.  If you invest in small-company stocks or stock funds, this index is an appropriate benchmark to compare your stock's performance to. 

Securities and Exchange Commission (SEC): The federal agency that administers U.S. securities laws and regulates and monitors investment companies, brokers, and financial advisors. 

simplified employee pension individual retirement account (SEP-IRA): Like other retirement plans, a SEP-IRA allows your money to compound over the years without the parasitic effect of taxes.  SEP-IRAs are relatively easy to set up, and they allow self-employed people to make annual contributions on a pretax basis. 

Social Security: If you're retired or disabled, Social Security is a government safety net that can provide you with some income.  The program is based on the idea that government is responsible for the social welfare of its citizens.  Whether you agree with this notion or not, part of your paycheck goes to Social Security, and when you retire, you receive money from the program. 

Standard & Poor's 500 Index: An index that measures the performance of 500 large-company U.S. stocks that account for about 80 percent of the total market value of all stocks traded in the United States.  If you invest in larger-company stocks or stock funds, the S&P 500 Index is an appropriate benchmark to compare the performance of your investments to. 

Standard & Poor's (S&P) ratings: Standard & Poor's rating service is one of two services that measure and rate the risks in buying a bond.  The S&P ratings use the following grading system, listed from highest to lowest: AAA, AA, A, BBB, BB, B, CCC, CC, C. See also Moody's ratings. 

stock: Shares of ownership in a company.  When a company goes public, it issues shares of stock to the public (see also initial public offering).  Many, but not all, stocks pay dividends — a distribution of a portion of the company's profits.  In addition to dividends, you make money investing in stock via appreciation in the price of the stock, which normally results from growth in revenues and corporate profits.  You can invest in stock by purchasing individual shares or by investing in a stock mutual fund that offers a diversified package of stocks. 

term life insurance: If people are dependent on your income for their living expenses, you may need this insurance.  Term life insurance functions simply: You determine how much protection you would like and then pay an annual premium based on that amount.  Although much less touted by insurance salespeople than cash value insurance, it's the best life insurance out there for the vast majority of people. 

Treasury bill: IOUs from the federal government that mature within a year.  The other types of loans that investors can make to the federal government are Treasury notes, which mature within one to ten years, and Treasury bonds, which mature in more than ten years.  The interest that these federal government bonds pay is free of state taxes, but it's federally taxable. 

underwriting: The process an insurance company uses to evaluate a person's likelihood of filing a claim on a particular type of insurance policy.  If significant problems are discovered, an insurer will often propose much higher rates or refuse to sell the insurance coverage. 

will: A legal document that ensures that your wishes regarding your assets and the care of your minor children are heeded when you die. 

zero-coupon bond: A bond that doesn't pay explicit interest during the term of the loan.  Zero-coupon bonds are purchased at a discounted price relative to the principal value paid at maturity.  Thus, the interest is implicit in the discount.  These bonds do not offer a tax break, because the investor must pay taxes on the implicit interest that is paid when the bond matures. 

To access the cheat sheet specifically for this book, go to www.dummies.com/cheatsheet/personalfinance. 

Find out "HOW" at Dummies.com

20 Rules for Successful Investing

  Saving is a prerequisite to investing.  Unless you have wealthy, benevolent relatives, living within your means and saving money are prerequisites to investing and building wealth. 

  Know the three best wealth-building investments.  People of all economic means make their money grow in ownership assets — stocks, real estate, and small business — where you share in the success and profitability of the asset. 

  Be realistic about expected returns.  Over the long term, 9 to 10 percent per year is about right for ownership investments (such as stocks and real estate).  If you run a small business, you can earn higher returns and even become a multimillionaire, but years of hard work and insight are required. 

  Think long term.  Because ownership investments are riskier (more volatile), you must keep a long-term perspective when investing in them.  Don't invest money in such investments unless you plan to hold them for a minimum of five years, and preferably a decade or longer. 

  Match the time frame to the investment.  Selecting good investments for yourself involves matching the time frame you have to the riskiness of the investment.  For example, for money that you expect to use within the next year, focus on safe investments, such as money market funds.  Invest your longer-term money mostly in wealth-building investments. 

  Diversify.  Diversification is a powerful investment concept that helps you to reduce the risk of holding more aggressive investments.  Diversifying simply means that you should hold a variety of investments that don't move in tandem in different market environments.  For example, if you invest in stocks, invest worldwide, not just in the U.S. market.  You can further diversify by investing in real estate. 

  Look at the big picture first.  Understand your overall financial situation and how wise investments fit within it.  Before you invest, examine your debt obligations, tax situation, ability to fund retirement accounts, and insurance coverage. 

  Ignore the minutiae.  Don't feel mystified by or feel the need to follow the short-term gyrations of the financial markets.  Ultimately, the prices of stocks, bonds, and other financial instruments are determined by supply and demand, which are influenced by thousands of external issues and millions of investors' expectations and fears. 

  Allocate your assets.  How you divvy up or allocate your money among major investments greatly determines your returns.  The younger you are and the more money you earmark for the long term, the greater the percentage you should devote to ownership investments. 

  Do your homework before you invest.  You work hard for your money, and buying and selling investments costs you money.  Investing isn't a field where acting first and asking questions later works well.  Never buy an investment based on an advertisement or a salesperson's solicitation of you. 

  Keep an eye on taxes.  Take advantage of tax-deductible retirement accounts and understand the impact of your tax bracket when investing outside tax-sheltered retirement accounts. 

  Consider the value of your time and your investing skills and desires.  Investing in stocks and other securities via the best mutual funds and exchange-traded funds is both time-efficient and profitable.  Real estate investing and running a small business are the most time-intensive investments. 

  Where possible, minimize fees.  The more you pay in commissions and management fees on your investments, the greater the drag on your returns.  And don't fall prey to the thinking that "you get what you pay for." 

  Don't expect to beat the market.  If you have the right skills and interest, your ability to do better than the investing averages is greater with real estate and small business than with stock market investing.  The large number of full-time, experienced stock market professionals makes it next to impossible for you to choose individual stocks that will consistently beat a relevant market average over an extended time period. 

  Don't bail when things look bleak.  The hardest time, psychologically, to hold on to your investments is when they're down.  Even the best investments go through depressed periods, which is the worst possible time to sell.  Don't sell when there's a sale going on; if anything, consider buying more. 

  Ignore soothsayers and prognosticators.  Predicting the future is nearly impossible.  Select and hold good investments for the long term.  Don't try to time when to be in or out of a particular investment. 

  Minimize your trading.  The more you trade, the more likely you are to make mistakes.  You also get hit with increased transaction costs and higher taxes (for non-retirement account investments). 

  Hire advisors carefully.  Before you hire investing help, first educate yourself so you can better evaluate the competence of those you may hire.  Beware of conflicts of interest when you consider advisors to hire. 

  You are what you read and listen to.  Don't pollute your mind with bad investing strategies and philosophies.  The quality of what you read and listen to is far more important than the quantity.  Find out how to evaluate the quality of what you read and hear. 

  Your personal life and health are the highest-return, lowest-risk investments.  They're far more important than the size of your financial portfolio. 

Copyright © 2011 Eric Tyson

Praise for Eric Tyson's Bestselling For Dummies Titles

"Eric Tyson For President!!!  Thanks for such a wonderful guide.  With a clear, no-nonsense approach to . . .  investing for the long haul, Tyson's book says it all without being the least bit long-winded.  Pick up a copy today.  It'll be your wisest investment ever!!!" 

— Jim Beggs, VA

"Eric Tyson is doing something important — namely, helping people at all income levels to take control of their financial futures.  This book is a natural outgrowth of Tyson's vision that he has nurtured for years.  Like Henry Ford, he wants to make something that was previously accessible only to the wealthy accessible to middle-income Americans." 

— James C. Collins, coauthor of the national bestsellers Built to Last and Good to Great

"The organization of this book is superb!  I could go right to the topics of immediate interest and find clearly written and informative material." 

— Lorraine Verboort, Beaverton, OR

"Among my favorite financial guides are . . .  Eric Tyson's Personal Finance For Dummies." 

— Jonathan Clements, The Wall Street Journal

"In Investing For Dummies, Tyson handily dispatches both the basics . . .  and the more complicated." 

— Lisa M. Sodders, The Capital-Journal

"Smart advice for dummies . . .  skip the tomes . . .  and buy Personal Finance For Dummies, which rewards your candor with advice and comfort." 

— Temma Ehrenfeld, Newsweek

"You don't have to be a novice to like Mutual Funds For Dummies.  Despite the book's chatty, informal style, author Eric Tyson clearly has a mastery of his subject.  He knows mutual funds, and he knows how to explain them in simple English." 

— Steven T. Goldberg, Kiplinger's Personal Finance Magazine

"Eric Tyson . . .  seems the perfect writer for a . . .  For Dummies book.  He doesn't tell you what to do or consider doing without explaining the why's and how's — and the booby traps to avoid — in plain English. . . .  It will lead you through the thickets of your own finances as painlessly as I can imagine." 

— Clarence Peterson, Chicago Tribune

"Personal Finance For Dummies is the perfect book for people who feel guilty about inadequately managing their money but are intimidated by all of the publications out there.  It's a painless way to learn how to take control." 

— Karen Tofte, producer, National Public Radio's Sound Money

More Bestselling For Dummies Titles by Eric Tyson

Personal Finance For Dummies®

Discover the best ways to establish and achieve your financial goals, reduce your spending and taxes, and make wise personal finance decisions.  Wall Street Journal bestseller with more than 1.5 million copies sold in all editions and winner of the Benjamin Franklin best business book award.  Also check out Personal Finance in Your 20s For Dummies and Personal Finance For Seniors For Dummies. 

Mutual Funds For Dummies®

This best-selling guide is now updated to include current fund and portfolio recommendations.  Using the practical tips and techniques, you'll design a mutual fund investment plan suited for your income, lifestyle, and risk preferences. 

Home Buying For Dummies®

America's #1 real estate book includes coverage of online resources in addition to sound financial advice from Eric Tyson and frontline real estate insights from industry veteran Ray Brown.  Also available from America's best-selling real estate team of Tyson and Brown — House Selling For Dummies and Mortgages For Dummies. 

Real Estate Investing For Dummies®

Real estate is a proven wealth-building investment, but many people don't know how to go about making and managing rental property investments.  Real estate and property management expert Robert Griswold and Eric Tyson cover the gamut of property investment options, strategies, and techniques. 

Small Business For Dummies®

Take control of your future and make the leap from employee to entrepreneur with this enterprising guide.  From drafting a business plan to managing costs, you'll profit from expert advice and real-world examples that cover every aspect of building your own business. 

Investing For Dummies®, 6th Edition

by Eric Tyson, MBA

Financial counselor, syndicated columnist, and author of six national bestsellers, including Personal Finance For Dummies®, Real Estate Investing For Dummies®, and Mutual Funds For Dummies®

Investing For Dummies®, 6th Edition

Published by  
John Wiley & Sons, Inc.  
111 River St.  
Hoboken, NJ 07030-5774  
www.wiley.com

Copyright © 2011 by Eric Tyson

Published by John Wiley & Sons, Inc., Hoboken, NJ

Published simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher.  Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at <http://www.wiley.com/go/permissions>. 

Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!,  The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com, Making Everything Easier, and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission.  All other trademarks are the property of their respective owners.  John Wiley & Sons, Inc., is not associated with any product or vendor mentioned in this book. 

LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE.  NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS.  THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION.  THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES.  IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT.  NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM.  THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FURTHER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE.  FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. 

For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

For technical support, please visit www.wiley.com/techsupport. 

Wiley also publishes its books in a variety of electronic formats and by print-on-demand.  Some content that appears in standard print versions of this book may not be available in other formats.  For more information about Wiley products, visit us at www.wiley.com. 

Library of Congress Control Number: 2011934636

ISBN 978-0-470-90545-6 (pbk); ISBN 978-1-118-11483-4 (ebk); ISBN 978-1-118-11484-1 (ebk); ISBN 978-1-118-11485-8 (ebk)

Manufactured in the United States of America

10 9 8 7 6 5 4 3 2 1

About the Author

Eric Tyson is an internationally acclaimed and best-selling personal finance author, lecturer, and advisor.  Through his work, he is dedicated to teaching people to manage their money better and to successfully direct their own investments. 

Eric is a former management consultant to businesses for which he helped improve operations and profitability.  Before, during, and after this time of working crazy hours and traveling too much, he had the good sense to focus on financial matters. 

He has been involved in the investing markets in many capacities for more than three decades.  Eric first invested in mutual funds back in the mid-1970s, when he opened a mutual fund account at Fidelity.  With the assistance of Dr. Martin Zweig, a now-famous investment market analyst, Eric won his high school's science fair in 1976 for a project on what influences the stock market.  In addition to investing in securities over the decades, Eric has also successfully invested in real estate and started and managed his own business.  He has counseled thousands of clients on a variety of investment quandaries and questions. 

He earned a bachelor's degree in economics at Yale and an MBA at the Stanford Graduate School of Business.  Despite these impediments to lucid reasoning, he came to his senses and decided that life was too short to spend it working long hours and waiting in airports for the benefit of larger companies. 

An accomplished freelance personal finance writer, Eric is the author of numerous best-selling books including For Dummies books on personal finance, mutual funds, taxes (coauthor), and home buying (coauthor) and is a syndicated columnist.  His work has been featured and quoted in hundreds of national and local publications, including Kiplinger's Personal Finance Magazine, Los Angeles Times, Chicago Tribune, The Wall Street Journal, and Bottom Line/Personal, and on NBC's Today Show, ABC, CNBC, PBS's Nightly Business Report, FOX, CNN, CBS national radio, Bloomberg Business Radio, National Public Radio, and Business Radio Network.  He's also been a featured speaker at a White House conference on retirement planning. 

To stay in tune with what real people care about and struggle with, Eric still maintains a financial counseling practice. 

You can visit him on the web at www.erictyson.com. 

Dedication

Actually, before I get to the thank-yous, please allow me a really major thank-you and dedication. 

This book is hereby and irrevocably dedicated to my family and friends, as well as to my counseling clients and customers, who ultimately have taught me everything I know about how to explain financial terms and strategies so that all of us may benefit. 

Author's Acknowledgments

First, I'd like to thank Chrissy Guthrie.  Thanks also to Jessica Smith for all of her fine editing and to all of the fine folks in Composition and Graphics for making this book and all of my charts and graphs look great!  Thanks also to everyone else who contributed to getting this book done well and on time. 

And last but not least, a tip of my cap to the fine technical reviewer who helped to ensure that I didn't write something that wasn't quite right.  For the sixth edition, this important job was well handled by Gary Karz. 

Publisher's Acknowledgments

We're proud of this book; please send us your comments at <http://dummies.custhelp.com>.  For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and Vertical Websites

Senior Project Editor: Christina Guthrie  
(Previous Edition: Georgette Beatty)

Acquisitions Editor: Erin Calligan Mooney

Copy Editor: Jessica Smith  
(Previous Edition: Victoria M. Adang)

Assistant Editor: David Lutton

Editorial Program Coordinator: Joe Niesen

Technical Editor: Gary Karz

Editorial Manager: Christine Meloy Beck

Editorial Assistant: Rachelle Amick

Cover Photos: © iStockphoto.com/3DStock

Cartoons: Rich Tennant (www.the5thwave.com)

Composition Services

Project Coordinator: Sheree Montgomery

Layout and Graphics: Carrie Cesavice, Joyce Haughey, S. D. Jumper

Proofreader: Laura Bowman

Indexer: Steve Rath

Special Help: Chad Sievers, Christine Pingleton, Amanda Langferman

Publishing and Editorial for Consumer Dummies

Kathleen Nebenhaus, Vice President and Executive Publisher

Kristin Ferguson-Wagstaffe, Product Development Director, Consumer Dummies

Ensley Eikenburg, Associate Publisher, Travel

Kelly Regan, Editorial Director, Travel

Publishing for Technology Dummies

Andy Cummings, Vice President and Publisher, Dummies Technology/General User

Composition Services

Debbie Stailey, Director of Composition Services

# Investing For Dummies®, 6th Edition

Visit www.dummies.com/cheatsheet/investing to view this book's cheat sheet. 

**Table of Contents**

Introduction

> How Savvy Investors Build Wealth
> 
> Conventions Used in This Book
> 
> Foolish Assumptions
> 
> How This Book Is Organized
>
>> Part I: Investing Fundamentals
>> 
>> Part II: Stocks, Bonds, and Wall Street
>> 
>> Part III: Growing Wealth with Real Estate
>> 
>> Part IV: Savoring Small Business
>> 
>> Part V: Investing Resources
>> 
>> Part VI: The Part of Tens
> 
> Icons Used in This Book
> 
> Where to Go from Here

Part I: Investing Fundamentals

> Chapter 1: Exploring Your Investment Choices
>
>> Getting Started with Investing
>> 
>> Building Wealth with Ownership Investments
>>
>>> Entering the stock market
>>> 
>>> Owning real estate
>>> 
>>> Running a small business
>> 
>> Generating Income from Lending Investments
>> 
>> Considering Cash Equivalents
>> 
>> Steering Clear of Futures and Options
>> 
>> Passing Up Precious Metals
>> 
>> Counting Out Collectibles
> 
> Chapter 2: Weighing Risks and Returns
>
>> Evaluating Risks
>>
>>> Market-value risk
>>> 
>>> Individual-investment risk
>>> 
>>> Purchasing-power risk
>>> 
>>> Career risk
>> 
>> Analyzing Returns
>>
>>> The components of total return
>>> 
>>> Savings and money market account returns
>>> 
>>> Bond returns
>>> 
>>> Stock returns
>>> 
>>> Real estate returns
>>> 
>>> Small-business returns
>> 
>> Considering Your Goals
> 
> Chapter 3: Getting Your Financial House in Order before You Invest
>
>> Establishing an Emergency Reserve
>> 
>> Evaluating Your Debts
>>
>>> Conquering consumer debt
>>> 
>>> Mitigating your mortgage
>> 
>> Establishing Your Financial Goals
>>
>>> Tracking your savings rate
>>> 
>>> Determining your investment tastes
>> 
>> Funding Your Retirement Accounts
>>
>>> Gaining tax benefits
>>> 
>>> Starting your savings sooner
>>> 
>>> Checking out retirement account options
>>> 
>>> Choosing retirement account investments
>> 
>> Taming Your Taxes in Non-Retirement Accounts
>>
>>> Figuring your tax bracket
>>> 
>>> Knowing what's taxed and when to worry
>> 
>> Choosing the Right Investment Mix
>>
>>> Considering your age
>>> 
>>> Making the most of your investment options
>>> 
>>> Easing into risk: Dollar cost averaging
>> 
>> Treading Carefully When Investing for College
>>
>>> Education Savings Accounts
>>> 
>>> Section 529 plans
>>> 
>>> Allocating college investments
>> 
>> Protecting Your Assets

Part II: Stocks, Bonds, and Wall Street

> Chapter 4: The Workings of Stock and Bond Markets
>
>> How Companies Raise Money through the Financial Markets
>>
>>> Deciding whether to issue stocks or bonds
>>> 
>>> Taking a company public: Understanding IPOs
>> 
>> Understanding Financial Markets and Economics
>>
>>> Driving stock prices through earnings
>>> 
>>> Weighing whether markets are efficient
>>> 
>>> Moving the market: Interest rates, inflation, and the Federal Reserve
> 
> Chapter 5: Building Wealth with Stocks
>
>> Taking Stock of How You Make Money
>> 
>> Defining "The Market"
>>
>>> Looking at major stock market indexes
>>> 
>>> Counting reasons to use indexes
>> 
>> Stock-Buying Methods
>>
>>> Buying stocks via mutual funds
>>> 
>>> Using exchange-traded funds and hedge funds
>>> 
>>> Selecting individual stocks yourself
>> 
>> Spotting the Best Times to Buy and Sell
>>
>>> Calculating price-earnings ratios
>>> 
>>> Citing times of speculative excess
>>> 
>>> Buying more when stocks are "on sale"
>> 
>> Avoiding Problematic Stock-Buying Practices
>>
>>> Beware of broker conflicts of interest
>>> 
>>> Don't short-term trade or try to time the market
>>> 
>>> Be wary of gurus
>>> 
>>> Shun penny stocks
>> 
>> The Keys to Stock Market Success
> 
> Chapter 6: Investigating and Purchasing Individual Stocks
>
>> Building on Others' Research
>>
>>> Discovering the Value Line Investment Survey
>>> 
>>> Considering independent brokerage research
>>> 
>>> Examining successful money managers' stock picks
>>> 
>>> Reviewing financial publications and websites
>> 
>> Understanding Annual Reports
>>
>>> Financial and business highlights
>>> 
>>> Balance sheet
>>> 
>>> Income statement
>> 
>> Exploring Other Useful Corporate Reports
>>
>>> 10-Ks
>>> 
>>> 10-Qs
>>> 
>>> Proxies
>> 
>> Getting Ready to Invest in Stocks
>>
>>> Understanding stock prices
>>> 
>>> Purchasing stock "direct" from companies
>>> 
>>> Placing your trade through a broker
> 
> Chapter 7: Exploring Bonds and Other Lending Investments
>
>> Banks: Considering the Cost of Feeling Secure
>>
>>> Facing the realities of bank insurance
>>> 
>>> Being wary of the certificate of deposit (CD)
>>> 
>>> Swapping your savings account for a money market fund
>> 
>> Why Bother with Bonds? 
>> 
>> Assessing the Different Types of Bonds
>>
>>> Determining when you get your money back: Maturity matters
>>> 
>>> Weighing the likelihood of default
>>> 
>>> Examining the issuers (and tax implications)
>> 
>> Buying Bonds
>>
>>> Deciding between individual bonds and bond mutual funds
>>> 
>>> Understanding bond prices
>>> 
>>> Purchasing Treasuries
>>> 
>>> Shopping for other individual bonds
>> 
>> Considering Other Lending Investments
>>
>>> Guaranteed-investment contracts
>>> 
>>> Private mortgages
> 
> Chapter 8: Mastering Mutual Funds
>
>> Discovering the Benefits of the Best Funds
>>
>>> Professional management
>>> 
>>> Cost efficiency
>>> 
>>> Diversification
>>> 
>>> Reasonable investment minimums
>>> 
>>> Different funds for different folks
>>> 
>>> High financial safety
>>> 
>>> Accessibility
>> 
>> Reviewing the Keys to Successful Fund Investing
>>
>>> Minimize costs
>>> 
>>> Reflect on performance and risk
>>> 
>>> Stick with experience
>>> 
>>> Consider index funds
>>> 
>>> Keep exchange-traded funds on your radar
>>> 
>>> Steer clear of leveraged and inverse exchange-traded funds
>> 
>> Creating Your Fund Portfolio with Asset Allocation
>>
>>> Allocating for the long term
>>> 
>>> Diversifying your stock fund investments
>> 
>> The Best Stock Mutual Funds
>>
>>> Making money with stock funds
>>> 
>>> Exploring different types of stock funds
>> 
>> The Best Bond Funds
>>
>>> Avoiding yield-related missteps
>>> 
>>> Treading carefully with actively managed bond funds
>>> 
>>> Stabilizing your portfolio by investing in short-term bond funds
>>> 
>>> Earning higher returns with intermediate-term bond funds
>>> 
>>> Using long-term bond funds to invest aggressively
>> 
>> The Best Hybrid Funds
>> 
>> The Best Money Market Funds
>>
>>> Taxable money market funds
>>> 
>>> U.S. Treasury money market funds
>>> 
>>> Municipal money market funds
> 
> Chapter 9: Choosing a Brokerage Firm
>
>> Getting Your Money's Worth: Discount Brokers
>>
>>> Ignoring the high-commission salespeople's arguments
>>> 
>>> Selecting a discount broker
>> 
>> Considering Online Brokers
>>
>>> Examining your online trading motives
>>> 
>>> Taking other costs into account
>>> 
>>> Looking at service quality
>>> 
>>> Listing the best online brokers

Part III: Growing Wealth with Real Estate

> Chapter 10: Investing in a Home
>
>> Considering How Home Ownership Can Help You Achieve Your Financial Goals
>> 
>> The Buying Decision
>>
>>> Weighing the pros and cons of ownership
>>> 
>>> Recouping transaction costs
>> 
>> Deciding How Much to Spend
>>
>>> Looking through lenders' eyes
>>> 
>>> Determining your down payment
>> 
>> Selecting Your Property Type
>> 
>> Finding the Right Property and Location
>>
>>> Keeping an open mind
>>> 
>>> Research, research, research
>>> 
>>> Understanding market value
>>> 
>>> Pounding the pavement
> 
> Chapter 11: Investing in Real Estate
>
>> Outlining Real Estate Investment Attractions
>>
>>> Limited land
>>> 
>>> Leverage
>>> 
>>> Appreciation and income
>>> 
>>> Ability to add value
>>> 
>>> Ego gratification
>>> 
>>> Longer-term focus
>> 
>> Figuring Out Who Should Avoid Real Estate Investing
>> 
>> Examining Simple, Profitable Real Estate Investments
>>
>>> Finding a place to call home
>>> 
>>> Trying out real estate investment trusts
>> 
>> Evaluating Direct Property Investments
>>
>>> Residential housing
>>> 
>>> Land
>>> 
>>> Commercial real estate
>> 
>> Deciding Where and What to Buy
>>
>>> Considering economic issues
>>> 
>>> Taking a look at the real estate market
>>> 
>>> Examining property valuation and financial projections
>>> 
>>> Discovering the information you need
>> 
>> Digging for a Good Deal
>> 
>> Recognizing Inferior Real Estate "Investments"
>>
>>> Avoiding ticking time shares
>>> 
>>> Staying away from limited partnerships
>>> 
>>> Ignoring hucksters and scams
> 
> Chapter 12: Real Estate Financing and Deal Making
>
>> Financing Your Real Estate Investments
>>
>>> Getting your loan approved
>>> 
>>> Comparing fixed-rate to adjustable-rate mortgages
>>> 
>>> Choosing between fixed and adjustable mortgages
>>> 
>>> Landing a great fixed-rate mortgage
>>> 
>>> Finding a suitable adjustable-rate mortgage
>>> 
>>> Examining other mortgage fees
>>> 
>>> Finding the best lenders
>>> 
>>> Refinancing for a better deal
>> 
>> Working with Real Estate Agents
>>
>>> Recognizing agent conflicts of interest
>>> 
>>> Picking out a good agent
>> 
>> Closing the Deal
>>
>>> Negotiating 101
>>> 
>>> Inspecting the property
>>> 
>>> Shopping for title insurance and escrow services
>> 
>> Selling Real Estate
>>
>>> Negotiating real estate agents' contracts
>>> 
>>> Forgoing a real estate agent

Part IV: Savoring Small Business

> Chapter 13: Assessing Your Appetite for Small Business
>
>> Testing Your Entrepreneurial IQ
>> 
>> Considering Alternative Routes to Owning a Small Business
>>
>>> Being an entrepreneur inside a company
>>> 
>>> Investing in your career
>> 
>> Exploring Small-Business Investment Options
>>
>>> Starting your own business
>>> 
>>> Buying an existing business
>>> 
>>> Investing in someone else's business
>> 
>> Drawing Up Your Business Plan
>>
>>> Identifying your business concept
>>> 
>>> Outlining your objectives
>>> 
>>> Analyzing the marketplace
>>> 
>>> Delivering your service or product
>>> 
>>> Marketing your service or product
>>> 
>>> Organizing and staffing your business
>>> 
>>> Projecting finances
>>> 
>>> Writing an executive summary
> 
> Chapter 14: Starting and Running a Small Business
>
>> Starting Up: Your Preflight Check List
>>
>>> Preparing to leave your job
>>> 
>>> Valuing and replacing your benefits
>> 
>> Financing Your Business
>>
>>> Going it alone by bootstrapping
>>> 
>>> Taking loans from banks and other outside sources
>>> 
>>> Borrowing from family and friends
>>> 
>>> Courting investors and selling equity
>> 
>> Deciding Whether to Incorporate
>>
>>> Looking for liability protection
>>> 
>>> Taking advantage of tax-deductible insurance and other benefits
>>> 
>>> Cashing in on corporate taxes
>>> 
>>> Making the decision to incorporate
>> 
>> Finding and Keeping Customers
>>
>>> Obtaining a following
>>> 
>>> Providing solid customer service
>> 
>> Setting Up Shop
>>
>>> Finding business space and negotiating a lease
>>> 
>>> Equipping your business space
>> 
>> Accounting for the Money
>>
>>> Maintaining tax records and payments
>>> 
>>> Paying lower taxes (legally)
>> 
>> Keeping a Life and Perspective
> 
> Chapter 15: Purchasing a Small Business
>
>> Examining the Advantages of Buying
>> 
>> Understanding the Drawbacks of Buying
>> 
>> Prerequisites to Buying a Business
>>
>>> Business experience
>>> 
>>> Financial resources
>> 
>> Focusing Your Search for a Business to Buy
>>
>>> Perusing publications
>>> 
>>> Networking with advisors
>>> 
>>> Knocking on some doors
>>> 
>>> Working with business brokers
>> 
>> Considering a Franchise or Multilevel Marketing Company
>>
>>> Finding a franchise
>>> 
>>> Considering a multilevel marketing company
>> 
>> Evaluating a Small Business
>>
>>> Doing due diligence
>>> 
>>> Determining a business's value

Part V: Investing Resources

> Chapter 16: Selecting Investing Resources Wisely
>
>> Dealing with Information Overload
>> 
>> Separating Financial Fact from Fiction
>>
>>> Understanding how advertising corrupts the quality of investment advice
>>> 
>>> Recognizing quality resources
> 
> Chapter 17: Perusing Periodicals, Radio, and Television
>
>> In Print: Magazines and Newspapers
>>
>>> Taking the scribes to task
>>> 
>>> Making the most of periodicals
>> 
>> Broadcasting Hype: Radio and Television Programs
>>
>>> You often get what you pay for
>>> 
>>> Information and hype overload
>>> 
>>> Poor method of guest selection
>> 
>> Fillers and Fluff: Being Wary of Investment Newsletters
> 
> Chapter 18: Selecting the Best Investment Books
>
>> Being Wary of Infomercial Books
>>
>>> Understanding how authors may take advantage of you
>>> 
>>> Learning by example
>> 
>> Ignoring Unaudited Performance Claims
>> 
>> Investing Books Worth Reading
>>
>>> A Random Walk Down Wall Street
>>> 
>>> Stocks for the Long Run
>>> 
>>> Built to Last and Good to Great
>>> 
>>> Mutual Funds For Dummies
> 
> Chapter 19: Investigating Internet and Software Resources
>
>> Evaluating Investment Software
>>
>>> Taking a look at investment tracking software
>>> 
>>> Considering investment research software
>> 
>> Investigating Internet Resources
>>
>>> Assessing online resources
>>> 
>>> Picking the best investment websites

Part VI: The Part of Tens

> Chapter 20: Ten Investing Obstacles to Conquer
>
>> Trusting Authority
>> 
>> Getting Swept Up by Euphoria
>> 
>> Being Overconfident
>> 
>> Giving Up When Things Look Bleak
>> 
>> Refusing to Accept a Loss
>> 
>> Overmonitoring Your Investments
>> 
>> Being Unclear about Your Goals
>> 
>> Ignoring Your Real Financial Problems
>> 
>> Overemphasizing Certain Risks
>> 
>> Believing in Gurus
> 
> Chapter 21: Ten Things to Consider When Weighing an Investment Sale
>
>> Remembering Your Preferences and Goals
>> 
>> Maintaining Balance in Your Portfolio
>> 
>> Deciding Which Investments Are Keepers
>> 
>> Tuning In to the Tax Consequences
>> 
>> Figuring Out What Shares Cost
>> 
>> Selling Investments with Hefty Profits
>> 
>> Cutting Your (Securities) Losses
>> 
>> Dealing with Investments with Unknown Costs
>> 
>> Recognizing Broker Differences
>> 
>> Finding a Trustworthy Financial Advisor
> 
> Chapter 22: Ten Tips for Investing in a Down Market
>
>> Don't Panic
>> 
>> Keep Your Portfolio's Perspective in Mind
>> 
>> View Major Declines as Sales
>> 
>> Identify Your Portfolio's Problems
>> 
>> Avoid Growth Stocks If You Get Queasy Easily
>> 
>> Tune Out Negative, Hyped Media
>> 
>> Ignore Large Point Declines, but Consider the Percentages
>> 
>> Don't Believe You Need a Rich Dad to Be a Successful Investor
>> 
>> Understand the Financial Markets
>> 
>> Talk to People Who Care about You

Cheat Sheet
Introduction

During the financial crisis of 2008, things got scary.  Large Wall Street firms were going under, stock prices were plummeting, and layoffs and unemployment rates were soaring.  And, all this was happening in the midst of the 2008 presidential election.  Talk of another Great Depression was in the air.  In fact, polls showed a majority of Americans feared another depression was actually happening.  Housing prices were dropping sharply in most communities, and more and more properties were ending up in foreclosure. 

Investing didn't seem so fun anymore.  However, despite the fact that the downturn was the worst in decades, it had similarities to prior downturns, and those who kept their perspective and their cash ready were able to invest at attractive prices. 

The best investment vehicles for building wealth — stocks, real estate, and small business — haven't changed.  But, you still need money to play in the investment world.  Like the first edition of Investing For Dummies, the sixth edition of this national best-seller includes complete coverage of these wealth-building investments as well as other common investments, such as bonds.  Here are the biggest changes in this edition:

  Completely revised and updated: I've freshened up the data and examples in this book to provide you the latest insights and analyses.  Confused about how tax law changes should affect your investment strategies?  Wondering about investing in gold and other commodities?  Seeking a way to invest in stocks without exposing yourself to the tremendous risks experienced during the financial crisis of the late 2000s?  Curious about what an exchange-traded fund or hedge fund is and whether you should invest in one?  Wondering how to use leveraged exchange-traded funds to boost your portfolio's return?  Weighing whether to invest in real estate given current market conditions and the severe downturn in the late 2000s?  Wondering what the best ways are to invest globally?  Having trouble making sense of various economic indicators and what they mean to your investment strategy?  Wanting to invest in a Health Savings Account (HSA) but don't know why, where, or how?  You can find the answers to these questions and many more in this edition. 

  Investing resources: With the continued growth in websites, software, publications, media outlets, and many other information sources offering investing advice and information, you're probably overwhelmed about how to choose among the numerous investing research tools and resources.  Equally problematic is knowing who you can trust and listen to — and who you need to ignore.  So many pundits and prognosticators claim excellent track records for their past predictions, but who, really, can you believe?  I explain how to evaluate the quality of current investment tools and resources, and I provide tips for who to listen to and who to tune out. 

How Savvy Investors Build Wealth

I know from working with people of modest and immodest economic means that the time-tested ways they increase their wealth are by doing the following:

  Living within their means and systematically saving and investing money, ideally in a tax-favored manner

  Buying and holding a diversified portfolio of stocks

  Building their own small business or career

  Investing in real estate

This book explains each of these wealth boosters in detail.  Equally, if not more, important, however, is the information I provide to help you understand and choose investments compatible with your personal and financial goals. 

You don't need a fancy college or graduate-school degree, and you don't need a rich dad (or mom), biological or adopted!  What you do need is a desire to read and practice the many simple yet powerful lessons and strategies in this book. 

Seriously, investing intelligently isn't rocket science.  By all means, if you're dealing with a complicated, atypical issue, get quality professional help.  But educate yourself first.  Hiring someone is dangerous if you're financially challenged.  If you do decide to hire someone, you'll be much better prepared if you educate yourself.  Doing so can also help you be more focused in your questions and better able to assess that person's competence. 

Conventions Used in This Book

I use the following conventions in this book to help you maneuver through topics:

  I italicize all new words and terms that are defined. 

  I boldface keywords or the main parts of bulleted items. 

  I use `monofont` for all web addresses. 

  I refer to the decade from 2000 to 2009 as the 2000s.  I just wanted to avoid any confusion in case you were thinking of, say, the year 2025. 

When this book was printed, some web addresses may have needed to break across two lines of text.  If that happened, rest assured that I haven't added any extra characters, such as hyphens, to indicate the break.  So when using one of these addresses, just type in exactly what you see in this book, pretending as though the line break doesn't exist. 

Foolish Assumptions

Every book is written with a certain reader in mind, and this book is no different.  Here are some assumptions I made about you:

  You may have some investments, but you're looking to develop a full-scale investment plan. 

  You'd like to strengthen your portfolio. 

  You want to evaluate your investment advisor's advice. 

  You have a company-sponsored investment plan, like a 401(k), and you're looking to make some decisions or roll it over into a new plan. 

If one or more of these descriptions sound familiar, you've come to the right place. 

How This Book Is Organized

This book helps you fill gaps in your investment knowledge.  It's structured so you can read it cover to cover or simply dive in to particular sections that most interest you.  Here are the major parts. 

Part I: Investing Fundamentals

Before you can confidently and intelligently choose investments, you need to be able to cut through the lingo and jargon to get to the heart of what investments are and aren't, and you also need to know how they differ from one another.  In this part, I explain what rate of return you can reasonably expect to earn and how much risk you need to take to get it.  This part also details how investments best fit your specific financial goals and situation. 

Part II: Stocks, Bonds, and Wall Street

I know you probably don't want to trade in your day job for one where you wear a three-piece suit and know which page of the daily Wall Street Journal shows the yield curves.  But you do need to understand what the financial markets are and how you can participate in them without suffering too many bumps and bruises.  In this part, I explain what stocks and bonds are all about and how to best buy them and build your future fortune. 

Part III: Growing Wealth with Real Estate

Everyone needs places to live, work, and shop, so it makes sense that real estate can be a profitable part of your investment portfolio.  Intelligently buying and managing real estate is harder than it looks, however, which is why this part covers lots of territory.  I show you the best ways to invest in real estate, and I provide a crash course in mortgages, landlording, buying low, selling high, taxes, and more. 

Part IV: Savoring Small Business

There's nothing small about the potential profits you can make from small business.  You can choose the small-business investment option that matches your skills and time.  If you aspire to be the best boss you've ever had, this part shows you the right ways to start your own small business or buy someone else's.  Or maybe you'd like to try your hand at spotting up-and-comers but don't want to be on the front lines.  In this case, you can try investing in someone else's small business. 

Part V: Investing Resources

Flip through your cable television channels, crack open a magazine or newspaper, or go website surfing, and you quickly discover that you can't escape investment advice.  Surprisingly, each new guru you stumble on to contradicts the one who came before him.  Before you know it, although you've spent a ton of your valuable free time on all this investment stuff, you're no closer to making an informed decision.  In fact, if you're like most people, you find yourself even more confused and paralyzed.  Fear not!  In this important part, I explain why many experts really aren't experts and why most of them try to make the world of investing so mysterious.  I highlight the best resources to use and the experts worth listening to. 

Part VI: The Part of Tens

These shorter chapters build your investment knowledge further.  You find advice about topics such as overcoming common psychological investment obstacles, points to ponder when you sell an investment, and tips for investing in a down market. 

Icons Used in This Book

Throughout this book, icons help guide you through the maze of suggestions, solutions, and cautions.  I hope you find that the following images make your journey through investment strategies smoother. 

  In the shark-infested investing waters, you'll find creatures that feast on novice waders, ready to take a bite out of a swimmer's savings.  This icon notes when and where the sharks may be circling. 

  If you see this icon, I'm pointing out companies, products, services, and resources that have proved to be exceptional over the years.  These are resources that I would or do use personally or would recommend to my friends and family. 

  I use this icon to highlight an issue that requires more detective work on your part.  Don't worry, though; I prepare you for your work so you don't have to start out as a novice gumshoe. 

  I think the name says it all, but this icon indicates something really, really important — don't you forget it! 

  Skip it or read it; the choice is yours.  You'll fill your head with more stuff that may prove valuable as you expand your investing know-how, but you risk overdosing on stuff that you may not need right away. 

  This icon denotes strategies that can enable you to build wealth faster and leap over tall obstacles in a single bound. 

  This icon indicates treacherous territory that has made mincemeat out of lesser mortals who have come before you.  Skip this point at your own peril. 

Where to Go from Here

If you have the time and desire, I encourage you to read this book in its entirety.  It provides you with a detailed picture of how to maximize your returns while minimizing your risks through wealth-building investments.  But you don't have to read this book cover to cover.  If you have a specific question or two that you want to focus on today, or you want to find some additional information tomorrow, it's not a problem.  Investing For Dummies, 6th Edition, makes it easy to find answers to specific questions.  Just turn to the table of contents to locate the information you need.  You can get in and get out, just like that. 

If you're the kind of reader who jumps around from topic to topic instead of reading from cover to cover, you'll be pleased to know that this book has a helpful index and that it highlights the pages where investing terms are defined. 
Part I

Investing Fundamentals

In this part . . . 

Like a good map or aerial photograph, this part helps you see the big picture of the investment world.  I explain the different types of investments, and I also tell you which ones are good and bad for a variety of circumstances, what returns you can expect, and how to make wise investing decisions that fit with your overall financial situation. 
Chapter 1

Exploring Your Investment Choices

In This Chapter

  Defining investing

  Seeing how stocks, real estate, and small business build wealth

  Understanding the role of lending and other investments

  Knowing where not to put your money

In many parts of the world, life's basic necessities — food, clothing, shelter, and taxes — gobble the entirety of people's meager earnings.  Although some Americans do truly struggle for basic necessities, the bigger problem for most Americans is that they consider just about everything — eating out, driving new cars, hopping on airplanes for vacation — to be a necessity.  I've taken it upon myself (using this book as my tool) to help you recognize that investing — that is, putting your money to work for you — is also a necessity.  If you want to accomplish important personal and financial goals, such as owning a home, starting your own business, helping your kids through college (and spending more time with them when they're young), retiring comfortably, and so on, you must know how to invest well. 

It has been said, and too often quoted, that the only certainties in life are death and taxes.  To these two certainties I add one more: being confused by and ignorant about investing.  Because investing is a confounding activity, you may be tempted to look with envious eyes at those people in the world who appear to be savvy with money and investing.  Remember that everyone starts with the same level of financial knowledge — none!  No one is born knowing this stuff!  The only difference between those who know and those who don't is that those who know have devoted their time and energy to acquiring useful knowledge about the investment world. 

Getting Started with Investing

Before I discuss the major investing alternatives in the rest of this chapter, I want to start with something that's quite basic, yet important.  What exactly do I mean when I say "investing"?  Simply stated, investing means you have money put away for future use. 

You can choose from tens of thousands of stocks, bonds, mutual funds, and other investments.  Unfortunately for the novice, and even for the experts who are honest with you, knowing the name of the investment is just the tip of the iceberg.  Underneath each of these investments lurks a veritable mountain of details. 

  If you wanted to and had the ability to quit your day job, you could make a full-time endeavor out of analyzing economic trends and financial statements and talking to business employees, customers, suppliers, and so on.  However, I don't want to scare you away from investing just because some people do it on a full-time basis.  Making wise investments need not take a lot of your time.  If you know where to get high-quality information, and you purchase well-managed investments, you can leave the investment management to the best experts.  Then you can do the work that you're best at and have more free time for fun stuff. 

An important part of making wise investments is knowing when you have enough information to do things well on your own and when you should hire others.  For example, investing in foreign stock markets is generally more difficult to research and understand compared with investing in domestic markets.  Thus, hiring a good money manager, such as through a mutual fund, makes more sense when investing overseas than going to all the time, trouble, and expense of picking your own individual stocks. 

I'm here to give you the information you need to make your way through the complex investment world.  In the rest of this chapter, I clear a path so you can identify the major investments and understand what each is good for. 

Building Wealth with Ownership Investments

  If you want your money to grow faster than the rate of inflation over the long-term, and you don't mind a bit of a roller-coaster ride from time to time in your investments' values, ownership investments are for you.  Ownership investments are those investments where you own a piece of some company or other asset (such as stock, real estate, or a small business) that has the ability to generate revenue and, potentially, profits. 

If you want to build wealth, observing how the world's richest have built their wealth is enlightening.  Not surprisingly, the champions of wealth around the globe gained their fortunes largely through owning a piece (or all) of a successful company that they (or others) built.  Take the case of Steve Jobs, co-founder and chief executive officer of Apple Inc. Apple makes computers, portable digital music players (such as the iPod and all its variations), mobile communication devices (specifically, the iPhone), and software, among other products. 

Every time I, or millions of other people, buy an iPad, iPod, iPhone, and so on, Apple makes more money (so long as they price their products properly and manage their expenses).  As an owner of more than 5 million shares of stock, each of which is valued at about $300 per share, Jobs makes more money as increasing sales and profits drive up the stock's price, which was less than $10 per share as recently as 2004. 

In addition to owning their own businesses, many well-to-do people have built their nest eggs by investing in real estate and the stock market.  With softening housing prices in many regions in the late 2000s, some folks newer to the real estate world incorrectly believe that real estate is a loser, not a long-term winner.  Likewise, the stock market goes through down periods but does well over the long-term. ( See Chapter 2 for the straight scoop on investment risks and returns.) 

And of course, some people come into wealth the old-fashioned way — they inherit it.  Even if your parents are among the rare wealthy ones and you expect them to pass on big bucks to you, you need to know how to invest that money intelligently. 

  If you understand and are comfortable with the risks and take sensible steps to diversify (you don't put all your investment eggs in the same basket), ownership investments are the key to building wealth.  For most folks to accomplish typical longer-term financial goals, such as retiring, the money that they save and invest needs to grow at a healthy clip.  If you dump all your money in bank accounts that pay little if any interest, you're likely to fall short of your goals. 

Not everyone needs to make his money grow, of course.  Suppose that you inherit a significant sum and/or maintain a restrained standard of living and work your whole life simply because you enjoy doing so.  In this situation, you may not need to take the risks involved with a potentially faster-growth investment.  You may be more comfortable with safer investments, such as paying off your mortgage faster than necessary.  Chapter 3 helps you think through such issues. 

Entering the stock market

Stocks, which are shares of ownership in a company, are an example of an ownership investment.  If you want to share in the growth and profits of companies like Apple, you can!  You simply buy shares of their stock through a brokerage firm.  However, even if Apple makes money in the future, you can't guarantee that the value of its stock will increase. 

Some companies today sell their stock directly to investors, allowing you to bypass brokers.  You can also invest in stocks via a stock mutual fund, where a fund manager decides which individual stocks to include in the fund. ( I discuss the various methods for buying stock in Chapter 6.) 

  You don't need an MBA or a PhD to make money in the stock market.  If you can practice some simple lessons, such as making regular and systematic investments and investing in proven companies and funds while minimizing your investment expenses and taxes, you'll be a winner. 

However, I don't believe you can "beat the markets," and you certainly can't beat the best professional money managers at their own, full-time game.  This book shows you time-proven, nongimmicky methods to make your money grow in the stock market as well as in other financial markets. ( I explain more about stocks and mutual funds in Part II.) 

Owning real estate

People of varying economic means build wealth by investing in real estate.  Owning and managing real estate is like running a small business.  You need to satisfy customers (tenants), manage your costs, keep an eye on the competition, and so on.  Some methods of real estate investing require more time than others, but many are proven ways to build wealth. 

John, who works for a city government, and his wife, Linda, a computer analyst, have built several million dollars in investment real estate equity (the difference between the property's market value and debts owed) over the past three decades. " Our parents owned rental property, and we could see what it could do for you by providing income and building wealth," says John.  Investing in real estate also appealed to John and Linda because they didn't know anything about the stock market, so they wanted to stay away from it.  The idea of leverage — making money with borrowed money — on real estate also appealed to them. 

John and Linda bought their first property, a duplex, when their combined income was just $20,000 per year.  Every time they moved to a new home, they kept the prior one and converted it to a rental.  Now in their 50s, John and Linda own seven pieces of investment real estate and are multimillionaires. " It's like a second retirement, having thousands in monthly income from the real estate," says John. 

John readily admits that rental real estate has its hassles. " We haven't enjoyed getting calls in the middle of the night, but now we have a property manager who can help with this when we're not available.  It's also sometimes a pain finding new tenants," he says. 

Overall, John and Linda figure that they've been well rewarded for the time they spent and the money they invested.  The income from John and Linda's rental properties allows them to live in a nicer home. 

Who wants to invest like a millionaire? 

Having a million dollars isn't nearly as rare as it used to be.  In fact, according to the Spectrem Group, a firm that conducts research on wealth, 8 million U.S. households now have at least $1 million in wealth (excluding the value of their primary home).  More than 1 million households have $5 million or more in wealth. 

Interestingly, households with wealth of at least $1 million rarely let financial advisors direct their investments.  Only one of ten such households allows advisors to call the shots and make the moves, whereas 30 percent don't use any advisors at all.  The remaining 60 percent consult an advisor on an as-needed basis and then make their own moves. 

As in past surveys, recent wealth surveys show that affluent investors achieved and built on their wealth with ownership investments, such as their own small businesses, real estate, and stocks. 

  Ultimately, to make your money grow much faster than inflation and taxes, you must absolutely, positively do at least one thing — take some risk.  Any investment that has real growth potential also has shrinkage potential!  You may not want to take the risk or may not have the stomach for it.  In that case, don't despair: I discuss lower-risk investments in this book as well.  You can find out about risks and returns in Chapter 2. 

Running a small business

I know people who have hit investing home runs by owning or buying businesses.  Unlike the part-time nature of investing in the stock market, most people work full time at running their businesses, increasing their chances of doing something big financially with them. 

  If you try to invest in individual stocks, by contrast, you're likely to work at it part time, competing against professionals who invest practically around the clock.  Even if you devote almost all your time to managing your stock portfolio, you're still a passive bystander in a business run by someone else.  When you invest in your own small business, you're the boss, for better or worse. 

For example, a decade ago, Calvin set out to develop a corporate publishing firm.  Because he took the risk of starting his business and has been successful in slowly building it, today, in his 50s, he enjoys a net worth of more than $10 million and can retire if he wants.  Even more important to many business owners — and the reason that financially successful entrepreneurs such as Calvin don't call it quits after they've amassed a lot of cash — are the nonfinancial rewards of investing, including the challenge and fulfillment of operating a successful business. 

Similarly, Sandra has worked on her own as an interior designer for more than two decades.  She previously worked in fashion as a model, and then she worked as a retail store manager.  Her first taste of interior design was redesigning rooms at a condominium project. " I knew when I did that first building and turned it into something wonderful and profitable that I loved doing this kind of work," says Sandra.  Today, Sandra's firm specializes in the restoration of landmark hotels, and her work has been written up in numerous magazines. " The money is not of primary importance to me . . .  my work is driven by a passion . . .  but obviously it has to be profitable," she says.  Sandra has also experienced the fun and enjoyment of designing hotels in many parts of the United States and overseas. 

Most small-business owners (myself included) know that the entrepreneurial life isn't a smooth walk through the rose garden — it has its share of thorns.  Emotionally and financially, entrepreneurship is sometimes a roller coaster.  In addition to the financial rewards, however, small-business owners can enjoy seeing the impact of their work and knowing that it makes a difference.  Combined, Calvin and Sandra's firms created dozens of new jobs. 

  Not everyone needs to be sparked by the desire to start her own company to profit from small business.  You can share in the economic rewards of the entrepreneurial world through buying an existing business or investing in someone else's budding enterprise.  I talk more about evaluating and buying a business in Part IV of this book (and in the latest edition of Small Business For Dummies, written by Jim Schell and me; published by John Wiley & Sons, Inc.). 

Generating Income from Lending Investments

Besides ownership investments (which I discuss in the earlier section "Building Wealth with Ownership Investments"), the other major types of investments include those in which you lend your money.  Suppose that, like most people, you keep some money in your local bank — most likely in a checking account, but perhaps also in a savings account or certificate of deposit (CD).  No matter what type of bank account you place your money in, you're lending your money to the bank. 

  How long and under what conditions you lend money to your bank depends on the specific bank and the account that you use.  With a CD, you commit to lend your money to the bank for a specific length of time — perhaps six months or even a year.  In return, the bank probably pays you a higher rate of interest than if you put your money in a bank account offering you immediate access to the money. ( You may demand termination of the CD early; however, you'll be penalized.) 

The double whammy of inflation and taxes

Bank accounts and bonds that pay a decent return are reassuring to many investors.  Earning a small amount of interest sure beats losing some or all of your money in a risky investment. 

The problem is that money in a savings account, for example, that pays 3 percent isn't actually yielding you 3 percent.  It's not that the bank is lying — it's just that your investment bucket contains some not-so-obvious holes. 

The first hole is taxes.  When you earn interest, you must pay taxes on it (unless you invest the money in a retirement account, in which case you generally pay the taxes later when you withdraw the money).  If you're a moderate-income earner, you end up losing about a third of your interest to taxes.  Your 3 percent return is now down to 2 percent. 

But the second hole in your investment bucket can be even bigger than taxes: inflation.  Although a few products become cheaper over time (computers, for example), most goods and services increase in price.  Inflation in the United States has been running about 3 percent per year.  Inflation depresses the purchasing power of your investments' returns.  If you subtract the 3 percent "cost" of inflation from the remaining 2 percent after payment of taxes, I'm sorry to say that you lost 1 percent on your investment. 

To recap: For every dollar you invested in the bank a year ago, despite the fact that the bank paid you your 3 pennies of interest, you're left with only 99 cents in real purchasing power for every dollar you had a year ago.  In other words, thanks to the inflation and tax holes in your investment bucket, you can buy less with your money now than you could have a year ago, even though you've invested your money for a year. 

As I discuss in more detail in Chapter 7, you can also invest your money in bonds, which are another type of lending investment.  When you purchase a bond that has been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest.  A bond may pay you 6 percent interest over the next five years, for example. 

An investor's return from lending investments is typically limited to the original investment plus interest payments.  If you lend your money to Apple through one of its bonds that matures in, say, ten years, and Apple triples in size over the next decade, you won't share in its growth.  Apple's stockholders and employees reap the rewards of the company's success, but as a bondholder, you don't (you simply get interest and the face value of the bond back at maturity). 

  Many people keep too much of their money in lending investments, thus allowing others to reap the rewards of economic growth.  Although lending investments appear safer because you know in advance what return you'll receive, they aren't that safe.  The long-term risk of these seemingly safe money investments is that your money will grow too slowly to enable you to accomplish your personal financial goals.  In the worst cases, the company or other institution to which you're lending money can go under and stiff you for your loan. 

Considering Cash Equivalents

Cash equivalents are any investments that you can quickly convert to cash without cost to you.  With most checking accounts, for example, you can write a check or withdraw cash by visiting a teller — either the live or the automated type. 

Money market mutual funds are another type of cash equivalent.  Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds produce higher yields than bank savings accounts.  The yield advantage of a money market fund over a savings account almost always widens when interest rates increase because banks move about as fast as molasses on a cold winter day to raise savings account rates. 

Why shouldn't you take advantage of a higher yield?  Many bank savers sacrifice this yield because they think that money market funds are risky — but they're not.  Money market mutual funds generally invest in ultrasafe things such as short-term bank certificates of deposit, U.S. government-issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue. 

Another reason people keep too much money in traditional bank accounts is that the local bank branch office makes the cash seem more accessible.  Money market mutual funds, however, offer many quick ways to get your cash.  You can write a check (most funds stipulate the check must be for at least $250), or you can call the fund and request that it mail or electronically transfer you money. 

  Move extra money that's dozing away in your bank savings account into a higher-yielding money market mutual fund!  Even if you have just a few thousand dollars, the extra yield more than pays for the cost of this book.  If you're in a high tax bracket, you can also use tax-free money market funds. ( See Chapter 8 to find out more about money market funds.) 

Steering Clear of Futures and Options

Suppose you think that IBM's stock is a good investment.  The direction that the management team is taking impresses you, and you like the products and services that the company offers.  Profits seem to be on a positive trend; everything's looking up. 

You can go out and buy the stock — suppose that it's currently trading at around $100 per share.  If the price rises to $150 in the next six months, you've made yourself a 50 percent profit ($150 – $100 = $50) on your original $100 investment. ( Of course, you have to pay some brokerage fees to buy and then sell the stock.) 

But instead of buying the stock outright, you can buy what are known as call options on IBM.  A call option gives you the right to buy shares of IBM under specified terms from the person who sells you the call option.  You may be able to purchase a call option that allows you to exercise your right to buy IBM stock at, say, $120 per share in the next six months.  For this privilege, you may pay $6 per share to the seller of that option (you will also pay trading commissions). 

If IBM's stock price skyrockets to, say, $150 in the next few months, the value of your options that allow you to buy the stock at $120 will be worth a lot — at least $30.  You can then simply sell your options, which you bought for $6 in the example, at a huge profit — you've multiplied your money five-fold! 

  Although this talk of fat profits sounds much more exciting than simply buying the stock directly and making far less money from a stock price increase, call options have two big problems:

  You could easily lose your entire investment.  If a company's stock price goes nowhere or rises only a little during the six-month period when you hold the call option, the option expires as worthless, and you lose all — that is, 100 percent — of your investment.  In fact, in my example, if IBM's stock trades at $120 or less at the time the option expires, the option is worthless. 

  A call option represents a short-term gamble on a company's stock price — not an investment in the company itself.  In my example, IBM could expand its business and profits greatly in the years and decades ahead, but the value of the call option hinges on the ups and downs of IBM's stock price over a relatively short period of time (the next six months).  If the stock market happens to dip in the next six months, IBM may get pulled down as well, despite the company's improving financial health. 

Futures are similar to options in that both can be used as gambling instruments.  Futures deal mainly with the value of commodities such as heating oil, corn, wheat, gold, silver, and pork bellies.  Futures have a delivery date that's in the not-too-distant future. ( Do you really want bushels of wheat delivered to your home?  Or worse yet, pork bellies?)  You can place a small down payment — around 10 percent — toward the purchase of futures, thereby greatly leveraging your "investment."  If prices fall, you need to put up more money to keep from having your position sold. 

My advice: Don't gamble with futures and options. 

Get rich with gold and oil? 

During the global economic expansion of the mid-2000s, precious metals (such as gold), oil, and other commodities increased significantly in value.  The surge in oil prices certainly garnered plenty of headlines when it surged past $100 per barrel.  So, too, did the price of gold as it surged past $1,000 per ounce in 2008, setting a new all-time high.  These prices represented tremendous increases over the past decade with the price of oil having increased more than 600 percent (from less than $20 per barrel) and gold more than tripling in value (from less than $300 per ounce). 

However, despite these seemingly major moves, when considering the increases in the cost of living, at $100-plus per barrel, oil prices were just reaching the levels attained in late 1979!  And even with gold hitting about $1,500 per ounce in 2011 as this book went to press, it was still far from the inflation-adjusted levels it reached nearly three decades earlier.  To reach those levels, gold would have to rise to more than $2,000 an ounce! 

So although the price increases in gold and oil (as well as some other commodities) were dramatic during the past decade, over the past 30 years, oil and gold increased in value less than the overall low rate of U.S. inflation.  So one would hardly have gotten rich investing in oil and gold over the long-term — rather it would have been more like treading water. 

I'd like to make one final and important point here: Over the long-term, investing in a stock mutual fund that focuses on companies involved with precious metals (see Chapter 8) has provided far superior returns compared with investing in gold, silver, or other commodities directly. 

  The only real use that you may (if ever) have for these derivatives (so called because their value is "derived" from the price of other securities) is to hedge.  Suppose you hold a lot of a stock that has greatly appreciated, and you don't want to sell now because of the tax bite.  Perhaps you want to postpone selling the stock until next year because you plan on not working, or you can then benefit from a lower tax rate.  You can buy what's called a put option, which increases in value when a stock's price falls (because the put option grants its seller the right to sell his stock to the purchaser of the put option at a preset stock price).  Thus, if the stock price does fall, the rising put option value offsets some of your losses on the stock you still hold.  Using put options allows you to postpone selling your stock without exposing yourself to the risk of a falling stock price. 

Passing Up Precious Metals

Over the millennia, gold and silver have served as mediums of exchange or currency because they have intrinsic value and can't be debased the way that paper currencies can (by printing more money).  These precious metals are used in jewelry and manufacturing. 

As investments, gold and silver perform well during bouts of inflation.  For example, from 1972 to 1980, when inflation zoomed into the double-digit range in the United States and stocks and bonds went into the tank, gold and silver prices skyrocketed more than 500 percent.  With precious metals pricing zooming upward again since 2000, some have feared the return of inflation. 

  Over the long term, precious metals are lousy investments.  They don't pay any dividends, and their price increases may, at best, just keep up with, but not ahead of, increases in the cost of living.  Although investing in precious metals is better than keeping cash in a piggy bank or stuffing it in a mattress, the long-term investment returns aren't nearly as good as bonds, stocks, and real estate. ( I discuss bonds, stocks, and real estate in detail in Parts II and III.)  One way to earn better long-term returns is to invest in a mutual fund containing the stocks of gold and precious metals companies (see Chapter 8 for more information). 

Counting Out Collectibles

The term collectibles is a catchall category for antiques, art, autographs, baseball cards, clocks, coins, comic books, diamonds, dolls, gems, photographs, rare books, rugs, stamps, vintage wine, writing utensils, and a whole host of other items. 

Although connoisseurs of fine art, antiques, and vintage wine wouldn't like the comparison of their pastime with buying old playing cards or chamber pots, the bottom line is that collectibles are all objects with little intrinsic value.  Wine is just a bunch of old mushed-up grapes.  A painting is simply a canvas and some paint that at retail would set you back a few bucks.  Stamps are small pieces of paper, usually less than an inch square.  What about baseball cards?  Heck, my childhood friends and I used to stick these between our bike spokes! 

I'm not trying to diminish contributions that artists and others make to the world's culture.  And I know that some people place a high value on some of these collectibles.  But true investments that can make your money grow, such as stocks, real estate, or a small business, are assets that can produce income and profits.  Collectibles have little intrinsic value and are thus fully exposed to the whims and speculations of buyers and sellers. ( Of course, as history has shown and as I discuss elsewhere in this book, the prices of particular stocks, real estate, and businesses can be subject to the whims and speculations of buyers and sellers, especially in the short-term.  Over the longer-term, however, market prices return to reality and sensible valuations.) 

  Here are some other major problems with collectibles:

  Markups are huge.  The spread between the price that a dealer pays for an object and the price he then sells the same object for is often around 100 percent.  Sometimes the difference is even greater, particularly if a dealer is the second or third middleman in the chain of purchase.  So at a minimum, your purchase must typically double in value just to get you back to even.  And a value may not double for 10 to 20 years or more! 

  Lots of other costs add up.  If the markups aren't bad enough, some collectibles incur all sorts of other costs.  If you buy more-expensive pieces, for example, you may need to have them appraised.  You may have to pay storage and insurance costs as well.  And unlike the markup, you pay some of these fees year after year of ownership. 

  You can get stuck with a pig in a poke.  Sometimes you may overpay even more for a collectible because you don't realize some imperfection or inferiority of an item.  Worse, you may buy a forgery.  Even reputable dealers have been duped by forgeries. 

  Your pride and joy can deteriorate over time.  Damage from sunlight, humidity, temperatures that are too high or too low, and a whole host of vagaries can ruin the quality of your collectible.  Insurance doesn't cover this type of damage or negligence on your part. 

  The returns stink.  Even if you ignore the substantial costs of buying, holding, and selling, the average returns that investors earn from collectibles rarely keep ahead of inflation, and they're generally inferior to stock market, real estate, and small-business investing.  Objective collectible return data are hard to come by.  Never, ever trust "data" that dealers or the many collectible trade publications provide. 

The best returns that collectible investors reap come from the ability to identify, years in advance, items that will become popular.  Do you think you can do that?  You may be the smartest person in the world, but you should know that most dealers can't tell what's going to rocket to popularity in the coming decades.  Dealers make their profits the same way other retailers do — from the spread or markup on the merchandise that they sell.  The public and collectors have fickle, quirky tastes that no one can predict.  Did you know that Beanie Babies, Furbies, Pet Rocks, or Cabbage Patch Kids were going to be such hits? 

  You can find out enough about a specific type of collectible to become a better investor than the average person, but you're going to have to be among the best — perhaps among the top 10 percent of such collectors — to have a shot at earning decent returns.  To get to this level of expertise, you need to invest hundreds if not thousands of hours reading, researching, and educating yourself about your specific type of collectible. 

Nothing is wrong with spending money on collectibles.  Just don't fool yourself into thinking that they're investments.  You can sink lots of your money into these non-income-producing, poor-return "investments."  At their best as investments, collectibles give the wealthy a way to buy quality stuff that doesn't depreciate. 

  If you buy collectibles, here are some tips to keep in mind:

  Collect for your love of the collectible, your desire to enjoy it, or your interest in finding out about or mastering a subject.  In other words, don't collect these items because you expect high investment returns, because you probably won't get them. 

  Keep quality items that you and your family have purchased and hope that someday they're worth something.  Keeping these quality items is the simplest way to break into the collectible business.  The complete sets of baseball cards I gathered as a youngster are now (30-plus years later) worth hundreds of dollars to, in one case, $1,000! 

  Buy from the source and cut out the middlemen whenever possible.  In some cases, you may be able to buy directly from the artist.  My brother, for example, purchases pottery directly from artists. 

  Check collectibles that are comparable to the one you have your eye on, shop around, and don't be afraid to negotiate.  An effective way to negotiate, after you decide what you like, is to make your offer to the dealer or artist by phone.  Because the seller isn't standing right next to you, you don't feel pressure to decide immediately. 

  Get a buyback guarantee.  Ask the dealer (who thinks that the item is such a great investment) for a written guarantee to buy back the item from you, if you opt to sell, for at least the same price you paid or higher within five years. 

  Do your homework.  Use a comprehensive resource, such as the books by Ralph and Terry Kovel or their website at www.kovels.com, to research, buy, sell, maintain, and improve your collectible. 
Chapter 2

Weighing Risks and Returns

In This Chapter

  Surveying different types of risks

  Reducing risk while earning decent returns

  Figuring out expected returns for different investments

  Determining how much you need your investments to return

A woman passes up eating a hamburger at a picnic because she heard that she could contract a deadly E. coli infection from eating improperly cooked meat.  The next week, that same woman hops in the passenger seat of her friend's car without buckling her seat belt. 

I'm not trying to depress or frighten anyone.  However, I am trying to make an important point about risk — something that everyone deals with on a daily basis.  Risk is in the eye of the beholder.  Many people base their perception of risk, in large part, on their experiences and what they've been exposed to.  In doing so, they often fret about relatively small risks while overlooking much larger risks. 

Sure, a risk of an E. coli infection from eating poorly cooked meat exists, so the woman who was leery of eating the hamburger at the picnic had a legitimate concern.  However, that same woman got into the friend's car without an airbag and placed herself at far greater risk of dying in that situation than if she had eaten the hamburger.  In the United States, more than 35,000 people die in automobile accidents each year. 

In the world of investing, most folks worry about certain risks — some of which may make sense and some of which may not — but at the same time they completely overlook other, more significant risks.  In this chapter, I discuss a range of investments and their risks and expected returns. 

Evaluating Risks

Everywhere you turn, risks exist; some are just more apparent than others.  Many people misunderstand risks.  With increased knowledge, you may be able to reduce or conquer some of your fears and make more sensible decisions about reducing risks.  For example, some people who fear flying don't understand that statistically, flying is much safer than driving a car.  You're approximately 40 times more likely to die in a motor vehicle than in an airplane.  But when a plane goes down, it's big news because dozens and sometimes hundreds of people, who weren't engaging in reckless behavior, perish.  Meanwhile, the media seem to pay less attention to the 100 people, on average, who die on the road every day. 

This doesn't mean that you shouldn't drive or fly or that you shouldn't drive to the airport.  However, you may consider steps you can take to reduce the significant risks you expose yourself to in a car.  For example, you can get a car with more safety features, or you can bypass riding with reckless taxi drivers whose cars lack seat belts. 

Although some people like to live life to its fullest and take "fun" risks (how else can you explain triathletes, mountain climbers, parachutists, and bungee jumpers?),  most people seek to minimize risk and maximize enjoyment in their lives.  But most people also understand that they'd be a lot less happy living a life in which they sought to eliminate all risks, and they likely wouldn't be able to do so anyway. 

  Likewise, if you attempt to avoid all the risks involved in investing, you likely won't succeed, and you likely won't be happy with your investment results and lifestyle.  In the investment world, some people don't go near stocks or any investment that they perceive to be volatile.  As a result, such investors often end up with lousy long-term returns and expose themselves to some high risks that they overlooked, such as the risk of inflation and taxes eroding the purchasing power of their money. 

You can't live without taking risks.  Risk-free activities or ways of living don't exist.  You can minimize, but never eliminate, risks.  Some methods of risk reduction aren't palatable because they reduce your quality of life.  Risks are also composed of several factors.  In the sections that follow, I discuss the various types of investment risks and go over a few of the methods you can use to sensibly reduce these risks while not missing out on the upside that growth investments offer. 

Market-value risk

Although the stock market can help you build wealth, most people recognize that it can also drop substantially — by 10, 20, or 30 percent (or more) in a relatively short period of time.  After peaking in 2000, U.S. stocks, as measured by the large-company S&P 500 index, dropped about 50 percent by 2002.  Stocks on the NASDAQ, which is heavily weighted toward technology stocks, plunged more than 76 percent from 2000 through 2002! 

After a multiyear rebound, stocks peaked in 2007 and then dropped sharply during the "financial crisis" of 2008.  From peak to bottom, U.S. and global stocks dropped by 50-plus percent. 

In a mere six weeks (from mid-July 1998 to early September 1998), large-company U.S. stocks fell about 20 percent.  An index of smaller-company U.S. stocks dropped 33 percent over a slightly longer period of two and a half months. 

If you think that the U.S. stock market crash that occurred in the fall of 1987 was a big one (the market plunged 36 percent in a matter of weeks), take a look at Table 2-1, which lists major declines over the past 100-plus years that were all worse than the 1987 crash.  Note that two of these major declines happened in the 2000s: 2000 to 2002 and 2007 to 2009. 

Table 2-1 Largest U.S. Stock Market Declines*

---

Period | Size of Fall

1929–1932 | 89% (ouch!) 

2007–2009 | 55%

1937–1942 | 52%

1906–1907 | 49%

1890–1896 | 47%

1919–1921 | 47%

1901–1903 | 46%

1973–1974 | 45%

1916–1917 | 40%

2000–2002 | 39%

*As measured by changes in the Dow Jones Industrial Average

Real estate exhibits similar unruly, annoying tendencies.  Although real estate (like stocks) has been a terrific long-term investment, various real estate markets get clobbered from time to time. 

U.S. housing prices took a 25 percent tumble from the late 1920s to the mid-1930s.  When the oil industry collapsed in the southern United States in the early 1980s, real estate prices took a beating in that area.  Later in the 1980s and early 1990s, the northeastern United States became mired in a severe recession, and real estate prices fell by 20-plus percent in many areas.  After peaking near 1990, many of the West Coast housing markets, especially those in California, experienced falling prices — dropping 20 percent or more in most areas by the mid-1990s.  The Japanese real estate market crash also began around the time of the California market fall.  Property prices in Japan collapsed more than 60 percent. 

Declining U.S. housing prices in the mid- to late 2000s garnered unprecedented attention.  Some folks and pundits acted like it was the worst housing market ever.  Foreclosures increased in part because of buyers who financed their home's purchase with risky mortgages (which I recommend against in my books, including this one — see Chapter 12).  I must note here that housing market conditions vary by area.  For example, some portions of the Pacific Northwest and South actually appreciated during the mid- to late 2000s, while other markets experienced declines. 

After reading this section, you may want to keep all your money in the bank — after all, you know you won't lose your money, and you won't have to be a nonstop worrier.  No one has lost 20, 40, 60, or 80 percent of his bank-held savings vehicle in a few years since the FDIC came into existence (major losses prior to then did happen, though).  But just letting your money sit around would be a mistake. 

  If you pass up the stock and real estate markets simply because of the potential market value risk, you miss out on a historic, time-tested method of building substantial wealth.  Instead of seeing declines and market corrections as horrible things, view them as potential opportunities or "sales."  Try not to give into the human emotions that often scare people away from buying something that others seem to be shunning. 

Later in this chapter, I show you the generous returns that stocks and real estate as well as other investments have historically provided.  The following sections suggest some simple things you can do to lower your investing risk and help prevent your portfolio from suffering a huge fall. 

Diversify for a gentler ride

If you worry about the health of the U.S. economy, the government, and the dollar, you can reduce your investment risk by investing overseas.  Most large U.S. companies do business overseas, so when you invest in larger U.S. company stocks, you get some international investment exposure.  You can also invest in international company stocks, ideally via mutual funds (see Chapter 8). 

Of course, investing overseas can't totally protect you.  You can't do much about a global economic catastrophe.  If you worry about the risk of such a calamity, you should probably also worry about a huge meteor crashing into Earth.  Maybe there's a way to colonize outer space. . . . 

  Diversifying your investments can involve more than just your stock portfolio.  You can also hold some real estate investments to diversify your investment portfolio.  Many real estate markets actually appreciated in the early 2000s while the U.S. stock market was in the doghouse.  Conversely, when U.S. real estate entered a multiyear slump in the mid-2000s, stocks performed well during that period.  In the late 2000s, stock prices fell sharply while real estate prices in most areas declined, but then stocks came roaring back. 

Consider your time horizon

Investors who worry that the stock market may take a dive and take their money down with it need to consider the length of time that they plan to invest.  In a one-year period in the stock and bond markets, anything can happen (as shown in Figure 2-1).  History shows that you lose money about once in every three years that you invest in the stock and bond markets.  However, stock market investors have made money (sometimes substantial amounts) approximately two-thirds of the time over a one-year period. ( Bond investors made money about two-thirds of the time, too, although they made a good deal less on average.) 

Although the stock market is more volatile in the short term than the bond market, stock market investors have earned far better long-term returns than bond investors have. ( See the "Stock returns" section later in this chapter for more details.)  Why?  Because stock investors bear risks that bond investors don't bear, and they can reasonably expect to be compensated for those risks.  Remember, however, that bonds generally outperform a boring old bank account. 

  History has shown that the risk of a stock or bond market fall becomes less of a concern the longer the period that you plan to invest.  As Figure 2-2 shows, as the holding period for owning stocks increases from 1 year to 3 years to 5 years to 10 years and then to 20 years, the likelihood of stocks increasing in value increases.  In fact, over any 20-year time span, the U.S. stock market, as measured by the S&P 500 index of larger company stocks, has never lost money, even after you subtract for the effects of inflation. 

**Figure 2-1:** What are the odds of making or losing money in the U.S. markets?  In a single year, anything can happen, but you win far more often (and bigger) than you lose with stocks. 

Most stock market investors I know are concerned about the risk of losing money.  Figure 2-2 clearly shows that the key to minimizing the probability that you'll lose money in stocks is to hold them for the longer term.  Don't invest in stocks unless you plan to hold them for at least five years — and preferably a decade or longer.  Check out Part II of this book for more on using stocks as a long-term investment. 

Pare down holdings in bloated markets

Perhaps you've heard the expression "Buy low, sell high."  Although I don't believe that you can time the markets (that is, predict the most profitable time to buy and sell), spotting a greatly overpriced market isn't too difficult. 

**Figure 2-2:** The longer you hold stocks, the more likely you are to make money. 

For example, in the second edition of this book, published in 1999, I warned readers about the grossly inflated prices of many Internet and technology stocks (see Chapter 5).  Throughout this book, I explain some simple yet powerful methods you can use to measure whether a particular investment market is of fair value, of good value, or overpriced.  You should avoid overpriced investments for two important reasons:

  If and when these overpriced investments fall, they usually fall farther and faster than more fairly priced investments. 

  You should be able to find other investments that offer higher potential returns. 

  Ideally, you want to avoid having a lot of your money in markets that appear overpriced (see Chapter 5 for how to spot pricey markets).  Practically speaking, avoiding overpriced markets doesn't mean that you should try to sell all your holdings in such markets with the vain hope of buying them back at a much lower price.  However, you may benefit from the following strategies:

  Invest new money elsewhere.  Focus your investment of new money somewhere other than the overpriced market; put it into investments that offer you better values.  As a result, without selling any of your seemingly expensive investments, you make them a smaller portion of your total holdings.  If you hold investments outside tax-sheltered retirement accounts, focusing your money elsewhere also offers the benefit of allowing you to avoid incurring taxes from selling appreciated investments. 

  If you have to sell, sell the expensive stuff.  If you need to raise money to live on, such as for retirement or for a major purchase, sell the big-ticket items.  As long as the taxes aren't too troublesome, it's better to sell high and lock in your profits.  Chapter 21 discusses issues to weigh when you contemplate selling an investment. 

Individual-investment risk

A downdraft can put an entire investment market on a roller-coaster ride, but healthy markets also have their share of individual losers.  For example, from the early 1980s through the late 1990s, the U.S. stock market had one of the greatest appreciating markets in history.  You'd never know it, though, if you held one of the great losers of that period. 

Consider a company now called Navistar, which has undergone enormous transformations in the past two decades.  This company used to be called International Harvester and manufactured farm equipment, trucks, and construction and other industrial equipment.  Today, Navistar makes mostly trucks. 

In late 1983, this company's stock traded at more than $140 per share.  It then plunged more than 90 percent over the ensuing decade (as shown in Figure 2-3).  Even with a rally in recent years, Navistar stock still trades at less than $50 per share (after dipping below $10 per share).  Lest you think that's a big drop, this company's stock traded as high as $455 per share in the late 1970s!  If a worker retired from this company in the late 1970s with $200,000 invested in the company stock, the retiree's investment would be worth about $25,000 today!  On the other hand, if the retiree had simply swapped his stock at retirement for a diversified portfolio of stocks, which I explain how to build in Part II, his $200,000 nest egg would've instead grown to more than $2,800,000! 

**Figure 2-3:** Even the bull market of the 1990s wasn't kind to every company. 

Just as individual stock prices can plummet, so can individual real estate property prices.  In California during the 1990s, for example, earthquakes rocked the prices of properties built on landfills.  These quakes highlighted the dangers of building on poor soil.  In the early 1980s, real estate values in the communities of Times Beach, Missouri, and Love Canal, New York, plunged because of carcinogenic toxic waste contamination. ( Ultimately, many property owners in these areas received compensation for their losses from the federal government, as well as from some real estate agencies that didn't disclose these known contaminants.) 

 Here are some simple steps you can take to lower the risk of individual investments that can upset your goals:

  Do your homework.  When you purchase real estate, a whole host of inspections can save you from buying a money pit.  With stocks, you can examine some measures of value and the company's financial condition and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems.  Parts II, III, and IV of this book give you more information on researching your investment. 

  Diversify.  Investors who seek growth invest in securities such as stocks.  Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely related industries.  To reduce this risk, purchase stocks in a variety of industries and companies within each industry. ( See Part II for details.) 

  Hire someone to invest for you.  The best mutual funds (see Chapter 8) offer low-cost, professional management and oversight as well as diversification.  Stock mutual funds typically own 25 or more securities in a variety of companies in different industries.  The best exchange-traded funds offer similar benefits at low cost.  In Part III, I explain how you can invest in real estate in a similar way (that is, by leaving the driving to someone else). 

The lowdown on liquidity

The term liquidity refers to how long and at what cost it takes to convert an investment into cash.  The money in your wallet is considered perfectly liquid — it's already cash. 

Suppose that you invested money in a handful of stocks.  Although you can't easily sell these stocks on a Saturday night, you can sell most stocks quickly through a broker for a nominal fee any day that the financial markets are open (normal working days).  You pay a higher percentage to sell your stocks if you use a high-cost broker or if you have a small amount of stock to sell. 

Real estate is generally much less liquid than stock.  Preparing your property for sale takes time, and if you want to get fair market value for your property, finding a buyer may take weeks or months.  Selling costs (agent commissions, fix-up expenses, and closing costs) can easily approach 10 percent of the home's value. 

A privately run small business is among the least liquid of the better growth investments that you can make.  Selling such a business typically takes longer than selling most real estate. 

So that you're not forced to sell one of your investments that you intend to hold for long-term purposes, keep an emergency reserve of three to six months' worth of living expenses in a money market account.  Also consider investing some money in highly rated bonds (see Chapter 7), which pay higher than money market yields without the high risk or volatility that comes with the stock market. 

Purchasing-power risk

Increases in the cost of living (that is, inflation) can erode the value of your retirement resources and what you can buy with that money — also known as its purchasing power.  When Teri retired at the age of 60, she was pleased with her retirement income.  She was receiving an $800-per-month pension and $1,200 per month from money that she had invested in long-term bonds.  Her monthly expenditures amounted to about $1,500, so she was able to save a little money for an occasional trip. 

Fast-forward 15 years.  Teri still receives $800 per month from her pension, but now she gets only $900 per month of investment income, which comes from some certificates of deposit.  Teri bailed out of bonds after she lost sleep over the sometimes roller-coaster-like price movements in the bond market.  Her monthly expenditures now amount to approximately $2,400, and she uses some of her investment principal (original investment).  She's terrified of outliving her money. 

Teri has reason to worry.  She has 100 percent of her money invested without protection against increases in the cost of living.  Although her income felt comfortable in the beginning of her retirement, it doesn't at age 75, and Teri may easily live another 15 or more years. 

The erosion of the purchasing power of your investment dollar can, over longer time periods, be as bad as or worse than the effect of a major market crash.  Table 2-2 shows the effective loss in purchasing power of your money at various rates of inflation and over differing time periods. 

  As a financial counselor, I often saw skittish investors try to keep their money in bonds and money market accounts, thinking they were playing it safe.  The risk in this strategy is that your money won't grow enough over the years for you to accomplish your financial goals.  In other words, the lower the return you earn, the more you need to save to reach a particular financial goal. 

A 40-year-old wanting to accumulate $500,000 by age 65 would need to save $722 per month if she earns a 6 percent average annual return but needs to save only $377 per month if she earns a 10 percent average return per year.  Younger investors need to pay the most attention to the risk of generating low returns, but so should younger senior citizens.  At the age of 65, seniors need to recognize that a portion of their assets may not be used for a decade or more from the present. 

Career risk

  Your ability to earn money is most likely your single biggest asset, or at least one of your biggest assets.  Most people achieve what they do in the working world through education and hard work.  By education, I'm not simply talking about what one learns in formal schooling.  Education is a lifelong process.  I've learned far more about business from my own front-line experiences and those of others than I've learned in educational settings.  I also read a lot. ( In Part V, I recommend books and other resources that I've found most useful.) 

Inflation ragin' outta control

You think 6, 8, or 10 percent annual inflation rates are bad?  How would you like to live in a country that experienced that rate of inflation in a day?  As I discuss in Chapter 4, too much money in circulation chasing after too few goods causes high rates of inflation. 

A government that runs amok with the nation's currency and money supply usually causes excessive rates of inflation — dubbed hyperinflation.  Over the decades and centuries, hyperinflation has wreaked havoc in more than a few countries. 

What happened in Germany in the late 1910s and early 1920s demonstrates how bad hyperinflation can get.  Consider that during this time period, prices increased nearly one-billionfold!  What cost 1 reichsmark (the German currency in those days) at the beginning of this mess eventually cost nearly 1,000,000,000 reichsmarks.  People had to cart around so much currency that at times they needed wheelbarrows to haul it!  Ultimately, this inflationary burden was too much for the German society, creating a social climate that fueled the rise of the Nazi party and Adolf Hitler. 

During the 1990s, a number of countries, especially many that made up the former U.S.S.R. and others such as Brazil and Lithuania, got themselves into a hyperinflationary mess with inflation rates of several hundred percent per year.  In the mid-1980s, Bolivia's yearly inflation rate exceeded 10,000 percent. 

Governments often try to slap on price controls to prevent runaway inflation (President Richard Nixon did this in the United States in the 1970s), but the underground economy, known as the black market, usually prevails. 

If you don't continually invest in your education, you risk losing your competitive edge.  Your skills and perspectives can become dated and obsolete.  Although that doesn't mean you should work 80 hours a week and never do anything fun, it does mean that part of your "work" time should involve upgrading your skills. 

The best organizations are those that recognize the need for continual knowledge and invest in their workforce through training and career development.  Just remember to look at your own career objectives, which may not be the same as your company's. 

Analyzing Returns

When you make investments, you have the potential to make money in a variety of ways.  Each type of investment has its own mix of associated risks that you take when you part with your investment dollar and, likewise, offers a different potential rate of return.  In this section, I cover the returns you can expect with each of the common investing avenues.  But first, I walk you through the different components of calculating the total return on an investment. 

The components of total return

To figure out exactly how much money you've made (or lost) on your investment, you need to calculate the total return.  To come up with this figure, you need to determine how much money you originally invested and then factor in the other components, such as interest, dividends, and appreciation (or depreciation). 

If you've ever had money in a bank account that pays interest, you know that the bank pays you a small amount of interest when you allow it to keep your money.  The bank then turns around and lends your money to some other person or organization at a much higher rate of interest.  The rate of interest is also known as the yield.  So if a bank tells you that its savings account pays 2 percent interest, the bank may also say that the account yields 2 percent.  Banks usually quote interest rates or yields on an annual basis.  Interest that you receive is one component of the return you receive on your investment. 

If a bank pays monthly interest, the bank also likely quotes a compounded effective annual yield.  After the first month's interest is credited to your account, that interest starts earning interest as well.  So the bank may say that the account pays 2 percent, which compounds to an effective annual yield of 2.04 percent. 

When you lend your money directly to a company — which is what you do when you invest in a bond that a corporation issues — you also receive interest.  Bonds, as well as stocks (which are shares of ownership in a company), fluctuate in value after they're issued. 

When you invest in a company's stock, you hope that the stock increases (appreciates) in value.  Of course, a stock can also decline, or depreciate, in value.  This change in market value is part of your return from a stock or bond investment:

For example, if one year ago you invested $10,000 in a stock (you bought 1,000 shares at $10 per share), and the investment is now worth $11,000 (each share is worth $11), your investment's appreciation looks like this:

Stocks can also pay dividends, which are the company's sharing of some of its profits with you as a stockholder.  Some companies, particularly those that are small or growing rapidly, choose to reinvest all their profits back into the company. ( Of course, some companies don't turn a profit, so they don't have anything to pay out!)  You need to factor these dividends into your return as well. 

Suppose that in the previous example, in addition to your stock appreciating $1,000 to $11,000, it paid you a dividend of $100 ($1 per share).  Here's how you calculate your total return:

You can apply this formula to the example, like so:

After-tax returns

Although you may be happy that your stock has given you an 11 percent return on your invested dollars, remember that unless you held your investment in a tax-sheltered retirement account, you owe taxes on your return.  Specifically, the dividends and investment appreciation that you realize upon selling are taxed, although often at relatively low rates.  The tax rates on so-called long-term capital gains and stock dividends are lower than the tax rates on other income.  In Chapter 3, I discuss the different tax rates that affect your investments and explain how to make tax-wise investment decisions that fit with your overall personal financial situation and goals. 

If you've invested in savings accounts, money market accounts, or bonds, you owe Uncle Sam taxes on the interest. 

Often, people make investing decisions without considering the tax consequences of their moves.  This is a big mistake.  What good is making money if the federal and state governments take away a substantial portion of it? 

If you're in a moderate tax bracket, taxes on your investment probably run in the neighborhood of 30 percent (federal and state).  So if your investment returned 7 percent before taxes, you're left with a return of 4.9 percent after taxes. 

Psychological returns

Profits and tax avoidance can powerfully motivate your investment selections.  However, like with other life decisions, you need to consider more than the bottom line.  Some people want to have fun with their investments.  Of course, they don't want to lose money or sacrifice a lot of potential returns.  Fortunately, less expensive ways to have fun do exist! 

Psychological rewards compel some investors to choose particular investment vehicles such as individual stocks, real estate, or a small business.  Why?  Because compared with other investments, such as managed mutual funds, they see these investments as more tangible and . . .  well, more fun. 

  Be honest with yourself about why you choose the investments that you do.  Allowing your ego to get in the way can be dangerous.  Do you want to invest in individual stocks because you really believe that you can do better than the best full-time professional money managers?  Chances are high that you won't. ( See Chapter 6 for the details.)  Do you like investing in real estate more because of the gratification you get from driving by and showing off your properties to others than because of their investment rewards?  Such questions are worth considering as you contemplate what investments you want to make. 

Savings and money market account returns

You need to keep your extra cash that awaits investment (or an emergency) in a safe place, preferably one that doesn't get hammered by the sea of changes in the financial markets.  By default and for convenience, many people keep their extra cash in a bank savings account.  Although the bank offers the U.S. government's backing via the Federal Deposit Insurance Corporation (FDIC), it comes at a high price.  Most banks pay a low interest rate on their savings accounts. 

Another place to keep your liquid savings is in a money market mutual fund.  These are the safest types of mutual funds around and, for all intents and purposes, equal a bank savings account's safety.  The best money market funds generally pay higher yields than most bank savings accounts.  Unlike a bank, money market mutual funds tell you how much they deduct for the service of managing your money.  If you're in a higher tax bracket, tax-free versions of money market funds exist as well.  See Chapter 8 for more on money market funds. 

  If you don't need immediate access to your money, consider using Treasury bills (T-bills) or bank certificates of deposit (CDs), which are usually issued for terms such as 3, 6, or 12 months.  Your money will surely earn more in one of these vehicles than in a bank savings account.  As rates vary by institution, it is essential to shop around.  The drawback to T-bills and bank certificates of deposit is that you incur a penalty (with CDs) or a transaction fee (with T-bills) if you withdraw your investment before the term expires (see Chapter 7). 

Bond returns

When you buy a bond, you lend your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time.  When you buy a bond, you expect to earn a higher yield than you can with a money market or savings account.  You're taking more risk, after all.  Companies can and do go bankrupt, in which case you may lose some or all of your investment. 

Generally, you can expect to earn a higher yield when you buy bonds that

  Are issued for a longer term: The bond issuer is tying up your money at a fixed rate for a longer period of time. 

  Have lower credit quality: The bond issuer may not be able to repay the principal. 

Wharton School of Business professor Jeremy Siegel has tracked the performance of bonds and stocks back to 1802.  Although you may say that what happened in the 19th century has little relevance to the financial markets and economy of today, the decades since the Great Depression, which most other return data track, are a relatively small slice of time.  Figure 2-4 presents the data, so if you'd like to give more emphasis to the recent numbers, you may. 

**Figure 2-4:** A historical view of bond performance: Inflation has eroded bond returns more in recent decades. 

Note that although the rate of inflation has increased since the Great Depression, bond returns have not increased over the decades.  Long-term bonds maintained slightly higher returns in recent years than short-term bonds.  The bottom line: Bond investors typically earn about 4 to 5 percent per year. 

Stock returns

Investors expect a fair return on investment.  If one investment doesn't offer a high enough rate of return, investors can choose to move their money into other investments that they believe will perform better.  Instead of buying a diversified basket of stocks and holding, some investors frequently buy and sell, hoping to cash in on the latest hot investment.  This tactic seldom works in the long run. 

  Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed strongly on the assumption (and the hope) that those investments will continue to earn strong returns.  But chasing after the strongest performing investments can be dangerous if you catch the stock at its peak, ready to begin a downward spiral.  You may have heard that the goal of investing is to buy low and sell high.  Chasing high-flying investments can lead you to buy high, with the prospect of having to sell low if the stock runs out of steam.  Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor.  See Chapters 5 and 6 for advice on making sound stock investment decisions. 

  A tremendous amount of data exists regarding stock market returns.  In fact, in the U.S. markets, data going back more than two centuries documents the fact that stocks have been a terrific long-term investment.  The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next. 

Going all the way back to 1802, the U.S. stock market has produced an annual return of 8.3 percent, while inflation has grown at 1.4 percent per year.  Thus, after subtracting for inflation, stocks have appreciated about 6.9 percent faster annually than the rate of inflation.  The U.S. stock market returns have consistently and substantially beaten the rate of inflation over the years (see Figure 2-5). 

Stocks don't exist only in the United States, of course (see Figure 2-6).  More than a few U.S. investors seem to forget this fact, especially during the sizzling performance of the U.S. stock market during the late 1990s.  As I discuss in the earlier section "Diversify for a gentler ride," one advantage of buying and holding overseas stocks is that they don't always move in tandem with U.S. stocks.  As a result, overseas stocks help diversify your portfolio. 

In addition to enabling U.S. investors to diversify, investing overseas has proved to be profitable.  The investment banking firm Morgan Stanley tracks the performance of stocks in both economically established countries and so-called emerging economies.  As the name suggests, countries with emerging economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, South Korea, and Taiwan) are "behind" economically but show high rates of growth and progress. 

**Figure 2-5:** History shows that stocks have been a consistent long-term winner. 

**Figure 2-6:** Plenty of investing opportunities exist outside the United States. 

Figure 2-7, courtesy of Investments Illustrated, ties together many of the points I make about investment returns and risks for various vehicles.  The chart shows, since 1926, the growth of $1 placed in U.S. stocks, a balanced portfolio (stocks and bonds), international stocks, bonds, and treasury bills compared with the rate of inflation.  As you can see, stocks are the best long-term performers, but they have more volatility.  A balanced portfolio gets you most of the long-term returns of stocks without much of the volatility.  This chart provides lots of other good information as well, so take a few minutes to peruse and digest. 

**Figure 2-7:** The "Big Picture" of investment returns and risk. 

Real estate returns

  Over the years, real estate has proved to be about as lucrative as investing in the stock market.  Whenever the U.S. has a real estate downturn, folks question this historic fact (see Chapter 11 for more details).  However, just as stock prices have down periods, so too do real estate markets. 

The fact that real estate offers solid long-term returns makes sense because growth in the economy, in jobs, and in population ultimately fuels the demand for real estate. 

Consider what has happened to the U.S. population over the past two centuries.  In 1800, a mere 5 million people lived within U.S. borders.  In 1900, that figure grew to 76.1 million, and today, it's more than 310 million.  All these people need places to live, and as long as jobs exist, the income from jobs largely fuels the demand for housing. 

Businesses and people have an understandable tendency to cluster in major cities and suburban towns.  Although some people commute, most people and businesses locate near major highways, airports, and so on.  Thus, real estate prices in and near major metropolises and suburbs generally appreciate the most.  Consider the areas of the world that have the most expensive real estate prices: Hong Kong, San Francisco, Los Angeles, New York, and Boston.  What these areas have in common are lots of businesses and people and limited land. 

Contrast these areas with the many rural parts of the United States where the price of real estate is relatively low because of the abundant supply of buildable land and the relatively lower demand for housing. 

Small-business returns

As I discuss in Part IV of this book, you have several choices for tapping into the exciting potential of the small-business world.  If you have the drive and determination, you can start your own small business.  Or perhaps you have what it takes to buy an existing small business.  If you obtain the necessary capital and skills to assess opportunities and risk, you can invest in someone else's small business. 

What potential returns can you get from small business?  Small-business owners like me who do something they really enjoy will tell you that the nonfinancial returns can be major!  But the financial rewards can be attractive as well. 

Every year, Forbes magazine publishes a list of the world's wealthiest individuals.  Perusing this list shows that most of these people built their wealth by taking a significant ownership stake and starting a small business that became large.  These individuals achieved extraordinarily high returns (often in excess of hundreds of percent per year) on the amounts they invested to get their companies off the ground. 

You may also achieve potentially high returns from buying and improving an existing small business.  As I discuss in Part IV, such small-business investment returns may be a good deal lower than the returns you may gain from starting a business from scratch. 

Unlike the stock market, where plenty of historic rate-of-return data exists, data on the success, or lack thereof, that investors have had with investing in small private companies is harder to come by.  Smart venture capitalist firms operate a fun and lucrative business: They identify and invest money in smaller start-up companies that they hope will grow rapidly and eventually go public.  Venture capitalists allow outsiders to invest with them via limited partnerships.  To gain entry, you generally need $1 million to invest. ( I never said this was an equal-opportunity investment club!) 

Venture capitalists, also known as general partners, typically skim off 20 percent of the profits and also charge limited partnership investors a hefty 2 to 3 percent annual fee on the amount that they've invested.  The return that's left over for the limited partnership investors isn't stupendous.  According to Venture Economics, venture funds have averaged comparable annual returns to what stock market investors have earned on average over this same period.  The general partners that run venture capital funds make more than the limited partners do. 

You can attempt to do what the general partners do in venture capital firms and invest directly in small, private companies.  But you're likely to be investing in much smaller and simpler companies.  Earning venture capitalist returns isn't easy to do.  If you think that you're up to the challenge, I explain the best ways to invest in small business in Chapter 15. 

Considering Your Goals

How much do you need or want to earn?  That may seem like an extraordinarily stupid question for me to ask you!  Who doesn't want to earn a high return?  However, although investing in stocks, real estate, or a small business can produce high long-term returns, investing in these vehicles comes with greater risk, especially over the short term. 

Some people can't stomach the risk.  Others are at a time in their lives when they can't afford to take great risk.  If you're near or in retirement, your portfolio and nerves may not be able to wait a decade for your riskier investments to recover after a major stumble.  Perhaps you have sufficient assets to accomplish your financial goals and are concerned with preserving what you do have rather than risking it to grow more wealth. 

If you work for a living, odds are that you need and want to make your investments grow at a healthy clip.  If your investments grow slowly, you may fall short of your goals of owning a home or retiring or changing careers. 

Are smaller-company stock returns higher? 

Stocks are generally classified by the size of the company.  Small-company stocks aren't stocks that physically small companies issue — they're simply stocks issued by companies that haven't reached the size of corporate behemoths such as IBM, AT&T, or Coca-Cola.  The Standard & Poor's 500 index tracks the performance of 500 large-company stocks in the United States.  The Russell 2000 index tracks the performance of 2,000 smaller-company U.S. stocks. 

Small-company stocks have outperformed larger-company stocks during the past seven decades.  Historically, small-company stocks have produced slightly higher compounded annual returns than large-company stocks.  However, nearly all this extra performance is due to just one high-performance time period, from the mid-1970s to the early 1980s.  If you eliminate this time period from the data, small stocks have had virtually identical returns to those of larger-company stocks. 

Also, be aware that small-company stocks can get hammered in down markets.  For example, during the Great Depression, small-company stocks plunged more than 85 percent between 1929 and 1932, while the S&P 500 fell 64 percent.  In 1937, small-company stocks plummeted 58 percent, while the S&P 500 fell 35 percent.  And in 1969 to 1970, small-company stocks fell 38 percent, while the S&P 500 fell just 5 percent. 
Chapter 3

Getting Your Financial House in Order before You Invest

In This Chapter

  Saving money for emergencies

  Managing your debt

  Setting financial goals

  Funding retirement and college accounts

  Understanding tax issues

  Exploring diversification strategies

Before you make any great, wealth-building investments, I recommend that you get your financial house in order.  Understanding and implementing some simple personal financial management concepts can pay off big for you in the decades ahead. 

You want to know how to earn healthy returns on your investments without getting clobbered, right?  Who doesn't?  Although you generally must accept greater risk to have the potential for earning higher returns (see Chapter 2), in this chapter, I tell you about some high-return, low-risk investments.  You have a right to be skeptical about such investments, but don't stop reading this chapter yet.  Here, I point out some of the easy-to-tap opportunities for managing your money that you may have overlooked. 

Establishing an Emergency Reserve

You never know what life will bring, so having a readily accessible reserve of cash to meet unexpected expenses makes good financial sense.  If you have a sister who works on Wall Street as an investment banker or a wealthy and understanding parent, you can use one of them as your emergency reserve. ( Although you should ask them how they feel about that before you count on receiving funding from them!)  If you don't have a wealthy family member, the ball's in your court to establish a reserve. 

Should you invest emergency money in stocks? 

As interest rates drifted lower during the 1990s, keeping emergency money in money market accounts became less and less rewarding.  When interest rates were 8 or 10 percent, fewer people questioned the wisdom of an emergency reserve.  However, in the late 1990s, which had low money market interest rates and stock market returns of 20 percent per year, more investors balked at the idea of keeping a low-interest stash of cash. 

I began seeing articles that suggested you simply keep your emergency reserve in stocks.  After all, you can easily sell stocks (especially those of larger companies) any day the financial markets are open.  Why not treat yourself to the 20 percent annual returns that stock market investors enjoyed during the 1990s rather than earning a paltry few percent? 

At first, that logic sounds great.  But, as I discuss in Chapter 2, stocks historically have returned about 9 to 10 percent per year.  In some years — in fact, about one-third of the time — stocks decline in value, sometimes substantially. 

Stocks can drop and have dropped 20, 30, or 50 percent or more over relatively short periods of time.  Consider what happened to stock prices in the early 2000s and then again in the late 2000s.  Suppose that such a drop coincides with an emergency — such as the loss of your job, major medical bills, and so on.  Your situation may force you to sell at a loss, perhaps a substantial one. 

Here's another reason not to keep emergency money in stocks: If your stocks appreciate and you need to sell some of them for emergency cash, you get stuck paying taxes on your gains. 

I suggest that you invest your emergency money in stocks (ideally through well-diversified mutual funds) only if you have a relative or some other resource to tap for money in an emergency.  Having a backup resource for money minimizes your need to sell your stock holdings on short notice.  As I discuss in Chapter 5, stocks are intended to be a longer-term investment, not an investment that you expect (or need) to sell in the near future. 

  Make sure you have quick access to at least three months' to as much as six months' worth of living expenses.  Keep this emergency money in a money market fund (see Chapter 8).  You may also be able to borrow against your employer-based retirement account or against your home equity should you find yourself in a bind, but these options are much less desirable. 

  If you don't have a financial safety net, you may be forced into selling an investment that you've worked hard for.  And selling some investments, such as real estate, costs big money (because of transaction costs, taxes, and so on). 

Consider the case of Warren, who owned his home and rented an investment property in the Pacific Northwest.  He felt, and appeared to be, financially successful.  But then Warren lost his job, accumulated sizable medical expenses, and had to sell his investment property to come up with cash for living expenses.  Warren didn't have enough equity in his home to borrow.  He didn't have other sources — a wealthy relative, for example — to borrow from either, so he was stuck selling his investment property.  Warren wasn't able to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades.  Between the costs of selling and taxes, getting rid of the investment property cost Warren about 15 percent of its sales price.  Ouch! 

Evaluating Your Debts

Yes, paying down debts is boring, but it makes your investment decisions less difficult.  Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash coming in exceeds the cash going out) may be your best high-return, low-risk investment.  Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off. 

Conquering consumer debt

Borrowing via credit cards, auto loans, and the like is an expensive way to borrow.  Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business.  The reason: Consumer loans are the riskiest type of loan for a lender. 

  Many folks have credit card or other consumer debt, such as an auto loan, that costs 8, 10, 12, or perhaps as much as 18-plus percent per year in interest (some credit cards whack you with interest rates exceeding 20 percent if you make a late payment).  Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt. 

For example, if you have outstanding credit card debt at 15 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return.  Because the interest on consumer debt isn't tax-deductible, you need to earn more than 15 percent by investing your money elsewhere in order to net 15 percent after paying taxes.  Earning such high investing returns is highly unlikely, and in order to earn those returns, you'd be forced to take great risk. 

Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings.  I often hear people say such things as "I can't afford to buy most new cars for cash — look at how expensive they are!"  That's true, new cars are expensive, so you need to set your sights lower and buy a good used car that you can afford.  You can then invest the money that you'd otherwise spend on your auto loan. 

  However, using consumer debt may make sense if you're financing a business.  If you don't have home equity, personal loans (through a credit card or auto loan) may actually be your lowest-cost source of small-business financing. ( See Chapter 14 for more details.) 

Mitigating your mortgage

Paying off your mortgage more quickly is an "investment" for your spare cash that may make sense for your financial situation.  However, the wisdom of making this financial move isn't as clear as paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.  When used properly, debt can help you accomplish your goals — such as buying a home or starting a business — and make you money in the long run.  Borrowing to buy a home generally makes sense.  Over the long term, homes generally appreciate in value. 

If your financial situation has changed or improved since you first needed to borrow mortgage money, you need to reconsider how much mortgage debt you need or want.  Even if your income hasn't escalated or you haven't inherited vast wealth, your frugality may allow you to pay down some of your debt sooner than the lender requires.  Whether paying down your debt sooner makes sense for you depends on a number of factors, including your other investment options and goals. 

Consider your investment opportunities

  When evaluating whether to pay down your mortgage faster, you need to compare your mortgage interest rate with your investments' rates of return (which I define in Chapter 2).  Suppose you have a fixed-rate mortgage with an interest rate of 6 percent.  If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of about 6 percent to come out ahead financially. ( This comparison, technically, should be done on an after-tax basis, but the outcome is unlikely to change.) 

Besides the most common reason of lacking the money to do so, other good reasons not to pay off your mortgage any quicker than necessary include the following:

  You instead contribute to your retirement accounts, such as a 401(k), an IRA, or a Keogh plan (especially if your employer offers matching money).  Paying off your mortgage faster has no tax benefit.  By contrast, putting additional money into a retirement plan can immediately reduce your federal and state income tax burdens.  The more years you have until retirement, the greater the benefit you receive if you invest in your retirement accounts.  Thanks to the compounding of your retirement account investments without the drain of taxes, you can actually earn a lower rate of return on your investments than you pay on your mortgage and still come out ahead. ( I discuss the various retirement accounts in detail in the "Funding Your Retirement Accounts" section later in this chapter.) 

  You're willing to invest in growth-oriented, volatile investments, such as stocks and real estate.  In order to have a reasonable chance of earning more on your investments than it costs you to borrow on your mortgage, you must be aggressive with your investments.  As I discuss in Chapter 2, stocks and real estate have produced annual average rates of return of about 8 to 10 percent.  You can earn even more by creating your own small business or by investing in others' businesses.  Paying down a mortgage ties up more of your capital, and thus reduces your ability to make other attractive investments.  To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry. 

  You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two. 

  Paying down the mortgage depletes your emergency reserves.  Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments.  You probably don't want to pay down your debt if doing so depletes your financial safety cushion.  Make sure that you have access — through a money market fund or other sources (a family member, for example) — to at least three months' worth of living expenses (as I explain in the earlier section "Establishing an Emergency Reserve"). 

  Don't be tripped up by the misconception that somehow a real estate market downturn, such as the one that most areas experienced in the mid- to late 2000s, will harm you more if you pay down your mortgage.  Your home is worth what it's worth — its value has nothing to do with your debt load.  Unless you're willing to walk away from your home and send the keys to the bank (also known as default), you suffer the full effect of a price decline, regardless of your mortgage size, if real estate prices drop. 

Don't get hung up on mortgage tax deductions

Although it's true that mortgage interest is usually tax-deductible, don't forget that you must also pay taxes on investment profits generated outside of retirement accounts (if you do forget, you're sure to end up in trouble with the IRS).  You can purchase tax-free investments like municipal bonds (see Chapter 7), but over the long haul, such bonds and other types of lending investments (bank savings accounts, CDs, and other bonds) are unlikely to earn a rate of return that's higher than the cost of your mortgage. 

And don't assume that those mortgage interest deductions are that great.  Just for being a living, breathing human being, you automatically qualify for the so-called "standard deduction" on your federal tax return.  In 2011, this standard deduction was worth $5,800 for single filers and $11,600 for married people filing jointly.  If you have no mortgage interest deductions — or have fewer than you used to — you may not be missing out on as much of a write-off as you think. ( Plus, it's a joy having one less schedule to complete on your tax return!) 

Establishing Your Financial Goals

You may have just one purpose for investing money, or you may desire to invest money for several different purposes simultaneously.  Either way, you should establish your financial goals before you begin investing.  Otherwise, you won't know how much to save. 

For example, when I was in my 20s, I put away some money for retirement, but I also saved a stash so I could hit the eject button from my job in management consulting.  I knew that I wanted to pursue an entrepreneurial path and that in the early years of starting my own business, I couldn't count on an income as stable or as large as the one I made from consulting. 

I invested my two "pots" of money — one for retirement and the other for my small-business cushion — quite differently.  As I discuss in the section "Choosing the Right Investment Mix" later in this chapter, you can afford to take more risk with the money that you plan on using longer term.  So I invested the bulk of my retirement nest egg in stock mutual funds. 

With the money I saved for the start-up of my small business, I took an entirely different track.  I had no desire to put this money in risky stocks — what if the market plummeted just as I was ready to leave the security of my full-time job?  Thus, I kept this money safely invested in a money market fund that had a decent yield but didn't fluctuate in value. 

Tracking your savings rate

In order to accomplish your financial goals (and some personal goals), you need to save money, and you also need to know your savings rate.  Your savings rate is the percentage of your past year's income that you saved and didn't spend.  Without even doing the calculations, you may already know that your rate of savings is low, nonexistent, or negative and that you need to save more. 

  Part of being a smart investor involves figuring out how much you need to save to reach your goals.  Not knowing what you want to do a decade or more from now is perfectly normal — after all, your goals and needs evolve over the years.  But that doesn't mean you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future. 

An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals.  Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments. 

During your working years, if you consistently save about 10 percent of your annual income, you're probably saving enough to meet your goals (unless you want to retire at a relatively young age).  On average, most people need about 75 percent of their pre-retirement income throughout retirement to maintain their standards of living. 

If you're one of the many people who don't save enough, you need to do some homework.  To save more, you need to reduce your spending, increase your income, or both.  For most people, reducing spending is the more feasible way to save. 

  To reduce your spending, first figure out where your money goes.  You may have some general idea, but you need to have facts.  Get out your checkbook register, examine your online bill-paying records, and review your credit card bills and any other documentation that shows your spending history.  Tally up how much you spend on dining out, operating your car(s), paying your taxes, and on everything else.  After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate.  Earning more income may help boost your savings rate as well.  Perhaps you can get a higher-paying job or increase the number of hours that you work.  But if you already work a lot, reining in your spending is usually better for your emotional and economic well-being. 

Investing as couples

You've probably learned over the years how challenging it is just for you to navigate the investment maze and make sound investing decisions.  When you have to consider someone else, dealing with these issues becomes doubly hard given the typically different money personalities and emotions that come into play. 

In most couples with whom I've worked as a financial counselor, usually one person takes primary responsibility for managing the household finances, including investments.  As with most marital issues, the couples that do the best job with their investments are those who communicate well, plan ahead, and compromise. 

Here are a couple of examples to illustrate my point.  Martha and Alex scheduled meetings with each other every three to six months to discuss financial issues.  With investments, Martha came prepared with a list of ideas, and Alex would listen and explain what he liked or disliked about each option.  Alex would lean toward more aggressive, growth-oriented investments, whereas Martha preferred conservative, less volatile investments.  Inevitably, they would compromise and develop a diversified portfolio that was moderately aggressive.  Martha and Alex worked as a team, discussed options, compromised, and made decisions they were both comfortable with.  Ideas that made one of them very uncomfortable were nixed. 

Henry and Melissa didn't do so well.  The only times they managed to discuss investments were in heated arguments.  Melissa often criticized what Henry was doing with their money.  Henry got defensive and counter-criticized Melissa for other issues.  Much of their money lay dormant in a low-interest bank account, and they did little long-term planning and decision making.  Melissa and Henry saw each other as adversaries, argued and criticized rather than discussed, and were plagued with inaction because they couldn't agree and compromise.  They needed a motivation to change their behavior toward each other and some counseling (or a few advice guides for couples) to make progress with investing their money. 

Aren't your long-term financial health and marital harmony important?  Don't allow your problems to fester!  Remember what the famous psychologist Dr. Phil McGraw says about problems and making changes: "You can't change what you don't acknowledge."  I couldn't agree more with this assessment when it comes to money problems, including investing issues. 

In my work as a financial counselor, one of the most valuable and difficult things I did for couples stuck in unproductive patterns of behavior was to help them get the issue out on the table.  For these couples, the biggest step was making an appointment to discuss their financial management.  Once they did, I could get them to explain their different points of view and then offer compromises. 

If you don't know how to evaluate and reduce your spending or haven't thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now's the time to do so.  Pick up the latest edition of my book Personal Finance For Dummies (John Wiley & Sons, Inc.) to find out all the necessary details for retirement planning and much more. 

Determining your investment tastes

Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own or some else's small business.  Or you can pay down mortgage debt more quickly.  What makes sense for you depends on your goals as well as your personal preferences.  If you detest risk-taking and volatile investments, paying down your mortgage, as recommended earlier in this chapter, may make better sense than investing in the stock market. 

To determine your general investment tastes, think about how you would deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less.  Some aggressive investments can fall fast. ( See Chapter 2 for examples.)  You shouldn't go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell low or make you a miserable, anxious wreck.  If you haven't tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them. 

  A simple way to "mask" the risk of volatile investments is to diversify your portfolio — that is, to put your money into different investments.  Not watching prices too closely helps, too — that's one of the reasons real estate investors are less likely to bail out when the market declines.  Stock market investors, unfortunately from my perspective, can get daily and even minute-by-minute price updates.  Add that fact to the quick phone call or click of your computer mouse that it takes to dump a stock in a flash, and you have all the ingredients for short-sighted investing — and potential financial disaster. 

Funding Your Retirement Accounts

Saving money is difficult for most people.  Don't make a tough job impossible by forsaking the tax benefits that come from investing through most retirement accounts. 

Gaining tax benefits

Retirement accounts should be called "tax-reduction accounts" — if they were, people may be more motivated to contribute to them.  Contributions to these plans are generally deductible on both your federal and state taxes.  Suppose that you pay about 35 percent between federal and state income taxes on your last dollars of income. ( See the section "Determining your tax bracket" later in this chapter.)  With most of the retirement accounts that I describe in this chapter, you can save yourself about $350 in taxes for every $1,000 that you contribute in the year that you make your contribution. 

After your money is in a retirement account, any interest, dividends, and appreciation grow inside the account without taxation.  With most retirement accounts, you defer taxes on all the accumulating gains and profits until you withdraw your money down the road, which you can do without penalty after age 59 1⁄2.  In the meantime, more of your money works for you over a long period of time.  In some cases, such as with the Roth IRAs described later in this chapter, withdrawals are tax free, too. 

The good, old U.S. government now provides a tax credit for lower-income earners who contribute up to $2,000 into retirement accounts.  The maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $17,000 and married couples filing jointly with an AGI of $34,000 or less.  Singles with an AGI of between $17,000 and $18,250 and married couples with an AGI between $34,000 and $36,500 are eligible for a 20 percent tax credit.  Single taxpayers with an AGI of more than $18,250 but no more than $28,250 and married couples with an AGI between $36,500 and $56,500 can get a 10 percent tax credit. 

Starting your savings sooner

  The common mistake that many investors make is neglecting to take advantage of retirement accounts because of their enthusiasm to spend or invest in non-retirement accounts.  Not investing in tax-sheltered retirement accounts can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings.  Add that loss up over the many years that you work and save, and not taking advantage of these tax reduction accounts can easily cost you tens of thousands to hundreds of thousands of dollars in the long term.  Ouch! 

To take advantage of retirement savings plans and the tax savings that accompany them, you must first spend less than you earn.  Only then can you afford to contribute to these retirement savings plans (unless you already happen to have a stash of cash from previous savings or inheritance). 

 The sooner you start to save, the less painful it is each year to save enough to reach your goals.  Why?  Because your contributions have more years to compound. 

Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals.  For example, if saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away 10 percent to reach that same goal; waiting until your 40s, 20 percent.  Beyond that, the numbers get truly daunting. 

If you enjoy spending money and living for today, you should be more motivated to start saving sooner.  The longer that you wait to save, the more you ultimately need to save and, therefore, the less you can spend today! 

Checking out retirement account options

If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money.  In most cases, your contributions to these retirement accounts are tax-deductible. 

Company-based plans

If you work for a for-profit company, you may have access to a 401(k) plan, which typically allows you to save up to $16,500 per year (for tax year 2011).  Many nonprofit organizations offer 403(b) plans to their employees.  As with a 401(k), your contributions to 403(b) plans are deductible on both your federal and state taxes in the year that you make them.  Nonprofit employees can generally contribute up to 20 percent or $16,500 of their salaries, whichever is less.  In addition to the upfront and ongoing tax benefits of these retirement savings plans, some employers match your contributions. 

Older employees (defined as being at least age 50) can contribute even more into these company-based plans — up to $22,000 in 2011.  Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions. 

If you're self-employed, you can establish your own retirement savings plans for yourself and any employees that you have.  In fact, with all types of self-employment retirement plans, business owners need to cover their employees as well.  Simplified employee pension individual retirement accounts (SEP-IRA) and Keogh plans allow you to sock away about 20 percent of your self-employment income (business revenue minus expenses), up to an annual maximum of $49,000 (for tax year 2011).  Each year, you decide the amount you want to contribute — no minimums exist (unless you do a Money Purchase Pension Plan type of Keogh). 

  Keogh plans require a bit more paperwork to set up and administer than SEP-IRAs.  Unlike SEP-IRAs, Keogh plans allow vesting schedules that require employees to remain with the company a number of years before they earn the right to their retirement account balances. ( If you're an employee in a small business, you can't establish your own SEP-IRA or Keogh — that's up to your employer.)  Many plans also allow business owners to exclude employees from receiving contributions until they complete a year or two of service. 

If an employee leaves prior to being fully vested, his unvested balance reverts to the remaining Keogh plan participants.  Keogh plans also allow for Social Security integration, which effectively allows those in the company who earn high incomes (usually the owners) to receive larger-percentage contributions for their accounts than the less highly compensated employees.  The logic behind this idea is that Social Security taxes and benefits top out after you earn $106,800 (for tax year 2011).  Social Security integration allows higher-income earners to make up for this ceiling. 

Owners of small businesses shouldn't deter themselves from doing a retirement plan because employees may receive contributions, too.  If business owners take the time to educate employees about the value and importance of these plans in saving for the future and reducing taxes, they'll see it as a rightful part of their total compensation package. 

IRAs

If you work for a company that doesn't offer a retirement savings plan, or if you've exhausted contributing to your company's plan, consider an individual retirement account (IRA).  Anyone with employment income (or who receives alimony) may contribute up to $5,000 each year to an IRA (or the amount of your employment or alimony income if it's less than $5,000 in a year).  If you're a nonworking spouse, you're eligible to put up to $5,000 per year into a spousal IRA.  Those age 50 and older can put away up to $6,000 per year (effective in 2011). 

Your contributions to an IRA may or may not be tax-deductible.  For tax year 2011, if you're single and your adjusted gross income is $56,000 or less for the year, you can deduct your full IRA contribution.  If you're married and you file your taxes jointly, you're entitled to a full IRA deduction if your AGI is $90,000 per year or less. 

  If you can't deduct your contribution to a standard IRA account, consider making a contribution to a nondeductible IRA account called the Roth IRA.  Single taxpayers with an AGI less than $107,000 and joint filers with an AGI less than $169,000 can contribute up to $5,000 per year to a Roth IRA.  Those age 50 and older can contribute $6,000.  Although the contribution isn't deductible, earnings inside the account are shielded from taxes, and, unlike a standard IRA, qualified withdrawals from the account are free from income tax. 

Annuities

If you've contributed all you're legally allowed to contribute to your IRA accounts and still want to put away more money for retirement, consider annuities.  Annuities are contracts that insurance companies back.  If you, the annuity holder (investor), should die during the so-called accumulation phase (that is, prior to receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment. 

Annuities, like IRAs, allow your capital to grow and compound tax deferred.  You defer taxes until you withdraw the money.  However, unlike an IRA that has an annual contribution limit of a few thousand dollars, you can deposit as much as you want in any year to an annuity — even millions of dollars, if you've got it!  However, as with a Roth IRA, you get no upfront tax deduction for your contributions. 

  Because annuity contributions aren't tax-deductible, and because annuities carry higher annual operating fees to pay for the small amount of insurance that comes with them, don't consider contributing to one until you've fully exhausted your other retirement account investing options.  Because of their higher annual expenses, annuities generally make sense only if you have 15 or more years to wait until you need the money. 

Choosing retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year.  You still must choose what investments you want to hold inside your retirement account shell. 

You may invest your IRA or self-employed plan retirement account (SEP-IRAs, Keoghs) money into stocks, bonds, mutual funds, and even bank accounts.  Mutual funds (offered in most employer-based plans), which I cover in detail in Chapter 8, are an ideal choice because they offer diversification and professional management.  After you decide which financial institution you want to invest through, simply obtain and complete the appropriate paperwork for establishing the specific type of account you want. ( Flip to the later section "Choosing the Right Investment Mix" for more information.) 

Taming Your Taxes in Non-Retirement Accounts

When you invest outside of tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation.  So the non-retirement account investments that make sense for you depend (at least partly) on your tax situation. 

  If you have money to invest, or if you're considering selling current investments that you hold, taxes should factor into your decision.  But tax considerations alone shouldn't dictate how and where you invest your money.  You should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the investment (see the "Choosing the Right Investment Mix" section, later in the chapter, for more information on these other factors). 

Figuring your tax bracket

You may not know it, but the government charges you different tax rates for different parts of your annual income.  You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings.  For example, if you're single and your taxable income totaled $50,000 during 2011, you paid federal tax at the rate of 10 percent on the first $8,500, 15 percent on the taxable income above $8,500 up to $34,500, and 25 percent on income above $34,500 up to $50,000. 

Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income.  In the example of a single person with taxable income of $50,000, that person's federal marginal tax rate is 25 percent.  In other words, he effectively pays a 25 percent federal tax on his last dollars of income — those dollars earned between $34,500 and $50,000. ( Don't forget to factor in the state income taxes that most states assess.) 

  Knowing your marginal tax rate allows you to quickly calculate the following:

  Any additional taxes that you would pay on additional income

  The amount of taxes that you save if you contribute more money into retirement accounts or reduce your taxable income (for example, if you choose investments that produce tax-free income)

Table 3-1 shows the federal income tax rates for singles and for married households that file jointly. 

Table 3-1 2011 Federal Income Tax Rates

---

Singles Taxable Income | Married Filing Jointly Taxable Income | Federal Tax Rate

Less than $8,500 | Less than $17,000 | 10%

$8,500 to $34,500 | $17,000 to $69,000 | 15%

$34,500 to $83,600 | $69,000 to $139,350 | 25%

$83,600 to $174,400 | $139,350 to $212,300 | 28%

$174,400 to $379,150 | $212,300 to $379,150 | 33%

More than $379,150 | More than $379,150 | 35%

Knowing what's taxed and when to worry

Interest you receive from bank accounts and corporate bonds is generally taxable.  U.S. Treasury bonds pay interest that's state-tax-free.  Municipal bonds, which state and local governments issue, pay interest that's federal-tax-free and also state-tax-free to residents in the state where the bond is issued. ( I discuss bonds in Chapter 7.) 

Taxation on your capital gains, which is the profit (sales minus purchase price) on an investment, works under a unique system.  Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal rate.  Profits from investments that you hold longer than 12 months are long-term capital gains.  These long-term gains cap at 15 percent, except for those in the two lowest tax brackets of 10 and 15 percent.  For these folks, the long-term capital gains tax rate is just 5 percent. 

  Use these strategies to reduce the taxes you pay on investments that are exposed to taxation:

  Opt for tax-free money markets and bonds.  If you're in a high enough tax bracket, you may find that you come out ahead with tax-free investments.  Tax-free investments yield less than comparable investments that produce taxable earnings, but because of the tax differences, the earnings from tax-free investments can end up being greater than what taxable investments leave you with.  In order to compare properly, subtract what you'll pay in federal as well as state taxes from the taxable investment to see which investment nets you more. 

  Invest in tax-friendly stock funds.  Mutual funds that tend to trade less tend to produce lower capital gains distributions.  For mutual funds held outside tax-sheltered retirement accounts, this reduced trading effectively increases an investor's total rate of return.  Index funds are mutual funds that invest in a relatively static portfolio of securities, such as stocks and bonds (this is also true of some exchange-traded funds).  They don't attempt to beat the market.  Rather, they invest in the securities to mirror or match the performance of an underlying index, such as the Standard & Poor's 500 (which I discuss in Chapter 5).  Although index funds can't beat the market, the typical actively managed fund doesn't either, and index funds have several advantages over actively managed funds.  See Chapter 8 to find out more about tax-friendly stock mutual funds, which includes some non-index funds, and exchange-traded funds. 

  Invest in small business and real estate.  The growth in value of business and real estate assets isn't taxed until you sell the asset.  Even then, with investment real estate, you often can roll over the gain into another property as long as you comply with tax laws.  However, the current income that small business and real estate assets produce is taxed as ordinary income. 

  Short-term capital gains (investments held one year or less) are taxed at your ordinary income tax rate.  This fact is another reason that you shouldn't trade your investments quickly (within 12 months). 

Choosing the Right Investment Mix

Diversifying your investments helps buffer your portfolio from being sunk by one or two poor performers.  In this section, I explain how to mix up a great recipe of investments. 

Considering your age

When you're younger and have more years until you plan to use your money, you should keep larger amounts of your long-term investment money in growth (ownership) vehicles, such as stocks, real estate, and small business.  As I discuss in Chapter 2, the attraction of these types of investments is the potential to really grow your money.  The risk: The value of your portfolio can fall from time to time. 

The younger you are, the more time your investments have to recover from a bad fall.  In this respect, investments are a bit like people.  If a 30-year-old and an 80-year-old both fall on a concrete sidewalk, odds are higher that the younger person will fully recover and the older person may not.  Such falls sometimes disable older people. 

  A long-held guiding principle says to subtract your age from 110 and invest the resulting number as a percentage of money to place in growth (ownership) investments.  So if you're 35 years old:

110 – 35 = 75 percent of your investment money can be in growth investments. 

If you want to be more aggressive, subtract your age from 120:

120 – 35 = 85 percent of your investment money can be in growth investments. 

Note that even retired people should still have a healthy chunk of their investment dollars in growth vehicles like stocks.  A 70-year-old person may want to totally avoid risk, but doing so is generally a mistake.  Such a person can live another two or three decades.  If you live longer than anticipated, you can run out of money if it doesn't continue to grow. 

  These tips are only general guidelines and apply to money that you invest for the long term (ideally for ten years or more).  For money that you need to use in the shorter term, such as within the next several years, more-aggressive growth investments aren't appropriate.  See Chapters 7 and 8 for short-term investment ideas. 

Making the most of your investment options

No hard-and-fast rules dictate how to allocate the percentage that you've earmarked for growth among specific investments like stocks and real estate.  Part of how you decide to allocate your investments depends on the types of investments that you want to focus on.  As I discuss in Chapter 5, diversifying in stocks worldwide can be prudent as well as profitable. 

Here are some general guidelines to keep in mind:

  Take advantage of your retirement accounts.  Unless you need accessible money for shorter-term non-retirement goals, why pass up the free extra returns from the tax benefits of retirement accounts? 

  Don't pile your money into investments that gain lots of attention.  Many investors make this mistake, especially those who lack a thought-out plan to buy stocks.  In Chapter 5, I provide numerous illustrations of the perils of buying attention-grabbing stocks. 

  Have the courage to be a contrarian.  No one likes to feel that he is jumping on board a sinking ship or supporting a losing cause.  However, just like shopping for something at retail stores, the best time to buy something of quality is when its price is reduced. 

  Diversify.  As I discuss in Chapter 2, the values of different investments don't move in tandem.  So when you invest in growth investments, such as stocks or real estate, your portfolio's value will have a smoother ride if you diversify properly. 

  Invest more in what you know.  Over the years, I've met successful investors who have built substantial wealth without spending gobs of their free time researching, selecting, and monitoring investments.  Some investors, for example, concentrate more on real estate because that's what they best understand and feel comfortable with.  Others put more money in stocks for the same reason.  No one-size-fits-all code exists for successful investors.  Just be careful that you don't put all your investing eggs in the same basket (for example, don't load up on stocks in the same industry that you believe you know a lot about). 

  Don't invest in too many different things.  Diversification is good to a point.  If you purchase so many investments that you can't perform a basic annual review of all of them (for example, reading the annual report from your mutual fund), you have too many investments. 

  Be more aggressive with investments inside retirement accounts.  When you hit your retirement years, you'll probably begin to live off your non-retirement account investments first.  Allowing your retirement accounts to continue growing can generally save you tax dollars.  Therefore, you should be relatively less aggressive with investments outside of retirement accounts because that money may be invested for a shorter time period. 

Easing into risk: Dollar cost averaging

Dollar cost averaging (DCA) is the practice of investing a regular amount of money at set time intervals, such as monthly or quarterly, into volatile investments, such as stocks and stock mutual funds.  If you've ever deducted money from a paycheck and pumped it into a retirement savings plan investment account that holds stocks and bonds, you've done DCA. 

  Most people invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA.  The biggest appeal of gradually feeding money into the market via DCA is that you don't dump all your money into a potentially overheated investment just before a major drop.  Thus, DCA helps shy investors psychologically ease into riskier investments. 

DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts.  For example, using DCA, an investor with $100,000 to invest in stock funds can feed her money into investments gradually — say, at the rate of $12,500 or so quarterly over two years — instead of investing her entire $100,000 in stocks at once and possibly buying all of her shares at a market peak.  Most large investment companies, especially mutual funds, allow investors to establish automatic investment plans so the DCA occurs without an investor's ongoing involvement. 

Of course, like any risk-reducing investment strategy, DCA has drawbacks.  If growth investments appreciate (as they're supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment.  Finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year. ( They studied data from the U.S. market over the past seven decades.) 

However, knowing that you'll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major plunge in prices.  In the fall of 1987, the U.S. stock market, as measured by the Dow Jones Industrial Average, plummeted 36 percent, and from late 2007 to early 2009, the market shed 55 percent of its value. 

So investors who fear that stocks are due for such a major correction should practice DCA, right?  Well, not so fast.  Apprehensive investors who shun lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA during a declining market. 

So what's an investor with a lump sum of money to do? 

  First, weigh the significance of the lump sum to you.  Although $100,000 is a big chunk of most people's net worth, it's only 10 percent if your net worth is $1,000,000.  It's not worth a millionaire's time to use DCA for $100,000.  If the cash that you have to invest is less than a quarter of your net worth, you may not want to bother with DCA. 

  Second, consider how aggressively you invest (or invested) your money.  For example, if you aggressively invested your money through an employer's retirement plan that you roll over, don't waste your time on DCA. 

DCA makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks.  If you fancy yourself a market prognosticator, you can also assess the current valuation of stocks.  Thinking that stocks are pricey (and thus riper for a fall) increases the appeal of DCA. 

  If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place.  If you practice DCA over too long of a period of time, you may miss a major upswing in stock prices.  I suggest using DCA over one to two years to strike a balance. 

As for the times of the year that you should use DCA, mutual fund investors should use DCA early in each calendar quarter because mutual funds that make taxable distributions tend to do so late in the quarter. 

Your money that awaits investment in DCA should have a suitable parking place.  Select a high-yielding money market fund that's appropriate for your tax situation. 

  One last critical point: When you use DCA, establish an automatic investment plan so you're less likely to chicken out.  And for the more courageous, you may want to try an alternative strategy to DCA — value averaging, which allows you to invest more if prices are falling and invest less if prices are rising. 

Suppose, for example, that you want to value average $500 per quarter into an aggressive stock mutual fund.  After your first quarterly $500 investment, the fund drops 10 percent, reducing your account balance to $450.  Value averaging suggests that you invest $500 the next quarter plus another $50 to make up the shortfall. ( Conversely, if the fund value had increased to $550 after your first investment, you would invest only $450 in the second round.)  Increasing the amount that you invest requires confidence when prices fall, but doing so magnifies your returns when prices ultimately turn around. 

Treading Carefully When Investing for College

  Many well-intentioned parents want to save for their children's future educational expenses.  The mistake they often make, however, is putting money in accounts in their child's name (in so-called custodial accounts) or saving outside of retirement accounts in general. 

The more money you accumulate outside tax-sheltered retirement accounts, the less assistance you're likely to qualify for from federal and state financial aid sources.  Don't make the additional error of assuming that financial aid is only for the poor.  Many middle-income and even some modestly affluent families qualify for some aid, which can include grants and loans available, even if you're not deemed financially needy. 

Under the current financial needs analysis that most colleges use in awarding financial aid, the value of your retirement plan is not considered an asset.  Money that you save outside of retirement accounts, including money in the child's name, is counted as an asset and reduces eligibility for financial aid. 

Also, be aware that your family's assets, for purposes of financial aid determination, also generally include equity in real estate and businesses that you own.  Although the federal financial aid analysis no longer counts equity in your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial aid determinations.  Thus, paying down your home mortgage more quickly instead of funding retirement accounts can harm you financially.  You may end up with less financial aid and pay more in taxes. 

  Don't forgo contributing to your own retirement savings plan(s) in order to save money in a non-retirement account for your children's college expenses.  When you do, you pay higher taxes both on your current income and on the interest and growth of this money.  In addition to paying higher taxes, you're expected to contribute more to your child's educational expenses (because you'll receive less financial aid). 

If you plan to apply for financial aid, it's a good idea to save non-retirement account money in your name rather than in your child's name (as a custodial account).  Colleges expect a greater percentage of money in your child's name (35 percent) to be used for college costs than money in your name (6 percent).  Remember, though, that from the standpoint of getting financial aid, you're better off saving inside retirement accounts. 

However, if you're affluent enough that you expect to pay for your cherub's full educational costs without applying for financial aid, you can save a bit on taxes if you invest through custodial accounts.  Prior to your child reaching age 19, the first $1,900 of interest and dividend income is taxed at your child's income tax rate rather than yours.  After age 19 (for full-time students, it's those under the age of 24), all income that the investments in your child's name generate is taxed at your child's rate. 

Education Savings Accounts

  Be careful about funding an Education Savings Account (ESA), a relatively new savings vehicle.  In theory, an ESA sounds like a great place to park some college savings.  You can make nondeductible contributions of up to $2,000 per child per year, and investment earnings and account withdrawals are free of tax as long as you use the funds to pay for elementary and secondary school or college costs.  However, funding an ESA can undermine your child's ability to qualify for financial aid.  It's best to keep the parents as the owners of such an account for financial aid purposes, but be forewarned that some schools may treat money in an ESA as a student's asset. 

Section 529 plans

Also known as qualified state tuition plans, Section 529 plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs (some states allow upward of $300,000 per student).  After you contribute to one of these state-based accounts, the invested funds grow without taxation.  Withdrawals are also tax free so long as the funds are used to pay for qualifying higher educational costs (which include college, graduate school, and certain additional expenses of special-needs students).  The schools need not be in the same state as the state administering the Section 529 plan. 

  As I discuss in the previous section dealing with Education Savings Accounts, Section 529 plan balances can harm your child's financial aid chances.  Thus, such accounts make the most sense for affluent families who are sure that they won't qualify for any type of financial aid.  If you do opt for an ESA and intend to apply for financial aid, you should be the owner of the accounts (not your child) to maximize qualifying for financial aid. 

How to pay for college

If you keep stashing away money in retirement accounts, it's reasonable for you to wonder how you'll actually pay for education expenses when the momentous occasion arises.  Even if you have some liquid assets that can be directed to your child's college bill, you will, in all likelihood, need to borrow some money.  Only the affluent can truly afford to pay for college with cash. 

One good source of money is your home's equity.  You can borrow against your home at a relatively low interest rate, and the interest is generally tax-deductible.  Some company retirement plans — 401(k)s, for example — allow borrowing as well. 

A plethora of financial aid programs allow you to borrow at reasonable interest rates.  The Unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), for example, are available, even when your family isn't deemed financially needy.  In addition to loans, a number of grant programs are available through schools and the government as well as through independent sources. 

Complete the Free Application for Federal Student Aid (FAFSA) to apply for the federal government programs.  Grants available through state government programs may require a separate application.  Specific colleges and other private organizations, including employers, banks, credit unions, and community groups, also offer grants and scholarships. 

Many scholarships and grants don't require any work on your part — simply apply for such financial aid through your college.  However, you may need to seek out other programs as well — check directories and databases at your local library, your kid's school counseling department, and college financial aid offices.  Also try local organizations, churches, employers, and so on, because you have a better chance of getting scholarship money through these avenues than through countrywide scholarship and grant databases. 

Your child also can work and save money during high school and college for school.  In fact, if your child qualifies for financial aid, she's generally expected to contribute a certain amount to education costs from employment (both during the school year and summer breaks) and from savings.  Besides giving your gangly teen a stake in her own future, this training encourages sound personal financial management down the road. 

Allocating college investments

If you keep up to 80 percent of your investment money in stocks (diversified worldwide) with the remainder in bonds when your child is young, you can maximize the money's growth potential without taking extraordinary risk.  As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative — scale back the stock percentage to 50 or 60 percent.  Finally, in the years just before entering college, whittle the stock portion down to no more than 20 percent or so. 

  Diversified mutual funds (which invest in stocks in the United States and internationally) and bonds are ideal vehicles to use when you invest for college.  Be sure to choose funds that fit your tax situation if you invest your funds in non-retirement accounts.  See Chapter 8 for more information. 

Protecting Your Assets

You may be at risk of making a catastrophic investing mistake: not protecting your assets properly due to a lack of various insurance coverages.  Manny, a successful entrepreneur, made this exact error.  Starting from scratch, he built up a successful million-dollar business.  He invested a lot of his own personal money and sweat into building the business over 15 years. 

One day, catastrophe struck: An explosion ripped through his building, and the ensuing fire destroyed virtually all the firm's equipment and inventory, none of which was insured.  The explosion also seriously injured several workers, including Manny, who didn't carry disability insurance.  Ultimately, Manny had to file for bankruptcy. 

  Decisions regarding what amount of insurance you need to carry are, to some extent, a matter of your desire and ability to accept financial risk.  But some risks aren't worth taking.  Don't overestimate your ability to predict what accidents and other bad luck may befall you. 

Here's what you need to protect yourself and your assets:

  Major medical health insurance: I'm not talking about one of those policies that pays $100 a day if you need to go into the hospital, or cancer insurance, or that $5,000 medical expense rider on your auto insurance policy.  I know it's unpleasant to consider, but you need a policy that pays for all types of major illnesses and major medical expenditures. 

  Consider taking a health plan with a high deductible, which can minimize your premiums.  Also consider channeling extra money into a Health Savings Account (HSA), which provides tremendous tax breaks.  As with a retirement account, contributions provide an upfront tax break, and money can grow over the years in an HSA without taxation.  You can also tap HSA funds without penalty or taxation for a wide range of current health expenses. 

  Adequate liability insurance on your home and car to guard your assets against lawsuits: You should have at least enough liability insurance to protect your net worth (assets minus your liabilities/debts) or, ideally, twice your net worth.  If you run your own business, get insurance for your business assets if they're substantial, such as in Manny's case.  Also consider professional liability insurance to protect against a lawsuit.  You may also want to consider incorporating your business (which I discuss more in Chapter 14). 

  Long-term disability insurance: What would you (and your family) do to replace your income if a major disability prevents you from working?  Even if you don't have dependents, odds are that you are dependent on you.  Most larger employers offer group plans that have good benefits and are much less expensive than coverage you'd buy on your own.  Also, check with your professional association for a competitive group plan. 

  Life insurance, if others are dependent on your income: If you're single or your loved ones can live without your income, skip life insurance.  If you need coverage, buy term insurance that, like your auto and home insurance, is pure insurance protection.  The amount of term insurance you need to buy largely depends on how much of your income you want to replace. 

  Estate planning: At a minimum, most people need a simple will to delineate to whom they would like to leave all their worldly possessions.  If you hold significant assets outside retirement accounts, you may also benefit from establishing a living trust, which keeps your money from filtering through the hands of probate lawyers.  Living wills and medical powers of attorney are useful to have in case you're ever in a medically incapacitated situation.  If you have substantial assets, doing more involved estate planning is wise to minimize estate taxes and ensure the orderly passing of your assets to your heirs. 

In my experience as a financial counselor, I've seen that although many people lack particular types of insurance, others possess unnecessary policies.  Many people also keep very low deductibles.  Remember to insure against potential losses that would be financially catastrophic for you — don't waste your money to protect against smaller losses. ( See the latest edition of my book Personal Finance For Dummies, published by John Wiley & Sons, Inc., to discover the right and wrong ways to buy insurance, what to look for in policies, and where to get good policies.) 
Part II

Stocks, Bonds, and Wall Street

In this part . . . 

Stocks, bonds, mutual funds, and exchange-traded funds are the core financial market instruments that investors play with these days.  But what the heck are these devices, and how can you invest in them, make some decent money, and not lose your shirt?  Here in this part, you find out how and where to evaluate and buy these securities and how to comprehend the mind-numbing jargon the money pros use. 
Chapter 4

The Workings of Stock and Bond Markets

In This Chapter

  Going from a private to public company

  Looking at the workings of the stock and bond markets and the economy

  Deciphering interest rates, inflation, and the Federal Reserve

To buy and enjoy a watch, you don't need to know the intricacies of how it's put together and how it works.  The same holds true for investing in stocks and bonds.  However, spending some time understanding how and why the financial markets function may make you more comfortable with investing and make you a better investor. 

In this chapter, I explain the ways that companies raise capital and give you a brief primer on financial markets and economics so you can understand and be comfortable with investing in the financial markets. 

How Companies Raise Money through the Financial Markets

All businesses start small — whether they begin in a garage, a spare bedroom, or a rented office.  As companies begin to grow, they often need more money (known as capital in the financial world) to expand and afford their growing needs, such as hiring more employees, buying computer systems, and purchasing other equipment.  Many smaller companies rely on banks to lend them money, but growing and successful firms have other options, too, in the financial markets.  Companies can choose between two major money-raising options when they go into the financial markets: issuing stocks or issuing bonds. 

Deciding whether to issue stocks or bonds

  A world of difference exists between the two major types of securities, both from the perspective of the investor and from that of the issuing company, as the following explanations illustrate:

  Bonds are loans that a company must pay back.  Rather than borrowing money from a bank, many companies elect to sell bonds, which are IOUs to investors.  The primary disadvantage of issuing bonds compared with issuing stock, from a company's perspective, is that the company must repay this money with interest.  On the other hand, the business doesn't have to relinquish ownership when it borrows money.  Companies are also more likely to issue bonds if the stock market is depressed, meaning that companies can't fetch as much for their stock. 

  Stocks are shares of ownership in a company.  Some companies choose to issue stock to raise money.  Unlike bonds, the money that the company raises through a stock offering isn't paid back, because it's not a loan.  When the investing public buys stock, these outside investors continue to hold and trade it. ( Although companies may occasionally choose to buy their own stock back, usually because they think it's a good investment, they're under no obligation to do so.) 

When a company issues stock, doing so allows its founders and owners to sell some of their relatively illiquid private stock and reap the rewards of their successful company.  Many growing companies also favor stock offerings because they don't want the cash drain that comes from paying loans (bonds) back. 

Although many company owners like to take their companies public (issuing stock) to cash in on their stake of the company, not all owners want to go public, and not all who do go public are happy that they did.  One of the numerous drawbacks of establishing your company as public includes the burdensome financial reporting requirements, such as publishing of quarterly earnings statements and annual reports.  These documents not only take lots of time and money to produce, but they can also reveal competitive secrets.  Some companies also harm their long-term planning ability because of the pressure and focus on short-term corporate performance that comes with being a public company. 

Ultimately, companies seek to raise capital in the lowest-cost way they can, so they elect to sell stocks or bonds based on what the finance folks tell them is the best option.  For example, if the stock market is booming and new stock can sell at a premium price, companies opt to sell more stock.  Some companies have preferences, for example, to avoid debt because they don't like carrying it. 

  From your perspective as a potential investor, you can usually make more money in stocks than bonds, but stocks are generally more volatile in the short term (see Chapter 2). 

Taking a company public: Understanding IPOs

Suppose that The Capitalist Company (TCC) wants to issue stock for the first time, which is called an initial public offering (IPO).  If TCC decides to go public, the company's management team works with investment bankers, who help companies decide when and at what price to sell stock. 

Suppose further that based upon their analysis of the value of TCC, the investment bankers believe that TCC can raise $20 million by issuing stock that represents a particular portion of the company.  When a company issues stock, the price per share that the stock is sold for is somewhat arbitrary.  The amount that a prospective investor will pay for a particular portion of the company's stock should depend on the company's profits and future growth prospects.  Companies that produce higher levels of profits and grow faster can generally command a higher sales price for a given portion of the company. 

Consider the following ways that investment bankers can structure the IPO for TCC:

Price of Stock | Number of Shares Issued

---|---

$5 | 4 million shares

$10 | 2 million shares

$20 | 1 million shares

In fact, TCC can raise $20 million in an infinite number of ways, thanks to varying stock prices.  If the company wants to issue the stock at a higher price, the company sells fewer shares. 

  A stock's price per share by itself is meaningless in evaluating whether to buy a stock.  Ultimately, the amount that investors will pay for a company's stock should depend greatly on the company's growth and profitable prospects.  To determine the price-earnings ratio of a particular company's stock, you take the price per share of the company's stock and divide it by the company's earnings per share. 

In the case of TCC, suppose that its stock is currently valued in the marketplace at $30 per share and that it earned $2 per share in the past year, which produces a price-earnings ratio of 15.  Here are the numbers:

In Chapter 5, I talk more about price-earnings ratios and the factors that influence stock prices. 

Understanding Financial Markets and Economics

Tens of thousands of books, millions of articles, and enough PhD dissertations to pack a major landfill explore the topics of how the financial markets and economy will perform in the years ahead.  You can spend the rest of your life reading all this stuff, and you still won't get through it.  In this section, I explain what you need to know about how the factors that influence the financial markets and economy work so you can make informed investing decisions. 

Driving stock prices through earnings

The goal of most companies is to make money, or earnings (also called profits).  Earnings result from the difference between what a company takes in (revenue) and what it spends (costs).  I say most companies because some organizations' primary purpose is not to maximize profits.  Nonprofit organizations, such as colleges and universities, are a good example.  But even nonprofits can't thrive and prosper without a steady money flow. 

Companies that trade publicly on the stock exchanges seek to maximize their profit — that's what their shareholders want.  Higher profits generally make stock prices rise.  Most private companies seek to maximize their profits as well, but they retain much more latitude to pursue other goals. 

  Among the major ways that successful companies increase profits are by doing the following:

  Building better mousetraps: Some companies develop or promote an invention or innovation that better meets customer needs.  For example, many consumers welcomed the invention of the digital camera that eliminated the need for costly and time-consuming development of film.  The digital camera also made transferring and working with pictures much easier. 

  Opening new markets to your products: Many successful U.S.-based companies, for example, have been stampeding into foreign countries to sell their products.  Although some product adaptation is usually required to sell overseas, selling an already proven and developed product or service to new markets generally increases a company's chances for success. 

  Being in related businesses: Consider the hugely successful Walt Disney Company, which was started in the 1920s as a small studio that made cartoons.  Over the years, it expanded into many new but related businesses, such as theme parks and resorts, movie studios, radio and television programs, toys and children's books, and video games. 

  Building a brand name: Popular sodas and many types of well-known beers rate comparably in blind taste tests to many generic colas and beers that are far cheaper.  Yet some consumers fork over more of their hard-earned loot because of the name and packaging.  Companies build brand names largely through advertising and other promotions. ( For Dummies is a brand name, but For Dummies books cost about the same as lower-quality and smaller books on similar subjects!) 

  Managing costs and prices: Smart companies control costs.  Lowering the cost of manufacturing their products or providing their services allows companies to offer their products and services more cheaply.  Managing costs may help fatten the bottom line (profit).  Sometimes, though, companies try to cut too many corners, and their cost-cutting ways come back to haunt them in the form of dissatisfied customers — or even lawsuits based on a faulty or dangerous product. 

  Watching the competition: Successful companies don't follow the herd, but they do keep an eye on what their competition is up to.  If lots of competitors target one part of the market, some companies target a less-pursued segment that, if they can capture it, may produce higher profits thanks to reduced competition. 

Weighing whether markets are efficient

Companies generally seek to maximize profits and maintain a healthy financial condition.  Ultimately, the financial markets judge the worth of a company's stock or bond.  Trying to predict what happens to the stock and bond markets and to individual securities consumes many a market prognosticator. 

In the 1960s, to the chagrin of some market soothsayers, academic scholars developed a theory called the efficient market hypothesis.  This theory basically maintains the following logic: Lots of investors collect and analyze all sorts of information about companies and their securities.  If investors think that a security, such as a stock, is overpriced, they sell it or don't buy it.  Conversely, if the investors believe that a security is underpriced, they buy it or hold what they already own.  Because of the competition among all these investors, the price that a security trades at generally reflects what many (supposedly informed) people think it's worth. 

Therefore, the efficient market theory implies that trading in and out of securities and the overall market in an attempt to obtain the right stocks at the right time is a futile endeavor.  Buying or selling a security because of "new" news is also fruitless because the stock price adjusts so quickly to this news that investors can't profit by acting on it.  As Burton Malkiel so eloquently said in his classic book A Random Walk Down Wall Street, this theory, "Taken to its logical extreme . . .  means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."  Malkiel added, "Financial analysts in pin-striped suits don't like being compared with bare-assed apes." 

Some money managers have beaten the market averages.  In fact, beating the market over a year or three years isn't difficult, but few can beat the market over a decade or more.  Efficient market supporters argue that some of those who beat the markets, even over a ten-year period, do so because of luck.  Consider that if you flip a coin five times, on some occasions you get five consecutive heads.  This coincidence actually happens, on average, once every 32 times you do five coin-flip sequences because of random luck, not skill.  Consistently identifying in advance which sequence gives you five consecutive heads isn't possible. 

Strict believers in the efficient market hypothesis say that it's equally impossible to identify the best money managers in advance.  Some money managers, such as those who manage mutual funds, possess publicly available track records.  Inspecting those track records (and understanding the level of risk taken for the achieved returns) and doing other common-sense things, such as investing in funds that have lower expenses, improve your odds of performing a bit better than the market. 

  Various investment markets differ in how efficient they are.  Efficiency means that the current price of an investment accurately reflects its true value.  Although the stock market is reasonably efficient, many consider the bond market to be even more efficient.  The real estate market is less efficient because properties are unique, and sometimes less competition and access to information exist.  If you can locate a seller who really needs to sell, you may be able to buy property at a sizeable discount from what it's really worth.  Small business is also less efficient.  Entrepreneurs with innovative ideas and approaches can sometimes earn enormous returns. 

Moving the market: Interest rates, inflation, and the Federal Reserve

For decades, economists, investment managers, and other (often self-anointed) gurus have attempted to understand the course of interest rates, inflation, and the monetary policies set forth by the Federal Reserve.  Millions of investors follow these economic factors.  Why?  Because interest rates, inflation, and the Federal Reserve's monetary policies seem to move the financial markets and the economy. 

Realizing that high interest rates are generally bad

Many businesses borrow money to expand.  People like you and me, who are affectionately referred to as consumers, also borrow money to finance home and auto purchases and education. 

Interest rate increases tend to slow the economy.  Businesses scale back on expansion plans, and some debt-laden businesses can't afford high interest rates and go under.  Most individuals possess limited budgets as well and have to scale back some purchases because of higher interest rates.  For example, higher interest rates translate into higher mortgage payments for home buyers. 

If high interest rates choke business expansion and consumer spending, economic growth slows or the economy shrinks — and possibly ends up in a recession.  The definition of a recession is two consecutive quarters (six months) of contracting economic activity. 

The stock market usually develops a case of the queasies as corporate profits shrink.  High interest rates may depress investors' appetites for stocks as the yields increase on certificates of deposit (CDs), Treasury bills, and other bonds. 

Higher interest rates actually make some people happy.  If you locked in a fixed-rate mortgage on your home or on a business loan, your loan looks much better than if you had a variable-rate mortgage.  Some retirees and others who live off the interest income on their investments are happy with interest rate increases as well.  Consider back in the early 1980s, for example, when a retiree received $10,000 per year in interest for each $100,000 that he invested in certificates of deposit that paid 10 percent. 

Fast-forward to the early 2000s: A retiree purchasing the same CDs saw interest income slashed by about 70 percent, because rates on the CDs were just 3 percent.  So for every $100,000 invested, only $3,000 in interest income was paid. 

If you try to live off the income that your investments produce, a 70 percent drop in that income is likely to cramp your lifestyle.  So higher interest rates are better if you're living off your investment income, right?  Not necessarily. 

Discovering the inflation and interest rate connection

Consider what happened to interest rates in the late 1970s and early 1980s.  After the United States successfully emerged from a terrible recession in the mid-1970s, the economy seemed to be on the right track.  But within just a few years, the economy was in turmoil again.  The annual increase in the cost of living (known as the rate of inflation) burst through 10 percent on its way to 14 percent.  Interest rates, which are what bondholders receive when they lend their money to corporations and governments, followed inflation skyward. 

  Inflation and interest rates usually move in tandem.  The primary driver of interest rates is the rate of inflation.  Interest rates were much higher in the 1980s because the United States had double-digit inflation.  If the cost of living increases at the rate of 10 percent per year, why would you, as an investor, lend your money (which is what you do when you purchase a bond or CD) at 5 percent?  Interest rates were so much higher in the early 1980s because you or I would never do such a thing. 

In recent years, interest rates have been low.  Therefore, the rate of interest that investors can earn lending their money has dropped accordingly.  Although low interest rates reduce the interest income that comes in, the corresponding low rate of inflation doesn't devour the purchasing power of your principal balance.  That's why lower interest rates aren't necessarily worse and higher interest rates aren't necessarily better as you try to live off your investment income. 

So what's an investor to do when he's living off the income he receives from his investments but doesn't receive enough because of low interest rates?  Some retirees have woken up to the risk of keeping all or too much of their money in short-term CD and bond investments. ( Review the sections in Chapter 3 dealing with asset allocation and investment mix.)  A simple but psychologically difficult solution is to use up some of your principal to supplement your interest and dividend income.  Using up your principal to supplement your income is what effectively happens anyway when inflation is higher — the purchasing power of your principal erodes more quickly.  You may also find that you haven't saved enough money to meet your desired standard of living — that's why you should consider your retirement goals well before retiring (see Chapter 3). 

Exploring the role of the Federal Reserve

When the chairman of the Federal Reserve Board, Ben Bernanke, speaks, an extraordinary number of people listen.  Most financial market watchers and the media want to know what the Federal Reserve has decided to do about monetary policy.  The Federal Reserve is the central bank of the United States.  The Federal Reserve Board comprises the 12 presidents from the respective Federal Reserve district banks and the 7 Federal Reserve governors, including the chairman who conducts the Federal Open Market Committee meetings behind closed doors eight times a year. 

What exactly is the Fed, as it's known, and what does it do?  The Federal Reserve sets monetary policy.  In other (perhaps clearer) words, the Fed influences interest-rate levels and the amount of money or currency in circulation, known as the money supply, in an attempt to maintain a stable rate of inflation and growth in the U.S. economy. 

Buying money is no different from buying lettuce, computers, or sneakers.  All these products and goods cost you dollars when you buy them.  The cost of money is the interest rate that you must pay to borrow it.  And the cost or interest rate of money is determined by many factors that ultimately influence the supply of and demand for money. 

The Fed, from time to time and in different ways, attempts to influence the supply and demand for money and the cost of money.  To this end, the Fed raises or lowers short-term interest rates, primarily by buying and selling U.S. Treasury bills on the open market.  Through this trading activity, known as open market operations, the Fed is able to target the Federal funds rate — the rate at which banks borrow from one another overnight. 

The senior officials at the Fed readily admit that the economy is quite complex and affected by many things, so it's difficult to predict where the economy is heading.  If forecasting and influencing markets are such difficult undertakings, why does the Fed exist?  Well, the Fed officials believe that they can have a positive influence in creating a healthy overall economic environment — one in which inflation is low and growth proceeds at a modest pace. 

  Over the years, the Fed has come under attack for various reasons.  Various pundits have accused former Fed Chairman Alan Greenspan of causing speculative bubbles (see Chapter 5), such as the boom in technology stock prices in the late 1990s or in housing in the early 2000s.  Some economists have argued that the Federal Reserve has, at times, goosed the economy by loosening up on the money supply, which leads to a growth spurt in the economy and a booming stock market, just in time to make El Presidente look good prior to an election.  Conveniently, the consequences of inflation take longer to show up — they're not evident until after the election.  In recent years, others have questioned the Fed's ability to largely do what it wants without accountability. 

  Many factors influence the course of stock prices.  Never, ever make a trade or investment based on what someone at the Federal Reserve says or what someone in the media or some market pundit reads into the Fed chairman's comments.  You need to make your investment plans based on your needs and goals, not what the Fed does or doesn't do. 
Chapter 5

Building Wealth with Stocks

In This Chapter

  Getting to know stock markets and indexes

  Buying stocks the smart way

  Understanding the importance of price-earnings ratios

  Learning from past bubbles and periods of pessimism

  Sidestepping common stock shopping mistakes

  Taking steps to improve your chance of success in the market

Some people liken investing in the stock market to gambling.  A real casino structures its games — such as slot machines, blackjack, and roulette — so that in aggregate, the casino owners siphon off a healthy slab (40 percent) of the money that people bring with them.  The vast majority of casino patrons lose money, in some cases all of it.  The few who leave with more money than they came with are usually people who are lucky and are smart enough to quit while they're ahead. 

I can understand why some individual investors feel that the stock market resembles legalized gambling.  Fortunately, the stock market isn't a casino — it's far from it.  Shares of stock, which represent portions of ownership in companies, offer a way for people of modest and wealthy means, and everybody in between, to invest in companies and build wealth.  History shows that long-term investors can win in the stock market because it appreciates over the years.  That said, some people who remain active in the market over many years manage to lose some money because of easily avoidable mistakes, which I can keep you from making in the future.  This chapter gets you up to speed on successful stock market investing. 

Taking Stock of How You Make Money

 When you purchase a share of a company's stock, you can profit from your ownership in two ways:

  Dividends: Most stocks pay dividends.  Companies generally make some profits during the year.  Some high-growth companies reinvest most or all of their profits right back into the business.  Many companies, however, pay out some of their profits to shareholders in the form of dividends. 

  Appreciation: When the price per share of your stock rises to a level greater than you originally paid for it, you make money.  This profit, however, is only on paper until you sell the stock, at which time you realize a capital gain. ( Such gains realized over periods longer than one year are taxed at the lower long-term capital gains tax rate; see Chapter 3.)  Of course, the stock price per share can fall below what you originally paid as well (in which case you have a loss on paper unless you realize that loss by selling at a lower price than you paid for the stock). 

If you add together dividends and appreciation, you arrive at your total return.  Stocks differ in the dimensions of these possible returns, particularly with respect to dividends. 

Defining "The Market"

You invest in stocks to share in the rewards of capitalistic economies.  When you invest in stocks, you do so through the stock market.  What is the stock market?  Everybody talks about "The Market" the same way they do the largest city nearby ("The City"):

The Market is down 137 points today. 

With The Market hitting new highs, isn't now a bad time to invest? 

The Market seems ready for a fall. 

When people talk about The Market, they're usually referring to the U.S. stock market.  Even more specifically, they're usually speaking about the Dow Jones Industrial Average, created by Charles Dow and Eddie Jones, which is a widely watched index or measure of the performance of the U.S. stock market.  Dow and Jones, two reporters in their 30s, started publishing a paper that you may have heard of — The Wall Street Journal — in 1889.  Like its modern-day version, the 19th-century Wall Street Journal reported current financial news.  Dow and Jones also compiled stock prices of larger, important companies and created and calculated indexes to track the performance of the U.S. stock market. 

The Dow Jones Industrial Average ("the Dow") market index tracks the performance of 30 large companies that are headquartered in the United States.  The Dow 30 includes companies such as telecommunications giant Verizon Communications; airplane manufacturer Boeing; beverage maker Coca-Cola; oil giant Exxon Mobil; technology behemoths IBM, Intel, and Microsoft; drug makers Merck and Pfizer; fast-food king McDonald's; and retailers Home Depot and Wal-Mart. 

Some criticize the Dow index for encompassing so few companies and for a lack of diversity.  The 30 stocks that make up the Dow aren't the 30 largest or the 30 best companies in America.  They just so happen to be the 30 companies that senior staff members at The Wall Street Journal think reflect the diversity of the economy in the United States (although utility and transportation stocks are excluded and tracked in other Dow indexes).  The 30 stocks in the Dow change over time as companies merge, decline, and rise in importance. 

Looking at major stock market indexes

Just as New York City isn't the only city to visit or live in, the 30 stocks in the Dow Jones Industrial Average are far from representative of all the different types of stocks that you can invest in.  Here are some other important market indexes and the types of stocks they track:

  Standard & Poor's (S&P) 500: Like the Dow Jones Industrial Average, the S&P 500 tracks the price of 500 larger-company U.S. stocks.  These 500 big companies account for more than 70 percent of the total market value of the tens of thousands of stocks traded in the United States.  Thus, the S&P 500 is a much broader and more representative index of the larger-company stocks in the United States than is the Dow Jones Industrial Average. 

  Unlike the Dow index, which is primarily calculated by adding the current share price of each of its component stocks, the S&P 500 index is calculated by adding the total market value (capitalization) of its component stocks. 

  Russell 2000: This index tracks the market value of 2,000 smaller U.S. company stocks of various industries.  Although small-company stocks tend to move in tandem with larger-company stocks over the longer term, it's not unusual for one to rise or fall more than the other or for one index to fall while the other rises in a given year.  For example, in 2001, the Russell 2000 actually rose 2.5 percent while the S&P 500 fell 11.9 percent.  In 2007, the Russell 2000 lost 1.6 percent versus a gain of 5.5 percent for the S&P 500.  Be aware that smaller-company stocks tend to be more volatile (I discuss the risks and returns in more detail in Chapter 2). 

  Wilshire 5000: Despite its name, the Wilshire 5000 index actually tracks the prices of about 4,000 stocks of U.S. companies of all sizes — small, medium, and large.  Thus, many consider this index the broadest and most representative of the overall U.S. stock market. 

  Morgan Stanley EAFE: Stocks don't exist only in the United States.  Morgan Stanley's EAFE index (EAFE stands for Europe, Australasia, and Far East) tracks the prices of stocks in the other major developed countries of the world. 

  Morgan Stanley Emerging Markets: This index follows the value of stocks in the less economically developed but "emerging" countries, such as Korea, Brazil, China, Russia, Taiwan, India, South Africa, Mexico, and so on.  These stock markets tend to be more volatile than those in established economies.  During good economic times, emerging markets usually reward investors with higher returns, but stocks can fall farther and faster than stocks in developed markets. 

  Conspicuously absent from this list of major stock market indexes is the NASDAQ index.  With the boom in technology stock prices in the late 1990s, CNBC and other financial media started broadcasting movements in the technology-laden NASDAQ index, thereby increasing investor interest and the frenzy surrounding technology stocks. ( See the section later in this chapter titled "The Internet and technology bubble.")  I'm not a fan of sector (industry) specific investing; it undermines diversification and places you in the role of a professional money manager in having to determine when and how much to invest in specific industry groups.  I suggest ignoring the NASDAQ as well as other industry-concentrated indexes. 

Counting reasons to use indexes

Indexes serve several purposes.  First, they can quickly give you an idea of how particular types of stocks fare and perform in comparison with other types of stocks.  In 1998, for example, the S&P 500 was up 28.6 percent, whereas the small-company Russell 2000 index was down 2.5 percent.  That same year, the Morgan Stanley foreign stock EAFE index rose 20.3 percent.  In 2001, by contrast, the S&P 500 fell 11.9 percent, and the EAFE foreign stock index had an even worse year — falling 21.4 percent. 

Indexes also allow you to compare or benchmark the performance of your stock market investments.  If you invest primarily in large-company U.S. stocks, for example, you should compare the overall return of the stocks in your portfolio to a comparable index — in this case, the S&P 500. ( As I discuss in Chapter 8, index mutual funds, which invest to match a major stock market index, offer a cost-effective, proven way to build wealth by investing in stocks.) 

Recognizing bull and bear markets

If you read magazines or newspapers or listen to people talk about the stock market, you often hear references to bull markets and bear markets.  You may know which term means a good market and which term means a bad market for investors, but you may not know where these silly terms come from. 

It's hard to find agreement on the origin of these terms, but my favorite description comes from Robert Claiborne's Loose Cannons and Red Herrings — A Book of Lost Metaphors (W. W. Norton & Company).  The term bear, according to Claiborne, originates from a proverb that mocks a man who "sells the bearskin before catching the bear."  Here's the connection to the stock market: When dealers in the stock market thought that the market had become too pricey and speculative, these dealers sold stock that they hadn't yet "caught" (bought).  These dealers were labeled "bearskin jobbers" and, later, "bears." 

The practice that these bearish dealers engaged in is referred to as short selling.  They hoped that when they ultimately bought the stock that they had first sold, they could buy it back at a lower price.  Their profit was the difference between the price that they originally sold it for and the price they later bought it for.  Short selling is simply investing in reverse: You sell first and buy back later.  The worst situation for a bear is when prices go up, and she must buy back the stock at a high price.  As Claiborne said, "He who sells what isn't his'n, must buy it back or go to prison." 

The bulls, according to Claiborne, are those who work the "other side" of the street.  Bulls buy stocks with the hope and expectation that they will rise in value.  Ben Travato, a man whom Claiborne describes as one prone to inventing colorful, but often inaccurate, etymologies, said that bulls toss stocks up in the air with their horns. 

An alternative explanation for these terms comes from research that economic and investment strategist Don Luskin shared with me.  He says that the terms were in use in the early 1700s in the financial markets in England, and that they derive from the staged fights between wild animals that were offered as cruel public amusements at the time.  When bulls were pitted against bears, the bull fought with an upward motion of its horns; the bear fought with a downward motion of its paws. 

As I explain in the section "Looking at major stock market indexes," earlier in this chapter, you may also hear about some other types of more narrowly focused indexes, including those that track the performance of stocks in particular industries, such as advertising, banking, computers, pharmaceuticals, restaurants, semiconductors, textiles, and utilities.  Other indexes cover other countries' stock markets, such as the United Kingdom, Germany, France, Canada, and Hong Kong. 

  Focusing your investments in the stocks of just one or two industries or smaller countries is dangerous due to the lack of diversification and your lack of expertise in making the difficult decision about what to invest in and when.  Thus, I suggest that you ignore these narrower indexes.  Many companies, largely out of desire for publicity, develop their own indexes.  If the news media report on these indexes, the index developer obtains free advertising. ( In Chapter 8, I discuss investing strategies, such as those that focus on value stocks or growth stocks, which also have market indexes.) 

Stock-Buying Methods

When you invest in stocks, many (perhaps too many) choices exist.  Besides the tens of thousands of stocks from which you can select, you also can invest in mutual funds, invest in exchange-traded funds (ETFs) or hedge funds, or have a stockbroker select for you. 

Buying stocks via mutual funds

If you're busy and suffer no delusions about your expertise, you'll love the best stock mutual funds.  Investing in stocks through mutual funds can be as simple as dialing a toll-free phone number or logging on to a fund company's website, completing some application forms, and zapping them some money. 

Mutual funds take money invested by people like you and me and pool it in a single investment portfolio in securities, such as stocks and bonds.  The portfolio is then professionally managed.  Stock mutual funds, as the name suggests, invest primarily or exclusively in stocks (some stock funds sometimes invest a bit in other stuff, such as bonds). 

 Stock mutual funds include many advantages:

  Diversification: Buying individual stocks on your own is relatively costly unless you buy reasonable chunks (100 shares or so) of each stock.  But in order to buy 100 shares each in, say, a dozen companies' stocks to ensure diversification, you need about $60,000 if the stocks that you buy average $50 per share. 

  Professional management: Even if you have big bucks to invest, mutual funds offer something that you can't deliver: professional, full-time management.  Mutual fund managers peruse a company's financial statements and otherwise track and analyze its business strategy and market position.  The best managers put in long hours and possess lots of expertise and experience in the field. ( If you've been misled into believing that with minimal effort you can rack up market-beating returns by selecting your own stocks, please be sure to read the rest of this chapter.) 

Look at it this way: Mutual funds are a huge time-saver.  It's Friday night.  Would you rather sit in front of your computer and do some research on semiconductor and toilet paper manufacturers, or would you rather enjoy dinner or a movie with family and friends? ( The answer to that question depends on who your family and friends are!) 

  Low costs — if you pick 'em right: To convince you that mutual funds aren't a good way for you to invest, those with a vested interest, such as stock-picking newsletter pundits, may point out the high fees that some funds charge.  An element of truth rings here: Some funds are expensive, charging you a couple percent or more per year in operating expenses on top of hefty sales commissions. 

But just as you wouldn't want to invest in a fund that a novice with no track record manages, why would you want to invest in a high-cost fund?  Contrary to the "You get what you pay for" notion often trumpeted by vthose trying to sell you something at an inflated price, some of the best managers are the cheapest to hire.  Through a no-load (commission-free) mutual fund, you can hire a professional, full-time money manager to invest $10,000 for a mere $20 to $100 per year. ( Some index funds and exchange-traded funds charge even less.) 

 As with all investments, mutual funds have some drawbacks.  Consider the following:

  The issue of control is a problem for some investors.  If you like being in control, sending your investment dollars to a seemingly black-box process where others decide when and in what to invest your money may unnerve you.  However, you need to be more concerned about the potential blunders that you may make investing in individual stocks of your own choosing or, even worse, those stocks pitched to you by a broker. 

  Taxes are a concern when you invest in mutual funds outside of retirement accounts.  Because the fund manager decides when to sell specific stock holdings, some funds may produce relatively high levels of taxable distributions.  Fear not — simply select tax-friendly funds if taxes concern you. 

In Chapter 8, I discuss investing in the best mutual funds that offer a time- and cost-efficient, high-quality way to invest in stocks worldwide. 

Using exchange-traded funds and hedge funds

Exchange-trade funds (ETFs) are the new kid on the block, certainly in comparison to mutual funds.  ETFs are in many ways similar to mutual funds, specifically index funds (see Chapter 8), except that they trade on a stock exchange.  The chief attractions are those ETFs that offer investors the potential for even lower operating expenses than comparable mutual funds.  I expand on ETFs and explain which ones to consider using in Chapter 8. 

Like mutual funds, hedge funds are a managed investment vehicle.  In other words, an investment management team researches and manages the funds' portfolio.  However, hedge funds are oriented to affluent investors and typically charge steep fees — a 1.0 to 1.5 percent annual management fee plus a 20 percent cut of the annual fund returns.  No proof exists that hedge funds as a group perform better than mutual funds.  In fact, the objective studies that I've reviewed show inferior hedge fund returns, which makes sense.  Those high hedge fund fees depress their returns. ( Notwithstanding the small number of hedge funds that have produced better long-term returns, too many affluent folks invest in hedge funds due to the fund's hyped marketing and the badge of exclusivity they offer.) 

Selecting individual stocks yourself

More than a few investing books suggest and enthusiastically encourage people to do their own stock picking.  However, the vast majority of investors are better off not picking their own stocks. 

I've long been an advocate of people educating themselves and taking responsibility for their own financial affairs, but taking responsibility for your own finances doesn't mean that you should do everything yourself.  Table 5-1 includes some thoughts to consider about choosing your own stocks. 

Table 5-1 Why You're Buying Your Own Stocks

---

Good Reasons to Pick Your Own Stocks | Bad Reasons to Pick Your Own Stocks

You enjoy the challenge.  | You think you can beat the best money managers. ( If you can, you're in the wrong profession!) 

You want to learn more about business.  | You want more control over your investments, which you think may happen if you understand the companies that you invest in. 

You possess a substantial amount of money to invest.  | You think that mutual funds are for people who aren't smart enough to choose their own stocks. 

You're a buy-and-hold investor.  | You're attracted to the ability to trade your stocks any time you want. 

Some popular investing books try to convince investors that they can do a better job than the professionals at picking their own stocks.  Amateur investors, however, need to devote a lot of study to become proficient at stock selection.  Many professional investors work 80 hours a week at investing, but you're unlikely to be willing to spend that much time on it.  Don't let the popularity of those do-it-yourself stock-picking books lead you astray. 

 Choosing a stock isn't as simple as visiting a restaurant chain (or buying a pair of shoes or an iGadget), liking it, buying its stock, and then sitting back and getting rich watching your stock zoom to the moon. 

If you invest in stocks, I think you know by now that guarantees don't exist.  But as in many of life's endeavors, you can buy individual stocks in good and not-so-good ways.  So if you want to select your own individual stocks, check out Chapter 6, where I explain how to successfully research and trade them. 

Spotting the Best Times to Buy and Sell

After you know about the different types of stock markets and ways to invest in stocks, you may wonder how you can build wealth with stocks and not lose your shirt.  Nobody wants to buy stocks before a big drop (which I discuss in Chapter 2). 

As I discuss in Chapter 4, the stock market is reasonably efficient.  A company's stock price normally reflects many smart people's assessments as to what is a fair price.  Thus, it's not realistic for an investor to expect to discover a system for how to "buy low and sell high."  Some professional investors may have an ability for spotting good times to buy and sell particular stocks, but consistently doing so is enormously difficult. 

  The simplest and best way to make money in the stock market is to consistently and regularly feed new money into building a diversified and larger portfolio.  If the market drops, you can use your new investment dollars to buy more shares.  The danger of trying to time the market is that you may be "out" of the market when it appreciates greatly and "in" the market when it plummets. 

Calculating price-earnings ratios

Suppose I tell you that the stock for Liz's Distinctive Jewelry sells for $50 per share, and another stock in the same industry, The Jazzy Jeweler, sells for $100.  Which would you rather buy? 

If you answer, "I don't have a clue because you didn't give me enough information," go to the head of the class!  On its own, the price per share of stock is meaningless.  Although The Jazzy Jeweler sells for twice as much per share, its profits may also be twice as much per share — in which case, The Jazzy Jeweler stock price may not be out of line given its profitability. 

 The level of a company's stock price relative to its earnings or profits per share helps you calibrate how expensively, cheaply, or fairly a stock price is valued. 

Over the long term, stock prices and corporate profits tend to move in sync, like good dance partners.  The price-earnings ratio, or P/E ratio (say "P E" — the "/" isn't pronounced), compares the level of stock prices to the level of corporate profits, giving you a good sense of the stock's value.  Over shorter periods of time, investors' emotions as well as fundamentals move stocks, but over longer terms, fundamentals possess a far greater influence on stock prices. 

P/E ratios can be calculated for individual stocks as well as entire stock indexes, portfolios, or funds. 

Over the past 100-plus years, the P/E ratio of U.S. stocks has averaged around 15.  During times of low inflation, the ratio has tended to be higher — in the high teens to low twenties.  As I cautioned in the second edition of this book, published in 1999, the P/E ratio for U.S. stocks got into the thirties, well above historic norms even for a period of low inflation.  Thus, the down market that began in 2000 wasn't surprising, especially given the fall in corporate profits that put even more pressure on stock prices. 

Just because U.S. stocks have historically averaged P/E ratios of about 15 doesn't mean that every individual stock will trade at such a P/E. Here's why: Suppose that you have a choice between investing in two companies, Superb Software, which makes computer software, and Tortoise Technologies, which makes typewriters.  Say both companies' stocks sell at a P/E of 15.  If Superb Software's business and profits grow 40 percent per year and Tortoise's business and profits remain flat, which would you buy? 

Because both stocks trade at a P/E of 15, Superb Software appears to be the better buy.  Even if Superb's stock continues to sell at 15 times the earnings, its stock price should increase 40 percent per year as its profits increase.  Faster-growing companies usually command higher price-earnings ratios. 

  Just because a stock price or an entire stock market seems to be at a high price level doesn't necessarily mean that the stock or market is overpriced.  Always compare the price of a stock to that company's profits per share or the overall market's price level to the overall corporate profits.  The price-earnings ratio captures this comparison.  Faster-growing and more-profitable companies generally sell for a premium — they have higher P/E ratios.  Also remember that future earnings, which are difficult to predict, influence stock prices more than current earnings, which are old news. 

Citing times of speculative excess

Because the financial markets move on the financial realities of the economy as well as on people's expectations and emotions (particularly fear and greed), you shouldn't try to time the markets.  Knowing when to buy and sell is much harder than you think. 

  Be careful that you don't get sucked into investing lots of your money in aggressive investments that seem to be in a hyped state.  Many people don't become aware of an investment until it receives lots of attention.  By the time everyone else talks about an investment, it's often nearing or at its peak. 

In the sections that follow, I walk you through some of the biggest speculative bubbles.  Although some of these examples are from prior decades and even centuries, I chose these examples because I find that they best teach the warning signs and dangers of speculative fever times. 

The Internet and technology bubble

Note: This first section is excerpted from the second edition of this book, published in 1999, which turned out to be just one year before the tech bubble actually burst. 

In the mid-1990s, a number of Internet-based companies launched initial public offerings of stock. ( I discuss IPOs in Chapter 4.)  Most of the early Internet company stock offerings failed to really catch fire.  By the late 1990s, however, some of these stocks began meteoric rises. 

The bigger-name Internet stocks included companies such as Internet service provider America Online, Internet auctioneer eBay, and Internet portal Yahoo!.  As with the leading new consumer product manufacturers of the 1920s that I discuss in the section "The 1920s consumer spending binge," later in this chapter, many of the leading Internet company stocks zoomed to the moon.  Please note that the absolute stock price per share of the leading Internet companies in the late 1990s was meaningless.  The P/E ratio is what mattered.  Valuing the Internet stocks based upon earnings posed a challenge because many of these Internet companies were losing money or just beginning to make money.  Some Wall Street analysts, therefore, valued Internet stocks based upon revenue and not profits. 

  Valuing a stock based upon revenue and not profits can be highly dangerous.  Revenues don't necessarily translate into high profits or any profits at all. 

Now, some of these Internet companies may go on to become some of the great companies and stocks of future decades.  However, consider this perspective from veteran money manager David Dreman. " The Internet stocks are getting hundredfold more attention from investors than, say, a Ford Motor in chat rooms online and elsewhere.  People are fascinated with the Internet — many individual investors have accounts on margin.  Back in the early 1900s, there were hundreds of auto manufacturers, and it was hard to know who the long-term survivors would be.  The current leaders won't probably be long-term winners." 

Internet stocks aren't the only stocks being swept to excessive prices relative to their earnings at the dawn of the new millennium.  Various traditional retailers announced the opening of Internet sites to sell their goods, and within days, their stock prices doubled or tripled.  Also, leading name-brand technology companies, such as Dell Computer, Cisco Systems, Lucent, and PeopleSoft, traded at P/E ratios in excess of 100.  Investment brokerage firm Charles Schwab, which expanded to offer Internet services, saw its stock price balloon to push its P/E ratio over 100.  As during the 1960s and 1920s, name-brand growth companies soared to high P/E valuations.  For example, coffee purveyor Starbucks at times had a P/E near 100. 

  What I find troubling about investors piling in to the leading, name-brand stocks, especially in Internet and technology-related fields, is that many of these investors don't even know what a price-earnings ratio is and why it's important.  Before you invest in any individual stock, no matter how great a company you think it is, you need to understand the company's line of business, strategies, competitors, financial statements, and price-earnings ratio versus the competition, among many other issues.  Selecting and monitoring good companies take lots of research, time, and discipline. 

Also, remember that if a company taps in to a product line or way of doing business that proves highly successful, that company's success invites lots of competition.  So you need to understand the barriers to entry that a leading company has erected and how difficult or easy it is for competitors to join the fray.  Also, be wary of analysts' predictions about earnings and stock prices.  As more and more investment banking analysts initiated coverage of Internet companies and issued buy ratings on said stocks, investors bought more shares.  Analysts, who are too optimistic (as shown in numerous independent studies), have a conflict of interest because the investment banks that they work for seek to cultivate the business (new stock and bond issues) of the companies that they purport to rate and analyze.  The analysts who say, "buy, buy, buy all the current market leaders" are the same analysts who generate much new business for their investment banks and get the lucrative job offers and multi-million-dollar annual salaries. 

  Simply buying today's rising and analyst-recommended stocks often leads to future disappointment.  If the company's growth slows or the profits don't materialize as expected, the underlying stock price can nose dive.  This happened to investors who piled in to the stock of computer disk drive maker Iomega back in early 1996.  After a spectacular rise to about $27 1⁄2 per share, the company fell on tough times.  Iomega stock subsequently plunged to less than $3 per share.  In 2008, it was acquired by EMC for less than $4 per share. 

Presstek, a company that uses computer technology for direct imaging systems, rose from less than $10 per share in mid-1994 to nearly $100 per share just two years later — another example of supposed can't-lose technology that crashed and burned.  As was the case with Iomega, herds of novice investors jumped on the Presstek bandwagon simply because they believed that the stock price would keep rising.  By 1999, less than three years after hitting nearly $100 per share, it plunged more than 90 percent to about $5 per share.  It's been recently trading under $2 per share. 

ATC Communications, which was similar to Iomega and glowingly recommended by the Motley Fool website, plunged by more than 80 percent in a matter of months before the Fools recommended selling. 

The Japanese stock market juggernaut

Lest you think that the United States cornered the market on manias, overseas examples abound.  A rather extraordinary mania happened not so long ago in the Japanese stock market. 

After Japan's crushing defeat in World War II, its economy was in shambles.  Two major cities — Hiroshima and Nagasaki — were destroyed, and more than 200,000 died from atomic bombs. 

Out of the rubble, Japan emerged a strengthened nation that became an economic powerhouse.  Over the course of 22 years, from 1967 to 1989, Japanese stock prices rose 30-fold (an amazing 3,000 percent) as the economy boomed.  From 1983 to 1989 alone, Japanese stocks soared more than 500 percent. 

In terms of the U.S. dollar, the Japanese stock market rise was all the more stunning, because the dollar lost value versus Japan's currency, the yen.  The dollar lost about 65 percent of its value during the big run-up in Japanese stocks.  In dollar terms, the Japanese stock market rose an astonishing 8,300 percent from 1967 to 1989. 

  Many considered investing in Japanese stocks close to a sure thing.  Increasing numbers of people became full-time stock market investors in Japan.  Many of these folks were actually speculators because they relied heavily on borrowed funds.  As the Japanese real estate market boomed in tandem with the stock market, real estate investors borrowed from their winnings to invest in stocks and vice versa. 

Borrowing heavily was easy to do; Japan's banks were awash in cash, and it was cheap to borrow.  Established investors could make property purchases with no money down.  Cash abounded from real estate as the price of land in Tokyo soared 500 percent from 1985 to 1990.  Despite the fact that Japan has only 1⁄25 as much land as the United States, Japan's total land values at the close of the 1980s were four times that of all the land in the United States! 

Speculators also used futures and options (discussed in Chapter 1) to gamble on higher short-term Japanese stock market prices. ( Interestingly, Japan doesn't allow selling short.) 

Price-earnings ratios?  Forget about it.  To justify the high prices that they paid for stocks, Japanese market speculators pointed out that the real estate that many companies owned was soaring to the moon and making companies more valuable. 

Price-earnings ratios on the Japanese market soared during the early 1980s and ballooned to more than 60 times earnings by 1987.  As I point out elsewhere in this chapter, such lofty P/E ratios were sometimes awarded to select individual stocks in the United States.  But the entire Japanese stock market, which included many mediocre and not-so-hot companies, possessed P/E ratios of 60-plus! 

When Japan's Nippon Telegraph and Telephone went public in February 1987, it met such frenzied enthusiasm that its stock price was soon bid up to a stratospheric 300-plus price-earnings ratio.  At the close of 1989, Japan's stock market, for the first time in history, unseated the U.S. stock market in total market value of all stocks.  And this feat happened despite the fact that the total output of the Japanese economy was less than half that of the U.S. economy. 

Even some U.S. observers began to lose sight of the big picture and added to the rationalizations for why the high levels of Japanese stocks were justified.  After all, it was reasoned, Japanese companies and executives were a tightly knit and closed circle, investing heavily in the stocks of other companies that they did business with.  The supply of stock for outside buyers was thus limited as companies sat on their shares. 

Corporate stock ownership went further, though, as stock prices were sometimes manipulated.  Speculators gobbled up the bulk of outstanding shares of small companies and traded shares back and forth with others whom they partnered with to drive up prices.  Company pension plans began to place all (as in 100 percent) of their employees' retirement money in stocks with the expectation that stock prices would always keep going up. 

The collapse of the Japanese stock market was swift.  After peaking at the end of 1989, the Tokyo market fell nearly 50 percent in the first nine months of 1990 alone.  By the middle of 1992, Japanese stocks had dropped nearly 65 percent — a decline that the U.S. market hasn't experienced since the Great Depression.  However, prices stagnated during the rest of the 1990s and then fell again in the 2000s until 2008, putting it at a level that was more than 80 percent lower than the peak reached nearly two decades prior.  Japanese investors who borrowed lost everything.  The total loss in stock market value was about $3 trillion, about the size of the entire Japanese annual output. 

Several factors finally led to the pricking of the Japanese stock market bubble.  Japanese monetary authorities tightened credit as inflation started to creep upward and concern increased over real estate market speculation.  As interest rates began to rise, investors soon realized that they could earn 15 times more interest from a safe bond versus the paltry yield on stocks. 

As interest rates rose and credit tightened, speculators were squeezed first.  Real estate and stock market speculators began to sell their investments to pay off mounting debts.  Higher interest rates, less-available credit, and the already grossly inflated prices greatly limited the pool of potential stock buyers.  The falling stock and real estate markets fed off each other.  Investor losses in one market triggered more selling and price drops in the other.  The real estate price drop was equally severe — registering 50 to 60 percent or more in most parts of Japan after the late 1980s. 

The 1960s weren't just about rock 'n' roll

The U.S. stock market mirrored the climate of the country during this decade of change and upheaval.  The stock market experienced both good years and bad years, but overall it gained. 

During the 1960s, consumer product companies' stocks were quite popular and were bid up to stratospheric valuations.  When I say "stratospheric valuations," I mean that some stock prices were high relative to the company's earnings — my old friend, the price-earnings (P/E) ratio.  Investors had seen such stock prices rise for many years and thought that the good times would never end. 

Take the case of Avon Products, which sells cosmetics door-to-door, primarily with an army of women.  During the late 1960s, Avon's stock regularly sold at a P/E of 50 to 70 times earnings. ( Remember, the market average is about 15.)  After trading as high as $140 per share in the early 1970s, Avon's stock took more than two decades to return to that high level.  Remember that during this time period the overall U.S. stock market rose more than tenfold! 

  When a stock such as Avon's sells at such a high multiple of earnings, two factors can lead to a bloodletting:

  The company's profits may continue to grow, but investors may decide that the stock isn't such a great long-term investment after all and not worth, say, a P/E of 60.  Consider that if investors decide it's worth only a P/E of 30 (still a hefty P/E), the stock price would drop 50 percent to cut the P/E in half. 

  The second shoe that can drop is the company's profits or earnings.  If profits fall, say, 20 percent, as Avon's did during the 1974–75 recession, the stock price will fall 20 percent, even if it continued to sell for 60 times its earnings.  But when earnings drop, investors' willingness to pay an inflated P/E plummets along with the earnings.  So when Avon's profits finally did drop, the P/E that investors were willing to pay plunged to 9.  Thus, in less than two years, Avon's stock price dropped nearly 87 percent! 

Avon wasn't alone in its stock price soaring to a rather high multiple of its earnings in the 1960s and early 1970s.  Well-known companies such as Black & Decker, Eastman Kodak, Kmart (which used to be called S.S. Kresge in those days), and Polaroid sold for 60 to as much as 100 times earnings.  All these companies, like Avon, sell today at about the same or at a lower price than they achieved decades ago.  Many other well-known and smaller companies sold at similar and even more outrageous premiums to earnings. 

The 1920s consumer spending binge

The Dow Jones Industrial Average soared nearly 500 percent in a mere eight years, from 1921 to 1929, allowing for one of the best bull market runs for the U.S. stock market.  The country and investors had good reason for economic optimism.  New devices — telephones, cars, radios, and all sorts of electric appliances — were making their way into the mass market.  The stock price of RCA, the radio manufacturer, for example, ballooned 5,700 percent during this eight-year stretch. 

Speculation in the stock market moved from Wall Street to Main Street.  Investors during the 1920s were able to borrow lots of money to buy stock through margin borrowing.  You can still margin borrow today — for every dollar that you put up, you may borrow an additional dollar to buy stock.  At times during the 1920s, investors could borrow up to nine dollars for every dollar that they had in hand.  The amount of margin loans outstanding swelled from $1 billion in the early 1920s to more than $8 billion in 1929.  When the market plunged, margin calls (which require putting up more money due to declining stock values) forced margin borrowers to sell their stock, thus exacerbating the decline. 

The steep run-up in stock prices was also due in part to market manipulation.  Investment pools used to buy and sell stocks among one another, thus generating high trading volume in a stock, which made it appear that interest in the stock was great.  Also, writers who dispensed enthusiastic prognostications about said stock were in cahoots with pool operators. ( Reforms later passed by the Securities and Exchange Commission addressed these problems.) 

Not only were members of the public largely enthusiastic, so too were the supposed experts.  After a small decline in September 1929, economist Irving Fisher said in mid-October, "Stock prices have reached what looks like a permanently high plateau."  High?  Yes!  Permanent plateau?  Investors wish! 

On October 25, 1929, just days before all heck began breaking loose, President Herbert Hoover said, "The fundamental business of the country . . .  is on a sound and prosperous basis."  Days later, multimillionaire oil tycoon John D. Rockefeller said, "Believing that fundamental conditions of the country are sound . . .  my son and I have for some days been purchasing sound common stocks." 

By December of that same year, the stock market had dropped by more than 35 percent.  General Electric President Owen D. Young said at that time, "Those who voluntarily sell stocks at current prices are extremely foolish."  Well, actually not.  By the time the crash had run its course, the market had plunged 89 percent in value in less than three years. 

The economy went into a tailspin.  Unemployment soared to more than 25 percent of the labor force.  Companies entered this period with excess inventories, which mushroomed further when people slashed their spending.  High overseas tariffs stifled American exports.  Thousands of banks failed, because early bank failures triggered "runs" on other banks. ( No FDIC insurance existed in those days.) 

  Psychologically, it's easier for many people to buy stocks after they've had a huge increase in price.  Just as you shouldn't attempt to drive your car looking solely through your rearview mirror, basing investments solely on past performance usually leads novice investors into overpriced investments.  If many people talk about the stunning rise in the market and new investors pile in based on the expectation of hefty profits, tread carefully. 

I'm not saying that you need to sell your current stock holdings if you see an investment market getting frothy and speculative.  As long as you diversify your stocks worldwide and hold other investments, such as real estate and bonds, the stocks that you hold in one market need to be only a fraction of your total holdings.  Timing the markets is difficult: You can never know how high is high and when it's time to sell, and then how low is low and when it's time to buy.  And if you sell non-retirement account investments at a profit, you end up sacrificing a lot of the profit to federal and state taxes. 

Manias in prior centuries

I could fill an entire book with modern-day stock market manias.  But bear with me as I roll back the clocks a couple of centuries to observe other market manias, the first being England's so-called South Seas bubble of 1719.  South Seas wasn't the kind of company that would've met today's socially responsible investors' needs.  Initially, the South Seas Company focused on the African slave trade, but too many slaves died in transit, so it wasn't a lucrative business. 

If you think government corruption is a problem today, consider what politicians of those days did without the scrutiny of a widely read press.  King George backed the South Seas Company and acted as its governor.  Politicos in Parliament bought tons of stock in the South Seas Company and even rammed through Parliament a provision that allowed investors to buy stock on borrowed money.  The stock of the South Seas Company soared from about £120 to more than £1000 in just the first six months of 1720. 

After such an enormous run-up, insiders realized that the stock price was greatly inflated and quietly bailed.  Citizens fell all over themselves to get into this surefire moneymaker.  Other seafaring companies pursued the South Seas trade business, so the greedy politicians passed a law that stated that only government-approved companies could pursue trade.  The stocks of these other companies tumbled, and investor losses led to a chain reaction that prompted selling of the South Seas Company stock, which plunged more than 80 percent by the autumn of that same year. 

England wasn't the only European country that was swept up in an investment mania.  Probably the most famous mania of them all was the tulip bulb (yes, those flowers that you can plant in your own home garden).  A botany professor introduced tulips into Holland from Turkey in the late 1500s.  Residents allowed a fascination with these bulbs to turn into an investment feeding frenzy. 

At their speculative peak, the price of a single tulip bulb was the equivalent of more than $10,000 in today's dollars.  Many people sold their land holdings to buy more.  Documented cases show that people traded a bulb for a dozen acres of land!  Laborers cut back on their work to invest.  Eventually, tulip bulb prices came crashing back to earth.  A trip to your local nursery shows you what a bulb sells for today. 

Buying more when stocks are "on sale"

Along with speculative buying frenzies come valleys of pessimism when stock prices are falling sharply.  Having the courage to buy when stock prices are "on sale" can pay big returns. 

In the early 1970s, interest rates and inflation escalated.  Oil prices shot up as an oil embargo choked off supplies, and Americans had to wait in long lines for gas.  Gold prices soared, and the U.S. dollar plunged in value on foreign currency markets. 

If the economic problems weren't enough to make most everyone gloomy, the U.S. political system hit an all-time low during this period as well.  Vice President Spiro Agnew resigned in disgrace under a cloud of tax-evasion charges; then Watergate led to President Richard Nixon's August 1974 resignation, the first presidential resignation in the nation's history. 

When all was sold and done, the Dow Jones Industrial Average plummeted more than 45 percent from early 1973 until late 1974.  Among the stocks that fell the hardest included those that were most popular and selling at extreme multiples of earnings in the late 1960s and early 1970s. ( See the section "The 1960s weren't just about rock 'n' roll," earlier in this chapter.) 

Take a gander at Table 5-2 to see the drops in some well-known companies and see how cheaply these stocks were valued relative to corporate profits (look at the P/E ratios) after the worst market drop since the Great Depression. 

Those who were too terrified to buy stocks in the mid-1970s actually had time to get on board and take advantage of the buying opportunities.  The stock market did have a powerful rally and, from its 1974 low, rose nearly 80 percent over the next two years.  But over the next half dozen years, the market backpedaled, losing much of its gains. 

In the late 1970s and early 1980s, inflation continued to escalate well into double digits.  Corporate profits declined further, and unemployment rose higher than in the 1974 recession.  Although some stocks dropped, others simply treaded water and went sideways for years after major declines in the mid-1970s.  As some companies' profits increased, P/E bargains abounded (as shown in Table 5-3). 

During the 2008 financial crisis, panic (and talk of another Great Depression) was in the air and stock prices dropped sharply.  Peak to trough, global stock prices plunged 50-plus percent.  While some companies went under (and garnered lots of news headlines), those firms were few in number and were the exception rather than the norm.  Many terrific companies weathered the storm, and their stock could be scooped up by investors with cash and courage at attractive prices and valuations. 

  When bad news and pessimism abound and the stock market has dropped, it's actually a much safer and better time to buy stocks.  You may even consider shifting some of your money out of your safer investments, such as bonds, and invest more aggressively in stocks.  Investors feel during these times that prices can drop farther, but if you buy and wait, you'll be amply rewarded.  Most of the stocks listed in the preceding several pages have appreciated 500 to 2,500-plus percent in the subsequent decades. 

Avoiding Problematic Stock-Buying Practices

  You may be curious about ways to buy individual stocks, but if I list the methods you're curious about in this section, it's because I don't recommend using them.  You can greatly increase your chances of success and earn higher returns if you avoid the commonly made stock-investing mistakes that I present in this section. 

Beware of broker conflicts of interest

Some investors make the mistake of investing in individual stocks through a broker who earns a living from commissions.  The standard pitch from these firms and their brokers is that they maintain research departments that monitor and report on stocks.  Their brokers, using this research, tell you when to buy, sell, or hold.  Sounds good in theory, but this system has significant problems. 

  Many brokerage firms happen to be in another business that creates enormous conflicts of interest in producing objective company reviews.  These investment firms also solicit companies to help them sell new stock and bond issues.  To gain this business, the brokerage firms need to demonstrate enthusiasm and optimism for the company's future prospects. 

Brokerage analysts who, with the best of intentions, write negative reports about a company find their careers hindered in a variety of ways.  Some firms fire such analysts.  Companies that the analysts criticize exclude those analysts from analyst meetings about the company.  So most analysts who know what's good for their careers and their brokerage firms don't write disapproving reports (but some do take chances). 

Although investment insiders know that analysts are pressured to be overly optimistic, historically it's been hard to find a smoking gun to prove that this pressuring is indeed occurring and few people are willing to talk on the record about it.  One firm was caught encouraging its analysts via a memo not to say negative things about companies.  As uncovered by Wall Street Journal reporter Michael Siconolfi, Morgan Stanley's head of new stock issues stated in a memo that the firm's policy should include "no negative comments about [its] clients."  The memo also stated that any analyst's changes in a stock's rating or investment opinion, "which might be viewed negatively" by the firm's clients, had to be cleared through the company's corporate finance department head. 

Various studies of the brokerage firm's stock ratings have conclusively demonstrated that from a predictive perspective, most of its research is barely worth the cost of the paper that it's printed on.  In Chapter 6, I recommend independent research reports that beat the brokerage industry track record hands down.  In Chapter 9, I cover the important issues that you need to consider when you select a good broker. 

Don't short-term trade or try to time the market

Unfortunately (for themselves), some investors track their stock investments closely and believe that they need to sell after short holding periods —months, weeks, or even days.  With the growth of Internet and computerized trading, such shortsightedness has taken a turn for the worse as more investors now engage in a foolish process known as day trading, where they buy and sell a stock within the same day! 

 If you hold a stock only for a few hours or a few months, you're not investing; you're gambling.  Specifically, the numerous drawbacks that I see to short-term trading include the following:

  Higher trading costs: Although the commission that you pay to trade stocks has declined greatly in recent years, especially through online trading (which I discuss in Chapter 9), the more you trade, the more of your investment dollars go into a broker's wallet.  Commissions are like taxes — once collected, those dollars are forever gone, and your return is reduced.  Similarly, the spread between the price you pay to purchase a stock and the price you would receive to sell the same stock (known as the bid-ask spread) can be a significant drag on your investment return. 

  More taxes (and tax headaches): When you invest outside of tax-sheltered retirement accounts, you must report on your annual income tax return every time that you buy and then sell a stock.  After you make a profit, you must part with a good portion of it through the federal and state capital gains tax that you owe from the sale of your stock.  If you sell a stock within one year of buying it, the IRS and most state tax authorities consider your profit short-term, and you owe a much higher rate of tax than if you hold your stock for more than a year.  Holding your stock for more than a year qualifies you for the favorable long-term capital gains tax rate (a topic that I discuss in Chapter 21).  The return that you keep (after taxes) is more important than the return that you make (before taxes). 

  Lower returns: If stocks increase in value over time, long-term buy-and-hold investors enjoy the fruits of the stock's appreciation.  However, if you jump in and out of stocks, your money spends a good deal of time not invested in stocks.  The overall level of stock prices in general and individual stocks in particular sometimes rises sharply during short periods of time.  Thus, day traders and other short-term traders inevitably miss some stock run-ups.  The best professional investors I know don't engage in short-term trading for this reason (as well as because of the increased transaction costs and taxes that such trading inevitably generates). 

Recognizing an investment gambling problem

Some gamblers spend their time at the racetrack, and you can find others in casinos.  Increasingly, though, you can find gamblers at their personal computers, tracking and trading stocks. 

More investors than ever are myopically focused on stocks' short-term price movements.  Several factors contribute to this troubling activity: the continued growth of the Internet, the increased responsibility more folks have in managing their own retirement investments, and increased media coverage (including cable stock market channels).  Also, companies touting themselves as educational institutions suck legions of novice investors into dangerous practices.  Masquerading under such pompous names as institutes or academies, these firms purport to teach you how to get rich by day trading stocks.  Perhaps you have heard their seminar or training ads on the radio or have seen them on stock market cable television channels or on the Internet.  All you have to do is part with several thousand dollars for the training, and then you're home free.  But the only people getting rich are the owners of such seminar companies. 

The nonprofit organization Gamblers Anonymous developed the following 20 questions to help you figure out whether you or someone you know is a compulsive gambler who needs help.  According to Gamblers Anonymous, compulsive gamblers typi-cally answer yes to seven or more of these questions:

1.  Did you ever lose time from work or school due to gambling? 

2.  Has gambling ever made your home life unhappy? 

3.  Did gambling affect your reputation? 

4.  Have you ever felt remorse after gambling? 

5.  Did you ever gamble to get money with which to pay debts or otherwise solve financial difficulties? 

6.  Did gambling cause a decrease in your ambition or efficiency? 

7.  After losing, did you feel you must return as soon as possible and win back your losses? 

8.  After a win, did you have a strong urge to return and win more? 

9.  Did you often gamble until your last dollar was gone? 

10.  Did you ever borrow money to finance your gambling? 

11.  Have you ever sold anything to finance gambling? 

12.  Were you reluctant to use "gambling money" for normal expenditures? 

13.  Did gambling make you careless of the welfare of your family? 

14.  Did you ever gamble longer than you had planned? 

15.  Have you ever gambled to escape worry or trouble? 

16.  Have you ever committed, or considered committing, an illegal act to finance gambling? 

17.  Did gambling cause you to have difficulty in sleeping? 

18.  Do arguments, disappointments, or frustrations create within you an urge to gamble? 

19.  Did you ever have an urge to celebrate any good fortune by a few hours of gambling? 

20.  Have you ever considered self-destruction as a result of your gambling? 

  Lost opportunities: Most of the short-term traders I've met over the years spend inordinate amounts of time researching and monitoring their investments.  During the late 1990s, I began to hear of more and more people who quit their jobs so they could manage their investment portfolios full time!  Some of the firms that sell day-trading seminars tell you that you can make a living trading stocks.  Your time is clearly worth something.  Put your valuable time into working a little more on building your own business or career instead of wasting all those extra hours each day and week watching your investments like a hawk, which hampers rather than enhances your returns. 

  Poorer relationships: Time is your most precious commodity.  In addition to the financial opportunities that you lose when you indulge in unproductive trading, you need to consider the personal consequences as well.  Like drinking, smoking, and gambling, short-term trading is an addictive behavior.  Spouses of day traders and other short-term traders report unhappiness over how much more time and attention their mates spend on their investments than on their families.  And what about the lack of attention that day traders and short-term traders give friends and other relatives? ( See the sidebar "Recognizing an investment gambling problem" in this chapter to help determine whether you or a loved one has a gambling addiction.) 

How a given stock performs in the next few hours, days, weeks, or even months may have little to do with the underlying financial health and vitality of the company's business.  In addition to short-term swings in investor emotions, unpredictable events (such as the emergence of a new technology or competitor, analyst predictions, changes in government regulation, and so on) push stocks one way or another in the short-term. 

All these reasons should convince you to avoid engaging in day trading or market timing (trying to jump in and out of particular investments based on current news and other factors).  Be skeptical of any market prognosticator who claims to be able to time the markets and boasts of numerous past correct calls and market-beating returns. 

  As I say throughout this part of the book, stocks are intended to be long-term holdings.  You shouldn't buy stocks if you don't plan to hold them for at least five years or more — and preferably seven to ten.  When stocks suffer a setback, it may take months or even years for them to come back. 

Be wary of gurus

It's tempting to wish that you could consult a guru who could foresee an impending major decline and get you out of an investment before it tanks.  Believe me when I say that plenty of these pundits are talking up such supposed prowess.  The financial crisis of 2008 brought an avalanche of prognosticators out of the woodwork claiming that if you had been listening to them, you could have not only sidestepped losses but also made money. 

  From having researched many such claims (see the "Guru Watch" section of my website, www.erictyson.com), I can tell you that nearly all these folks significantly misrepresented their past predictions and recommendations.  And the very, very few who made some halfway decent predictions in the recent short-term had poor or unremarkable longer-term track records. 

As you develop your plans for an investment portfolio, you should be sure to take a level of risk and aggressiveness with which you are comfortable.  Remember that no pundit has a working crystal ball that can tell you what's going to happen with the economy and financial markets in the future. 

Shun penny stocks

Even worse than buying stocks through a broker whose compensation depends on what you buy and how often you trade is purchasing penny stocks through brokers that specialize in such stocks.  Tens of thousands of smaller-company stocks trade on the over-the-counter market.  Some of these companies are quite small and sport low prices per share that range from pennies to several dollars, hence the name penny stocks. 

Here's how penny-stock brokers typically work: Many of these firms purchase prospect lists of people who have demonstrated a propensity for buying other lousy investments by phone.  Brokers are taught to first introduce themselves by phone and then call back shortly thereafter with a tremendous sense of urgency about a great opportunity to get in on the "ground floor" of a small but soon-to-be stellar company.  Not all these companies and stocks have terrible prospects, but many do. 

  The biggest problem with buying penny stocks through such brokers is that they're grossly overpriced.  Just as you don't make good investment returns by purchasing jewelry that's marked up 100 percent, you don't have a fighting chance to make decent money on penny stocks that the broker may flog with similar markups.  The individual broker who cons you into "investing" in such cheap stocks gains a big commission, which is why he continues to call you with "opportunities" until you send him a check.  Many brokers in this business who possess records of securities violations also possess an ability to sell, so they have no problem gaining employment with other penny-stock peddlers. 

A number of penny-stock brokerage firms are known for engaging in manipulation of stock prices.  They drive up prices of selected shares to suck in gullible investors and then leave the public holding the bag.  These firms may also encourage companies to issue new overpriced stock that their brokers can then sell to folks. 

If you remember a fellow by the name of Robert Brennan, you know that he's the granddaddy of this reptilian business.  I won't bore you with all the details except to say that after more than a decade of financial shenanigans, Brennan was ordered by a judge to pay investors more than $70 million for all the bad stuff that he did.  And Brennan was sentenced to nearly a decade of prison time. 

I remember when Brennan ran his infamous "Come Grow with Us" television ads, in which he hopped out of a helicopter.  Brennan was always nicely dressed and maintained a polished image.  In addition to being in the penny-stock business, it's interesting to note that Brennan owned a horse racetrack and wanted to get into the casino business.  All Brennan's businesses share the same characteristics — they don't involve investments, and they stack the deck against the gullible members of the public whom they hoodwink. 

The Keys to Stock Market Success

  Anybody, no matter what their educational background, IQ, occupation, income, or assets, can make good money through stock investments.  Over long periods of time, based on historic performance, you can expect to earn an average of 9 to 10 percent per year total return by investing in stocks. 

  To maximize your chances of stock market investment success, do the following:

  Don't try to time the markets.  Anticipating where the stock market and specific stocks are heading is next to impossible, especially over the short term.  Economic factors, which are influenced by thousands of elements as well as human emotions, determine stock market prices.  Be a regular buyer of stocks with new savings.  As I discuss earlier in this chapter, buy more stocks when they're on sale and market pessimism is running high. 

  Diversify your investments.  Invest in the stocks of different-sized companies in varying industries around the world.  When assessing your investments' performance, examine your whole portfolio at least once a year, and calculate your total return after expenses and trading fees. 

  Keep trading costs, management fees, and commissions to a minimum.  These costs represent a big drain on your returns.  If you invest through an individual broker or a financial advisor who earns a living on commissions, odds are that you're paying more than you need to be.  And you're likely receiving biased advice, too. 

  Pay attention to taxes.  Like commissions and fees, federal and state taxes are a major investment "expense" that you can minimize.  Contribute most of your money to your tax-advantaged retirement accounts.  You can invest your money outside of retirement accounts, but keep an eye on taxes (see Chapter 3).  Calculate your annual returns on an after-tax basis. 

  Don't overestimate your ability to pick the big-winning stocks.  One of the best ways to invest in stocks is through mutual funds (see Chapter 8), which allow you to use an experienced, full-time money manager at a low cost to perform all the investing grunt work for you. 
Chapter 6

Investigating and Purchasing Individual Stocks

In This Chapter

  Looking at the best research resources

  Figuring out what those annual reports really mean

  Deciphering 10-Ks, 10-Qs, and proxies

  Placing stock trades

This chapter provides a crash course in researching individual companies and their stocks.  Be sure you consider your reasons for taking this approach before you head down the path of picking and choosing your own stocks.  If you haven't already done so, take a look at Chapter 5 to better understand the process of purchasing stocks on your own. 

If you decide to tackle the task of researching your own stocks, you don't have to worry about finding enough information: The problem to worry about is information overload.  You can literally spend hundreds of hours researching and reading information on one company alone.  Therefore, unless you're financially independent and want to spend nearly all your productive time investing, you need to focus on where you can get the best bang for your buck and time. 

Building on Others' Research

If you were going to build a house, you probably wouldn't try to do it on your own.  Instead, you'd likely find some sort of kit or a set of plans drawn up by people who have built many houses.  You can do the same when picking individual stocks.  In this section, I highlight useful resources that allow you to hit the ground running when you're trying to pick the best stocks.  In addition to the resources I cover here, check out Part V for other useful resources for researching individual stocks. 

Discovering the Value Line Investment Survey

  Value Line is an investment research company.  Value Line's securities analysts have been tracking and researching stocks since the Great Depression.  Their analysis and recommendation track record is quite good, and their analysts are beholden to no one.  Many professional money managers use the Value Line Investment Survey, Value Line's weekly newsletter, as a reference because of its comprehensiveness. 

The beauty of Value Line's service is that it condenses the key information and statistics about a stock (and the company behind the stock) to a single page.  Suppose you're interested in investing in Starbucks, the retail coffeehouse operator.  You've seen all its stores, and you figure that if you're going to shell out more than $3 for a cup of its flavored hot water, you may as well participate in the profits and growth of the company.  You look up the recent stock price (I explain how to do so later in this chapter if you don't know how) and see that it's about $33 per share. 

Take a look at the important elements of the Value Line Investment Survey page for Starbucks in Figure 6-1; I explain these elements in detail in the following sections. 

  The information in Value Line's reports is in no way insider information.  Look at these reports the same way that you review a history book: They provide useful background information that can keep you from repeating common mistakes. 

1.  Business

This section of the report describes the business(es) that Starbucks participates in.  You can see that Starbucks is the largest retailer of specialty coffee in the world.  Although 84 percent of the company's sales come from retail, note that 16 percent come from other avenues — such as mail order, online, and supermarket sales.  You also find details about joint ventures, such as the partnership of Starbucks and Pepsi to develop and sell bottled coffee drinks.  This section also shows you that the senior executives and directors of the company own a sizeable stake (4.8 percent) of the stock; seeing that these folks have a financial stake in the success of the company and stock is a good thing. 

2.  Analyst assessment

A securities analyst (in this case, Justin Hellman) follows each Value Line Investment Survey stock.  An analyst focuses on specific industries and follows a few dozen stocks.  This section of the Value Line report provides the analyst's summary and commentary of the company's current situation and future plans. 

**Figure 6-1:** Value Line Investment Survey report on Starbucks. 

Copyright 2008 by Value Line Publishing, Inc. Reprinted by Permission; All Rights Reserved

3.  Value Line's ratings

The Value Line Investment Survey provides a numerical ranking for each stock's timeliness (expected performance) over the next year.  One is highest and 5 is lowest, but only about 5 percent of all stocks receive these extreme ratings.  A 2 rating is above average and a 4 rating is below average; about one-sixth of the ranked stocks receive each of these ratings.  All remaining stocks — a little more than half of the total ranked — get the average 3 rating. 

The safety rating works the same way as the timeliness rating, with 1 representing the best and least volatile stocks and the most financially stable companies.  Five is the worst safety ranking; it denotes the most volatile stocks and least financially stable companies. 

Starbuck's current ratings are 3, which is average.  I've never been a fan of predictions and short-term thinking. ( One year is a very short period of time for the stock market.)  However, historically, Value Line's ranking system holds one of the best overall track records according to the Hulbert Financial Digest, which tracks the actual performance of investment newsletter recommendations.  Even so, you shouldn't necessarily run out and buy a particular stock because of its high ranking.  Just keep in mind that higher-ranked stocks within the Value Line Investment Survey have historically outperformed those without such ratings. 

4.  Stock price performance

The graph in Figure 6-1 shows you the stock price's performance over the past decade or so.  The highest and lowest points of the line on the graph indicate the high and low stock prices for each month.  At the top of the graph, you see the year's high and low prices.  Starbucks stock has steadily risen since it first issued stock in 1992, but the company certainly has experienced some down periods. ( The small box in the lower-right corner of the graph shows you the total return that an investor in this stock earned over the previous one, three, and five years and compares those returns to the average stock.  The graph in Figure 6-1 shows you that Starbucks declined significantly from 2006 through 2008 but has since rebounded smartly.) 

The graph also shows how the price of the stock moves with changes in the company's cash flow (money coming in minus money going out).  The solid line in the Starbuck's graph represents 16 times the company's cash flow.  Over time, just as stock prices tend to track corporate profits, so too should they generally follow cash flow.  Cash flow is an important measure of a company's financial success and health — it's different from net profits, which the company reports for tax purposes.  For example, the tax laws allow companies to take a tax deduction each year for the depreciation (devaluation) of the company's equipment and other assets.  Although depreciation is good because it helps lower a company's tax bill, subtracting it from the company's revenue gives an untrue picture of the company's cash flow.  Thus, in calculating a company's cash flow, you don't subtract depreciation from revenue. 

5.  Historic financials

This section shows you 12 to 18 years of financial information on the company (in the case of Starbucks, you get information going back to just 1995).  The two most helpful pieces of information in this section are

  Book value per share: This number indicates the value of the company's assets, including equipment, manufacturing plants, and real estate, minus any liabilities.  Book value gives somewhat of a handle on the amount that the company can sell for if it has a "going-out-of-business sale."  I say somewhat because the value of some assets on a company's books isn't correct.  For example, some companies own real estate, bought long ago, that is worth far more than the company's current financial statements indicate.  Conversely, some manufacturers with equipment find that if they have to dump some equipment in a hurry, they need to sell the equipment at a discount to entice a buyer. 

The book value of a bank, for example, can mislead you if the bank makes loans that won't be paid back, and the bank's financial statements don't document this fact.  All these complications with book value are one of the reasons full-time, professional money managers exist. ( If you want to delve more into a company's book value, you need to look at other financial statements, such as the company's annual report, which I discuss in the section "Understanding Annual Reports" later in this chapter.) 

  Market share: For some companies (not Starbucks), the Value Line Investment Survey also provides another useful number in this section of the report: the market share, which indicates the portions of the industry that the company has captured in a given year.  A sustained decline in a company's market share is a dangerous sign that may indicate its customers are leaving for other companies that presumably offer better products at lower prices.  But a decline in market share doesn't necessarily mean that you should avoid investing in a particular company.  You can produce big returns if you identify companies that reposition and strengthen their product offerings to reverse a market share decrease. 

6.  P/E ratio

This section tells you that Starbucks sells at a P/E (price-to-earnings ratio) of 21.8 because of its recent stock price and earnings.  This particular P/E is higher than that of the overall market. ( You can see that Starbucks' P/E is 1.32 times that of the overall market.)  To understand the importance of P/E in evaluating a stock, refer to Chapter 5. 

7.  Capital structure

This section summarizes the amount of outstanding stocks and bonds that the company possesses.  Remember that when a company issues these securities, it receives capital (money).  The most useful number to examine in this section is the company's debt.  If a company accumulates a lot of debt, the burden of interest payments can create a real drag on profits.  If profits stay down for too long, debt can even push some companies into bankruptcy. 

Value Line delineates between two types of debt:

  Short-term debt: Debt due within one year

  Long-term debt: Debt that has to be paid back in more than a year

Figure 6-1 shows you that Starbucks has outstanding debt of $549.4 million.  But how do you know if this is a lot, a little, or just the right amount of debt?  You can calculate long-term interest earned, which compares a company's annual profits to the yearly interest payments on its long-term debt.  For example, if a company has long-term interest earned of 4.5x, the company's most recent yearly profits can cover the interest payments on its long-term debt for about 4 1⁄2 years.  Starbuck's most recent annual profits of $982.5 million dwarf its long-term interest payments of $27.5 million by a factor of more than 35 to 1. 

Possessing a larger cushion to cover debt is more important when the company's business is volatile.  Total interest coverage represents a similar comparison of profits to interest owed for all the debt that a company owes, not just long-term debt.  This number tells you the number of years that the company's most recent annual profits can cover interest on all the company's debt.  Warning signs for total interest coverage numbers include a steep decline in this number over time and profits that cover less than one year's worth of interest. 

8.  Current position

This section provides a quick look at how the company's current assets (assets that the company can sell and convert into cash within a year relatively easily) compare with its current liabilities (debts due within the year).  Trouble may be brewing if a company's current liabilities exceed or are approaching its current assets. 

  Some financial analysts calculate the quick ratio.  The quick ratio ignores inventory when comparing current assets to current liabilities.  A company may have to dump inventory at a relatively low price if it needs to raise cash quickly.  Thus, some analysts argue, you need to ignore inventory as a current asset. 

Getting your hands on Value Line's reports

The least costly way to obtain Value Line's pages on stocks that interest you is to visit your local library.  Most libraries that have decent business sections subscribe to the full Value Line Investment Survey. 

If you want your own copy of the Value Line Investment Survey to read in the comfort of your home, Value Line offers a 13-week trial subscription for $75.  An annual subscription costs $598.  At the start of your subscription, you receive a rather large binder, divided into 13 sections, that includes the most recent reports on the 1,700-plus larger-company stocks that the publication tracks.  Every week, you receive a new packet of reports that replaces one of the 13 sections.  Thus, at the end of 13 weeks, you have new reports on all the stocks.  Call 800-634-3583 for details.  If you prefer, an electronic edition is available for $65 for the 13-week trial, $538 yearly. 

The trial subscription is a great place to start your research because you receive all the current reports plus three months' worth of updates for a reasonable fee.  You can also see how much use you get out of the reports.  The trial offer is available to each household only once every three years. 

Value Line also offers a Small and Mid-Cap Edition that contains reports on about 1,800 additional smaller companies.  Unlike traditional Value Line pages, these pages include no analyst commentary or projections.  A 13-week trial costs $49, and a one-year subscription to this edition costs $249. 

9.  Annual rates

This nifty section can save wear and tear on your calculator.  The good folks at Value Line calculate rates of growth (or shrinkage) on important financial indicators, such as sales (revenues) and earnings (profits) over the past five and ten years.  This section also lists Value Line's projections for the next five years. 

 Projections can prove highly unreliable, even from a research firm as good as Value Line.  In most cases, the projections assume that the company will continue as it has in the most recent couple years. 

10.  Quarterly financials

For the most recent years, the Value Line Investment Survey shows you an even more detailed quarterly breakout of sales and profits, which may disclose changes that annual totals mask.  In this section of the report, you can also see the seasonality of some businesses.  Starbucks, for example, tends to have its slowest quarter in the winter (quarter ending March 31).  This trend makes sense if you figure that many of the customers who frequent Starbucks' coffee shops do so as they walk around town, which people tend to do less of on blustery winter days. 

Considering independent brokerage research

If you're going to invest in individual stocks, you need a brokerage account.  In addition to offering low trading fees, the best brokerage firms allow you to easily tap into useful research, especially through the firm's website, that you can use to assist you with your investing decisions. 

Because discount brokers aren't in the investment banking business of working with companies to sell new issues of stock, discount brokers have a level of objectivity in their research reports that traditional brokers (ones like Merrill Lynch, Morgan Stanley, and so on) too often lack.  Some discount brokers, such as Charles Schwab, produce their own highly regarded research reports, but most discount brokers simply provide reports from independent third parties.  See Chapter 9 for how to select a top-notch brokerage firm. 

Examining successful money managers' stock picks

  To make money in stocks, you certainly don't need an original idea.  In fact, it makes sense to examine what the best money managers are buying for their portfolios.  Don't worry; I'm not suggesting that you invade their privacy or ask rude questions! 

Mutual fund managers, for example, are required to disclose at least twice a year what stocks they hold in their portfolio.  You can call the best fund companies and ask them to send their most recent semiannual reports that detail their stock holdings, or you can view those reports on many fund companies' websites. ( See Chapter 8 for more information on the best stock mutual funds.) 

Through its website, Morningstar (www.morningstar.com) allows you to see which mutual funds hold large portions of a given stock that you may be researching and what the success or lack thereof is of the funds that are buying a given stock. 

Finally, you can follow what investment legend Warren Buffett is buying through his holding company, Berkshire Hathaway.  If you'd like to review Berkshire's complete corporate filings on your own, visit the Securities and Exchange Commission website at www.sec.gov. 

Reviewing financial publications and websites

Many publications and websites cover the world of stocks.  But you have to be careful.  Just because certain columnists or publications advocate particular stocks or investing strategies doesn't mean you'll achieve success by following their advice. 

  The following publications offer useful columns and commentary, sometimes written by professional money managers, on individual stocks: Barron's, Business Week, Forbes, Kiplinger's, and The Wall Street Journal.  In addition, hundreds of websites are devoted to stock picking.  I name my favorite investing sites in Chapter 19. 

Understanding Annual Reports

After you review the Value Line Investment Survey page on a company and want to dig further into financial documents, the next step is to ask yourself why.  Why do you want to torture yourself so? 

After successfully completing one of the better MBA programs (Stanford's), taking more than my fair share of accounting and finance courses, and then living and working in the real world, I've gotten to know investment managers and financial analysts who research companies.  Although some financial documents aren't that difficult to read (I show you how in this section), interpreting what they mean in respect to a company's future isn't easy. 

  All publicly traded companies must annually file certain financial documents.  Consider reviewing these documents to enhance your understanding of a company's businesses and strategies rather than for the predictive value that you may hope they provide. 

The first of such useful documents that companies produce is the annual report.  This yearly report provides standardized financial statements as well as management's discussion about how the company has performed and how it plans to improve its performance in the future.  If you're a bit of the skeptical sort, as I am, you may think, "Aren't the company's officials going to make everything sound rosy and wonderful?" 

To a certain extent, yes, but not as badly as you may think, especially at companies that adhere to sound accounting principles and good old-fashioned ethics.  First, a large portion of annual reports include the company's financial statements, which an accounting firm must audit.  However, audits don't mean that companies and their accounting firms can't (often legally) structure the company's books to make them look rosier than they really are.  And some companies have pulled the wool over the eyes of their auditors, who then become unwitting accomplices in producing false financial figures. 

  You've surely heard of the accounting scandals at companies such as Enron and WorldCom.  These companies manipulated their financial books, with the blessing of supposedly blue-chip corporate auditors, to mislead investors into believing that they were more profitable than they really were. ( Identifying trouble before other investors do is a skill that many professional investors haven't mastered.  If you can identify trouble early, go manage other people's money!) 

Also keep in mind that more than a few companies have been sued for misleading shareholders with inflated forecasts or lack of disclosure of problems.  Responsible companies try to present a balanced and, of course, hopeful perspective in their annual reports.  Most companies' annual reports are also written by nontechno geeks, so you have a decent chance of understanding them. 

The following sections walk you through the three main elements of the standard annual report: financial and business highlights, the balance sheet, and the income statement. 

Financial and business highlights

The first section of most annual reports presents a description of a company's recent financial highlights and business strategies.  You can use this information to find out about the businesses that the company is in and where the company is heading.  For example, in Figure 6-1, the Value Line Investment Survey report mentions that Starbucks is also in the specialty sales business.  Starbucks' annual report can provide more detail about that specialty sales business. 

Okay, enough about the coffee business; it's time to expose you to another industry.  T. Rowe Price is a publicly traded investment management company that offers some good mutual funds. 

Balance sheet

You can find a company's hard-core financials in the back portion of most annual reports. ( You can find many of these same numbers in Value Line Investment Survey reports, but you get more specific details in the company's annual report.)  All annual reports contain a balance sheet, which is a snapshot summary of all the company's assets (what the company owns) and liabilities (what the company owes).  The balance sheet covers the company's assets and liabilities from the beginning of the year to the last day of the company's year-end, which is typically December 31.  Some companies use a fiscal year that ends at other times of the year. 

A company's balance sheet resembles a personal balance sheet.  The entries, of course, look a little different because you likely don't own things like manufacturing equipment.  Figure 6-2 shows a typical corporate balance sheet. 

**Figure 6-2:** The balance sheet from a T. Rowe Price annual report. 

Source: T. Rowe Price Associates, Inc. 2010 Annual Report

Assets

The assets section of the balance sheet lists the following items that a company holds or owns that are of significant value:

  Cash: I suspect that you know what cash is.  Lest you think that stacks of green bills sit around in corporate vaults, rest assured that companies invest this money to earn interest.  Explanatory notes often follow the balance sheet to explain certain items in more detail.  Note 1 (which is referenced in Figure 6-2 next to the "Cash" line) explains that T. Rowe Price eats its own cooking; in other words, the company keeps its extra cash in its own money market funds. 

  Accounts receivable: This item represents money that is owed to the company, such as customer invoices that haven't been paid yet. 

  As companies grow, their accounts receivable usually do, too.  Watch out for cases where the receivables grow faster than the sales (revenue).  This growth may indicate that the company is having problems with its products' quality or pricing.  Unhappy customers pay more slowly or demand bigger price discounts. 

  Investments: In addition to cash, some companies may invest in other securities, such as bonds and stocks.  Just as with your own personal situation, companies usually invest money that they don't expect to use in the near future. ( As with the company's cash investments, the balance sheet in Figure 6-2 includes an explanatory note that states that T. Rowe Price invests in its own bond and stock funds as well as other lending investments listed as debt securities.) 

  Property and equipment: All companies need equipment to run their businesses.  This equipment can include office furniture, computers, real estate they own, and manufacturing machinery that companies use to make their products.  Equipment becomes less valuable over time, so a company must consider this depreciation as a cost of doing business each year.  Therefore, if a company ceases buying new equipment, this entry on the balance sheet gradually decreases because the company continues to subtract the depreciation from the value of the equipment. 

  Goodwill: One of the assets that doesn't show up on most companies' balance sheets is their goodwill.  Companies work hard through advertising, product development, and service to attract and retain customers and to build name-brand recognition. 

Companies can't put a value on the goodwill that they've generated, but when they purchase (acquire) another firm, some of the purchase price is considered goodwill.  Specifically, if a company is acquired for $100 million but has a net worth (assets minus liabilities) of just $50 million, the extra $50 million goes to goodwill.  The goodwill then becomes an asset on the acquiring company's balance sheet. 

  Other assets: This catch-all category may include some stuff that can make your eyes glaze over.  For example, companies keep a different set of books for tax purposes (yes, this is legal).  Not surprisingly, companies do so because the IRS allows, in some cases, more deductions than what the company is required to show from an accounting standpoint on their financial statements. ( If you were a company, wouldn't you want your shareholders, but not the IRS, to see gobs of profits?)  Companies treat tax deferment as an asset until the IRS receives more of its share down the road. 

  Manufacturing and retail companies also track and report inventory (the product that hasn't yet been sold) as an asset.  Generally speaking, as a business grows, so does its inventory.  If inventory grows more quickly than revenue, such growth may be a warning sign.  This growth can indicate that customers are scaling back purchases and that the company miscalculated and overproduced.  It can also be a leading indicator of an obsolete or inferior product offering. 

Liabilities

This section summarizes all the money that a company owes to other entities:

  Accounts payable: When a company places orders to purchase things for its business, it sometimes has a lag between receiving a bill and paying it; the money owed is called accounts payable.  As with inventory and accounts receivable, accounts payable generally increase with a company's increasing revenue. 

  If accounts payable increase faster than revenue, the company may have a problem.  On the other hand, that increase can also be a sign of good financial management.  The longer you take to pay your bills, the longer you have the money in your pocket working for you. 

  Accrued compensation: This line tallies money that the company must someday pay its employees.  For example, many larger firms maintain pension plans.  These plans promise workers who retire with at least five years of service a monthly income check in retirement.  Thus, the company must reserve this money that it owes and list it as a liability or debt that it must someday pay. 

  Income taxes payable: Companies are in business to make a profit, and as they earn those profits, they need to reserve a portion to pay income taxes.  As I explain in the preceding section, some of the taxes that the company owes can be the result of accounting differences between the company's financial statements and those filed with the IRS. 

  Dividends payable: Not all companies pay dividends (see Chapter 4) to their shareholders.  But those companies that do pay dividends typically declare the dividend several weeks in advance of when they actually owe the dividend.  During this interim period, the company lists the not-yet-paid dividends as a liability. 

Stockholders' equity

The difference between a company's assets and liabilities is known as stockholders' equity.  Stockholders' equity is what makes balance sheets always balance. 

  When companies issue stock, they receive cash, which they then list as an asset.  Companies divide stock proceeds between par value and capital in excess of par value.  In the case of T. Rowe Price (see Figure 6-2), the par value is $0.20 per share.  Par values are arcane — and largely meaningless. 

Income statement

The other big financial statement in an annual report is the income statement (see Figure 6-3 for a T. Rowe Price income statement).  I discuss the elements of a corporate income statement in the following sections. 

**Figure 6-3:** A T. Rowe Price income statement. 

Source: T. Rowe Price Associates, Inc. 2010 Annual Report

Revenue

Revenue is simply the money that a company receives from its customers as compensation for its products or services.  Just as you can earn income from your job(s) as well as from investments and other sources, a company can make money from a variety of sources.  In the case of mutual fund provider T. Rowe Price, the firm collects fees (investment advisory and administrative) for the mutual fund investments that it manages on behalf of its customers as well as privately managed money for wealthy individuals and institutions.  The company also receives income from its own money that it has invested. 

  Ideally, you want to see a steady or accelerating rate of growth in a company's revenue.  If a company's revenue grows more slowly, you need to inquire why.  Is it because of poor service or product performance, better competitor offerings, ineffective marketing, or all the above? 

For companies with multiple divisions or product lines, the annual report may detail the revenue of each product line in a later section.  If it doesn't, check out some of the other financial statements that I recommend in the next section, "Exploring Other Useful Corporate Reports."  Examine what spurs or holds back the company's overall growth and what different businesses the company operates in.  Look for businesses that were acquired but don't really fit with the company's other business units as a red flag.  Large companies that have experienced stalled revenue growth sometimes try to enter new businesses through acquisition but then don't manage them well because they don't understand the keys to their success. 

  When researching retail stores, such as restaurant chains (for example, McDonald's) or clothing stores (for example, The Gap), examine the revenue changes that come from opening new locations versus the changes at existing locations, sometimes referred to as same stores.  Be concerned if you find that a company's revenue growth comes from opening new locations rather than growth at existing locations.  This situation may indicate that opening more locations is masking weakness in the company's business. 

Expenses

Just as personal income taxes and housing, food, and clothing expenses gobble up much of your personal income, company expenses use up much, and sometimes all, of a company's revenue. 

Even healthy, growing businesses can get into trouble if their expenses grow faster than their revenues.  Well-managed companies stay on top of their expenses during good and bad times.  Unfortunately, it's easy for companies to get sloppy during good times. 

  It's particularly useful to examine each category of expenses relative to (in other words, as a percentage of) the company's revenue to see which ones grow or shrink.  As a well-managed and financially healthy company grows, expenses as a percentage of revenue should decrease.  In turn, profits as a percentage of revenue increase. 

T. Rowe Price's total operating expenses relative to total revenues have decreased while profits (net operating income) relative to total revenues have increased from 2008 to 2010 (although the expense portion increased and profits dipped in 2009 due to the recession and financial market turmoil).  Not all expense categories necessarily decrease. 

Net income calculations

The net result of expenses that increase slower than revenues is a fatter bottom line.  In T. Rowe Price's case, net operating income increased from 40.0 percent to 43.7 percent of total revenues between 2008 and 2010.  When you examine how a company's profits change relative to total revenue received, focus on operating income.  Sometimes companies experience one-time events, such as the sale of a division, which can change profits temporarily.  Companies usually list these one-time events in the section under expenses. 

  I encourage you to review the company's statement of cash flows included in its annual report.  Cash can flow into and out of a company from normal business operations, investment activities, and financing activities.  Sometimes a company may report higher profits but actually be facing decreased cash flow from operations, for example, if its customers are getting slower with paying bills (which could indicate that its customers are having financial problems or that they're unhappy with the product or service being provided). 

Earnings per share

Last but not least, and of great importance to shareholders, is the calculation of earnings per share.  Higher profits per share generally help fuel a higher stock price, and declining profits feed falling stock prices.  Remember, though, that smart financial market participants are looking ahead, so if you run out to buy stock in a company that's reporting higher profits, those higher profits are old news and likely have already been priced into the company's current market value. 

Exploring Other Useful Corporate Reports

In addition to annual reports, companies produce other financial statements, such as 10-Ks, 10-Qs, and proxies, that you may want to peruse.  You can generally obtain these reports from the companies' websites, from the companies' investor relations departments, or from the Securities and Exchange Commission website, www.sec.gov (see Chapter 19 for more on this site). 

10-Ks

10-Ks are expanded versions of the annual report.  Most investment professionals read the 10-K rather than the annual report because the 10-K contains additional data and information, especially for a company's various divisions and product lines.  Also, 10-Ks contain little of the verbal hype that you find in most annual reports.  In fact, the 10-K is probably one of the most objective reports that a company publishes.  If you're not intimidated by annual reports or if you want more company meat, read the 10-Ks from the companies you want to check out. 

10-Qs

10-Qs provide information similar to the 10-K but on a quarterly basis.  10-Qs are worth your time if you like to read reasonably detailed discussions by management of the latest business and financial developments at a certain company.  However, I recommend leaving the research to Value Line's analysts (see the earlier section "Discovering the Value Line Investment Survey"). 

The financial data in 10-Qs is unaudited and not of great use for the long-term investor.  But if you want to watch your investments like a hawk and try to be among the first to detect indications of financial problems (easier said than done), this report is required reading. 

  Some companies go back to restate their quarterly financials.  Remember that the accountants haven't fully approved these interim numbers.  Companies may take their financial lumps in one quarter to get problems behind them, so one bad quarter doesn't necessarily indicate a harmful long-term trend. 

Proxies

The final corporate document that you may want to review is the annual proxy statement, which companies send out to its shareholders in advance of their annual meeting.  The proxy statement contains some of the more important financial information and discussions that you can find in the 10-K. It also contains information on other corporate matters, such as the election of the board of directors. ( Directors — who are usually corporate executives, lawyers, accountants, and other knowledgeable luminaries — serve as sounding boards, counselors, and sometimes overseers to the management team of a company.) 

Fundamental versus technical analysis

Throughout this chapter and Chapter 5, I talk a lot about the financial statements and analysis of a company — balance sheets, revenues, expenses, earnings, price-earnings ratios, and so on.  Analyzing financial statements and making investing decisions based on them is known as fundamental analysis. 

Another school of stock market analysis, known as technical analysis, involves examining chart patterns, volume of trading in a stock, and all sorts of indicators that have little, if anything, to do with the underlying stock. 

Technical analysts say things like, "Stock XYZ has a major support area at $20 per share" and "Stock ABC has broken out above $30 per share."  Although it may be an extreme to say that all the technical analysts who have ever existed have never produced anything of value, you can safely ignore this school of thinking.  In fact, ignoring the technical analysts will likely increase your stock market profits.  Why?  Because technical analysis thinking encourages a trader's, not an investor's, mindset. 

Many technical analysts work for brokerage firms and write daily, weekly, or monthly assessments of the entire stock market and some individual stocks.  Recommendations and advice change over time, and the result is that you trade more.  Not coincidentally, these brokerage firms make more money the more you trade!  Investment newsletter writers are the other big advocates of this Ouija-board approach to investment management.  Again, it's a great approach for the newsletter writers who hook you on a $200-per-year newsletter. 

The proxy statement becomes much more important when a company faces a takeover or some other controversial corporate matter, such as the election of an alternative board of directors.  As a shareholder, you get to vote on proposed board members and on select other corporate issues, which you can read about in the proxy statement. 

The proxy statement tells you who serves on the board of directors as well as how much they and the executives of the company are paid.  At annual meetings, where the board of directors discusses proxy statements, shareholders sometimes get angry and ask why the executives are paid so much when the company's stock price and business underperform. 

Getting Ready to Invest in Stocks

Especially during the late 1990s, amid the chorus of self-anointed gurus saying that you can make fat profits if you pick your own stocks, I sometimes thought I was a lone voice urging caution and sensible thinking. 

  Unless you're extraordinarily lucky or unusually gifted at analyzing company and investor behavior, you won't earn above-average returns if you select your own stocks. 

Keep the amount that you dedicate to individual stock investments to a minimum — ideally, no more than 20 percent of your invested dollars.  I encourage you to do such investing for the educational value and enjoyment that you derive from it, not because you smugly think you're as skilled as the best professional money managers. ( If you want to find out more about analyzing companies, read the chapters in Part IV on small business as well as the chapters in Part V on investing resources.) 

Understanding stock prices

Just about every major financial and news site on the Internet offers stock quotes, usually for free as a lure to get you to visit the site.  To view a stock price quote online, all you need is the security's trading symbol (which you obtain by using the stock symbol look-up feature universally offered with online quote services).  Most major newspapers print a listing of the prior day's stock prices.  Daily business papers, such as The Wall Street Journal and Investor's Business Daily, also publish stock prices daily. 

Cable business channels, such as Bloomberg, CNBC, and Fox Business, have stock quotes streaming across the bottom of the screen.  You can stop by a local brokerage office and see the current stock quotes whizzing by on a long, narrow screen on a wall.  Many brokerage firms also maintain publicly accessible terminals (that look a lot like personal computers) on which you can obtain current quotes. 

The following table is a typical example of the kinds of information that you can find in daily price quotes in papers and online; the quotes in this table are for the information technology giant International Business Machines (also known as Big Blue or IBM).  After the name of the company, you see the trading symbol, IBM, which is the code that you and brokers use to look up the price on computer-based quotation systems. 

International Business Machines (IBM)

---

52-wk range | 116.00–147.53

Last trade | 2:29 pm EST (144.35)

Change | +0.61 (+0.42%)

Day's range | 143.27–144.75

Open | 143.85

Volume | 2,062,344

P/E ratio | 13.1

Mkt cap | 179.3B

Div/Shr | 2.60

Yield | 1.80%

Here's a breakdown of what the information in this table means:

  52-week range: These two numbers indicate the low ($116.00) and high ($147.53) trading prices for IBM during the past 52 weeks. 

  Last trade: This line indicates the most recent price that the stock traded at (you can see that I happened to get this IBM quote at 2:29 p.m. eastern standard time). 

  Change: This entry indicates how that price differs from the previous day's close.  In this case, you can see that the stock was up 0.61 points (0.42 percent) from the prior day's close. 

  Day's range: These two numbers are the lowest and highest prices that the stock traded at during the day. 

  Open: This line tells you the trade price at the market's open. 

  Volume: This number indicates the number of shares that traded through this point in the trading day. ( To conserve space, many newspapers indicate the volume in hundreds of shares — in other words, you must add two zeros to the end of the number to arrive at the actual number of shares.) 

  The P/E ratio: As I explain in Chapters 4 and 5, the P/E ratio measures the price of IBM's stock relative to the company's earnings or profits. 

  Market capitalization (mkt cap): This number tells you the current market value of all of IBM's stock, which in this case is $179.3 billion.  You calculate this value by multiplying the current price per share by the total number of shares outstanding. ( See Chapter 8 for an explanation of so-called market caps as they apply to stocks and stock funds.) 

  Dividends/share (div/shr): This number shows you the current dividend, which in this case is $2.60 per share, which the company pays yearly to shareholders.  Most companies actually pay out one-quarter of their total annual dividend every three months. 

  Yield: This number indicates the effective percentage yield that the stock's dividend produces.  To calculate the effective yield, divide the dividend by the current stock price.  Thus, IBM shareholders can expect to receive a dividend worth about 1.8 percent of the current stock price. 

Now you know how to read stock quotes! 

Purchasing stock "direct" from companies

Over the years, increasing numbers of companies have begun to sell their stock directly to the public.  Proponents of these direct stock purchase plans say that you can invest in stocks without paying any commissions.  Well, the commission-free spiel isn't quite true, and investing in such plans poses other challenges. 

If you want to purchase directly from Home Depot, for example, you need a minimum initial investment of $500.  Buying stock "direct" isn't free; in the case of Home Depot, for example, you have to pay a $5 enrollment fee.  Although that may not sound like much on a $500 investment, $5 represents 1 percent of your investment.  For subsequent purchases, you pay 5 percent up to a maximum of $2.50 per purchase plus 5 cents per share. 

If you want to sell your shares, you have to pay a fee to do that, too — $10 plus 15 cents per share.  Overall, these fees compare to what you would pay to buy stock through a discount broker (see Chapter 9 for details).  In some cases, these fees are actually higher!  For example, you can reinvest dividends at no cost through many discount brokers. 

Some direct stock purchase plans entail even more hassle and cost than the type I just discussed.  With other plans, you must buy your initial shares through a broker and then transfer your shares to the issuing company in order to buy more!  Also, you can't pursue most direct stock purchase plans within retirement accounts. 

  Every time you want to set up a stock purchase plan with a company, you must request and complete the company's application forms.  If you go through the headache of doing so, say, a dozen times, you're rewarded with a dozen statements on a regular basis from each individual company.  Frankly, because of this drawback alone, I prefer to buy stock through a discount brokerage account that allows centralized purchasing and holding of various stocks as well as consolidated tax-reporting statements. 

Placing your trade through a broker

Unless you decide to buy stock directly, you generally need a broker.  As I explain in Chapter 9, discount brokers are the best way to go — they take your orders and charge far less than conventional brokerage firms, which generally pay their brokers on commission. 

After you decide which discount broker you want to use (again, I provide all the info you need to make this decision in Chapter 9), request (by phone or via the Internet) an account application package for the type of account that you desire (non-retirement, IRA, Keogh, and so on).  Complete the forms (call the firm's toll-free number or visit a branch office if you get stuck) and mail or take them back to the discounter. 

When you're ready to place your order, simply call the discount broker and explain what you want to do (or use your touch-tone phone or computer to place your order).  You have two options:

  Market order: I recommend placing what's known as a market order.  Such an order instructs your broker to buy you the amount of stock that you desire (100 shares, for example) at the current and best (lowest) price available.  With securities in which there's little trading or generally volatile price movements, market orders are a bit riskier.  As a result, you may want to instead consider a limit order. 

  Limit order: Alternatively, you can try to buy a desired stock at a specific price.  For example, you can place a purchase order at $32 per share when the stock's last trade was $33 per share.  This type of order is known as a limit order and is good until you cancel it.  I don't recommend that you try this tactic because it requires you to hope and gamble that the stock drops a little before it rises.  If the stock simply rises from its current price of $33 per share or drops to $32.10 before it makes a big move higher, you may kick yourself.  If you think that the stock is a good buy for the long haul, go buy it with a market order.  If you don't think it's a good buy, don't buy it. 

  One final word of advice: Try to buy stock in good-size chunks, such as 100 shares.  Otherwise, commissions gobble a large percentage of the small dollar amount that you invest.  If you don't have enough money to build a diversified portfolio all at once, don't sweat it.  Diversify over time.  Purchase a chunk of one stock after you have enough money accumulated and then wait to buy the next stock until you've saved another chunk to invest. 
Chapter 7

Exploring Bonds and Other Lending Investments

In This Chapter

  Getting the most out of a bank

  Selecting the right type of bonds for you

  Choosing among individual bonds and bond mutual funds

  Understanding other lending investments

Lending investments are those in which you lend your money to an organization, such as a bank, company, or government, which typically pays you a set or fixed rate of interest. ( Ownership investments, by contrast, provide partial ownership of a company or some other asset, such as real estate, that has the ability to generate revenue and potential profits.) 

Lending investments aren't the best choice if you really want to make your money grow.  However, even the most aggressive investors should consider placing some of their money into lending investments.  The following table shows when such investments do and don't make sense. 

Consider Lending Investments If . . .  | Consider Ownership Investments When . . . 

---|---

You need current income.  | You don't need or want much current income. 

You expect to sell within five years.  | You're investing for the long term (seven to ten-plus years). 

Investment volatility makes you a wreck, or you just want to cushion some of the volatility of your other riskier investments.  | You don't need to make your money grow after inflation and taxes. 

You don't need to make your money grow after inflation and taxes.  | You don't need to make your money grow after inflation and taxes. 

Lending investments are everywhere — through banks, credit unions, brokerage firms, insurance companies, and mutual fund companies.  Lending investments that you may have heard of include bank accounts (savings and certificates of deposit), treasury bills and other bonds, bond mutual funds (and now exchange-traded bond funds), mortgages, and guaranteed-investment contracts. 

In this chapter, I walk you through these investments, explain what's good and bad about each, and show you when you should and shouldn't use them.  I also tell you what to look for (and look out for) when comparing them. 

Banks: Considering the Cost of Feeling Secure

Putting your money in a bank may make you feel safe for a variety of reasons.  If you're like most people, your first investing experience was at your neighborhood bank where you established checking and savings accounts. 

Part of the comfort of keeping money in the bank stems from the fact that the bank is where your parents may have first steered you financially.  Also, at a local branch, often within walking distance of your home or office, you find vaults, security-monitoring cameras, and barriers in front of the tellers.  Most of these latter accoutrements shouldn't make you feel safer about leaving your money with the bank, however — they're needed because of bank robberies! 

  Bank branches cost a lot of money to operate.  Guess where that money comes from?  From bank depositors, of course!  These operating costs are one of the reasons the interest rates that banks pay often pale in comparison to some of the similarly secure alternatives discussed in this chapter. 

Facing the realities of bank insurance

Some people are consoled by the Federal Deposit Insurance Corporation (FDIC) insurance that comes with bank accounts.  It's true that if your bank fails, your account is insured by the U.S. government up to $250,000.  So what?  Every Treasury bond is issued and backed by the federal government — the same debt-laden organization that stands behind the FDIC.  Plenty of other equally safe lending investments yield higher returns than bank accounts. 

  Just because the federal government stands behind the banking FDIC system doesn't mean that your money is 100 percent safe in the event of a bank failure.  Although you're insured for $250,000 in a bank, if the bank crashes, you may wait quite a while to get your money back — and you may get less interest than you thought you would.  Banks fail and will continue to fail.  During the 1980s and early 1990s, and again in the late 2000s, hundreds of insured banks and savings and loans failed annually. ( Between the early 1990s and late 2000s, only a handful of banks failed annually.) 

Any investment that involves lending your money to someone else or to some organization, including putting your money in a bank or buying a Treasury bond that the federal government issues, carries risk.  Although I'm not a doomsayer, any student of history knows that governments and civilizations fail. 

Being wary of the certificate of deposit (CD)

Other than savings accounts, banks also sell certificates of deposit (CDs).  CDs are an often overused bank investment — investors use them by default, often without researching their pros and cons.  The attraction is that you get a higher rate of return on a CD than on a bank savings or money market account.  And unlike a bond (which I discuss in the "Why Bother with Bonds?"  section later in this chapter), a CD's principal value doesn't fluctuate.  CDs also give you the peace of mind afforded by the government's FDIC insurance program. 

The reason that CDs pay higher interest rates than savings accounts is that you commit to tie up your money for a period of time, such as 6, 12, or 24 months.  The bank pays you 2 to 3 percent and then turns around and lends your money to others through credit cards, auto loans, and so on.  The bank then charges those borrowers an interest rate of 10 percent or more.  Not a bad business! 

When you tie up your money in a CD and later decide you want it back before the CD matures, a hefty penalty (typically about six months' interest) is shaved from your return.  With other lending investments, such as bonds and bond mutual funds, you can access your money without penalty and generally at little or no cost. 

In addition to penalties for early withdrawal, CDs yield less than a high-quality bond with a comparable maturity (for example, two, five, or ten years).  Often, the yield difference is 1 percent or more, especially if you don't shop around and simply buy CDs from the local bank where you keep your checking account. 

High-tax-bracket investors who purchase CDs outside of their retirement accounts should be aware of a final and perhaps fatal flaw of CDs: The interest on CDs is fully taxable at the federal and state levels.  Bonds, by contrast, are available (if you desire) in tax-free (federal and/or state) versions. 

  You can earn higher returns and have better access to your money when it's in bonds than you can when it's in CDs.  Bonds make especially good sense when you're in a higher tax bracket and would benefit from tax-free income in a non-retirement account.  CDs make the most sense when you know, for example, that you can invest your money for one year, after which you need the money for some purchase that you expect to make.  Just make sure that you shop around to get the best interest rate.  If having the U.S. government insurance gives you peace of mind, also take a look at Treasury bonds, which I discuss later in this chapter.  Treasury bonds (also known as Treasuries) tend to pay more interest than many CDs. 

Swapping your savings account for a money market fund

Because bank savings accounts generally pay pretty crummy interest rates, you need to think long and hard about keeping your spare cash in the bank. 

You can, if you so choose, keep your checking account at your local bank.  But you don't have to.  I don't because I use a money market fund that offers unlimited check writing at a mutual fund company.  I also don't keep my extra savings in the bank. 

Instead of relying on the bank, try money market funds, which are a type of mutual fund (other funds focus on bonds or stocks), as a place to keep your extra savings.  Money market funds offer a higher-yielding alternative to bank savings and bank money market deposit accounts. 

Money market funds, which are offered by mutual fund companies (see Chapter 8), are unique among mutual funds because they don't fluctuate in value and maintain a fixed $1-per-share price.  As with a bank savings account, your principal investment in a money market fund doesn't change in value.  If you invest your money in a money market fund, it earns dividends (which is just another name for the interest you would receive in a bank account). 

Money market fund advantages

The best money market mutual funds offer the following significant benefits over bank savings accounts:

  They provide higher yields.  Money market mutual funds pay higher yields because they don't have the high overhead that banks do.  The most efficient mutual fund companies (I discuss them in Chapter 8) don't have scads of branch offices. 

Banks can get away with paying lower yields because they know that many depositors believe that the FDIC insurance that comes with a bank savings account makes it safer than a money market mutual fund.  Also, the FDIC insurance is an expense that banks ultimately pass on to their customers. 

  They come in a variety of tax-free versions.  So if you're in a high tax bracket (see Chapter 3), tax-free money market funds offer you something that bank accounts don't. 

Another useful feature of money market mutual funds is the ability they provide you to write checks, without charge, against your account.  Most mutual fund companies require that the checks that you write be for larger amounts — typically at least $250.  They don't want you using these accounts to pay all your small household bills because checks cost money to process. 

However, a few money market funds (such as those that brokerage cash management accounts at firms like Charles Schwab, TD Ameritrade, Vanguard, and Fidelity) allow you to write checks for any amount and can completely replace a bank checking account.  Do keep in mind that some brokerage firms hit you with service fees if you don't have enough assets with them or don't have regular monthly electronic transfers, such as through direct deposit of your paycheck or money transfer from your bank account.  With these types of money market funds, you can leave your bank altogether because these brokerage accounts often come with debit cards that you can use at bank ATMs for a nominal fee. 

  Money market funds are a good place to keep your emergency cash reserve of at least three to six months' living expenses.  They're also a great place to keep money awaiting investment elsewhere in the near future.  If you're saving money for a home that you expect to purchase soon (in the next year or so), a money market fund can be a safe place to accumulate and grow the down payment.  You don't want to risk placing such money in the stock market, because the market can plunge in a relatively short period of time. 

Just as you can use a money market fund for your personal purposes, you also can open a money market fund for your business.  I have one for my business.  You can use this account to deposit checks that you receive from customers, to hold excess funds, and to pay bills via the check-writing feature. 

Money market fund disadvantages (if you'd really call them that)

Higher yields, tax-free alternatives, and check writing — money market funds almost sound too good to be true.  What's the catch?  Good money market funds really don't have a catch, but you need to know about one difference between bank accounts and money market mutual funds: Money market funds aren't insured (they were for a one-year period during the 2008–2009 financial crisis). 

As I discuss earlier in this chapter, bank accounts come with FDIC insurance that protects your deposited money up to $250,000.  So if a bank fails because it lends too much money to people and companies that go bankrupt or abscond with the funds, you should get your money back from the FDIC. 

The lack of FDIC insurance on a money market fund shouldn't trouble you.  Mutual fund companies can't fail because they have a dollar invested in securities for every dollar that you deposit in their money market funds.  By contrast, banks are required to have available just a portion, such as 10 to 12 cents, for every dollar that you hand over to them (the exact amount depends on the type of deposit). 

  A money market fund's investments can decline slightly in value, which can cause the money market fund's share price to fall below a dollar.  Cases have occurred where money market funds bought some bad investments (this happened more during the 2008–2009 financial crisis).  However, in nearly every case, the parent company running the money market fund infused cash into the affected fund, thus enabling it to maintain the $1-per-share price. 

The only money market funds that did "break the buck" didn't take in money from people like you or me but was run in one case by a bunch of small banks for themselves.  This money market fund made some poor investments.  The share price of the fund declined by 6 percent, and the fund owners decided to disband the fund; they didn't bail it out because they would only have been repaying themselves.  In another case, a money market fund that took in money from institutions declined by 3 percent. 

  Stick with bigger mutual fund companies if you're worried about the lack of FDIC insurance.  They have the financial wherewithal and the largest incentive to save a foundering money market fund.  Fortunately, the bigger fund companies have the best money market funds anyway.  You can find more details about money market funds in Chapter 8. 

Why Bother with Bonds? 

Conservative investors prefer bonds (that is, conservative when it comes to taking risk, not when professing their political orientation).  Otherwise-aggressive investors who seek diversification or investments for shorter-term financial goals also prefer bonds.  The reason?  Bonds offer higher yields than bank accounts, usually without the volatility of the stock market. 

Bonds are similar to CDs, except that bonds are securities that trade in the market with a fluctuating value.  For example, you can purchase a bond, scheduled to mature five years from now, that a company such as the retailing behemoth Wal-Mart issues.  A Wal-Mart five-year bond may pay you 5.25 percent interest.  The company sends you interest payments on the bond for five years.  And as long as Wal-Mart doesn't have a financial catastrophe, the company returns your original investment to you after the five years is up.  So in effect, you're loaning your money to Wal-Mart (instead of the bank when you deposit money in a bank account). 

  The worst that can happen to your bond investment is that Wal-Mart's business goes into a tailspin and the company ends up in financial ruin — also known as bankruptcy.  If the company does go bankrupt, you may lose all your original investment and miss out on the remaining interest payments you were supposed to receive. 

But bonds that high-quality companies such as Wal-Mart issue are quite safe — they rarely default.  Besides, you don't have to invest all your money in just one or two bonds.  If you own bonds in many companies and one bond unexpectedly takes a hit, it affects only a small portion of your portfolio.  And unlike CDs, you can generally sell your bonds anytime you want at minimal cost. ( Selling and buying most bond mutual funds costs nothing, as I explain in Chapter 8.) 

  Bond investors accept the risk of default because bonds generally pay you more than bank savings accounts and money market mutual funds.  But there's a catch.  As I discuss later in this chapter, bonds are riskier than money market funds and savings accounts because their value can fall if interest rates rise.  Plus you're forgoing the security of FDIC insurance (which bank accounts have).  However, bonds tend to be more stable in value than stocks. ( I cover the risks and returns of bonds and stocks in Chapter 2.) 

Investing in bonds is a time-honored way to earn a better rate of return on money that you don't plan to use within the next couple of years or more.  As with stocks, bonds can generally be sold any day that the financial markets are open.  Because their value fluctuates, though, you're more likely to lose money if you're forced to sell your bonds sooner rather than later.  In the short term, if the bond market happens to fall and you need to sell, you could lose money.  In the longer-term, as is the case with stocks, you're far less likely to lose money. 

  Don't put your emergency cash reserve into bonds — that's what a money market fund or bank savings account is for.  And don't put too much of your longer-term investment money into bonds, either.  As I explain in Chap-ter 2, bonds are generally inferior investments for making your money grow.  Growth-oriented investments, such as stocks, real estate, and your own business, hold the greatest potential to build real wealth. 

The following list provides some common situations when investing in bonds can make sense:

  You're looking to make a major purchase.  This purchase should be one that won't happen for at least two years, such as buying a home or some other major expenditure.  Shorter-term bonds may work for you as a higher-yielding and slightly riskier alternative to money market funds. 

  You want to diversify your portfolio.  Bonds don't move in tandem with the performance of other types of investments, such as stocks.  In fact, in a terrible economic environment (such as during the Great Depression in the early 1930s or the financial crisis of 2008), bonds may appreciate in value while riskier investments such as stocks plunge. 

  You're interested in long-term investments.  You may invest some of your money in bonds as part of a longer-term investment strategy, such as for retirement.  You should have an overall plan for how you want to invest your money, sometimes referred to as an asset allocation strategy (see Chapter 8).  Aggressive, younger investors should keep less of their retirement money in bonds than older folks who are nearing retirement. 

  You need income-producing investments.  If you're retired or not working, bonds can be useful because they're better at producing current income than many other investments. 

Assessing the Different Types of Bonds

Bonds differ from one another according to a number of factors — length to maturity, credit quality, and the entities that issue the bonds (the latter of which has associated tax implications that you need to be aware of).  After you have a handle on these issues, you're ready to consider investing in individual bonds and bond mutual funds. 

Unfortunately, due to shady marketing practices by some investing companies and salespeople who sell bonds, you can have your work cut out for you while trying to get a handle on what many bonds really are and how they differ from their peers.  But don't worry.  I help you wade through the muddy waters in the following sections. 

Determining when you get your money back: Maturity matters

  Maturity simply means the time at which the bond promises to pay back your principal — next year, in 7 years, in 15 years, and so on.  You need to care about how long a bond takes to mature because a bond's maturity gives you a good (although far-from-perfect) sense of how volatile a bond may be if interest rates change.  If interest rates fall, bond prices rise; if interest rates rise, bond prices fall.  Longer-term bonds drop more in price when the overall level of interest rates rises. 

Suppose you're considering investing in two bonds that the same organization issues, and both yield 7 percent.  The bonds differ from one another only in when they will mature: One is a 2-year bond; the other is a 20-year bond.  If interest rates were to rise just 1 percent (from 7 percent to 8 percent), the 2-year bond may decline about 2 percent in value, whereas the 20-year bond could fall approximately five times as much — 10 percent. 

If you hold a bond until it matures, you get your principal back unless the issuer defaults.  In the meantime, however, if interest rates rise, bond prices fall.  The reason is simple: If the bond that you hold is issued at, say, 7 percent, and interest rates on similar bonds rise to 8 percent, no one (unless they don't know any better) wants to purchase your 7 percent bond.  The value of your bond has to decrease enough so that it effectively yields 8 percent. 

Bonds are generally classified by the length of time until maturity:

  Short-term bonds mature in the next few years. 

  Intermediate-term bonds come due within three to ten years. 

  Long-term bonds mature in more than 10 years and generally up to 30 years.  Although rare, a number of companies issue 100-year bonds!  A number of railroads did as well as Coca-Cola, Disney, IBM, the New York Port Authority, and the government of China!  Such bonds are quite dangerous to purchase, especially if they're issued during a period of relatively low interest rates. 

Most of the time, longer-term bonds pay higher yields than short-term bonds.  You can look at a chart of the current yield of similar bonds plotted against when they mature — such a chart is known as a yield curve.  At most times, this curve slopes upward.  Investors generally demand a higher rate of interest for taking the risk of holding longer-term bonds. ( To see the current yield curve, visit my website at www.erictyson.com.) 

Weighing the likelihood of default

In addition to being issued for various lengths of time, bonds also differ from one another in the creditworthiness of the issuer.  To minimize investing in bonds that default, purchase highly rated bonds.  Credit rating agencies such as Moody's, Standard & Poor's, and Duff & Phelps rate the credit quality and likelihood of default of bonds. 

The credit rating of a bond depends on the issuer's ability to pay back its debt.  Bond credit ratings are usually done on some sort of a letter-grade scale where, for example, AAA is the highest rating and ratings descend through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on.  Here's the lowdown on the ratings:

  AAA- and AA-rated bonds are considered high-grade or high-credit quality bonds.  Such bonds possess little chance — a fraction of 1 percent — of default. 

  A- and BBB-rated bonds are considered investment-grade or general-quality bonds. 

  BB- or lower-rated bonds are known as junk bonds (or by their marketed name, high-yield bonds).  Junk bonds, also known as non-investment grade bonds, are more likely to default — perhaps as many as a couple of percent per year actually default. 

Why would any sane investor buy a bond with a low credit rating?  They may purchase one of these bonds because issuers pay a higher interest rate on lower-quality bonds to attract investors.  The lower a bond's credit rating and quality, the higher the yield you can and should expect from such a bond.  Poorer-quality bonds, though, aren't for the faint of heart because they're generally more volatile in value. 

 I don't recommend buying individual junk bonds — consider investing in these only through a well-run junk-bond fund. 

Examining the issuers (and tax implications)

Bonds also differ from one another according to the type of organization that issues them — in other words, what kind of organization you lend your money to.  The following sections go over the major options and tell you when each option may make sense for you. 

Treasury bonds

Treasuries are IOUs from the U.S. government.  The types of Treasury bonds include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years).  These distinctions and delineations are arbitrary — you don't need to know them for an exam. 

Treasuries pay interest that's state-tax-free but federally taxable.  Thus, they make sense if you want to avoid a high state-income-tax bracket but not a high federal-income-tax bracket.  However, most people in a high state-income-tax bracket also happen to be in a high federal-income-tax bracket.  Such high-tax-bracket investors may be better off in municipal bonds (explained in the next section), which are both federal- and state-income-tax-free (in their state of issuance). 

  The best use of Treasuries is in place of bank CDs.  If you feel secure with the federal government insurance (which is limited to $250,000) that a bank CD provides, check out a Treasury bond (which has the unlimited backing of the U.S. government).  Treasuries that mature in the same length of time as a CD may pay the same or a better interest rate.  Remember that bank CD interest is fully taxable, whereas a Treasury's interest is state-tax-free.  Unless you really shop for a bank CD, you'll likely earn a lower return on a CD than on a Treasury.  I explain how to purchase Treasury bonds in the section "Purchasing Treasuries," later in this chapter. 

Municipal bonds

Municipal bonds are state and local government bonds that pay interest that's federal-tax-free and state-tax-free to residents in the state of issue.  For example, if you live in California and buy a bond issued by a California government agency, you probably won't owe California state or federal income tax on the interest. 

International bonds

You can buy bonds outside of the country that you call home.  If you live in the United States, for example, you can buy most of the bonds that I describe in this chapter from foreign issuers as well.  These bonds, called international bonds, are riskier to you because their interest payments can be offset by currency price changes. 

The prices of international bonds tend not to move in tandem with U.S. bonds.  International bond values benefit from and thus protect against a declining U.S. dollar and, therefore, offer some diversification value.  Although the declining dollar during most of the 2000s boosted the return of international bonds, the U.S. dollar appreciated versus most currencies during the 1980s and 1990s, which lowered a U.S. investor's return on international bonds. 

International bonds aren't a vital holding for a diversified portfolio.  International bonds are generally more expensive to purchase and hold than comparable domestic bonds. 

The government organizations that issue municipal bonds know that the investors who buy these bonds don't have to pay most or any of the income tax that is normally required on other bonds — which means that the issuing governments can pay a lower rate of interest. 

  If you're in a high tax bracket and want to invest in bonds outside of your tax-sheltered retirement accounts, you may end up with a higher after-tax yield from a municipal bond (often called muni) than a comparable bond that pays taxable interest.  Compare the yield on a given municipal bond (or muni bond fund) to the after-tax yield on a comparable taxable bond (or bond fund). 

Corporate bonds

Companies such as Boeing, Johnson & Johnson, and Sunoco issue corporate bonds.  Corporate bonds pay interest that's fully taxable.  Thus, they're appropriate for investing inside retirement accounts.  Lower-tax-bracket investors should consider buying such bonds outside a tax-sheltered retirement account. ( Higher-bracket investors should instead consider municipal bonds, which I discuss in the preceding section.)  In the section "Understanding bond prices," later in this chapter, I show you how to read price listings for such bonds.  If you buy corporate bonds through a well-managed mutual fund, an approach I advocate, you don't need to price such bonds. 

Mortgage bonds

Remember that mortgage you took out when you purchased your home?  Well, you can actually purchase a bond, naturally called a mortgage bond, to invest in a portfolio of mortgages just like yours!  Many banks actually sell their mortgages as bonds in the financial markets, which allows other investors to invest in them.  The repayment of principal on such bonds is usually guaranteed at the bond's maturity by a government agency, such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or the Federal National Mortgage Association (FNMA, also known as Fannie Mae). 

 The vast majority of mortgage bonds are quite safe to invest in.  The risky ones that were in the news in the late 2000s for defaulting were so-called subprime mortgages, which lacked government agency backing. 

Convertible bonds

Convertible bonds are hybrid securities — they're bonds you can convert under a specified circumstance into a preset number of shares of stock in the company that issued the bond.  Although these bonds do pay taxable interest, their yield is lower than nonconvertible bonds because convertibles offer you the upside potential of being able to make more money if the underlying stock rises. 

Inflation-protected Treasury bonds

The U.S. government offers bonds called Treasury inflation-protected securities (TIPS).  Compared with traditional Treasury bonds (which I discuss earlier in this chapter), the inflation-indexed bonds carry a lower interest rate.  The reason for this lower rate is that the other portion of your return with these inflation-indexed bonds comes from the inflation adjustment to the principal you invest.  The inflation portion of the return gets added back into principal. 

For example, if inflation were 3 percent the first year you hold your inflation-indexed bond into which you invested $10,000, your principal would increase to $10,300 at the end of the first year. 

What's appealing about these bonds is that no matter what happens with the rate of inflation, investors who buy inflation-indexed bonds always earn some return (the yield or interest rate paid) above and beyond the rate of inflation.  Thus, holders of inflation-indexed Treasuries can't have the purchasing power of their principal or interest eroded by high inflation. 

Because inflation-indexed Treasuries protect the investor from the ravages of inflation, they represent a less risky security.  However, consider this little known fact: If the economy experiences deflation (falling prices), your principal isn't adjusted down so these bonds offer deflation protection as well.  As I discuss in Chapter 2, lower risk usually translates into lower returns. 

Zero coupon bonds

Some bonds that you may have heard of or are interested in have unusual features.  For instance, not all bonds make regular interest payments.  An example is a zero coupon bond, which is sold at a substantial discount to its future maturity value.  Thus, an investor in a zero coupon bond implicitly earns interest if the value of the bond should rise over time to reach full value by maturity.  Zero coupon bonds are highly sensitive to interest rate changes, which is why I don't generally recommend them. 

Buying Bonds

You can invest in bonds in one of two major ways: You can purchase individual bonds, or you can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund. ( Newer exchange-traded funds are a twist on mutual funds.  See Chapter 8.) 

In this section, I help you make the decision on how to invest in bonds.  If you want to take the individual-bond route, I cover that path here, where I explain how to decipher bond listings you find in financial newspapers or online.  I also explain the purchasing process for Treasuries (a different animal in that you can buy them directly from the government) and all other bonds.  If you fall on the side of mutual funds, head to Chapter 8 for more information. 

Deciding between individual bonds and bond mutual funds

Unless the bonds you're considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you're generally better off investing in bonds through a mutual fund.  Here's why:

  Diversification is more difficult with individual bonds.  You shouldn't put your money into a small number of bonds of companies in the same industry or that mature at the same time.  It's difficult to cost-effectively build a diversified bond portfolio with individual issues unless you have a substantial amount of money ($1 million) that you want to invest in bonds. 

  Individual bonds cost you more money.  If you purchase individual bonds through a broker, you're going to pay a commission.  In most cases, the commission cost is hidden — the broker quotes you a price for the bond that includes the commission.  Even if you use a discount broker, these fees take a healthy bite out of your investment.  The smaller the amount that you invest, the bigger the bite — on a $1,000 bond, the commission fee can equal several percent.  Commissions take a smaller bite out of larger bonds — perhaps less than 0.5 percent if you use discount brokers. 

On the other hand, investing in bonds through a mutual fund is cost effective.  Great bond funds are yours for less than 0.5 percent per year in operating expenses.  Selecting good bond funds isn't hard, as I explain in Chapter 8. 

  You've got better things to do with your time.  Do you really want to research bonds and go bond shopping?  Bonds are boring to most people!  And bonds and the companies that stand behind them aren't that simple to understand.  For example, did you know that some bonds can be called before their maturity dates?  Companies often call bonds (which means they repay the principal before maturity) to save money if interest rates drop significantly.  After you purchase a bond, you need to do the same things that a good bond mutual fund portfolio manager needs to do, such as track the issuer's creditworthiness and monitor other important financial developments. 

Understanding bond prices

Business-focused publications, such as The Wall Street Journal, provide daily bond pricing.  You may also call a broker or browse websites to obtain bond prices.  The following steps walk you through the bond listing for PhilEl (Philadelphia Electric) in Figure 7-1:

1.  Bond name: This column tells you who issued the bond.  In this case, the issuer is a large utility company, Philadelphia Electric. 

2.  Funny numbers after the company name: The first part of the numerical sequence here — 7 1⁄8 — refers to the original interest rate (7.125 percent) that this bond paid when it was issued.  This interest rate is known as the coupon rate, which is a percent of the maturity value of the bond.  The second part of the numbers — 23 — refers to the year that the bond matures (2023, in this case). 

3.  Current yield: Divide the interest paid, 7.125, by the current price per bond, $93, to arrive at the current yield.  In this case, it equals (rounded off) 7.7 percent. 

4.  Volume: Indicates the number of bonds that traded on this day.  In the case of PhilEl, 15 bonds were traded. 

5.  Close: Shows the last price that the bond traded at.  The last PhilEl bond price is $93. 

6.  Change: Indicates how this day's close compares with the previous day's close.  In the example figure, the bond rose 2 1⁄8 points.  Some bonds don't trade all that often.  Notice that some bonds were up and others were down on this particular day.  The demand of new buyers and the supply of interested sellers influence the price movement of a given bond. 

**Figure 7-1:** Sample bond listings. 

  In addition to the direction of overall interest rates, changes in the financial health of the issuing entity company that stands behind the bond strongly affect the price of an individual bond. 

Purchasing Treasuries

If you want to purchase Treasury bonds, buying them through the Federal Reserve is the lowest-cost method.  The Federal Reserve doesn't charge for accounts with less than $100,000, and it charges $25 annually for accounts with more than $100,000 in Treasury bonds.  Contact a Federal Reserve branch near you (check the government section of your local phone directory), and ask it to mail you information about how to purchase Treasury bonds through the Treasury Direct program.  Or you can call 800-722-2678 or visit the U.S. Department of Treasury's website (www.treasurydirect.gov). 

You may also purchase and hold Treasury bonds through brokerage firms and mutual funds.  Brokers typically charge a flat fee for buying a Treasury bond.  Buying Treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold.  Selling Treasury bonds held through the Federal Reserve is now much easier than it used to be.  With a Treasury Direct account, you can sell online for $45 per transaction. 

  The advantage of a mutual fund that invests in Treasuries is that it typically holds Treasuries of differing maturities, thus offering diversification.  You can generally buy and sell no-load (commission-free) Treasury bond mutual funds easily and without fees.  Funds, however, do charge an ongoing management fee. ( See Chapter 8 for my recommendations of Treasury mutual funds with good track records and low management fees.) 

Shopping for other individual bonds

Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying Treasuries.  Here's my advice for doing it right and minimizing the chance of mistakes:

  Don't buy through salespeople.  Brokerage firms that employ representatives on commission are in the sales business.  Many of the worst bond-investing disasters have befallen customers of such brokerage firms.  Your best bet is to purchase individual bonds through discount brokers (see Chapter 9). 

  Don't be suckered into high yields — buy quality.  Yes, junk bonds pay higher yields, but they also have a much higher chance of default.  And did you know what a subprime mortgage was before it was all over the news in 2007 that defaults were on the rise?  Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default.  Nothing personal, but you're not going to do as good a job as a professional money manager at spotting problems and red flags.  Stick with highly rated bonds so you don't have to worry about and suffer through these unfortunate consequences. 

Assessing individual bonds that you already own

If you already own individual bonds, and they fit your financial objectives and tax situation, you can hold them until maturity because you already incurred a commission when they were purchased; selling them now would just create an additional fee.  When the bonds mature, the broker who sold them to you will probably be more than happy to sell you some more.  That's the time to check out good bond mutual funds (see Chapter 8). 

Don't mistakenly think that your current individual bonds pay the yield that they had when they were originally issued. ( That yield is the number listed in the name of the bond on your brokerage account statement.)  As the market level of interest rates changes, the effective yield (the interest payment divided by the bond's price) on your bonds fluctuates to rise and fall with the market level of rates for similar bonds.  So if rates have fallen since you bought your bonds, the value of those bonds has increased — which in turn reduces the effective yield that you're earning on your invested dollars. 

  Understand that bonds may be called early.  Many bonds, especially corporate bonds, can legally be called before maturity.  In this case, the bond issuer pays you back early because it doesn't need to borrow as much money or because interest rates have fallen and the borrower wants to reissue new bonds at a lower interest rate.  Be especially careful about purchasing bonds that were issued at higher interest rates than those that currently prevail.  Borrowers pay off such bonds first. 

  Diversify.  Invest in and hold bonds from a variety of companies in different industries to buffer changes in the economy that adversely affect one industry or a few industries more than others.  Of the money that you want to invest in bonds, don't put more than 5 percent into any one bond.  So you need to hold at least 20 bonds.  Diversification requires a good amount to invest given the size of most bonds and because trading fees erode your investment balance if you invest too little.  If you can't achieve this level of diversification, use a bond mutual fund. 

  Shop around.  Just like when you buy a car, shop around for good prices on the bonds that you have in mind.  The hard part is doing an apples-to-apples comparison because different brokers may not offer the same exact bonds as other brokers.  Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating (both of which I discuss earlier in this chapter). 

  Unless you invest in boring, simple-to-understand bonds such as Treasuries, you're better off investing in bonds via the best bond mutual funds.  One exception is if you absolutely, positively must receive your principal back on a certain date.  Because bond funds don't mature, individual bonds with the correct maturity for you may best suit your needs.  Consider Treasuries because they carry such low default risk.  Otherwise, you need a lot of time, money, and patience to invest well in individual bonds. 

Considering Other Lending Investments

Bonds, money market funds, and bank savings vehicles are hardly the only lending investments.  A variety of other companies are more than willing to have you lend them your money and pay you a relatively fixed rate of interest.  In most cases, though, you're better off staying away from the investments in the following sections. 

 Too many investors get sucked into lending investments that offer higher yields.  Always remember: Risk and return go hand in hand.  Higher yields mean greater risk, and vice versa. 

Guaranteed-investment contracts

Insurance companies sell and back guaranteed-investment contracts (GICs).  The allure of GICs is that your account value doesn't appear to fluctuate.  Like a one-year bank certificate of deposit, GICs generally quote you an interest rate for the next year.  Some GICs lock in the rate for longer periods of time, whereas others may change the interest rate several times per year. 

But remember that the insurance company that issues the GIC does invest your money, mostly in bonds and maybe a bit in stocks.  Like other bonds and stocks, these investments fluctuate in value — you just don't see it. 

Typically once a year, you receive a new statement showing that your GIC is worth more, thanks to the newly added interest.  This statement makes otherwise-nervous investors who can't stand volatile investments feel all warm and fuzzy. 

The yield on a GIC is usually comparable to those available on shorter-term, high-quality bonds.  Yet the insurer invests in longer-term bonds and some stocks.  The difference between what these investments generate for the insurer and what the GIC pays you in interest goes to the insurer. 

  The insurer's take can be significant and is generally hidden.  Unlike a mutual fund, which is required to report the management fee that it collects and subtracts before paying your return, GIC insurers have no such obligations.  By having a return guaranteed in advance, you pay heavily — an effective fee of 2-plus percent per year — for the peace of mind in the form of lower long-term returns. 

The high effective fees that you pay to have an insurer manage your money in a GIC aren't the only drawbacks.  When you invest in a GIC, your assets are part of the insurer's general assets.  Insurance companies sometimes fail, and although they often merge with a healthy insurer, you can still lose money.  The rate of return on GICs from a failed insurance company is often slashed to help restore financial soundness to the company.  So the only "guarantee" that comes with a GIC is that the insurer agrees to pay you the promised rate of interest (as long as it is able)! 

Private mortgages

In the section "Mortgage bonds," earlier in this chapter, I discuss investing in mortgages that resemble the ones you take out to purchase a home.  To directly invest in mortgages, you can loan your money to people who need money to buy or refinance real estate.  Such loans are known as private mortgages or second mortgages, in the case where your loan is second in line behind someone's primary mortgage. 

Private mortgage investments appeal to investors who don't like the volatility of the stock and bond markets and aren't satisfied with the seemingly low returns on bonds or other common lending investments.  Private mortgages seem to offer the best of both worlds — stock-market-like, 10-plus percent returns without volatility. 

  Mortgage and real estate brokers often arrange mortgage investments, so you must tread carefully because these people have a vested interest in seeing the deal done.  Otherwise, the mortgage broker doesn't get paid for closing the loan, and the real estate broker doesn't get a commission for selling a property. 

One broker who also happens to write about real estate wrote a newspaper column describing mortgages as the "perfect real estate investment" and added that mortgages are a "high-yield, low-risk investment."  If that wasn't enough to get you to whip out your checkbook, the writer/broker further gushed that mortgages are great investments because you have "little or no management, no physical labor." 

Out of sight: Fluctuations of private mortgages, GICs, and CDs

One of the allures of non-bond lending investments, such as private mortgages, GICs, and CDs, is that they don't fluctuate in value — at least not that you can see.  Such investments appear safer and less volatile.  You can't watch your principal fluctuate in value because you can't look up the value daily the way you can with bonds and stocks. 

But the principal values of your mortgage, GIC, and CD investments really do fluctuate; you just don't see the fluctuations!  As I explain in the section "Determining when you get your money back: Maturity matters," earlier in this chapter, just as the market value of a bond drops when interest rates rise, so does the market value of these investments (and for the same reasons).  At higher interest rates, investors expect a discounted price on your fixed-interest rate investment because they always have the alternative of purchasing a new mortgage, GIC, or CD at the higher prevailing rates.  Some of these investments are actually bought and sold (and behave just like bonds) among investors on what's known as a secondary market. 

If the normal volatility of a bond's principal value makes you queasy, try not to follow your investments so closely! 

You know by now that a low-risk, high-yield investment doesn't exist.  Earning a relatively high interest rate goes hand in hand with accepting relatively high risk.  The risk is that the borrower can default — which leaves you holding the bag. ( In the mid- to late 2000s, mortgage defaults escalated significantly.)  More specifically, you can get stuck with a property that you may need to foreclose on, and if you don't hold the first mortgage, you're not first in line with a claim on the property. 

The fact that private mortgages are high risk should be obvious when you consider why the borrower elects to obtain needed funds privately rather than through a bank.  Put yourself in the borrower's shoes.  As a property buyer or owner, if you can obtain a mortgage through a conventional lender, such as a bank, wouldn't you do so?  After all, banks generally give better interest rates.  If a mortgage broker offers you a deal where you can, for example, borrow money at 11 percent when the going bank rate is, say, 7 percent, the deal must carry a fair amount of risk. 

  I would avoid private mortgages.  If you really want to invest in such mortgages, you must do some time-consuming homework on the borrower's financial situation.  A banker doesn't lend someone money without examining a borrower's assets, liabilities, and monthly expenses, and you shouldn't either.  Be careful to check the borrower's credit, and get a large down payment (at least 20 percent).  The best circumstance in which to be a lender is if you sell some of your own real estate and you're willing to act as the bank and provide the financing to the buyer in the form of a first mortgage. 

Also recognize that your mortgage investment carries interest rate risk: If you need to "sell" it early, you'd have to discount it, perhaps substantially if interest rates have increased since you purchased it.  Try not to lend so much money on one mortgage that it represents more than 5 percent of your total investments. 

  If you're willing to lend your money to borrowers who carry a relatively high risk of defaulting, consider investing in high-yield (junk) bond mutual funds instead.  With these funds, you can at least diversify your money across many borrowers, and you benefit from the professional review and due diligence of the fund management team.  You can also consider lending money to family members. 
Chapter 8

Mastering Mutual Funds

In This Chapter

  Looking at reasons to invest in mutual funds

  Uncovering the secrets of successful fund investing

  Deciding how to allocate your assets

  Finding the best stock, bond, hybrid, and money market funds

Good mutual funds, which are big pools of money from investors that a mutual fund manager uses to buy a bunch of stocks, bonds, and other assets that meet the fund's investment criteria, enable you to have some of the best money managers in the country direct the investment of your money.  Because efficient funds take most of the hassle and cost out of deciding which companies to invest in, they're among the finest investment vehicles available today. 

Different types of mutual funds can help you meet various financial goals, which is why investors have more than $11 trillion invested in these funds!  You can use money market funds for something most everybody needs — an emergency savings stash of three to six months' living expenses.  Or perhaps you're thinking about saving for a home purchase, retirement, or future educational costs.  If so, you can consider some stock and bond mutual funds. 

  If you haven't taken a comprehensive look at your personal finances, read Chapter 3 to begin this important process.  Too many people plunge in to mutual funds without looking at their overall financial situation and, in their haste, often end up paying more taxes and overlooking other valuable financial strategies. 

Discovering the Benefits of the Best Funds

The best mutual funds are superior investment vehicles for people of all economic means, and they can help you accomplish many financial objectives.  The following sections go over the main reasons for investing in mutual funds rather than individual securities. ( If you wish to invest in individual stocks, I provide information on how best to do so in Chapter 6.) 

Professional management

The mutual fund investment company hires a portfolio manager and researchers whose full-time jobs are to analyze and purchase suitable investments for the fund.  These people screen the universe of investments for those that meet the fund's stated objectives. 

Typically, fund managers are graduates of the top business and finance schools, where they learned portfolio management and securities valuation and selection.  Many have additional investing credentials, such as being a Chartered Financial Analyst (CFA).  In addition to their educational training, the best fund managers typically possess ten or more years of experience in analyzing and selecting investments. 

For most fund managers and researchers, finding the best investments is more than a full-time job.  Fund managers do tons of analysis that you probably lack the time or expertise to perform.  For example, fund managers do the following: assess company financial statements; interview a company's managers to get a sense of the company's business strategies and vision; examine competitor strategies; speak with company customers, suppliers, and industry consultants; and attend trade shows and read industry periodicals. 

  In short, a mutual fund management team does more research, number crunching, and due diligence than most people could ever have the energy or expertise to do in what little free time they have.  Investing in mutual funds frees up time for friendships, family relationships, and maybe even your sex life — don't miss the terrific time-saving benefits of fund investing! 

Cost efficiency

Mutual funds are a cheaper, more communal way of getting your investment work done.  When you invest your money in an efficiently managed mutual fund, it likely costs you less than trading individual securities on your own.  Fund managers can buy and sell securities for a fraction of the cost that you pay. 

Funds also spread the cost of research over thousands of investors.  The most efficiently managed mutual funds cost less than 1 percent per year in fees. ( Bonds and money market funds cost much less — in the neighborhood of 0.5 percent per year or less.)  Some of the larger and more established funds can charge annual fees less than 0.2 percent per year — that's less than a $2 annual charge per $1,000 you invest. 

Newer exchange-traded funds (ETFs) are like index mutual funds (see the section "Consider index funds" later in this chapter), except that they trade on a stock exchange and, in the best cases, may have a slightly lower management fee than their sibling index mutual funds. 

Diversification

Diversification is a big attraction for many investors who choose mutual funds.  Most funds own stocks or bonds from dozens of companies, thus diversifying against the risk of bad news from any single company or sector.  Achieving such diversification on your own is difficult and expensive unless you have a few hundred thousand dollars and a great deal of time to invest. 

Mutual funds typically invest in 25 to 100 securities or more.  Proper diversification increases the chances of the fund earning higher returns with less risk. 

  Although most mutual funds are diversified, some aren't.  For example, some stock funds invest exclusively in stocks of a single industry (for example, healthcare) or country (such as Mexico).  I'm not a fan of these funds because of the narrowness of their investments and their typically higher operating fees. 

Reasonable investment minimums

Most funds have low minimum investment requirements.  Many funds have minimums of $1,000 or less.  Retirement account investors can often invest with even less.  Some funds even offer monthly investment plans so you can start with as little as $50 per month. 

  Even if you have lots of money to invest, you should consider mutual funds.  Increasing numbers of fund companies offer their higher-balance customers special funds with lower annual operating expenses and thus even better returns. ( I provide more information on these funds later in this chapter.) 

Different funds for different folks

  Some people think that mutual funds = stock market investing = risky.  This line of thinking is wrong.  The majority of money in mutual funds isn't in the stock market.  You can select the funds that take on the kinds of risks that you're comfortable with and that meet your financial goals.  Following is a list of the three major types of mutual funds:

  Stock funds: If you want your money to grow over a long period of time (and you can handle down as well as up years), choose funds that invest more heavily in stocks. 

  Bond funds: If you need current income and don't want investments that fluctuate as widely in value as stocks do, consider some bond funds. 

  Money market funds: If you want to be sure that your invested principal doesn't decline in value because you may need to use your money in the short term, select a money market fund. 

Most investors (myself included) choose a combination of these three types of funds to diversify and help accomplish different financial goals. ( I cover each type of fund in depth later in this chapter.) 

High financial safety

Thousands of banks and insurance companies have failed in recent decades.  Banks and insurers can fail because their liabilities (the money that customers give them to invest, which they can be called on to return on short notice) can exceed their assets (the money that they've invested or lent). 

For example, when big chunks of a bank's loans go sour at the same time that its depositors want their money, the bank fails, because banks typically have less than 15 cents on deposit for every dollar that you and I place with them.  Likewise, if an insurance company makes several poor investments or underestimates the number of insurance policyholder claims, it too can fail. 

  Such failures can't happen with a mutual fund because the value of the fund's shares fluctuates as the securities in the fund rise and fall in value.  For every dollar of securities they hold for their customers, mutual funds have a dollar's worth of securities.  The worst that can happen with a fund is that if you want your money, you may get less money than you originally put into the fund due to a market value decline of the fund's holdings — but you won't lose all your original investment. 

For added security, the specific stocks, bonds, and other securities that a mutual fund buys are held at a custodian, a separate organization independent of the mutual fund company.  A custodian ensures that the fund management company can't embezzle your funds or use assets from a better-performing fund to subsidize a poor performer. 

Accessibility

What's really terrific about dealing with mutual funds is that they're set up for people who value their time and don't like going to a local branch office and standing in long lines.  With mutual funds, you can fill out a simple form (often online, if you want) and write a check in the comfort of your home (or authorize electronic transfers from your bank or other accounts) to make your initial investment.  You can then typically make subsequent investments by mailing in a check or zapping in money electronically. 

Additionally, most money market funds offer check-writing privileges.  Many mutual fund companies also allow you to electronically transfer money back and forth from your local bank account; you can access your money almost as quickly through a money market fund as you can through your local bank. 

Selling shares of your mutual fund is usually simple.  Generally, all you need to do is call the fund company's toll-free number or visit its website.  Some companies have representatives available around the clock, year-round.  Most fund companies also offer online account access and trading capabilities as well. ( Although, as I discuss in Chapter 9, some people are prone to overtrading online, so beware.) 

Reviewing the Keys to Successful Fund Investing

This chapter helps explain why mutual funds are a good investment vehicle to use.  However, keep in mind that not all funds are worthy of your investment dollars.  Would you, for example, invest in a mutual fund run by an inexperienced and unproven 18-year-old?  How about a fund that charges high fees and produces inferior returns in comparison to other similar funds?  You don't have to be an investing wizard to know the correct answers to these questions. 

When you select a fund, you can use a number of simple, common-sense criteria to greatly increase your chances of investment success.  The criteria presented in this section have been proven to dramatically increase your fund investing returns. ( Visit my website at www.erictyson.com to see the studies.) 

Minimize costs

The charges that you pay to buy or sell a fund, as well as the ongoing fund operating expenses, can have a big impact on the rate of return that you earn on your investments.  So, because hundreds of choices are available for a particular type of mutual fund (larger-company U.S. stock funds, for example), you have no reason to put up with inflated costs. 

  Fund costs are an important factor in the return that you earn from a mutual fund because fees are deducted from your investment returns and can attack a fund from many angles.  All other things being equal, high fees and other charges depress your returns. 

  Stick with funds that maintain low total operating expenses and that don't charge sales loads (commissions).  Both types of fees come out of your pocket and reduce your rate of return.  Plenty of excellent funds are available at reasonable annual operating expense ratios (less than 1 percent for stock funds; less than 0.5 percent for bond funds).  See my recommendations in the respective sections on the best stock mutual funds, bond funds, and money market funds, later in this chapter. 

Avoid load funds

The first fee you need to minimize is the sales load, which is a commission paid to brokers and "financial planners" who work on commission and sell mutual funds.  Commissions, or loads, generally range from 4.0 to 8.5 percent of the amount that you invest.  Sales loads are an additional and unnecessary cost that's deducted from your investment money.  You can find plenty of outstanding no-load (commission-free) funds. 

  Brokers, being brokers, sing the praises of buying a load fund, warn against no-loads, and sometimes even try to obscure the load.  For example, brokers may tell you that the commission doesn't cost you because the mutual fund company pays it.  Remember that the commission always comes out of your investment dollars, regardless of how cleverly some load funds and brokers disguise the commission. 

Brokers also may say that load funds perform better than no-load funds.  One reason, brokers claim, is that load funds supposedly hire better fund managers.  Absolutely no relationship exists between paying a sales charge to buy a fund and gaining access to better investment managers.  Remember that the sales commission goes to the selling broker, not to the fund managers.  Objective studies demonstrate time and again that load funds not only don't outperform but, in fact, underperform no-loads.  Common sense suggests why: When you factor in the higher commission and the higher average ongoing operating expenses charged on load funds, you pay more to own a load fund, so your returns are less. 

Another problem with commission-driven load-fund sellers is the power of self-interest.  This issue is rarely talked about, but it's even more important than the extra costs that you pay with load funds.  When you buy a load fund through a salesperson, you miss out on the chance to get holistic advice on other personal finance strategies.  For example, you may be better off paying down your debts or investing in something entirely different from a mutual fund.  But in my experience, salespeople almost never advise you to pay off your credit cards or your mortgage — or to invest through your company's retirement plan or in real estate — instead of buying an investment through them. 

Some mutual fund companies, such as Fidelity, try to play it both ways.  They sell load (through brokers) as well as no-load funds (direct to investors).  Be aware of this when a "financial advisor" says he can get you into funds from the leading companies, such as Fidelity, because what he really may be telling you is that he's pitching load funds. 

Hiding loads

Unfortunately, fund companies have come up with crafty ways of hiding sales loads.  Increasing numbers of brokers and financial planners sell funds that they call no-loads, but these funds aren't no-loads. 

In back-end or deferred sales load funds, the commission is hidden, thanks to the different classes of shares, known as A, B, C, and D classes.  Salespeople tell you that as long as you stay in a fund for five to seven years, you need not pay the back-end sales charge that applies when you sell the investment.  This claim may be true, but it's also true that these funds pay investment salespeople a hefty commission. 

The salespeople can receive their commissions because the fund company charges you exorbitant continuing operating expenses (which are usually at least 1 percent more per year than the best funds).  So one way or another, they get their commissions from your investment dollars. 

Beware of high operating expenses

In addition to loads, the other costs of owning funds are the ongoing operating expenses.  All mutual funds charge fees as long as you keep your money in the fund.  The fees pay for the costs of running a fund, such as employees' salaries, marketing, toll-free phone lines, printing and mailing prospectuses (legal disclosure of the fund's operations and fees), and so on. 

A mutual fund's operating expenses are essentially invisible to you because they're deducted from the fund's share price.  Companies charge operating expenses on a daily basis, so you don't need to worry about trying to get out of a fund at a particular time of the year before the company deducts these fees. 

  Although operating expenses are invisible to you, their impact on your returns is quite real.  Studying the expenses of various money market mutual funds and bond funds is critical; these funds buy securities that are so similar and so efficiently priced in the financial markets that most fund managers in a given type of money market or bond fund earn quite similar returns before expenses. 

With stock funds, expenses may play less of an important role in your fund decision.  However, don't forget that, over time, stocks have averaged returns of about 9 to 10 percent per year.  So if one stock fund charges 1.5 percent more in operating expenses than another and your expected long-term return is about 10 percent per year, you give up an extra 15 percent of your expected (pre-tax) annual returns (and an even greater portion of your after-tax returns). 

  All types of funds with higher operating expenses tend to produce lower rates of return on average.  Conversely, funds with lower operating costs can more easily produce higher returns for you than a comparable type of fund with high costs.  This effect makes sense because companies deduct operating expenses from the returns that your fund generates.  Higher expenses mean a lower return to you. 

Fund companies quote a fund's operating expenses as a percentage of your investment.  The percentage represents an annual fee or charge.  You can find this number in a fund's prospectus, in the fund expenses section, usually in a line that says something like "Total Fund Operating Expenses."  You also can call the mutual fund's toll-free phone number and ask a representative, or you can find the information at the fund company's website.  Make sure that a fund doesn't appear to have low expenses simply because it's temporarily waiving them. ( You can ask the fund representative or look at the fees in the fund's prospectus to find this information.) 

Reflect on performance and risk

A fund's historic rate of return or performance is another important factor to weigh when you select a mutual fund.  Keep in mind, however, that, as all mutual fund materials must tell you, past performance is no guarantee of future results.  In fact, many former high-return funds achieved their results only by taking on high risk or simply by relying on short-term luck.  Funds that assume higher risk should produce higher rates of return.  But high-risk funds usually decline in price faster during major market declines.  Thus, a good fund should consistently deliver a favorable rate of return given the level of risk that it takes. 

  A big mistake that many investors make when they choose a mutual fund is overemphasizing the importance of past performance numbers.  The shorter the time period you analyze, the greater the danger that you'll misuse high performance as an indicator for a good future fund. 

Although past performance can be a good sign, high returns for a fund, relative to its peers, are largely possible only if a fund takes more risk (or if a fund manager's particular investment style happens by luck to come into favor for a few years).  The danger of taking more risk is that it doesn't always work the way you'd like.  The odds are high that you won't be able to pick the next star before it vaults to prominence in the investing sky.  You have a far greater chance of getting on board when a recently high performing fund is ready to plummet back to Earth. 

  One clever way that fund managers make mutual funds look better than other comparable funds is to compare them to funds that aren't really comparable.  The most common ploy is for a manager to invest a fund in riskier types of securities and then compare its performance to funds that invest in less risky securities.  Examine the types of securities that a fund invests in, and then make sure that the comparison funds or indexes invest in similar securities. 

Stick with experience

A great deal of emphasis is placed on who manages a specific mutual fund.  Although the individual fund manager is important, a manager isn't an island unto himself.  The resources and capabilities of the parent company are equally, if not more, important.  Managers come and go, but fund companies usually don't. 

Different companies maintain different capabilities and levels of expertise with different types of funds.  Vanguard, for example, is terrific at money market, bond, and conservative stock funds, thanks to its low operating expenses.  Fidelity has significant experience with investing in U.S. stocks. 

A fund company gains more or less experience than others not only from the direct management of certain fund types but also through hiring out.  For example, some fund families contract with private money management firms that possess significant experience.  In other cases, private money management firms, such as PIMCO, Tweedy Browne, and Dodge & Cox, with long histories in private money management offer mutual funds. 

Consider index funds

Index funds are funds that are mostly managed by a computer.  Unlike other mutual funds, in which the portfolio manager and a team of analysts scour the market for the best securities, an index fund manager simply invests to match the makeup, and thus also the performance, of an index (such as the Standard & Poor's 500 index of 500 large U.S. company stocks). 

Index funds deliver relatively good returns by keeping expenses low, staying invested, and not trying to jump around.  Over ten years or more, index funds typically outperform about three-quarters of their peers!  Most so-called actively managed funds can't overcome the handicap of high operating expenses that pull down their rates of return.  Index funds can run with far lower operating expenses because significant ongoing research isn't needed to identify companies to invest in. 

The average U.S. stock mutual fund, for example, has an operating expense ratio of 1.4 percent per year. ( Some funds charge expenses as high as 2 percent or more per year.)  That being the case, a U.S. stock index fund with an expense ratio of just 0.2 percent per year has an advantage of 1.2 percent per year over the average fund.  A 1.2 percent difference may not seem like much, but in fact it is a significant difference.  Because stocks tend to return about 10 percent per year, you end up throwing away about 12 percent of your expected (pre-tax) stock fund returns with an "average fund" in terms of expenses (and an even greater portion of your post-tax returns). 

With actively managed stock funds, a fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks.  An actively managed fund can easily underperform the overall market index that it's competing against. 

  Don't try to pick in advance one of the few elite money managers who manages to beat the market averages by a few percentage points per year.  Also, don't overestimate the pros' ability to consistently pick the right stocks.  Index funds make sense for a portion of your investments, especially when you invest in bonds and larger, more conservative stocks, where beating the market is difficult for portfolio managers. 

In addition to lower operating expenses, which help boost your returns, index mutual funds are usually tax-friendlier to invest in when you invest outside retirement accounts.  Mutual fund managers of actively managed portfolios, in their attempts to increase returns, buy and sell securities more frequently.  However, this trading increases a fund's taxable capital gains distributions and reduces a fund's after-tax return. 

  Vanguard is the largest and best mutual fund provider of index funds because it maintains the lowest annual operating fees in the business.  Vanguard has all types of bond and stock (both U.S. and international) index mutual funds.  See my recommended-fund sections later in this chapter. 

Keep exchange-traded funds on your radar

Exchange-traded funds (ETFs) are relatively new.  Although the first one was created in 1993, they've gained some traction in recent years (they now hold about 8 percent of the total assets of the mutual fund industry). 

ETFs are similar to mutual funds.  The most significant difference is that in order to invest, you must buy an ETF through a stock exchange where ETFs trade, just as individual stocks trade.  Thus, you need a brokerage account to invest in ETFs. ( See Chapter 9 for general information on selecting a brokerage firm.) 

ETFs are also like index mutual funds in that each ETF generally tracks a major market index. ( Beware that more and more companies are issuing ETFs that track narrowly focused indexes such as an industry group or small country.)  The best ETFs may also have slightly lower operating expenses than the lowest-cost index funds.  However, you must pay a brokerage fee to buy and sell an ETF, and the current market price of the ETF may deviate slightly from the underlying market value of the securities in its portfolio. 

To find out more about ETFs, especially as an alternative or complement to your mutual fund portfolio, check out the latest edition of my book Mutual Funds For Dummies (John Wiley & Sons, Inc.). 

Steer clear of leveraged and inverse exchange-traded funds

Since their introduction in 2006, leveraged and inverse exchange-traded funds have taken in tens of billions in assets.  Here's the lowdown on these funds:

  Leveraged ETFs: These claim to magnify the move of a particular index, for example the Standard & Poor (S&P) 500 stock index, by double or even triple in some cases.  So a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for a 1 percent increase in the S&P 500 index. 

  Inverse ETFs: These are supposed to move in the opposite direction of a given index.  So, for example, an inverse S&P 500 ETF is supposed to increase by 1 percent for a 1 percent decrease in the S&P 500 index. 

The steep 2008 decline in stock market indexes around the globe and the increasing volatility in that year created the perfect environment for leveraged and inverse ETFs.  With these new vehicles, you could easily make money from major stock market indexes when they were falling.  Or, if you were convinced a particular index or industry group was about to zoom higher, you could buy a leveraged ETF that would magnify market moves by double or even triple. 

Suppose that back in early 2008, when the Dow Jones Industrial Average had declined about 10 percent from its then recent peak above 14,000, you were starting to get nervous and wanted to protect your portfolio from a major market decline.  So you bought some of the ProShares UltraShort Dow 30 ETF (trading symbol DXD), which is an inverse ETF designed to move twice as much in the opposite direction as the Dow.  So if the Dow goes down, DXD goes up twice as much and you make money. 

Now consider what happened when you held on to the ETF through early 2010 — two years after you bought the fund in early 2008.  Over this entire two-year period, the Dow was down about 20 percent.  So your original thinking that the market was going to fall proved to be correct.  If the ETF did what it was supposed to do and moved twice as much in the other direction, it should have increased 40 percent in value over this period, thus giving you a tidy return.  But, it didn't.  It wasn't even close.  The ETF actually plummeted nearly 50 percent in value! 

My overall investigations of whether the leveraged (and inverse) ETFs actually deliver on their objectives show that they don't.  In recent years, ETF issuers have come out with increasingly risky and costly ETFs.  Leveraged and inverse ETFs are especially problematic in that regard.  And now the issuers of these leveraged and inverse ETFs are in trouble for their poor disclosure and misleading marketing.  Buried in the fine print of the prospectuses of these ETFs, you usually see notes that these ETFs are only designed to accomplish their stated objectives for one trading day.  As a result, they're only really suitable for day traders!  Of course, few investors read (and understand) the dozens of pages of legal boilerplate in a prospectus. 

Brokerage firms and industry regulators are taking notice of these problems.  The Financial Industry Regulatory Authority (FINRA), the largest independent regulator for U.S. securities firms, issued a lengthy warning to brokers and financial advisors that:

"...inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets." 

Retail investors pumped billions of dollars into leveraged and inverse ETFs without FINRA's clear explanation and disclosure.  If they had, and if they had known how poorly these ETFs actually do over extended periods of time, they wouldn't have invested. 

A number of brokerage firms have suspended trading in these ETFs.  They're worried about their legal exposure as well about what happens if their customers invest in leveraged and inverse ETFs and get burned. 

  Leveraged and inverse ETFs aren't investments.  They're gambling instruments for day traders.  As an individual investor, if you happen to guess correctly before a short-term major market move, you may do well over a short period of time (longer than one day but no more than a few months).  However, the odds are heavily stacked against you.  You can reduce risk and hedge yourself through sensible diversification.  If, for example, you don't want 80 percent of your portfolio exposed to stock market risk, invest a percentage you're comfortable with and don't waste your time and money with leveraged and inverse ETFs. 

Creating Your Fund Portfolio with Asset Allocation

Asset allocation simply means that you decide what percentage of your investments you place — or allocate — into bonds versus stocks and into international stocks versus U.S. stocks. ( Asset allocation can also include other assets, such as real estate and small business, which are discussed throughout this book.) 

When you invest money for the longer term, such as for retirement, you can choose among the various types of funds that I discuss in this chapter.  Most people get a big headache when they try to decide how to spread their money among the choices.  This section helps you begin cutting through the clutter. ( I discuss recommended funds for shorter-term goals later in this chapter as well.) 

Allocating for the long term

Many working folks have time on their side, and they need to use that time to make their money grow.  You may have two or more decades before you need to draw on some portion of your retirement account assets.  If some of your investments drop a bit over a year or two — or even over five years — the value of your investments has plenty of time to recover before you spend the money in retirement. 

  Your current age and the number of years until you retire are the biggest factors in your allocation decision.  The younger you are and the more years you have before retirement, the more comfortable you should be with volatile, growth-oriented investments, such as stock funds. ( See Chapter 2 for the risks and historic returns of different investments.) 

Table 8-1 lists guidelines for allocating mutual fund money that you've earmarked for long-term purposes, such as retirement.  You don't need an MBA or PhD to decide your asset allocation — all you need to know is how old you are and the level of risk that you desire! 

Table 8-1 Mutual Fund Asset Allocation for the Long Haul

---

Your Investment Attitude | Bond Fund Allocation (%) | Stock Fund Allocation (%)

Play it safe | = Age | = 100 – age

Middle of the road | = Age – 10 | = 110 – age

Aggressive | = Age – 20 | = 120 – age

What's it all mean, you ask?  Consider this example: If you're a conservative sort who doesn't like a lot of risk, but you recognize the value of striving for some growth to make your money work harder, you're a middle-of-the-road type.  Using Table 8-1, if you're 35 years old, you may consider putting 25 percent (35 – 10) into bond funds and 75 percent (110 – 35) into stock funds. 

  Now divvy up your stock investment money between U.S. and international funds.  Here's what portion of your stock allocation I recommend investing in overseas stocks:

  20 percent (for a play-it-safe attitude)

  35 percent (for a middle-of-the-road attitude)

  50 percent (for an aggressive attitude)

If, for example, in Table 8-1, the 35-year-old, middle-of-the-road type invests 75 percent in stocks, she can then invest about 35 percent of the stock fund investments (which works out to be around 25 percent of the total) in international stock funds. 

So here's what the 35-year-old, middle-of-the-road investor's portfolio asset allocation looks like:

Bonds | 25%

---|---

U.S. stocks | 50%

International stocks | 25%

Diversifying your stock fund investments

Suppose that your investment allocation decisions suggest that you invest 50 percent in U.S. stock funds.  Which ones do you choose?  As I explain in the section "Exploring different types of stock funds" later in this chapter, stock funds differ on a number of levels.  You can choose from growth-oriented stocks and funds and those that focus on value stocks as well as funds that focus on small-, medium-, or large-company stocks.  I explain these types of stocks and funds later in this chapter.  You also need to decide what portion you want to invest in index funds (which I discuss in the "Consider index funds" section earlier in the chapter) versus actively managed funds that try to beat the market. 

 Generally, it's a good idea to diversify into different types of funds.  You can diversify in one of two ways:

  Purchase several individual funds, each of which focuses on a different style.  For example, you can invest in a large-company value stock fund and in a small-company growth fund.  I find this approach somewhat tedious.  Granted, it does allow a fund manager to specialize and gain greater knowledge about a particular type of stock.  But many of the best managers invest in more than one narrow range of security. 

  Invest in a handful of funds (five to ten), each of which covers several bases and that together cover them all.  Remember, the investment delineations are somewhat arbitrary, and most funds focus on more than just one type of investment.  For example, a fund may focus on small-company value stocks but may also invest in medium-company stocks.  It may also invest in some that are more growth oriented. 

Deciding how much you should use index versus actively managed funds is really a matter of personal taste.  If you're satisfied knowing that you'll get the market rate of return and that you can't underperform the market (after accounting for your costs), index your entire portfolio.  On the other hand, if you enjoy the challenge of trying to pick the better managers and want the potential to earn better than the market level of returns, don't use index funds at all.  Investing in a happy medium of both, like I do, is always a safe bet. 

  If you haven't experienced the sometimes significant plummets in stock prices that occur, you may feel queasy the next time it happens and you've got a chunk of your nest egg in stocks.  Be sure to read Chapters 2 and 5 to understand the risk in stocks and what you can and can't do to reduce the volatility of your stock holdings. 

The Best Stock Mutual Funds

Stock mutual funds are excellent investment vehicles that reduce your risk, compared to purchasing individual stocks, because they

  Invest in dozens of stocks: Unless you possess a lot of money to invest, you're likely to buy only a handful of stocks.  If you end up with a lemon in your portfolio, it can devastate your other good choices.  If such a stock represents 20 percent of your holdings, the rest of your stock selections need to increase about 25 percent in value just to get you back to even.  Stock funds mitigate this risk. 

For example, if a fund holds equal amounts of 50 stocks, and one goes to zero, you lose only 2 percent of the fund value if the stock was an average holding.  Similarly, if the fund holds 100 stocks, you lose just 1 percent.  Remember that a good fund manager is more likely than you to sidestep disasters (see the earlier section "Professional management" for details). 

  Invest in different types of stocks: Some funds invest in stocks of different size companies in a variety of industries.  Others may hold U.S. and international stocks.  Different types of stocks (which are explained in the upcoming section titled "Exploring different types of stock funds") generally don't move in tandem.  So if smaller-company stocks get beat up, larger-company stocks may fare better.  If U.S. stocks are in the tank, international stocks may be on an upswing. 

  In Chapters 2 and 5, I make the case for investing in stocks (also known as equities) to make your money grow.  However, stocks sometimes plummet or otherwise remain depressed for a few years.  Thus, stock mutual funds (also known as equity funds), which, as their name suggests, invest in stocks, aren't a place for money that you know you may need to protect in the next few years. 

Making money with stock funds

When you invest in stock mutual funds, you can make money in three ways:

  Dividends: As a mutual fund investor, you can choose to receive your share of the dividends paid out to the fund as cash or to reinvest them in purchasing more shares in the fund.  Higher-growth companies tend to pay lower dividends. 

  Unless you need the income to live on (if, for example, you're already retired), reinvest your dividends into buying more shares in the fund.  If you reinvest outside of a retirement account, keep a record of those reinvestments because you need to factor those additional purchases into the tax calculations that you make when you sell your shares. 

  Capital gains distributions: When a fund manager sells stocks for more than he paid, the resulting profits, known as capital gains, must be netted against losses and paid out to the fund's shareholders.  Just as with dividends, you can reinvest your capital gains distributions in the fund. 

  Appreciation: The fund manager isn't going to sell all the stocks that have gone up in value.  Thus, the price per share of the fund increases to reflect the gains in its stock holdings.  For you, these profits are on paper until you sell the fund and lock them in.  Of course, if a fund's stocks decline in value, the share price depreciates. 

If you add together dividends, capital gains distributions, and appreciation, you arrive at the total return of a fund. 

Exploring different types of stock funds

Stock funds and the stocks that they invest in are usually pigeonholed into particular categories based on the types of stocks that they focus on.  Categorizing stock funds is often tidier in theory than in practice, though, because some funds invest in an eclectic mix of stocks.  So don't get bogged down with the names of funds — they sometimes have misleading names and don't necessarily do what those names imply.  The investment strategies of the fund and the fund's typical investments are what matter.  The following characteristics are what you need to pay attention to:

  Company size: The first dimension on which a stock fund's stock selection differs is based on the size of the company in which the fund invests — small, medium, or large.  The total market value (capitalization) of a company's outstanding stock defines the categories that define the stocks that the fund invests in. ( The term capitalization is often shortened to "cap," so you may hear financial folks tossing around terms like large cap and small cap.)  The dollar amounts are arbitrary, and as stock prices increase over time, investment market analysts have moved up their cutoffs.  Here's the latest:

• Small-capitalization stocks are usually defined as stocks of companies that possess total market capitalization of less than $2 billion. 

• Medium-capitalization stocks have market values between $2 billion and $10 billion. 

• Large-capitalization stocks are those of companies with market values greater than $10 billion. 

  Growth versus value: Stock fund managers and their funds are further categorized by whether they invest in growth or value stocks:

• Growth stocks have high prices in relation to the company's assets, profits, and potential profits.  Growth companies typically experience rapidly expanding revenues and profits.  These companies tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay low dividends.  For example, eBay pays no dividends and reinvests most of its profits in its business. 

• Value stocks are priced cheaply in relation to the company's assets, profits, and potential profits.  Value stocks tend to pay higher dividends than growth stocks and historically have produced higher total returns than growth stocks. 

Mutual fund companies sometimes use other terms to describe other types of stock funds.  Aggressive growth funds tend to invest in the most growth-oriented companies and may undertake riskier investment practices, such as frequent trading.  Growth and income funds tend to invest in stocks that pay higher-than-average dividends, thus offering the investor the potential for growth and income.  Income funds tend to invest more in higher-yielding stocks.  Bonds usually make up the other portion of income funds. 

  Company location: Stocks and the companies that issue them are also divvied up based on the location of their main operations and headquarters.  Funds that specialize in U.S. stocks are, not surprisingly, called U.S. stock funds; those focusing in overseas stocks are typically called international or overseas funds. 

Putting together two or three of these major classifications, you can start to comprehend all those silly, lengthy names that mutual funds give their stock funds.  You can have funds that focus on large-company value stocks or small-company growth stocks.  You can add in U.S., international, and worldwide funds to further subdivide these categories into more fund types.  So you can have international stock funds that focus on small-company stocks or growth stocks. 

You can purchase several stock funds, each focusing on a different type of stock, to diversify into various types of stocks.  Two potential advantages result from doing so:

  Not all your money rides in one stock fund and with one fund manager. 

  Each of the different fund managers can look at and track particular stock investment possibilities. 

Using the selection criteria I outline in the earlier section "Reviewing the Keys to Successful Fund Investing," the following sections describe the best stock funds that are worthy of your consideration.  The funds differ primarily in terms of the types of stocks that they invest in.  Keep in mind as you read through these funds that they also differ in their tax-friendliness (see Chap-ter 3).  However, if you invest inside a retirement account, you don't need to worry about tax-friendliness. 

U.S. stock funds

Of all the different types of funds offered, U.S. stock funds are the largest category.  Stock funds differ mainly in terms of the size of the companies that they invest in and in whether the funds focus on growth or value companies.  Some funds hold all these characteristics, and some funds may even invest a bit overseas. 

  The only way to know for sure where a fund currently invests (or where the fund may invest in the future) is to ask.  You can call the mutual fund company that you're interested in to start your information search, or you can visit the company's website.  You can also read the fund's annual report (just a little light reading before heading off to the land of Nod).  Don't waste your time looking for this information in the fund's prospectus, because it doesn't give you anything beyond general parameters that guide the range of investments.  The prospectus generally doesn't tell you what the fund currently invests in, or has invested in. 

For mutual funds that you hold outside of retirement accounts, you owe current income tax on distributed dividends and capital gains.  As I discuss in Chapter 3, long-term capital gains and stock dividends are taxed at lower rates than ordinary income and other investment income. 

 Here's my short list of U.S. stock funds:

  Dodge & Cox Stock

  Fairholme Fund

  Fidelity Low Priced Stock

  Sequoia

  T. Rowe Price Spectrum Growth (holds some foreign stocks)

  Vanguard Total Stock Market Index, Primecap, Selected Value, Tax-Managed Capital Appreciation, and Tax-Managed Small Capitalization

International stock funds

For diversification and growth potential, you should include in your portfolio stock funds that invest overseas.  Normally, you can tell that you're looking at a fund that focuses its investments overseas if its name contains words such as international (foreign only), global (foreign and U.S.), or worldwide (foreign and U.S.). 

  As a general rule, avoid foreign funds that invest in just one country, regardless of whether that country is Australia, Zimbabwe, or anywhere in between.  As with investing in a sector fund that specializes in a particular industry (see the following section), this lack of diversification defeats the whole purpose of investing in funds.  Funds that focus on specific regions, such as Southeast Asia, are better but still generally problematic because of poor diversification and higher expenses than other, more-diversified international funds. 

If you want to invest in more geographically limiting international funds, take a look at T. Rowe Price's and Vanguard's offerings, which invest in broader regions, such as investing just in Europe, Asia, and the volatile but higher-growth-potential emerging markets in Southeast Asia and Latin America. 

In addition to the risks normally inherent with stock fund investing, changes in the value of foreign currencies relative to the U.S. dollar cause price changes in the international securities.  A decline in the value of the U.S. dollar helps the value of foreign stock funds (and conversely, a rising dollar versus other currencies can reduce the value of foreign stocks).  Some foreign stock funds hedge against currency changes.  Although this hedging helps reduce volatility a bit, it does cost money. 

 Here are my picks for diversified international funds:

  Dodge & Cox International

  Harbor International

  Masters' Select International Equity

  Oakmark International and Global (holds some U.S. stocks)

  Tweedy Browne Global Value (invests in the U.S. as well)

  Vanguard Global Equity (invests in the U.S. too), International Growth, Tax-Managed International, and Total International Stock Index

Sector funds

 Sector funds invest in securities in specific industries.  In most cases, you should avoid sector funds for a number of reasons, including the following:

  Lack of diversification: Investing in stocks of a single industry defeats a major purpose of investing in mutual funds — you give up the benefits of diversification.  Also, even if you're lucky enough to jump into a sector fund just before it becomes "hot," you can't assume that the fund will pick the right securities within that sector. 

  High fees: They tend to carry much higher fees than other mutual funds. 

  Taxable distributions: Many sector funds have high rates of trading or turnover of their investment holdings.  Investors who use these funds outside of retirement accounts have to pay the tax man for the likely greater taxable distributions that this trading produces. 

The only types of specialty funds that may make sense for a small portion (10 percent or less) of your entire investment portfolio are funds that invest in real estate or precious metals.  These funds can help diversify your portfolio because they can perform better during times of higher inflation — which often depresses bond and stock prices. ( However, you can comfortably skip these funds because diversified stock funds tend to hold some of the same stocks as these specialty funds.)  Here are some details about these two specialty fund types:

  Real estate funds: Real estate investment trusts (REITs) are stocks of companies that invest in real estate.  REITs typically invest in properties such as apartment buildings, shopping centers, and other rental properties.  REITs allow you to invest in real estate without the hassle of being a landlord.  It's a hassle to evaluate REIT stocks, but you can always invest in a mutual fund of REITs. 

REITs usually pay healthy levels of dividends, which, unlike stock dividends, are taxed at ordinary income tax rates.  As such, they're less appropriate for people in a higher tax bracket who invest money outside of retirement accounts.  Some good no-load REIT funds include Fidelity Real Estate, Vanguard REIT Index, and Cohen & Steers Realty Shares. 

  Precious metals: If you expect higher inflation, consider a gold fund.  But know that these funds swing wildly in value and aren't for the faint of heart.  A good precious-metals fund is the Vanguard Precious Metals and Mining Fund. 

  Don't buy bullion itself; storage costs and the concerns over whether you're dealing with a reputable company make buying gold bars a pain.  Also avoid futures and options, which are gambles on short-term price movements (see Chapter 1 for more information). 

The Best Bond Funds

Bond funds can make you money in the same three ways that a stock fund can — dividends, capital gains distributions, and appreciation. ( See the earlier section "Making money with stock funds" for more on these ways of making money.)  However, most of the time, the bulk of your return in a bond fund comes from dividends. 

  Although an overwhelming number of bond fund choices exists (thousands, in fact), not that many remain after you eliminate high-cost funds (those with loads and high ongoing fees), low-performance funds (which are often the high-cost funds), and funds managed by fund companies and fund managers with minimal experience investing in bonds.  Here are the aspects to consider when choosing bond funds:

  Length to maturity: Bond fund objectives and names usually fit one of three maturity categories — short-, intermediate-, and long-term.  You can earn a higher yield from investing in a bond fund that holds longer-term bonds, but as I explain in Chapter 7, such bond prices are more sensitive to changes in interest rates. 

  Quality: Generally speaking, the lower their issuer's credit rating, the riskier the bond.  As with the risk associated with longer maturities, a fund that holds lower-quality bonds should provide higher returns for the increased risk you take.  A higher yield is the bond market's way of compensating you for taking greater risk.  Funds holding higher-quality bonds provide lower returns but more security. 

  Loads and fees: After you settle on the type of bonds that you want, you must consider a bond fund's costs, including its sales commissions and annual operating fees.  Stick with no-load funds that maintain lower annual operating expenses. 

  Tax implications: Pay attention to the taxability of the dividends that bonds pay.  If you're investing in bonds inside of retirement accounts, you want taxable bonds.  If you invest in bonds outside of retirement accounts, the choice between taxable versus tax-free depends on your tax bracket (see Chapter 3). 

 Since they fluctuate in value, invest in bond funds only if you have sufficient money in an emergency reserve. 

If you invest money for longer-term purposes, particularly retirement, you need to come up with an overall plan for allocating your money among a variety of different funds, including bond funds. ( See the section "Allocating for the long term" earlier in this chapter.) 

Avoiding yield-related missteps

When selecting bond funds to invest in, investors are often led astray as to how much they can expect to make.  The first mistake is to look at recent performance and assume that you'll get that return in the future.  Investing in bond funds based on recent performance is particularly tempting immediately after a period where interest rates have declined (as in the 1990s and the early and late 2000s), because declines in interest rates pump up bond prices and, therefore, bond fund total returns.  Remember that an equal but opposite force waits to counteract pumped-up bond returns — bond prices fall when interest rates rise. 

Don't get me wrong: Past performance is an important issue to consider.  In order for performance numbers to be meaningful and useful, you must compare bond funds that are comparable (such as intermediate-term funds that invest exclusively in high-grade corporate bonds). 

Bond mutual funds calculate their yield after subtracting their operating expenses.  When you contact a mutual fund company seeking a fund's current yield, make sure you understand what time period the yield covers.  Fund companies are supposed to give you the SEC yield, which is a standard yield calculation that allows for fairer comparisons among bond funds.  The SEC yield, which reflects the bond fund's yield to maturity, is the best yield to use when you compare funds because it captures the effective rate of interest that an investor can receive in the future. 

  Unfortunately, if you select bond funds based on advertised yield, you're quite likely to purchase the wrong bond funds.  Bond funds and the mutual fund companies that sell them can play more than a few games to fatten a fund's yield.  Such sleights of hand make a fund's marketing and advertising departments happy because higher yields make it easier for salespeople and funds to hawk their bond funds.  But remember that yield-enhancing shenanigans can leave you poorer.  Here's what you need to watch out for:

  Lower quality: When comparing one short-term bond fund to another, you may discover that one pays 0.5 percent more and decide that it looks better.  However, you may find out later that the higher-yielding fund invests 20 percent of its money in junk (non-investment grade) bonds, whereas the other fund fully invests in high-quality bonds. 

  Longer maturities: Bond funds can usually increase their yield just by increasing their maturity a bit.  So if one long-term bond fund invests in bonds that mature in an average of 17 years, and another fund has an average maturity of 12 years, comparing the two is a classic case of comparing apples and oranges. 

  Giving your money back without you knowing it: Some funds return a portion of your principal in the form of dividends.  This move artificially pumps up a fund's yield but depresses its total return.  When you compare bond funds, make sure you compare their total return over time (in addition to making sure that the funds have comparable portfolios of bonds). 

  Waiving of expenses: Some bond funds, particularly newer ones, waive a portion or even all of their operating expenses to temporarily inflate the fund's yield.  Yes, you can invest in a fund that has a sale on its operating fees, but you'd also buy yourself the bother of monitoring things to determine when the sale is over.  Bond funds that engage in this practice often end sales quietly when the bond market is performing well.  Don't forget that if you sell a bond fund (held outside of a retirement account) that has appreciated in value, you owe taxes on your profits. 

Treading carefully with actively managed bond funds

Some bond funds are aggressively managed.  Managers of these funds possess a fair degree of latitude to purchase and trade bonds that they think will perform best in the future.  For example, if a fund manager thinks interest rates will rise, she usually buys shorter-term bonds and keeps more of a fund's assets in cash.  The fund manager may invest more in lower-credit-quality bonds if she thinks that the economy is improving and that more companies will prosper and improve their credit standing. 

  Aggressively managed funds are a gamble.  If interest rates fall instead of rise, the fund manager who moved into shorter-term bonds and cash experiences worse performance.  If interest rates fall because the economy sinks into recession, the lower-credit-quality bonds will likely suffer from a higher default rate and depress the fund's performance even further. 

Some people think the "experts" have no trouble predicting which way interest rates or the economy is heading.  The truth is that economic predictions are always difficult, and the experts are often wrong.  Few bond fund managers have been able to beat a buy-and-hold approach.  However, William Gross, who manages the PIMCO and Harbor bond funds, is one fund manager who has pretty consistently beaten the market averages. 

But remember that trying to beat the market can lead to getting beaten!  Increasing numbers of examples have occurred in recent years of bond funds falling on their faces after risky investing strategies backfire.  Interestingly, bond funds that charge sales commissions (loads) and higher ongoing operating fees are the ones that are more likely to blow up, perhaps because these fund managers are under more pressure to pump up returns to make up for higher operating fees. 

  It's fine to invest some of your bond fund money in funds that try to hold the best position for changes in the economy and interest rates, but remember that if these fund managers are wrong, you can lose more money.  Over the long term, you'll probably do best with efficiently managed funds that stick with an investment objective and that don't try to time and predict the bond market.  Index funds that invest in a relatively fixed basket of bonds so as to track a market index of bond prices are a good example of this passive approach. 

Stabilizing your portfolio by investing in short-term bond funds

Of all bond funds, short-term bond funds are the least sensitive to interest rate fluctuations.  The stability of short-term bond funds makes them appropriate investments for money that you seek a better rate of return on than a money market fund can produce for you.  But with short-term bond funds, you also have to tolerate the risk of losing a percent or two in principal value if interest rates rise. 

 Short-term bonds work well for money that you earmark for use in a few years, such as the purchase of a home or a car, or for money that you plan to withdraw from your retirement account in the near future. 

Taxable short-term bond funds

 Consider bond funds that pay taxable dividends when you're not in a high tax bracket and for investing inside of retirement accounts.  My favorite is the Vanguard Short-Term Investment-Grade fund. 

Important note: Many of the Vanguard funds recommended in this chapter offer "Admiral" versions that have even lower operating fees for customers investing at least $100,000 (or $50,000, if the account has been in existence for at least ten years; or $10,000 for an index fund that offers Admiral shares). 

U.S. Treasury short-term bond funds

  U.S. Treasury bond funds may be appropriate if you prefer a bond fund that invests in U.S. Treasuries (which possess the safety of government backing; see Chapter 7 for details).  They're also a fine choice if you're not in a high federal tax bracket but you're in a high state tax bracket (5 percent or higher).  Vanguard Short-Term Treasury is a good choice. 

I don't recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. 

Federally tax-free short-term bond funds

  State and federally tax-free short-term bond funds are scarce.  If you want shorter-term bonds, and if you're in a high federal bracket but in a low state bracket (less than 5 percent), consider investing in these federally tax-free bond funds (whose dividends are state taxable):

  Vanguard Short-Term Tax-Exempt

  Vanguard Limited-Term Tax-Exempt

If you live in a state with high taxes, consider checking out the state and federal tax-free intermediate-term bond funds (which I discuss in the next section) — if you can withstand their volatility.  Another option is to use a state money market fund, which is covered later in this chapter in "The Best Money Market Funds." 

Earning higher returns with intermediate-term bond funds

Intermediate-term bond funds hold bonds that typically mature in a decade or so.  They're more volatile than shorter-term bonds but can also prove more rewarding.  The longer you own an intermediate-term bond fund, the more likely you are to earn a higher return on it than on a short-term fund unless interest rates continue to rise over many years. 

  As an absolute minimum, don't purchase an intermediate-term fund unless you expect to hold it for three to five years — or even longer, if you can.  Therefore, you need to make sure that the money you put into an intermediate-term fund is money that you don't expect to use in the near future. 

Taxable intermediate-term bond funds

 Taxable intermediate-term bond funds to consider include the following:

  Dodge & Cox Income

  Harbor Bond

  Vanguard GNMA, High Yield Corporate, and Total Bond Market Index

U.S. Treasury intermediate-term bond funds

Consider U.S. Treasury bond funds if you prefer a bond fund that invests in U.S. Treasuries (which maintain the safety of government backing).  You can also invest in them if you're not in a high federal tax bracket but you're in a high state tax bracket (5 percent or higher).  I don't recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. 

 A couple of my favorites are Vanguard Inflation-Protected Securities and Vanguard Intermediate-Term Treasury. 

Federally tax-free intermediate-term bond funds

You should consider federally tax-free bond funds if you're in a high federal bracket but a relatively low state bracket (less than 5 percent). 

 A few good ones include the following:

  Fidelity Intermediate Municipal Income

  Vanguard Intermediate-Term Tax-Exempt

If you're in high federal and state tax brackets, refer to the state and federal tax-free bonds that I mention later in this chapter. 

Using long-term bond funds to invest aggressively

Long-term bond funds are the most aggressive and volatile bond funds around.  If interest rates on long-term bonds increase substantially, you can easily see the principal value of your investment decline 10 percent or more. ( See the discussion in Chapter 7 of how interest rate changes impact bond prices.) 

 Long-term bond funds are generally used for retirement investing in one of two situations:

  Investors don't expect to tap their investment money for a decade or more. 

  Investors want to maximize current dividend income and are willing to tolerate volatility. 

Remember: Don't use these funds to invest money that you plan to use within the next five years, because a bond market drop can leave your portfolio short of your monetary goal. 

Taxable long-term bond funds

 I have just one favorite taxable bond fund that holds longer-term bonds.  Can you guess which fund company offers it?  If you guessed Vanguard, you're correct — the Vanguard Long-Term Investment-Grade fund. 

U.S. Treasury long-term bond funds

U.S. Treasury bond funds may be advantageous if you want a bond fund that invests in U.S. Treasuries.  They're also great if you're not in a high federal tax bracket but you're in a high state tax bracket (5 percent or higher).  I recommend Treasuries for non-retirement accounts only because Treasuries pay less interest than fully taxable bond funds. 

 I recommend the Vanguard Long-Term Treasury fund. 

Federally tax-free long-term bond funds

 A municipal (federally tax-free) long-term bond fund that I recommend is Vanguard Long-Term Tax-Exempt. 

State and federally tax-free long-term bond funds

  State and federally tax-free bond funds may be appropriate when you're in high federal and high state (5 percent or higher) tax brackets.  Fidelity, T. Rowe Price, and Vanguard offer good funds for a number of states.  If you can't find a good, state-specific fund for where you live, or if you're only in a high federal tax bracket, you can use the nationwide Vanguard Municipal bond funds. 

The Best Hybrid Funds

Hybrid funds invest in a mixture of different types of securities.  Most commonly, they invest in both bonds and stocks.  These funds are usually less risky and less volatile than funds that invest exclusively in stocks; in an economic downturn, bonds usually hold value better than stocks. 

  Hybrid funds make it easier for investors who are skittish about investing in stocks to hold stocks because they reduce the volatility that normally comes with pure stock funds.  Because of their extensive diversification, hybrid funds are excellent choices for an investor who doesn't have much money to start with. 

Hybrid funds come in two forms:

  Balanced funds generally try to maintain a fairly constant percentage of investment in stocks and bonds. 

  Asset allocation funds, by contrast, normally adjust the mix of different investments according to the portfolio manager's expectations.  Some asset allocation funds, however, tend to keep more of a fixed mix of stocks and bonds, whereas some balanced funds shift the mix around quite frequently. ( Although the concept of a manager being in the right place at the right time and beating the market averages sounds good in theory, most funds that shift assets fail to outperform a buy-and-hold approach.) 

  Because hybrid funds pay decent dividends from the bonds that they hold, they're not appropriate for some investors who purchase funds outside tax-sheltered retirement accounts.  With the exception of the Vanguard Tax-Managed Balanced Fund, which holds federally tax-free bonds, avoid hybrid funds if you're in a higher tax bracket. ( Chapter 7 has more details on tax-free bonds.)  You should consider buying separate tax-friendly stock funds and tax-free bond funds (both discussed earlier in this chapter) to create your own hybrid portfolio. 

 Here's my recommended short list of great balanced-type mutual funds:

  Dodge & Cox Balanced

  Fidelity Freedom Funds and Fidelity Puritan

  T. Rowe Price Balanced

  Vanguard LifeStrategy funds, Wellesley Income, and Wellington

The Best Money Market Funds

As I explain in Chapter 7, money market funds are a safe, higher-yielding alternative to bank accounts. ( If you're in a higher tax bracket, money market funds have even more appeal because you can get tax-free versions of money market funds.)  Under Securities and Exchange Commission regulations, money market funds can invest only in the highest-credit-rated securities, and their investments must have an average maturity of less than 90 days.  The short-term nature of these securities effectively eliminates the risk of money market funds being sensitive to changes in interest rates. 

The securities that money market funds use are extremely safe.  General-purpose money market funds invest in government-backed securities, bank certificates of deposit, and short-term corporate debt that the largest and most creditworthy companies and the U.S. government issue. 

When shopping for a money market fund, consider these factors:

  Expenses: Within a given category of money market funds (general, Treasury, municipal, and so on), fund managers invest in the same basic securities.  The market for these securities is pretty darn efficient, so "superstar" money market fund managers may eke out an extra 0.1 percent per year in yield, but not much more. 

  Select a money market fund that does a good job controlling its expenses.  The operating expenses that the fund deducts before payment of dividends are the biggest determinant of yield.  All other things being equal (which they usually are with different money market funds), lower operating expenses translate into higher yields for you. 

You have no need or reason to tolerate annual operating expenses of greater than 0.5 percent.  Some top-quality funds charge a third of 1 percent or less annually.  Remember, lower expenses don't mean that a fund company cuts corners or provides poor service.  Lower expenses are possible in most cases because a fund company is successful in attracting a lot of money to invest. 

  Tax consequences: With money market funds, all your return comes from dividends.  What you actually get to keep of these returns (on non-retirement account investments) is what is left over after the federal and state governments take their cut of your investment income.  If you invest money that's held outside of a retirement account, and you're in a high tax bracket, you may come out ahead if you invest in tax-free money market funds.  If you're in a high-tax state, a state money market fund, if good ones exist for your state, may be a sound move. 

 Tax-free refers to the taxability of the dividends that the fund pays.  You don't get a tax deduction for money that you put into the fund, as you do with 401(k) or other retirement-type accounts. 

  Location of other funds: Consider what other investing you plan to do at the fund company where you establish a money market fund.  Suppose that you decide to make mutual fund investments in stocks and bonds at T. Rowe Price.  In that case, keeping a money market fund at a different firm that offers a slightly higher yield may not be worth the time and administrative hassle, especially if you don't plan on holding much cash in your money market fund. 

  Associated services: Good money market funds offer other useful services, such as free check writing, telephone exchange and redemptions, and automated electronic exchange services with your bank account. 

Most mutual fund companies don't have many local branch offices.  Generally, this fact helps fund companies keep their expenses low so they can pay you greater money market fund yields.  You may open and maintain your mutual fund account via the fund's toll-free phone lines, the mail, or the company's website.  You don't really get much benefit, except psychological, if you select a fund company with an office in your area.  However, having said that, I don't want to diminish the importance of your emotional comfort level. 

Using the criteria that I just discussed, in this section, I recommend the best money market funds — those that offer competitive yields, check writing, access to other excellent mutual funds, and other commonly needed money market services. 

Taxable money market funds

Money market funds that pay taxable dividends may be appropriate for retirement account funds that await investment as well as non-retirement account money when you're not in a high federal tax bracket and aren't in a high state tax bracket (less than 5 percent). 

 Here are the best taxable money market funds to consider:

  Fidelity Cash Reserves

  T. Rowe Price Summit Cash Reserves (higher yields if you invest $25,000)

  Vanguard's Prime Money Market

U.S. Treasury money market funds

Consider U.S. Treasury money market funds if you prefer a money market fund that invests in U.S. Treasuries, which maintain the safety of government backing, or if you're not in a high federal tax bracket but are in a high state tax bracket (5 percent or higher). 

 The following lists U.S. Treasury funds that I recommend:

  Fidelity's Government Money Market ($25,000 minimum)

  USAA's Treasury Money Market

  Vanguard Admiral Treasury Money Market

Municipal money market funds

Municipal (also known as muni) money market funds invest in short-term debt that state and local governments issue.  A municipal money market fund, which pays you federally tax-free dividends, invests in munis issued by state and local governments throughout the country.  A state-specific municipal fund invests in state and local government-issued munis for one state, such as New York.  So if you live in New York and buy a New York municipal fund, the dividends on that fund are federal and New York state tax-free. 

How to contact fund providers

The following list provides the phone numbers and websites you can use to contact mutual fund companies and discount brokers that sell the mutual funds I discuss in this chapter.  To find out more about selecting and investing in mutual funds, pick up a copy of the latest edition of my book Mutual Funds For Dummies, published by John Wiley & Sons, Inc.

Cohen & Steers Realty Shares, Inc.: 800-437-9912; www.cohenandsteers.com

Dodge & Cox Funds: 800-621-3979; www.dodgeandcox.com

Fairholme Funds: 866-202-2263; www.fairholmefunds.com

Fidelity Funds: 800-544-8888; www.fidelity.com

Harbor Funds: 800-422-1050; www.harborfunds.com

Masters' Select Funds: 800-960-0188; www.mastersselect.com

Oakmark: 800-625-6275; www.oakmark.com

Sequoia: 800-686-6884; www.sequoiafund.com

T. Rowe Price Funds: 800-638-5660; www.troweprice.com

Tweedy Browne Funds: 800-432-4789; www.tweedybrowne.com

USAA Funds: 800-382-8722; www.usaa.com

The Vanguard Group: 800-662-7447; www.vanguard.com

  So how do you decide whether to buy a nationwide or state-specific municipal money market fund?  Federally tax-free-only money market funds may be appropriate when you're in a high federal tax bracket but not in a high state bracket (less than 5 percent).  State tax-free municipal money market funds are worth considering when you're in a high federal and a high state tax bracket (5 percent or higher). 

  If you're in a higher state tax bracket, your state may not have good (or any) state tax-free municipal money market funds available.  If you live in any of those states, you're likely best off with one of the following national municipal money market funds:

  T. Rowe Price Summit Municipal Money Market ($25,000 minimum)

  USAA Tax-Exempt Money Market

  Vanguard Tax-Exempt Money Market

Fidelity, USAA, and Vanguard have good funds for a number of states.  If you can't find a good, state-specific fund for your state, or you're only in a high federal tax bracket, use one of the nationwide muni money markets that I describe in the previous list. 
Chapter 9

Choosing a Brokerage Firm

In This Chapter

  Understanding the different types of brokerage firms

  Shopping for a discount broker

  Surfing for an online broker

When you invest in certain securities — such as stocks and bonds and exchange-traded funds — and when you wish to hold mutual funds from different companies in a single account, you need brokerage services.  Brokers execute your trades to buy or sell stocks, bonds, and other securities and enable you to centralize your holdings of mutual funds and other investments.  Your broker can also assist you with other services that may interest you. 

In this chapter, I explain the ins and outs of discount brokers and online brokers to help you find the right one for your investment needs. 

Getting Your Money's Worth: Discount Brokers

Prior to 1975, all securities brokerage firms charged the same fee, known as a commission, to trade stocks and bonds.  The Securities and Exchange Commission (SEC), the federal government agency responsible for overseeing investment firms and their services, regulated these commissions. 

Beginning May 1, 1975 — which is known in the brokerage business as "May Day" — brokerage firms were free to compete with one another on price, like companies in almost all other industries.  Most of the firms in existence at that time, such as Prudential, Merrill Lynch, E. F. Hutton, and Smith Barney, largely continued with business as usual, charging relatively high commissions. 

However, a new type of brokerage firm, the discount broker, was born.  The earlier generations of discount brokerage firms charged substantially lower commissions — typically 50 to 75 percent lower — than the other firms.  Today, discount brokers, which include many online brokers, abound and continue to capture the lion's share of new business.  Many do stock trades, regardless of size, for less than $10 per transaction. 

  When you hear the word discount, you probably think of adjectives like cheap, inferior quality, and such.  However, in the securities brokerage field, the discount brokers who place your trades at substantial discounts can offer you even better value and service than high-cost brokers.  The following list offers some of the reasons discount brokers give you more bang for your buck:

  They can place your trades at a substantially lower price because they have much lower overhead. 

  They tend not to rent the posh downtown office space, complete with mahogany-paneled conference rooms, in order to impress customers. 

  They don't waste tons of money employing economists and research analysts to produce forecasts and predictive reports. 

In addition to lower commissions, another major benefit of using discount brokers is that they generally work on salary.  Working on salary removes a significant conflict of interest that continues to get commission-paid brokers and their firms into trouble.  People who sell on commission to make a living aren't inherently evil, but, given the financial incentives they have, don't expect to receive holistic, in-your-best-interest investing counsel from them. 

Ignoring the high-commission salespeople's arguments

  One of the many sales tactics of high-commission brokerage firms is to try to disparage discounters by telling you that "You'll receive poor service from discounters."  My own experience, as well as that of others, suggests that in many cases, discounters actually offer better service. 

Many of the larger discounters with convenient branch offices offer assistance with filling out paperwork and access to independent research reports.  From discounters, you also can buy no-load (commission-free) mutual funds that are run by management teams that make investment decisions for you.  Such funds can be bought from mutual fund companies as well. ( See Chapter 8 for more on these mutual funds.) 

High-commission firms used to argue that discount brokerage customers received worse trade prices when they bought and sold.  This assertion is a bogus argument because all brokerage firms use a computer-based trading system for smaller retail trades.  Trades are processed in seconds.  High-commission brokers also say that discounters are only "for people who know exactly what they're doing and don't need any help."  This statement is also false, especially given the abundance of financial information and advice available today. 

Selecting a discount broker

Deciding which discount broker is best for you depends on what your needs and wants are.  In addition to fees, consider how important having a local branch office is to you.  If you seek to invest in mutual funds, the discount brokerage firms that I list later in this section offer access to good funds.  In addition, these firms offer money market funds into which you can deposit money awaiting investment or proceeds from a sale. 

Within the discount brokerage business, deep discounters are firms that offer the lowest rates but fewer frills and other services.  Generally, deep discounters don't have local branch offices like big discounters do, and they also don't offer money market funds with the highest yields. 

 Be careful of some deep discounters that offer bargain commissions but stick it to you in other ways, such as by charging high fees for particular services or offering below-market interest rates on money awaiting investment. 

 Here are my top picks for discount brokers:

  T. Rowe Price (800-225-5132; www.troweprice.com): T. Rowe Price offers a solid family of no-load mutual funds.  The company's brokerage fees are competitive and among those on the lower end for discounters.  Its 15 branch offices are scattered throughout the Northeast, Florida, California, Colorado, and Illinois. 

  Vanguard (800-992-8327; www.vanguard.com): Vanguard is best known for its excellent family of no-load mutual funds, but its discount brokerage services have improved over the years.  Vanguard has also reduced its brokerage fees in recent years, and its prices are now near the low end of discount brokers. 

  TD Ameritrade (800-934-4448; www.tdameritrade.com): This firm was created by the merger of TD Waterhouse with Ameritrade. ( Waterhouse Securities merged in the late 1990s with Jack White and company to form TD Waterhouse.)  TD Ameritrade offers competitive commission rates and more than 100 branch offices.  The company offers 'round-the-clock customer assistance. 

  All the preceding firms offer mutual funds from many fund companies in addition to their family of funds (if they have a family of funds).  In other words, you may purchase mutual funds that aren't in the T. Rowe Price family of funds through the T. Rowe Price brokerage department.  Other discounters certainly have good service and competitive rates, so shop around if you desire.  Note, however, that you generally pay a transaction fee to buy funds from firms that don't offer their own family of funds. 

Absent from my list are the large discounters, Fidelity and Schwab.  The simple reason they're missing is that they charge significantly higher transaction fees than the competition does.  These firms can get away with premium pricing, despite comparable services, because enough investors prefer to do business with name-brand companies.  Although I think that both companies can offer investors a fine base from which to do their investing, I don't feel that their fees are justified unless you want to do business with a broker that maintains a branch office in your area.  If you're going to invest in individual stocks (as discussed in Chapter 6), Schwab and Fidelity deserve more consideration because they offer a comprehensive array of useful and independent research resources. 

Considering Online Brokers

To get the lowest trading commissions, you generally must place your trades online.  Even if you've never visited an online brokerage site, ads for them online, in print publications, and even on national television have surely bombarded you.  Visit any website that's remotely related to investing in stocks, and you're sure to find ads for various Internet brokers.  Anyone familiar with the economics of running a brokerage firm can tell you that technology, when properly applied, reduces a broker's labor costs.  Some brokerages — thanks to technology — can now perform market orders (which means they'll execute your trade at the best current available price) for a few bucks.  Hence the attraction of online trading. 

Before you jump at the chance to save a few dollars by trading online, read the following sections for other considerations that should factor in to your choice of an online broker — or your decision to trade online at all. 

Examining your online trading motives

If trading online attracts you, first examine why.  If you're motivated by the ease of checking account balances, beware.  Tracking prices daily (or, worse, minute by minute) and frequently checking your account balances leads to addictive trading.  A low fee of $5 or $10 per trade doesn't really save you any money if you trade a lot and rack up significant total commissions, and you pay more in capital gains taxes when you sell at a profit.  Don't forget that as with trading through a regular brokerage firm, you also lose the spread (difference between the bid and ask prices when you trade stocks and bonds) and incur the explicit commission rates that online brokers charge. 

Frankly, trading online is also an unfortunately easy way for people to act impulsively and emotionally when making important investment decisions.  If you're prone to such actions, or you find yourself tracking and trading investments too closely, stay away from this form of trading and use the Internet only to check account information and gather factual information. 

Most of the best investment firms also allow you to trade via touch-tone phone.  In most cases, touch-tone phone trading is discounted when you compare it to trading through a live broker, although it's admittedly less glamorous than trading through a website. 

 Some brokers also offer account information and trading capabilities via personal digital assistants, which, of course, add to your costs.  Digital assistants can also promote addictive investment behaviors. 

Investment websites also push the surging interest in online trading with the pitch that you can beat the market averages and professionals at their own game if you do your own research and trade online.  Beating the market and professionals is highly unlikely.  You can save some money trading online, but perhaps not as much as the hype has you believe.  Online trading is good for the convenience and low costs if you're not obsessive about it. 

Taking other costs into account

  Online brokerage customers often shop for low costs.  However, by simply talking with enough people who have traded online and by reviewing online message boards where customers speak their minds, I have discovered that shopping merely for low-cost trading prices often causes investors to overlook other important issues.  Some online discounters

  Don't provide toll-free phone numbers.  Bear this in mind if you need to call with questions and service problems. 

  Nickel and dime you with fees.  For instance, some charge fees for real-time stock quotes (as opposed to quotes that may be 15 to 20 minutes old and are free).  Other brokers whack you $20 here and $50 there for services such as wiring money or simply closing your account.  Also beware of "inactivity fees" that some brokers levy on accounts that have infrequent trading.  So before you sign up with any broker, make sure that you examine its entire fee schedule. 

Why you should keep your securities in a brokerage account

When most investors purchase stocks or bonds today, they don't receive the actual paper certificate demonstrating ownership.  Brokerage accounts often hold the certificate for your stocks and bonds on your behalf.  Holding your securities through a brokerage account is beneficial because most brokers charge an extra fee to issue certificates. 

Sometimes people hold stock and bond certificates themselves, though this practice was more common among previous generations.  The reason: During the Great Depression, many brokerage firms failed and took people's assets down with their sinking ships.  Since then, various reforms have greatly strengthened the safety of money and the securities that you hold in a brokerage account. 

Just as the FDIC insurance system backs up money in bank accounts, the Securities Investor Protection Corporation (SIPC) provides insurance to investment brokerage firm customers.  The base level of insurance is $500,000 per account.  However, many firms purchase additional protection — some as high as $100 million total! 

Brokerage firms don't often fail these days, but unlike during the Depression, the SIPC protects you if they do.  However, the SIPC coverage doesn't protect you against a falling stock market.  If you invest your money in stocks or bonds that drop in value, that's your own problem! 

Besides not having to worry about losing your securities if a brokerage firm fails, another good reason to hold securities with a broker is so you don't lose them — literally!  Surprising numbers of people — the exact number is unknown — have lost their stock and bond certificates.  Those who realize their loss can contact the issuing firms to replace them, but doing so takes a good deal of time.  However, just like future goals and plans, some certificates are simply lost, and owners never realize their loss.  This financial fiasco sometimes happens when people die and their heirs don't know where to look for the certificates or the securities that their loved ones held. 

Another reason to hold your securities in a brokerage account is that doing so cuts down on processing all those dividend checks.  For example, if you own a dozen stocks and each pays you a quarterly dividend, you must receive, endorse, and otherwise deal with 48 separate checks.  Some people enjoy this practice — they say that doing so is part of the "fun" of owning securities.  My advice: Stick all your securities in one brokerage account that holds your paid dividends.  Brokerage accounts offer you the ability to move these payments into a reasonably good-yielding money market fund.  Most of the better discount brokers even allow you to reinvest stock dividends in the purchase of more shares of that stock at no charge. 

  Pay subpar money market rates.  When you buy or sell an investment, you may have cash sitting around in your brokerage account.  Not surprisingly, the online brokers pitching their cheap online trading rates in 3-inch-high numbers don't reveal their money market rates in such large type (if at all).  Some don't pay interest on the first $1,000 or so of your cash balance, and even then, some companies pay half a percent to a full percent less than their best competitors.  In the worst cases, some online brokers have paid up to 3 percent less (during periods of normal interest rates).  Under those terms, you'd earn up to $150 less in interest per year if you averaged a $5,000 cash balance during the year. 

Looking at service quality

Common complaints among customers of online brokers include slow responses to e-mail queries, long dead time as you wait to speak with a live person to answer questions or resolve problems, delays in opening accounts and receiving literature, unclear statements, incorrect processing of trading requests, and slow web response during periods of heavy traffic.  With a number of firms that I called, I experienced phone waits of up to ten minutes and was transferred several times to retrieve answers to simple questions, such as whether the firm carried a specific family of mutual funds. 

 When you shop for an online broker, check your prospects thoroughly.  Here are some things to do:

  Call for literature and to see how long reaching a live human being takes.  Ask some questions and see how knowledgeable and helpful the representatives are.  For non-retirement accounts, if the quality of the firm's year-end account statements concern you, ask prospective brokerages to send you a sample.  If you're a mutual fund investor, check out the quality of the funds that the company offers.  In other words, don't allow the sheer number of funds that the company offers impress you.  Also, inquire about the interest rates that the company pays on cash balances as well as the rates that the company charges on margin loans, if you want such borrowing services.  Try sending some questions to the broker's website and see how accurate and timely the response is. 

  Consider checking online message boards to see what current and past customers say about the firms that you're considering.  Most online brokers that have been around for more than six months lay claim to a number-one rating with some survey or ranking of online brokers.  Place little value on such claims. 

  Examine what the firm did before it got into the online brokerage business.  Would you rather put your money and trust in the hands of an established and respected financial service company that has been around for a number of years or an upstart firm run by a couple of people hoping to strike it rich on the Internet?  Transact business only with firms that offer sufficient account insurance (enough to protect your assets) through the Securities Investor Protection Corporation (SIPC).  The severe stock market downturns in the early and late 2000s led to major shakeouts, and you need to protect yourself. 

Listing the best online brokers

  Among the e-brokers I've reviewed, my top picks are the following:

Broker | Phone Number | Website

---|---|---

E*Trade | 800-387-2331 | etrade.com

Muriel Siebert | 800-872-0711 | siebertnet.com

Scottrade | 800-619-7283 | scottrade.com

T. Rowe Price | 800-638-5660 | troweprice.com

Vanguard | 800-992-8327 | vanguard.com

TD Ameritrade | 800-934-4448 | tdameritrade.com
Part III

Growing Wealth with Real Estate

In this part . . . 

Owning a home and investing in real estate are time-proven methods for building wealth.  However, if you're not careful, you can easily fall prey to a number of pitfalls.  In this part, you discover the right and wrong ways to purchase real estate and build your real estate empire.  Even if you don't want to be a real estate tycoon, you can see how simply owning a home can help build your net worth and accomplish future financial goals. 
Chapter 10

Investing in a Home

In This Chapter

  Using homeownership to meet financial goals

  Deciding whether to rent or buy

  Determining how much you can afford

  Finding the best properties to purchase

For most people, buying a home in which to live is their first, best, and only real estate investment.  Homes may require a lot of financial feeding, but over the course of your life, owning a home (instead of renting) can make and save you money.  Although the pile of mortgage debt seems daunting in the years just after your purchase, someday your home may be among your biggest assets. 

And, yes, real estate is still a good investment despite its declines in the late 2000s in many areas.  Like stocks, real estate does well over the long term but doesn't go continuously higher (see my website at www.erictyson.com for up-to-date, long-term graphs of housing prices in different parts of the U.S.).  Smart investors take advantage of down periods; they consider these periods to be times to buy at lower prices just like they do when their favorite retail stores are having a sale. 

Considering How Home Ownership Can Help You Achieve Your Financial Goals

Even though your home consumes a lot of dough (mortgage payments, property taxes, insurance, maintenance, and so on), while you own it, it can help you accomplish important financial goals:

  Retiring: By the time you hit your 50s and 60s, the size of your monthly mortgage payment, relative to your income and assets, should start to look small or nonexistent.  Relatively low housing costs can help you afford to retire or cut back from full-time work.  Some people choose to sell their homes and buy less-costly ones or to rent the homes out and use some or all of the cash to live on in retirement.  Other homeowners enhance their retirement income by taking out a reverse mortgage to tap the equity (market value of the home minus the outstanding mortgage debt) that they've built up in their properties. 

  Pursuing your small-business dreams: Running your own business can be a source of great satisfaction.  Financial barriers, however, prevent many people from pulling the plug on a regular job and taking the entrepreneurial plunge.  You may be able to borrow against the equity that you've built up in your home to get the cash you need to start your own business.  Depending on what type of business you have in mind, you may even be able to run your enterprise from your home. ( I discuss small-business issues in more detail in Part IV.) 

  Financing college: It may seem like only yesterday that your kids were born, but soon enough they'll be ready for an expensive four-year undertaking: college.  Borrowing against the equity in your home is a viable way to help pay for your kids' educational costs. 

Perhaps you won't use your home's equity for retirement, a small business, educational expenses, or other important financial goals.  But even if you decide to pass your home on to your children, a charity, or a long-lost relative, it's still a valuable asset and a worthwhile investment.  This chapter explains how to make the most of it. 

The Buying Decision

I believe that most people should buy and own a home.  But homeownership isn't for everybody and certainly not at all times in your adult life. 

The decision about if and when to buy a home can be complex.  Money matters, but so do personal and emotional issues.  Buying a home is a big deal — you're settling down.  Can you really see yourself coming home to this same place day after day, year after year?  Of course, you can always move, but doing so can be costly and cumbersome, and now you've got a financial obligation to deal with. 

Weighing the pros and cons of ownership

To some people — particularly enthusiastic salespeople in the real estate business — everybody should own a home.  You may hear them say things like the following:

  Buy a home for the tax breaks. 

  Renting is like throwing your money away. 

  As I discuss later in this chapter, the bulk of homeownership costs — namely, mortgage interest and property taxes — are tax-deductible.  However, these tax breaks are already largely factored into the higher cost of owning a home.  So don't buy a home just because of the tax breaks. ( If such tax breaks didn't exist, housing prices would be lower because the effective cost of owning would be so much higher.  I wouldn't be put off by tax reform discussions that may mention eliminating home buying tax breaks — the odds of these reforms passing are slim to none.) 

Renting isn't necessarily equal to "throwing your money away."  In fact, renting can have a number of benefits, such as the following:

  In some communities, with a given type of property, renting is less costly than buying.  Happy and successful renters I've seen include people who pay low rent, perhaps because they've made housing sacrifices.  If you can sock away 10 percent or more of your earnings while renting, you're probably well on your way to accomplishing your future financial goals. 

  You can save money and hopefully invest in other financial assets.  Stocks, bonds, and mutual funds (see Part II) are quite accessible and useful in retirement.  Some long-term homeowners, by contrast, have a substantial portion of their wealth tied up in their homes. ( Remember: Accessibility is a double-edged sword because it may tempt you as a cash-rich renter to blow the money in the short term.) 

  Renting has potential emotional and psychological rewards.  The main reward is the not-so-inconsequential fact that you have more flexibility to pack up and move on.  You may have a lease to fulfill, but you may be able to renegotiate it if you need to move on.  As a homeowner, you have a major monthly payment to take care of.  To some people, this responsibility feels like a financial ball and chain.  After all, you have no guarantee that you can sell your home in a timely fashion or at the price you desire if you want to move. 

  Although renting has its benefits, renting has at least one big drawback: exposure to inflation.  As the cost of living increases, your landlord can keep increasing your rent (unless you live in a rent-controlled unit).  If you're a homeowner, however, the big monthly expense of the mortgage payment doesn't increase, assuming that you buy your home with a fixed-rate mortgage. ( Your property taxes, homeowners insurance, and maintenance expenses are exposed to inflation, but these expenses are usually much smaller in comparison to your monthly mortgage payment or rent.) 

Here's a quick example to show you how inflation can work against you as a long-term renter.  Suppose that you're comparing the costs of owning a home that costs $160,000 to renting a similar property for $800 a month. ( If you're in a high-cost urban area and these numbers seem low, please bear with me and focus on the general insights, which you can apply to higher-cost areas.)  Buying at $160,000 sounds a lot more expensive than renting, doesn't it?  But this isn't a fair apples-to-apples comparison.  You must compare the monthly cost of owning to the monthly cost of renting.  You must also factor in the tax benefits of homeownership (mortgage interest and property taxes are tax-deductible) to your comparison so that you compare the after-tax monthly cost of owning versus renting.  Figure 10-1 does just that over 30 years. 

**Figure 10-1:** Because of inflation, renting is generally more costly in the long run. 

As you can see in Figure 10-1, although it costs more in the early years to own, owning should be less expensive in the long run.  Renting is costlier in the long term because all your rental expenses increase with inflation.  Note: I haven't factored in the potential change in the value of your home over time.  Over long periods of time, home prices tend to appreciate, which makes owning even more attractive. 

  The example in Figure 10-1 assumes that you make a 20 percent down payment and take out a 7 percent fixed-rate mortgage to purchase the property.  It also assumes that the rate of inflation of your homeowners insurance, property taxes, maintenance, and rent is 4 percent per year.  If inflation is lower, renting doesn't necessarily become cheaper in the long term.  In the absence of inflation, your rent should escalate less, but your homeownership expenses, which are subject to inflation (property taxes, maintenance, and insurance), should increase less, too.  And with low inflation, you can probably refinance your mortgage at a lower interest rate, which reduces your monthly mortgage payments.  With low or no inflation, owning can still cost less, but the savings versus renting usually aren't as dramatic as when inflation is greater. 

Recouping transaction costs

Financially speaking, I recommend that you wait to buy a home until you can see yourself staying put for a minimum of three years.  Ideally, I'd like you to think that you have a good shot of staying with the home for five or more years.  Why?  Buying and selling a home cost big bucks, and you generally need at least five years or low appreciation to recoup your transaction costs.  Some of the expenses you face when buying and selling a home include the following:

  Inspection fees: You shouldn't buy a property without thoroughly checking it out, so you'll incur inspection expenses.  Good inspectors can help you identify problems with the plumbing, heating, and electrical systems.  They also check out the foundation, roof, and so on.  They can even tell you whether termites are living in the house.  Property inspections typically cost at least a few hundred dollars up to $1,000 for larger homes. 

  Loan costs: The costs of getting a mortgage include such items as the points (upfront interest that can run 1 to 2 percent of the loan amount), application and credit report fees, and appraisal fees. 

  Title insurance: When you buy a home, you and your lender need to protect yourselves against the chance — albeit small — that the property seller doesn't actually legally own the home that you're buying.  That's where title insurance comes in — it protects you financially from unscrupulous sellers.  Title insurance costs vary by area; 0.5 percent of the purchase price of the property is about average. 

  Moving costs: You can transport all your furniture, clothing, and other personal belongings yourself, but your time is worth something, and your moving skills may be limited.  Besides, do you want to end up in a hospital emergency room after being pinned at the bottom of a staircase by a runaway couch?  Moving costs vary wildly, but you can count on spending hundreds to thousands of dollars. 

Knowing when to buy

If you're considering buying a home, you may be concerned whether home prices are poised to rise or fall.  No one wants to purchase a home that then plummets in value.  And who wouldn't like to buy just before prices go on an upward trajectory? 

It's not easy to predict what's going to happen with real estate prices in a particular city, state, or country over the next one, two, three, or more years.  Ultimately, the economic health and vitality of an area drive the demand and prices for homes in that area.  An increase in jobs, particularly ones that pay well, increases the demand for housing.  And when demand goes up, so do prices. 

If you first buy a home when you're in your 20s, 30s, or even your 40s, you may end up as a homeowner for several decades.  Over such a long time, you may experience numerous ups and downs.  But you'll probably see more ups than downs, so don't be too concerned about trying to predict what's going to happen to the real estate market in the near term.  I know some long-term renters who avoided buying homes decades ago because they thought that prices were expensive.  Consequently, they missed out on tremendous appreciation in real estate values. ( The one silver lining to the late 2000s decline in home prices is that homes are more affordable than they have been in a long, long time.) 

That said, you may be, at particular times in your life, ambivalent about buying a home.  Perhaps you're not sure whether you'll stay put for more than three to five years.  Therefore, part of your home-buying decision may hinge on whether current home prices in your local area offer you a good value.  The state of the job market, the number of home listings for sale, and the level of real estate prices as compared to rent are useful indicators of the housing market's health.  Trying to time your purchase has more importance if you think you may move in less than five years.  In that case, avoid buying in a market where home prices are relatively high compared to their rental costs.  If you expect to move so soon, renting generally makes more sense because of the high transaction costs of buying and selling real estate. 

  Real estate agents' commissions: A commission of 5 to 7 percent of the purchase price of most homes is paid to the real estate salespeople and the companies they work for. 

  On top of all these transaction costs of buying and then selling a home, you'll also face maintenance expenses — for example, fixing leaky pipes and painting.  To cover all the transaction and maintenance costs of homeownership, the value of your home needs to appreciate about 15 percent over the years that you own it for you to be as well off financially as if you had continued renting.  Fifteen percent!  If you need or want to move elsewhere in a few years, counting on that kind of appreciation in those few years is risky.  If you happen to buy just before a sharp rise in housing prices, you may get this much appreciation in a short time.  But you can't count on this upswing — you're more likely to lose money on such a short-term deal. 

Some people invest in real estate even when they don't expect to live in the home for long, and they may consider turning their home into a rental if they move within a few years.  Doing so can work well financially in the long haul, but don't underestimate the responsibilities that come with rental property, which I discuss in Chapter 11. 

Deciding How Much to Spend

Buying a home is a long-term financial commitment.  You'll probably take out a 15- to 30-year mortgage to finance your purchase, and the home that you buy will need maintenance over the years.  So before you decide to buy, take stock of your overall financial health. 

  If you have good credit and a reliable source of employment, lenders will eagerly offer to loan you money.  They'll tell you how much you may borrow from them — the maximum that you're qualified to borrow.  Just because they offer you that maximum amount, however, doesn't mean that you should borrow the maximum. 

Buying a home without considering your other monthly expenditures and long-term goals may cause you to end up with a home that dictates much of your future spending.  Have you considered, for example, how much you need to save monthly to reach your retirement goals?  How about the amount you want to spend on recreation and entertainment? 

If you want to continue your current lifestyle, you have to be honest with yourself about how much you can really afford to spend as a homeowner.  First-time homebuyers in particular run into financial trouble when they don't understand their current spending.  Buying a home can be a wise decision, but it can also be a huge burden.  And you can buy all sorts of nifty things for a home.  Some people prop up their spending habits with credit cards — a dangerous practice. 

  Don't let your home control your financial future.  Before you buy a property or agree to a particular mortgage, be sure that you can afford to do so — be especially careful not to ignore your retirement planning (if you hope to someday retire).  Start by reading Chapter 3.  After reading the following sections, you can also check out Chapter 12, where I cover mortgages and financing options in greater detail. 

Looking through lenders' eyes

Mortgage lenders calculate the maximum amount that you can borrow to buy a piece of real estate.  All lenders want to gauge your ability to repay the money that you borrow, so you have to pass a few tests. 

Homeownership tax savings

Your mortgage interest and property taxes are tax-deductible on Form 1040, Schedule A of your personal tax return.  When you calculate the costs of owning a home, subtract the tax savings to get a more complete and accurate sense of what homeownership will cost you. 

When you finally buy a home, be sure to refigure how much you need to pay in income tax, because your mortgage interest and property tax deductions can help lower your tax bill.  If you work for an employer, ask your payroll/benefits department for Form W-4.  If you're self-employed, you can complete a worksheet that comes with Form 1040-ES. ( Call 800-TAX-FORM [800-829-3676] for a copy.)  Many new homebuyers don't bother with this step, and they receive a big tax refund on their next filed income tax return.  Although getting money back from the IRS may feel good, it means that at a minimum, you gave the IRS an interest-free loan.  In the worst-case scenario, the reduced cash flow during the year may cause you to accumulate debt or miss out on contributing to tax-deductible retirement accounts. 

If you want a more precise estimate as to how homeownership may affect your tax situation, get out your tax return and plug in some reasonable numbers to guesstimate how your taxes may change.  You can also speak with a tax advisor. 

Last but not least, eligible homeowners can exclude from taxable income a significant portion of their gain on the sale of a principal residence: up to $250,000 for single taxpayers and up to $500,000 for married couples filing jointly. 

For a home in which you will reside, lenders total your monthly housing expenses.  They define your housing costs as:

Mortgage payment + property taxes + insurance

  A lender doesn't consider maintenance and upkeep expenses (including utilities) in owning a home.  Although lenders may not care where you spend money outside your home, they do care about your other debt.  A lot of other debt, such as credit cards or auto loans, diminishes the funds that are available to pay your housing expenses.  Lenders know that having other debt increases the possibility that you may fall behind or actually default on your mortgage payments. 

If you have consumer debt (for example, credit cards, auto loans, and so on) that requires monthly payments, lenders calculate another ratio to determine the maximum that you can borrow.  Lenders add the amount that you need to pay down your other consumer debt to your monthly housing expense. 

  Consumer debt is bad news even without considering that it hurts your qualification for a mortgage.  This type of debt is costly and encourages you to live beyond your means.  Unlike the interest on mortgage debt, consumer debt interest isn't tax-deductible.  Get rid of it — curtail your spending and adjust to living within your means.  If you can't live within your means as a renter, doing so is going to be even harder as a homeowner. 

Determining your down payment

When deciding how much to borrow for a home, keep in mind that most lenders require you to purchase private mortgage insurance (PMI) if your down payment is less than 20 percent of your home's purchase price.  PMI protects the lender from getting stuck with a property that may be worth less than the mortgage you owe, in the event that you default on your loan.  On a moderate-size loan, PMI can add hundreds of dollars per year to your payments. 

If you have to take PMI to buy a home with less than 20 percent down, keep an eye on your home's value and your loan balance.  Over time, your property should appreciate, and your loan balance should decrease as you make monthly payments.  After your mortgage represents 80 percent or less of the market value of the home, you can get rid of the PMI.  Doing so usually entails contacting your lender and paying for an appraisal. 

  As I have said in the earlier editions of this book, I have never been a fan of interest-only loans, which entice cash-strapped buyers with lower monthly payments, because all the initial payments go toward interest.  These loans typically have worse terms (interest rate and fees) than conventional mortgages and cause some buyers to take on more debt than they can handle.  After a number of years, the payment amount jumps higher when the principal and interest begin to be repaid together. 

What if you have so much money that you can afford to make more than a 20 percent down payment?  How much should you put down then? ( This problem doesn't usually arise — most buyers, especially first-time buyers, struggle to get a 20 percent down payment together.)  The answer depends on what else you can or want to do with the money.  If you're considering other investment opportunities, determine whether you can expect to earn a higher rate of return on those other investments versus the interest rate that you'd pay on the mortgage.  Forget about the tax deduction for your mortgage interest.  The interest is deductible, but remember that the earnings from your investments are ultimately taxable. 

During the past century, stock market and real estate investors have enjoyed average annual returns of around 9 to 10 percent per year.  So if you borrow mortgage money at around 6 to 7 percent, in the long term you should come out a few percent ahead if you use the money you would have put toward a larger down payment to invest in such growth investments.  You aren't guaranteed, of course, that your investments will earn 9 to 10 percent yearly. ( Remember that past returns don't guarantee the future.)  And don't forget that all investments come with risk.  The advantage of putting more money down and borrowing less is that it's essentially a risk-free investment (as long as you have adequate insurance on your property). 

  If you prefer to put down just 20 percent and invest more money elsewhere, that's fine.  Just don't keep the extra money (beyond an emergency reserve) under the mattress, in a savings account, or in bonds that pay less interest than your mortgage costs you in interest.  Invest in stocks, real estate, or a small business.  Otherwise, you don't have a chance at earning a higher return than the cost of your mortgage, and you'd therefore be better off paying down your mortgage. 

Selecting Your Property Type

If you're ready to buy a home, you must make some decisions about what and where to buy.  If you grew up in the suburbs, your image of a home may include the traditional single-family home with a lawn, kids, and family pets.  But single-family homes, of course, aren't the only or even the main type of residential housing in many areas, especially in some higher-cost, urban neighborhoods.  Other common types of higher-density housing include the following:

  Condominiums: Condominiums are generally apartment-style units that are stacked on top of and adjacent to one another.  Many condo buildings were originally apartments that were converted — through the sale of ownership of separate units — into condos.  When you purchase a condominium, you purchase a specific unit as well as a share of the common areas (for example, the pool, landscaping, entry and hallways, laundry room, and so on). 

  Townhomes: Townhome is just a fancy way of saying attached or row home.  Think of a townhome as a cross between a condominium and a single-family house.  Townhomes are condolike because they're attached (generally sharing walls and a roof) and are homelike because they're often two-story buildings that come with a small yard. 

  Cooperatives: Cooperatives (usually called co-ops) resemble apartment and condominium buildings.  When you buy a share in a cooperative, you own a share of the entire building, including some living space.  Unlike in a condo, you generally need to get approval from the cooperative association if you want to remodel or rent your unit to a tenant.  In some co-ops, you must even gain approval from the association for the sale of your unit to a proposed buyer.  Co-ops are generally much harder to obtain loans for and to sell, so I don't recommend that you buy one unless you get a good deal and can easily obtain a loan. 

 All types of shared housing (the types of housing in the preceding list) offer two potential advantages:

  This type of housing generally gives you more living space for your dollars.  This value makes sense because with a single-family home, a good chunk of the property's cost is for the land that the home sits on.  Land is good for decks, recreation, and playing children, but you don't live "in" it the way you do with your home.  Shared housing maximizes living space for the housing dollars that you spend. 

  In many situations, you're not personally responsible for general maintenance.  Instead, the homeowners association (which you pay into) takes care of it.  If you don't have the time, energy, or desire to keep up a property, shared housing can make sense.  Shared housing units may also give you access to recreation facilities, such as a pool, tennis courts, and exercise equipment. 

So why doesn't everyone purchase shared housing?  Well, as investments, single-family homes generally outperform other housing types.  Shared housing is easier to build (and to overbuild) — and the greater supply tends to keep its prices from rising as much.  Single-family homes tend to attract more potential buyers — most people, when they can afford it, prefer a stand-alone home, especially for the increased privacy. 

  If you can afford a smaller single-family home instead of a larger shared-housing unit and don't shudder at the thought of maintaining a home, buy the single-family home.  Shared housing makes more sense for people who don't want to deal with building maintenance and who value the security of living in a larger building with other people.  Keep in mind that shared-housing prices tend to hold up better in developed urban environments.  If possible, avoid shared housing units in suburban areas where the availability of developable land makes building many more units possible, thus increasing the supply of housing and slowing growth in values. 

If shared housing interests you, make sure that you have the property thoroughly inspected.  Also, examine the trend in maintenance fees over time to ensure that these costs are under control. ( See Chapter 11 for more specifics on how to check out property.) 

Finding the Right Property and Location

Some people know where they want to live, so they look at just a handful of properties and then buy.  Most people take much more time — finding the right house in a desired area at a fair price can take a lot of time.  Buying a home can also entail much compromise when you buy with other family members (particularly spouses). 

Be realistic about how long it may take you to get up to speed about different areas and to find a home that meets your various desires.  If you're like most people and have a full-time job that allows only occasional weekends and evenings to look for a house, three to six months is a short time period to settle on an area and actually find and successfully negotiate on a property.  Six months to a year isn't unusual or slow.  Remember that you're talking about an enormous purchase that you'll come home to daily. 

  Real estate agents can be a big barrier to taking your time with this monumental decision.  Some agents are pushy and want to make a sale and get their commission.  Don't work with such agents as a buyer — they can make you miserable, unhappy, and broke.  If necessary, begin your search without an agent to avoid this outside pressure.  See Chapter 12 for additional information on working with an agent. 

Keeping an open mind

Before you start your search for a new home, you may have an idea about the type of property and location that interests you or that you think you can afford.  You may think, for example, that you can only afford a condominium in the neighborhood that you want.  But if you take the time to check out other communities, you may find another area that meets most of your needs and has affordable single-family homes.  You'd never know that, though, if you narrowed your search too quickly. 

  Even if you've lived in an area for a while and think that you know it well, look at different types of properties in a variety of locations before you start to narrow your search.  Be open-minded and make sure that you know which of your many criteria for a home you really care about.  You'll likely have to be flexible with some of your preferences. 

  After you focus on a particular area or neighborhood, make sure you see the full range of properties available.  If you want to spend $200,000 on a home, look at properties that are more expensive.  Most real estate sells for less than its listing price, and you may feel comfortable spending a little bit more after you see what you can purchase if you stretch your budget a little bit.  Also, if you work with an agent, make sure that you don't overlook homes that are for sale by their owners (that is, properties not listed with real estate agents).  Otherwise, you may miss out on some good prospects. 

Research, research, research

Thinking that you can know what an area is like from anecdotes or from a small number of personal experiences is a mistake.  You may have read or heard that someone was mugged in a particular area.  That incident doesn't make that area dangerous — or more dangerous than others.  Get the facts.  Anecdotes and people's perceptions often aren't accurate reflections of the facts.  Check out the following key items in an area:

  Amenities: Hopefully, you don't spend all your time at work, slaving away to make your monthly mortgage payment.  I hope that you have time to use parks, sports and recreation facilities, and so on.  You can drive around the neighborhood you're interested in to get a sense of these attractions.  Most real estate agents just love to show off their favorite neighborhoods.  Cities and towns can also mail you information booklets that detail what they have to offer and where you can find it. 

  Schools: If you have kids, you care about this issue a lot.  Unfortunately, many people make snap judgments about school quality without doing their homework.  Visit the schools and don't blindly rely on test scores.  Talk to parents and teachers and discover what goes on at the schools. 

  If you don't have (or want!)  school-age children, you may be tempted to say, "What the heck do I care about the quality of the schools?"  You need to care about the schools because even if you don't have kids, the quality of the local schools and whether they're improving or faltering affects property values.  Consider schooling issues even if they're not important to you, because they can affect the resale value of your property. 

  Property taxes: What will your property taxes be?  Property tax rates vary from community to community.  Check with the town's assessment office or with a good real estate agent. 

  Crime: Call the local police department or visit your public library to get the facts on crime.  Cities and towns keep all sorts of crime statistics for neighborhoods — use them! 

  Future development: Check with the planning department in towns that you're considering living in to find out what types of new development and major renovations are in the works.  Planning people may also be aware of problems in particular areas. 

  Catastrophic risks: Are the neighborhoods that you're considering buying a home in susceptible to major risks, such as floods, tornadoes, mudslides, fires, or earthquakes?  Although homeowners insurance can protect you financially, consider how you may deal with such catastrophes emotionally — insurance eases only the financial pain of a home loss.  All areas have some risk, and a home in the safest of areas can burn to the ground.  Although you can't eliminate all risks, you can at least educate yourself about the potential catastrophic risks in various areas. 

  If you're new to an area or don't have a handle on an area's risks, try a number of different sources.  Knowledgeable and honest real estate agents may help, but you can also dig for primary information.  For example, the U.S. Geologic Survey (USGS) puts together maps that help you see potential earthquake risks by area.  The USGS maintains offices all around the country — check your local phone directory in the government White Pages section (or visit the agency online at www.usgs.gov).  The Federal Emergency Management Agency (FEMA) provides maps that show flood risk areas. ( Call FEMA at 800-358-9616 or check its Web site at www.fema.gov.)  Insurance companies and agencies can also tell you what they know about risks in particular areas. 

Understanding market value

Over many months, you'll perhaps look at dozens of properties for sale.  Use these viewings as an opportunity to find out what specific homes are worth.  The listing price isn't what a house is worth — it may be, but odds are it's not.  Property that's priced to sell usually does just that — it sells.  Properties left on the market are often overpriced.  The listing price on such properties may reflect what an otherwise greedy or uninformed seller and his agent hope that some fool will pay. 

  Of the properties that you see, keep track of the prices that they end up selling for. ( Good agents can provide this information.)  Properties usually sell for less than the listed price.  Keeping track of selling prices gives you a good handle on what properties are really worth and a better sense of what you can afford. 

Pounding the pavement

After you set your sights on that special home, thoroughly check out the surroundings — you should know what you're getting yourself into. 

  Go back to the neighborhood in which the property is located at different times of the day and on different days of the week.  Knock on a few doors and meet your potential neighbors.  Ask questions.  Talk to property owners as well as renters.  Because they don't have a financial stake in the area, renters are often more forthcoming with negative information about an area. 

After you decide where and what to buy, you're ready to try to put a deal together.  I cover issues common to both home and investment property purchases — such as mortgages, negotiations, inspections, and so on — in Chapter 12. 
Chapter 11

Investing in Real Estate

In This Chapter

  Looking at the attractions and drawbacks of real estate investing

  Understanding what it takes to become a successful property investor

  Discovering simple and profitable ways to invest in real estate

  Exploring some hands-on real estate investments

  Avoiding bad real estate investments

If you've already bought your own home (and even if you haven't), using real estate as an investment may interest you.  Over the decades and generations, real estate investing, like the stock market and small-business investments, has generated tremendous wealth for participants. ( See Chap-ter 2 for more on the rate of return from various investments.) 

  Real estate is like other types of ownership investments, such as stocks, where you have an ownership stake in an asset.  Although you have the potential for significant profits, don't forget that you also accept greater risk.  Real estate isn't a gravy train or a simple way to get wealthy.  Like stocks, real estate goes through good and bad performance periods.  Most people who make money investing in real estate do so because they invest and hold property over many years.  The vast majority of people who don't make money in real estate don't because they make easily avoidable mistakes.  In this chapter, I discuss how to make the best real estate investments and avoid the rest. 

Outlining Real Estate Investment Attractions

Many people build their wealth by investing in real estate.  Some people focus exclusively on property investments, but many others build their wealth through the companies that they started or through other avenues and then diversify into real estate investments.  What do these wealthy folks know, and why do they choose to invest in real estate?  In the following sections, I cover some of real estate's attractions. 

  Real estate, like all investments, has its pros and cons.  Investing in real estate is time intensive and carries risks.  Invest in real estate because you enjoy the challenge and because you want to diversify your portfolio. ( An advantage of real estate is that its value doesn't move in lockstep with other investments, such as stocks or small-business investments that you hold, so it's a useful diversification tool.)  Don't take this route because you seek a get-rich-quick outlet. 

Limited land

The supply of buildable, desirable land on this planet is limited.  And because people are prone to reproduce, demand for land and housing continues to grow.  Land and what you can do with it are what make real estate valuable.  Cities and islands such as Hawaii, Hong Kong, San Francisco, Los Angeles, and New York City have the highest housing costs around because land is limited in these places. 

Leverage

Real estate is different from most other investments because you can borrow 75 to 80 percent (or more) of the value of the property to buy it.  Thus, you can use your down payment of 20 to 25 percent of the purchase price to buy, own, and control a much larger investment; this concept is called leverage.  Of course, you hope that the value of your real estate goes up — if it does, you make money on your original dollars invested as well as on the money that you borrowed. 

Here's a quick example to illustrate.  Suppose you purchase a rental property for $150,000 and make a $30,000 down payment (and borrow the other $120,000).  Over the next three years, imagine that the property appreciates to $180,000.  Thus, you have a profit (on paper at least) of $30,000 on an investment of just $30,000.  In other words, you've made a 100 percent return on your investment. ( Note that in this scenario, I ignore whether your expenses from the property exceed the rental income that you collect.) 

  Leverage is good for you if property prices appreciate, but leverage can also work against you.  Say, for example, that your $150,000 property decreases in value to $120,000.  Even though it has dropped only 20 percent in value, you actually lose (on paper) 100 percent of your original $30,000 investment.  If you have an outstanding mortgage of $120,000 on this property and you need to sell, you actually have to pay money into the sale to cover selling costs — in addition to losing your entire original investment.  Ouch! 

Roll over those rental property profits

When you sell a stock or mutual fund investment that you hold outside a retirement account, you must pay tax on your profits.  By contrast, if you roll over your real estate gain into another like-kind investment real estate property, you can avoid paying tax on your rental property profit when you sell. 

The rules for properly making one of these (IRS code section) 1031 exchanges (also called Starker exchanges) are complex and usually involve third parties.  With like-kind transactions, you don't receive the proceeds of the sale.  Instead, they must go into an escrow account (explained in Chapter 12).  You must complete the rollover within a six-month time limit, and you must also identify a replacement property within 45 days of the sale of the first property.  Make sure you find an attorney or tax advisor who's an expert at these transactions to ensure that everything goes smoothly (and legally). 

If you don't roll over your gain, you may owe significant taxes because of how the IRS defines your gain.  For example, if you buy a property for $200,000 and sell it for $250,000, you not only owe tax on that difference, but you also owe tax on an additional amount, depending on the property's depreciation.  The amount of depreciation that you deducted on your tax returns reduces the original $200,000 purchase price, making the taxable difference that much larger.  For example, if you deducted $25,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $250,000 and $175,000 ($200,000 purchase price minus $25,000 depreciation). 

Appreciation and income

Another reason that real estate is a popular investment is that you can make money from it in two major ways: through appreciation and from income.  I explain both in the following list:

  Appreciation: You hope and expect that over the years, your real estate investments will appreciate in value.  The appreciation of your properties compounds tax deferred during your years of ownership.  You don't pay tax on this profit until you sell your property — and even then you can roll over your gain into another investment property to avoid paying tax. ( See the "Roll over those rental property profits" sidebar for details on tax-deferred exchanges of investment properties.) 

If you choose to simply take your profits and not roll them over, the federal tax rate on gains from property held more than one year — known as long-term capital gains — are taxed at no more than 15 percent (at least through 2012).  That's a heck of a deal when you consider that ordinary income can be taxed at rates approaching 40 percent. 

  Income: You also hope to make money from the ongoing business that you run — renting the property.  You rent out investment property to make a profit based on the property's rental income in excess of its expenses (mortgage, property taxes, insurance, maintenance, and so on).  Unless you make a large down payment, your monthly operating profit is usually small or nonexistent in the early years of rental property ownership.  Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than your expenses.  During soft periods in the local economy, however, rents may rise more slowly than your expenses (or rents may even fall). 

Ability to add value

You, as a small investor, can't add value to stocks by "fixing them up," but you may have some good ideas about how to improve a property and make it more valuable.  Perhaps you can fix up a property or develop it further and raise the rental income and resale value accordingly.  Through legwork, persistence, and good negotiating skills, you may also be able to make money by purchasing a property below its fair market value. 

  Relative to investing in the stock market, tenacious and savvy real estate investors can more easily buy property below its fair market value.  You can do the same in the stock market, but the scores of professional, full-time money managers who analyze stocks make finding bargains more difficult. 

Ego gratification

Face it.  Investing in real estate appeals to some investors because land and buildings are tangible.  Although few admit it, some real estate investors get an ego rush from a tangible display of their wealth.  You can drive past investment real estate and show it off to others. 

In an article in The New York Times titled "What My Ego Wants, My Ego Gets," Donald Trump publicly admitted what most everyone else knew long ago: He holds his real estate investments partly for his ego.  Trump confessed of his purchase of the famed Plaza Hotel in the Big Apple, "I realized it was 100 percent true — ego did play a large role in the Plaza purchase and is, in fact, a significant factor in all of my deals." 

Real estate investing isn't as wonderful as they say

If you've attempted to read or have read some of the many real estate investment books or have attended seminars, you may need deprogramming!  Too often, pundits attempt to make real estate investments sound like the one and only sure way to become a multimillionaire with little effort.  Consider the following statements made by real estate book authors.  My rebuttals to their claims follow. 

"Rather than yielding only a small interest payment or dividend, real estate in prime locations can appreciate 20 percent a year or more." 

Bank accounts, bonds, and stocks pay interest or dividends that typically amount to 2 to 6 percent per year (the total return on stocks has historically been about 9 to 10 percent per year).  However, bank accounts and bonds aren't comparable investments to stocks or real estate — they're far more conservative and liquid and therefore don't offer the potential for double-digit returns.  Stock market investing is comparable to investing in real estate, but you shouldn't go into real estate investments expecting annual returns of 20 percent or more.  Those who purchased good Los Angeles real estate in the 1950s and held onto it for the next three decades earned handsome returns as the population of this area boomed.  However, keep in mind that finding areas like Los Angeles and knowing how long to hold on to investments in these areas is easier said than done. 

"A good piece of property can't do anything but go up!" 

Every city, town, or community has good pieces of real estate.  But that doesn't mean communities can't and won't have slow or depressed years.  The real estate decline of the late 2000s, which hit most communities, was a reminder that real estate prices can do something other than go up! 

"Real estate is the best way of preserving and enhancing wealth . . . . [ it] stands head and shoulders above any other form of investment." 

Investing in stocks or in a small business is every bit as profitable as investing in real estate.  In fact, more great fortunes have been built in small business than in any other form of investment.  Over the long term, stock market investors have enjoyed (with less hassle) average annual rates of return comparable to real estate investors' returns. 

Longer-term focus

One problem with investing in the securities markets, such as the stock market, is that prices are constantly changing.  Television news programs, websites, PDAs, and other communication devices dutifully report the latest price quotes. 

From my observations and work with individual investors, I've seen that the constant reports on price changes cause some investors to lose sight of the long term and the big picture.  In the worst cases, large short-term drops, such as what happened during the 2008 financial crisis, lead investors to panic and sell at what end up being bargain prices.  Or headlines about big increases pull investors in lemminglike fashion into an overheated and peaking market.  Because all you need to do is click your computer mouse or dial a toll-free phone number to place your sell or buy order, some stock market investors fall prey to snap, irrational judgments. 

  While the real estate market is constantly changing, short-term, day-to-day, and week-to-week changes are invisible.  Publications don't report the value of your real estate holdings daily, weekly, or even monthly.  These less-frequent publications are good because they encourage a longer-term focus.  If prices do decline over the months and years, you're much less likely to sell in a panic with real estate.  Preparing a property for sale and eventually getting it sold take a good deal of time, and this barrier to quickly selling helps keep your vision in focus. 

Figuring Out Who Should Avoid Real Estate Investing

  Real estate investing isn't for everyone.  Most people do better financially when they invest their ownership holdings in a diversified portfolio of stocks, such as through stock mutual funds.  Definitely shy away from real estate investments that involve managing property if you fall into either of the following categories:

  You're time starved and anxious.  Buying and owning investment property and being a landlord take a lot of time.  If you fail to do your homework before purchasing real estate, you can end up overpaying — or buying a heap of trouble.  You can hire a property manager to help with screening and finding good tenants and troubleshooting problems with the building you purchase, but this step costs money and still requires some time involvement.  Also, remember that most tenants don't care for a property the same way property owners do.  If every little scratch or carpet stain sends your blood pressure skyward, avoid distressing yourself as a landlord. 

  You're not interested in real estate.  Some people simply don't feel comfortable and informed when it comes to investing in real estate.  If you've had experience and success with other investments, such as stocks, stick with them and avoid real estate.  Over long periods of time, both stocks and real estate provide comparable returns. 

Examining Simple, Profitable Real Estate Investments

Investing in rental real estate that you're responsible for can be a lot of work.  Think about it this way: With rental properties, you have all the headaches of maintaining a property, including finding and dealing with tenants, without the benefits of living in and enjoying the property. 

 Unless you're extraordinarily interested in and motivated to own investment real estate, start with and perhaps limit yourself to a couple of the much simpler yet still profitable methods I discuss in this section. 

Finding a place to call home

During your adult life, you need to put a roof over your head.  You may be able to sponge off your folks or some other friend or relative for a number of years to cut costs and save money.  If you're content with this arrangement, you can minimize your housing costs and save more for a down payment and possibly toward other goals.  Go for it, if your friend or relative will! 

But what if neither you nor your loved ones are up for the challenge of cohabitating?  For the long term, because you need a place to live, why not own real estate instead of renting it?  Real estate is the only investment that you can live in or rent to produce income.  You can't live in a stock, bond, or mutual fund!  Unless you expect to move within the next few years, buying a place probably makes good long-term financial sense.  In the long term, owning usually costs less than renting, and it allows you to build equity in an asset.  Read Chapter 10 to find out more about profiting from homeownership. 

Trying out real estate investment trusts

Real estate investment trusts (REITs) are entities that generally invest in different types of property, such as shopping centers, apartments, and other rental buildings.  For a fee, REIT managers identify and negotiate the purchase of properties that they believe are good investments, and then they manage these properties, including all tenant relations.  Thus, REITs are a good way to invest in real estate if you don't want the hassles and headaches that come with directly owning and managing rental property. 

Think carefully before converting your home into a rental

If you move into another home, turning your current home into a rental property may make sense.  After all, it saves you the time and cost of finding a separate rental property. 

Unfortunately, many people make the mistake of holding on to their current home for the wrong reasons when they buy another.  Homeowners often make this mistake when they must sell their homes in a depressed market (such as the one that existed in many areas in the late 2000s).  Nobody likes to lose money by selling their home for less than they paid for it.  So some owners hold on to their homes until prices recover. 

If you plan to move and want to keep your current home as a long-term investment property, you can.  But turning your home into a short-term rental is usually a bad move for the following reasons. 

  You may not want the responsibilities of a landlord, yet you force yourself into the landlord business when you convert your home into a rental. 

  If the home eventually does rebound in value, you owe tax on the profit if your property is a rental when you sell it and you don't buy another rental property.  You can purchase another rental property through a 1031 exchange to defer paying taxes on your profit. ( See the "Roll over those rental property profits" sidebar in this chapter.) 

  Surprisingly, most books that focus on real estate investing neglect REITs.  Why?  I have come to the conclusion that they overlook these entities for the following reasons:

  If you invest in real estate through REITs, you don't need to read a long, complicated book on real estate investment.  Therefore, books often focus on more complicated direct (where you buy and own property yourself) real estate investments. 

  Real estate brokers write many of these books.  Not surprisingly, the real estate investment strategies touted in these books include and advocate the use of such brokers.  You can buy REITs without real estate brokers. 

  A certain snobbishness prevails among people who consider themselves to be "serious" real estate investors.  These folks thumb their noses at the benefit of REITs in an investment portfolio.  One real estate writer/investor went so far as to say that REITs aren't "real" real estate investments. 

Please.  No, you can't drive your friends by a REIT to show it off.  But those who put their egos aside when making real estate investments are happy that they considered REITs and have enjoyed double-digit annualized gains over the decades. 

You can research and purchase shares in individual REITs, which trade as securities on the major stock exchanges.  An even better approach is to buy a mutual fund that invests in a diversified mixture of REITs (see Chapter 8). 

In addition to providing you with a diversified, low-hassle real estate investment, REITs offer an additional advantage that traditional rental real estate doesn't: You can easily invest in REITs through a retirement account (for example, an IRA).  As with traditional real estate investments, you can even buy REITs and mutual fund REITs with borrowed money.  You can buy with 50 percent down, called buying on margin, when you purchase such investments through a non-retirement brokerage account. 

Evaluating Direct Property Investments

Every year Forbes magazine profiles the 400 wealthiest Americans, known as the Forbes 400.  To get on the list, you must make the money through legitimate and legal channels (Forbes leaves out mobsters and drug kingpins).  Numerous people made the most recent list primarily because of their real estate investments.  For others on the list, real estate was an important secondary factor that contributed to their wealth. 

Consider the case of Thomas Flatley, an Irish immigrant.  He was practically broke when he came to America in 1950 at age 18.  After dabbling in his own small business, he got into real estate development and accumulated thousands of apartments, more than a dozen hotels, and millions of square feet of office and retail space, growing his net worth to more than $1 billion. 

If you think you're cut out to be a landlord and are ready for the responsibility of buying, owning, and managing rental real estate, you have lots of direct real estate investment options from which to choose. 

  Before you begin this potentially treacherous journey through the process of real estate investing, read Chapter 10.  Many concepts that you need to know to be a successful real estate investor are similar to those that you need when you buy a home.  The rest of this chapter focuses on issues that are more unique to real estate investing. 

Some investors prefer to buy properties, improve them, and then move on.  Ideally, however, you should plan to make real estate investments that you hold until, and perhaps through, your retirement years.  But what should you buy?  The following is my take on various real estate investments. 

Residential housing

  Your best bet for real estate investing is to purchase residential property.  People always need places to live.  Residential housing is easier to understand, purchase, and manage than most other types of property, such as office and retail property.  If you're a homeowner, you already have experience locating, purchasing, and maintaining residential property. 

The most common residential housing options are single-family homes, condominiums, and townhouses.  You can also purchase multiunit buildings.  In addition to the considerations that I address in Chapter 10, from an investment and rental perspective, consider the following issues when you decide what type of property to buy:

  Tenants: Single-family homes with just one tenant (which could be a family, a couple, or a single person) are simpler to deal with than a multiunit apartment building that requires the management and maintenance of multiple renters and units. 

  Maintenance: From the property owner's perspective, condominiums are generally the lowest-maintenance properties because most condominium associations deal with issues such as roofing, gardening, and so on for the entire building.  Note that as the owner, you're still responsible for maintenance that's needed inside your unit, such as servicing appliances, interior painting, and so on.  Beware, though, that some condo complexes don't allow rentals. 

With a single-family home or apartment building, you're responsible for all the maintenance.  Of course, you can hire someone to do the work, but you still have to find the contractors and coordinate, oversee, and pay for the work they do. 

  Appreciation potential: Look for property where simple cosmetic and other fixes may allow you to increase rents and increase the market value of the property.  Although condos may be easier on the unit owner to maintain, they tend to appreciate less than homes or apartment buildings, unless the condos are located in a desirable urban area. 

One way to add value to some larger properties is to "condo-ize" them.  In some areas, if zoning allows, you can convert a single-family home or multiunit apartment building into condominiums.  Keep in mind, however, that this metamorphosis requires significant research, both on the zoning front as well as with estimating remodeling and construction costs. 

  Cash flow: As I discuss in the "Estimating cash flow" section later in the chapter, your rental property brings in rental income that you hope covers and exceeds your expenses.  The difference between the rental income that you collect and the expenses that you pay out is known as your cash flow.  With all properties, as time goes on, generating a positive cash flow gets easier as you pay down your mortgage debt and (hopefully) increase your rents. 

  Unless you can afford a large down payment of 25 percent or more (to help pay down your debt), the early years of rental property ownership may financially challenge you.  Making a profit in the early years from the monthly cash flow of a single-family home may be hard because some properties sell at a premium price relative to the rent that they can command.  Remember, you pay extra for the land, which you can't rent.  Also, the downside to having just one tenant is that when you have a vacancy, you have no rental income. 

Apartment buildings, particularly those with more units, can generally produce a small positive cash flow, even in the early years of rental ownership. 

  Unless you really want to minimize maintenance responsibilities, avoid condominium investments.  Similarly, apartment building investments are best left to sophisticated investors who like a challenge and can manage more complex properties.  Single-family home investments are generally more straightforward for most people.  Just make sure you run the numbers on your rental income and expenses to see whether you can afford the negative cash flow that often occurs in the early years of ownership (I show you how in the "Estimating cash flow" section later in this chapter).  As I discuss in Chapter 12, do thorough inspections before you buy any rental property. 

Land

If tenants are a hassle and maintaining a building is a never-ending pain, you can consider investing in land.  To do so, you buy land in an area that will soon experience a building boom, hold on to it until prices soar, and then cash in. 

  Such an investment idea sounds good in theory.  In practice, however, making the big bucks through land investments isn't easy.  Although land doesn't require upkeep and tenants, it does require financial feeding.  Here are some reasons investing in land can be problematic:

  Investing in land is a cash drain, and because it costs money to purchase land, you also have a mortgage payment to make.  Mortgage lenders charge higher interest rates on loans to purchase land because they see it as a more speculative investment. 

  You don't get depreciation tax write-offs because land isn't depreciable.  You also have property tax payments to meet as well as other expenses.  However, with land investments, you don't receive income from the property to offset these expenses. 

  If you decide that you someday want to develop the property, you'll have to fork over a hefty chunk of money.  Obtaining a loan for development is challenging and more expensive (because it's riskier for the lender) than obtaining a loan for a developed property. 

  Identifying many years in advance which communities will experience rapid population and job growth isn't easy.  Land in those areas that people believe will be the next hot spot already sells at a premium price.  If property growth doesn't meet expectations, appreciation will be low or nonexistent. 

  If you decide to invest in land, be sure that you

  Can afford it: Tally up the annual carrying costs so you can see what your cash drain may be.  What are the financial consequences of this cash outflow?  For example, will you be able to fund your tax-advantaged retirement accounts?  If you can't, count the lost tax benefits as another cost of owning land. 

  Understand what further improvements the land needs: Running utility lines, building roads, landscaping, and so on all cost money.  If you plan to develop and build on the land that you purchase, research what these things may cost.  Remember that improvements almost always cost more than you expect. 

  Know its zoning status: The value of land depends heavily on what you can develop on it.  Never purchase land without thoroughly understanding its zoning status and what you can and can't build on it.  Also research the disposition of the planning department and nearby communities.  Areas that are antigrowth and antidevelopment are less likely to be good places for you to invest in land, especially if you need permission to do the type of project that you have in mind.  Beware that zoning can change for the worse — sometimes a zoning alteration can reduce what you can develop on a property and, consequently, the property's value. 

  Become familiar with the local economic and housing situations: In the best of all worlds, buy land in an area that's home to rapidly expanding companies and that has a shortage of housing and developable land.  I discuss how to research these issues in the upcoming section "Deciding Where and What to Buy." 

Commercial real estate

Ever thought about owning and renting out a small office building or strip mall?  If you're really motivated and willing to roll up your sleeves, you may want to consider commercial real estate investments.  However, you're generally better off not investing in such real estate because it's much more complicated than investing in residential real estate.  It's also riskier from an investment and tenant-turnover perspective.  When tenants move out, new tenants sometimes require extensive and costly improvements. 

If you're a knowledgeable real estate investor and you like a challenge, here are two good times to invest in commercial real estate:

  When your analysis of the local market suggests that it's a good time to buy

  When you can use some of the space to run your own small business

Just as owning your home is generally more cost-effective than renting over the years, so it is with commercial real estate if — and this is a big if — you buy at a reasonably good time and hold the property for many years. 

  So how do you evaluate the state of your local commercial real estate market?  Examine the supply-and-demand statistics over recent years.  Determine how much space is available for rent and how that number has changed over time.  Also discover the vacancy rate, and find out how it has changed in recent years.  Finally, investigate the rental rates, usually quoted as a price per square foot.  See the section "Deciding Where and What to Buy," later in this chapter, to find out how to gather this kind of information. 

  One way to tell that purchasing a commercial property in an area is a bad idea is a market where the supply of available space has increased faster than demand, leading to falling rental rates and higher vacancies.  A slowing local economy and an increasing unemployment rate also spell trouble for commercial real estate prices.  Each market is different, so make sure you check out the details of your area.  In the next section, I explain where you can find such information. 

Deciding Where and What to Buy

If you're going to invest in real estate, you can do tons of research to decide where and what to buy.  Keep in mind, though, that as in other aspects of life, you can spend the rest of your days looking for the perfect real estate investment, never find it, never invest, and miss out on lots of opportunities, profit, and even fun.  In the following sections, I explain what to look for in a community and area that you seek to invest in. 

  I'm not suggesting that you need to conduct a nationwide search for the best areas.  In fact, investing in real estate closer to home is best because you're probably more familiar with the local area, allowing you to have an easier time researching and managing the properties. 

Considering economic issues

  People need places to live, but an area doesn't generally attract homebuyers if jobs don't exist there.  Ideally, look to invest in real estate in communities that maintain diverse job bases.  If the local economy relies heavily on jobs in a small number of industries, that dependence increases the risk of your real estate investments.  The U.S. Bureau of Labor Statistics compiles this type of data for metropolitan areas and counties.  Visit www.bls.gov for more information. 

Also, consider an area's likelihood of appreciation or depreciation.  Determine which industries are more heavily represented in the local economy.  If most of the jobs come from slow-growing or shrinking employment sectors, real estate prices are unlikely to rise quickly in the years ahead.  On the other hand, areas with a greater preponderance of high-growth industries stand a greater chance of faster price appreciation. 

Finally, check out the unemployment situation and examine how the jobless rate has changed in recent years.  Good signs to look for are declining unemployment and increasing job growth.  The Bureau of Labor Statistics also tracks this data. 

Taking a look at the real estate market

The price of real estate, like the price of anything else, is driven by supply and demand.  The smaller the supply and the greater the demand, the higher prices climb.  An abundance of land and available credit, however, inevitably lead to overbuilding.  When the supply of anything expands at a much faster rate than demand, prices usually fall. 

Upward pressure on real estate prices tends to be greatest in areas with little buildable land.  This characteristic was one of the things that attracted me to invest in real estate in the San Francisco Bay Area decades ago.  If you look at a map of this area, you can see that the city of San Francisco and the communities to the south are on a peninsula.  Ocean, bay inlets, and mountains bound the rest of the Bay Area.  More than 80 percent of the land in the greater Bay Area isn't available for development because state and federal government parks, preserves, and other areas protect the land from development or the land is impossible to develop.  Of the land available for development, nearly all of it in San Francisco and the vast majority of it in nearby counties had been developed. 

In the long term, the lack of buildable land in an area can be a problem.  Real estate prices that are too high may cause employers and employees to relocate to less expensive areas.  If you want to invest in real estate in an area with little buildable land and sky-high prices, run the numbers to see whether the deal makes economic sense. ( I explain how to do this later in this chapter.) 

  In addition to buildable land, consider these other important real estate market indicators to get a sense of the health, or lack thereof, of a particular market:

  Building permits: The trend in the number of building permits tells you how the supply of real estate properties may soon change.  A long and sustained rise in permits over several years can indicate that the supply of new property may dampen future price appreciation. 

  Vacancy rates: If few rentals are vacant, you can assume that the area has more competition and demand for existing units, which bodes well for future real estate price appreciation.  Conversely, high vacancy rates indicate an excess supply of real estate, which may put downward pressure on rental rates as many landlords compete to attract tenants. 

  Listings of property for sale and number of sales: Just as the construction of many new buildings is bad for future real estate price appreciation, increasing numbers of property listings are also an indication of potential future trouble.  As property prices reach high levels, some investors decide that they can make more money cashing in and investing elsewhere.  When the market is flooded with listings, prospective buyers can be choosier, exerting downward pressure on prices.  At high prices (relative to the cost of renting), more prospective buyers elect to rent, and the number of sales relative to listings drops. 

A sign of a healthy real estate market is a decreasing and relatively low level of property listings, indicating that the demand from buyers meets or exceeds the supply of property for sale from sellers.  When the cost of buying is relatively low compared with the cost of renting, more renters can afford and choose to purchase, thus increasing the number of sales. 

  Rents: The trend in rental rates that renters are willing and able to pay over the years gives a good indication as to the demand for housing.  When the demand for housing keeps up with the supply of housing and the local economy continues to grow, rents generally increase.  This increase is a positive sign for continued real estate price appreciation.  Beware of buying rental property subject to rent control; the property's expenses may rise faster than you can raise the rents. 

Refuting the wisdom of buying in the "best" areas

Some people, particularly those in the real estate business, say, "Buy real estate in the best school districts" or "Buy the least expensive home in the best neighborhood."  Such conventional wisdom is often wrong. 

Remember that as a real estate investor, you hope to profit from someday selling your properties, many years in the future, for a much higher price than you purchased them.  If you buy into the "best," you may not have as much room for growth. 

Take school districts, for example.  Conventional wisdom says that you should look at the test scores of different districts and buy real estate in the best (that is, highest-scoring) districts.  But odds are that real estate in those areas is probably already priced at a premium level.  If the situation deteriorates, such an area may experience more decline than an area where property buyers haven't bid prices up into the stratosphere. 

The biggest appreciation often comes from those areas and properties that benefit the most from improvement.  Identifying these in advance isn't easy.  Look for communities where the trend in recent years has been positive.  Even some "average" areas perform better in terms of property value appreciation than today's "best" areas. 

Examining property valuation and financial projections

How do you know what a property is really worth?  Some say it's worth what a ready, willing, and financially able buyer is willing to pay.  But some buyers pay more than what a property is truly worth.  And sometimes buyers who are patient, do their homework, and bargain hard are able to buy property for less than its fair market value. 

  Crunching some numbers to figure what revenue and expenses a rental property may have is one of the most important exercises that you can go through when determining a property's worth and making an offer.  In the sections that follow, I walk you through these important calculations. 

Estimating cash flow

Cash flow is the difference between the money that a property brings in minus what goes out for its expenses.  If you pay so much for a property that its expenses (including the mortgage payment and property taxes) consistently exceed its income, you have a money drain on your hands.  Maybe you have the financial reserves to withstand the temporary drain for the first few years, but you need to know upfront what you're getting yourself into. 

  Here are two big mistakes that novice rental property investors make:

  They fail to realize all the costs associated with investment property.  In the worst cases, some investors end up in personal bankruptcy from the drain of negative cash flow (expenses exceeding income).  In other cases, negative cash flow hampers their ability to accomplish important financial goals. 

  They believe the financial statements that sellers and their real estate agents prepare.  Just as an employer views a resume, you should always view such financial statements as advertisements rather than sources of objective information.  In some cases, sellers and agents lie.  In most cases, these statements contain lots of projections and best-case scenarios. 

  For property that you're considering purchasing, ask for a copy of Schedule E (Supplemental Income and Losses) from the property seller's federal income tax return.  When most people complete their tax returns, they try to minimize their revenue and maximize their expenses — the opposite of what they and their agents normally do on the statements they sometimes compile to hype the property sale.  Confidentiality and privacy aren't an issue when you ask for Schedule E because you're asking only for this one schedule and not the person's entire income tax return. ( If the seller owns more than one rental property for which financial data is compiled on Schedule E, he can simply black out this other information if he doesn't want you to see it.) 

You should prepare financial statements based on facts and a realistic assessment of a property (see Figures 11-1, 11-2, and 11-3).  A time and a place exist for unbridled optimism and positive thinking, such as when you're lost in a major snowstorm.  But deciding whether to buy a rental property isn't a life-or-death situation.  Take your time, and make the decision with your eyes and ears open and with a healthy degree of skepticism. 

  The monthly rental property financial statement that you prepare in Figures 11-1 through 11-3 is for the present.  Over time, you hope and expect that your rental income will increase faster than the property's expenses, thus increasing the cash flow.  If you want, you can use this financial statement for future years' projections as well. 

Valuing property

Estimating a property's cash flow is an important first step to figuring a property's value.  But on its own, a building's cash flow doesn't provide enough information to intelligently decide whether to buy a particular real estate investment.  Just because a property has a positive cash flow doesn't mean you should buy it.  Real estate generally sells for less and may have better cash flow in areas that investors expect to earn lower rates of appreciation. 

**Figure 11-1:** Monthly rental property financial statement (Page 1 of 3). 

In the stock market, you have more clues about a specific security's worth.  Most companies' stocks trade on a daily basis, so you at least have a recent sales price to start with.  Of course, just because a stock recently traded at $20 per share doesn't mean that it's worth $20 per share.  Investors may be overly optimistic or pessimistic. 

Just as you should evaluate a stock versus other comparable stocks, so too should you compare the asking price of a property with other comparable real estate.  But what if all real estate is overvalued?  Such a comparison doesn't necessarily reveal the state of inflated prices.  In addition to comparing a real estate investment property to comparable properties, you also need to perform some local area evaluations of whether prices from a historic perspective appear too high, too low, or just right.  To answer this last question, see Chapter 10. 

**Figure 11-2:** Monthly rental property financial statement (Page 2 of 3). 

**Figure 11-3:** Monthly rental property financial statement (Page 3 of 3). 

Here are the pros and cons of the different approaches you can use to value property:

  Appraisers: The biggest advantage of hiring an appraiser is that she values property for a living.  An appraisal also gives you some hard numbers to use for negotiating with a seller.  Hire a full-time appraiser who has experience valuing the type of property that you're considering.  Ask her for examples of a dozen similar properties in the area that she has appraised in the past three months. 

The drawback of appraisers is that they cost money.  A small home may cost several hundred dollars to appraise, and a larger multiunit building may cost $1,000 or more.  The danger is that you can spend money on an appraisal for a building that you don't end up buying. 

  Real estate agents: If you work with a good real estate agent (I discuss how to find one in Chapter 12), ask him to draw up a list of comparable properties and help you estimate the value of the property that you're considering buying.  The advantage of having your agent help with this analysis is that you don't pay extra for this service. 

  The drawback of asking an agent what to pay for a property is that his commission depends on your buying a property and on the amount that you pay for that property.  The more you're willing to pay for a property, the more likely the deal flies, and the more the agent makes on commission. 

  Do-it-yourself: If you're comfortable with numbers and analysis, you can try to estimate the value of a property yourself.  The hard part is identifying comparable properties.  Finding identical properties usually is impossible, so you need to find similar properties and then make adjustments to their selling prices so you can do an apples-to-apples comparison. 

Among the factors that should influence your analysis of comparable properties are the date the properties sold; the quality of their location; the lot size; the building age and condition; the number of units; the number of rooms, bedrooms, and bathrooms; the number of garages and fireplaces; and the size of the yard.  A real estate agent can provide this information, or you can track it down for properties that you've seen or that you know have recently sold. 

For example, if a similar property sold six months ago for $250,000 but prices overall have decreased 3 percent in the last six months, subtract 3 percent from the sales price.  Ultimately, you have to attach a value or price to each difference between comparable properties and the one that you're considering buying.  Through a series of adjustments, you can then compare the value of your target property to others that have recently sold. 

  These approaches aren't mutually exclusive — obtain the numbers and analysis that an appraiser or real estate agent puts together. 

Discovering the information you need

When you evaluate properties, you need to put on your detective hat.  If you're creative and inquisitive, you soon realize that this isn't a hard game to play.  You can collect useful information about a property and the area in which it's located in many ways. 

  The first place to begin your inquiries is with the real estate agent who listed the property for sale.  One thing that most agents love to do is talk and schmooze.  Try to understand why the seller is selling.  This knowledge helps you negotiate an offer that's appealing to the seller. 

As for specifics on the property's financial situation, ask the sellers for specific independent documents, including Schedule E from their tax return. ( See the earlier section "Estimating cash flow" for more information.)  Hire inspectors to investigate the property's physical condition (I advise you on hiring inspectors in Chapter 12). 

Local government organizations can be treasure troves of information about their communities.  Check out the other recommended sources in Chapter 10 as well as those that I suggest earlier in this chapter. 

Digging for a Good Deal

Everyone likes to get a deal or feel like they bought something at a relatively low price.  How else can you explain the American retail practice of sales?  merchandise is first overpriced, and what doesn't sell quickly enough is then marked down to create the illusion that you're getting a bargain!  Some real estate sellers and agents do the same thing.  They list property for sale at an inflated price and then mark it down after they realize that no one will pay their asking price. " A $30,000 price reduction!"  the new listing screams.  Of course, such reductions aren't a deal. 

  It's possible to get a good buy on a problem property that provides a discount larger than the cost of fixing the property.  However, these opportunities are hard to find, and sellers of such properties are often unwilling to sell at a discount that's big enough to leave you much room for profit.  If you don't know how to thoroughly and correctly evaluate the property's problems, you can end up overpaying. 

Scores of books claim to have the real estate investment strategy that can beat the system.  Often these promoters claim that you can become a multimillionaire through investing in distressed properties.  A common strategy is to purchase property that a seller has defaulted on or is about to default on.  Or how about buying a property in someone's estate through probate court?  Maybe you'd like to try your hand at investing in a property that has been condemned or has toxic-waste contamination! 

In some cases, the strategies that these real estate gurus advocate involve taking advantage of people's lack of knowledge.  For example, some people don't know that they can protect the equity in their home through filing for personal bankruptcy.  If you can find a seller in such dire financial straits and desperate for cash, you may get a bargain buy on the home. ( You may struggle with the moral issues of buying property cheaply this way, however.) 

Other methods of finding discounted property take lots of time and digging.  Some involve cold-calling property owners to see whether they're interested in selling.  This method is a little bit like trying to fill a job opening by interviewing people you run into on a street corner.  Although you may eventually find a good candidate this way, if you factor in the value of your time, the deal seems like less of a bargain. 

Without making things complicated or too risky, you can use some of the following time-tested and proven ways to buy real estate at a discount to its fair market value:

  Find a motivated seller.  Be patient and look at lots of properties, and sooner or later you'll come across one that someone needs to sell (and these aren't necessarily the ones advertised as having motivated sellers).  Perhaps the seller has bought another property and needs the money to close on the recent purchase.  Having access to sufficient financing can help secure such deals. 

  Buy unwanted properties with fixable flaws.  The easiest problems to correct are cosmetic.  Some sellers and their agents are lazy and don't even bother to clean a property.  One single-family home that I bought had probably three years' worth of cobwebs and dust accumulated.  It seemed like a dungeon at night because half the light bulbs were burned out. 

Painting, tearing up old, ugly carpeting, refinishing hardwood floors, and putting new plantings in a yard are relatively easy jobs.  They make the property worth more and make renters willing to pay higher rent.  Of course, these tasks take money and time, and many buyers aren't interested in dealing with problems.  If you have an eye for improving property and are willing to invest the time that coordinating the fix-up work requires, go for it!  Just make sure you hire someone to conduct a thorough property inspection before you buy. ( See Chapter 12 for more details.) 

  Be sure to factor in the loss of rental income if you can't rent a portion of the property during the fix-up period.  Some investors have gone belly up from the double cash drain of fix-up expenses and lost rents. 

  Buy when the real estate market is depressed.  When the economy takes a few knocks and investors rush for the exits (like the late 2000s downturn), it's time to go shopping!  Buy real estate when prices and investor interest are down. ( Interest rates are usually lower then too.)  During times of depressed markets, obtaining properties that produce a positive cash flow (even in the early years) is easier.  In Chapter 10, I explain how to spot a depressed market. 

  Check for zoning opportunities.  Sometimes you can make more productive use of a property.  For example, you can legally convert some multiunit apartment buildings into condominiums.  Some single-family residences may include a rental unit if local zoning allows for it.  A good real estate agent, contractor, and the local planning office in the town or city where you're looking at the property can help you identify properties that you can convert.  However, if you're not a proponent of development, you probably won't like this strategy. 

  If you buy good real estate and hold it for the long term, you can earn a healthy return from your investment.  Over the long haul, having bought a property at a discount becomes an insignificant issue.  You make money from your real estate investments as the market appreciates and as a result of your ability to manage your property well.  So don't obsess over buying property at a discount and don't wait for the perfect deal, because it won't always come along. 

Recognizing Inferior Real Estate "Investments"

Some supposedly "simple" ways to invest in real estate rarely make sense because they're near-certain money losers.  In this section, I discuss real estate investments that you should generally (but not always) avoid. 

Avoiding ticking time shares

  Time shares are near-certain money losers.  With a time share, you buy a week or two of ownership or usage of a particular unit, usually a condominium, in a resort location.  If you pay $8,000 for a week of "ownership," you would pay the equivalent of more than $400,000 a year for the whole unit ($8,000/week × 52 weeks).  However, a comparable unit nearby may sell for only $150,000.  The extra markup pays the salespeople's commissions, administrative expenses, and profits for the time-share development company. ( This little analysis also ignores the not-so-inconsequential ongoing time-share maintenance fees.) 

People usually get hoodwinked into buying a time share when they're enjoying a vacation someplace.  Vacationers are easy prey for salespeople who, often using high-pressure sales tactics, want to sell them a souvenir of the trip.  The cheese in the mousetrap is an offer of something free (for example, a free night's stay in a unit) for going through the sales presentation. 

  If you can't live without a time share, consider buying a used one.  Many previous buyers, who almost always have lost much of their original investment, try to dump their time shares.  However, this fact tells you something about time shares.  You may be able to buy a time share from an existing owner at a fair price, but why commit yourself to taking a vacation in the same location and building at the same time each year?  Many time shares let you trade your weeks; however, doing so is a hassle, and you're limited by what time slots you can trade for, which are typically dates that other people don't want. 

Staying away from limited partnerships

In Chapter 2, I give you good reasons to avoid limited partnerships.  High sales commissions and ongoing management fees burden limited partnerships sold through stockbrokers and financial planners who work on commission.  Quality real estate investment trusts (REITs), which I discuss earlier in this chapter, are infinitely better alternatives.  REITs, unlike limited partnerships, are also completely liquid. 

Keeping a second home

Some folks dream of having a weekend cottage or condo — a place you can retreat to when crowded urban or suburban living conditions get on your nerves.  When it's not in use, you may decide to rent out your vacation home and earn some income to help defray part of the maintenance expenses. 

If you can realistically afford the additional costs of a second, or vacation, home, I'm not going to tell you how to spend your money.  Investment real estate is property that you rent out 90 percent or more of the time.  Most second-home owners I know rent their property out very little — 10 percent or less of the time.  As a result, second homes are usually money drains.  Even if you do rent your second home most of the time, high tenant turnover decreases your net rental income. 

I have seen some people make a decent return with second homes that were infrequently rented.  Usually these homes are held over many years and located in areas that have become increasingly popular. 

Part of the allure of a second home is the supposed tax benefits.  Even when you qualify for some or all of them, tax benefits only partially reduce the cost of owning a property.  I've seen more than a few cases in which the second home is such a cash drain that it prevents its owners from contributing to and taking advantage of tax-deductible retirement savings plans. 

If you don't rent out a second home most of the time, ask yourself whether you can afford such a luxury.  Can you accomplish your other financial goals — saving for retirement, paying for the home in which you live, and so on — with this added expense?  Keeping a second home is more of a consumption than an investment decision. 

Ignoring hucksters and scams

  Real estate investors with lofty expectations for high returns become bait for various hucksters who promise these investors great riches.  It's bad enough when the deck is stacked against you.  Even worse is to put your money into scams. 

In the following sections, I provide some examples of hucksters and scams that could severely hamper your financial success.  Take heed, my friend. 

  If an investment "opportunity" sounds too good to be true, it is.  If you want to invest in real estate, avoid the hucksters and scams and instead invest directly in properties that you can control or invest through reputable REITs (or REIT mutual funds), which I discuss earlier in this chapter. 

Don't believe the hucksters

Cable television infomercials (and now websites) bring investors a never-ending stream of real estate hucksters.  The faces and names change over the years, but the pitch is often the same.  If you're a cable television viewer, you've likely seen the chirpy Dean Graziosi and his lengthy real estate infomercials on various cable television channels, including CNBC.  Graziosi claims that he can teach you to make great riches investing in real estate without putting up any of your own money. 

Graziosi has been selling advice since 1999.  He started with advice about inspecting a car with his CarPro VHS tapes.  However, Graziosi didn't have the expertise — he interviewed an experienced auto mechanic.  He then pitched a program on television called Motor Millions, which he claimed could help folks break into the billion-dollar used car market and make an easy profit to "make your dreams a reality."  Graziosi has been recently selling his book Profit From Real-Estate Right Now!  The Proven No Money Down System For Today's Market.  Over the years, Graziosi has written and promoted other real estate books with similar content. 

If the descriptions of these programs and books aren't enough to make you run in the other direction, Graziosi also appears to have no training or educational background to qualify him for his self-anointed real estate guru status.  In his books and through interviews, Graziosi says that he "chose" not to go to college and got started in the working world by joining his father in his small car business.  That business, according to Graziosi, subsequently failed. 

In the mid-2000s, Graziosi began flogging various real estate programs to the public.  The books, audio tapes, and DVDs I've reviewed are filled with excessive motivational nonsense wherein Graziosi preaches about the importance of having the right mindset and attitude to succeed as a real estate investor.  He provides little in the way of details and how-to information.  It turns out that there's a good reason for this lack of information (besides his lack of training and experience).  After customers have bought a book or DVD set direct from his company, his salespeople use high-pressure tactics to sell personal real estate coaching services for thousands of dollars. 

Graziosi's lack of experience and lack of common sense are exposed many times in his publications.  Consider the following:

  In his recent book, he claims that when he saw a real estate agent putting up a for sale sign on a $525,000 house across the street from a home he already owned, he did a quick walk-through of the property and immediately wrote a near full-price purchase offer.  In that offer, he claimed to buy the home as is without having it professionally inspected.  This tactic is dangerous for anyone who isn't a contractor and an expert on all the operating systems of a home.  Graziosi clearly lacks this expertise; his not telling the reader the importance of doing such an inspection is a horrible oversight. 

  Recent years have clearly shown that Graziosi changes his stripes and story.  In the mid-2000s, he encouraged taking out risky mortgages and layering on heavy debts.  The real estate market slide in the late 2000s clearly exposed the dangers in that short-sighted approach. 

Now that real estate prices have corrected significantly in most parts of the country, Graziosi is claiming that his system enables novice investors to take advantage of low prices and depressed market conditions.  Graziosi suggests that people buy foreclosures (for no money down, of course), and then rent out the property.  He also claims that by getting such good deals when you buy foreclosed property, you can refinance and pull lots of cash out of your property and buy more.  If you believe this is simplistic and naïve, go to the head of the class!  Most foreclosures happen in the highly depressed areas where decent renters are hard to come by.  And, expecting that you're going to get such a steal on a property that you can turn around and find a lender willing to do a refinance that enables you to pull out cash is wishful thinking. 

Stand strong against the scams

In addition to hucksters, the real estate field has outright scams you should be on guard against.  Here are just a few examples:

  First Pension was an outfit run by loan broker William Cooper, who bilked investors out of more than $100 million.  First Pension was sold as a limited partnership that invested in mortgages.  Using a Ponzi-type (pyramid) scheme, Cooper used the money from new investors to pay dividends to earlier investors. 

  New York attorney Alan Harris defrauded real estate investors (including actress Shirley Jones) out of millions of dollars when he pocketed money that was set aside for property investments.  The lure: Harris promised investors far higher yields than they could get elsewhere. 

  Stephen Murphy was a real estate investor who claimed to make a fortune by buying foreclosed commercial real estate and wrote and self-published a book to share his techniques with the public.  Murphy's organization called the people who bought his book and pitched them into collaborating with him on property purchases that supposedly would return upwards of 100 percent or more per year.  However, Murphy had other ideas, and he siphoned off nearly two-thirds of the money for himself and for promotion of his books!  He even hoodwinked Donald Trump into writing praise for his book and work. 

  Time shares, a truly terrible investment that I discuss earlier in this chapter, have also been subject to bankruptcy and fraud problems. 
Chapter 12

Real Estate Financing and Deal Making

In This Chapter

  Selecting the best real estate investment financing

  Locating an excellent real estate agent

  Negotiating and inspecting your deals

  Making smart selling decisions

In this chapter, I discuss issues such as understanding and selecting mortgages, working with real estate agents, negotiating, and other important details that help you put a real estate deal together.  I also provide some words of wisdom about taxes and selling your property that may come in handy down the road. ( In Chapter 10, I cover what you need to know to purchase a home, and in Chapter 11, I review the fundamentals of investing in real estate.) 

Financing Your Real Estate Investments

Unless you're affluent or buying a low-cost property, you likely need to borrow some money, via a mortgage, to make the purchase happen.  Without financing, your dream to invest in real estate remains just that — a dream.  So first you've got to maximize your chances of getting approved for a loan, which, unfortunately, has become tougher since the real estate market downturn in the late 2000s.  Shopping wisely for a good mortgage can save you thousands, perhaps even tens of thousands, of dollars in extra interest and fees.  Don't get saddled with a loan that you may not be able to afford someday and that could push you into foreclosure or bankruptcy. 

Getting your loan approved

Even if you have perfect or near-perfect credit, you may encounter financing problems with some properties.  And, of course, not all real estate buyers have a perfect credit history, tons of available cash, and no debt.  Because of the soft real estate market in the late 2000s and the jump in foreclosures since that time, lenders tightened credit standards to avoid making loans to people likely to default.  If you're one of those borrowers who ends up jumping through more hoops than others to get a loan, don't give up hope.  Few borrowers are perfect from a lender's perspective, and many problems are fixable. 

  To head off any potential rejection before you apply for a loan, you can sometimes disclose to your lender anything that may cause a problem.  For example, if you already know that your credit report indicates some late payments from when you were out of the country for several weeks five years ago, write a letter that explains this situation. 

Solving down payment problems

Most people, especially when they make their first real estate purchase, are strapped for cash.  In order to qualify for the most attractive financing, lenders typically require that your down payment be at least 20 percent of the property's purchase price.  The best investment property loans sometimes require 25 to 30 percent down for the best terms.  In addition, you need reserve money to pay for other closing costs, such as title insurance and loan fees. 

  If you don't have 20-plus percent of a property's purchase price available, don't despair.  You can still own real estate with the following strategies:

  Take out private mortgage insurance.  Some lenders may offer you a mortgage even though you can put down only, say, 10 percent of the purchase price.  These lenders will likely require you to purchase private mortgage insurance (PMI) for your loan, however.  This insurance generally costs a few hundred dollars per year and protects the lender if you default on your loan. ( When you have at least 20 percent equity in the property, you can generally eliminate the PMI.) 

  Dip in to your retirement savings.  Some employers allow you to borrow against your retirement account balance under the condition that you repay the loan within a set number of years.  Subject to eligibility requirements, first-time homebuyers can make penalty-free withdrawals of up to $10,000 from IRA accounts. ( Note: You still must pay regular income tax on the withdrawal.) 

  Postpone your purchase.  If you don't want the cost and strain of extra fees and bad mortgage terms, you can also postpone your purchase.  Go on a financial austerity program and boost your savings rate. 

  Consider lower-priced properties.  Lower-priced properties can help keep down the purchase price and the required down payment. 

  Find a partner.  Sharing the financial load with a partner often makes buying real estate easier.  Just make sure you write up a legal contract to specify what happens if a partner wants out.  Family members sometimes make good partners.  Your parents, grandparents, and maybe even your siblings may have some extra cash they'd like to loan, invest, or even give to you as a gift! 

  Look into seller financing.  Some property owners or developers may finance your purchase with as little as 5 to 10 percent down.  However, you can't be as picky about such seller-financed properties because a limited supply is available and many that are available need work or haven't yet sold for other reasons. 

Improving your credit score

Late payments, missed payments, or debts that you never bothered to pay can tarnish your credit report and squelch a lender's desire to offer you a mortgage.  If you're turned down for a loan because of your less-than-stellar credit history, find out the details of why by requesting (at no charge to you) a copy of your credit report from the lender that turned down your loan. 

  If you think that your credit history may be a problem as you're looking for a loan, the first thing to do is get the facts.  By law, you're entitled to one free credit report per year from each of the three consumer credit reporting companies — Equifax, Experian, and TransUnion.  You can get all three reports at once or space them out throughout the year (checking in on one each at four-month intervals).  The companies have set up one central website where you can access these reports (www.annualcreditreport.com), or you can call toll-free at 877-322-8228.  Just be careful not to buy the credit services these companies will pitch you. 

If you do find credit report problems, explain them to your lender.  If the lender is unsympathetic, try calling other lenders.  Tell them your credit problems upfront and see whether you can find one willing to offer you a loan.  Mortgage brokers may also be able to help you shop for lenders in these cases. ( I discuss working with mortgage brokers later in this chapter.) 

Sometimes you may feel that you're not in control when you apply for a loan.  In reality, however, you can fix a number of credit problems yourself, and you reap great rewards (access to better loan terms, including lower interest rates) for doing so.  And you can often explain those that you can't fix.  Remember that some lenders are more lenient and flexible than others.  Just because one mortgage lender rejects your loan application doesn't mean that all the others will as well. 

  If you discover erroneous information on your credit report, get on the phone to the credit bureaus and start squawking.  If specific creditors are the culprits, call them too.  Keep notes from your conversations and make sure that you put your case in writing and add your comments to your credit report.  If the customer service representatives you talk with are no help, send a letter to the president of each company.  Let the head honcho know that his or her organization caused you problems in obtaining credit.  For more information on examining and disputing items on your credit report and managing credit in general, check out the Federal Trade Commission's website at www.ftc.gov/credit. 

Besides late or missed payments, another common credit problem is having too much consumer debt at the time you apply for a mortgage.  The more consumer debt you rack up (including credit card and auto loan debt), the less mortgage credit you qualify for.  If you're turned down for a mortgage, consider it a wake-up call to get rid of your high-cost debt.  Hang on to the dream of buying real estate and plug away at paying off your debts before you attempt another foray into real estate. 

To find out more about how credit scores work and techniques to improve yours, see the latest edition of my book Personal Finance For Dummies (John Wiley & Sons, Inc.). 

Dealing with low appraisals

Even if you have sufficient income, a clean credit report, and an adequate down payment, a lender may deny your loan if the appraisal of the property that you want to buy comes in lower than you agreed to pay for the property. 

  If you still like the property, renegotiate a lower price with the seller by using the low appraisal to strengthen your case.  If you encounter a low appraisal on a property that you already own and are refinancing, you need to follow a different path.  If you have the cash available, you can simply put more money down to get the loan balance to a level for which you qualify.  If you don't have the cash, you may need to try another lender or forgo the refinance until you save more money or until the property value rises. ( I discuss refinancing in more detail later in this chapter.) 

Handling insufficient income

If you're self-employed or have changed jobs, your current income may not resemble your past income or, more importantly, your income may be below what a mortgage lender likes to see given the amount that you want to borrow.  A way around this problem, although challenging, is to make a larger down payment. 

  If you can't make a large down payment, another option is to get a cosigner for the loan.  For example, your relatives may be willing to sign with you.  As long as they aren't overextended themselves, they may be able to help you qualify for a larger loan than you can get on your own.  As with partnerships, put your agreement in writing so that no misunderstandings occur. 

Comparing fixed-rate to adjustable-rate mortgages

Two major types of mortgages exist: those with a fixed interest rate and those with an adjustable rate.  Your choice depends on your financial situation, how much risk you're willing to accept, and the type of property you want to purchase.  For example, obtaining a fixed-rate loan on a property that lenders perceive as a riskier investment is more difficult than getting an adjustable-rate mortgage for the same property. 

Locking into fixed-rate mortgages

Fixed-rate mortgages, which are typically for a 15- or 30-year term, have interest rates that stay fixed or level — you lock in an interest rate that doesn't change over the life of your loan.  Because the interest rate stays the same, your monthly mortgage payment stays the same.  You have nothing complicated to track and no uncertainty.  Fixed-rate loans give people peace of mind and payment stability. 

  Fixed-rate mortgages do, however, carry risks.  If interest rates fall significantly after you obtain your mortgage and you're unable to refinance, you face the danger of being stuck with a higher-cost mortgage, which could be problematic if you lose your job or the value of your property decreases. ( This scenario — declining interest rates and falling real estate values — happened to plenty of people in the late 2000s.)  Even if you're able to refinance, you'll probably have to spend significant time and money to complete the paperwork. 

Understanding adjustable-rate mortgages (ARMs)

In contrast to a fixed-rate mortgage, an adjustable-rate mortgage (ARM) carries an interest rate that varies over time (based on a formula the lender establishes).  Such a mortgage begins with one interest rate, and you may pay different rates for every year, possibly even every month, that you hold the loan.  Thus, the size of your monthly payment fluctuates.  Because a mortgage payment makes a large dent in most property owners' checkbooks, signing up for an ARM without fully understanding it is fiscally foolish. 

Beware of balloon loans

Balloon loans generally start the way traditional fixed-rate mortgages start.  You make level payments based on a long-term payment schedule — over 15 or 30 years, for example.  But at a predetermined time, usually within ten years from the loan's inception, the remaining loan balance becomes fully due. 

Balloon loans may save you money because they have a lower interest rate than a longer-term fixed-rate mortgage and you pay that interest over a shorter period of time.  However, balloon loans are dangerous — your financial situation can change, and you may not be able to refinance when your balloon loan is due.  What if you lose your job or your income drops?  What if the value of your property drops and the appraisal comes in too low to qualify you for a new loan?  What if interest rates rise and you can't qualify at the higher rate on a new loan?  You're still going to have to pay off your balloon loan when it comes due. 

Sometimes, balloon loans may be the only option for the buyer (or so the buyer thinks).  Buyers are more commonly backed into these loans during periods of high interest rates.  When a buyer can't afford the payments on a conventional mortgage and really wants a particular property, a seller may offer a balloon loan. 

Shun balloon loans.  Consider a balloon loan if, and only if, such a loan is your only financing option, you've really done your homework to exhaust other financing alternatives, and you're certain that you can refinance when the balloon comes due.  If you take a balloon loan, get one with as much time as possible, preferably ten years, before it becomes due. 

The advantage of an ARM is that if you purchase your property during a period of higher interest rates, you can start paying your mortgage with a relatively low initial interest rate, compared with fixed-rate loans. ( With a fixed-rate mortgage, a mortgage lender takes extra risk in committing to a fixed interest rate for 15 to 30 years.  To be compensated for accepting this additional risk, lenders charge a premium with fixed-rate mortgages in case interest rates, which they have to pay on their source of funds in the form of deposits, move much higher in future years.)  If interest rates decline, you can capture many of the benefits of lower rates without the cost and hassle of refinancing by taking out an ARM. 

Choosing between fixed and adjustable mortgages

You can't predict the future course of interest rates.  Even the professional financial market soothsayers and investors can't predict where rates are heading.  If you could foretell interest rate movements, you could make a fortune investing in bonds and interest-rate futures and options.  So cast aside your crystal ball and ask yourself the following two vital questions to decide whether a fixed or adjustable mortgage will work best for you. 

How comfortable are you with taking risk? 

How much of a gamble can you take with the size of your monthly mortgage payment?  For example, if your job and income are unstable and you need to borrow an amount that stretches your monthly budget, you can't afford much risk.  If you're in this situation, stick with fixed-rate mortgages because you likely won't be able to handle a large increase in interest rates and the payment on an ARM. 

If, on the other hand, you're in a position to take the financial risks that come with an adjustable-rate mortgage, you have a better chance of saving money with an adjustable loan rather than a fixed-rate loan.  Your interest rate starts lower and stays lower if the market level of interest rates remains unchanged.  Even if rates go up, they'll likely come back down over the life of your loan.  If you can stick with your adjustable-rate loan for better and for worse, you may come out ahead in the long run. 

Adjustables also make more sense if you borrow less than you're qualified for.  Or perhaps you regularly save a sizable chunk — more than 10 percent — of your monthly income.  If your income significantly exceeds your spending, you may feel less anxiety about fluctuating interest rates.  If you do choose an adjustable loan, you may be more financially secure if you have a hefty financial cushion (at least six months' to as much as a year's worth of expenses reserved) that you can access if rates go up. 

  Almost all adjustables limit, or cap, the rise in the interest rate that your loan allows.  Typical caps are 2 percent per year and 6 percent over the life of the loan.  Ask your lender to calculate the highest possible monthly payment that your loan allows.  The number that the lender comes up with is the payment that you face if the interest rate on your loan goes to the highest level allowed, or the lifetime cap.  If you can't afford the highest-allowed payment on an adjustable-rate mortgage, don't take one.  You shouldn't take the chance that the rate may not rise that high — it can, and you could lose the property. 

  Don't take an adjustable mortgage because the lower initial interest rates allow you to afford the property that you want to buy (unless you're absolutely certain that your income will rise to meet future payment increases).  Instead, try setting your sights on a property that you can afford to buy with a fixed-rate mortgage. 

How many years do you expect to stay put? 

Saving interest on most adjustables is usually a certainty in the first two or three years.  By nature, an adjustable-rate mortgage starts at a lower interest rate than a fixed-rate mortgage.  However, if rates rise while you hold an ARM, you can end up giving back the savings that you achieve in the early years of the mortgage. 

  If you aren't going to keep your mortgage for more than five to seven years, you'll probably end up paying more interest to carry a fixed-rate mortgage.  Also consider a hybrid loan, which combines features of fixed- and adjustable-rate mortgages.  For example, the initial rate may hold constant for several years and then adjust once a year or every six months thereafter.  Such loans may make sense for you if you foresee a high probability of keeping your loan seven years or less but want some stability in your monthly payments.  The longer the initial rate stays locked in, the higher the interest rate. 

Landing a great fixed-rate mortgage

You may think that comparing one fixed-rate loan to another is quite simple because the interest rate on a fixed-rate loan is the rate that you pay every month over the entire life of the loan.  And as with your golf score and the number of times that your boss catches you showing up late for work, a lower number (or interest rate) is better, right? 

Unfortunately, banks generally charge an upfront interest fee, known as points, in addition to the ongoing interest over the life of the loan.  Points are actually percentages: One point is equal to 1 percent of the loan amount.  So when a lender tells you a quoted loan has 1.5 points, you pay 1.5 percent of the amount you borrow as points.  On a $100,000 loan, for example, 1.5 points cost you $1,500.  The interest rate on a fixed-rate loan must always be quoted with the points on the loan, if the loan has points. 

  You may want to take a higher interest rate on your mortgage if you don't have enough cash to pay for a lot of points, which you pay upfront when you close the loan.  On the other hand, if you're willing and able to pay more points, you can lower your interest rate.  You may want to pay more points because the interest rate on your loan determines your payments over a long period of time — 15 to 30 years. 

Suppose that one lender quotes you a rate of 5.75 percent on a 30-year fixed-rate loan and charges one point (1 percent).  Another lender, which quotes 6 percent for 30 years, doesn't charge any points.  Which is better?  The answer depends on how long you plan to keep the loan. 

The 5.75 percent loan is 0.25 percent less than the 6 percent loan.  However, it takes you about four years to earn back the savings to cover the cost of that point because you have to pay 1 percent (one point) upfront on the 5.75 percent loan.  So if you expect to keep the loan more than four years, go with the 5.75 percent option.  If you plan to keep the loan less than four years, go with the 6 percent option. 

  To make it easier to perform an apples-to-apples comparison of mortgages from different lenders, get interest rate quotes at the same point level.  For example, ask each lender for the interest rate on a loan for which you pay one point.  And, remember that if a loan has no points, it's sure to have a higher interest rate.  I'm not saying that no-point loans are better or worse than comparable loans from other lenders.  Just don't get sucked into a loan because of a no-points sales pitch.  Lenders who spend big bucks on advertising these types of loans rarely have the best mortgage terms. 

All things being equal, no-point loans make more sense for refinances because points aren't immediately tax-deductible as they are on purchases. ( You can deduct the points that you pay on a refinance only over the life of the mortgage.)  On a mortgage for a property that you're purchasing, a no-point loan may help if you're cash poor at closing. 

Consider a no-point loan if you can't afford more out-of-pocket expenditures now or if you think that you'll keep the loan only a few years.  Shop around and compare different lenders' no-point loans. 

Finding a suitable adjustable-rate mortgage

Selecting an ARM has a lot in common with selecting a home to buy.  You need to make trade-offs and compromises.  In the following sections, I explain the numerous features and options — caps, indexes, margins, and adjustment periods — that you find with ARMs (these aren't issues with fixed-rate loans). 

Getting off to a good start rate

  Just as the name implies, your start rate is the rate that your adjustable mortgage begins with.  Think of the start rate as a teaser rate — the initial rate on ARMs is often set artificially low to entice you.  Don't judge an ARM by this rate alone.  You won't pay this attractively low rate for long.  With ARMs, interest rates generally rise as soon as the terms of the mortgage allow.  Even if the market level of interest rates doesn't change, your adjustable rate is destined to increase.  An increase of one or two percentage points is common. 

The formula for determining the rate caps and the future interest rates on an adjustable-rate mortgage (see the following section) are far more important in determining what a mortgage will cost you in the long run.  For more on rate caps, see the section "Analyzing adjustments," later in this chapter. 

Determining your future interest rate

The first thing you need to ask a mortgage lender or broker about an adjustable rate is the exact formula they use for determining the future interest rate on your particular loan.  You need to know how a lender figures your interest rate changes over the life of your loan.  All adjustables are based on the following general formula, which specifies how the interest rate is set on your loan in the future:

index + margin = interest rate

The index determines the base level of interest rates that the mortgage contract specifies in order to calculate the specific interest rate for your loan.  Indexes are generally (but not always) widely quoted in the financial press. 

For example, suppose that the current index value for a given loan is equal to the six-month treasury bill index, which is, say, 2 percent.  The margin is the amount added to the index to determine the interest rate that you pay on your mortgage.  Most loans have margins of around 2.5 percent.  Thus, the rate of a mortgage driven by the following formula

6-month Treasury bill rate + 2.5 percent

is set at 2 + 2.5 = 4.5 percent.  This figure is known as the fully indexed rate.  If the advertised start rate for this loan is just 3 percent, you know that if the index (six-month treasuries) stays at the same level, your loan will increase to 4.5 percent. 

  Compare the fully indexed rate to the current rate for fixed-rate loans.  During particular time periods, you may be surprised to discover that the fixed-rate loan is at about the same interest rate or even a tad lower.  This insight may cause you to reconsider your choice of an adjustable-rate loan, which can, of course, rise to an even higher rate in the future. 

Looking at common indexes for adjustable-rate mortgages

The different indexes vary mainly in how rapidly they respond to changes in interest rates.  Some common indexes include the following:

  Treasury bills: Treasury bills, which are often referred to as T-bills, are IOUs (bonds) that the U.S. government issues.  Most adjustables are tied to the interest rate on 6-month or 12-month T-bills.  T-bill interest rates move relatively quickly. 

  Certificates of deposit: Certificates of deposit, or CDs, are interest-bearing bank investments that lock you in for a specific period of time.  ARMs are usually tied to the average interest rate that banks are currently paying on six-month CDs.  Like T-bills, CDs tend to respond quickly to changes in the market's level of interest rates. 

  The 11th District cost of funds: The cost of funds index (COFI) is among the slower-moving indexes.  Adjustable-rate mortgages tied to the 11th District (a Western region of several states) cost of funds index tend to start out at a higher interest rate.  A slower-moving index has the advantage of moving up less quickly when rates are on the rise.  On the other hand, you have to be patient to benefit from falling interest rates. 

If you select an adjustable-rate mortgage that's tied to one of the faster-moving indexes, you take on more of a risk that the next adjustment may reflect interest rate increases.  Because you take on more of the risk that interest rates may increase, lenders cut you breaks in other ways, such as through lower caps or points.  If you want the security of an ARM tied to a slower-moving index, you pay for that security in one form or another, such as through a higher start rate, caps, margin, or points. 

  Trying to predict interest rates is risky business.  When selecting a mortgage, keeping sight of your own financial situation is far more important than trying to guess future interest rates. 

Analyzing adjustments

After the initial interest rate expires, the interest rate on an ARM fluctuates based on the loan formula that I discuss earlier in the chapter.  Most ARMs adjust every 6 or 12 months, but some may adjust as frequently as monthly.  In advance of each adjustment, the lender sends you a notice telling you your new rate. 

All things being equal, the less frequently your loan adjusts, the less financial uncertainty you have in your life.  However, less-frequent adjustments usually have a higher starting interest rate. 

Almost all adjustables come with an adjustment cap, which limits the maximum rate change (up or down) at each adjustment.  On most loans that adjust every six months, the adjustment cap is 1 percent.  In other words, the interest rate that the loan charges can move up or down no more than one percentage point in a given adjustment period. 

Loans that adjust more than once per year usually limit the maximum rate change that's allowed over the entire year as well.  On the vast majority of such loans, 2 percent is the annual rate cap.  Likewise, almost all adjustables come with lifetime caps.  These caps limit the highest rate allowed over the entire life of the loan.  It's common for adjustable loans to have lifetime caps 5 to 6 percent higher than the initial start rate. 

  Never take an ARM without rate caps!  Doing so is worse than giving a credit card with an unlimited line of credit to your teenager for the weekend — at least you get the credit card back on Monday!  When you want to take an ARM, you must identify the maximum payment that you can handle.  If you can't handle the highest allowed payment, don't look at ARMs. 

Avoiding negative amortization ARMs

  As you make mortgage payments over time, the loan balance you still owe is gradually reduced or amortized.  Negative amortization — increasing your loan balance — is the reverse of this process.  Some ARMs allow negative amortization.  How can your outstanding loan balance grow when you continue to make mortgage payments?  This phenomenon occurs when your mortgage payment is less than it really should be. 

Some loans cap the increase of your monthly payment but don't cap the interest rate.  Thus, the size of your mortgage payment may not reflect all the interest that you owe on your loan.  So rather than paying the interest that you owe and paying off some of your loan balance (or principal) every month, you end up paying off some, but not all, of the interest that you owe.  Thus, lenders add the extra, unpaid interest that you still owe to your outstanding debt. 

Negative amortization resembles paying only the minimum payment that your credit card bill requires.  You continue to rack up finance charges (in this case, greater interest) on the balance as long as you make only the artificially low payment.  Taking a loan with negative amortization defeats the whole purpose of borrowing an amount that fits your overall financial goals. 

  Avoid adjustables with negative amortization.  Most lenders and mortgage brokers aren't forthcoming about telling you, so the only way to know whether a loan includes negative amortization is to explicitly ask.  You find negative amortization more frequently on loans that lenders consider risky.  If you have trouble finding lenders that will deal with your financial situation, make sure you're especially careful. 

Examining other mortgage fees

  In addition to points and the ongoing interest rate, lenders tack on all sorts of other upfront charges when processing your loan.  Get an itemization of these other fees and charges in writing from all lenders that you're seriously considering. ( I explain how to find the best lenders for your needs in the next section.)  You need to know the total of all lender fees so you can accurately compare different lenders' loans and determine how much closing on your loan will cost you.  These other mortgage fees can pile up in a hurry.  Here are the common ones you may see:

  Application and processing fees: Most lenders charge a few hundred dollars to work with you to complete your paperwork and funnel it through their loan evaluation process.  If your loan is rejected, or if it's approved and you decide not to take it, the lender needs to cover its costs.  Some lenders return this fee to you upon closing with their loan. 

  Credit report charge: Most lenders charge you for the cost of obtaining your credit report, which tells the lender whether you've repaid other loans on time.  Credit report fees typically run about $20. 

  Appraisal fee: The property for which you borrow money needs to be valued.  If you default on your mortgage, a lender doesn't want to get stuck with a property that's worth less than you owe.  The cost for an appraisal typically ranges from several hundred dollars for most residential properties to as much as $1,000 or more for larger investment properties. 

Some lenders offer loans without points or other lender charges.  However, remember that if they don't charge points or other fees, they charge a higher interest rate on your loan to make up the difference.  Such loans may make sense for you when you lack the cash to close a loan or when you plan to keep the loan for just a few years. 

  To minimize your chances of throwing money away applying for a loan that you may not qualify for, ask the lender whether he sees any reason your loan request may be denied. ( Also consider getting pre-approved.)  Be sure to disclose any problems on your credit report or any problems with the property that you're aware of.  Lenders may not take the time to ask about these sorts of things in their haste to get you to complete their loan applications. 

Finding the best lenders

You can easily save thousands of dollars in interest charges and other fees if you shop around for a mortgage deal.  It doesn't matter whether you do so on your own or hire someone to help you, but you definitely should shop because a lot of money is at stake! 

Shopping through a mortgage broker

A competent mortgage broker can be a big help in getting you a good loan and closing the deal, especially if you're too busy or disinterested to dig for a good deal on a mortgage.  A good mortgage broker also stays abreast of the many different mortgages in the marketplace.  She can shop among lots of lenders to get you the best deal available.  The following list presents some additional advantages to working with a mortgage broker:

  An organized and detail-oriented mortgage broker can help you through the process of completing all those tedious documents that lenders require. 

  Mortgage brokers can help polish your loan package so the information you present is favorable yet truthful. 

  The best brokers can help educate you about various loan options and the pros and cons of available features. 

  Be careful when you choose a mortgage broker, because some brokers are lazy and don't shop the market for the best current rates.  Even worse, some brokers may direct their business to specific lenders so they can take a bigger cut or commission. 

  A mortgage broker typically gets paid a percentage, usually 0.5 to 1 percent, of the loan amount.  This commission is completely negotiable, especially on larger loans that are more lucrative.  So be sure to ask what the commission is on loans that a broker pitches.  Some brokers may be indignant that you ask — that's their problem.  You have every right to ask.  After all, it's your money. 

Even if you plan to shop on your own, talking to a mortgage broker may be worthwhile.  At the very least, you can compare what you find with what brokers say they can get for you.  But, again, be careful.  Some brokers tell you what you want to hear — that they can beat your best find — and then can't deliver when the time comes. 

If your loan broker quotes you a really good deal, ask who the lender is. ( However, do be aware that most brokers refuse to reveal this information until you pay the necessary fee to cover the appraisal and credit report.)  You can then check with the actual lender to verify the interest rate and points that the broker quotes you and make sure that you're eligible for the loan. 

Shopping by yourself

Many mortgage lenders compete for your business.  Although having a large number of lenders to choose from is good for keeping interest rates lower, it also makes shopping a chore, especially if you're going it alone (instead of using a broker).  But there's no substitute for taking the time to speak with numerous lenders and exploring the range of options. 

Real estate agents may refer you to lenders with whom they've done business.  Just keep in mind that those lenders won't necessarily offer the most competitive rates — the agent simply may have done business with them in the past or received client referrals from them. 

  You can start searching for a good deal by looking in the real estate section of a large, local Sunday newspaper for charts of selected area lender interest rates.  You also can visit Internet sites that advertise rates.  However, newspaper tables and Internet sites are by no means comprehensive or reflective of the best rates available.  In fact, many of these rates are sent to newspapers for free by firms that distribute mortgage information to mortgage brokers.  Use them as a starting point and then call the lenders that list the best rates. 

Refinancing for a better deal

When you buy a property, you take out a mortgage based on your circumstances and available loan options at that time.  But things change.  Maybe interest rates have dropped, or you have access to better loan options now than when you first purchased.  Or perhaps you want to tap into some of your real estate equity for other investments. 

If interest rates drop and you're able to refinance, you can lock in interest rate savings.  But getting a lower interest rate than the one you got when you took out your original mortgage isn't reason enough to refinance your mortgage.  When you refinance a mortgage, you have to spend money and time to save money.  So you need to crunch a few numbers to determine whether refinancing makes sense for you. 

  Calculate how many months it will take you to recoup the costs of refinancing, such as appraisal costs, loan fees and points, title insurance, and so on.  You also have to consider tax issues.  For example, if the refinance costs you $2,000 to complete and reduces your monthly payment by $100, it may appear that you can recoup the cost of the refinance in 20 months.  However, because you lose some tax write-offs if you reduce your mortgage interest rate and payment, you can't simply look at the reduced amount of your monthly payment. 

If you want a better estimate but don't want to spend hours crunching numbers, take your tax rate as specified in Chapter 3 (for example, 28 percent) and reduce your monthly payment savings on the refinance by this amount.  That means, continuing with the preceding example, that if your monthly payment drops by $100, you're actually saving only around $72 a month after you factor in the lost tax benefits.  So it takes about 28 months ($2,000 divided by $72), not 20 months, to recoup the refinance costs. 

  Consider refinancing when you can recover the costs of the refinance within a few years or less and you don't plan to move in that time frame.  If it takes longer to recoup the refinance costs, refinancing may still make sense if you anticipate keeping the property and mortgage that long.  If you estimate that breaking even will take more than five to seven years, refinancing is probably too risky to justify the costs and hassles. 

When to consider a home equity loan

Home equity loans, also known as second mortgages, allow you to borrow against the equity in your home in addition to the mortgage that you already have (a first mortgage). 

A home equity loan may benefit you if you need more money for just a few years or if your first mortgage is at such a low interest rate that refinancing it to get more cash would be too costly.  Otherwise, I advise you to avoid home equity loans. 

If you need a larger mortgage, why not refinance the first one and wrap it all together?  Home equity loans have higher interest rates than comparable first mortgages because they're riskier from a lender's perspective.  They're riskier because the first mortgage lender gets first claim against your property if you file bankruptcy or you default on the mortgage. 

Interest on home mortgage loans of up to $1 million (first or second residences) is tax-deductible for loans taken out after October 13, 1987. ( Loans taken before that date have no monetary limit.)  Interest deduction on home equity loans is limited to the first $100,000 of such debt. 

Refinancing a piece of real estate that you own to pull out cash for some other purpose can make good financial sense because under most circumstances, mortgage interest is tax-deductible.  Perhaps you want to purchase another piece of real estate, start or purchase a business, or get rid of an auto loan or some high-cost credit card debt.  The interest on consumer debt isn't tax-deductible and is usually at a much higher interest rate than what mortgage loans charge you. 

  Be careful that you don't borrow more than you need to accomplish your financial goals.  For example, just because you can borrow more against the equity in your real estate doesn't mean you should do so to buy an expensive new car or take your dream vacation. 

Working with Real Estate Agents

If you're like most people, when you purchase real estate, you enlist the services of a real estate agent.  A good agent can help screen property so you don't spend all your free time looking at potential properties, negotiating a deal, helping coordinate inspections, and managing other preclosing items. 

Recognizing agent conflicts of interest

All real estate agents (good, mediocre, and awful) are subject to a conflict of interest because of the way they're compensated — on commission.  I respect real estate agents for calling themselves what they are.  They don't hide behind an obscure job title, such as "shelter consultant." ( Many financial "planners," "advisors," or "consultants," for example, actually work on commission and sell investments and life insurance and, therefore, are really stockbrokers and insurance brokers, not planners or advisors.) 

Real estate agents aren't in the business of providing objective financial counsel.  Just as car dealers make their living selling cars, real estate agents make their living selling real estate.  Never forget this fact as a buyer. 

  The pursuit of a larger commission may encourage an agent to get you to do things that aren't in your best interest, such as the following:

  Buy, and buy sooner rather than later: If you don't buy, your agent doesn't get paid for all the hours she spends working with you.  The worst agents fib and use tricks to motivate you to buy.  They may say, for example, that other offers are coming in on a property that interests you, or they may show you a bunch of dumps and then one good listing to motivate you to buy the nicer property. 

  Spend more than you should: Because real estate agents get a percentage of the sales price of a property, they have a built-in incentive to encourage you to spend more on a property than what fits comfortably with your other financial objectives and goals.  An agent doesn't have to consider or care about your other financial needs. 

  Purchase their company's listings: Agents also have a built-in incentive (higher commission) to sell their own listings.  So don't be surprised when an agent pushes you in the direction of one of her own company's properties. 

  Buy in their territory: Real estate agents typically work a specific territory.  As a result, they usually can't objectively tell you the pros and cons of the surrounding region. 

  Use people who scratch their backs: Some agents refer you to mortgage brokers, lenders, inspectors, and title insurance companies that have referred customers to them.  Some agents also solicit and receive referral fees (or bribes) from mortgage lenders, inspectors, and contractors to whom they refer business. 

Picking out a good agent

A mediocre, incompetent, or greedy agent can be a real danger to your finances.  Whether you're hiring an agent to work with you as a buyer or as a seller, you want someone who's competent and with whom you can get along.  Working with an agent costs a good deal of money, so make sure you get your money's worth out of him. 

  Interview several agents and check references.  Ask agents for the names and phone numbers of at least three clients with whom they've worked in the past six months in the geographical area in which you're looking.  By narrowing the period during which they worked with these references, you maximize the chances of speaking with clients other than the agent's all-time-favorite clients. 

As you speak with an agent's references, ask about these traits in any agent that you're considering working with, whether as a buyer or as a seller:

  Full-time employment: Some agents work in real estate as a second or even third job.  Information in this field changes constantly, so keeping track of it is difficult enough on a full-time basis.  It's hard to imagine a good agent being able to stay on top of the market while moonlighting elsewhere. 

  Experience: Hiring someone with experience doesn't necessarily mean looking for an agent who's sold real estate for decades.  Many of the best agents come into the field from other occupations, such as business and teaching.  Agents can acquire some sales, marketing, negotiation, and communication skills in other fields.  However, keep in mind that some experience in real estate does count. 

  Honesty and integrity: You need to trust your agent with a lot of information.  If the agent doesn't level with you about what a neighborhood or particular property is really like, you suffer the consequences. 

  Interpersonal skills: An agent must get along not only with you but also with a whole host of other people who are involved in a typical real estate deal: other agents, property sellers, inspectors, mortgage lenders, and so on.  An agent needs to know how to put your interests first without upsetting others. 

  Negotiation skills: Putting a real estate deal together involves negotiation.  Is your agent going to exhaust all avenues to get you the best deal possible?  Most people don't like the sometimes aggravating process of negotiation, so they hire someone else to do it for them.  Be sure to ask the agent's former client references how the agent negotiated for them. 

  High quality standards: Sloppy work can lead to big legal or logistical problems down the road.  If an agent neglects to recommend an inspection, for example, you may get stuck with undiscovered problems after the deal is done and paid for. 

Agents who pitch themselves as buyers' brokers claim that they work for your interests.  However, agents who represent you as a buyer's broker still get paid only when you buy.  And agents still get paid a commission that's a percentage of the purchase price.  So they still have an incentive to sell you a piece of real estate that's more expensive because their commission increases. 

  Some agents market themselves as top producers, meaning that they sell a relatively larger volume of real estate.  This title doesn't matter much to you, the buyer.  In fact, you may use this information as a potential red flag for an agent who focuses on completing as many deals as possible.  Such an agent may not be able to give you the time and help that you need to get the house you want. 

When you buy a home, you need an agent who is patient and allows you the necessary time to educate yourself and who helps you make the decision that's best for you.  The last thing you need is an agent who tries to push you into making a deal. 

You also need an agent who's knowledgeable about the local market and community.  If you want to buy a home in an area where you don't currently live, an informed agent can have a big impact on your decision. 

  Finding an agent with financing knowledge is a plus for buyers, especially first-time buyers or those with credit problems.  Such an agent may be able to refer you to lenders that can handle your type of situation, which can save you a lot of legwork. 

Buying without a real estate agent

You can purchase property without an agent if you're willing to do some additional legwork.  You need to do the things that a high-quality real estate agent does, such as searching for properties, scheduling appointments to see those properties, determining fair market value, negotiating the deal, and coordinating inspections. 

If you don't work with an agent, have a real estate attorney review the various contracts.  Having someone else not vested in the transaction look out for your interests helps your situation.  Real estate agents generally aren't legal experts, so getting legal advice from an attorney is generally better. ( In fact, in some states, you need to hire an attorney in addition to the real estate agent.) 

One possible drawback to working without an agent is performing the negotiations yourself.  Negotiating can be problematic if you lack these skills or get too caught up emotionally in the situation. 

Closing the Deal

After you locate a property that you want to buy and you understand your financing options, the real fun begins.  At this point, you have to put the deal together.  The following sections discuss key things to keep in mind. 

Negotiating 101

When you work with an agent, she usually carries the burden of the negotiation process.  But even if you delegate that responsibility to your agent, you still should have a strategy in mind.  Otherwise, you may overpay for real estate.  Here's what you should do:

  Find out about the property and the owner before you make your offer.  How long has the property been on the market?  What are its flaws?  Why is the owner selling?  The more you understand about the property you want to buy and the seller's motivations, the better your ability to draft an offer that meets everyone's needs.  Some listing agents love to talk and will tell you the life history of the seller.  Either you or your agent may be able to get a listing agent to reveal helpful information about the seller. 

  Bring facts to the bargaining table.  Get comparable sales data to support your price.  Too often, homebuyers and their agents pick a number out of the air when they make an offer.  If you were the seller, would you be persuaded to lower your asking price?  Pointing to recent and comparable home sales to justify your offer price strengthens your case. 

  Price is only one of several negotiable items.  Sometimes sellers fixate on selling their homes for a certain amount.  Perhaps they want to get at least what they paid for it several years ago.  You may get a seller to pay for certain repairs or improvements or to offer you an attractive loan without all the extra fees that a bank charges.  Also, be aware that the time for closing on the purchase is a bargaining point.  Some sellers may need cash fast and may concede other terms if you can close quickly.  Likewise, the real estate agent's commission is negotiable. 

  Try to leave your emotions out of any property purchase.  Being objective rather than emotional regarding a purchase is easier said than done, and it's hardest to do when buying a home in which you'll live.  So do your best not to fall in love with a property.  Keep searching for other properties even when you make an offer because you may be negotiating with an unmotivated seller. 

Inspecting the property

Unless you've built homes and other properties and performed contracting work yourself, you probably have no idea what you're getting yourself into when it comes to furnaces and termites. 

  Spend the money and take the time to hire inspectors and other experts to evaluate the major systems and potential problem areas of the home.  Because you can't be certain of the seller's commitment, I recommend that you do the inspections after you've successfully negotiated and signed a sales contract.  Even though you won't have the feedback from the inspections to help with this round of negotiating, you can always go back to the seller with the new information.  Make your purchase offer contingent on a satisfactory inspection. 

Hire people to help you inspect the following features of the property:

  Overall condition of the property (for example, look for peeling paint, level floors, appliances that work properly, and so on)

  Electrical, heating and air conditioning, and plumbing systems

  Foundation

  Roof

  Pest control and dry rot

  Seismic/slide/flood risk

With multiunit rental property, be sure to read Chapter 11 for other specifics that you need to check out, such as parking. 

Inspection fees often pay for themselves.  If you uncover problems that you weren't aware of when you negotiated the original purchase price, the inspection reports give you the information you need to go back and ask the property seller to fix the problems or reduce the property's purchase price. 

  Never accept a seller's inspection report as your only source of information.  When a seller hires an inspector, he may hire someone who isn't as diligent and critical of the property.  Review the seller's inspection reports if available, but also get your own evaluation.  Also, beware of inspectors who are popular with real estate agents.  They may be popular because they don't bother to document all the property's problems. 

As with other professionals whose services you retain, interview a few different inspection companies.  Ask which systems they inspect and how detailed a report they can prepare for you.  Consider asking the company that you're thinking of hiring for customer references.  Ask for names and phone numbers of three people who used the company's services within the past six months.  Also request from each inspection company a sample of one of its reports. 

  The day before you close on the purchase, take a brief walk-through of the property to make sure that everything is still in the condition it was before and that all the fixtures, appliances, curtains, and other items the contract lists are still there.  Sometimes, sellers ignore or don't recall these things, and consequently, they don't leave what they agreed to leave in the sales contract. 

Shopping for title insurance and escrow services

Mortgage lenders require title insurance to protect against someone else claiming legal title to your property.  For example, when a husband and wife split up, the one who remains in the home may decide to sell and take off with the money.  If the title lists both spouses as owners, the spouse who sells the property (possibly by forging the other's signature) has no legal right to do so.  The other spouse can come back and reclaim rights to the home even after it has been sold.  In this event, both you and the lender can get stuck holding the bag. ( If you're in the enviable position of paying cash for a property, buying title insurance is still wise to protect your investment, even though a mortgage lender won't prod you to do so.) 

  Title insurance and escrow charges vary from company to company. ( Escrow charges pay for neutral third-party services to ensure that the instructions of the purchase contract or refinance are fulfilled and that everyone gets paid.)  Don't simply use the company that your real estate agent or mortgage lender suggests — shop around.  When you call around for title insurance and escrow fee quotes, make sure that you understand all the fees.  Many companies tack on all sorts of charges for things such as courier fees and express mail.  If you find a company with lower prices and want to use it, consider asking for an itemization in writing so you don't receive any unpleasant surprises. 

An insurance company's ability to pay claims is always important.  Most state insurance departments monitor and regulate title insurance companies.  Title insurers rarely fail, and most state departments of insurance do a good job of shutting down financially unstable ones.  Check with your state's department if you're concerned.  You can also ask the title insurer for copies of its ratings from insurance-rating agencies. 

Selling Real Estate

Buying and holding real estate for the long term really pays off.  If you do your homework, buy in a good area, and work hard to find a fairly priced or underpriced property, why sell it quickly and incur all the selling costs, time, and hassle to locate and negotiate another property to purchase (and a seller to buy your current property)? 

  Some real estate investors like to buy properties in need of improvement, fix them up, and then sell them and move on to another.  Unless you're a contractor or experienced real estate investor and have a real eye for this type of work, don't expect to make a windfall or even to earn back more than the cost of the improvements.  The process of buying, fixing, and flipping can be profitable, but it's not as easy as the home-improvement television shows and some books would have you believe.  In fact, it's more likely that you'll erode your profit through the myriad costs of frequent buying and selling.  The vast majority of your profits should come from the long-term appreciation of the overall real estate market in the communities in which you own property. 

Use the reasons that you bought in an area as a guide if you think you want to sell.  Use the criteria that I discuss in Chapter 11 as a guideline.  For example, if the schools in the community are deteriorating and the planning department is allowing development that will hurt the value of your property and the rents that you can charge, you may have cause to sell.  Unless you see significant problems like these in the future, holding good properties over many years is a great way to build your wealth and minimize transaction costs. 

Negotiating real estate agents' contracts

Most people use an agent to sell real estate.  As I discuss in "Picking out a good agent," earlier in this chapter, selling and buying a home demand agents with different strengths.  When you sell a property, you want an agent who can get the job done efficiently and for as high a sales price as possible. 

  As a seller, seek agents who have marketing and sales expertise and who are willing to put in the time and money necessary to sell your house.  Don't be impressed by an agent just because she works for a large company.  What matters more is what the agent can do to market your property. 

When you list a property for sale, the contract that you sign with the listing agent includes specification of the commission that you pay the agent if she succeeds in selling your property.  In most areas of the country, agents usually ask for a 6 percent commission for single-family homes.  In an area that maintains lower-cost housing, agents may ask for 7 percent.  For small multifamily properties and commercial properties, commissions often hover around the 3 to 5 percent range. 

  Regardless of the commission an agent says is "typical," "standard," or "what my manager requires," always remember that you can negotiate commissions.  Because the commission is a percentage, you have a much greater ability to get a lower commission on a higher-priced property.  If an agent makes 6 percent selling both a $200,000 and a $100,000 property, the agent makes twice as much on the $200,000 property.  Yet selling the higher-priced property doesn't usually take twice as much work. 

If you live in an area with generally higher-priced properties, you may be able to negotiate a 5 percent commission.  For really expensive properties, a 4 percent commission is reasonable.  You may find, however, that your ability to negotiate a lower commission is greatest when an offer is on the table.  Because of the cooperation of agents who work together through the multiple listing service (MLS), if you list your real estate for sale at a lower commission than most other properties, some agents won't show it to prospective buyers.  For this reason, you're better off having your listing agent cut his take instead of cutting the commission that you pay to a real estate agent who brings a buyer for your property. 

  In terms of the length of the listing agreement, three months is reasonable.  If you give an agent too long to list your property (6 to 12 months), the agent may simply toss your listing into the multiple listing database and not expend much effort to get your property sold.  Practically speaking, you can fire your agent whenever you want, regardless of the length of the listing agreement, but a shorter listing may motivate your agent more. 

Forgoing a real estate agent

The temptation to sell real estate without an agent is usually to save the commission that an agent deducts from your property's sale price.  If you have the time, energy, and marketing experience, you can sell sans agent and possibly save some money. 

  The major problem with attempting to sell real estate on your own is that you can't list it in the MLS, which, in most areas, only real estate agents can access.  If you're not listed in the MLS, many potential buyers never know that your home is for sale.  Agents who work with buyers don't generally look for or show their clients properties that are for sale by owner or listed with discount brokers. 

Besides saving you time, a good agent can help ensure that you're not sued for failing to disclose known defects of your property.  If you decide to sell on your own, contact a local real estate legal advisor who can review the contracts.  Take the time to educate yourself about the many facets of selling property for top dollar.  Read the latest edition of House Selling For Dummies, which I coauthored with Ray Brown (published by John Wiley & Sons, Inc.). 
Part IV

Savoring Small Business

In this part . . . 

Although the businesses may be small, the potential for earning profits and finding a fulfilling career isn't.  In this part's chapters, I explain such things as how to develop a business plan, identify marketable products or services, find customers, and wallop the competition!  If starting your own shop seems either too overwhelming or too uninspiring, you also find out how to buy an existing business. 
Chapter 13

Assessing Your Appetite for Small Business

In This Chapter

  Knowing what it takes to be a successful entrepreneur

  Exploring alternatives to starting your own company

  Looking at small-business investment options

  Mapping out your small-business plans

Many people dream about running their own companies, and for good reason.  If you start your own business, you can pursue something that you're passionate about, and you have more control over how you do things.  Plus, successful business owners can reap major economic bounties. 

  But tales of entrepreneurs becoming multimillionaires focus attention on the financial rewards without revealing the business and personal challenges and costs associated with being in charge.  Consider what your company has to do well to survive and succeed in the competitive business world:

  Develop products and services that customers will purchase

  Price your offerings properly and promote them

  Deal with the competition

  Manage the accounting

  Interpret lease contracts and evaluate office space

  Stay current with changes in your field

  Hire, train, and retain good employees

Business owners also face personal and emotional challenges, which rarely get airtime among all the glory of the rags-to-riches tales of multimillionaire entrepreneurs.  Major health problems, divorces, fights and lawsuits among family members who are in business together, the loss of friends, and even suicides have been attributed to the passions of business owners who are consumed with winning or become overwhelmed by their failures.  I'm not trying to scare you, but I do want you to be realistic about starting your own business. 

In this chapter, I help you to assess whether starting a company fits with your goals and aptitude.  I also present numerous alternatives that may better fit you and your situation. 

Testing Your Entrepreneurial IQ

The keys to success and enjoyment as an entrepreneur vary as much as the businesses do.  But if you can answer yes to most of the following questions, you probably have the qualities and perspective needed to succeed as a small-business owner:

1.  Are you a self-starter?  Do you like challenges?  Are you persistent?  Are you willing to do research to solve problems? 

Most of the time, running your own business isn't glamorous, especially in the early years.  You have many details to remember and many things to do.  Success in business is the result of doing lots of little things well.  If you're accustomed to working for large organizations where much of the day is spent attending meetings and keeping up on office politics and gossip, with little accountability, running your own business may come as a bit of a shock at first. 

2.  Do you value independence and self-control? 

Particularly in the early days of your business, you need to enjoy working on your own.  When you leave a company environment and work on your own, you give up a lot of socializing.  Of course, if you work in an unpleasant environment or with people you don't really enjoy socializing with, venturing out on your own may be a plus. 

  If you're a people person, many businesses offer lots of contact.  But you must recognize the difference between socializing for fun with co-workers versus the often more demanding and goal-oriented networking with business contacts and customers. 

3.  Can you develop a commitment to an idea, a product, or a principle? 

If you work about 50 hours per week over 50 or so weeks per year, you'll work around 2,500 hours per year.  If the product, service, or cause you're pursuing doesn't excite you and you can't motivate others to work hard for you, you're going to have a long year! 

  One of the worst reasons to start your own business is for the pursuit of great financial riches.  Don't get me wrong — if you're good at what you do and you know how to market your services or products, you may make more money working for yourself.  But for most people, money isn't enough of a motivation, and many people make the same or less money on their own than they did working for a company. 

4.  Are you willing to make financial sacrifices and live a reduced lifestyle before and during your early entrepreneurial years? 

"Live like a student, before and during the start-up of your small business" was the advice that my best business school professor, James Collins, gave me before I started my business.  With most businesses, you expend money during the start-up years and likely have a reduced income compared to the income you receive while working for a company.  You also have to buy your own benefits. 

  To make your entrepreneurial dream a reality, you need to live within your means both before and after you start your business.  But if running your own business really makes you happy, sacrificing expensive vacations, overpriced luxury cars, the latest designer clothing, and $4 lattes at the corner cafe shouldn't be too painful. 

5.  Do you recognize that when you run your own business, you must still report to bosses? 

Besides the allure of huge profits, the other reason some people mistakenly go into business for themselves is that they're tired of working for other people.  Obnoxious, evil bosses can make anyone want to become an entrepreneur. 

When you run your own business, you may have customers and other people to please who are miserable to deal with.  Fortunately, even the worst customers usually can't make your life anywhere near as miserable as the worst bosses. ( And, if you have enough customers, you can simply decide not to do business with such misfits.) 

6.  Can you withstand rejection, naysayers, and negative feedback? 

"I thought every no that I got when trying to raise my funding brought me one step closer to a yes," says Alex Popov, an entrepreneur I once met.  Unless you come from an entrepreneurial family, don't expect your parents to endorse your "risky, crazy" behavior.  Even other entrepreneurs can ridicule your good ideas.  Two of my entrepreneurial friends were critical of each other's ideas, yet both have succeeded!  Some people (especially parents) simply think that working for a giant company makes you safer and more secure (which, of course, is a myth, because corporations can lay you off in a snap).  It's also easier for them to say to their friends and neighbors that you're a big manager at a well-known corporation (such as IBM, GE, Enron, or WorldCom) than to explain that you're working on some kooky business idea out of a spare bedroom. ( How secure do you think those former employees of Enron and WorldCom feel now about having lost their jobs at their former large company?) 

7.  Are you able to identify your shortcomings and hire or align yourself with people and organizations that complement your skills and expertise? 

To be a successful entrepreneur, you need to be a bit of a jack-of-all-trades: marketer, accountant, customer service representative, administrative assistant, and so on.  Unless you get lots of investor capital, which is rare for a true start-up, you can't afford to hire help in the early months, or perhaps even years, of your business. 

  Partnering with or buying certain services or products rather than trying to do everything yourself may make sense for you.  And over time, if your business grows and succeeds, you should be able to afford to hire more help.  If you can be honest with yourself and surround and partner yourself with people whose skills and expertise complement yours, you can build a winning team! 

8.  Do you deal well with ambiguity?  Do you believe in yourself? 

When you're on your own, determining whether you're on the right track is difficult.  Some days, things don't go well — and such days are much harder to take flying solo.  Therefore, being confident, optimistic, and able to work around obstacles are necessary skills. 

9.  Do you understand why you started the business or organization and how you personally define success? 

Many business entrepreneurs define success by such measures as sales revenue, profits, number of branch offices and employees, and so on.  These are fine measures, but other organizations, particularly nonprofits, have other measures.  For example, the Jacksonville, Florida–based nonpartisan Wounded Warrior Project was founded by a ". . .  group of veterans and friends who took action to help the injured service men and women of this generation." 

Money is necessary for the Wounded Warrior Project to accomplish its purpose, but such a cause-focused organization has a "bottom line" that's very different from a for-profit organization. 

10.  Can you accept lack of success in the early years of building your business? 

A few rare businesses are instant hits, but most businesses take time to build momentum — it may take years, perhaps even decades.  Some successful corporate people suffer from anxiety when they go out on their own and encounter the inevitable struggles and lack of tangible success as they build their companies. 

  Don't be deterred by the questions that you can't answer in the affirmative.  A perfect entrepreneur doesn't exist.  Part of succeeding in business is knowing what you can and can't do and then finding creative ways (or people) to help you achieve your goals. 

Myths of being an entrepreneur

Many myths persist about what it takes to be an entrepreneur, partly because those who aren't entrepreneurs tend to hang out with others who aren't.  The mass media's popularization of "successful" entrepreneurs such as Bill Gates, Donald Trump, and Oprah Winfrey leads to numerous misperceptions and misconceptions, including these often-cited nuggets:

  You have to be well-connected or know "important" people.  I think that being a decent human being is far more important.  Enough rude, inconsiderate, and self-centered people are in the business world (and, yes, some of them do succeed in spite of their character flaws), and if you're not that way, you'll be able to meet people who can help you in one way or another.  But remember that looking in the mirror shows you your best and most trusted resource. 

  You need to have an MBA or some other fancy degree.  Many successful entrepreneurs — Bill Gates and Steve Jobs, for example — don't even have the most basic college degrees.  Perusing Forbes magazine's lists of the most financially successful small companies shows that about 15 percent of the CEOs didn't earn a college degree and about half don't have advanced degrees!  These statistics are even more amazing when you consider that a relatively large number of entrepreneurs with humble backgrounds leave or are forced out of the successful enterprises they started. 

I'm not saying that a good education isn't worthwhile in general and that it can't help you succeed in your own business. ( For example, Ivy Leaguers run about 6 percent of the 200 best small businesses, yet Ivy League college grads make up less than 1 percent of all graduates.)  What I am saying is that a formal education isn't necessary. 

  You need to be a genius.  Intelligence is admittedly a difficult thing to measure, but the majority of entrepreneurs have IQs under 120, and a surprising percentage have IQs under the average of 100.  In fact, more entrepreneurs have IQs under 100 than have IQs greater than 130! 

  You must be a gregarious, big-egoed extrovert.  Although some studies show that more entrepreneurs are extroverted, many entrepreneurs are not. 

  You have to be willing to take a huge risk.  Some people focus on the potential for failure.  But, consider the worst-case scenario: If your venture doesn't work out, you can probably go back to a job similar to the one you left behind (although you've lost some income in the interim).  Also, recognize that risk is a matter of perception, and as with investments, people completely overlook some risks.  What about the risk to your happiness and career if you stay in a boring, claw-your-way-up-the-corporate-ladder kind of job?  You also risk a layoff when you work for a company.  An even greater risk is that you'll wake up in your 50s and 60s and think that it's too late to do something on your own and wish you had tried sooner. 

Considering Alternative Routes to Owning a Small Business

Sometimes entrepreneurial advocates imply that running your own business or starting your own nonprofit is the greatest thing in the world and that all people would be happy owning their own businesses if they just set their minds to it. 

  The reality is that some people won't be blissful as entrepreneurs.  If you didn't score highly on my ten-question entrepreneur assessment in the preceding section, don't despair.  You can probably be happier and more successful doing something other than starting your own business.  Some people are better off working for someone else.  If you're one of these people, consider the options in the following sections. 

Being an entrepreneur inside a company

A happy medium is available for people who want the challenge of running their own show without giving up the comforts and security that come with a company environment.  For example, you can manage an entrepreneurial venture at a company.  That's what John Kilcullen, president and chief executive officer of IDG Books Worldwide (former publisher of this book), did when he helped launch the book publishing division of IDG in 1990. ( IDG Books was subsequently bought by John Wiley & Sons, Inc., in 2001.) 

Kilcullen had publishing industry experience and wanted to take on the responsibility of growing a successful publishing company.  But he also knew that being a player in the book publishing industry takes a lot of money and resources.  Because he was a member of the founding team of the new IDG Books division, Kilcullen had the best of both worlds. 

Kilcullen always had a passion to start his own business but found that most traditional publishers weren't interested in giving autonomy and money to a division and letting it run with the ball. " I wanted the ability to build a business on my own instincts . . .  the appeal of IDG was that it was decentralized.  IDG was willing to invest and provide the freedom to spend as we saw fit." 

If you're able to secure an entrepreneurial position inside a larger company, in addition to significant managerial and operational responsibility, you can also negotiate your share of the financial success that you help create.  The parent company's senior management wants you to have the incentive that comes from sharing in the financial success of your endeavors.  Bonuses, stock options, and the like are often tied to a division's performance. 

Investing in your career

Some people are happy or content as employees.  Companies need and want lots of good employees, so you should be able to find a job if you have skills, a solid work ethic, and the ability to get along with others. 

  You can improve your income-earning ability and invest in your career in a variety of ways:

  Work: Be willing to work extra hours and take on more responsibility.  Those who take extra initiative and then deliver really stand out in a company where many people working on a salary have a time-clock, 9-to-5 mentality.  But be careful that the extra effort doesn't contribute to workaholism, a dangerous addiction that causes too many people to neglect important personal relationships and their own health.  Don't bite off more than you can chew; otherwise, your supervisors won't have faith that they can count on you to deliver.  Find ways to work smarter, not just longer, hours. 

  Read: One of the reasons you don't need a PhD, master's degree, or even an undergraduate college degree from a top college to succeed in business is that you can find out a lot on your own.  You can gain insight by doing, but you can also gain expertise by reading a lot.  A good bookstore has no entrance requirements, such as an elevated high school grade point average or high SAT scores — you only have to walk through the doors.  A good book isn't free, but it costs a heck of lot less than taking college or graduate courses! 

  Study: If you haven't completed your college or graduate degree and the industry you're in values those who have, consider investing the time and money to finish your education.  Speak with others who have taken that path and see what they have to say. 

Exploring Small-Business Investment Options

Only your imagination limits the ways you can make money with small businesses.  Choosing the option that best meets your needs isn't unlike choosing other investments, such as in real estate (see Part III) or in the securities markets (see Part II).  In the following sections, I discuss the major ways you can invest in small business, including what's attractive and not about each option. 

Starting your own business

Of all your small-business options, starting your own business involves the greatest amount of work.  Although you can perform this work on a part-time basis in the beginning, most people end up working in their business full time. 

For most of my working years, I've run my own business, and overall, I really like it.  In my experience counseling small-business owners, I've seen many people of varied backgrounds, interests, and skills achieve success and happiness running their own businesses. 

  Most people perceive starting their own business as the riskiest of all small-business investment options.  But if you get into a business that uses your skills and expertise, the risk isn't nearly as great as you may think.  Suppose, for example, that as a teacher you make $35,000 per year, and now you decide you want to set up your own tutoring service, making a comparable amount of money.  If you find through your research that others who perform these services charge $40 per hour, you need to tutor about 20 or so hours per week, assuming that you work 50 weeks per year.  Because you can run this business from your home (which can possibly generate small tax breaks) without purchasing new equipment, your expenses should be minimal. 

Instead of leaving your job cold turkey and trying to build your business from scratch, you can start moonlighting as a tutor.  Over a couple of years, if you can build the tutoring up to ten hours per week, you're halfway to your goal.  If you leave your job and focus all your energies on your tutoring business, getting to 20 hours per week of billable work shouldn't be a problem.  Still think starting a business is risky? 

  You can start many businesses with little money by leveraging your existing skills and expertise.  If you have the time to devote to building "sweat equity," you can build a valuable company and job.  As long as you check out the competition and offer a valued product or service at a reasonable cost, the principal risk with your business is that you won't do a good job marketing what you have to offer.  If you can market your skills, you should succeed.  See Chapter 14 for more details on starting and running your own business. 

Don't start a business for tax write-offs

"Start a small business for fun, profit, and huge tax deductions," a financial advice book declares, adding that "the tax benefits alone are worth starting a small business."  A seminar company offers a course titled "How to Have Zero Taxes Deducted from Your Paycheck."  This tax seminar tells you how to solve your tax problems: "If you have a sideline business, or would like to start one, you're eligible to have little or no taxes taken from your pay." 

All this sounds too good to be true — and of course it is.  Not only are the strategies sure to lead to IRS-audit purgatory, but such books and seminars may also seduce you to pony up $100 or more for audiotapes or notebooks of "inside information." 

Unfortunately, many self-proclaimed self-help gurus state that you can slash your taxes simply by finding a product or service that you can sell on the side of your regular employment.  The problem, they argue, is that as a regular wage earner who receives a paycheck from an employer, you can't write off many of your other (personal) expenses.  Open a sideline business, they say, and you can deduct your personal expenses as business expenses. 

The pitch is enticing, but the reality is something quite different.  You have to spend money to get tax deductions, and the spending must be for legitimate purposes of your business in its efforts to generate income.  If you think that taking tax deductions as a hobby is worth the risk because you won't get caught unless you're audited, the odds are stacked against you.  The IRS audits an extraordinarily large portion of small businesses that show regular losses. 

The bottom line is that you need to operate a real business for the purpose of generating income and profits, not tax deductions.  The IRS considers an activity a hobby (and not a business) if it shows a loss for three or more of the preceding five tax years. ( Exception: The IRS considers horse racing and breeding a hobby if it shows a loss for at least six of the preceding seven tax years.)  Some years, a certain number of businesses lose money, but a real business can't afford to do so year after year and remain in operation.  Even if your sideline business passes this hobby test, as well as other IRS requirements, deducting any expenses that aren't directly applicable to your business is illegal. 

If these loss rules indicate that you're engaging in a hobby but you still want to claim your losses, you must convince the IRS that you're seriously trying to make a profit and run a legitimate business.  The IRS wants to see that you're actively marketing your services, building your skills, and accounting for income and expenses.  The IRS also wants to see that you don't derive too much pleasure from an activity.  If you do, the IRS says that what you're doing is a hobby and not a business.  Business isn't supposed to give you too much enjoyment! 

Buying an existing business

If you don't have a specific idea for a business that you want to start but you have business management skills and an ability to improve existing businesses, consider buying an established business.  Although you don't have to go through the riskier start-up period if you take this route, you'll likely need more capital to buy a going enterprise. 

You also need to be able to deal with potentially sticky personnel and management issues.  The history of the organization and the way things work predates your ownership of the business.  If you don't like making hard decisions, firing people who don't fit with your plans, and coercing people into changing the way they did things before you arrived on the scene, buying an existing business likely isn't for you.  Also realize that some of the good employees may be loyal to the old owner and his style of running the business, so they may split when you arrive. 

  Some people perceive that buying an existing business is safer than starting a new one, but buying someone else's business can actually be riskier.  You have to put out far more money upfront, in the form of a down payment, to buy a business.  And if you don't have the ability to run the business and it does poorly, you may lose much more financially.  Another risk is that the business may be for sale for a reason — perhaps it's not very profitable, it's in decline, or it's generally a pain in the posterior to operate. 

Good businesses that are for sale don't come cheaply.  If the business is a success, the current owner has removed the start-up risk from the business, so the price of the business should include a premium to reflect this lack of risk.  If you have the capital to buy an established business and the skills to run it, consider going this route.  Chapter 15 discusses how to buy a good business. 

Investing in someone else's business

If you like the idea of profiting from successful small businesses but don't want the day-to-day headaches of being responsible for managing the enterprise, you may want to invest in someone else's small business.  Although this route may seem easier, fewer people are actually cut out to be investors in other people's businesses. 

Choosing to invest for the right reasons

Consider investing in someone else's business if you meet the following criteria:

  You have sufficient assets.  You need enough assets so that what you invest in small privately held companies is a small portion (20 percent or less) of your total financial assets. 

  You can afford to lose what you invest.  Unlike investing in a diversified stock mutual fund (see Chapter 8), you may lose all of your investment when you invest in a small, privately held company. 

  You're astute at evaluating financial statements and business strategies.  Investing in a small, privately held company has much in common with investing in a publicly traded firm.  A main difference is that private firms aren't required to produce comprehensive, audited financial statements that adhere to certain accounting principles the way that public companies are.  Thus, you have a greater risk of not receiving sufficient or accurate information when you evaluate a small private firm. ( There are also liquidity differences; with a small, private company, you may not be able to sell out when you want and at a fair current price.) 

Putting money into your own business (or someone else's) can be a high-risk — but potentially high-return — investment.  The best options are those that you understand well.  If you hear about a great business idea or company from someone you know and trust, do your research and make your best judgment.  That company or idea may be a terrific investment. 

  Before you invest, ask to see a copy of the business plan and compare it with the business plan model that I suggest later in this chapter.  Thoroughly check out the people running the business.  Talk to others who don't have a stake in the investment; you can benefit from their comments and concerns.  But don't forget that many a wise person has rained on the parade of what turned out to be a terrific business idea.  See the sidebar in this chapter "Wet blankets throughout history" for some amusing rejections that turned out to be huge mistakes. 

Avoiding investing mistakes

  Although some people are extra careful when they invest other people's money, others aren't.  For example, many small-business owners seek investors' money for the wrong reasons, including the following:

  They are impatient and perhaps don't understand the feasibility of making do with a small amount of capital (a process called bootstrapping, which I discuss in Chapter 14). 

  They need money because they're in financial trouble.  One small furniture retailer in my area conducted a stock offering to raise money.  On the surface, everything seemed fine, and the company made it onto the Inc. 500 list of fast-growing small companies.  But it turns out that the company wanted to issue stock because it expanded too quickly and didn't sell enough merchandise to cover its high overhead.  The company ended up in bankruptcy. 

Here's another problem with small businesses that seek investors: Many small-business owners take more risk and do less upfront planning and homework with other people's money.  In fact, many well-intentioned people fail at their businesses. 

An MBA I know from a top business school — I'll call him Jacob — convinced an investor to put up about $300,000 to purchase a small manufacturing company.  Jacob put a small amount of his own money into the business and immediately blew about $100,000 on a fancy computer-scheduling and order-entry system.  Jacob wasn't interested much in sales (a job that the previous owner managed), so he also hired a sales manager.  The sales manager he hired was a disaster — many of the front-line salespeople fled to competitors, taking key customers with them.  He tried to cut costs, but doing so hurt the quality and timeliness of the company's products.  By the time Jacob came to his senses, it was too late.  The business dissolved, and the investor lost everything. 

Drawing Up Your Business Plan

If you're motivated to start your own business, the next step is to figure out what you want to do and how you're going to do it.  In other words, you need a business plan.  You need a general plan that helps you define what you think you want to do and the tasks that you need to perform to accomplish your goal.  The business plan — which you use to plan your goals, obtain loans, and show potential investors — should be a working document or blueprint for the early days, months, and years of your business. 

You don't need a perfectly detailed plan that spells out all the minutiae.  Making such an involved plan is a waste of your time because things change and evolve.  The amount of detail that your plan needs depends on your goals and the specifics of your business.  A simple, more short-term focused plan (ten pages or so) is fine if you don't aspire to build an empire.  However, if your goal is to grow, hire employees, and open multiple locations, your plan needs to be longer (20 to 50 pages) to cover longer-term issues.  If you want to pick up outside investor money, a longer business plan is a necessity. 

  As you put together your plan and evaluate your opportunities, open your ears and eyes.  Expect to do research and speak with other entrepreneurs and people in the industry.  Most folks will spend time talking with you as long as they realize that you don't want to compete with them.  For more details on crafting a business plan, check out the latest edition of my book Small Business For Dummies, written with Jim Schell and published by John Wiley & Sons, Inc.

Identifying your business concept

What do you want your business to do?  What product or service do you want to offer?  Maybe, for example, your business goal is to perform tax-preparation services for small-business owners.  Or perhaps you want to start a consulting firm, open a restaurant that sells healthy fast-food, run a gardening service, or design and manufacture toys. 

  Your concept doesn't need to be unique to survive in the business world.  Consider the legions of self-employed consultants, plumbers, tax preparers, and restaurant owners.  The existence of many other people who already do what you want to do validates the potential for your small-business ideas.  I know many wage slaves who say they would love to run their own business if they could only come up with "the idea."  Most of these people still dream about their small-business plans as they draw their Social Security checks.  Being committed to the idea of running your own business is more important than developing the next great product or service.  In the beginning, the business opportunities that you pursue can be quite general to your field of expertise or interest.  What you eventually do over time will evolve. 

I'm not saying that an innovative idea lacks merit.  Indeed, a creative idea gives you the chance to hit a big home run, and being the first person to successfully develop a new idea can help you achieve big success. 

Even if you aspire to build the next billion-dollar company, you can put a twist on older concepts.  Suppose that you're a veterinarian, but you don't want a traditional office where people must bring their cats and dogs for treatment.  You believe that because many people are starved for free time or have pets that despise a trip to the vet's office, they want a vet who makes house calls.  Thus, you open your Vet on Wheels business.  You may also want to franchise the business and open locations around the country.  However, you can also succeed by doing what thousands of other vets are now doing and have done over the years with a traditional office. 

Outlining your objectives

The reasons for starting and running your own small business are as varied as the entrepreneurs behind their companies.  Before you start your firm, it's useful to think about your objectives, or what you're seeking to achieve.  Your objectives need not be cast in concrete and will surely change over time.  If you like, you can write a short and motivating mission statement. 

Wet blankets throughout history

"This 'telephone' has too many shortcomings to be seriously considered as a means of communication.  The device is inherently of no value to us." —  Western Union internal memo in response to Alexander Graham Bell's telephone, 1876. 

"The concept is interesting and well formed, but in order to earn better than a C, the idea must be feasible." —  A Yale University management professor in response to Fred Smith's paper proposing reliable overnight delivery service.  Smith went on to found Federal Express Corporation. 

"We don't tell you how to coach, so don't tell us how to make shoes." —  A large sporting shoe manufacturer to Bill Bowerman, inventor of the waffle shoe and cofounder of NIKE, Inc.

"So we went to Atari and said, 'Hey, we've got this amazing thing, even built with some of your parts, and what do you think about funding us?  Or we'll give it to you.  We just want to do it.  Pay our salary, we'll come work for you.'  And they said, 'No.'  So then we went to Hewlett-Packard, and they said, 'Hey, we don't need you.  You haven't got through college yet.'" —  Steve Jobs, speaking about attempts to get Atari and Hewlett-Packard interested in his and Steve Wozniak's personal computer.  Jobs and Wozniak founded Apple Computer. 

"'You should franchise them,' I told them. ' I'll be your guinea pig.'  Well, they just went straight up in the air!  They couldn't see the philosophy. . . .  When they turned us down, that left Bud and me to swim on our own." —  Sam Walton, describing his efforts to get the Ben Franklin chain interested in his discount retailing concept in 1962.  Walton went on to found Wal-Mart. 

"We don't like their sound, and guitar music is on the way out." —  Decca Recording Company when rejecting The Beatles, 1962. 

In 1884, John Henry Patterson was ridiculed by his business friends for paying $6,500 for the rights to the cash register — a product with "limited" or no potential.  Patterson went on to found National Cash Register (NCR) Corporation. 

"What's all this computer nonsense you're trying to bring into medicine?  I've got no confidence at all in computers and I want nothing whatsoever to do with them." —  A medical professor in England to Dr. John Alfred Powell, about the CT scanner. 

"That is good sport.  But for the military, the airplane is useless." —  Ferdinand Foch, Commander in Chief, Allied Forces on the Western Front, World War I.

"The television will never achieve popularity; it takes place in a semidarkened room and demands continuous attention." —  Harvard Professor Chester L. Dawes, 1940. 

These quotes were reprinted with permission from Beyond Entrepreneurship: Turning Your Business into an Enduring Great Company, James C. Collins and William C. Lazier (Prentice Hall). 

  Introductory economics courses teach students that the objective of every for-profit firm is to maximize profits.  As with many things taught in economics courses, this theory has one problem — it doesn't hold up in reality.  Most small-business owners I know don't manage their businesses maniacally in the pursuit of maximum profits.  The following list gives you some other possible objectives to consider:

  Working with people you like and respect: Some customers may buy your products and services, and some employees and suppliers may offer you their services for a good price, but what if you can't stand working with them?  If you have sufficient business or just have your own standards, you can choose whom you do business with. 

  Educating others: Maybe part of your business goal is to educate the public about something that you're an expert in.  I know that when I started my financial counseling and writing business, I saw education as a core part of my company's purpose. 

  Improving an industry or setting a higher standard: Perhaps part of your goal in starting your business is to show how your industry can better serve its customers.  John Bogle, who founded the Vanguard Group of mutual funds, is a good example of someone who wanted to improve an industry.  When he started Vanguard, Bogle structured the company so the shareholders (customers) of the company's individual mutual funds would own the company. 

Because he relinquished ownership of his company, Bogle gave up the opportunity to build a personal net worth that would easily be worth several billion dollars today.  But Bogle wanted to build a mutual fund company that kept operating costs to a minimum and returned profits to the customers in the form of lower operating fees, which are deducted from a mutual fund's returns.  He's also been outspoken about how owners of many mutual fund companies operate their funds too much out of self-interest instead of keeping their customers in mind. 

Of course, you can't accomplish these objectives without profits, and doing these things isn't inconsistent with generating greater profits.  But if your objectives are more than financial or your financial objectives aren't your number-one concern, don't worry — that's usually a good sign.  Remember the expression, "Do what you love, the money will follow." 

Analyzing the marketplace

  The single most important area to understand is the marketplace in which your business competes.  To be successful, your business must not only produce a good product or service, but it must also reach customers and convince them to buy your product at a price at which you can make a profit.  You should discern what the competition has to offer as well as its strengths and vulnerabilities.  In most industries, you also need to understand government regulations that affect the type of business that you're considering. 

Meeting customer needs

If the market analysis is the most important part of the business plan, understanding your potential customers is the most important part of your market analysis.  Understanding your desired customers and their needs is one key to having a successful business. 

If you're in a business that sells to consumers, consider your customers' characteristics, including gender, age, income, geographic location, marital status, number of children, education, living situation (rent or own), and the reasons they want your product or service.  In other words, find out who your prospective customers are.  Find out where they live and what they care about.  If you sell to businesses, you need to understand similar issues.  For instance, what types of businesses may buy your product or services?  Why? 

  The best way to get to know your potential customers is to get out and talk to them.  Even though they're more time consuming, live interviews allow you to go with the flow of the conversation, improvise questions, and probe more interesting areas.  Although you can mail, e-mail, or fax paper-based surveys to many people with a minimal investment of your time, the response rate is usually quite low, and the answers aren't usually as illuminating.  To encourage better response, offer a product or service sample or some other promotional item to those who help you with your research.  Doing so attracts people who are interested in your product or service, which helps you define your target customers. 

Also try to get a sense of what customers do pay and will pay for the products or services that you offer.  Analyzing the competition's offerings helps, too.  Some products or services require follow-up or additional servicing.  Understand what customers need and what they'll pay for your services. 

If you want to raise money from investors, include some estimates as to the size of the market for your product or services.  Of course, such numbers are ballpark estimates, but sizing the market for your product helps you estimate profitability, the share of the market needed to be profitable, and so on. 

Besting the competition

Always examine the products, services, benefits, and prices that competitors offer.  Otherwise, you go on blind faith that what you offer stacks up well to the alternatives in the industry. 

  Examine your competitors' weaknesses so you can exploit them.  Rather than trying to beat them on their terms, maybe you've identified a need for a neighborhood pet supply store that offers a more specialized range of pet supplies than the big-selling brands of dog and cat food that warehouse stores sell.  Providing knowledgeable customer sales representatives to answer customer questions and make product suggestions can also give you a competitive edge.  Thus, you may be able to surpass the warehouse stores on three counts: convenience of location for people in your neighborhood, breadth of product offerings, and customer assistance. 

  Even if you have a completely innovative product or service that no other business currently offers, don't make the mistake of thinking that you don't have competitors.  All businesses have competitors.  In the event that you've developed something truly unique that has little competition, your success will surely breed competition as imitators follow or attempt to leapfrog your lead. 

Complying with regulations

Most businesses are subject to some sort of regulation.  If you want to start a retail business, for example, few communities permit you to run it out of your home.  If you lease or purchase a private location, the zoning laws in that location may restrict you.  Therefore, you need to check what you can and can't sell at that location.  Check with your city's or town's zoning department — don't simply believe a real estate broker or property owner who says, "No problem!"  That person's goal, after all, is to sell the property. 

If, for instance, you were going to start a veterinary practice, you would quickly discover that special zoning is required to use a piece of real estate for a vet's office.  Convincing a local zoning board to allow a new location to get such special zoning is quite difficult, if not impossible, in some areas. 

Many businesses face other local, state, and even federal regulatory issues, including ordinances, laws, and the need for specific licenses and filings.  For example, if you were opening a restaurant, you'd have to heed ordinances and laws that regulate everything from signage to operating hours to your ability to serve alcohol.  And you'd be subject to an amazing array of health codes, building codes, and fire codes, to name a few. 

  If you enter an industry that you're relatively new to, ask questions and open your ears to find out more about where you should locate and how you should design and run your business.  Speak to people who are currently in the field and to your local chamber of commerce to see what, if any, licenses or filings you must complete.  Read books and trade magazines that may deal with your questions.  Libraries have books and online services that can help you locate specific articles on topics that interest you. 

Delivering your service or product

Every business has a product or service to sell.  How are you going to provide this product or service to your customers?  Suppose, for example, that you want to start a business that delivers groceries and runs errands for busy people or older and disabled people who can't easily perform daily tasks for themselves.  Delineate the steps that you'll take to provide the service. 

When potential customers call to inquire about your business, what kinds of information do you want to record about their situation?  Contact software can assist with this task.  Also, you can create a pricing sheet and other marketing literature (discussed in the next section) that you can send to curious potential customers. 

If you want to manufacture a product, you definitely need to scope out the process that you're going to use.  Otherwise, you have no idea how much time the manufacturing process may take or what the process may cost. 

As your business grows and you hire employees to provide services or create your products, the more you codify what you do and the better your employees can replicate your good work. 

Marketing your service or product

After you determine more in-depth information about delivering your company's services or products, you need to decide on specific marketing information.  Answer the following questions:

  How much will you charge for your services and products?  Look at what competing products and services cost.  Estimating your costs helps you figure out what you need to charge to cover your costs and make a reasonable profit. 

  How will you position your products and services compared to the competition?  Consider, for example, how books position themselves in the book marketplace.  I hope, in your mind, that my financial books are down-to-earth, practical, answer-oriented, and educational. 

  Where will you sell your product or service?  Business consultants label this decision the distribution channel question.  For example, if you have a toy to sell, you may consider selling via mail order and the Internet, through toy stores, or through discount warehouse stores.  Selling through each of these different distribution channels requires unique marketing and advertising programs.  If you market a product or service to companies, you need to find out who the key decision makers are at the company and what will persuade them to buy your product or service. 

Having a great product or service isn't enough if you keep it a secret — you gotta get the word out.  You likely won't have the budget or the desire to reach the same region that television and radio reach.  So start marketing your product to people you know.  Develop a punchy, informative one-page letter that announces your company's inception and the products or services it offers, and then mail it to your contacts.  Include an envelope with a reply form that allows recipients to provide the addresses of others who may be interested in what you have to offer.  Send these folks a mailing as well, referencing who passed their names along to you. 

Finding and retaining customers is vital to any business owner who wants his company to grow and be profitable.  One simple, inexpensive way to stay in touch with customers you've dealt with or others who have made inquiries and expressed interest in your company's offerings is via a mailing list.  Once a quarter, once a year, or whatever makes sense for your business, send out a simple, professional-looking postcard or newsletter announcing new information about your business and the customer needs you can fulfill.  Such mailings allow you to remind people that you're still in business and that you provide a wonderful product or service.  Computer software and websites (for example, Constant Contact) give you fast, efficient ways to keep customer mailing lists up to date and print mailing labels. 

  E-mailing your marketing information has the attraction of no out-of-pocket expenses.  However, due to the deluge of junk e-mail most people get, your e-mail is likely to be deleted without being opened.  At least a snail-mailed postcard gets a prospective customer's attention, even if only for a brief period. 

Organizing and staffing your business

Many small businesses are one-person operations.  So much the better for you — you have none of the headaches of hiring, payroll, and so on.  You only have to worry about you — and that may be a handful in itself! 

But if you hope to grow your business and would rather manage the work being done instead of doing all of it yourself, you eventually want to hire people. ( I explain the best way to fill your personnel needs in Chapter 14.)  Give some thought now to the skills and functional areas of expertise that future hires need.  If you want to raise money, the employment section of your business plan is essential to show your investors that you're planning long-term. 

Maybe you want an administrative assistant, researcher, marketing director, or sales representative.  What about a training specialist, finance guru, or real estate manager if your company expands?  Consider the background that you want in those you hire, and look at the types of people that similar companies select. 

  You should also consider what legal form of organization — for example, a sole proprietorship, partnership, S corporation, limited liability company, and so on — your business will adopt.  The legal form of your organization impacts, among other important issues, how the business is taxed and what its liabilities are in the event of a lawsuit.  See Chapter 14 for details. 

Projecting finances

  An idea may become a business failure if you neglect to consider, or are unrealistic about, the financial side of the business that you want to start.  If you're a creative or people-person type who hates numbers, the financial side may be the part of the business plan that you most want to avoid.  Don't — doing so can cost you tens of thousands of dollars in avoidable mistakes.  Ignoring the financial side can even lead to the bankruptcy of a business founded with a good idea. 

Before you launch your business, do enough research so you can come up with some decent financial estimates.  Financial projections are mandatory, and knowledgeable investors will scrutinize them if you seek outside money.  You also need to think through how and when investors can cash out. 

Start-up and development costs

Spending money to get your business from the idea stage to an operating enterprise is inevitable.  Before the revenue begins to flow in, you incur expenditures as you develop and market your products and services.  Therefore, you need to understand what you must spend money on and the approximate timing of the needed purchases. 

If you were going to build a house, you would develop a list of all the required costs.  How much are the land, construction, carpeting, landscaping, and so on going to cost?  You can try to develop all these cost estimates yourself, or you can speak with local builders and have them help you.  Likewise, with your business, you can hire a business consultant who knows something about your type of business.  However, I think you're best served by doing the homework yourself — you discover a lot more, and it's cheaper. 

If you're going to work in an office setting, whether at home or in outside space, you need furniture (such as a desk, chair, filing cabinets, and so on), a computer, printer, and other office supplies.  Don't forget to factor in the costs of any licenses or government registrations that you may need. 

If you run a retailing operation, you also need to estimate your cost for establishing and maintaining an inventory of goods.  Remember, selling your inventory takes time, especially when you first start up, and you need to have adequate stock on hand to fulfill reasonable customer orders in a timely fashion.  And as a new business, suppliers won't give you months on end to pay.  Be realistic — otherwise, the money that you tie up in inventory can send you to financial ruin. 

Income statement

Preparing an estimated income statement that summarizes your expected revenue and expenses is a challenging and important part of your business plan. ( I explain the elements of an income statement in Chapter 6.)  Many estimates and assumptions go into it.  As you prepare your estimated income statement, you may discover that making a decent profit is tougher than you thought.  This section of your business plan helps you make pricing decisions. 

Consider the Vet on Wheels business idea that I discuss in the "Identifying your business concept" section earlier in this chapter.  What range of veterinary services can you provide if you make house calls?  You can't perform all the services that you can in a larger office setting, so decide which ones are feasible.  What equipment do you need to perform the services?  How much should you charge for the services?  You need to estimate all these things to develop a worthwhile income statement.  You should be able to answer these questions from the insights and information you pulled together regarding what customers want and what your competitors are offering. 

  With service businesses in which you or your employees sell your time, be realistic about how many hours you can bill.  You may end up being able to bill only a third to half of your time, given the other management activities that you need to perform. 

Because building a customer base takes several years, try to prepare estimated income statements for the first three years.  In the earlier years, you have more start-up costs, so creating income statements more often ensures you have a good handle on this typically lean period.  In later years, you reap more profits as your customer rolls expand.  Doing income statements over several years is also essential if you're seeking investor money. 

Balance sheet

An income statement measures the profitability of a business over a span of time, such as a year, but it tells you nothing of a business's resources and obligations.  That's what a balance sheet does.  Just as your personal balance sheet itemizes your personal assets (for example, investments) and liabilities (debts you owe), a business balance sheet details a company's assets and liabilities. 

If you operate a cash business — you provide a service and are paid for that service, and you don't hold any inventory, for example — a balance sheet has limited use.  An exception is if you're trying to get a bank loan for your service business. 

  A detailed balance sheet isn't as important as tracking your available cash, which will likely be under pressure in the early years of a business because expenses can continue to exceed revenue for quite some time. 

A complete balance sheet is useful for a business that owns significant equipment, furniture, inventory, and so on.  The asset side of the balance sheet provides insight into the financial staying power of the company.  For example, how much cash does your business have on hand to meet expected short-term bills?  Conversely, the liability side of the ledger indicates the obligations, bills, and debts the company has coming due in the short and long term.  See Chapter 6 for more information on all the elements of a balance sheet. 

Writing an executive summary

An executive summary is a two- to three-page summary of your entire business plan that you can share with interested investors who may not want to first wade through a 40- to 50-page plan.  The executive summary whets the prospective investor's appetite by touching on the highlights of your entire plan.  Although this summary should go in the front of your plan document, I list this element last because you can't write an intelligent summary of your plan until you flesh out the body of your business plan. 
Chapter 14

Starting and Running a Small Business

In This Chapter

  Preparing to start your business

  Figuring out how to finance your business

  Deciding whether you should incorporate

  Attracting and retaining customers

  Finding and equipping your business space

  Keeping track of the money

After you research and evaluate the needs of your prospective business (see Chapter 13 for more information), at some point you need to decide whether to actually start your business.  In reference to his business plan, Alex Popov, founder of Smart Alec's, a healthy fast-food restaurant, says, "Something just clicked one day, and I said to myself, 'Yes, this is a business that is viable and appropriate now.'" 

Most entrepreneurs experience this sudden realization, including me — I've experienced it with every business that I've ever started.  If you really want to, you can conduct and analyze market research and crunch numbers until the cows come home.  Even if you're a linear, logical, analytic, quantitative kind of person, you ultimately need to make a gut-level decision: Do you jump in the water and start swimming, or do you stay on the sidelines and remain a spectator?  In my opinion, watching isn't nearly as fun as doing.  If you feel ready but have some trepidation, you're normal — just go for it! 

Starting Up: Your Preflight Check List

When you take off into the world of small-business ownership, you need to make decisions about a number of important issues.  Just like a pilot before he launches an airplane into flight, you need to make sure that all systems are in order and ready to do the job.  If your fuel tanks aren't adequately filled, your engines clean and in working order, and your wing flaps in the proper position, you may never get your business off the ground. 

Preparing to leave your job

  You may never discover that you have the talent to run your own business, and perhaps have a good idea to boot, unless you prepare yourself financially and psychologically to leave your job.  Financial and emotional issues cause many aspiring entrepreneurs to remain chained to their employers and cause those who do break free to soon return to their bondage. 

The money side of this self-exploration is easier to deal with than the emotional side, so I'll focus on finances.  Dealing with a net reduction in the income that you bring home from work — at least in the early years of your business — is a foregone conclusion for the vast majority of small-business opportunities that you may pursue.  Accept this fact and plan accordingly. 

  Do all you can to reduce your expenses to a level that fits the entrepreneurial life that you want to lead.  Examine your monthly spending patterns to make your budget lean, mean, and entrepreneurially friendly.  Determine what you spend each month on your rent (or mortgage), groceries, eating out, phone calls, insurance, and so on.  Unless you're someone who keeps all this data detailed, you need to whip out your checking transactions, ATM receipts, credit card statements, and anything else that documents your spending habits.  Don't forget to estimate your cash purchases that don't leave a trail, like when you eat lunch out or spend $35 on gas. 

Beyond the bare essentials of food, shelter, healthcare, and clothing, most of what you spend money on is discretionary — that is, you spend money on luxuries.  Even the amount that you spend on the necessities, such as food and shelter, is probably only part necessity and may include a fair amount of luxury and waste.  So make sure you question all expenditures!  If you don't, you'll have to continue working as an employee, and you'll never be able to pursue your entrepreneurial dream.  If you need a helping hand and an analyst's eye in preparing and developing strategies for reducing your spending, pick up a copy of the latest edition of my book Personal Finance For Dummies (John Wiley & Sons, Inc.). 

In addition to reducing your spending before and during the period that you start your business, also figure how to manage the income side of your personal finances.  The following list gives you some proven strategies to ensure that you have sufficient income:

  Transition gradually.  One way to pursue your entrepreneurial dreams (and not starve while doing so) is to continue working part time in a regular job while you work part time at your own business.  If you have a job that allows you to work part time, seize the opportunity.  Some employers may even allow you to maintain your benefits.  In addition to ensuring a steady source of income, splitting your time allows you to adjust to a new way of making a living.  Some people have a hard time adjusting to their new lifestyle if they quit their jobs cold turkey and plunge headfirst into full-time entrepreneurship. 

Another option is to completely leave your job but line up a chunk of work that provides a decent income for a portion of your weekly work hours.  Consulting for your old employer is a time-tested first "entrepreneurial" option with low risk. 

  Get (or stay) married.  Actually, as long as you're attached (married or not) to someone who maintains a regular job and you manage your spending so you can live on that person's income alone, you're golden!  Just make sure you talk things through with the love of your life to minimize misunderstandings and resentments.  Maybe someday you can return the favor — that's what my wife and I did.  She was working in education (no big bucks there!)  when I started an entrepreneurial venture after business school.  We lived a Spartan lifestyle and made do just fine on her income.  Several years later, when things were going well for me, she left her job to work on her own business. 

Valuing and replacing your benefits

For many people, walking away from their employer's benefits, including insurance, retirement funds, and paid days off, is both financially and emotionally challenging.  Benefits are valuable, but you may be surprised by how efficiently you can replicate them in your own business. 

Health insurance

Some prospective entrepreneurs fret over finding new health insurance.  However, unless you have a significant existing medical problem (known as a preexisting condition), getting health insurance as an individual isn't difficult.  If you have such a condition, many states have high-risk pools that offer coverage options.  And you also will have new protections under the newest health care bill (see the sidebar, "The 2010 Federal Health Care Bill"). 

The first option to explore is whether your existing coverage through your employer's group plan can be converted into individual coverage.  Just don't act on this potentially attractive option until you've explored other health plans on your own, which may offer similar benefits at lower cost.  Also, get proposals for individual coverage from major health plans in your area. 

  Take a high deductible, if available, to keep costs down.  Having a high-deductible health plan, which is defined as an individual plan with a deductible of at least $1,200 or a family plan with a minimum $2,400 deductible for tax year 2011 (this amount increases over time with inflation), qualifies you to contribute money into a Health Savings Account (HSA).  The contribution limits are up to $3,050 for individuals and $6,150 for families for tax year 2011, and these amounts increase over time with inflation. ( Folks age 55 or older can put away an extra $1,000 per year.)  Contributions to an HSA reduce your current year's taxable income, and the money compounds without taxation over time.  Withdrawals aren't taxed so long as you use the money for qualified healthcare expenses, which are fairly broadly defined and include traditional out-of-pocket medical expenses (doctors and hospital care) as well as dental care, prescription drugs, psychologist expenses, vision care, vitamins, and so on. 

  Government regulations called COBRA require an employer with 20 or more employees to continue health insurance coverage (at your own expense) for up to 18 months after terminating employment.  Moreover, if you have or develop a health problem while covered under COBRA, the law enables you to purchase an individual policy at the same price that a healthy individual can.  These laws create a nice buffer zone for the budding entrepreneur, but don't get lazy and wait until the last minute of the 18th month to start shopping for your individual plan — COBRA plans can be costly.  Shopping around and locking in an individual plan as soon as possible can save money and prevent headaches. 

Long-term disability insurance

For most working people, their greatest asset is their ability to earn money.  If you suffer a disability and can't work, how would you manage financially?  Long-term disability insurance protects your income in the event of a disability. 

  Before you leave your job, secure an individual long-term disability policy.  After you leave your job and are no longer earning steady income, you won't qualify for a policy.  Most insurers want to see at least six months of self-employment income before they'll write you a policy.  If you become disabled during this time, you're uninsured and out of luck — that's a big risk to take! 

  Check with any professional associations that you belong to or could join to see whether they offer long-term disability plans.  Association plans are sometimes less expensive because of the group's purchasing power. 

Life insurance

If you have dependents who count on your income, you need life insurance.  And unlike with disability insurance, you can generally purchase a life insurance policy at a lower cost than you can purchase additional coverage through your employer. 

The 2010 Federal Health Care Bill

In 2010, Congress passed two large bills, signed into law by President Barack Obama, to enact comprehensive health care reform.  This bill included numerous provisions affecting small businesses.  Here are the highlights. 

Effective in 2011, employer group health plans:

  Must offer non-taxable coverage to adult children up to age 26 who aren't eligible for coverage under another employer's health plan.  In 2014, the requirement that the nondependent child must not be eligible for coverage under another employer's plan would no longer apply. 

  May not impose lifetime limits and could impose only "restricted" annual limits.  No annual limits would be permitted beginning in 2014. 

  May not impose preexisting condition exclusions on children younger than 19 years old.  No preexisting conditions would be permitted for any participants beginning in 2014. 

Effective in 2014, the following group health plan provisions take effect:

  "Pay or play" responsibility begins.  Companies must offer minimum essential coverage to full-time employees or make nondeductible payments to the government. 

  Must remove all annual dollar limits on all participants. 

  Must limit cost sharing and deductibles to levels that don't exceed those applicable to a health savings account–eligible, high-deductible health plan. 

  Must remove all preexisting condition exclusions on all participants. 

  Must remove waiting periods longer than 90 days. 

For updated information on this topic, please visit my website at www.erictyson.com. 

Retirement plans

If your employer offers retirement savings programs, such as a 401(k) plan or a pension plan, don't despair about not having these in the future. ( Of course, what you've already earned and accumulated while employed is yours.)  One of the best benefits of self-employment is the availability of retirement savings plans — SEP-IRAs (Simplified Employee Pension Individual Retirement Accounts) and Keoghs — that allow you to sock away a hefty chunk of your earnings on a tax-deductible basis. 

Retirement plans are a terrific way for you and your employees to shield a sizeable portion of earnings from taxation.  If you don't have employees, regularly contributing to one of these plans is usually a no-brainer.  With employees, the decision is a bit more complicated but often still a great idea.  Small businesses with a number of employees can also consider 401(k) plans.  I explain retirement plans in more detail in Chapter 3. 

Other benefits

Besides insurance and retirement plans, employers also offer other benefits that you may value.  But, don't get too bummed yet.  These benefits aren't true benefits, so you won't miss much if you branch out on your own.  For example, you seem to get paid holidays and vacations.  In reality, though, your employer simply spreads your salary over all 52 weeks of a year, thus paying you for actually working the other 47 weeks or so out of the year.  You can do the same by building the cost of this paid time off into your product and service pricing. 

Another "benefit" of working for an employer is that the employer pays for half of your Social Security and Medicare taxes.  Although you must pay the entire tax when you're self-employed, the IRS allows you to take half of this amount as a tax deduction on your annual tax Form 1040.  So, really, this tax isn't as painful as you think.  As with vacations and holidays, you can simply build the cost of this tax into your product and service pricing.  Just think: Your employer could pay you a higher salary if it weren't paying half of these taxes as a benefit. 

  Some employers offer other insurance plans, such as dental or vision care plans.  Ultimately, these plans only cover small out-of-pocket expenditures that aren't worth insuring.  Don't waste your money purchasing such policies when you're self-employed. 

Financing Your Business

When you create your business plan (which I explain how to do in Chapter 13), you should estimate your start-up and development costs.  Luckily, you can start many worthwhile small businesses with little capital.  The following sections explain methods for financing your business. 

Going it alone by bootstrapping

Making do with a small amount of capital and only spending what you can afford is known as bootstrapping.  Bootstrapping is just a fancy way of saying that a business lives within its own means and without external support.  This strategy forces a business to be more resourceful and less wasteful.  Bootstrapping is also a great training mechanism for producing cost-effective products and services.  It offers you the advantage of getting into business with little capital. 

Millions of successful small companies were bootstrapped at one time or another.  Like small redwood saplings that grow into towering trees, small companies that had to bootstrap in the past can eventually grow into hundred million–dollar (and even multi-billion-dollar) companies.  For example, Hewlett-Packard's founders started their company out of a garage in Palo Alto, California.  Microsoft, Motorola, Sony, and Disney were all bootstrapped, too. 

Whether you want to maintain a small shop that employs just yourself, hire a few employees, or dream about building the next large company, you need capital.  However, misconceptions abound about how much money a company needs to achieve its goals and sources of funding. 

"There's an illusion that most companies need tons of money to get established and grow," says James Collins, former lecturer at the Stanford Graduate School of Business and coauthor of the best-sellers Built to Last and Good to Great: Why Some Companies Make the Leap . . .  and Others Don't. " The Silicon Valley success stories of companies that raise gobs of venture capital and grow 4,000 percent are very rare.  They are statistically insignificant but catch all sorts of attention," he adds. 

Studies show that the vast majority of small businesses obtain their initial capital from personal savings and family and friends rather than outside sources, such as banks and venture capital firms.  A Harvard Business School study of the Inc. 500 (500 large, fast-growing private companies) found that more than 80 percent of the successful companies started with funds from the founder's personal savings.  The median start-up capital was a modest $10,000, and these are successful, fast-growing companies!  Slower-growing companies tend to require even less capital. 

With the initial infusion of capital, many small businesses can propel themselves for years after they develop a service or product that brings in more cash flow.  Jim Gentes, the founder of Giro, the bike helmet manufacturer, raised $35,000 from personal savings and loans from family and friends to make and distribute his first product.  He then used the cash flow from the first product for future products. 

  Eventually, a successful, growing company may want outside financing to expand faster.  Raising money from investors or lenders is much easier after you demonstrate that you know what you're doing and that a market exists for your product or service. ( Check out the following section for more on getting a bank loan.) 

As I explain in the earlier section "Preparing to leave your job," aspiring entrepreneurs must examine their personal finances for opportunities to reduce their own spending.  If you want to start a company, the best time for you to examine your finances is years before you want to hit the entrepreneurial path.  As with other financial goals, advance preparation can go a long way toward helping start a business.  The best funding source and easiest investor to please is you. 

Alan Tripp, founder and CEO of Score Learning, a chain of storefront interactive learning centers, planned for seven years before he took the entrepreneurial plunge.  He funded his first retail center fully from personal savings.  He and his wife lived frugally to save the necessary money.  Tripp's first center proved the success of his business concept: retail learning centers where kids can use computers to improve their reading, math, and science skills.  With a business plan crafted over time and hard numbers to demonstrate the financial viability of his operation, Tripp then successfully raised funds from investors to open many more centers. ( Kaplan Inc. ultimately bought his company.) 

Some small-business founders put the cart before the horse and don't plan and save for starting their business the way Tripp did.  And in many cases, small-business owners want capital but don't have a clear plan or need for it. 

Taking loans from banks and other outside sources

If you're starting a new business or have been in business for just a few years, borrowing, particularly from banks, may be difficult.  Borrowing money is easier when you don't really need to do so.  No one knows this fact better than small-business owners. 

  Small-business owners who successfully obtain bank loans do their homework.  To borrow money from a bank, you generally need a business plan, three years of financial statements and tax returns for the business and its owner, and projections for the business.  Seek out banks that are committed to and understand the small-business marketplace. 

The Small Business Administration (SBA) guarantees some small-business loans that banks originate.  Because many small businesses lack collateral and pose a higher loan risk, banks wouldn't otherwise make many of these loans.  The SBA, in addition to guaranteeing loans for existing businesses, grants about 20 percent of its loans to start-up businesses, which must have founders who put up at least a third of the funds needed and demonstrate a thorough understanding of the business, ideally through prior related industry experience. 

  The SBA offers a number of workshops and counseling services for small-business owners.  Its SCORE (Service Corps of Retired Executives) consulting services (www.score.org; 800-634-0245) provide free advice and critiques of business plans as well as advice on raising money for your business.  The SBA charges a nominal fee for seminars.  To get more information on SBA's services and how to contact a local office, call 800-827-5722 or visit its website at www.sba.gov. 

If you don't have luck with banks or the SBA, consider the following:

  Credit unions can be a source of financial help.  They're often more willing to make personal loans to individuals. 

  Borrowing against the equity in your home or other real estate is advantageous.  This strategy is helpful because real estate loans generally entail lower and tax-deductible interest. 

  Retirement savings plans can bridge the gap.  You may be able to borrow against your investment balance, and such loans are usually available at competitive rates through employer-based plans.  Just make sure you don't take on too much debt and jeopardize your retirement savings. 

  Credit cards may be useful as a last resort.  If you've got the itch to get your business going but can't wait to save the necessary money and lack other ways to borrow, the plastic in your wallet may be your ticket to operation.  You can acquire some credit cards at interest rates of 10 percent or less.  Remember: Because credit cards are unsecured loans, if your business fails and you can't pay back your debt, your home equity and assets in retirement accounts aren't at risk. 

  No matter what type of business you have in mind and how much money you think you need to make it succeed, be patient.  Start small enough that you don't need outside capital (unless you're in an unusual situation where your window of opportunity is now and will close if you don't get funding quickly).  Starting your business without outside capital instills the discipline required for building a business piece by piece over time.  The longer you can wait to get a loan or an equity investment, the better the terms are for you and your business because the risk is lower for the lender or investor. 

Borrowing from family and friends

Because they know you and hopefully like and trust you, your family and friends may seem like good sources of investment money for your small business.  They also likely have the added advantage of offering you better terms than a banker, wealthy investor, or a venture capitalist. 

  However, before you solicit and accept money from those you love, consider the following pitfalls:

  Defaulting on a loan can cause hard feelings.  If your business hits the skids, defaulting on a loan made by a large, anonymous lender is one thing, but defaulting on a loan from your dear relatives can make future Thanksgiving meals mighty uncomfortable! 

  Most entrepreneurs receive surprisingly little encouragement from the people they're close to.  Your parents, for example, may think that you've severed some of your cerebral synapses if you announce your intention to quit your job, which provides a lofty job title, decent pay, and benefits.  The lack of emotional support can discourage you far more than the lack of financial support. 

  You lose out on the experience of a seasoned investor.  Family and friends may lack important practical experience with similar ventures and may be unable to provide the type of guidance that a venture capitalist or other seasoned investor could. 

  Family investments in a small business work best under the following conditions:

  You prepare and sign a letter of agreement that spells out the terms of the investment or loan.  In other words, you act as if you're doing business with a banker or some other investor you know for business purposes only.  I also recommend clearly disclosing in writing the risk of losing one's entire investment.  As time goes on, people have selective recall.  Putting things in writing reminds everyone what was agreed to. 

  You're quite certain that you can repay the loan.  Otherwise, you run into the issue I discuss earlier: You default on the loan and burn bridges with your closest loved ones.  No business is worth losing your family or friends. 

  You can start your business with an equity investment.  With an equity investment, a person is willing and able to lose all the money invested but hopes to hit a home run while helping you with your dream. ( Check out the next section for more on equity investments.) 

Courting investors and selling equity

Beyond family members and friends, private individuals with sufficient funds — also known as wealthy individuals — are your next best source of capital if you want an equity investor (and not a loan from a lender).  However, before you approach wealthy people, you must have a solid business plan, which I explain how to prepare in Chapter 13. 

A worthwhile angel investor (a wealthy individual who invests in small companies) has a track record of success with somewhat similar businesses that she's funded and brings other things to the table besides money, such as strategic advice, helpful business contacts, and so on. 

Although you want an investor to care about your business, it's best if his investment in your business is no more than 5 to 10 percent of his total investment portfolio.  No one wants to lose money, but doing so is less painful when you diversify well.  A $50,000 investment from an investor with a five million dollar portfolio is risking 1 percent of his portfolio. 

  Finding people who may be interested in investing requires persistence and creativity.  Consider these approaches:

  Consult tax advisors and attorneys you know who may have contacts. 

  Network with successful entrepreneurs in similar fields. 

  Think about customers or suppliers who like your business and believe in its potential. 

Alex Popov, whom I introduce at the beginning of this chapter, sent hundreds of letters to people who lived in upscale neighborhoods.  The letter, a one-page summary of Alex's investment opportunity, got an astounding 5 percent response for interest in receiving a business plan.  Ultimately through this search method, Popov found one wealthy investor who funded his entire deal. 

Here's how to determine how much of the business you're selling for the amount invested.  Basically, the equity percentage should hinge on what the whole business is worth (see Chapter 15 for details on valuing a business).  If your whole business is worth $500,000 and you're seeking $100,000 from investors, that $100,000 should buy 20 percent of the business. 

  New businesses are the hardest to value — yet another reason you're best off trying to raise money after you demonstrate some success.  The farther along you are, the lower the risk to an investor and the lower the cost to you (in terms of how much equity you must give up) to raise money. 

Deciding Whether to Incorporate

Most businesses operate as sole proprietorships, a status limited to one owner or a married couple.  If you run a sole proprietorship, you report your business income and costs on your tax return on Schedule C (Profit or Loss From Business), which you attach to your personal income tax return, Form 1040. 

Incorporating, which establishes a distinct legal entity under which you do business, takes time and costs money.  Therefore, incorporation must offer some benefits.  Here are two main benefits of going through the process:

  Because corporations are legal entities distinct from their owners, they offer features that a proprietorship or partnership doesn't.  For example, corporations can have shareholders who own a piece or percentage of the company.  These shares can be sold or transferred to other owners, subject to any restrictions in the shareholder's agreement. 

  Corporations offer continuity of life.  In other words, corporations can continue to exist despite an owner's death or the owner's transfer of her stock in the company. 

In the following sections, I detail the other benefits, along with possible drawbacks, of incorporating so you can decide whether it's the right choice for you. 

  Don't waste your money incorporating if you simply want to maintain a corporate-sounding name.  If you operate as a sole proprietor, you can choose to operate under a different business name ("doing business as," or d.b.a.)  without the cost and hassles of incorporating. 

Looking for liability protection

A major reason to consider incorporation is liability protection.  Incorporation effectively separates your business from your personal finances, thereby better protecting your personal assets from lawsuits that may arise from your business. 

  Before you incorporate, ask yourself (and perhaps others in your line of business or advisors — legal, tax, and so on — who work with businesses like yours) what can cause someone to sue you.  Then see whether you can purchase insurance to protect against these potential liabilities.  Insurance is superior to incorporation because it pays claims, and people can still sue you if you're incorporated.  If you incorporate and someone successfully sues you, your company must cough up the money for the claim, and doing so may sink your business.  Only insurance can cover such financially destructive claims. 

People can also sue you if, for example, they slip and suffer an injury while on your property.  To cover these types of claims, you can purchase a property or premises liability policy from an insurer. 

  Accountants, doctors, and a number of other professionals can buy liability insurance.  A good place to start searching for liability insurance is through the associations for your profession.  Even if you're not a current member, check out the associations anyway — you may be able to access the insurance without membership, or you can join the association long enough to sign up. ( Associations also sometimes offer competitive rates on disability insurance.) 

Taking advantage of tax-deductible insurance and other benefits

A variety of insurance and related benefits are tax-deductible for all employees of an incorporated business.  These benefits include the full cost of health and disability insurance as well as up to $50,000 in term life insurance per employee. 

  A new health insurance premium tax credit is available to qualifying small employers.  Among other requirements, employers must have fewer than 25 full-time employees, and the annual employee wages must average less than $50,000.  The credit is available for tax years 2010 through 2013 and can be up to 35 percent of the employer's qualifying health insurance premium expenses.  The credit is calculated and claimed on IRS Form 8941. 

In addition to insurance, incorporated companies can also hold dependent-care plans in which up to $5,000 per employee may be put away on a tax-deductible basis for child care and care for elderly parents.  Corporations can also offer cafeteria or flexible spending plans that allow employees to pick and choose which benefits they spend their benefit dollars on. 

  If your business isn't incorporated, you and the other business owners can't deduct the cost of insurance plans for yourselves.  However, you can deduct these costs for your employees as well as your health insurance costs for yourself and covered family members. 

Cashing in on corporate taxes

Aside from the tax treatment of insurance and other benefits, another difference between operating as a sole proprietor and as a corporation is that the government taxes a corporation's profits differently than those realized in a sole proprietorship.  Which is better for your business depends on your situation. 

Suppose that your business performs well and makes lots of money.  If your business isn't incorporated, the government taxes all profits from your business on your personal tax return in the year that your company earns those profits.  If you intend to use these profits to reinvest in your business and expand, incorporating can potentially save you some tax dollars. ( However, this tax-reducing tactic doesn't work for personal service corporations, such as accounting, legal, and medical firms, which pay a higher tax rate.) 

  Resist the short-term temptation to incorporate just so you can have money left in the corporation taxed at a lower rate.  If you want to pay yourself the profits in the future, you can end up paying more taxes.  Why?  Because you first pay taxes at the corporate tax rate in the year that your company earns the money, and then you pay taxes again on your personal income tax return when the corporation pays you. 

Another reason not to incorporate, especially in the early months of a business, is that you can't immediately claim the losses for an incorporated business on your personal tax return.  Because most businesses produce little revenue in their early years and have all sorts of start-up expenditures, losses are common. 

S corporations and limited liability companies: The best of both worlds? 

Wouldn't it be nice to get the liability protection and other benefits that come with incorporating without the tax complications and hassles?  Well, S corporations or limited liability companies may be for you. 

Subchapter S corporations provide the liability protection that comes with incorporation.  Likewise, the business profit or loss passes through to the owner's personal tax return, so if the business shows a loss in some years, the owner may claim those losses in the current year of the loss on his personal tax return.  If you plan to take all the profits out of the company (instead of reinvesting them), an S corporation may make sense for you. 

The IRS allows most small businesses to operate as S corporations, but not all.  In order to be an S corporation, a company must be a U.S. company, have just one class of stock, and have no more than 35 shareholders (who are all U.S. residents or citizens and who are not partnerships, corporations, or, with certain exceptions, trusts). 

Limited liability companies (LLCs) offer business owners benefits similar to those of S corporations but are even better in some cases.  Like an S corporation, an LLC offers liability protection for the owners.  LLCs also pass the business's profits and losses through to the owner's personal income tax returns. 

But limited liability companies have fewer restrictions regarding shareholders.  For example, LLCs have no limits on the number of shareholders, and the shareholders in an LLC can be foreigners, corporations, and partnerships. 

Compared with S corporations, the only additional restriction LLCs carry is that sole proprietors and professionals can't always form an LLC (although they can in some states).  Most state laws require you to have at least two partners and not be a professional service firm (for example, accounting, legal, or medical firms). 

Making the decision to incorporate

If you're totally confused about whether to incorporate because your business is undergoing major financial changes, it's worth getting competent professional help.  The hard part is knowing where to turn, because finding one advisor who can put together all the pieces of the puzzle (including the financial, legal, and tax-related aspects) is challenging.  Also be aware that you may get wrong or biased advice. 

  Although most attorneys and tax advisors don't understand the business side of business, some do.  So try to find one who does.  Or, if necessary, you may need to hire a business advisor along with your attorney or tax advisor.  Attorneys who specialize in advising small businesses can help explain the legal issues.  Tax advisors who perform a lot of work with business owners can help explain the tax considerations. 

If you've weighed the factors and you still can't decide, my advice is to keep your business simple — don't incorporate.  Why?  Because after you incorporate, unincorporating takes time and money.  Start off your business as a sole proprietorship and then take it from there.  Wait until the benefits of incorporating your business clearly outweigh the costs and drawbacks. 

Finding and Keeping Customers

When you write your business plan (see Chapter 13), you need to think about your business's customers.  Just as the sun is the center of the solar system, everything in your business revolves around your customers.  If you take care of your customers, they'll take care of you and your business for many years. 

Obtaining a following

When you're ready to attract customers, put together a mailing list of people you know who may be interested in what you're offering.  Draft and mail an upbeat, one-page letter that provides an overview of what your business offers.  As you have news to report — successes, new products and services, and so on — do another mailing. 

  Short letters are read more than glossy advertising newsletters.  Most people are busy and don't care about your business enough to read a lengthy piece of mail.  E-mail lists may work as well and are attractive due to their lower costs.  Use a service like Constant Contact, which enables you to track how many people actually open and click on links in your e-mails. 

In addition to mailings, other successful ways to get the word out and attract customers are limited only to your imagination and resourcefulness.  Consider the following ideas:

  If your business idea is innovative or somehow different, or if you have grand expansion plans, add some local media people to your mailing list.  Newspaper, radio, and even television business reporters are always looking for story ideas.  So include them in your mailings, and send them the one-page updates as well.  Just remember to make your press releases information pieces and not advertisements. 

  If your business seeks customers in a specific geographic area, blanket that area by mailing your one-page letter or delivering it door to door.  You can include a coupon that offers your products or services at a reduced cost (perhaps at the cost you pay) to get people to try them.  Make sure that people know this deal is a special opening-for-business bargain. 

Providing solid customer service

  After you attract customers, treat them as you would like to be treated by a business.  If customers like your products and services, they not only come back to buy more when the need arises, but they also tell others. ( However, keep in mind that they're even more likely to tell others when they have a bad experience!)  Satisfied customers are every business's best cost-effective marketers. 

I never cease to be amazed by how many businesses have mediocre or poor customer service.  One reason for poor service is that as your business grows, your employees are on the customer service front lines.  If you don't hire good people and give them the proper incentives to serve customers, many of them won't do it.  For most employees on a salary, the day-to-day task of assisting customers may be just an annoyance for them. 

  One way to make your staff care about customer service is to base part of their pay on the satisfaction of the customers they work with.  Tie bonuses and increases at review time to this issue.  You can easily measure customer satisfaction with a simple survey form. 

Treating the customer right starts the moment that the selling process begins.  Honesty is an often-underused business tool.  More than a few salespeople mislead and lie in order to close a sale.  Many customers discover after their purchase that they've been deceived, and they get angry.  These unethical businesses likely lose not only future business from customers but also surely — and justifiably — referrals. 

If your business doesn't perform well for a customer, apologize and bend over backward to make the customer happy.  Offer a discount on the problem purchase or, if possible, a refund on product purchases.  Also, make sure you have a clear return-and-refund policy.  Bend that policy if doing so helps you satisfy an unhappy customer or rids you of a difficult customer. 

Setting Up Shop

No matter what type of business you have in mind, you need space to work from, whether it's a spare room in your home, shared office space, or a small factory.  You also need to outfit that space with tools of your trade.  This section explains how to tackle these tasks. 

Finding business space and negotiating a lease

Unless you can run your business from your home, you may be in the market for office or retail space.  Finding good space and buying or leasing it both take tons of time if done right. 

  In the early years of your business, buying an office or a retail building generally doesn't make sense.  The down payment consumes important capital, and you may end up spending lots of time and money on a real estate transaction for a location that may not interest you in the long term.  Buying this type of real estate rarely makes sense unless you plan to stay put for five or more years.  Leasing a space for your business is far more practical. 

Renting office space is simpler than renting retail space because a building owner worries less about your business and its financial health.  Your business needs more credibility to rent a retail building because your retail business affects the nature of the strip mall or shopping center where you lease.  Owners of such properties don't want to move in quick failures or someone who does a poor job of running his business. 

If you and your business don't have a track record with renting space, getting references is useful.  If you seek well-located retail space, you must compete with national chains like Walgreens, so you better have a top-notch credit rating and track record.  Consider subletting — circulate flyers to businesses that may have some extra space in the area in which you want to locate your business.  Also prepare financial statements that show your personal and business creditworthiness. 

Brokers list most spaces for lease.  Working with a broker can be useful, but the same conflicts exist as with residential brokers (see Chapter 12).  So also examine spaces for lease without a broker, and deal with the landlord directly.  Such landlords may give you a better deal, and they don't worry about recouping a brokerage commission. 

  The biggest headaches with leasing space are understanding and negotiating the lease contract.  Odds are that the lessor presents you with a standard, preprinted lease contract that she says is fair and is the same lease that everyone else signs.  Don't sign it!  This contract is the lessor's first offer.  Have an expert review it and help you modify it.  Find yourself an attorney who regularly deals with such contracts. 

Should you work from home? 

You may be able to run a relatively simple small business from your home.  If you have the choice of running your business out of your home versus securing outside office space, consider the following issues:

  Cost control: As I discuss earlier in this chapter, bootstrapping your business can make a lot of financial and business sense.  If you have space in your home that you can use, you've found yourself a rent-free business space. ( However, if you're considering buying a larger home to have more space, you can't really say that your home office is rent-free.) 

  Business issues: What are the needs of your business and customers?  If you don't require fancy office space to impress others or to meet with clients, work at home.  If you operate a retail business that requires lots of customers coming to you, getting outside space is probably the best (and legally correct) choice.  Check with the governing authorities of your town or city to find out what local regulations exist for home-based businesses. 

  Discipline: At home, do you have the discipline to work the number of hours that you need and want, or will the kitchen goodies tempt you to make half a dozen snack trips?  Can you refrain from turning on the television every hour for late-breaking news or constantly surfing the Internet for stock quotes, personal research, and entertainment?  The sometimes amorphous challenge of figuring out how to grow the business may cause you to focus your energies elsewhere. 

  Family matters: Last, but not least, your home life should factor into where you decide to work.  One advantage to working at home when you're a parent is that you can be a more involved parent.  If nothing else, you can spend the one to two hours per day with your kids that you would have spend commuting!  Just make sure you try to set aside work hours during which time your office is off limits. 

Ask other family members how they feel about your working at home.  Be specific about what you plan to do, where, when, and how.  Will clients come over?  What time of day and where in the home will you meet with them?  You may not think that your home office is an imposition, but your spouse may.  Home business problems come between many couples.  If you're single and living alone, home life is less of an issue. 

Office leases are usually simpler than retail leases.  About the most complicated issue you face with office leases is that they can be full service, which includes janitorial benefits.  Retail leases, however, are usually triple-net, which means that you as the tenant pay for maintenance (for example, resurfacing the parking lot, cleaning, and gardening), utilities, and property taxes.  You're correct to worry about a triple-net retail lease because you can't control many of these expenses.  For example, if the property is sold, property taxes can jump. 

  Here are provisions to keep in mind when dealing with a triple-net lease:

  Compare your site's costs to other sites to evaluate the deal that the lessor offers you. 

  Your lease contract needs to include a cap for the triple-net costs at a specified limit per square foot. 

  Try to make sure that the lease contract doesn't make you responsible for removal costs for any toxic waste you may discover during your occupation.  Also exclude increased property taxes that the sale of the property may cause. 

  If feasible, get your landlord to pay for remodeling.  It's cheaper for the landlord to do it and entails fewer hassles for you. 

  With retail leases, get an option for renewal.  This renewal option is critical in retail, where location is important.  The option should specify the cost — for example, something like 5 percent below market, as determined by arbitration. 

  Get an option that the lease can be transferred to a new owner if you sell the business. 

If you really think you want to purchase (not lease) because you can see yourself staying in the same place for at least five years, head to Chapter 11. 

Equipping your business space

You can easily go overboard spending money when leasing or buying office space and outfitting that space.  The most common reason that small-business owners spend more than they should is to attempt to project a professional, upscale image.  You can have an office or retail location that works for you and your customers without spending a fortune if you observe some simple rules:

  Buy — don't lease or finance — equipment.  Unless you're running a manufacturing outfit where the cost of buying equipment is prohibitive, try to avoid borrowing and leasing.  If you can't buy office furniture, computers, cash registers, and so on with cash, you probably can't afford them!  Buying such things on credit or leasing them — leasing is invariably the most expensive way to go — encourages you to spend beyond your means. 

Consider buying used equipment, especially furniture, which takes longer to become obsolete.  The more popular a piece of equipment, the more beneficial it is for you to purchase rather than lease: If many other businesses would be willing to buy the equipment, you'll have an easier time unloading it if you ever want to sell it.  Leasing may make more sense with oddball-type equipment that is more of a hassle and costly for you to unload after a short usage period. 

  Don't get carried away with technological and marketing gadgets.  Some small-business owners spend excessively on the latest tech gadgets that they don't really need because they feel the need to be "competitive" and "current."  Don't forget the virtues of picking up the phone or meeting in person — these forms of communication are much more personal ways of doing business. 

Bootstrap-equipping your office makes sense within certain limits (see "Going it alone by bootstrapping," earlier in this chapter).  If customers come to you, of course, you don't want a shabby-looking store or office.  However, you don't have to purchase the Rolls Royce equivalent of everything that you need for your office. 

Accounting for the Money

One of the less glamorous aspects of running your own business is dealing with accounting.  Unlike when you work for an employer, you must track your business's income, expenses, and taxes (for you and your employees).  Although you may be able to afford to hire others to help with these dreary tasks, you still must know the inner workings of your business to keep control of your company, to stay out of trouble with the tax authorities, and to minimize your taxes.  The following sections show you how to handle the accounting aspect of your business. 

Maintaining tax records and payments

With revenue hopefully flowing into your business and expenses surely heading out, you must keep records to help satisfy your tax obligations and keep a handle on the financial status and success of your business.  You can't accurately complete the necessary tax forms for your business if you don't properly track your income and expenses.  And should the IRS audit you (the probability of being audited as a small-business owner is about four times higher than when you're an employee at a company), you may need to prove some or even all of your expenses and income. 

  In order to keep your sanity, and keep the IRS at bay, make sure you do the following:

  Pay your taxes each quarter and on time.  When you're self-employed, you're responsible for the accurate and timely filing of all taxes that you owe on your income on a quarterly basis.  You must pay taxes by the 15th of January, April, June, and September. ( If the 15th falls on the weekend, payment is due the Monday that follows the 15th.)  Call the IRS at 800-TAX-FORM (800-829-3676) and ask for Form 1040-ES (Estimated Tax for Individuals), or download this form from www.irs.gov.  This form comes with an easy-to-use estimated tax worksheet and four payment coupons that you send in with your quarterly tax payments.  Mark the due dates for your quarterly taxes on your calendar so you don't forget! 

If you have employees, you also need to withhold taxes from each paycheck they receive.  You must then use the money that you deduct from their paychecks to make timely payments to the IRS and the appropriate state authorities.  In addition to federal and state income tax, you also need to withhold and send in Social Security and any other state or locally mandated payroll taxes.  Pay these taxes immediately after withholding them from your employees' paychecks and never use the money to fund your business needs. 

I recommend using a payroll service to ensure that your payments are made correctly and on time to all the different places that these tax filings need to go. 

  Keep your business accounts separate from your personal accounts.  The IRS knows that small-business owners have more opportunity to hide business income and inflate business expenses.  Thus, the IRS looks skeptically at business owners who use and commingle funds in personal checking and credit card accounts for business transactions. 

Although you may find opening and maintaining separate business accounts bothersome, do so.  And remember to pay for only legitimate business expenses through your business account.  You'll be thankful come tax preparation time to have separate records.  Having separate records can also make the IRS easier to deal with if you're audited. 

  Keep good records of your business income and expenses.  You can use file folders, software, or a shoebox to collect your business income and expenses.  Whatever your method, just do it!  When you're ready to file your annual return, you need the documentation that allows you to figure your business income and expenses. 

Charging expenses on a credit card or writing a check can make the documentation for most businesses easier.  These methods of payment leave a paper trail that simplifies the task of tallying up your expenses come tax time, and they also make the IRS auditor less grumpy in the event that he audits you. ( Just make sure you don't overspend, as many people do with credit cards!) 

In addition to keeping good records, you also need to decide on what basis, cash or accrual, you want your company to keep its books.  Here's the lowdown on the options:

  Cash: Most small-business owners use the cash method, which simply means that for tax purposes, you recognize or report income in the year it's received and expenses in the year they're paid. 

  Accrual: The accrual method, by contrast, records income when the sale is made, even if the customer hasn't yet paid; expenses are recognized when incurred even if your business hasn't paid the bill yet. 

Sole proprietorships, partnerships, and S and personal service corporations generally can use the cash method.  C corporations and partnerships that have C corporations as partners may not use the cash accounting method. 

  The advantage of operating on a cash basis is that you can have some control over the amount of your business income and expenses that your business reports for tax purposes year to year.  Doing so can lower your tax bill.  Suppose that, looking ahead to the next tax year, you have good reason to believe that your business will make more money, pushing you into a higher tax bracket.  You can likely reduce your tax bill if you pay more of your expenses in the next year.  For example, instead of buying a new computer late this year, you can wait until early next year. ( Note: The IRS recognizes credit card expenses by the date when you make the charges, not when you pay the bill.)  Likewise, you can somewhat control when your customers pay you.  If you expect to make less money next year, simply don't invoice customers in December of this year.  Wait until January so you receive the income from those sales next year. 

Paying lower taxes (legally)

Every small business must spend money, and spending money in your business holds the allure of lowering your tax bill.  But don't spend money on your business just for the sake of generating tax deductions.  Spend your money to make the most of the tax breaks that you can legally take.  The following are some examples of legal tax breaks:

  Take it all off now or spread it around for later.  As a small-business owner, if you have net income, you can deduct up to $500,000 (for tax year 2011) per year for equipment purchases (for example, espresso machines, computers, desks, and chairs) for use in your business.  By deducting via a Section 179 deduction, you can immediately deduct the entire amount that you spend on equipment for your business.  Normally, equipment for your business is depreciated over a number of years.  With depreciation, you claim a tax deduction yearly for a portion of the total purchase price of the equipment.  For example, if you drop two grand on a new computer, you can take a $400 deduction annually for this computer's depreciation (if you elect straight-line depreciation).  If you elect the special 179 deduction, you can claim the entire $2,000 outlay at once (as long as you haven't exceeded the $500,000 annual cap). 

  Taking all the deduction in one year by using the Section 179 deduction method is enticing, but you may pay more taxes in the long run that way.  Consider that in the early years of most businesses, profits are low.  When your business is in a low tax bracket, the value of your deductions is low.  If your business grows, you may come out ahead if you depreciate your early-year big-ticket expenses, thereby postponing to higher-tax-bracket years some of the deductions that you can take off. 

  Make the most of your auto deductions.  If you use your car for business, you can claim a deduction, but don't waste a lot of money on a new car, thinking that the IRS pays for it — because it doesn't.  The IRS limits how large an annual auto expense you can claim for depreciation.  Another advantage of purchasing a more reasonably priced car: You won't be burdened with documenting your actual auto expenses and calculating depreciation.  You can use the auto expense method of just claiming a flat 51 cents per mile (for tax year 2011). 

  Deduct travel, meal, and entertainment expenses.  For the IRS to consider your expense deductible, your travel must be for a bona fide business purpose.  For example, if you live in Chicago, fly to Honolulu for a week, and spend one day at a seminar for business purposes and then the other six days snorkeling and sunning, you can deduct only the expenses for the one day of your trip that you devoted to business. ( An exception to this rule enables you to write off more of your trip: If you extend a business trip to stay over a Saturday night to qualify for a lower airfare and you save money in total travel costs, you can claim the extra costs that you incurred to stay over through Sunday!) 

Don't waste your money on meal and entertainment expenses.  You can deduct only 50 percent of your business expenses; by all means, take that 50 percent deduction when you can legally do so, but don't spend frivolously on business trips and think that you can deduct everything.  The IRS doesn't allow business deductions for club dues (such as for health, business, airport, or social clubs) or entertainment (such as executive boxes at sports stadiums). 

Keeping a Life and Perspective

David Packard, co-founder of Hewlett-Packard, said, "You are likely to die not of starvation for opportunities, but of indigestion of opportunities." 

Most small businesses succeed in keeping their owners more than busy — in some cases, too busy.  If you provide needed products or services at a fair price, customers will beat a path to your door.  Your business will grow and be busier than you can personally handle.  You may need to start hiring people.  I know small-business owners who work themselves into a frenzy by putting in 70 or more hours a week. 

If you enjoy your work so much that it's not really work, and you end up putting in long hours because you enjoy it, terrific!  But success in your company can cause you to put less energy into other important aspects of your life that perhaps don't come as easily. 

  Although careers and business successes are important, don't place these successes higher than fourth on your overall priority list.  You can't replace your health, family, and friends, but you can replace a job or a business. 
Chapter 15

Purchasing a Small Business

In This Chapter

  Evaluating the pros and cons of buying a small business

  Considering the skills you need to buy a small business

  Selecting the right business for yourself

  Examining franchises and multilevel marketing companies

  Checking out and negotiating a successful purchase

Each year, hundreds of thousands of small businesses are sold to new owners.  This chapter is for those of you who want to run or invest in an existing small business but don't want to start the business yourself.  And of course, this chapter can show you how to make good money and have fun along the way! 

Examining the Advantages of Buying

I don't want to scare you off if you want to start a business.  However, buying someone else's business works better for some people.  The following list reflects the main advantages of buying a business:

  You avoid start-up hassles and headaches.  Starting a business from scratch requires dealing with many issues.  For instance, in the early years, along with formulating a business plan, you must also develop a marketing plan, find customers, locate space, hire employees, and incorporate.  If you buy a good existing business, you buy into an ongoing enterprise with customers, assets, and hopefully profits (although you still need to fix any problems the business may have). 

  Consider the learning curve for the type of business you're contemplating purchasing.  Buying an existing business makes more sense if the business is complicated.  For example, purchasing a business that manufactures musical instruments may make more sense than starting one on your own.  Unless you've built musical instruments before and understand the intricacies of the production process, starting such a business from scratch is quite risky and perhaps foolhardy. ( Purchasing an existing business also makes sense if, for example, you don't want to build a stable of customers from scratch.) 

  You reduce risk.  Although investing in something with a solid track record is still far from a sure thing, your risk may be significantly lower than the risk involved in a start-up.  After a business has an operating history and offers a product or service with a demonstrated market, some of the risk in the company is removed.  Looking at historic financial statements also helps you make more accurate financial forecasts than you could make with a start-up venture. 

  You enhance your ability to attract investor or lender money.  You should have less difficulty raising money from investors and lenders for your existing business than with a start-up.  Why?  You'll likely find it easier to attract investors to something that's more than an idea.  And for the amount that they invest, investors demand a smaller piece of an existing business than they would with an investment in an idea. 

  You can enter industries where buying an existing business is your only ticket in.  You can enter some industries only through your purchase of a business that already exists.  For instance, if you want to be involved in a bottling or car dealership business, you're mostly limited to purchasing existing businesses. 

  You can find businesses where you can add value.  Some entrepreneurs who start businesses don't see the potential for growth or don't want to grow their businesses — they may be burned out, content with their current profit, or simply ready to retire.  Finding businesses where the potential exists to improve operating efficiency and to expand into new markets isn't too hard.  Finding small companies that are undervalued relative to the potential that they can offer is easier for a business-minded person. 

  Just because you think you see potential to improve a business doesn't mean you should pay a high price based on your high expectations.  You can be wrong — you may be looking at the business through rose-colored glasses.  Even if you're correct about the potential, don't pay the current owner for the hard work and ingenuity that you'll bring to the business if you purchase it.  Offer a fair price based on the conditions and value of the business now — I explain how to figure this value in the section "Evaluating a Small Business" later in this chapter. 

Understanding the Drawbacks of Buying

Not everyone enjoys running or cooking, and, similarly, some people don't enjoy the negatives that come with buying an existing business.  If the following issues don't turn you off, purchasing an existing business may be right for you:

  You buy the baggage.  When you buy an existing business, the bad comes with the good, and all businesses include their share of the bad.  The business may employ problem employees, for example, or it may have a less-than-stellar reputation in the marketplace.  Even if the employees are good, they and the company culture may not mesh with where you want to take the company in the future. 

Do you have the ability to motivate people to change — or to fire them if they don't?  Do you have the patience to work at improving the company's products and reputation?  You need these types of skills and traits to run and add value to a company.  Some people enjoy and thrive on such challenges, and others find such pressures hard to swallow.  Think back on your other work experiences for information about what challenges you've tackled and how you felt about them. 

  You need to do a lot of inspection.  If you think that buying a company is easier than starting one, think again.  You must know what you're buying before you buy it.  So you need to do a thorough inspection.  For example, you need to rip apart financial statements to ascertain whether the company is really as profitable as it appears and to determine its financial health. 

  After you close the deal and the money is transferred, you can't change your mind.  Unless a seller commits fraud or lies, which is difficult and costly for a buyer to legally prove, it's "buyer beware" about the quality of the business you're buying. ( In "Evaluating a Small Business," later in this chapter, I cover the homework that you need to do before you buy.) 

  You need more capital.  Existing businesses have value, which is why you generally need more money to buy a business than you do to start one.  If you're short of cash, starting a company is generally a lower-cost path. 

  Lower risk means lower returns.  If you purchase a good business and run it well, you can make decent money.  In some cases, you can make a lot of money.  But you generally have less potential for hitting it big with an existing business than you do with a business you start.  Those who have built the greatest wealth from small businesses are generally those who have started them rather than those who have purchased existing ones. 

  You don't get the satisfaction of creating a business.  Entrepreneurs who build their own businesses get a different experience than those who buy someone else's enterprise.  You can make your mark on a business that you buy, but doing so takes a number of years.  Even then, the business is never completely your own creation. 

Prerequisites to Buying a Business

Not everyone is cut out to succeed when buying an existing business.  A couple prerequisites are necessary to improve your chances of success.  The following sections explain. 

Business experience

You definitely need business experience to succeed when buying an existing business.  If you were an economics or business major in college and took accounting and other quantitatively oriented courses, you're off to a good start. 

Even better than academic learning, however, is work experience in the type of business that you want to buy.  If you want to run a restaurant, go work in one.  Consider the experience as paid on-the-job training for running your own restaurant. 

If you've worked as a consultant on business-management issues with a variety of industries, you also have a good background.  However, the danger in having done only consulting is that you're usually not on the front lines where operational issues arise. 

Should none of the previous examples apply to you, I won't say that you're doomed to fail if you buy a business, but I will say that the odds are against you. 

  If you don't have business experience, you'll likely do far better in your first business venture after some remedial work.  Get some hands-on experience, which is more valuable than any degree or credential that you can earn through course work.  No substitute exists for the real-life experiences of marketing to and interacting with customers, grappling with financial statements, dealing with competitive threats, and doing the business of business.  However, I don't endorse skipping academic course work.  You may, in fact, be required to get a credential to be able to do the work that you want to do.  If you don't need a specific credential, taking selected courses and reading good business books (I recommend some in Chapter 18) can boost your knowledge. 

Financial resources

To purchase a business, as with real estate, you need to make a down payment on the purchase price.  Bankers and business sellers who make loans to business buyers normally require down payments of 25 to 30 percent to protect their loans.  Small-business buyers who make sizeable down payments are less likely to walk away from a loan obligation if the business gets into financial trouble. 

  If you lack sufficient capital for a down payment, try asking family or friends to invest.  You can also set your sights on a less expensive business or seek business owners willing to accept a smaller down payment.  If you can find a business for sale where the owner wants less than 20 percent down, you may be on to something good.  Be careful, though, because an owner who accepts such a small down payment may be having a difficult time selling because of problems inherent in the business or because the business is overpriced. 

You can purchase some existing small businesses with a loan from the selling owner.  Also, check for loans with banks in your area that specialize in small-business loans. ( See Chapter 14 for other financing ideas.) 

Focusing Your Search for a Business to Buy

Unless you're extraordinarily lucky, finding a good business to buy takes a great deal of time.  If you spend time outside of your work hours, finding a quality business that's right for you can easily take a year or two.  Even if you can afford to look full time, finding and closing on a business can still take you many months. 

  Above all else, it pays to be persistent, patient, and willing to spend time on things that don't lead to immediate results.  You must be willing to sort through some rubbish.  If you require immediate gratification in terms of completing a deal, you can make yourself miserable in your search or rush into a bad deal. 

Unless you set some boundaries for your business search, you're going to end up spinning your wheels (and likely end up with the wrong type of business for yourself).  You don't need to be rigid or to precisely define every detail of the business that you want to purchase, but you do need to set some parameters so you can start laying the groundwork to purchase. 

Each person has unique shopping criteria.  The following list exemplifies some useful ones to narrow your search:

  Size/purchase price: The money you have available to invest in a business determines the size of business you can afford.  As a rough rule, figure that you can afford to pay a purchase price of about three times the amount of cash you have earmarked for the business.  For example, if you have $50,000 in the till, you should look at buying a business for about $150,000.  Because many business sellers overprice their businesses, you can probably look at businesses listed at a price above $150,000, perhaps as high as $200,000. 

  Location: If you're already rooted and don't want to move or deal with a long commute, the business's location further narrows the field.  Although you may be willing to look at a broader territory, maybe even nationally if you're willing to relocate, evaluating businesses long-distance is difficult and costly.  Unless you want a highly specialized type of company, try to keep your business search local. 

  Industry: Industry-specific expertise that you want to use in the business you buy can help whittle the pool of businesses down further.  If you don't have industry-specific expertise, I highly recommend that you focus on some specific niches in industries that interest you or in which you have some knowledge or expertise.  Focusing on an industry helps you conduct a more thorough search and find higher-quality companies.  The industry knowledge that you accumulate in your search process can pay big dividends during your years of ownership in the business. 

  If you have a hard time brainstorming about specific industries, use this trick to jump-start your creativity: Take a walk through the yellow pages!  Many business types known to exist in your area are listed alphabetically.  Remember that a separate yellow pages directory exists for businesses that sell mainly to consumers; a business-to-business yellow pages directory lists businesses whose customers are primarily other businesses.  Look at either or both, depending on the types of businesses that interest you.  You also may want to buy a business in a sector that's experiencing fast growth so you, too, can ride the wave.  Check out Inc. magazine's annual Inc. 5,000 list of the fastest-growing private companies in America. 

  Opportunity to add value: Some buyers want to purchase a business with untapped opportunities or problems that need to be fixed.  As with real estate, however, many people are happier leaving the fixer-uppers to the contractors.  Some businesses without major problems can offer significant untapped potential. 

After you define your shopping criteria, you're ready to go to the marketplace of businesses for sale.  I recommend that you type up your criteria on a single page so you can hand it to others who may put you in touch with businesses for sale.  The following sections give you the best techniques for identifying solid businesses that meet your needs. 

Perusing publications

If you're focused on specific industry sectors, you may be surprised to find out that all sorts of specialty newsletters and magazines are published.  Just think of the fun you can have reading publications such as Alternative Energy Retailer, Specialty Foods Merchandising, Coal Mining Newsletter, Advanced Battery Technology, or Gas Turbine World!  Specialty publications get you into the thick of an industry and also contain ads for businesses for sale or business brokers who work in the industry. 

Conducting literature searches of general interest business publications can help you identify articles on your industry of interest.  Online computer searches can help you find articles as well.  Websites worth examining include www.bizbuysell.com and www.sba.gov. 

  A useful reference publication that you can find in public libraries with decent business sections is a two-volume set titled Small Business Sourcebook (Gale).  Organized alphabetically by industry, this reference contains listings of publications, trade associations, and other information sources. 

Networking with advisors

Speak with accountants, attorneys, bankers, and business consultants who specialize in working with small businesses.  These advisors are sometimes the first to hear of a small-business owner's desire to sell.  Advisors may also suggest good businesses that aren't for sale but whose owners may consider selling (see the next section). 

Knocking on some doors

Some business owners who haven't listed their businesses for sale may be thinking about selling, so if you approach enough owners, you may find some of these not-yet-on-the-market businesses with owners interested in selling.  You can increase the possibility of finding your desired business and may get a good deal on such a business because you can negotiate with such a seller from the beneficial position of not having to compete with other potential buyers. 

  Instead of calling on the phone or literally knocking on the business's door, start your communications by mail.  Sending a concise letter of introduction explaining what kind of business you're looking for and what a wonderful person you are demonstrates that you're investing some time in this endeavor.  Follow up with a call a week or so after you send the letter. 

Working with business brokers

Numerous small businesses for sale list their enterprises through business brokers.  Just as a real estate agent makes a living selling real estate, a business broker makes a living selling businesses. 

Business brokers generally sell smaller small businesses — those with less than $1 million in annual sales.  These businesses tend to be family-owned companies or sole proprietorships, such as restaurants, dry cleaners, other retailers, and service firms.  About half of such small businesses are sold through brokers.  Most business brokerage firms sell different types of businesses.  Some firms, however, specialize in one industry or a few industries. 

One advantage of working with brokers to buy a business is that a broker can expose you to other businesses you may not have considered (a doughnut shop, for example, instead of a restaurant).  Brokers can also share their knowledge with you — like the fact that you need to get up at 4 a.m. to make doughnuts. 

  The pitfalls of working with brokers include the following:

  Commission conflicts: Brokers aren't your business advisors; they're salespeople.  That fact doesn't necessarily make them corrupt or dishonest, but it does mean that their interests aren't aligned with yours.  Their goal is to do a deal and to do the deal as soon as possible.  And the more you pay for your business, the more they make.  Business brokers typically get paid 10 to 12 percent of the sales price of a business.  Technically, the seller pays this fee, but as with real estate deals done through brokers, the buyer actually pays.  Remember, if a broker isn't involved, the seller can sell for a lower price and still clear more money, and the buyer is better off, too. 

  Undesirable businesses: Problem businesses are everywhere, but a fair number end up with brokers when the owners encounter trouble selling on their own. 

  Packaging: This problem relates to the preceding two.  Brokers (who are on commission) help not-so-hot businesses look better than they really are.  Doing so may involve lying, but more typically, it involves stretching the truth, omitting negatives, and hyping potential. ( Owners who sell their businesses themselves may do these things as well.) 

You (and your advisors) need to perform due diligence on any business that you may buy.  Never, ever trust or use the selling package that a broker prepares for a business as your sole source of information.  Remember: Brokers, as well as sellers, may stretch the truth, lie, and commit fraud. 

  Access to limited inventory: Unlike real estate brokers (who can access all homes listed with brokers for sale in an area through a shared listing service), a business broker can generally tell you only about his office's listings. ( Confidentiality is an issue because a shared listing service increases the number of people who can find out that a business is for sale and the particulars of the sale.  This information may cause some customers to find another company to do business with and may lead some key employees to leave as well.) 

If you want to work with a business broker, use more than one.  Working with a larger business brokerage firm or one that specializes in listing the type of business that you're looking for can maximize the number of possible prospects that you see.  Some state associations of business brokers share their listings.  However, even in such states, some of the larger brokerages opt to not include themselves because they benefit less from sharing their information. 

  Few licensing requirements: The business brokerage field isn't tightly regulated.  The majority of states have no requirements — anyone can hang out a shingle and work as a business broker.  Some states allow those with securities brokerage licenses to operate as business brokers, whereas most states require real estate licenses. 

Ask tax, legal, and business consultants for names of good brokers they may know.  If you find a broker you'd like to work with, first check references from other buyers who have worked with that broker.  Be sure the broker works full time and has solid experience. ( Some business brokers dabble in the field part time and make a living in other ways.) 

  Ask the broker you're interested in for the names of several buyers of similar businesses whom she's worked with over the past six months.  By narrowing down the field to the past six months and only your particular business interest, the broker can't just refer you to the three best deals of her career.  Also, check whether anyone has filed complaints against the brokerage with the local Better Business Bureau, or BBB (although the BBB favors member companies and is less likely to entertain and retain complaints against members), and the state regulatory departments (real estate, attorney general, department of corporations, and so on) that oversee business brokers. 

Considering a Franchise or Multilevel Marketing Company

Among the types of businesses that you may buy are franchises and multilevel marketing companies.  Both of these types of businesses offer more of a prepackaged and defined system for running a business.  Although both types may be worth your exploration, significant pitfalls can trip you up, especially with multilevel marketing companies. 

Finding a franchise

Some companies expand their locations through selling replicas, or franchises, of their business.  Purchasing a good franchise can be your ticket into the world of small-business ownership.  When you purchase a franchise, you buy the local rights to a specified geographic territory to sell the company's products or services under the company's name and to use the company's system of operation.  In addition to an upfront franchisee fee, franchisers also typically charge an ongoing royalty. 

Franchising makes up a huge part of the business world.  Companies that franchise — such as McDonald's, Pizza Hut, H&R Block, Jiffy Lube, 7-11 stores, Gymboree, Century 21 Real Estate, Holiday Inn, Avis, Subway, and Foot Locker — account for more than $1 trillion in sales annually. 

Franchise advantages

When you purchase a new franchise, you don't automatically have customers.  Just like starting a business, you must find your patrons.  However, the parent company should have a track record and multiple locations with customers. ( You can also purchase existing franchises from owners who want to sell, and these businesses come complete with customers.) 

So why would you want to pay a good chunk of money to buy a business without customers? 

  Proven business: A company that has been in business for a number of years and has successful franchisees proves the demand for the company's products and services and shows that the company's system for providing those products and services works.  The company has worked out the bugs and has hopefully solved common problems.  As a franchise owner, you benefit from and share in the experience that the parent company has gained over the years. 

  Name-brand recognition: Some consumers recognize the company name of a larger and successful franchise company and may be more inclined to purchase its products and services.  For example, some consumers feel more comfortable getting an oil change at franchiser Jiffy Lube rather than from a local Ollie's Oil Changers.  The comfort that comes from dealing with Jiffy Lube may stem from the influence of advertisements, recommendations of friends, or your own familiarity with their services in another part of the country.  Most free-standing small businesses for sale in a community lack this name-brand recognition. 

  Centralized purchasing power: You would hope and expect that Jiffy Lube, as a corporation made up of hundreds of locations, buys oil and other car supplies at a low price. ( Volume purchasing generally leads to bigger discounts.)  In addition to possibly saving franchisees money on supplies, the parent company can also take the hassle out of figuring out where and how to purchase supplies.  Again, most unattached small businesses that you could buy won't offer this advantage.  However, quality business associations can provide some of these benefits. 

Franchise pitfalls

  As with purchasing other small businesses, pitfalls abound in buying a franchise.  Franchises aren't for everyone.  Here are some common problems that may cause you to reconsider buying a franchise:

  You're not the franchise type.  When you buy a franchise, you buy into an established system.  People who like structure and following established rules and systems adapt more easily to the franchise life.  But if you're the creative sort who likes to experiment and change things, you may be an unhappy franchisee.  Unlike starting your own business, where you can get into the game without investing lots of your time and money, buying a franchise that you end up not enjoying can make for an expensive learning experience. 

  You may be locked in to buying overpriced supplies.  Centralized, bulk purchasing through the corporate headquarters supposedly saves franchisees time and money on supplies and other expenditures.  Some franchisers, however, take advantage of franchisees through large markups on proprietary items that franchisees must buy from the franchisers. 

  The franchise is unproven.  If the company's concept hasn't stood the test of time, don't make yourself a guinea pig.  Some franchisers show more interest in simply selling franchises to collect the upfront franchise money.  Reputable franchisers want to help their franchisees succeed so they can collect an ongoing royalty from the franchisees' sales. 

  The franchise is a pyramid scheme.  Unscrupulous, short-term-focused business owners sometimes attempt to franchise their businesses and sell as many franchises as they can as quickly as possible.  Some push their franchisees to sell franchises.  The business soon focuses on selling franchises rather than operating a business that sells a product or service well.  In rare cases, franchisers engage in fraud and sell next to nothing, except the hopes of getting rich quick. 

Evaluating a franchise

Make sure you do plenty of homework before you agree to buy a franchise.  You may be tempted to cut corners when reviewing a franchise from a long-established company.  Don't.  You may not be right for the specific franchise, or perhaps the "successful" company has mostly been good at keeping problems under wraps. 

In "Evaluating a Small Business," later in this chapter, I explain the homework you should complete prior to buying an existing business.  That section is especially important if you want to purchase an existing franchise from another franchisee. 

Work-from-home "opportunities"

"We made $18,269.56 in just 2 1⁄2 weeks!  Remarkable home-based business!  We do over 90 percent of the work for you!  Free info: 800-555-8975." 

"You can be earning $4,000 to $10,000 each month in less than 30 days!  We'll even help you hire agents to do the work for you . . .  FREE!" 

You can find lots of ad copy like this, especially in magazines and e-mails and on websites that small-business owners and wannabe small-business owners read.  In most cases, these ads come from grossly overhyped multilevel marketing companies.  In other ads, no legitimate company exists; instead, a person (or two or three) simply tries to sell you some "information" that explains the business opportunity.  This information may cost several hundred dollars or more.  Sadly, such packages end up being worthless marketing propaganda and rarely provide useful information that you couldn't find at a far lower cost or no cost at all. 

Remember: Never buy into anything like these ads that companies (or people) pitch to you through the mail or over the phone. 

Considering a multilevel marketing company

A twist, and in most cases a bad one, on the franchising idea is multilevel marketing (MLM) companies.  Sometimes known as network companies, MLM companies can be thought of as a poor person's franchise.  I know dozens of people, from clients I've worked with to students I've taught in my courses, who have been sorely disappointed with the money and time they've spent on MLM companies. 

  In companies that use multilevel marketing, representatives who work as independent contractors recruit new representatives, known in the industry as your downline, as well as solicit customers.  For those weary of traditional jobs, the appeal of multilevel marketing is obvious.  You can work at home, part time if you want.  You have no employees.  You don't need any experience.  Yet you're told you can still make big bucks ($10,000, $25,000, $50,000, or more per month).  If your parents raised you right, however, you should be skeptical of deals like these. 

A big problem to watch out for when dealing with MLM companies is the business equivalent of the pyramid scheme — businesses that exist to sign up other people.  Beware of MLM companies that advocate the following: "Sell directly to those that you have direct influence over.  The system works great because you don't need to resell month after month.  It's an opportunity for anybody — it's up to that person how much work he wants to put into it." 

Quality multilevel marketing companies are the exception

A number of multilevel marketing (MLM) companies have achieved success over the years.  Amway, Herbalife, and Mary Kay have stood the test of time and achieved significant size.  Amway founders Richard De Vos and Jay Van Andel achieved multibillionaire status. 

Not all MLM companies are created equal, and few are worth a look.  However, Mary Kay, which sells primarily makeup and skin care products, is an example of a successful MLM company with a 30-plus year history.  Mary Kay has hundreds of thousands of sales representatives and does business worldwide.  Although not shy about the decent money that its more successful salespeople make, Mary Kay doesn't hype the income potential.  Local sales directors typically earn $50,000 to $100,000 per year, but this income comes after many years of hard work.  Mary Kay rewards top sellers with gifts, such as the famous pink Cadillac. 

The ingredients for Mary Kay's success include competitive pricing, personal attention, and social interaction, which many stores don't or can't offer their customers. " We make shopping and life fun . . .  we make people look and feel good," says Mary Gentry, one of Mary Kay's sales directors. 

Mary Kay encourages prospective representatives to try the products first and then host a group before they sign up and fork over the $100 to purchase a showcase of items to sell.  To maximize sales, the company encourages Mary Kay reps to keep a ready inventory because customers tend to buy more when products are immediately available.  If reps want out of the business, they can sell their inventory back to the company at 90 cents on the dollar originally paid, a good sign that the company stands behind its product. 

Quality multilevel marketing companies make sense for people who really believe in and want to sell a particular product or service and don't want to or can't tie up a lot of money buying a franchise or other business.  Just remember to check out the MLM company, and realize that you won't get rich in a hurry, or probably ever. 

  Any MLM company examination should start with the company's product or service.  How does its product or service stack up to the competition on price and quality?  Contact the Better Business Bureau in the city where the MLM company is headquartered to see what kinds of complaints are on file. 

  The bottom line on any network marketing "opportunity" is to remember that it's a job.  No company is going to pay you a lot of money for little work.  As with any other small-business venture, if you hope to earn a decent income, multilevel marketing opportunities require at least three to five years of low income to build up your business.  Most people who pay to buy into networks make little money, and many quit and move on. 

Also, think twice before you sign up relatives, friends, and co-workers — they're often the first people network marketers encourage you to sell to.  A danger in doing business with those people whom you have influence over is that you put your reputation and integrity on the line.  You could be putting your friendships and family relations on the line as well. 

  Do your homework and remember that due diligence requires digging for facts and talking to people who don't have a bias or reason to sell to you.  Do the same homework that I recommend for franchises in the later section "Evaluating a Small Business."  Be skeptical of multilevel marketing systems, unless the company has a long track record and many people who are happy.  In other words, assume that an MLM company isn't worth pursuing until your extensive due diligence proves otherwise. 

Evaluating a Small Business

If you put in many hours, you may eventually come across a business that interests and intrigues you so much that you consider purchasing it.  As with purchasing a piece of real estate, major hurdles stand between you and ownership of the business.  You need to inspect what you want to buy, negotiate a deal, and finalize a contract.  When done correctly, these processes take a lot of time. 

Doing due diligence

The American legal system presumes a person is innocent until a jury proves that person is guilty beyond a reasonable doubt.  When you purchase a business, however, you must assume that the selling business owner is guilty of making the business appear better than what it is (and possibly of lying) until you prove otherwise with due diligence. 

I don't want to sound cynical, but a business owner can use more than a few tricks to make a business look more profitable, financially healthier, and more desirable than it really is.  You can't decide how much inspection or due diligence to conduct on a business based on your gut feelings. 

  Because you can't guess what hidden surprises exist in a business, you must dig for them.  Until you prove to yourself beyond a reasonable doubt that these surprises don't exist, don't go through with a business purchase. 

When you find a business you may want to purchase, you absolutely, positively must do your homework before you buy.  However, just as with purchasing a home, you don't want to expend buckets of money and time on detailed inspections until you can reach an agreement with the seller.  What if you deal with a seller who is unrealistic about what the business is worth?  You need to perform the most serious, time-consuming, and costly due diligence after you have an accepted offer to purchase a business.  Make such inspections a contingency in your purchase contract. 

Ultimately, if you're going to buy a business, you need to follow a plan similar to, but likely shorter than, the business plan I present in Chapter 13.  Addressing such issues in a plan goes a long way toward helping you perform your due diligence. 

Following are some additional questions you should answer about a business you're contemplating purchasing (address as many of the questions as possible before you make your offer):

  Why is the owner selling?  Ask the owner or the owner's advisors why the owner wants to sell and why now.  The answer may shed insight on the owner's motivations and need to sell.  Some owners want to bail when they see things getting worse. 

  What is the value of the assets that you want to buy?  This value includes not only equipment but also "soft" assets, such as the firm's name and reputation with customers and suppliers, customer lists, patents, and so on.  Interview key employees, customers, suppliers, advisors, and competitors.  Ask key customers and key employees whether they would still be loyal to the business if you took it over. 

  What do the financial statements reveal?  Search for the same things that you would look for in a company whose stock you're considering purchasing. ( See Chapter 6 for information on how to read financial statements and what to look for.)  Don't take the financial statements at face value simply because they're audited.  The accountant who did the audit may be incompetent or chummy with the seller. 

  One way to check for shenanigans is to ask the seller for a copy of the business's tax returns.  Owners are more likely to try to minimize reported revenue and maximize expenses on their tax return to keep from paying more tax.  After you have an accepted purchase offer, ask a tax advisor experienced in such matters to do an audit (see the "Questioning profits" sidebar in this chapter for more information). 

  If the company leases its space, what does the lease contract say?  A soon-to-expire lease at a low rate can ruin a business's profit margins.  With a retail location, the ability to maintain a good location is also vital.  Check comparables — that is, what other similar locations lease for — to see whether the current lease rate is fair, and talk to the building owner to determine his plans for the building.  Ask for and review (with the help of a legal advisor) the current owner's lease contract. 

  What liabilities, including those that may be hidden "off" the balance sheet, are you buying with a business?  Limit liabilities, such as environmental contaminations, through a contract.  Conduct legal searches for liens, litigation, and tax problems. 

  What does a background check turn up on the owners and key employees?  Do they have good business experience, or do they have criminal records and a trail of unpaid debts? 

Questioning profits

Don't blindly take the profit from the bottom line of a business's financial statement as the gospel.  As part of your due diligence, ask a tax advisor to perform an audit after you negotiate a deal. 

Even if the financial statements of a business are accurate, you (and your tax advisor) must still look for subtle problems that can make the profits of the business appear better than they truly are.  The issues that I tell you to look for in Chapter 6, when you analyze the financial statements of public companies that issue stock, also apply to evaluating the financial statements of small businesses. 

If necessary, factor out one-time events from the profit analysis.  For example, if the business last year received an unusually large order that is unlikely to be repeated and hasn't been the norm in the past, subtract this amount from the profitability analysis.  Also, examine the owner's salary to see whether it's low for the field.  Owners can reduce their draw to a minimum or pay family members less than fair market salaries to pump up the profitability of their company in the years before they sell.  Also examine whether the rent or mortgage expense may change when you buy the business.  Consider what will happen to profits when you factor in your expected rent or mortgage costs. 

Determining a business's value

After you find what you think is a good business and do your homework, you're ready to make an offer.  Negotiating takes time and patience.  Unless you're legally savvy, find an attorney who focuses her practice on small-business dealings.  Have that attorney review and work with your contract.  Also consider obtaining input from a qualified tax advisor. 

Good advisors can help you inspect what you're buying and look for red flags in the company's financial statements.  Advisors can also help structure the purchase to protect what you're buying and to gain maximum tax benefits.  If you work with a business broker, use an attorney and accountant as well. 

  The price that a business is listed for is often in excess of — and sometimes grossly so — the business's true worth.  A smart homebuyer or real estate investor looks at comparable properties when he's ready to make an offer.  So you should do the same and look at what similar businesses have sold for as a starting point for valuing a business that you want to buy. 

  When you look at sales prices of comparable businesses, calculate how many times the companies' earnings that these businesses sold for. ( In Chapter 5, I discuss how the price/earnings ratio works for evaluating the value of larger, publicly traded companies.)  Because they're less well established and riskier from an investment standpoint, small, privately held businesses sell for a lower multiple of earnings than comparable, but larger, companies. 

Some advisors and business brokers advocate calculating how many times revenue a company should sell for to determine the value of the business.  Revenue is a poor proxy for profitability: Two businesses in the same field can have identical revenue yet quite different profitability because of how well they're run, the pricing of their products and services, and the types of customers they attract. 

In addition to looking at the sales price of other businesses relative to earnings, you can also consider the value of a company's assets.  The so-called book value of a company's assets is what the assets are worth per the company's balance sheet.  Check these figures to ensure that their asset values are correct.  Another, more conservative way to value such assets is to consider the liquidation or replacement cost. 
Part V

Investing Resources

In this part . . . 

Everywhere you turn these days, you're bombarded with investing tidbits, sound bites, trivia, advice, and opinions.  So in this important part, I help you evaluate the reliability of a given source.  Whether you're reading a magazine article, a blog, or a book, perusing an Internet site, using software, watching television, or listening to the radio, you need to know how to evaluate what's worth considering and what's best to ignore. 
Chapter 16

Selecting Investing Resources Wisely

In This Chapter

  Overcoming information and advice overload

  Evaluating investing resources

  Deciphering online information and guru claims

In the past, finding financial information was much simpler, largely because the available resources were limited.  Today's investor faces information overload.  Radio, television, magazines, newspapers, books, the Internet, family, friends, neighbors, and cabdrivers — everywhere you turn, someone is offering investing opinions, tips, and advice.  You can't pick up a newspaper or magazine or turn on the television or radio without bumping into articles, stories, segments, and entire programs devoted to investment issues.  Blogs on the topic continue to sprout like weeds during the dog days of summer. 

Because investment information and advice is so widespread and constantly growing, knowing how to sift through it is just as important as hearing what the best resources are today.  When chosen wisely, the best investing resources can further your investment knowledge and enable you to make better decisions.  Throughout this book, I name the best investment resources that I'm familiar with, but in this chapter, I explain how you can separate the good from the mediocre and awful. 

Dealing with Information Overload

Early in the year 2000, one of my clients, Roseanne, called me in a near panic.  She said, "Eric, I'm not satisfied with my investments.  Why are so many of my friends doubling and tripling their money in technology stocks, and my mutual funds are going nowhere?  Everywhere I turn, people are talking about these high-growth companies.  I want my piece of the pie, too!"  I explained to her that many of her diversified mutual funds held some technology stocks as well as stocks in many other industries.  I also reminded her that because she was nearing 50 years of age, she had a healthy helping of bonds in her portfolio as well. 

She urged me to put her money in some technology stocks and technology-focused funds, but I stood my ground.  I further encouraged her to read this book (the second edition was out at the time), wherein I highlighted technology stocks as a bubble waiting to burst (see Chapter 5).  I'm glad that Roseanne followed my advice, and now, years later, she is, too.  During the severe stock market decline in the early 2000s, technology stocks got clobbered, but other market segments (such as bonds and value-oriented stocks) actually increased in value. 

A major reason so many people were talking about making money with technology stocks was that so many media outlets (radio, television, websites, and so on) were talking about these investments and other personal money management issues around the clock.  All this talk logically makes one wonder why everybody in the media and publishing world is putting out investing information.  Has money become that much more complicated over the years?  Are there simply more media and publishing executives who want to help us? 

The following list explains some of the reasons investing has become such a hot topic:

  Communications options are expanding.  Over the years, the number of television channels has mushroomed as a result of cable television.  Flip through your cable channels at any hour of the day, and you see infomercials that promise to make you a real estate tycoon or stock market day trader in your spare time.  Similarly, the explosion of the Internet has introduced a whole new medium.  Now, at a relatively low cost, anybody can "publish" online.  The accessibility of these communications mediums allows just about anyone with an animated personality or access to a computer to appear to be an expert.  These newer communications options are primarily structured around selling advertising rather than offering quality content. 

  A rough decade combined with a panic.  The 2000s were the worst for U.S. stocks since the Great Depression.  The decade featured two severe bear markets, the second of which (in 2008) culminated in a panic.  Because many folks invest through retirement accounts such as IRAs and 401(k)s, heightened stock market volatility gets more attention. 

  Economic change breeds uncertainty.  Global competition and technological advances are causing most industries to undergo dramatic changes in much shorter periods of time.  Fear of job loss and financial instability run high in people's minds.  Economic change and widespread cynicism about Social Security's ability to provide a reasonable retirement income to baby boomers has also caused many to seek investment guidance. 

  Investment choices and responsibilities are increasing.  More employees today are forced to take responsibility for saving money for their retirement and deciding how to invest that money.  In the past, more employers offered pension plans.  In these plans, the employer set aside money on behalf of employees and retained a pension manager who decided how to invest it.  All the employees had to do was learn the level of benefits they had earned and when they could begin drawing a monthly check. 

  With today's retirement plans, such as 401(k)s, employees have to educate themselves about how much money they need to save and how to invest it.  In addition to mastering retirement planning and investment allocation, individuals face a dizzying number of financial products, such as the thousands of mutual funds that are on the market. 

Read the next section to find out how you can filter out the best information and advice and skip the rest. 

Separating Financial Fact from Fiction

Just because more sources than ever offer investing advice doesn't mean that you should read, listen to, or watch all of it.  In fact, most of the advice out there can easily steer you in the wrong direction.  So, in this section, I offer prescriptions for how to intelligently choose among all the available financial content. 

Understanding how advertising corrupts the quality of investment advice

  The first rule for maximizing your chances of finding the best investing information and advice is to recognize that there are no free lunches.  Too many people get sucked into supposedly free resources when looking for information. 

The Internet is packed with scores of "free" investing sites.  And if you turn on your television or radio, you come across mountains of "free" stuff.  Of course, someone is paying for all this "free" content, and it's all available for some reason.  Most of the free Internet sites are run by investment companies or someone else with something to sell.  What these sites give away is nothing but subtle and not-so-subtle advertising for whatever products and services they sell.  Advertising also foots the bill in the vast majority of cases involving free investment advice on TV and radio. 

As I discuss in Chapter 18, many investing and personal finance books also contain subtly veiled advertisements.  Some "authors" choose to write books that are the equivalent of an infomercial for something else — such as high-priced seminars — that he or she really wants to sell.  Such writers aren't interested in educating and helping you as much as they're seeking to sell you something.  So, for example, an author may write about how complicated the investing markets are and some indicators he follows to time investments.  However, at the end of such a book, the author says that investing is too complicated to do on your own and that you really need a personal investment manager — which, to no great surprise, the author happens to be. 

  Whether in print or on the Internet, television, or radio, advertising often compromises the quality of the investment advice it accompanies. 

I won't say that you can't find some useful investment resources in mediums with lots of advertising.  In fact, you can find some good investing programs on radio and television and some helpful investing sites on the Internet.  However, these resources are the exception to the rule that sources with lots of advertising contain little valuable information and advice.  Likewise, just because some publications have advertising doesn't mean that some of their columnists and articles aren't worthy of your time. 

In the following sections, I outline the problems that advertising can cause within all the media outlets. 

Influencing content

Many organizations, such as newspaper and magazine publishers and radio and television stations that accept ads, say that their ad departments are separate from their editorial departments.  The truth, however, is that in most of these organizations, advertisers wield influence over the content.  At a minimum, the editorial environments at these organizations must be perceived as conducive to the sale of the advertiser's product. 

The stock market cable television channels, for example, carry many ads from brokers catering to investors who pick and trade their own stocks.  Furthermore, such stations carry ads from firms that purport to teach folks how to make big bucks day trading (see Chapter 5).  Not surprisingly, such stations offer many "news" segments on their shows that cater to stock traders and condone and endorse foolish strategies, such as day trading, instead of condemning them.  Instead of asking themselves what's in the best interests of their viewers, listeners, and readers, executives at too many media and publishing firms ask what will attract attention and advertisers. 

Corrupting content

In most organizations, advertisers can have a direct and adulterating influence on editorial content.  Specifically, some media organizations and publishers simply won't say negative comments about a major advertiser.  And sometimes they highlight and praise investment companies that are big advertisers. 

More than a few publications have attempted to edit out critical comments that I've made about companies with lousy products.  These companies always turned out to be advertisers in the publications.  Some editors simply say they don't want to bite the hand that feeds them.  Others are less candid about why they remove such criticism.  The bottom line is still the same: Advertisers' influence prevents readers, viewers, and listeners from getting the truth and best advice. ( By the way, I don't write for organizations that edit my work in such a fashion.) 

Recognizing quality resources

With the tremendous increase in the coverage of investing and other personal money issues, more and more journalists are writing about increasingly technical issues — often in areas in which they have no expertise. ( This type of reporting is true in traditional print publications but especially so online.)  Some writers provide good information and advice.  Unfortunately, others dish out bad advice.  You probably aren't so willing to take medical or legal advice from non-experts, so why would you care any less about your money? 

  How can you know what information is good and whom you can trust?  Although I can suggest resources that I hold in high regard (as I do throughout this book, especially in Chapters 17, 18, and 19), I recognize that you may encounter many different investment resources and need to understand how to tell the best from the rest.  The answer to the question, dear reader, rests in educating thyself.  The more knowledgeable you are about sound and flawed investment strategies, the better able you are to tell good from not-so-good investment resources. 

The best thing to do when you encounter a financial magazine, newspaper, website, or other resource for the first time is to scrutinize it.  The following sections suggest some investigative work you should do before you take anyone's investment advice. 

Following the money

All things being equal, you have a greater chance of finding quality content when subscriber fees account for the bulk of a company's revenue and advertising accounts for little or none of the revenue.  This generalization, of course, is just that — a generalization.  Some publications that derive a reasonable portion of their revenues from advertising have some good columns and content.  Conversely, some relatively ad-free sources aren't very good. 

Figuring out their philosophy and agenda

Deciphering an author's philosophy and agenda is important to determining whether she provides quality information.  Readers of my books, for example, can clearly understand my philosophies about investing.  I advocate buying and holding, not trading and gambling.  I explain how to build wealth through proven vehicles, including stocks, real estate, and small-business ownership.  My guiding beliefs are clearly detailed on the Cheat Sheet in the front of this book. 

Unfortunately, many publications and programs don't make it as easy for you to see or hear their operating beliefs.  You may have to do some homework.  For example, with a radio program, you probably have to listen to at least portions of several shows to get a sense of the host's investment philosophies. 

  Red flags include publications and programs that make investing sound overly complicated and that imply or say you won't succeed or do as well if you don't hire a financial advisor or follow your investments like a hawk. 

Considering whether the information is constructive

Just about everywhere you turn these days — radio, television, and the Internet — you can get up-to-the-minute updates on financial markets around the globe.  Although most investors have a natural curiosity about how their investments are doing, from my experience, the constant barrage of updates causes a loss of focus on the bigger, more important issues.  In many cases, publishing and media companies report what I call the "noise" rather than the news of the day.  Some companies are far worse about doing so than others. 

  Over the next week, take a close look at how you spend your time keeping up with financial news and other information.  Do the programs and publications that you use most heavily really help you better understand and map out sound investment strategies, or do they end up confusing, overwhelming, and paralyzing you with bits and pieces of contradictory and often hyped noise?  I'm not saying that you should tune these resources out completely, but you should devote less time to the noise of the day and more time to self-education.  How can you do that?  Read some good books (a topic that I discuss in detail in Chapter 18). 

Investigating their qualifications

Examine the backgrounds, including professional work experience and education credentials, of a resource's writers, hosts, or anchors.  If such information isn't given or easily found, consider this secrecy a red flag.  People who have something to hide or lack something significantly redeeming about themselves usually don't promote their backgrounds. 

  Of course, just because someone seems to have a relatively impressive background doesn't mean that she has your best interests in mind or has honestly presented her qualifications.  For example, Forbes journalist William P. Barrett was skeptical of financial author Suze Orman's biographical and business claims.  He investigated and presented a sobering review of Orman's stated credentials and qualifications in Forbes magazine, revealing that they were largely exaggerated.  A writer for The San Francisco Chronicle later substantiated this fact. 

Examining gurus' claims

The tremendous growth in media outlets, such as through cable television, radio and television programs, and lots of websites, means that more pundits are making claims about the value of their predictions.  Such activity also tends to increase after a major event, such as the severe recession and stock market decline and associated financial crisis in 2008.  In the aftermath, many gurus claim "I told you so" status.  Unfortunately, many publications and media outlets that interview and give airtime to these pundits fail to independently investigate most of such claims. 

In Chapters 17, 18, and 19, I detail how to evaluate various claims.  I also provide a short list of worthwhile resources. ( Also visit the "Guru Watch" section of my website, www.erictyson.com, for analysis of many of the popular gurus in the media today.) 
Chapter 17

Perusing Periodicals, Radio, and Television

In This Chapter

  Sifting through financial magazines and newspapers

  Surveying radio and television programs

  Steering clear of most investment newsletters

Newspapers, magazines, newsletters, and radio and television programs inundate you and other investors with a constant barrage of investing information and advice.  In this chapter, I explain what to look for — and what to look out for — when you tune in to these traditional media sources in the hopes of investing better. 

In Print: Magazines and Newspapers

Visit a newsstand, and you find many investing publications as well as general interest publications with investing columns.  I've written investing articles for various magazines and newspapers.  Some of the experiences have been enjoyable, others okay, and a few miserable.  The best publications and editors I've written for take seriously their responsibility to provide quality information and advice to their readers. 

Taking the scribes to task

Perusing high-quality publications is fun, but reading those that include tons of hype and inaccurate information is mind-numbing.  In this section, I discuss the problems with magazine and newspaper investment articles so you can easily recognize and avoid them. 

Highlighting hype and horror

Whenever the stock market suffers a sharp decline, many in the media bring out the gloom and doom.  For example, when the stock and real estate markets slid sharply in the late 2000s, scores of "Great Depression II" pieces populated the pages.  First came talk that the "real" unemployment rate was actually closer to 20 percent instead of the reported (and already high) 10 percent.  Other similar negative stories weren't far behind. 

Then came the news stories that the local, state, and federal governments were so laden with debts that bankruptcy loomed and the very existence of the United States was in jeopardy. ( Global stock prices, meanwhile, doubled from their lows in early 2009, once again proving that the best values and opportunities come to those brave enough to buy when others are fearful of doing so and when bad news is easy to find.) 

Another particularly popular subject for such hyped-up reporting is the cost of a college education. ( See, you can write a sentence about the cost of education without including the word skyrocketing.)  Scores of these articles horrify parents with estimates of the expected costs associated with sending Junior to campus.  The typical advice they provide goes like this: Start saving and investing early so you don't have to tell Junior that you can't afford to send him to college. 

  Cost-of-college stories typify another failing of the media's horror stories.  The horror is that the story and the accompanying advice can be shortsighted.  Completely overlooked and ignored are the tax and financial aid consequences of the recommended investment strategies.  For example, if parents don't take advantage of tax-deductible retirement accounts and instead save outside of them to pay for expected college costs, they not only pay more in taxes but also generally qualify for less financial aid.  Sound investing decisions require a holistic approach that acknowledges that people have limited money and must make trade-offs.  And, unfortunately, magazines and newspapers can't always supply that type of advice. 

Quoting "experts" who don't know their stuff

Historically, one way that finance journalists have attempted to overcome technical gaps in their knowledge is to interview and quote financial experts.  Although these quotes may add to the accuracy and quality of a story, journalists who aren't experts themselves often have difficulty telling qualified experts from hacks. ( See Chapter 16 for a discussion on examining the qualifications of writers who offer up financial guidance.) 

  One glaring example of this phenomenon that continues to amaze me is how many newspaper and magazine financial writers quote unproven advice from investment newsletter writers.  As I discuss in the section "Fillers and Fluff: Being Wary of Investment Newsletters," later in this chapter, the predictive advice of many newsletter writers is often poor and causes investors to earn lower returns and miss more investment gains due to frequent trading than if they simply bought and held.  Journalists who simply parrot this type of information and provide an endorsement that unqualified sources are "experts" do readers an immense disservice. 

Focusing on noise and minutiae

Daily financial press writers contribute to today's shortsighted investment environment and encourage readers to adopt similarly misguided outlooks.  A focus on the noise of the day causes nervous investors to make panicked, emotionally based decisions, such as deciding to sell after major stock market falls. 

Of course, the daily print media aren't the only ones chronicling the minutiae.  As I discuss elsewhere, other media, including television, radio, and the Internet, cause many investors to lose sight of the long term and the big picture. ( I discuss television and radio resources later in this chapter; you can read about Internet resources in Chapter 19.) 

  The short length of newspaper and magazine articles can easily lead writers to oversimplify complex issues and offer flawed advice, so make sure to be judicious when reading them.  For example, some pieces on mutual funds focus on a fund's returns and investment philosophies, devoting little, if any, space to the risks or tax consequences of investing in the recommended funds. 

Making the most of periodicals

So what should you do if you want to find out more about investing but don't want to be overloaded with information?  Educate yourself and be selective.  If you're considering subscribing to financial publications, review some old issues and articles first.  Try to determine whether the information and advice was useful and error free.  The more you know, the easier it is to separate the wheat from the chaff. 

Shy away from publications that claim to be able to predict the future — few people have a knack for forecasting financial numbers, and those who do are usually busy managing money.  Unfortunately, as the financial markets got more volatile in the late 1990s and early 2000s, and then again in the late 2000s, I witnessed more and more publications promoting columnists and headlines that attempted to prognosticate the future. 

  Read bylines and biographies and get to know writers' strengths and weaknesses.  Ditto for the entire publication.  Any writer or publisher can make mistakes.  Some make many more than others, however.  So follow their advice at your own peril.  Start by evaluating advice in the areas that you know the most about.  For example, if you're interested in investing in Microsoft or Intel and are reasonably familiar with the computer industry, find out what the publications say about technology investments. 

And remember that you're not going to outfox the financial markets, because they're reasonably efficient (see Chapter 4).  Spend your time seeking out information and advice that help you flesh out your goals and develop a plan rather than hunting for the next hot stock tip or worrying about short-term trends. 

Broadcasting Hype: Radio and Television Programs

As you move from the world of magazines and newspapers to radio and television, the entertainment component usually increases.  In this section, I highlight some common problems with radio and television programs. 

I've been a guest on hundreds of radio and television programs.  Just as Dorothy discovered in The Wizard of Oz, seeing how things work behind the scenes tends to deglamorize these mediums.  Here are the main problems I've discovered from my years observing radio and television. 

You often get what you pay for

Not surprisingly, some of the worst financial advice is brought to you for "free."  Nationally, thousands of radio stations have financial and money talk shows.  Money and investing shows are proliferating on television cable channels.  Because listeners don't pay for these shows, advertising often drives who and what gets on the air, as I discuss in Chapter 16. 

I've found that some of the worst offenders are local — and even national — radio advice programs.  Some of these shows are "hosted" by a person who is nothing more than a financial salesperson.  That person's first, and sometimes only, motivation for hosting the show is to pick up clients.  Many local radio investing programs are hosted by a local stockbroker (who usually calls himself a financial consultant or planner).  A broker who reels in just one big fish a month — a person with, say, $300,000 to invest — can generate commissions totaling $15,000 by selling investments with a 5 percent commission. 

  I know from personal experience what too many radio stations look for in the way of hosts for financial programs.  The host's integrity, knowledge, and lack of conflict of interest don't matter.  Willingness to work for next to nothing helps.  In fact, one radio station program director told me that she liked the broker who was hosting a financial talk show because the broker was willing to work for so little compensation from the radio station.  Never mind the fact that the broker rarely gave useful advice and was obviously trolling for new clients.  Those things didn't matter to the program director, who told me, "We're in the entertainment business." 

Information and hype overload

At 9:30 a.m. EST, the New York Stock Exchange opens, and transactions start streaming across the bottom of television screens that are tuned to financial cable stations.  Changes in the major market indexes — the Dow Jones Industrial Average, the S&P 500, and the NASDAQ index — also flash on the screen.  In fact, these indexes are updated almost every second on the screen.  Far more exciting than a political race or sporting event, this event never ends and offers constant change and excitement.  Even after the markets close, reporting of still-open overseas markets continues.  The performance of futures of U.S. stock market indexes then appears on the screen. 

  This constant reporting doesn't make people better investors.  Although the conventionally accepted notion is that this information overload levels the playing field for the individual investor, I know too many investors who make emotionally based decisions prodded by all this noise, prognostication, opinion, and hearsay. 

Poor method of guest selection

Some journalists, often in an effort to overcome their own lack of knowledge, interview "experts."  A classic example of this problem is the media exposure that author Charles Givens used to receive.  Givens became a darling of the media and the public following an unprecedented, consecutive three-day appearance on NBC's Today show. 

"When Charles Givens talks, everyone listens," said Jane Pauley, then co-host of the Today show.  Bryant Gumbel, the other co-host, said of Givens, "Last time he was here, the studio came to a complete stop. . . .  Everyone started taking notes, and I was asking for advice."  Givens regularly held court on the talk show circuit with the likes of Larry King and Oprah Winfrey. 

The Givens case highlights some of the media's inability to distinguish between good and bad experts.  It's relatively easy for the financially sophisticated to see the dangerous, oversimplified, and biased advice that Givens offers in his books.  In his first best-seller, Wealth Without Risk, Givens recommended investing in limited partnerships and provided a phone number and address of a firm, Delta Capital Corp. in Florida, where readers could buy the partnerships.  Those who bought these products ended up paying hefty sales commissions and owning investments worth half or less of their original value.  Besides the problematic partnerships he recommended, court proceedings against Givens in a number of states uncovered that he owned a major share of Delta Capital. 

  Other investing advice from Givens that gives true experts pause: In his chapters on investing, he said that the average yearly return you earn investing in mutual funds will be 25 percent or 30 percent.  The reality: An investor would be fortunate to earn half of these inflated returns. 

So how did Givens get on all these national programs?  He had a shrewd publicist, and the show producers either didn't read his books or were financially illiterate themselves.  Talk shows and many reporters often don't take the time to check out people like Givens.  Most of the time, they never read the books these so-called experts write.  Producers, who themselves usually don't know much about investing, often decide to put someone on the air on the basis of a press kit or a call from a publicist. 

Fillers and Fluff: Being Wary of Investment Newsletters

Particularly in the newsletter business, prognosticators fill your mailbox and e-mail inbox with promotional material making outrageous claims about their returns.  Private money managers, not subject to the same scrutiny and auditing requirements as mutual fund managers, can do the same. 

  Be especially wary of any newsletters making claims of high returns.  Stephen Leeb's Personal Finance newsletter ads, for example, claim that he has developed a brilliant proprietary model, which he calls the "Master Key Indicator."  His model supposedly has predicted the last 28 consecutive upturns in the market without a single miss.  The odds of doing this, according to Leeb, are more than 268 million to 1!  The ad goes on to claim that Leeb's "Master Key" market-timing system could have turned a $10,000 investment over 12 years into $39.1 million, a return of 390,000 percent! 

Turns out that this outrageous claim was based on backtesting, looking back over historic returns and creating "what if" scenarios.  In other words, Leeb didn't turn anyone's $10,000 into $39 million.  Much too late after that ad appeared, the SEC finally charged Leeb with false advertising. ( Leeb settled out of court.) 

According to the Hulbert Financial Digest, the worst investment newsletters have underperformed the market averages by dozens of percentage points; some would even have caused you to lose money during decades (like the 1980s and 1990s) when the financial markets performed extraordinarily well.  Newsletter purveyor Joe Granville, for example, has long been known for making outrageous and extreme stock market predictions and is often quoted in financial publications.  He claims to have the number-one-rated newsletter, but he fails to mention that it was number one for one year only (in 1989).  Over the subsequent decade — one of the best decades ever for the stock market (with U.S. stocks more than quadrupling in value) — followers of Granville's advice lost 99 percent of their investments! 

  Be highly suspicious of past investment performance claims made by investment newsletters.  Don't believe a track record unless a reputable accounting firm with experience doing such audits has audited it.  You don't need predictions and soothsayers to make sound investing choices.  If you choose to follow this "expert" advice and you're lucky, little harm will be done.  But more often than not, you can lose lots of money by following a prognosticator's predictions.  Stay far away from publications that purport to be able to tell what's going to happen next.  No one has a crystal ball. 

The best investment publications can assist you with research and ideas.  For individual stock selection, please see my recommended resources in Chapter 6. 
Chapter 18

Selecting the Best Investment Books

In This Chapter

  Recognizing that some books advertise more than they educate

  Being skeptical about authors' claimed returns

  Presenting my favorite investing books

Over the years, I've read hundreds of investing and financial books.  You may have read a few yourself!  I hope that if you have, you've begun to learn that you need to be choosy and not take everything at face value. 

  Although most books have something to offer, too many investing books are burdened with biased, wrongheaded advice and misinformation.  As a non-expert, you may have a hard time sifting through the heap for the tidbits of treasure.  And, sadly, the bad stuff can pollute your thinking and cause you to make investing mistakes that millions before you have made. 

When reading investing books, remember not to believe everything you read.  Publishing is no different from any other business — companies are in it to make money.  As with other industries, the shortsighted desire to reap quick profits causes some companies to publish content that seems attractive in the short term but is toxic to readers in the long term.  In this chapter, I help you sift through the confusion to find books worth reading. 

Being Wary of Infomercial Books

When you're watching television, it's generally easy to identify infomercials.  You've got the overly energetic salesman pitching a product or service for up to 30 minutes.  With books, however, it's much more difficult to decipher such a pitch woven throughout a lengthy book.  In this section, I highlight what to look out for and give you a ring-side seat for a notorious book infomercial that duped too many folks. 

Understanding how authors may take advantage of you

  The worst books steer you toward purchasing a crummy investment product that the author has a vested interest in selling you.  They also tend to confuse more than they convey.  In fact, some authors have an incentive to make things complicated and mysterious.  Their agenda may be to sell you a high-priced newsletter or persuade you to turn your money over to them to manage. 

One book author said to me, "I write books to hook people into my monthly newsletter.  I can make $185 per year off of a $195 newsletter sale.  You can't do that with a book."  You sure can't.  However, this salesman isn't satisfied to just turn out books that are short on information and advice but long on pitches to keep up with the latest market developments through his newsletter.  When you subscribe to his newsletter, you're told that the financial markets are so complicated and change so rapidly that the newsletter is really no substitute for using his money-management service! 

  Unfortunately, most publishers don't do their homework to check out prospective authors.  They don't care what the author is up to or whether the author is really an expert on the topic.  As long as she's willing and able to write and promote a salable book, the publishers are happy.  Authors who run around the country conducting seminars and making publicity appearances are actually a plus to the publisher. 

Learning by example

In his books and seminar promotional materials, Wade Cook claimed to be able to teach people how to earn monthly returns of 20 percent or more (that's right — monthly, not yearly) by using his stock market investing strategies. ( If you've read this book, you know that the promise of such returns is a major red flag.) 

Cook's self-published books, which were short on specifics, were largely infomercials for his high-priced seminars.  His get-rich-quick investment seminars — which cost a whopping $4,695 — had been so successful at attracting attendees that Cook's company, Profit Financial Corporation, went public and generated more than $100 million in revenues annually!  Cook wasn't shy about promising people they could get rich quick without much effort.  Here's a passage from his book Stock Market Miracles:

I want millions of dollars and I don't want to have to work a 9 to 5 job to get them.  Boy, that's a conundrum.  It's almost impossible to work a typical American job, with average income and accumulate millions.  Yes, in 40 to 50 years maybe, but who wants to wait that long?  That's the rub — accomplishing the task of having millions without having to work for millions. 

You see my method is simple.  I want to use a small amount of money — risk capital if you will — to generate cash flow which will exponentially generate more income. 

Cook promised his followers several hundred percent annualized returns by teaching them how to successfully gamble (not invest) in the stock market.  Cook's "techniques" included trading in and out of stocks and options on stocks after short holding periods of weeks, days, or even hours. 

Cook's trading strategies were loosely based on technical analysis — that is, examining a stock's price movements and volume history through charting. ( See Chapter 6 for more details on the foolishness of technical analysis.)  His investment seminar, which was offered in cities throughout the country, was marketed to folks like this: "If you aren't getting 20 percent per month, or 300 percent annualized returns on your investments, you need to be there." 

Steven Thomas, a truck driver, went to a seminar with his wife so both of them could follow and implement Cook's strategies.  In addition to spending $4,695 on the seminar, they also spent another $2,000 on audiotapes and videotapes.  Six months later, Thomas spent $1,500 on a paging system from Cook's company.  The results?  Thomas eventually lost $36,000, which he borrowed against his home's equity, on investments that were made following Cook's strategies. " I saw this as an opportunity to quit my job and just invest in the stock market," says Thomas. " This has had a terrible impact on my family, and I'm super-depressed." 

Of course, if Cook had invested just $1 million of the income he supposedly earned in real estate and indeed earned the 300 percent annual returns his seminars claimed to be able to teach the masses how to achieve, he would have, in about a decade, become the world's wealthiest individual.  Look out, Bill Gates and Warren Buffett!  Any investor starting with just $10,000 would vault to the top of the list of the world's wealthiest people in about 15 years if Cook's teachings really worked! 

So how did Cook get his start in the investing world?  Here's what his website said:

He was a taxicab driver in the '70s.  Borrowing $500 from his father, Wade Cook started buying real estate.  His innovative ideas and gutsy follow-through enabled him to turn that $500 into several million.  But that's nothing compared with what he's doing on Wall Street.  Starting with $1,300, using his "Rolling Rock" and "Range Rider" methods, he's showing students how to create millions. 

Why is Wade so smart?  He says he's "street smart."  What he discovered driving a cab changed his life forever.  While his fellow cabbies were out looking for the big runs, Wade was taking every little run he could find — $4 here, $5 here.  You see it costs $2 just to get into a cab (something called a meter drop) even if you only go two blocks.  At the end of a month, Wade made three times what every other taxicab driver made.  Now, Wade applies his "meter drop" technique to his stock market investment business — making a ton of money on a lot of little deals. 

Imagine that — this investing genius honed his craft driving a cab!  Although Cook's investment return expectations were completely unrealistic, he got away with claiming these hyped and undocumented returns for many years because he didn't manage money for others.  Seminar promoters and newsletter writers face no SEC scrutiny of their inflated performance claims or what they do in their seminars as long as no securities laws are violated.  The SEC refers to such organizations as nonregulated entities. 

Of course, Cook wasn't the first person to profit in this fashion.  Numerous other seminar promoters and authors (some are discussed later in this chapter) have made big bucks as well, including the Beardstown investment club, which couldn't document its supposedly market-beating returns of 23-plus percent per year (see the next section for details).  In addition to puffed-up expected stock market returns, Cook has more to his past than simply driving a taxi.  According to Smart Money magazine, Cook's dubious business practices had him in trouble throughout the '80s.  At the end of his real estate seminars, which touted that average people could become millionaires by buying property with little money down, Cook began peddling stock in his own business ventures. 

State securities regulators in six states — Missouri, Utah, Minnesota, Illinois, Oregon, and Arizona — issued Cook cease-and-desist orders for selling securities without a license, selling unregistered securities, and omitting material facts (such as the fact that he had declared bankruptcy in 1987).  In fact, Arizona charged that Cook had duped $390,841 out of 150 investors by selling unregistered securities and funneling $48,000 of that money into a Scottsdale home purchase and federal income tax payments.  The state ordered him to pay back the money and slapped him with a $150,000 penalty. 

Cook answered by filing bankruptcy (again).  He then moved back to his home state of Washington, where he didn't lay low for long.  His new company, Profit Financial Corporation, became wildly successful when he began selling his Wall Street Workshop seminars and publishing his two stock-picking books.  The attorneys general of several states sought millions of dollars in consumer refunds and sued the company.  These states alleged the company lied about its investment track record. ( Now that's a big surprise — the company only claimed you would make 300 percent per year in stocks!)  Cook's company settled the blizzard of state and Federal Trade Commission (FTC) lawsuits against his firm by agreeing to accurately disclose his company's trading record in future promotions and to give refunds to customers who were misled by past inflated return claims. 

Although Profit Financial Corporation was a public company, SEC documents indicated that it wasn't exactly shareholder friendly.  Cook had set up a rather clever business structure whereby the public company (of which he is the majority owner) was required to pay him for the right to print his words and teach his methods.  This enabled Cook to funnel much of the revenue stream directly into his pockets before it ever got to the shareholders.  According to SEC filings, Cook's total corporate compensation in one year exceeded $8 million!  According to a report by Bloomberg News, Cook's firm lost a whopping 89 percent of its own money trading in 2000.  As Deb Bortner, director of the Washington State Securities Division and president of the North American Securities Administrators Association, observed, "Either Wade is unable to follow his own system, which he claims is simple to follow, or the system doesn't work." 

And as if Cook's financial dealings didn't have enough unsavory aspects, he also was sentenced in 2007 to more than seven years in federal prison for tax evasion, filing false tax returns, and obstructing a tax investigation.  He was ordered to pay nearly $4 million in additional taxes as well. 

  The moral of the story is this: Be highly skeptical and suspicious of investing books that direct you to high-priced seminars and other expensive products and services from the author.  The best investing books, which I recommend later in this chapter, seek to instruct and educate (not sell and scam). 

Ignoring Unaudited Performance Claims

  Book authors' claims of especially high returns generally aren't scrutinized.  But if a performance claim hasn't been independently audited, don't believe it.  Remember also that the stock market, over the long term, provides annualized returns of about 9 to 10 percent.  View skeptically any prognosticator or author claiming substantially higher returns that sound too good to be true. 

Some book publishers are happy to look the other way or even to solicit and encourage great boasts that they then use in the packaging to sell books.  Consider these two examples:

  The Beardstown Ladies' Common-Sense Investment Guide: How We Beat the Stock Market — and How You Can, Too: The Beardstown investment club claimed a whopping 23.4 percent annualized return since the club's inception.  In the book, the authors advocated forming an investment club, pooling your money, and using a simple stock selection method to beat the pants off the market and the suspendered managers of mutual funds.  The bulk of this book walked readers through how this investment club evaluated and selected individual stocks. 

  The Whiz Kid of Wall Street's Investment Guide by Matt Seto: This book boasted, "Matt Seto manages a portfolio that consistently outperforms 99 percent of all mutual fund managers . . .  and returns an annual average of 34 percent."  In his book, this then 17-year-old investing genius told readers to forget bonds, real estate, and mutual funds and grow rich by investing entirely in individual stocks. 

  Each of these books made prominently displayed and marketed performance claims.  The Beardstown club's returns and Seto's returns, versus the market averages, would've placed them shoulder to shoulder with the legendary Peter Lynch, former manager of the Fidelity Magellan fund, and Warren Buffett, an investor whom Peter Lynch described as "the Greatest Investor of them all."  Problem is, neither book contained information as to how these investment gurus calculated their returns, nor were the authors able to substantiate their claimed returns when asked to. 

When I first wrote about the Beardstown book for The San Francisco Examiner, I offered to work with an accounting firm to calculate the club's returns if the club supplied the necessary information.  I asked the same of Seto when I read his book.  Neither of these authors could supply the documentation to prove their claims, and they backpedaled when pressed. 

Initially, the Beardstown club said it would send the information, but months passed, and it never arrived.  The club's media spokesperson then told me that the club has "chosen not to make our return an issue. . . .  we're not out to be bragging."  This statement was surprising, given the claims prominently plastered all over the book. 

A later piece in Chicago magazine proved that although the Beardstown investment club claimed 23 percent per year returns versus 14 percent for the market over the same time period, the club actually tremendously underperformed the market and earned only 9 percent per year.  The publisher of the Beardstown book, Buena Vista Publishing (which was doing business as Hyperion and Seth Godin Productions), was ultimately sued.  Under the terms of the settlement, buyers of the Beardstown investment club's books, audiotapes, or videotapes received certificates that could be redeemed for other books published by Hyperion. 

Do you think the Beardstown ladies would have acquired their book deal (and landed on best-seller lists) if the facts had been known?  Seto, likewise, couldn't ever prove his claim of an astounding 34 percent return. 

Investing Books Worth Reading

Exceptional investing books — ones that are readable, educational, and insightful — are rare.  Some of the better investment books are technical in nature and are written by career investment folks, so don't be surprised if they require more than one read.  Make the investment of time; it'll pay big dividends (and capital gains!).  Following are my picks for books that are worth the trouble of tracking down and reading. 

A Random Walk Down Wall Street

  Now in its tenth edition, A Random Walk Down Wall Street (Norton), by Burton Malkiel, is a classic that was first published in 1973.  Malkiel is an entertaining and intelligent writer.  Drawing from examples from this century and others, Malkiel teaches how speculative bubbles (frenzied buying) and fear and greed, as well as economic and corporate fundamentals, can move the financial markets. 

One fundamental premise of his book is that the financial markets can't be predicted, especially in the short term.  Common sense confirms this premise: If someone could figure out a system to forecast the markets and make a fortune, that person wouldn't waste time writing a book, publishing a newsletter, and so on.  Malkiel, in fact, is one of the pioneers and proponents of index mutual funds, which simply invest in a relatively fixed basket of securities in order to track the overall market performance rather than to attempt to beat it. ( See Chapter 8 to find out about index funds and how to use them.) 

Needless to say, many Wall Street types aren't enamored of this book.  But Malkiel presents a mountain of compelling arguments and data to support his case that most Wall Street firms and their investment research aren't worthy of an investor's hard-earned money.  He also convincingly rebukes technical analysis, which supposedly can help predict security prices based on charting and following past price movements. ( See Chapter 6 for more about technical analysis.) 

Malkiel explains how to look at some common-sense indicators, such as whether the stock and bond markets are fairly valued and your own personal goals and desire to take risk, to develop a thoughtful and successful investment plan.  Instead of trying to predict the future, Malkiel explains how the level of risk an investor accepts with investments will ultimately determine future returns. 

Stocks for the Long Run

  Finance professor Jeremy J. Siegel loves investing data, especially data he can examine over long time periods.  In Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 4th Edition (McGraw-Hill), Siegel presents an analysis of U.S. stock and bond returns since 1802! 

The book is packed with charts and graphs for the analytic, graphical folks.  Even if you don't completely comprehend all these graphs, the book can still be beneficial.  Siegel provides comprehensive discussion of the worldwide financial markets as well as how the economic environment affects stocks.  The book focuses on stock market investing, but it also discusses bonds if for no other reason than to compare their returns and risk to stocks. 

Built to Last and Good to Great

  Some people may think that Built to Last: Successful Habits of Visionary Companies (HarperCollins) is just for the small number of people who want to build a large company.  However, the book, written by management consultant James Collins and Stanford Business School Professor Jerry Porras, is an excellent book for all entrepreneurs and people who work in leadership positions.  It's also great for people interested in investing in individual stocks. 

The book presents the findings from an extensive six years' worth of research into what's behind the success of companies such as 3M, Boeing, Ford, Hewlett-Packard, Motorola, Sony, and Wal-Mart, all of which have achieved great success in their respective industries over many years.  The average company in the Collins and Porras study was founded in 1897.  In all, the authors tracked 18 extraordinary companies (referred to as the gold-medal winners in their respective industries) and compared the traits of these companies with those of similarly long-lived but less successful peer companies (in the same industries). 

Collins and Porras's findings not only yield insight into how to build or identify a great business in which to invest, but they also destroy some commonly held myths.  For example, some people feel that a great idea is behind every great company.  This concept is wrong, and in fact, according to the authors' research, companies founded on the basis of a great idea can lead to focusing on the idea rather than laying the groundwork for building a great company.  Sony's founder, for example, wrote a nine-page philosophical prospectus setting the stage for this great company, yet he had few product ideas in his firm's early days.  Early products, such as a rice cooker, failed. 

Great, visionary companies are rigid and unyielding when it comes to respecting their core ideologies and principles.  On the other hand, such companies also tinker and experiment to stimulate positive change and innovation.  And despite their often-stunning financial success, great companies usually have an aspiration higher than or equal to maximizing profits: fulfilling a purpose and being driven by values.  This book is packed with insights, information, and examples, so don't expect to absorb all of its contents in one reading. 

Collins subsequently wrote another outstanding book, Good to Great: Why Some Companies Make the Leap . . .  And Others Don't (HarperCollins), which he calls the prequel to Built to Last.  In Good to Great, Collins presents the engaging and insightful results of another long-term study of numerous companies that over time moved from being average companies to outstanding companies.  As with Built to Last, this newer book can assist readers not only with managing their own small businesses but also with selecting companies to invest in. 

Mutual Funds For Dummies

The latest edition of my Mutual Funds For Dummies (John Wiley & Sons, Inc.) book, is the perfect complement to this book because it details how to build and manage a stock and bond portfolio by using the best mutual funds and exchange-traded funds (ETFs).  In Mutual Funds For Dummies, I discuss dozens of the best funds available and provide sample portfolios for investors in differing situations. 
Chapter 19

Investigating Internet and Software Resources

In This Chapter

  Choosing investing software

  Recognizing Internet pitfalls and opportunities

  Finding the best investing websites

Thousands of investing software packages, blogs, and websites claim to enable you to more easily make profitable investments.  As with most other advertising claims, the reality of using your computer for investing and other tasks often falls short of the promises and the hype. 

  In this chapter, I show you ways that your computer may help you with your investing challenges and chores.  Throughout this discussion, however, remember the following important caveats:

  Some highly successful investors don't use their computers, or they use them infrequently, to deal with their investments. ( Warren Buffett comes to mind.  He's reported not to have a computer on his office desk.) 

  You may subject yourself to information overload and spend a fair amount of money without seeing many benefits if you don't choose wisely. 

  You can't believe everything you read, especially in the online world, where expertise, filters, and editors are often absent. ( Of course, as I discuss elsewhere in this book, filters and editors don't guarantee that you'll find quality investment advice and information when you read financial publications.) 

Evaluating Investment Software

Good investment software should be user-friendly and provide quality information for making sound decisions.  Software that helps you make personal investment decisions also needs to provide, if applicable, well-founded advice. 

  The software that's best for you depends on what you're trying to accomplish as well as your level of investment knowledge and computer savvy.  Software can help you with a variety of investment tasks, from tracking your investments to researching, planning, and placing trades through your computer (a topic that I discuss in Chapter 9).  The following sections help you find the best software for your needs. 

Taking a look at investment tracking software

Software that can help you with investment tracking falls into one of two main groups:

  Personal finance software that also includes investment-tracking capabilities

  Software that focuses exclusively on investment tracking

  The broader personal finance packages, such as Quicken, are more user-friendly and probably more familiar if you already use these packages' other features (such as a bill-paying feature). 

In the following sections, I outline what I see as the advantages and disadvantages of using tracking software based on your needs and offer a few alternative approaches to tracking your investments. 

Reviewing the benefits

Investment tracking software offers a number of positive features that may appeal to you:

  Organization: One of the best benefits of these packages is that using them can help you get organized.  If you enter your investments into the program, the software can help you make sure you don't lose track of your holdings.  The fact that investors lose billions of dollars annually to escheatment — a situation in which financial institutions turn money over to the state because the owner loses track of his investment (often because the investor moved or passed away) — is testimony to the disarray of some investors' tracking systems. 

  At-a-glance access: In addition to organizing all your investment information in one place, investment software allows you to track the original purchase price, current market values, and rates of return on your investments.  If you have accounts at numerous investment firms, using software can reduce some of the complications involved in tracking your investing kingdom. 

  Overall return data: Investment software can be useful for helping you keep track of your returns.  Monitoring all those numbers yourself isn't always easy.  People usually know their CD and bond yields, but ask most people investing in individual stocks and bonds what the total return was on their entire portfolio, and, at best, you get a guess.  It's the rare person who can quote you total returns or tell you whether her returns are on pace to reach her future financial goals.  If an investor does know her investments' returns, she probably doesn't know whether that return is good or bad.  For example, she may feel good having made 22 percent on her portfolio of stocks over the past year, but she shouldn't if an index of comparable stocks was up 35 percent over the same period. 

Investment tracking software can be more useful for stock traders.  In my experience, stock traders, the people who would most benefit from using these programs, often don't track their overall returns.  If they did, they could calculate the benefit (or lack thereof) of all their trading. ( I've never worked with a stock picker who completed this exercise with me and had return numbers that beat the market indexes over the long term.) 

Surveying the drawbacks

My review of investment tracking packages suggests that you need to be prepared to make a substantial time commitment to find out how to use these programs and that you know that other, less high-tech alternatives may be more efficient and enlightening.  Also know that a good portion of program users tire of entering all the required data and then feel guilty for falling behind. 

If you want to see what your investment returns have been over the years, be aware that entering historic data from your account statements (if you can find them) is a time-consuming process, regardless of which package you use.  To calculate your returns, you generally have to enter each new investment that you make as well as all your reinvestments of dividends, interest, and capital gains distributions (such as those made on mutual funds).  Ugh!  Head to the following section to discover some alternatives to using these time-consuming products. 

Checking out some alternatives

  If you're not into data entry, you have some alternative routes to consider.  The following list shows you what to do if you want

  To organize: Keeping a current copy of each of your investment statements in a binder or file folder can accomplish the same result as organizing all your holdings. 

  At-a-glance access: Investment software can track all the facts and figures for all your investments — purchase price, market value, rates of return, and so on.  But you can accomplish the same things by consolidating your investments at one investment company. ( See my discussion of discount brokers in Chapter 9.) 

  To know your overall return data: You can easily estimate the return of your overall portfolio using the old-fashioned paper-and-pencil method.  Simply weight the return of each investment by the portion of your portfolio that's invested in it.  For example, with a simple portfolio equally divided between two investments that returned 10 percent and 20 percent, respectively, your overall portfolio return would be 15 percent (10 × 0.50 + 20 × 0.50 = 15).  If you're not adding to or taking money from a portfolio, you can simply compare the portfolio's value at year end to the prior year end. 

People who make investments at various times throughout the year and want to know what their actual returns were during the year can use software to get answers.  However, unless you're a frequent trader trying to measure the success of your trading, knowing the exact returns based on the precise dates that you fed money into investments has limited value.  This fact is especially true if you're a regular, dollar-cost-averaging investor (see Chapter 3).  In this situation, instead of opting for a software program, know that increasing numbers of investment companies provide personal return data via their website and/or on account statements. 

And if you're a buy-and-hold mutual fund and exchange-traded fund investor, a path that I find great value in, tracking software gives you limited benefits because of the time required to enter your data.  Funds and many other published resources tell you what a fund's total return was for the past year, so you don't need to enter every dividend and capital gain distribution. 

Considering investment research software

Investment research software packages usually separate investment beginners (and others who don't want to spend a lot of their time managing their money) from those who enjoy wallowing in data and conducting primary research.  If you already have a plan in mind and just want to get on with investing, then go to it!  But even if you don't want to conduct more specific research, some of the packages that I discuss in this section can also help you conduct online investment transactions and track an investment's performance. 

  When working with research software, you may have the problems of sifting through too much data and differentiating the best from the mediocre and downright awful.  And unless cost is no object, you need to make sure you don't spend too much of your loot simply accessing the information. 

Before you plunge in to the data jungle and try to become the next Peter Lynch or Warren Buffett by picking individual stocks, be honest about your reasons for wanting to research.  Some investors fool themselves into believing that their research will help them beat the markets.  However, few investors, even so-called professionals, ever succeed at that goal.  Witness the fact that over long time periods (ten-plus years), mutual funds that invest in a fixed-market index, such as the Standard & Poor's 500, outperform about three-quarters of their actively managed peers thanks to the index fund's lower operating expenses (see Chapter 8 for more information on fund investing options). 

The best software for researching individual securities

  If you like to invest in individual securities, the Value Line Investment Analyzer helps you research individual stocks using the data that the Value Line Investment Survey provides (as I discuss in Chapter 6).  This software package lets you sift through Value Line's data efficiently.  You can also use it to track your stock portfolio. 

A three-month introductory offer for Value Line's software costs $75 ($95 for the "Plus Edition," which also tracks small- and medium-company stocks), and an annual subscription costs $598 for monthly updates ($995 for the more comprehensive version).  The software is available from Value Line at 800-654-0508 or by visiting its website at www.valueline.com. 

Morningstar, which is better known for its mutual fund information, has followed in Value Line's footsteps in providing lots of data on individual stocks.  Morningstar's Principia for Stocks has data and features equivalent to what Value Line's Plus Edition offers.  This program is intended for those with in-depth knowledge of how to analyze stocks, so it's most definitely not for beginners.  An annual subscription to Principia for Stocks with monthly updates costs $690.  You can reach Morningstar at 800-735-0700 or visit its website at www.morningstar.com.  Morningstar offers a number of ways to tap in to the more basic stock data it collects through its website. 

The best software for researching mutual funds

  For mutual funds and exchange-traded funds (ETFs), Morningstar and Value Line both publish a number of software packages, the best of which are similar in price to the Value Line Investment Survey.  These packages are geared toward more sophisticated investors who understand mutual funds and ETFs and how to select them.  For more details, pick up a copy of the latest edition of my book Mutual Funds For Dummies (John Wiley & Sons, Inc.). 

Understanding how software calculates returns

Most software programs calculate returns in one of two ways:

  The effective or internal rate of return method: The programs calculate your effective or internal rate of return (IRR) by comparing your original amounts invested to the current market value.  Of those programs I've tested that calculate IRR — and some don't — the results were accurate.  After you calculate your returns, knowing how they compare with relevant market averages would be nice.  Unfortunately, not all programs allow you to compare your performance to various market indexes. 

  The tax or cost basis method: All the software packages I've reviewed calculate your cost basis for accounting purposes.  Your cost basis is your original investment plus reinvested dividends and capital gains, for which you have already paid taxes in a non-retirement account.  To get an accurate cost basis, you need to enter all your investments, including reinvested distributions.  Time-starved investors can take solace in the fact that most investment companies, particularly larger mutual fund providers, provide cost basis information for you upon request or when you sell an investment. 

Some packages provide only this cost basis information and don't report actual returns.  Cost basis reports make your returns look less generous because reinvested distributions increase your original investment and seemingly reduce your returns.  I know from experience with counseling clients and students who have taken my courses that investors often look at cost basis reports and assume that the reports tell them what their investment returns are.  This happens partly because of the cost basis reports' misleading names, such as "investment performance" or "investment analysis." 

The difference between the rate of return using the cost basis and IRR methods is generally substantial.  For the data that I used in my research, the cost basis method software calculated a 2.7 percent annual return, and the IRR method software calculated a 13 percent annual return.  The actual portfolio's total return was 13 percent, but an investor using a software package that calculates only cost basis is led to believe that her profit was just 2.7 percent (which is correct for tax purposes only for a non-retirement account). 

Is all this calculation method mumbo jumbo too technical for your taste?  I don't blame you.  Luckily, because they already have the data on your accounts, some investment firms can produce your account's performance numbers.  Still, surprisingly few investment firms provide personal investment returns. ( See Chapter 9 for more information regarding brokerage firms and the services they provide.) 

Investigating Internet Resources

Because people interested in managing their money surf the Internet today more than ever, thousands of websites have sprung up to meet the demand.  Although the low barriers to entry in the online world make it easy for scammers and incompetents to flog their wares and flawed advice, this medium can offer some helpful resources if you know where to look and how to discern the good from the not-so-good. 

The Securities and Exchange Commission (SEC) shutters numerous online scams, such as the one that bilked investors out of millions of dollars by promising to double investors' money in four months in a fictitious security they called "prime bank." 

  Although you may be smart enough to avoid offers that promise pie in the sky, you're far more likely to fall for unsound financial advice, which is abundant online.  You can find plenty of self-serving advertorial content and bad advice online, so you should be wary and cautious.  The next section offers tips for evaluating Internet resources. 

Assessing online resources

Fraud and bad financial advice existed long before the Internet came around.  The SEC describes online scams as "new medium, same message."  But don't worry.  The tips in the following sections can help you find the nuggets of helpful online advice and avoid the land mines. 

Being aware of agendas

Get an idea of who's behind a site before you trust its information.  Some sites go to extraordinary lengths — including providing lots of information and advice and attempting to conceal the identity of the company that runs the site — to disguise their agendas.  Therefore, don't turn to the web for advice or opinions, because the advice and opinions you find usually aren't objective.  Similarly, approach online financial calculators with skepticism; most are simplistic and biased. 

  Many websites and blogs have icons (or About tabs) that you can click on to see some background regarding the site's sponsor and find out whether the site solicits potential advertisers.  With a simple click, you can quickly see that a site purporting to be a reference service of the best small-company stocks in which to invest may be nothing more than an online yellow pages of companies that paid the site an advertising fee.  Look for sites that exercise quality control in what they post and that use sensible screening criteria for outside information or companies they list. 

Just because every Tom, Dick, and Jane can easily and at a relatively low cost set up an Internet site or blog doesn't mean that their sites and advice are worthy of your time.  Not surprisingly, the financial companies with reputations for integrity offline are the ones that offer some of the best integrity online.  For example, as I discuss later in this chapter, the leading and most investor-friendly investment companies often have the best education-oriented websites. 

Soliciting grassroots customer feedback

The Internet can be a useful place to do consumer research.  The more enlightening message board conversations that I encounter usually start with someone asking what others thought about particular financial service firms, such as brokerage firms.  If you're investigating a certain financial service, the Internet can be an efficient way to get feedback from other people who have experience dealing with that firm. 

  In order to find a dozen people offline who have done business with a given firm, you'd probably have to speak with hundreds of people.  Online, finding customers is a snap.  Those who feel wronged by a particular firm are more than willing to share their gripes through sites such as www.PlanetFeedback.com.  As in the offline world, though, don't believe everything you hear, and watch out for employees of a given firm who post flattering comments about their firms and dis the competition. 

Verifying online advice and information by fact checking

  Enhance the value of the online information you gather by verifying it elsewhere.  You can do some fact checking both online and offline.  For example, if you're contemplating the purchase of some stock based on financial data that you read on an investing site, first check out those numbers at the library or at one of the websites I recommend later in this chapter. 

Lots of Internet investment advice (and most of the scams) focuses on smaller companies and investment start-ups; unfortunately, these are often the most difficult businesses to locate information about.  The SEC requires companies that are raising less than $1 million to file a Form D, so you should check to see whether a small company that's soliciting you has filed one. 

To inquire whether a company has filed Form D, call the SEC's Office of Investor Education and Advocacy at 202-551-8090, or send an e-mail to `publicinfo@sec.gov`.  Also check with your state securities regulator.  For contact information for state regulators, call the North American Securities Administrators Association at 202-737-0900, or visit its website at www.nasaa.org/QuickLinks/ContactYourRegulator.cfm. 

  If something sounds too good to be true, check out and possibly report your concerns to Internet fraud-fighting organization sites.  In addition to the SEC's website, check out the Financial Industry Regulatory Authority website (www.finra.org) and the National Consumers League's Fraud Information Center (www.fraud.org; 800-876-7060). 

Picking the best investment websites

The quality of the investing information that's on the Internet is gradually improving, and a handful of sites are setting a high standard.  The consumer advocacy sites that I recommend earlier in this chapter are a start.  And in the following sections, I provide my top picks for those investing sites that are worthy of your online time. ( Also, check out my website, www.erictyson.com, for updated analysis of investments, economic news, research, books worth reading, and more.) 

CorporateInformation.com

  CorporateInformation.com is owned and operated by Wright Investors' Services, which, in addition to managing money for affluent individuals, publishes comprehensive reports on thousands of companies around the globe.  Those who are interested in web-based stock research will also enjoy the many links to other Internet-investing and research sites.  This site also provides plenty of current business news. 

Morningstar.com

The behemoth of the mutual fund data business, Morningstar.com has a website (www.morningstar.com) that provides information and tools for mutual fund and stock research.  The basic stuff is free, but you have to pay $185 per year to access the analyst reports, stock research reports, and other premium content.  In addition to providing more data than you could ever possibly digest on funds and stocks, this site also includes short, insightful articles that are useful to more educated investors. 

St. Louis Federal Reserve

For those who enjoy analyzing economic data, the St. Louis Federal Reserve website (www.research.stlouisfed.org) is the place to be.  In addition to sometimes heady articles, such as "Pandemic Economics: The 1918 Influenza and Its Modern-Day Implications," this site provides a treasure trove of current economic data along with graphs.  The long-term graphs are particularly useful in providing the often missing long-term perspective in your daily diet of news. 

For example, I had to laugh the other day when I saw a headline online that screamed, "Dollar at Record Low."  The article only mentioned the euro, and it never pointed out that the euro only came into existence in 1999!  In fact, when you compare the dollar to a broad basket of other currencies represented by U.S. trading partners, the U.S. dollar is still more than double the value it was a generation ago.  You can see this fact for yourself by examining the trade weighted exchange index on the St. Louis Fed site. 

Look who's talking

If you're at a cocktail party and you receive investing information and advice from someone you've just met, check him out to determine how much credence you should give to his words.  And no matter how wise he seems, don't judge his investing savvy on just one conversation. 

In the online world, you need to be just as cautious, but you may have greater difficulty determining who's doing the talking and why.  Not only do some site owners conceal their identities, but on some sites, visitors may post comments and opinions (often anonymously) on message boards. 

As the Financial Industry Regulatory Authority (FINRA) says on its website, "In most instances, there is simply no way to uncover someone's true identity.  Are you getting information from a broker, short seller, corporate insider, amateur investor, or stock touter?"  You have to use a little induction and a lot of intuition.  Start by eliminating any advice from online posters who are totally anonymous.  Pseudonyms are common online as well, and some salespeople try to use them to hide their true identities. 

Among the more popular message boards on the Internet are those where people debate and discuss the prospects for individual stocks.  The postings play fast and loose with the facts. " Investors need to understand that, although they may be reading honest conversations, they could just as easily be looking at the work of a corporate insider, stock promoter, or short seller using an alias to deceive the unsuspecting or to manipulate the market," says the FINRA Regulation unit. 

According to the St. Louis Fed site, the trade weighted exchange index is "A weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.  Broad currency index includes the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile, and Colombia." 

Sec.gov

  All publicly held companies and mutual funds must file annual and quarterly reports and other documents electronically with the U.S. Securities and Exchange Commission.  This information is easily accessible for free (paid for by tax dollars) on the SEC website (www.sec.gov). 

If you're researching individual companies, you can find all the corporate reports — annual reports, 10-Ks, and the like — that I discuss in Chapter 6 through this website.  Or you can call the individual companies that interest you and ask them to mail you the desired material. 

The SEC site isn't pretty, and searching the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR) database can be challenging, especially for the novice investor.  But if you're tenacious, you may find something that's hard to come by on the web these days: cold, hard facts and no spin. 

Vanguard.com

  Few sites run by investment companies are worth visiting unless you're an account holder at the firm and you want to review your accounts or conduct transactions online.  Here's why: Much of the content is self-serving, biased, and advertorial in nature.  However, the nation's second-largest mutual fund company, the Vanguard Group, operates a site (www.vanguard.com) that is the exception. 

Of course, at its website, you can find details on Vanguard's fine family of funds, but you also find some useful educational materials.  I'm not surprised — one reason that I've long liked the company is that it advocates for investors' best interests. 

And if you're one of the millions of Vanguard shareholders, you can access your accounts and perform most transactions online.  Vanguard's discount brokerage division, also accessible online, allows you to invest in many other fund companies' funds (as well as Vanguard's) through a single account.  The company's website also enables you to link accounts that you may hold through most other financial institutions. 

Online investing "geniuses"

Nowhere will you find more self-proclaimed investing geniuses than online (well, except maybe on cable).  Here are some important perspectives and lessons to keep in mind as you surf the web:

  Beware of promises of easy riches.  To deter investors from mutual funds, one website says of its stock picking, "We hope to have put you in position to nearly double the S&P 500 . . .  it'll demand little research per year, and present you little, if any, long-term risk."  If investing were that easy, everyone would be rich!  And as any professional money manager knows firsthand, successfully managing a portfolio of individual stocks takes a lot of time, not just a few hours per year. 

  Beware of bloated performance claims.  Not surprisingly, many online investing pundits hype claimed returns from their investment recommendations.  If you can't independently verify a performance claim, don't believe it.  Also, keep in mind that even if performance numbers are indeed accurate, calculated returns often overlook trading commissions and taxes (which can be especially high for sites that advocate selling investments after holding them for less than one year). 

  Successful investing doesn't require following the market closely.  Buying and holding index or other quality mutual funds for many years doesn't take much review time — perhaps as little as a few hours per year to read the fund's annual reports.  The daily and even minute-by-minute tracking of stock prices on many sites causes investors to lose sight of the long term and the big picture (although it draws more visitors to the site, which satisfies advertisers and enriches the site owners). 

The bottom line?  Be skeptical of financial prognosticators.  Like politicians, they're out to make themselves look as good as possible, taking credit when things go well and blaming external forces when they don't.  For more on popular investment and economic gurus, see the "Guru Watch" section of my website at www.erictyson.com.  Also, see Chapter 17 for more about investment newsletters. 
Part VI

The Part of Tens

In this part . . . 

The Part of Tens contains shorter chapters, each including ten items on important investing topics.  The topics in this part cover the psychological issues you need to overcome to be a successful investor, the info you need to know when you're considering selling an investment, and the advice that can help you invest during a down market. 
Chapter 20

Ten Investing Obstacles to Conquer

In This Chapter

  Knowing which investing road bumps to steer clear of

  Committing to picking up better investing habits

Just as with raising children or as in one's career, "success" with personal investing is in the eye of the beholder.  In my work as a financial counselor, instructor, and writer, I've come to define a successful investor as someone who, with a modest commitment of time, develops an investment plan to accomplish financial and personal goals and who earns competitive returns given the risk he's willing to accept. 

In this chapter, I point out ten common obstacles that may keep you from being successful and fully realizing your financial goals.  I also share tips and advice for overcoming those obstacles on the road to investing success. 

Trusting Authority

Some investors assume that an advisor is competent and ethical if she has a lofty title (financial consultant, vice president, and so on), dresses well, and works in a snazzy office.  Unfortunately, such accessories are often indicators of salespeople — not objective advisors — who recommend investments that will earn them big commissions that come out of your investment dollars. 

If you overtrust an advisor, you may not research and monitor your investments as carefully as you should.  Figuring that Mr. Vice President is an expert, some investors go along without ever questioning his advice or watching what's going on with their investments.  Too many investors blindly follow analysts' stock recommendations without considering the many conflicts of interest that such brokerage firm employees have.  Brokerage analysts are often cheerleaders for buying various companies' stock because their firms are courting the business of new stock and bond issuance of the same companies.  And just because a big-name accounting firm has blessed a company's financial statements (Enron) or a company's CEO says everything is fine (Bear Stearns) doesn't make a firm's financial statements accurate or its conditions sound. 

  You can't possibly evaluate the competence and agenda of someone you hire until you understand the basics.  Without the basics, you can't know that an analyst's report or a professional service firm's recommendation or approval of a company is worth the paper it's printed on.  Read good publications (see Part V) on the topic to master the jargon and figure out how to evaluate investments.  Seek independent second opinions before you act on someone's recommendations.  If you're in the market for a broker, be sure to read Chapter 9. 

Getting Swept Up by Euphoria

Feeling strength and safety in numbers, some investors are lured into buying hot stocks and sectors (for example, industries like technology, health care, biotechnology, retail, and so on) after major price increases.  Psychologically, it's reassuring to buy into something that's going up and gaining accolades.  The obvious danger with this practice is buying into investments selling at inflated prices that will soon deflate. 

By the late 1990s, investors in the U.S. stock market were being spoiled with gains year after year in excess of the historic average annual return of 9 to 10 percent.  Numerous surveys conducted during this period showed that many investors expected to earn returns in the range of 15 to 20 percent annually, nearly double the historic average.  As always happens, though, after a period of excessively high returns such as those of the 1990s, returns were below average in the subsequent period beginning in 2000 (and were quite negative in the early and late 2000s).  During the market slump in the early 2000s, real estate–related stocks continued to do well; some folks mistakenly believed that the housing sector was immune to setbacks and were surprised by the slump in that sector in the late 2000s. 

  Develop an overall allocation among various investments (especially diversified mutual funds), and don't make knee-jerk decisions to change your allocation based on what the latest hot sectors are.  If anything, de-emphasize or avoid stocks and sectors that are at the top of the performance charts.  Think back to the last time you went bargain shopping for a consumer item — you looked for value, not high prices.  See Chapter 5 to find out how to spot good values in the financial markets and which speculative bubbles to avoid. 

Being Overconfident

As I discuss in Part V, newsletters, books, blogs, and financial periodicals lead investors to believe that they can be the next Peter Lynch or Warren Buffett if they follow a simple stock-picking system.  The advent of the Internet and online trading capabilities has spawned a whole new generation of short-term (sometimes even same-day) traders. 

In my work as a financial counselor, I came across plenty of people who lost a lot of money after they had an early winner and had attributed that success to their investing genius.  These folks usually landed on my doorstep after great and humbling losses woke them up. 

  If you have the speculative bug, earmark a small portion of your portfolio (no more than 10 to 20 percent) for more aggressive investments.  See Chapter 5 for information to help you decide whether you or someone you know has a gambling problem. 

Giving Up When Things Look Bleak

Inexperienced or nervous investors may be tempted to bail out when it appears that an investment isn't always profitable and enjoyable.  Some investors dump falling investments precisely at the times when they should be doing the reverse — buying more.  Sharp stock market pullbacks attract a lot of attention, which leads to concern, anxiety, and, in some cases, panic.  This situation occurred during the financial crisis of 2008.  As layoffs mushroomed and stocks sank, fear and talk of another Great Depression took hold. 

Investing always involves uncertainty.  Many people forget this, especially during good economic times.  I find that investors are more likely to feel comfortable with riskier investments, such as stocks, when they recognize that all investments carry uncertainty and risk — just in different forms. 

  History has repeatedly proved that continuing to buy stocks during down markets increases your long-term returns.  The worst thing you can do in a slumping market is to throw in the towel.  Folks who dumped their stocks in late 2008 and early 2009 missed out on the doubling in stock values over the subsequent two years. 

Unfortunately, the short-term focus that the media so often takes causes some investors to worry that their investments are in shambles during the inevitable bumps in the road.  As I discuss in Part V, the media are often to blame because they hype short-term events and blow those events out of proportion to captivate viewers and listeners.  History has shown that financial markets and economies generally recover.  If you invest for the long term, then the last six weeks — or even the last couple of years — is a short period.  Plus, countless studies demonstrate that no one can predict the future, so you gain little from trying to base your investment plans on predictions.  In fact, you can lose more money by trying to time the markets. 

Larger-than-normal market declines hold a significant danger for investors: They may encourage decision making that's based on emotion rather than logic.  Just ask anyone who sold after the stock market collapsed in 1987 — the U.S. stock market dropped 35 percent in a matter of weeks in the fall of that year.  Since then, even with the significant declines in the early and late 2000s, the U.S. market has risen more than sevenfold! 

Investors who can't withstand the volatility of riskier growth-oriented investments, such as stocks, may be better off not investing in such vehicles to begin with.  Examining your returns over longer periods helps you keep the proper perspective.  If a short-term downdraft in your investments depresses you, avoid tracking your investment values closely.  Also, consider investing in highly diversified, less-volatile funds that hold stocks worldwide as well as bonds (see Chapter 8). 

Refusing to Accept a Loss

Although some investors realize that they can't withstand losses and sell at the first signs of trouble, other investors find that selling a losing investment is so painful and unpleasant that they continue to hold a poorly performing investment despite the investment's poor future prospects.  Psychological research backs these feelings — people find the pain of accepting a given loss twice as intense as the pleasure of accepting a gain of equal magnitude. 

  Analyze your lagging investments to identify why they perform poorly.  If a given investment is down because similar ones are also in decline, hold on to it.  However, if something is inherently wrong with the investment — such as high fees or poor management — you can make taking the loss more palatable:

  Remember that if your investment is a non-retirement account investment, selling at a loss helps reduce your income taxes. 

  Consider the "opportunity cost" of continuing to keep your money in a lousy investment.  In other words, what returns can you get in the future if you switch to a "better" investment? 

Overmonitoring Your Investments

The investment world seems so risky and fraught with pitfalls that some people believe that closely watching an investment can help alert them to impending danger. " The constant tracking is not unlike the attempt to relieve anxiety by fingering worry beads.  Yet paradoxically, it can increase emotional distress because it requires a constant state of vigilance," says psychologist Dr. Paul Minsky. 

In my work as a financial counselor, I noticed that investors who were the most anxious about their investments and most likely to make impulsive trading decisions were the ones who watched their holdings too closely, especially those who monitored prices daily.  The proliferation of Internet sites and stock market cable television programs offering up-to-the-minute quotations gives these investors even more temptation to overmonitor investments. 

  Restrict your "diet" of financial information and advice.  Quality is far more important than quantity.  Watching the daily price gyrations of investments is akin to eating too much junk food — doing so may satisfy your short-term cravings but at the cost of your long-term health.  If you invest in diversified mutual funds (see Chapter 8), you really don't need to examine your fund's performance more than twice per year.  An ideal time to review your funds is when you receive their annual or semiannual reports.  Although many investors track their funds daily or weekly, far fewer read their annual reports.  Reading these reports can help you keep a long-term perspective and gain some understanding as to why your funds perform as they do and how they compare to major market averages. 

Being Unclear about Your Goals

Investing is more complicated than simply setting your financial goals (see Chapter 3) and choosing solid investments to help you achieve them.  Awareness and understanding of the less tangible issues can maximize your chances for investing success. 

  In addition to considering your goals in a traditional sense (when you want to retire and how much of your kids' college costs you want to pay, for example) before you invest, you should also consider what you want and don't want to get from the investment process.  Do you treat investing as a hobby or simply as another one of life's tasks, such as maintaining your home?  Do you enjoy the intellectual challenge of picking your own stocks?  Don't just ponder these questions on your own; discuss them with family members, too — after all, you're all going to have to live with your decisions and the investment results. 

Ignoring Your Real Financial Problems

I know plenty of high-income earners, including more than a few who earn six figures annually, who have little to invest.  Some of these people have high-interest debt outstanding on credit cards and auto loans, yet they spend endless hours researching and tracking investments.  I also know folks who built significant personal wealth despite having modest-paying jobs.  The difference is the ability to live within their means. 

  You may be tempted to think that you can't save if you don't earn a high income.  Even if you're a high-income earner, you may think that you can hit an investment home run to accomplish your goals or that you can save more if you can bump up your income.  This way of thinking justifies spending most of what you earn and saving little now.  Investing is far more exciting than examining your spending and making cutbacks.  If you need help coming up with more money to invest, see the latest edition of my book Personal Finance For Dummies (John Wiley & Sons, Inc.). 

Overemphasizing Certain Risks

Saving money is only half the battle.  The other half is making your money grow.  Over long time periods, earning just a few percent more makes a big difference in the size of your nest egg.  Earning inflation-beating returns is easy if you're willing to invest in stocks, real estate, and small businesses.  Figure 20-1 shows you how much more money you'll have in 25 years if you earn investment returns that are greater than the rate of inflation (which historically has been about 3 percent). 

**Figure 20-1:** Slightly higher returns compound to really make your money grow. 

As I discuss in Chapter 2, ownership investments (stocks, real estate, and small business) have historically generated returns that are 6 or more percent greater than the inflation rate, while lending investments (savings accounts and bonds) tend to generate returns of only 1 to 2 percent greater than inflation.  However, some investors keep too much of their money in lending investments out of fear of holding an investment that can fall greatly in value.  Although ownership investments can plunge in value, you need to keep in mind that inflation and taxes eat away at your lending investment balances. 

Believing in Gurus

Stock market declines, like earthquakes, bring all sorts of prognosticators, soothsayers, and self-anointed gurus out of the woodwork, particularly among those in the investment community, such as newsletter writers, who have something to sell.  The words may vary, but the underlying message doesn't: "If you had been following my sage advice, you'd be much better off now." 

  People spend far too much of their precious time and money in pursuit of a guru who can tell them when and what to buy and sell.  Peter Lynch, the former manager of the Fidelity Magellan Fund, amassed one of the best long-term stock market investing track records.  His stock-picking ability allowed him to beat the market averages by just a few percent per year.  However, even he says (as does investment legend Warren Buffett) that you can't time the markets.  He also acknowledges knowing many pundits who have correctly predicted the future course of the stock market "once in a row"! 

Clearly, in the world of investing, the most successful investors earn much better returns than the worst ones.  But what may surprise you is that you can end up much closer to the top of the investing performance heap than the bottom if you follow some relatively simple rules, such as regularly saving and investing in low-cost growth investments. 
Chapter 21

Ten Things to Consider When Weighing an Investment Sale

In This Chapter

  Considering your investment goals and other big-picture issues

  Factoring taxes into your profit

You can and should hold good investments for years and decades.  Each year, people sell trillions of dollars' worth of investments.  My experience helping folks get a handle on their investments suggests that too many people sell for the wrong reasons (while other investors hold on to investments that they should sell for far too long).  In this chapter, I highlight ten important issues to consider when you contemplate selling your investments. 

Remembering Your Preferences and Goals

  If your life has changed (or you've inherited investments) since the last time you took a good look at your investment portfolio, you may discover that your current portfolio may no longer make sense for you.  To avoid wasting time and money on investments that aren't good for you, be sure to review your holdings at least annually.  But don't make quick decisions about selling.  Instead, take your time and be sure that you understand tax and other ramifications before you sell. 

The time that it takes you to manage your portfolio, for example, is a vital matter if you're starved for time or weary of managing time-consuming investments.  Leo, for example, loved to research, track, and trade individual stocks — until his daughter was born.  Then Leo realized how many hours his hobby was taking away from his family.  This realization put his priorities into perspective.  Leo now invests in time-friendly mutual funds and exchange-traded funds and doesn't follow them like a hawk. 

One of my clients, Mary, loves investing in real estate because she enjoys the challenge of researching, selecting, and managing her properties.  She works in a job where she has to put up with lots of controlling, stressed-out bosses.  For Mary, real estate isn't just a profitable investment; it's also a way of expressing herself and growing personally. 

Maintaining Balance in Your Portfolio

A good reason to sell an investment is to allow yourself to better diversify your portfolio.  Suppose, for example, that before reading this book, you purchased a restaurant stock every time you read about one.  Now your portfolio resembles several strip malls, and restaurant stocks comprise 80 percent of your holdings.  Or maybe, through your job, you've accumulated such a hefty chunk of stock in your employer that this stock now overwhelms the rest of your investments. 

If your situation sounds anything like these, it's time for you to diversify.  Sell off some of the holdings that you have too much of and invest the proceeds in some of the solid investments that I recommend in this book.  If you think your employer's stock is going to be a superior investment, holding a big chunk is your gamble.  At a minimum, review Chapter 6 to see how to evaluate a particular stock.  But remember to consider the consequences if you're wrong about your employer's stock. 

Conservative investors often keep too much of their money in bank accounts, Treasury bills, and the like.  Read Chapter 3 to come up with an overall investment strategy that fits with your personal financial situation. 

Deciding Which Investments Are Keepers

Often, people are tempted to sell an investment for the wrong reasons.  One natural human tendency is to want to sell investments that have declined in value.  Some people fear a further fall, and they don't want to be affiliated with a loser, especially when money is involved. 

  Instead, step back, take some deep breaths, and examine the merits of the investment you're considering selling.  If an investment is otherwise still sound, why bail out when prices are down and a sale is going on?  What are you going to do with the money?  If anything, you should be contemplating buying more of such an investment.  Also, don't make a decision to sell based on your current emotional response, especially to recent news events.  If bad news has recently hit, it's already old news.  Don't base your investment holdings on such transitory events.  Use the criteria in this book for finding good investments to evaluate the worthiness of your current holdings.  If an investment is fundamentally sound, don't sell it. 

A better reason to sell an investment is that it comes with high fees relative to comparable investments.  For example, if you own a bond mutual fund that is socking it to you with fees of 1 percent per year, check out Chapter 8 to discover high-performing, lower-cost funds. 

Tuning In to the Tax Consequences

When you sell investments that you hold outside a tax-sheltered retirement account, such as in an IRA or a 401(k), taxes should be one factor in your decision. ( See Chapter 3 to find out about tax rates that apply to the sale of an investment as well as to the distributions that investments make.)  If the investments are inside retirement accounts, taxes aren't an issue because the accounts are sheltered from taxation until you withdraw funds from them. 

  Just because you pay tax on a profit from selling a non-retirement account investment doesn't mean you should avoid selling.  With real estate that you buy directly, as opposed to publicly held securities like REITs, you can often avoid paying taxes on the profit that you make (see Chapters 10 and 11 for details). 

With stocks and mutual funds, you can specify which shares you want to sell.  This option makes selling decisions more complicated, but you may want to consider specifying what shares you're selling because you may be able to save taxes. ( Read the next section for more information on this option.)  If you sell all your shares of a particular security that you own, you don't need to concern yourself with specifying which shares you're selling. 

Figuring Out What Shares Cost

When you sell a portion of the shares of a security (for example, stock, bond, or mutual fund) that you own, specifying which shares you're selling may benefit you taxwise.  Here's an example to show you why you may want to specify selling certain shares — especially those shares that cost you more to buy — so you can save on your taxes. 

Suppose you own a total of 300 shares of a stock and you want to sell 100 shares to pay for a root canal.  Suppose further that you bought 100 of these shares a long time ago at $10 per share, 100 shares two years ago at $16 per share, and the last 100 shares one year ago at $14 per share.  Today the stock is at $20 per share. 

The IRS allows you to choose which shares you want to sell.  Electing to sell the 100 shares that you purchased at the highest price — those you bought for $16 per share two years ago — saves you in taxes.  To comply with the tax laws, you must identify the shares that you want the broker to sell by the original date of purchase and/or the cost when you sell the shares.  The brokerage firm through which you sell the stock should include this information on the confirmation slip that you receive for the sale. 

The other method of accounting for which shares are sold is the method that the IRS forces you to use if you don't specify before the sale which shares you want to sell — the first-in-first-out (FIFO) method.  FIFO means that the first shares that you sell are simply the first shares that you bought.  Not surprisingly, because most stocks appreciate over time, the FIFO method usually leads to you paying more tax sooner.  The FIFO accounting procedure leads to the conclusion that the 100 shares you sell are the 100 that you bought long, long ago at $10 per share.  Thus, you owe a larger amount of taxes than if you sold the higher-cost shares under the specification method. 

  Although you save taxes today if you specify selling the shares that you bought more recently at a higher price, remember that when you finally sell the other shares, you'll then owe taxes on the larger profit.  The longer you expect to hold these other shares, the greater the value you'll likely derive from postponing, realizing the larger gains and paying more in taxes.  If you expect your tax rate to decline in the future, you have another good reason to hold off selling the shares in which you have greater profit. 

When you sell shares in a mutual fund, the IRS has yet another accounting method, known as the average cost method, for figuring your taxable profit or loss when you sell a portion of your holdings in a mutual fund.  This method comes in handy if you bought shares in chunks over time or reinvested the fund payouts into purchasing more shares of the fund.  As the name suggests, the average cost method allows you to take an average cost for all the shares you bought over time. 

Selling Investments with Hefty Profits

Of course, no one likes to pay taxes, but if an investment you own has appreciated in value, someday you'll have to pay taxes on it when you sell — unless, of course, you plan to pass the investment to your heirs upon your death.  The IRS wipes out the capital gains tax on appreciated assets at your death. 

Capital gains tax applies when you sell an investment at a higher price than you paid for it (see Chapter 3). 

Odds are, the longer you've held securities such as stocks, the greater the capital gains you'll have, because stocks tend to appreciate over time.  If all your assets have appreciated significantly, you may resist selling to avoid taxes.  However, if you need money for a major purchase, sell what you need and pay the tax.  Even if you have to pay state as well as federal taxes totaling some 35 percent of the profit, you'll have lots left. ( For "longer-term" profits from investments held more than one year, your federal and state capital gains taxes would probably total less than 20 to 25 percent.) 

  Before you sell, do some rough figuring to make sure you'll have enough money left to accomplish what you want.  If you seek to sell one investment and reinvest in another, you'll owe tax on the profit unless you're selling and rebuying real estate (see Chapters 10 and 11). 

If you hold a number of assets, in order to diversify and meet your other financial goals, give preference to selling your largest holdings with the smallest capital gains.  If you have some securities that have profits and some that have losses, you can sell some of each to offset the profits with the losses. 

Cutting Your (Securities) Losses

Perhaps you have some losers in your portfolio.  If you need to raise cash for some particular reason, you may consider selling select securities at a loss.  You can use losses to offset gains as long as you hold both offsetting securities for more than one year (long term) or you hold both for no more than one year (short term).  The IRS makes this delineation because the IRS taxes long-term gains and losses on a different rate schedule than short-term gains and losses (see Chapter 3). 

  If you need to sell securities at a loss, be advised that you can't claim more than $3,000 in net losses in any one year.  If you sell securities with net losses totaling more than $3,000 in a year, you must carry the losses over to future tax years.  This situation not only creates more tax paperwork but also delays realizing the value of deducting a tax loss.  So try not to have net losses (losses + gains) that exceed $3,000 in a year. 

Some tax advisors advocate doing year-end tax-loss selling with stocks, bonds, and mutual funds.  The logic goes that if you hold a security at a loss, you should sell it, take the tax write-off, and then buy it (or something similar) back. 

  When selling investments for tax-loss purposes, be careful of the so-called wash sale rules.  The IRS doesn't allow the deduction of a loss for a security sale if you buy that same security back within 30 days.  As long as you wait 31 or more days, you won't encounter any problems.  If you're selling a mutual fund or exchange-traded fund, you can purchase a fund similar to the one you're selling to easily sidestep this rule. 

Dealing with Investments with Unknown Costs

Sometimes you may not know what an investment originally cost you.  Or you may have received some investments from another person, and you're not sure what he or she paid for them.  If you don't have the original statement, start by calling the firm where the investment was purchased.  Whether it's a brokerage firm or a mutual fund company, the company should be able to send you copies of old account statements, although you may have to pay a small fee for this service. 

Also, increasing numbers of investment firms, especially mutual fund companies, can tell you upon the sale of an investment what its original cost was.  The cost calculated is usually the average cost for the shares you purchased. 

Recognizing Broker Differences

If you're selling securities such as stocks and bonds, you need to know that some brokers charge more — in some cases, lots more — to sell.  Luckily, even if the securities that you want to sell currently reside at a high-cost brokerage firm, you can transfer them to a discount brokerage firm.  Head to Chapter 9 to read about the different types of brokerage firms and how to select the best one for your situation. 

Finding a Trustworthy Financial Advisor

If you delegate your investment decision-making to an advisor, you may be disappointed in your returns.  Few financial advisors offer objective and knowledgeable advice.  Unfortunately, if you're grappling with a selling decision, finding a competent and impartial financial advisor to help with the decision is about as difficult as finding a politician who doesn't accept special-interest money.  Most financial consultants work on commission, and the promise of that commission can cloud their judgment.  Among the minority of fee-based advisors, almost all manage money, which creates other conflicts of interest.  The more money you give them to invest and manage, the more money these advisors make. 

  If you need advice about whether to sell some investments, turn to a tax or financial advisor who works on an hourly basis. 
Chapter 22

Ten Tips for Investing in a Down Market

In This Chapter

  Taking care of your investments when the market is on the decline

  Keeping a level head amid the doom and gloom

Unless a lot of other breaking news occurs on a particular day, sharp drops in the stock market make headlines — stock market gyrations are great media fodder.  Every day the market environment is different, and new stocks are always plunging and rising.  And now, with more individuals holding stocks (including mutual funds and exchange-traded funds) through company and personal retirement plans, most folks watch financial market movements.  In this chapter, I discuss how to maximize your chances for investing success when stocks take an extended turn for the worse. 

Don't Panic

No one enjoys turning on his car radio, clicking on his television set, or logging on to the Internet and getting this news: "Stocks plunge.  The Dow Jones Industrial plummeted 400 points today."  When you hear this news, don't panic — it's just one day's events. ( In 2008, the market seemingly had day after day of such drops, and the events could accurately be described as a financial panic, the likes of which the nation hadn't experienced in generations.  I describe this situation more in the later section "View Major Declines as Sales.") 

Just because a home burned to the ground recently in your town and the news is being broadcast all over the local media, you probably wouldn't start living on the street out of fear of being at home during a fire.  But you may take some sensible precautions, such as installing smoke alarms and repairing any malfunctioning appliances that may cause a fire, to ensure that your home isn't likely to become the next fire department statistic. 

Likewise, don't shun stocks, which produce terrific long-term returns, just because of the down periods.  As I discuss in Chapter 2, risk and return go hand in hand.  If you want wealth-building investments that provide superior long-term returns, you must be willing to accept risk (that is, volatility and down periods).  You should take sensible precautions — with diversification being the star of the show — to reduce your risk. 

Although other wealth-building investments, such as real estate and small business, go through significant declines, you generally see few headlines on their daily price movements.  A good reason for this lack of headlines is that no one reports on the pricing of real estate and small businesses minute by minute every business day, as is done with stock prices. 

Keep Your Portfolio's Perspective in Mind

If you follow my advice, your portfolio will consist of diversified stock holdings, including some international stocks and some bonds.  Having a diversified portfolio can help in a down market because some investments will increase as others decrease, thus balancing the losses. 

One of my counseling clients called me when the stock market was dropping precipitously during the summer of 2002. " I just saw that the S&P 500 is now down 28 percent so far this year, and the NASDAQ is down 34 percent.  Should I sell?" 

He was quite surprised when I crunched some numbers and determined that his portfolio of stocks and bonds was down just 8 percent for the year.  Now, mind you, I wasn't trying to minimize or trivialize the fact that he had lost money so far that year.  However, he overlooked the fact that the bonds in his portfolio had actually increased in value, as had some of his stock funds that were invested in value-oriented stocks.  See Chapter 8 for tips on how to build a diversified fund portfolio. 

View Major Declines as Sales

  Unlike retail stores, which experience larger crowds when prices are cut, fewer investors, especially individual investors, want to buy stocks after they've suffered a sharp decline.  However, when stock prices decline, don't get swept up in the pessimism.  View declines as the financial markets having a sale on stocks.  Stocks usually bottom when pessimism reaches a peak.  Why?  Those who were motivated to sell have done so, and the major selling has exhausted itself. 

During the recession and stock market decline that reached a crescendo in 2008, negativity and pessimism were rampant.  Global stock prices dropped by half in about one year's time.  The banking and financial system was in crisis and governments were intervening.  Talk of a depression became common as U.S. unemployment surged past 10 percent.  After bottoming in early 2009, stocks went on an upward rampage that resulted in a doubling in value in just two years — a rare historic event. 

Now, I'm not saying you should randomly buy just any stock after a decline.  For example, as I discuss in Part II, I'm not an advocate of buying individual stocks, especially a collection of stocks focused in the same industry (such as technology or auto manufacturing).  When technology stocks started declining in 2000, some investors made the mistake of buying more of them after prices dropped 10 or 20 percent.  What such "buy on the dip" investors didn't realize was that the technology stocks they were buying were still grossly overpriced when measured by price-earnings ratios and other valuation measures (see Chapter 5). 

  You're best off buying stocks gradually over time through well-managed, diversified mutual funds (see Chapter 8).  When the broad stock market suffers a substantial decline and stocks are at reduced prices — on sale — you can step up your buying. 

Identify Your Portfolio's Problems

Stock market declines can be effective at quickly exposing problems with your portfolio, such as having too many investments from the same industry. 

For example, when technology stocks tumbled in the early 2000s, I started getting lots of e-mails and letters from investors who had loaded up on these stocks and wanted my advice on what they should do with their holdings.  Many of these investors kept thinking about how much more their technology stocks were worth at their peak before the decline set in.  I urged such investors to acknowledge the huge risk they were taking by putting so many eggs in one basket.  I also highlighted the dangers of chasing after a hot sector, and I pointed out that today's hot sector often becomes tomorrow's laggard. 

In addition to poorly diversified portfolios, a declining stock market can also expose the high fees you may be paying on your investments.  Fewer investors care about getting whacked with fees amounting to, say, 2 percent annually when they're making 20 percent yearly.  But after a few years of low or negative returns, such high fees become quite painful and more obvious. 

Avoid Growth Stocks If You Get Queasy Easily

In a sustained stock market slide (bear market), the stocks that get clobbered the most tend to be the ones that were most overpriced from the period of the previous market rise (bull market).  Like fads such as hula hoops, pet rocks, and Cabbage Patch dolls, in each bull market, particular types of growth stocks, such as Internet companies or biotechnology companies, can be especially hot. 

  Predicting the duration and magnitude of a bear market is nearly impossible.  Consequently, it makes sense to focus your stock investing on those stocks that produce solid long-term returns and that tend to decline less in major market declines.  For instance, so-called value stocks tend to be among the safer types of stocks to hold during a bear market.  Value stocks generally have less downside risk because they have relatively greater underlying asset values in comparison to their stock valuations. ( Value stocks also typically pay higher dividends.) 

As has happened in some other past bear markets, numerous value-oriented stocks actually appreciated during the bear market in the early 2000s. ( This didn't happen during the more severe, late-2000s bear market, however.)  Check out Chapter 8 for my discussion of the different types of stocks and mutual funds that practice value stock investing. 

Tune Out Negative, Hyped Media

When the stock market is crumbling, subjecting yourself to a daily diet of bad news and conflicting opinions about what to do next makes most investors do the wrong things.  Just like a steady diet of junk food is bad for your physical health, a continuous stream of negative, hyped news is bad for your financial health.  In my observations, dwelling on bad news doesn't do such great things for people's emotional health either. 

  The economy goes through periods of expansion and occasional periods of decline (with the former generally being longer and stronger than the latter).  Conflict is always occurring somewhere in the world.  The business world will always have some unethical and corrupt company executives.  Holding stocks always carries risk.  So those who see the glass as half full and who see the positive and not just the negative build wealth by holding stocks, real estate, and small business over the long term. 

Ignore Large Point Declines, but Consider the Percentages

It drives me crazy when the news media show a one-day chart of a major stock market index, such as the Dow Jones Industrial Average, on a day when the index drops a large number of points.  In recent years, 200- and 300-point drops in the Dow happened fairly frequently. 

  Look at an index's percentage decline rather than at its point decline.  Although 200 to 300 points sounds like a horrendous drop, such a drop amounts to a move of about 2 percent for an index trading around 12,500.  No one likes losing that portion of their wealth invested in stocks in one day, but the percentage of change sounds less horrifying than the point change. 

Don't Believe You Need a Rich Dad to Be a Successful Investor

A young man wrote to me about an interview that he had read about the Rich Dad, Poor Dad series, by author Robert Kiyosaki.  In the interview, Kiyosaki said that the rich are different from the rest of the population because "They teach their children how to be rich. . . .  These get-rich techniques include investing with leverage . . .  and staying away from mutual funds and 401(k)s, which are way too risky." 

The young man came from a humble background and had been salting money away in mutual funds through his company's retirement plan.  But he thought that he may be doomed to a lifetime of poverty after reading what the Rich Dad guru had to say.  Luckily, I was able to set the young man straight. 

I've known plenty of people over the years who have come from nonwealthy families and have built substantial wealth by living within their means and investing in the three wealth-building assets that I focus on in this book: stocks, real estate, and small business. 

In addition to Kiyosaki saying that mutual funds and 401(k)s are way too risky, he also says, "Those vehicles are only good for about 20 percent of the population, people making $100,000 or more."  I couldn't disagree more.  In fact, my experience is that mutual funds and exchange-traded funds are tailor-made for nonwealthy people who don't have the assets to properly create a diversified portfolio themselves. 

Kiyosaki also says that he doesn't like mutual funds because "Mutual funds have got no insurance from a stock market crash.  To me, that's sad, and I am concerned."  As I discuss in Parts I and II of this book, the best way to reduce the risk of investing in stocks is to diversify your holdings not only in a variety of stocks, which is precisely what good stock mutual funds do, but also in other investments that don't move in tandem with the stock market (such as bond funds). 

Kiyosaki claims that he invests with the benefit of insurance when investing in real estate.  He says, "My banker requires me to have insurance from catastrophic losses."  This is a nonsensical comparison because such an insurance policy would cover losses from say, a fire, but not from a decline in market value of the real estate due to overall market conditions.  Interestingly, Kiyosaki followers got clobbered by piling into real estate, which dropped sharply in most areas in the mid- to late-2000s. 

Understand the Financial Markets

When the going gets tough in the stock market, you can easily lose perspective and start making rash decisions.  Instead, you must have the long-term perspective you need to succeed with stock investing, and you really need to understand how the financial markets work.  So, even if you've already read them, go back and read Chapters 4 and 5 again.  These chapters explain how the stock market works and what influences stock prices in the short term versus the longer term. 

Talk to People Who Care about You

Life's challenging events can be humbling and sometimes depressing.  Holding an investment that's dropped a lot in value — whether it's a stock, a mutual fund, real estate, or a small business — is one such event.  But you don't have to carry the burden yourself.  Talk about your feelings with someone who understands and cares about you.  Be clear about and communicate what you're seeking — empathy, good listening, a sounding board, or advice. 

To access the cheat sheet specifically for this book, go to www.dummies.com/cheatsheet/investing. 

Find out "HOW" at Dummies.com
Mutual Funds For Dummies®

by Eric Tyson, MBA

Mutual Funds For Dummies®

Published by  
Wiley Publishing, Inc.  
111 River St.  
Hoboken, NJ 07030-5774  
www.wiley.com

Copyright © 2010 by Wiley Publishing, Inc., Indianapolis, Indiana

Published simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600.  Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at <http://www.wiley.com/go/permissions>. 

Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!,  The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com, Making Everything Easier!,  and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission.  All other trademarks are the property of their respective owners.  Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. 

Limit of Liability/Disclaimer of Warranty: The contents of this work are intended to further general scientific research, understanding, and discussion only and are not intended and should not be relied upon as recommending or promoting a specific method, diagnosis, or treatment by physicians for any particular patient.  The publisher and the author make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation any implied warranties of fitness for a particular purpose.  In view of ongoing research, equipment modifications, changes in governmental regulations, and the constant flow of information relating to the use of medicines, equipment, and devices, the reader is urged to review and evaluate the information provided in the package insert or instructions for each medicine, equipment, or device for, among other things, any changes in the instructions or indication of usage and for added warnings and precautions.  Readers should consult with a specialist where appropriate.  The fact that an organization or Website is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Website may provide or recommendations it may make.  Further, readers should be aware that Internet Websites listed in this work may have changed or disappeared between when this work was written and when it is read.  No warranty may be created or extended by any promotional statements for this work.  Neither the publisher nor the author shall be liable for any damages arising herefrom. 

For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

For technical support, please visit www.wiley.com/techsupport. 

Wiley also publishes its books in a variety of electronic formats.  Some content that appears in print may not be available in electronic books. 

Library of Congress Control Number: 2010929313

ISBN: 978-0-470-62321-3

Manufactured in the United States of America

10 9 8 7 6 5 4 3 2 1

About the Author

Eric Tyson, MBA, is a bestselling author and syndicated columnist.  Through his counseling, writing, and teaching, he teaches people to manage their personal finances better and successfully direct their own investments. 

He has been involved in the investing markets in many capacities for the past two decades.  Eric first invested in mutual funds back in the mid-1970s, when he opened a mutual fund account at Fidelity.  With the assistance of Dr. Martin Zweig, a now-famous investment market analyst and frequent guest on PBS's Wall Street Week, Eric won his high school's science fair for a project on what influences the stock market! 

Since that time, Eric has (among other things) worked as a management consultant to Fortune 500 financial service firms and earned his bachelor's degree in economics at Yale and an MBA at the Stanford Graduate School of Business.  Despite these handicaps to clear thinking, he had the good sense to start his own company, which took an innovative approach to teaching people of all economic means about investing and money. 

An accomplished freelance personal finance writer, Eric is the author of the national bestsellers Personal Finance For Dummies and Investing For Dummies and coauthor of Home Buying For Dummies and Taxes For Dummies and was an award-winning columnist for the San Francisco Examiner.  His work has been featured and quoted in dozens of national and local publications, including Newsweek, The Wall Street Journal, Forbes, Kiplinger's Personal Finance Magazine, the Los Angeles Times, and Bottom Line/Personal, and on NBC's Today Show, ABC, CNBC, PBS's Nightly Business Report, CNN, CBS national radio, Bloomberg Business Radio, and Business Radio Network.  He's also been a featured speaker at a White House conference on retirement planning. 

Despite his "wealth" of financial knowledge, Eric is one of the rest of us.  He maintains a large inventory of bumble-bee colored computer books on his desk for those frequent times when his computer makes the (decreasing amount of) hair on his head fall out. 

Eric's Web site is www.erictyson.com. 

Dedication

To my wife, Judy; my family — especially my parents, Charles and Paulina; my friends; and to my counseling clients and students of my courses for teaching me how to teach them about managing their finances. 

Author's Acknowledgments

Many people contribute to the birth of a book, and this book is no exception.  First, I owe a deep debt of gratitude to James Collins, who inspired me when I was a young and impressionable business school student.  Jim encouraged me to try to improve some small part of the business world by being an entrepreneur and focusing solely on what customers needed rather than on what made the quickest buck. 

The technical reviewer for this edition of the book was Mercer Bullard.  He helped to improve each and every chapter, and I am thankful for that. 

Thanks to all the good people in the media and other fields who have taken the time to critique and praise my previous writing so that others may know that it exists and is worth reading.  And to those too lazy to open the book just because of its bright yellow color and title, I say, "Don't judge a book by its cover!" 

And a final and heartfelt thanks to all the people on the front lines and behind the scenes at Wiley who helped to make this book and my others a success.  A big round of applause, please, for Kelly Ewing as project editor and as outstanding copy editor.  Special thanks to Mike Baker.  Thanks also to the Composition, Graphics, Proofreading, and Indexing staff for their great efforts in producing this book. 

P.S. Thanks to you, dear reader, for buying my books. 

Publisher's Acknowledgments

We're proud of this book; please send us your comments through our online registration form located at <http://dummies.custhelp.com>.  For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. 

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and Media Development

Project Editor: Kelly Ewing

(Previous Edition: Chad R. Sievers, Mike Baker)

Senior Acquisitions Editor: Mike Baker

Assistant Editor: Erin Calligan Mooney

Senior Editorial Assistant: David Lutton

General Reviewer: Mercer Bullard

Senior Editorial Manager: Jennifer Ehrlich

Editorial Supervisor and Reprint Editor: Carmen Krikorian

Editorial Assistant: Jennette ElNaggar

Cover Photo: © Gaertner/Alamy

Cartoons: Rich Tennant (www.the5thwave.com)

Composition Services

Project Coordinator: Katherine Crocker

Layout and Graphics: Carl Byers

Proofreaders: John Greenough, Toni Settle

Indexer: Sharon Shock

Publishing and Editorial for Consumer Dummies

Diane Graves Steele, Vice President and Publisher, Consumer Dummies

Kristin Ferguson-Wagstaffe, Product Development Director, Consumer Dummies

Ensley Eikenburg, Associate Publisher, Travel

Kelly Regan, Editorial Director, Travel

Publishing for Technology Dummies

Andy Cummings, Vice President and Publisher, Dummies Technology/General User

Composition Services

Debbie Stailey, Director of Composition Services
Introduction

Whether you're a regular reader of investing books or this is your first, Mutual Funds For Dummies, 6th Edition, which is completely revised and updated, provides practical and profitable techniques of mutual fund investing that you can put to work now and for many years to come. 

Mutual funds aren't literally for dummies — in fact, they're a wise investment choice for people from all walks of life.  Mutual funds are investment companies that combine your money with that from many other people to create a large pool of assets that can be invested in stocks, bonds, or other securities.  Because your assets are part of a much larger whole, the best mutual funds enable you to invest in securities that give you low-cost access to leading professional money managers. 

With the best money managers investing your nest egg in top-flight investments that match your financial goals, you can spend your time doing the activities in life that you enjoy and are best at.  Mutual funds should improve your investment returns as well as your social life! 

I practice what I preach.  All my investments that I've devoted to securities (stocks and bonds) are invested through funds.  Why?  For the simple reason that I'm confident the best fund managers that I recommend in this book can do a superior job (higher returns, less cost) than I could by researching and selecting individual stocks and bonds on my own. 

I've enjoyed successfully investing in mutual funds for more than 25 years.  As a financial counselor, writer, and lecturer, I've helped investors make informed investing decisions with mutual funds as part of comprehensive personal financial management.  So I know the questions and challenges that you face when you invest in funds.  I wrote this book to answer, in plain English, your fund-investing questions. 

What's New in This Edition

Life and the investment world change.  Although the essence of what makes mutual funds worthy of your investment dollars hasn't changed since the last edition of this book was published several years ago, the fund industry has certainly seen new developments.  In this newly updated sixth edition, here are the major issues:

  Coverage of the 2008–09 global stock market panic and how funds and fund investors fared and what can be learned from that experience

  Alternatives to mutual funds — growth of exchange-traded funds, shake-out in hedge funds, researching your own stocks and bonds and creating your own fund, private money managers, closed-end funds, and so on

  Increasing numbers of specialized funds, such as those investing in gold, real estate, market-neutral funds, and so on

  Opportunities and pitfalls investing in funds online with expanded and updated coverage of Web sites and software

  New tax laws and their impact on smart fund-investing strategies

  Updates to the funds and resources that I recommend

How This Book Is Different

Many investment books confuse folks.  They present you with some newfangled system that you never figure out how to use without the help of mathematicians and a Nobel laureate as your personal tutors.  Books that bewilder more than enlighten may be intentional because the author may have another agenda: to get you to turn your money over to him to manage or to sell you his pricey newsletter(s).  Writers with an agenda may imply — and sometimes say — that you really can't invest well, at least not without what they're selling. 

Going another route, too many investment books glorify rather than advise.  They place on a pedestal the elite few who, during decidedly brief periods in the history of the world and financial markets, managed to beat the market averages by a few percentage points or so per year.  Many of these books (and their publishers) suggest that reading them shows you the strategies that led Superstar Money Manager of the Moment to the superlative performance that the book glorifies. " He did it his way; now you can, too," trumpets the marketing material.  Not so.  Reading a book about what made Kobe Bryant a phenomenal basketball player or Shakespeare a great playwright won't help you shoot a basket or versify like these famous folks.  By the same token, you can't discover from a book the way to become the next Wall Street investment wizard. 

Mutual Funds For Dummies, 6th Edition, helps you avoid fund-investing pitfalls and maximizes your chances for success.  When you want to buy or sell a mutual fund, your decision needs to fit your overall financial objectives and individual situation.  Fund investors make many mistakes in this regard.  For example, they invest in funds that don't fit their tax situation. 

This book also covers pesky issues completely ignored by other mutual fund books.  For novice fund investors, simply finding and completing the correct application in the blizzard of forms that fund companies offer can be a challenge.  And if you invest in mutual funds outside of tax-sheltered retirement accounts, you're greeted by the inevitable headache from figuring out how to report distributions at tax time.  This book puts you on the right path in order to avoid these problems. 

The truth is, investing isn't all that difficult — and funds are the great equalizer.  There's absolutely no reason, except perhaps a lack of time and effort on your part, why you can't successfully invest in mutual funds.  In fact, if you understand some basic concepts and find out how to avoid major mistakes that occur for some fairly obvious reasons, you can be even more successful than most so-called investment professionals. 

Foolish Assumptions

Whenever an author sits down to write a book, he has to make some assumptions about his audience, and I've made a few that may apply to you:

  You're looking for sensible investments. 

  You've done some research (or perhaps thought about doing some) on mutual funds and found the thousands of fund choices to be a bit daunting. 

  Your investment portfolio contains or has contained mutual funds, and you're looking for up-to-date information on how changes in the economy and financial markets can affect the decisions you make. 

If one or more of these descriptions rings true, you're in the right place.  Mutual funds are a huge business, and they can be confusing.  Today, thousands of mutual funds account for more than $11 trillion under management.  Although the basic principle behind mutual funds sounds simple enough — pooled money from many individuals that's invested in stocks, bonds, or other securities — you have to understand the different types of investments, such as stocks and bonds, and the way they work. 

Unfortunately, you have too many individual funds from which to choose — hundreds of mutual fund companies, brokerage firms, insurers, banks, and so on are selling thousands of funds.  Even experienced investors suffer from information overload.  Lucky for you, I present short lists of great funds that meet different needs. 

And because no investment, not even one of the better mutual funds, is free of flaws and shortcomings, I explain how to avoid the worst funds — and the numerous mediocre ones — that clutter the investment landscape.  I also help you understand when investing in funds may not be appropriate for you and what your best options may be. 

How This Book Is Organized

The sections that follow contain a preview, of sorts, of the various sections in this book and what they cover. 

Part I: Mutual Funds: Sharing Risks and Rewards

Part I defines and demystifies what mutual funds are and discusses what they're good for.  Before you're even ready to start investing in funds, your personal finances need to be in order, so I give you some financial housecleaning tips.  You can also discover the importance of fitting mutual funds to your financial goals.  Part I also covers how to pick great funds, how to avoid loser funds, where and how to purchase funds, and how to read all those pesky reports that fund companies tend to produce. 

Part II: Evaluating Alternatives to Funds

Mutual funds are hardly the only game in town for those folks seeking someone to manage their money.  In recent years, exchange-traded funds and hedge funds, for example, have been pitched to many investors.  Other investors believe that they can be their own best stock and bond pickers.  This part discusses all the fund-investing alternatives and more to help you select which option(s) are best for your situation. 

Part III: Separating the Best from the Rest

This part explains what makes a fund and fund company worth investing in.  You see how to read and understand common fund documents.  I also explain the best venues and avenues for buying funds and help you think through whether to enlist the services of an adviser. 

Part IV: Crafting Your Fund Portfolio

This part shows you how to build a portfolio that includes mutual funds to accomplish your specific financial goals.  You start off by exploring the basic strategies of portfolio construction.  Then for each of the major fund types — money market, bond, and stock — you get specific fund recommendations.  I also discuss specialty funds.  A chapter of sample fund portfolios based on real-life scenarios brings together the important concepts in this section.  Last but not least, I cover how to complete the often-pesky paperwork funds demand of you. 

Part V: Keeping Current and Informed

After you have a good fund portfolio up and running, you shouldn't have to devote much time to maintaining it.  This part covers what you do need to do, including chapters on how to evaluate your funds' performance and deal with the tax issues that come up on your investments.  I also offer some tips on how to minimize aggravations when you deal with fund companies and discount brokers. 

If you're still not satisfied, you can find out about the scores of individuals, companies, and publications that rank and predict financial market gyrations.  I warn you about the bad ones and the dangers of blindly following gurus, and I reveal which, if any, of them really are gurus.  You also discover how to use the best mutual fund information sources, how to tell the difference between good and bad newsletters, and where to turn for more information.  You may want to know how to use your computer to track and even invest in mutual funds online — so this part tells you how to do that, too. 

Part VI: The Part of Tens

Broaden your thinking with these chapters that offer ten or more ideas about important fund issues and concepts.  I discuss common fund-investing mistakes made by investors, ease some fund-investing fears that you may have, and cover issues to consider before hiring an adviser.  In the appendix, you find the contact information for all the top-notch funds I recommend. 

Icons Used in This Book

Throughout this book, you can find friendly and useful icons that enhance your reading pleasure and flag special types of information.  So, when you meet one of these margin-hugging doodads, consider the following:

  This icon points out something that can save you time, headaches, money, or all of the above! 

  The warning icon helps steer you away from mistakes and boo-boos that others have made when investing in mutual funds. 

  Something around here could really cost you big bucks (maybe even an arm and a leg!)  if you don't devote your attention to these icons. 

  This icon denotes Eric's favorite mutual funds. 

  Eminently skippable stuff here, but if you don't read it, you may not seem as astute at the next cocktail party when mutual fund trivia games begin.  Neat but nonessential stuff — read at your leisure. 

  Eric's told me as much as he can, but he thinks that I may need or want to check it out more on my own before I make a move. 

  This icon designates something important that I want you to make sure you don't forget when you're making your own fund-investing decisions! 

Where to Go from Here

You don't need to read this book cover to cover.  But if you're a beginner or you want to fully immerse yourself in the world of fund investing, go for it!  However, you may have some specific questions today, and you'll want some other information tomorrow.  No problem there, either.  Mutual Funds For Dummies, 6th Edition, is well organized and easier to use than other fund investing books.  Use the Table of Contents or the Index to speed your way toward what you need to know and get on with your life. 
Part I

Mutual Funds: Sharing Risks and Rewards

In this part . . . 

This part gives you an excellent grounding in the fundamentals of mutual fund investing.  You also find out how to fit mutual funds neatly with the rest of your finances, and you get an inside look at how and when to invest in the best mutual funds. 
Chapter 1

Making More Money, Taking Less Risk

In This Chapter

  Defining mutual funds

  Understanding investments

  Weighing your options

  Seeing the big picture: returns, risks, and risk reduction

In my years of work as a financial adviser and a columnist answering many readers' questions, I've seen the same, avoidable mistakes being made over and over.  Often, these investing mistakes occurred for one simple reason: a lack of investment understanding.  People didn't know what their investing options were and why particular options were inferior or superior to others. 

By reading this book, you can prevent yourself from making investment mistakes.  And you can take advantage of an excellent investment vehicle: mutual funds — the best of which offer you diversification, which reduces your risks, and low-cost access to highly diversified portfolios and professional money managers, who can boost your returns with less risk.  And mutual funds can fit nicely in the context of your overall financial plans and goals.  This chapter gives you an investment overview so that you can see how mutual funds fit into the overall investment world. 

Introducing Mutual Funds

If you already understand stocks and bonds, their risks and potential returns, and the benefits of diversification, terrific.  You can skip this chapter.  Most people, however, don't really comprehend investment basics, which is one of the major reasons why people make investment mistakes in the first place. 

After you understand the specific types of securities (stocks, bonds, and so on) that funds can invest in, you've mastered one of the important building blocks to understanding mutual funds.  A mutual fund is a vehicle that holds other investments: When you invest in a mutual fund, you're contributing to a big pool of money that a mutual fund manager uses to buy other investments, such as stocks, bonds, and/or other assets that meet the fund's investment objectives. 

Differences in investment objectives are how mutual funds broadly categorize themselves, like the way an automaker labels a car a sedan or a sport utility vehicle.  This label helps you, the buyer, have a general picture of the product even before you see the specifics.  On the dealer's lot, the salesmen take for granted that you know what sedan and sport utility vehicle mean.  But what if the salesman asks you whether you want a Pegasus or a Stegosaurus?  If you don't know what those names mean, how can you decide? 

Mutual fund terms, such as municipal bond fund or small-cap stock fund, are thrown around casually.  Fact is, thanks to our spending-oriented culture, the average American knows car models better than types of mutual funds!  In this chapter (and in Chapter 2), I explain the investment and mutual fund terms and concepts that many writers assume you already know (or perhaps that they don't understand well enough themselves to explain to you).  But don't take the plunge into mutual funds until you determine your overall financial needs and goals. 

Making Sense of Investments

Your eyes can perceive dozens of different colors, and hundreds, if not thousands, of shades in between.  In fact, you can see so many colors that you can easily forget what you discovered back in your early school days — that all colors are based on some combination of the three primary colors: red, blue, and yellow.  Well, believe it or not, the world of investments is even simpler than that.  The seemingly infinite number of investments out there is based on just two primary kinds of investments: lending investments and ownership investments. 

Lending investments: Interest on your money

Lending is a type of investment in which the lender charges the borrower a fee (generally known as interest) until the original loan (typically known as the principal) gets paid back.  Familiar lending investments include bank certificates of deposit (CDs), United States (U.S.) Treasury bills, and bonds issued by corporations, such as Coca-Cola.  In each case, you're lending your money to an organization — the bank, the federal government, or a company — that pays you an agreed-upon rate of interest.  You're also promised that your principal (the original amount that you loaned) will be returned to you in full on a specific date. 

The best thing that can happen with a lending investment is that you're paid all the interest in addition to your original investment, as promised.  Although getting your original investment back with the promised interest won't make you rich, this result isn't bad, given that the investment landscape is littered with the carcasses of failed investments that return you nothing — including lunch money loans that you never see repaid! 

  Lending investments have several drawbacks:

  You may not get everything you were promised.  Under extenuating circumstances, promises get broken.  When a company goes bankrupt (remember Bear Stearns, Enron, Lehman, WorldCom, and so on), for example, you can lose all or part of your original investment (from purchased bonds). 

  You get what you were promised, but because of the ravages of inflation, your money is simply worth less than you expected it to be worth.  Your money has less purchasing power than you thought it would.  Suppose that you put $5,000 into an 18-year lending investment that yielded 4 percent.  You planned to use it in 18 years to pay for one year of college.  Although a year of college cost $5,000 when you invested the money, college costs rose 8 percent a year; so in 18 years when you needed the money, one year of college cost nearly $20,000.  But your investment, yielding just 4 percent, would only be worth around $10,100 — nearly 50 percent short of the cost of college because the cost of college rose faster than did the value of your investment. 

  You don't share in the success of the organization to which you lend your money.  If the company doubles or triples in size and profits, the growth is good for the company and its owners.  As a bondholder (lender), you're sure to get your interest and principal back, but you don't reap any of the rewards.  If Bill Gates had approached you many years ago for money to help make computer software, would you rather have loaned him the money or owned a piece of the company, Microsoft? 

Ownership investments: More potential profit (and risk)

You're an owner when you purchase an asset, whether a building or part of a multinational corporation, that has the ability to generate earnings or profits.  Real estate and stock are common ownership investments. 

  Ownership investments can generate profits in two ways:

  Through the investment's own cash flow/income: For example, as the owner of a duplex you receive rental income from tenants.  If you own stock in a corporation, many companies elect to pay out a portion of their annual profits (in the form of a dividend). 

  Through appreciation in the value of the investment: When you own a piece of real estate in an economically vibrant area or you own stock in a growing company, your investment should increase in value over time.  If and when you sell the investment, the difference between what you sold it for and what you paid for it is your (pre-tax) profit. ( The IRS, of course, will eventually expect its share of your investment profits.)  This potential for appreciation is the big advantage of being an owner versus a lender. 

On the downside, ownership investments may come with extra responsibilities.  If the furnace goes out or the plumbing springs a leak, you, as the property owner, are the one who must fix and pay for it while your tenant gets to kick back in his recliner watching football games and guzzling beer.  And you're the one who must pay for insurance to protect yourself against risks, such as fire damage or accidents that occur on your property. 

Moreover, where the potential for appreciation exists, the potential for depreciation also exists.  Ownership investments can decline in value as we most recently saw in the late 2000s.  Real estate markets can slump, stock markets can plummet, and individual companies can go belly up.  For this reason, ownership investments tend to be riskier than lending investments. 

Surveying the Major Investment Options

When you understand that fundamentally only two kinds of investments — ownership and lending— exist, you can more easily understand how a specific investment works . . .  and whether it's an attractive choice to help you achieve your specific goals. 

Which investment vehicle you choose for a specific goal depends on where you're going, how fast you want to get there, and what risks you're willing to take.  Here's an inventory of investment vehicles to choose from, along with my thoughts on which vehicle would be a good choice for your situation. 

Savings and money market accounts

You can find savings and money market accounts at banks; money market funds are available through mutual fund companies.  All are lending investments based on short-term loans and are about the safest in terms of risk to your investment among the various lending investments around.  Relative to the typical long-term returns on growth-oriented investments, such as stocks, the interest rate (also known as the yield) paid on savings and money market accounts is low but doesn't fluctuate as much over time. ( The interest rate on savings and money market accounts generally fluctuates as the level of overall market interest rates changes.) 

Bank savings accounts are backed by an independent agency of the federal government through Federal Deposit Insurance Corporation (FDIC) insurance.  If the bank goes broke, you still get your money back (up to $250,000 per depositor, per insured bank).  Money market funds, however, aren't insured. 

  Should you prefer a bank account because your investment (principal) is insured?  No.  Savings accounts and money market funds have essentially equivalent safety, but money market funds tend to offer higher yields.  Chapter 11 provides more background on money market funds. 

Bonds

Bonds are the most common lending investment traded on securities markets.  Bond funds also account for about 20 percent of all mutual fund assets.  When issued, a bond includes a specified maturity date — the date when your principal is repaid.  Also specified when a bond is issued is the interest rate, which is typically fixed (meaning it doesn't change over time). 

Bonds, therefore, can fluctuate in value with changes in interest rates.  If, for example, you're holding a bond issued at 5 percent and the market level of interest rates increase to 7 percent for newly issued similar bonds, your bond will decrease in value.  Why would anyone want to buy your bond at the price that you paid if it yields just 5 percent and she can get a similar bond yielding 7 percent somewhere else? ( See Chapter 12 for more information.) 

Bonds differ from each other in the following ways:

  The type of institution to which you're lending your money: Institutions include state and local governments (municipal bonds), the federal government (treasuries), mortgage holders (Government National Mortgage Association, or GNMA), and corporations (corporate bonds).  Foreign governments or corporations can also issue bonds.  The taxability of the interest paid by a bond is tied to the type of entity issuing the bond.  Corporate, mortgage, and foreign government bond interest is fully taxable.  Interest on government bonds issued by U.S. entities is usually free of state and/or federal income tax. 

  The credit quality of the borrower to whom you lend your money: The probability that a borrower will pay you the interest and return your entire principal on schedule varies from institution to institution.  Bonds issued by less-creditworthy institutions tend to pay higher yields to compensate investors for the greater risk that the loan will not be fully repaid. 

  The length of maturity of the bond: Short-term bonds mature in a few years, intermediate bonds in around 5 to 10 years, and long-term bonds within 30 years.  Longer-term bonds generally pay higher yields, but their value is more sensitive to changes in interest rates. 

Stocks

Stocks are the most common ownership investment traded on securities markets.  They represent shares of ownership in a company.  Companies that sell stock to the general public (called publicly held companies) include aircraft manufacturers, automobile manufacturers, banks, computer software producers, food manufacturers, hotels, Internet companies, mining companies, oil and gas firms, publishers, restaurant chains, supermarkets, wholesalers, and many types of other (legal) businesses! 

When you hold stock in a company, you share in the company's profits in the form of annual dividends (although some companies don't pay dividends) as well as an increase (you hope) in the stock price if the company grows and makes increasing profits.  That's what happens when all is going well.  The downside is that if the company's business declines, your stock can plummet or even go to $0 per share. 

Besides occupying different industries, companies also vary in size.  In the financial press, you often hear companies referred to by their market capitalization, which is the total value of their outstanding stock.  This is what the stock market and the investors who participate in it think a company is worth. 

You can choose from two very different ways to invest in bonds and stocks.  You can purchase individual securities, or you can invest in a portfolio of securities through a mutual fund.  I discuss stock mutual funds in Chapter 13 and individual securities (and other alternatives to mutual funds) in Part II. 

Overseas investments

Overseas investment is a potentially misleading category.  The types of overseas investment options, such as stocks and bonds and real estate, aren't fundamentally different from your domestic options.  However, overseas investments are often categorized separately because they come with their own set of risks and rewards. 

  Here are some good reasons to invest overseas:

  Diversification: International securities markets don't move in lock step with U.S. markets, so adding foreign investments to a domestic portfolio offers you a smoother ride over the long term. 

  Growth potential: When you confine your investing to U.S. securities, you're literally missing a world of opportunities.  The majority of investment opportunities are overseas.  If you look at the total value of all stocks and bonds outstanding worldwide, the value of U.S. securities is now in the minority.  The U.S. isn't the world — numerous overseas economies are growing faster. 

Some people hesitate to invest in overseas securities because they feel that doing so hurts the U.S. economy and contributes to a loss of U.S. jobs.  Fair enough.  But I have two counterarguments:

  If you don't profit from the growth of economies and companies overseas, someone else will.  If money is to be made there, Americans may as well make some of it. 

  The U.S. already participates in a global economy — making a distinction between U.S. companies and foreign companies is no longer appropriate.  Many companies headquartered in the U.S. also have overseas operations.  Some U.S. firms derive a large portion of their revenue and profits from their international divisions.  Conversely, many firms based overseas also have operations in the U.S. Increasing numbers of companies are worldwide operations. 

  Dividends and stock price appreciation recognize no national boundaries!  You aren't unpatriotic if you invest globally.  Profits from a foreign company are distributed to all stockholders, no matter where they live. 

Real estate

Perhaps the most fundamental of ownership investments, real estate has made many people wealthy.  Not only does real estate produce consistently good rates of return (averaging around 8 to 10 percent per year) over long investment periods, but you can also purchase it with borrowed money.  This leverage helps enhance your rate of return when real estate prices are rising. 

As with other ownership investments, the value of real estate depends on the health and performance of the economy, as well as on the specifics of the property that you own:

  If the local economy grows and more jobs are being produced at higher wages, real estate should do well. 

  If companies in the community are laying off people, and excess housing is sitting vacant because of previous overbuilding, rents and property values are likely to fall. 

  For investors who have time, patience, and capital, real estate can make sense as part of an investment portfolio — check out Real Estate Investing For Dummies (Wiley), which I coauthored.  If you don't want the headaches that come with purchasing and maintaining a property, you can buy mutual funds that invest in real estate properties and related companies (see Chapter 14). 

Gold, silver, and the like

Whenever bad things happen, especially inflation, credit crises, and international conflicts, some investors seek out gold, silver, and other precious metals.  Over the short term, these commodities may produce hefty returns, but their long-term record is more problematic.  See Chapter 14 for all the details and how you might diversify your portfolio using specialty funds investing in this sector. 

Annuities

Annuities are investment products with some tax and insurance twists.  They behave like savings accounts, except that they should give you slightly higher yields, and insurance companies back them.  As with other types of retirement accounts, the money that you put into an annuity compounds without taxation until withdrawal.  However, unlike most other types of retirement accounts — 401(k)s, SEP-IRAs, and Keoghs — an annuity gives you no upfront tax deductions for your contributions. 

Annuities also charge relatively high fees.  That's why it makes sense to consider contributing to an annuity after you fully fund the tax-deductible retirement accounts that are available to you.  The best annuities available today are distributed by no-load (commission-free) mutual fund companies.  For more information about the best annuities and situations for which annuities may be appropriate, be sure to read Chapter 15. 

Life insurance

Some insurance agents love to sell cash-value life insurance.  That's because these policies that combine life insurance protection with an account that has a cash value — usually known as universal, whole, or variable life policies — generate big commissions for the agents who sell them. 

Cash-value life insurance isn't a good investment vehicle.  First, you should be saving and investing through tax-deductible retirement savings plans, such as 401(k)s, IRAs, and Keoghs.  Contributions to a cash-value life insurance plan provide you no upfront tax benefit.  Second, you can earn better investment returns through efficiently managed mutual funds that you invest in outside of a life policy. 

The only reason to consider cash-value life insurance is that the proceeds paid to your beneficiaries can be free of estate taxes.  Especially in light of recent years' tax law changes, you need to have a substantial estate at your death to benefit from this feature.  Through the use of bypass trusts, married couples can pass along double these amounts.  And, by giving away money to your heirs while you're still alive, you can protect even more of your nest egg from the federal estate taxes. ( Term life insurance is best for the vast majority of people.  Please consult the latest edition of my book, Personal Finance For Dummies, 6th Edition (Wiley), which has all sorts of good stuff on insurance and other important personal finance issues.) 

  Don't fall prey to life insurance agents and their sales pitches.  You shouldn't use life insurance as an investment, especially if you haven't exhausted your ability to contribute to retirement accounts. ( Even if you've exhausted contributing to retirement accounts, you can do better than cash-value life insurance by choosing tax-friendly mutual funds and/or variable annuities that use mutual funds; see Chapters 11 through 15 for the details.) 

Limited partnerships

  Avoid limited partnerships (LPs) sold directly through brokers and financial planners.  They are inferior investment vehicles.  That's not to say that no one has ever made money on them, but LPs are so burdened with high sales commissions and investment-depleting management fees that you can do better with other vehicles. 

LPs invest in real estate and a variety of businesses.  They pitch that you can get in on the ground floor of a new investment opportunity and make big money.  Usually, they also tell you that while your investment is growing at 20 percent or more per year, you'll get handsome dividends of 8 percent or so per year.  It sounds too good to be true because it is. 

  Many of the yields on LPs have turned out to be bogus.  In some cases, partnerships propped up their yields by paying back investors' principal (original investment), without telling them, of course.  The other hook with LPs is tax benefits.  What few loopholes that did exist in the tax code for LPs have largely been closed.  The other problems with LPs overwhelm any small tax advantage, anyway. 

The investment salesperson who sells LPs stands to earn a commission of up to 10 percent or more.  That means that only 90 cents (or less) per dollar that you put into an LP actually gets invested.  Each year, LPs typically siphon off 2 percent or more of your money for management and other expenses.  Efficient, no-load mutual funds, in contrast, put 100 percent of your capital to work (thanks to no commissions) and charge 1 percent per year or less in operating fees. 

Most LPs have little or no incentive to control costs.  In fact, they may have a conflict of interest that leads them to charge more to enrich the managing partners.  And, unlike mutual funds, in LPs you can't vote with your feet.  If the partnership is poorly run and expensive, you're stuck.  That's why LPs are called illiquid — you can't withdraw your money until the partnership is liquidated, typically seven to ten years after you buy in. ( If you want to sell out to a third party in the interim, you have to sell at a huge discount.  Don't bother unless you're totally desperate for cash.) 

  The only thing limited about an LP is its ability to make you money.  If you want to make investments that earn you healthy returns, stick with stocks (using mutual funds), real estate, or your own business. 

Reviewing Important Investing Concepts

If you reviewed the beginning of this chapter, you have the fundamental building blocks of the investing world.  Of course, as the title of this book suggests, I focus on a convenient and efficient way to put it all together — mutual funds.  But before doing that, this section reviews some key investing concepts that you continually come across as an investor. 

Getting a return: Why you invest

An investment's return measures how much the investment has grown (or shrunk, as the case may be).  Return figures are usually quoted as a rate or percentage that measures how much the investment's value has changed over a specified period of time.  So if an investment has a five-year annualized return of 8 percent, then every year for the past five years that investment, on average, has gotten 8 percent bigger than it was the year before. 

So what kind of returns can you expect from different kinds of investments?  I say "can" because we're looking at history, and history is a record of the past.  Using history to predict the future, especially the near future, is dangerous.  History won't exactly repeat itself, not even in the same fashion and not necessarily when you expect it to. 

  Over the past century, ownership investments like stocks and real estate returned around 8 to 10 percent per year, handily beating lending investments such as bonds (around 5 percent) and savings accounts (roughly 4 percent) in the investment performance race.  Inflation averaged around 3 percent per year, so savings account and bond returns barely kept up with increases in the cost of living.  Factoring in the taxes that you must pay on your investment earnings, the returns on lending investments actually didn't keep up with these increases. ( For comparisons of various mutual funds' returns, please see Chapter 17.) 

Measuring risks: Investment volatility

Obviously, if you read the previous section, you know you should put all your money in stocks and real estate, right?  The returns sure look great.  So what's the catch? 

  The greater an investment's potential return, the greater (generally) is its risk, particularly in the short term.  But the main drawback to ownership investments is volatility (the size of the fluctuations in the value of an investment).  Last century, for example, stocks declined by more than 10 percent in a year approximately once every five years.  Drops in stock prices of more than 20 percent occurred about once every ten years (see Figure 1-1).  Thus, in order to earn those generous long-term stock market returns of about 10 percent per year, you had to tolerate volatility and be able to hold onto the investment for a number of years to wait out sharp, short-term declines.  That's why you absolutely should not put all your money in the stock market. 

**Figure 1-1:** Historic probability of different U.S. stock returns. 

In Figure 1-2, you see bonds that have had fewer years in which they've provided rates of return that were as tremendously negative or positive as stocks.  Bonds are less volatile, but, as I discuss in the preceding section, on average you earn a lower rate of return. 

  Some types of bonds have higher yields than others, but nothing is free, either.  A bond generally pays you a higher rate of interest as compared with other bonds when it has

  Lower credit quality, which compensates for the higher risk of default and the higher likelihood that you'll lose your investment. 

  Longer-term maturity, which compensates for the risk that you'll be unhappy with the bond's interest rate if interest rates move up. 

  Callability, which retains an organization's or company's right to buy back (pay off) the issued bonds before the bonds mature. 

Companies like to be able to pay off early if they've found a cheaper way to borrow the money.  Early payback is a risk to bondholders because they may get their investment money returned to them when interest rates have dropped. 

**Figure 1-2:** Historic probability of different U.S. bond market returns. 

Diversifying: A smart way to reduce risk

Diversification is one of the most powerful investment concepts.  It requires you to place your money in different investments with returns that aren't completely correlated.  Now for the plain-English translation: With your money in different places, when one of your investments is down in value, the odds are good that at least one other is up. 

  To decrease the odds that all your investments will get clobbered at the same time, put your money in different types or classes of investments.  The different kinds of investments include money market funds, bonds, stocks, real estate, and precious metals.  You can further diversify your investments by investing in international, as well as domestic markets. 

  You should also diversify within a given class of investments.  For example, with stocks, diversify by investing in different types of stocks that perform well under various economic conditions.  For this reason, mutual funds, which are diversified portfolios of securities, are highly useful investment vehicles.  You buy into the mutual fund, which in turn pools your money with that of many others to invest in a vast array of stocks or bonds. 

You can look at the benefits of diversification in two ways:

  Diversification reduces the volatility in the value of your whole portfolio.  In other words, when you diversify, you can achieve the same rate of return that a single investment can provide, but with reduced fluctuations in value. 

  Diversification allows you to obtain a higher rate of return for a given level of risk. 
Chapter 2

Mutual Funds: Pros and Cons

In This Chapter

  Seeing how mutual funds work

  Discovering reasons to choose mutual funds

  Considering the drawbacks

I'm not sure where the mutual in mutual funds comes from; perhaps it's so named because the best funds allow many people of differing economic means to mutually invest their money for

  Easy diversification

  Access to professional money managers

  Low investment management costs

No matter where the word came from, mutual funds, like any other investment, have their strengths and weaknesses that you need to know about before you invest your money.  This chapter discusses the advantages and disadvantages of mutual funds. 

Getting a Grip on Mutual Funds

A mutual fund is a collection of investment money pooled from many investors to be invested for a specific objective.  When you invest in a mutual fund, you buy shares and become a shareholder of the fund.  The fund manager and his team of assistants determine which specific securities (for example, stocks or bonds) they should invest the shareholders' money in, in order to accomplish the objectives of the fund and keep shareholders happy. 

A misconception some investors hold regarding mutual funds is that they invest in stocks and, therefore, are too risky.  They don't, and they're not.  By using mutual funds, you can invest in a whole array of securities, ranging from money market funds, bonds, stocks, and even real estate. 

All mutual funds aren't created equal.  Some funds, such as money market funds, carry virtually zero risk that your investment will decline in value.  Bond funds that invest in shorter-term bonds don't generally budge by more than several percentage points per year.  And you may be surprised to find out in Chapter 13 that some conservative stock funds aren't that risky if you can plan on holding them for a decade or more. 

  Because good mutual funds take most of the hassle out of figuring out which securities to invest in, they're among the best investment vehicles ever created:

  Mutual funds allow you to diversify your investments — that is, invest in many different industries and companies instead of in just one or two.  By spreading the risk over a number of different securities representing many different industries and companies, mutual funds lessen your portfolio's instability and the chances of a large loss. 

  Mutual funds enable you to give your money to the best money management firms and managers in the country. 

  Mutual funds are the ultimate couch potato investment!  However, unlike staying home and watching television or playing video games, investing in mutual funds can pay you big rewards. 

What's really cool about mutual funds is that when you understand them, you realize that they can help you meet many different financial goals.  Maybe you're building up an emergency savings stash of three to six months' living expenses (a prudent idea, by the way).  Perhaps you're saving for a home purchase, retirement, or future educational costs.  You may know what you need the money for, but you may not know how to protect the money you have and make it grow. 

Don't feel bad if you haven't figured out a long-term financial plan or don't have a goal in mind for the money you're saving.  Many people don't have their finances organized, which is why I write books like this one!  I talk more specifically in Chapter 3 about the kinds of goals mutual funds can help you accomplish. 

Financial intermediaries

A mutual fund is a type of financial intermediary. ( Now that's a mouthful!)  Why should you care?  Because if you understand what a financial intermediary is and how mutual funds stack up to other financial intermediaries, you'll better understand when funds are appropriate for your investments and when they probably aren't.  A financial intermediary is nothing more than an organization that takes money from people who want to invest and then directs the money to those who need investment capital (another term for money). 

Suppose that you want to borrow money to invest in your own business.  You go to a bank that examines your financial records and agrees to loan you $20,000 at 8 percent interest for five years.  The money that the banker is lending you has to come from somewhere, right?  Well, the banker got that money from a bunch of people who deposited money with the bank at, say, 2 percent interest.  Therefore, the banker acts as a financial intermediary, or middleman — one who receives money from depositors and lends it to borrowers who can use it productively. 

Insurance companies do similar things with money.  They sell investments, such as annuities (see Chapter 1) and then turn around and lend the money — by investing in bonds, for example — to businesses that need to borrow. ( Remember, a bond is nothing more than a company's promise to repay borrowed money over a specified period of time at a specified interest rate.) 

The best mutual funds are often the best financial intermediaries for you to invest through because they skim off less (that is, they charge lower management fees) to manage your money and allow you more choice and control over how you invest your money. 

Open-end versus closed-end funds

Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund:

  Open-end funds: Open end simply means that the fund issues as many (or as few) shares as investors demand.  Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold.  You buy and sell shares in such a fund from the fund company. 

  Closed-end funds: Closed-end funds are those where the mutual fund companies decide upfront, before they take on any investors, exactly how many shares they'll issue.  After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker.  This process happens with buying and selling stock, too. 

  The vast majority of funds in the marketplace are open-end funds, and they're also the funds that I focus on in this book because the better open-end funds are superior to their closed-end counterparts. 

Open-end funds are usually preferable to closed-end funds for the following reasons:

  Management talent: The better open-end funds attract more investors over time.  Therefore, they can afford to pay the necessary money to hire leading managers.  I'm not saying that closed-end funds don't have good managers, too, but generally, open-end funds attract better talent. 

  Expenses: Because they can attract more investors, and therefore more money to manage, the better open-end funds charge lower annual operating expenses.  Closed-end funds tend to be much smaller and, therefore, more costly to operate.  Remember, operating expenses are deducted out of shareholder returns before a fund pays its investors their returns; therefore, relatively higher annual expenses depress the returns for closed-end funds. 

  Brokers who receive a hefty commission generally handle the initial sale of a closed-end fund.  Brokers' commissions usually siphon anywhere from 5 to 8 percent out of your investment dollars, which they generally don't disclose to you. ( Even if you wait until after the initial offering to buy closed-end fund shares on the stock exchange, you still pay a brokerage commission, although it is generally a lot less than the initial sale commission.)  You can avoid these high commissions by purchasing a no-load (commission-free), open-end mutual fund. ( See "Funds save you money and time," later in this chapter, for details on no-load funds.) 

  Fee-free selling: With an open-end fund, the value of a share (known as the net asset value) always equals 100 percent of what the fund's investments (less liabilities) are currently worth.  And you don't have the cost and troubles of selling your shares to another investor as you do with a closed-end fund.  Because closed-end funds trade like securities on the stock exchange and because you must sell your shares to someone who wants to buy, closed-end funds sometimes sell at a discount.  Even though the securities in a closed-end fund may be worth, say, $20 per share, the fund may sell at only $19 per share if sellers outnumber buyers. 

You could buy shares in a closed-end fund at a discount and hold on to them in hopes that the discount disappears or — even better — turns into a premium (which means that the share price of the fund exceeds the value of the investments it holds).  You should never pay a premium to buy a closed-end fund, and you shouldn't generally buy one without getting at least a 5 percent discount (to make up for its deficiencies, versus its open-ended peers, especially higher expenses). 

  Sorry to complicate things, but I need to make one clarification.  Open-end funds can, and sometimes do, decide at a later date to "close" their funds to new investors.  This doesn't make it a closed-end fund, however, because investors with existing shares can generally buy more shares from the fund company.  Instead, the fund becomes an open-end fund that's closed to new investors! 

Opting for Mutual Funds

To understand why funds are so sensible is to understand how and why funds can work for you.  Keep reading in this section to discover their many benefits. ( Funds also have their drawbacks — I cover them in the section, "Addressing the Drawbacks," later in this chapter.)  In Part II of this book, I compare mutual funds to other investing alternatives so you can clearly understand when funds are and aren't your best choice. 

Fund managers' expertise

Mutual funds are investment companies that pool your money with the money of hundreds, thousands, or even millions of other investors.  The company hires a portfolio manager and a team of researchers whose full-time job is to analyze and purchase investments that best meet the fund's stated objectives. 

Typically, fund managers are Chartered Financial Analysts (CFAs) and/or graduates of the top business and finance schools in the country, where they study the principles of portfolio management and securities valuation and selection.  In addition to their educational training, the best fund managers typically have a decade or more of experience in analyzing and selecting investments. 

  A mutual fund management team does more research and due diligence than you could ever have the energy or expertise to do in what little free time you have.  Investing in mutual funds can help your friendships, and maybe even your love life, because you'll have more free time and energy! 

Consider the following activities that an investor should do before investing in stocks and bonds:

  Analyze company financial statements: Companies whose securities trade in the financial markets are required to issue reports every three months detailing their revenue, expenses, profits and losses, and assets and liabilities.  Unless you're a numbers geek, own a financial calculator, and enjoy dissecting tedious corporate financial statements, this first task alone is reason enough to invest through a mutual fund and leave the driving to the mutual fund management team. 

  Talk with the muckety-mucks: Most fund managers log thousands of frequent-flier miles and hundreds of hours talking to the folks running the companies they're invested in or are thinking about investing in.  Because of the huge amount of money they manage, large fund companies even get visits from company executives, who fly in to grovel at the fund managers' feet.  Now, do you have the correct type of china and all the place settings that etiquette demands of people who host such high-level folks?! 

  Analyze company and competitor strategies: Corporate managers have an irritating tendency to talk up what a great job they're doing.  Some companies may look as if they're making the right moves, but what if their products are soon to lag behind the competition's?  The best fund managers and their researchers take a skeptical view of what a company's execs say — they read the fine print and check under the rugs.  They also keep on top of what competitors are doing.  Sometimes they discover investment ideas better than their original ones this way. 

  Talk with company customers, suppliers, competitors, and industry consultants: Another way the mutual fund managers find out whether a company's public relations story is full of holes instead of reality is by speaking with the company's customers, suppliers, competitors, and other industry experts.  These people often have more balanced viewpoints and can be a great deal more open about the negatives.  These folks are harder to find but can provide valuable information. 

  Attend trade shows and review industry literature: It's truly amazing how specialized the world's becoming.  Do you really want to subscribe to business newsletters that track the latest happenings with ball bearing or catalytic converter technology?  They'll put you to sleep in a couple of pages.  Unlike popular mass-market publications, they'll also charge you an arm and a leg to subscribe. 

Are you, as the investor, going to do all these tasks and do them well?  Nothing personal, but I doubt that you will.  Even in the unlikely event that you could perform investment research as well as the best fund managers, don't you value your time?  A good mutual fund management team happily performs all the required research for you, does it well, and does it for a fraction of what it costs you to do it haphazardly on your own. 

Funds save you money and time

Chances are the last thing you want to do with your free time is research where to invest your savings.  If you're like many busy people, you've kept your money in a bank just to avoid the hassles.  Or maybe you turned your money over to some smooth-talking broker who sold you a high-commission investment that you still don't understand but are convinced will make you rich. 

  Mutual funds are a cheaper, more communal way to get the investing job done.  A mutual fund spreads out the cost of extensive — and expensive — research over thousands of investors.  How does a mutual fund save you time and money?  Let me count the ways:

A (brief) history of mutual funds

Mutual funds date back to the 1800s, when English and Scottish investment trusts sold shares to investors.  Funds arrived in the United States in 1924.  They were growing in assets until the late 1920s, when the Great Depression derailed the financial markets and the economy.  Stock prices plunged and so did mutual funds that held stocks. 

As was common in the stock market at that time, mutual funds were leveraging their investments — leveraging is a fancy way of saying that they put up only, for example, 25 cents on the dollar for investments they actually owned.  The other 75 cents was borrowed.  That's why, when the stock market plunged in 1929, some investors and fund shareholders got clobbered.  They were losing money on their investments and on all the borrowed money.  But, like the rest of the country, mutual funds, although bruised, pulled through this economic calamity. 

The Securities Act of 1933 and the Investment Company Act of 1940 established ground rules and oversight of the fund industry by the Securities and Exchange Commission (SEC).  Among other benefits, this landmark federal legislation required funds to register and have those materials be reviewed by the SEC before issuing or selling any fund shares to the public.  Funds were required to disclose cost, risk, and other information in a uniform format through a legal document called a prospectus (see Chapter 8). 

During the 1940s, '50s, and '60s, funds grew at a fairly high and constant rate.  From less than $1 billion in assets in 1940, fund assets grew to more than $50 billion by the late '60s — more than a fiftyfold increase.  Before the early '70s, funds focused largely on investing in stocks.  Since then, however, money market mutual funds and bond mutual funds have mushroomed.  They now account for about 50 percent of all mutual fund assets. 

Today, thousands of mutual funds manage about $11 trillion. 

  Mutual funds can produce a much better rate of return over the long haul than a dreary, boring bank or insurance company account.  You can purchase by writing a check or calling a toll-free number.  What does it cost to hire such high-powered talent to do all the dreadful research and analysis?  A mere pittance if you pick the right funds.  In fact, when you invest your money in an efficiently managed mutual fund, the cost should be less than it would be to trade individual securities on your own. 

  Mutual funds manage money efficiently through effective use of technology.  Innovations in information-management tools enable funds to monitor and manage billions of dollars from millions of investors at a very low cost.  In general, moving around $5 billion in securities doesn't cost them much more than moving $500 million.  Larger investments just mean a few more zeros in the computer data banks. 

The most efficiently managed mutual funds cost less than 1 percent per year in expenses. ( Bond funds and money market funds cost much less — good ones charge just 0.5 percent per year or less.)  Some of the larger and more established funds, including index funds (see Chapter 10), charge annual expenses of less than 0.2 percent per year. 

  Many mutual funds don't charge a commission (load) to purchase or redeem shares.  Commission-free funds are called no-load funds.  Such opportunities used to be rare.  Fidelity and Vanguard, the two largest distributors of no-load funds today, exacted sales charges as high as 8.5 percent during the early 1970s.  Even today, some mutual funds known as load funds charge you a commission for buying or selling shares in their funds. ( See Chapter 7 for the complete story on fund fees.) 

Fund diversification minimizes your risk

Diversification is a big attraction for many investors who choose mutual funds.  Here's an example of why, which should also explain what diversification is all about: Suppose you heard that Phenomenal Pharmaceuticals developed a drug that stops cancer cells in their tracks.  You run to the phone, call your broker, and invest all your savings in shares of Phenomenal stock.  Years later, the Food and Drug Administration (FDA) denies the company approval for the drug, and the company goes belly up, taking your entire nest egg with it. 

Your money would've been much safer in a mutual fund.  A mutual fund may buy some shares of a promising, but risky, company like Phenomenal without exposing investors like you to financial ruin.  A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector.  So when Phenomenal goes belly up, the fund may barely feel a ripple. 

Diversifying like that on your own would be difficult — and expensive —unless you have a few hundred thousand dollars and a great deal of time to invest.  You'd need to invest money in at least 8 to 12 different companies in various industries to ensure that your portfolio could withstand a downturn in one or more of the investments. 

Mutual funds typically invest in 25 to 100 securities, or more.  Proper diversification increases the probability that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund. 

I'm not suggesting that mutual funds escape without share-price declines during major market downturns.  For example, during the early 2000s bear market, many mutual funds declined in value.  But again, the investors who were most harmed were those who held individual stocks that, in the worst cases, ended up plummeting to zero as companies went bankrupt or those investors who loaded up on technology and Internet stocks that dropped 80 to 90 percent or more.  The same fate befell investors who were overloaded with stock in financial firms like AIG, Bear Stearns, Lehman, and so on that plunged far more than the broad market averages in the late 2000s bear market. 

  Although most mutual funds are diversified, some aren't.  For example, some stock funds, known as sector funds, invest exclusively in stocks of a single industry (for instance, healthcare).  Others focus on a single country (such as India).  I'm not a fan of such funds because of the lack of diversification and because such funds typically charge higher operating fees.  It's also worth noting that investors who bought sector funds investing exclusively in Internet stocks got hammered in the technology stock crash of the early 2000s.  Many of those funds dropped 80 percent or more, whereas broadly diversified funds fared far better. ( The same thing happened in the late 2000s to investors in financial sector funds.)  I talk more about narrowly focused stock funds in Chapter 13. 

Funds undergo regulatory scrutiny

Before a fund can take in money from investors, the fund must go through a tedious review process by the Securities and Exchange Commission (SEC).  After it offers shares, a mutual fund is required to publish in its prospectus (see Chapter 8) historical data on the fund's returns, its operating expenses and other fees, and its rate of trading (turnover) of the fund's investments. 

But know that government regulators aren't perfect.  Conceivably, a fund operator could try to slip through some bogus numbers, but I wouldn't lose sleep worrying about this, especially if you invest through the larger, reputable fund companies recommended in this book. 

You choose your risk level

Choosing from a huge variety of mutual funds, you can select the funds that meet your financial goals and take on the kinds of risks that you're comfortable with.  Funds to choose from include

  Stock funds: If you want your money to grow over a long period of time (and you can put up with some bad years thrown in with the good), select funds that invest more heavily in stocks. ( Check out Chapter 13 for the complete story on stock funds.) 

  Bond funds: If you need current income and don't want investments that fluctuate as widely in value as stocks do, consider bond funds (see Chapter 12). 

  Money market funds: If you want to be sure that your invested principal doesn't drop in value because you may need to use your money in the short term, you can choose a money market fund (see Chapter 11). 

Most investors choose a combination of these three types of funds to diversify and help meet different financial goals.  I get into all that information in the chapters to come. 

Fund risk of bankruptcy is nil

Mutual funds don't work like banks and insurance companies, hundreds of which have failed in recent decades. ( The number going under spiked during the late 2000s recession.)  Banks and insurers can fail because their liabilities (the money customers have given them to invest) can exceed their assets (the money they've invested or lent).  When a big chunk of a bank's loans goes sour at the same time that its depositors want their money back, the bank fails.  That happens because banks have less than 20 cents on deposit for every dollar that you and I place with them.  Likewise, if an insurance company makes several poor investments or underestimates the number of claims that insurance policyholders will make, it too can fail. 

Such failures can't happen with a mutual fund.  The situation in which the investors' demand for withdrawals of their investment exceeds the value of a fund's assets simply can't occur because for every dollar of assets that a fund holds for its customers, that mutual fund has a dollar's worth of redeemable securities. 

  That's not to say that you can't lose money in a mutual fund.  The share price of a mutual fund is tied to the value of its underlying securities: If the underlying securities, such as stocks, decrease in value, so, too, does the net asset value (share price) of the fund.  If you sell your shares when their price is less than what you paid for them, you get back less cash than you originally put into the fund.  But that's the worst that can happen; you can't lose all your investment in a mutual fund unless every single security owned by that fund simultaneously becomes worthless — an extraordinarily unlikely event. 

You may be interested to know that the specific stocks and/or bonds that a mutual fund buys are held by a custodian — a separate organization or affiliate of the mutual fund company.  The employment of a custodian ensures that the fund management company can't embezzle your funds (like hedge fund crook Bernie Madoff did) or use assets from a better-performing fund to subsidize a poor performer. 

Funds save you from sales sharks

  Stockbrokers (also known as financial consultants) and commission-based financial planners make more money by encouraging trading activity and by selling you investments that provide them with high commissions — limited partnerships and mutual funds with high-load fees, for example.  Brokers and planners also get an occasional message from the top brass asking them to sell some newfangled investment product.  All this creates inherent conflicts of interest that can prevent brokers from providing objective investment and financial advice and recommendations. 

The better no-load (commission-free) fund companies discussed in this book generally don't push specific products.  Their toll-free telephone lines are staffed with knowledgeable people who earn salaries, not commissions.  Sure, they want you to invest with their company, but the size of their next paycheck doesn't depend on how much they persuade you to buy or trade. 

You have convenient access to your money

What I find really terrific about dealing with the best mutual fund companies is that they're set up for people who don't like to waste time going to a local branch office and waiting in line.  I don't know about you, but I enjoy waiting in lines, especially in places like a bank, about as much as I enjoy having my dentist fill a cavity. 

With mutual funds, you can make your initial investment from the comfort of your living room by filling out and mailing a simple form and writing a check. ( Computer lovers can open and fund accounts online as I discuss in Chapter 16.)  Later, you can add to your investment by mailing in a check or by authorizing money transfers by phone or online from one mutual fund account to another. 

Selling shares of your mutual fund for cash is usually easy.  Generally, all you need to do is call the fund company's toll-free number or click your computer mouse at your investment firm's Web site 24/7.  Some companies even have representatives available by phone 24 hours a day, 365 days a year. ( Signature guarantees, although much less common, are still sometimes required by fund companies.) 

Many mutual fund companies also allow you to wire money back and forth from your local bank account, allowing you to access your money almost as quickly through a money market fund as through your local bank. ( As I discuss in Chapter 11, you probably need to keep a local bank checking account to write smaller checks and for immediate ATM access to cash.) 

Don't fret about the crooks

Folks who grew up only dealing with local banks often worry about others having easy access to the money you've invested in mutual funds.  Even if someone were able to convince a fund company through the toll-free phone line or on its Web site that he were you (say, by knowing your account number and Social Security number), the impostor, at worst, could only request a transaction to occur between accounts registered in your name.  You'd find out about the shenanigans when the confirmation arrived in the mail, at which time you could call the mutual fund company and undo the whole mess. ( Just by listening to a tape of the phone call, which the fund company records, or a record of the online transaction, the company could confirm that you didn't place the trade.) 

No one can actually take money out of your account, either.  Suppose that someone does know your personal and account information and calls a fund company to ask that a check be sent from a redemption on the account.  Even in such a scenario, the check would be sent to the address on the account and be made payable to you. 

The only way that someone can actually take money out of your account is with your authorization.  And there's only one way to do that: by completing a full trading authorization or power-of-attorney form.  I generally recommend that you not grant this authority to anyone.  If you do, make sure that the investment firm makes checks payable only to you, not to the person requesting the money from the account. 

  When dealing with a money market fund, in particular, the ease of access is even greater.  Most money market funds also offer check-writing privileges.  These accounts often carry a restriction, however, that your bank checking account doesn't have: Money market checks must be greater than a specified minimum amount — typically $250. 

If you like to conduct some transactions in person, some of the larger fund companies, such as Fidelity, and certain discount brokers, such as Charles Schwab and TD Ameritrade, have branch offices in convenient locations. 

Addressing the Drawbacks

  Although I'm a fan of the best mutual funds, I'm also well aware of their drawbacks, and you need to know them, too.  After all, no investment vehicle is perfect, and you need to understand mutual fund negatives before you take the plunge. 

Still, the mutual fund drawbacks that I'm concerned about are different from the ones that some critics like to harp on.  Here's my take on which mutual fund drawbacks you shouldn't worry about — and which ones you should stop and think about a little more. 

Don't worry about these . . . 

If you've read some articles or heard some news stories about the downsides of mutual funds, you may have heard of some of the following concerns.  However, you shouldn't let them trouble you:

  The investment Goliath: One of the concerns I still hear about is the one that, because the fund industry is growing, if stock fund investors head for the exits at the same time, they may get stuck or trampled at the door.  You could make this argument about any group of investors including institutions.  Little evidence suggests that most individual investors are prone to rash moves.  Mutual funds have grown in importance simply because they're a superior alternative for a whole lot of people. 

  Doing business long distance: Some people, particularly older folks who grew up doing all their saving through a local bank, feel uncomfortable doing business with a company that they can reach only via a toll-free number, the mail, or a Web site.  But please recognize the enormous benefits of mutual funds not having branch offices all over the country.  Branch offices cost a lot of money to operate, which is one of the reasons why bank account interest rates are so scrawny. 

  If you feel better dropping your money off in person to an organization that has local branch offices, invest in mutual funds through one of the firms that I recommend in Chapter 9.  Or do business with a fund company that's headquartered near your abode. ( See the Appendix for the main addresses of the fund companies recommended in this book.) 

  Fund company scandals: A number of funds (none that were recommended in the previous editions of this book) earned negative publicity due to their involvement in problematic trading practices.  In the worst cases, some fund managers placed their own selfish agendas (or that of certain favored investors) ahead of their shareholders' best interests.  Rightfully, these fund companies have been hammered for such behavior and forced to reimburse shareholders and pay penalties to the government.  However, the amount of such damage and reimbursement has been less than 1 percent of the affected fund's assets, which pales in comparison to the ongoing drag of high expenses discussed in the next section.  The parent company responsible for an individual fund should be an important consideration when deciding which funds to entrust with your money.  Avoid fund companies that don't place their shareholders' interests first. ( I definitely don't recommend those companies in this book.) 

Worry about these (but not too much) . . . 

No doubt you hear critics in the investment world state their case for why you should shun funds.  Not surprisingly, the most vocal critics are those who compete with fund companies. 

  You can easily overcome the common criticisms raised about fund investing if you do your homework and buy the better available mutual funds, which I show you how to do in this book.  Make sure that you consider and accommodate these factors before you invest in any mutual fund:

  Volatility of your investment balance: When you invest in mutual funds that hold stocks and/or bonds, the value of your funds fluctuates with the general fluctuations in those securities markets.  These fluctuations don't happen if you invest in a bank certificate of deposit (CD) or a fixed insurance annuity that pays a set rate of interest yearly.  With CDs or annuities, you get a statement every so often that shows steady — but slow — growth in your account value.  You never get any great news, but you never get any bad news either (unless your insurer or bank fails, which could happen). 

Over the long haul, if you invest in solid mutual funds — ones that are efficiently and competently managed — you should earn a better rate of return than you would with bank and insurance accounts.  And if you invest in stock funds, you'll be more likely to keep well ahead of the double bite of inflation and taxes. 

  If you panic and rush to sell when the market value of your mutual fund shares drops (instead of holding on and possibly taking advantage of the buying opportunity), then maybe you're not cut out for funds.  Stock fund investors who joined the panic taking place in late 2008 and early 2009 and sold got out at fire sale prices and missed out on an enormous rebound that took place beginning in early 2009.  Take the time to read and internalize the investment lessons in this book, and you'll soon be an honors graduate from my Mutual Fund University! 

  Mystery (risky) investments: Some mutual funds (not those that I recommend) have betrayed their investors' trust by taking unnecessary risks by investing in volatile financial instruments such as futures and options (also known as derivatives).  Because these instruments are basically short-term bets on the direction of specific security prices (see Chapter 1), they're very risky when not properly used by a mutual fund.  If a fund discloses in its prospectus that it uses derivatives, look to see whether the derivatives are used only for hedging purposes to reduce risk instead of as speculation on stock and bond price movements, which would increase risk. 

  Investments that cost an arm and a leg: Not all mutual funds are created equal.  Some charge extremely high annual operating expenses that put a real drag on returns. ( Again, you won't find such funds on my recommended lists in this book.)  I talk more about expense ratios and how to find great funds with low expenses in Chapter 7. 

  Taxable distributions: The taxable distributions that funds produce can also be a negative.  When fund managers sell a security at a profit, the fund must distribute that profit to shareholders in the fund (dividends are also passed through).  For funds held outside tax-sheltered retirement accounts, these distributions are taxable.  I fill you in on taxes and mutual funds in Chapter 10. 

  Some people — especially brokers and self-anointed gurus who advocate investing in individual securities — argue that taxes on mutual fund distributions are a problem big enough to justify the avoidance of mutual funds altogether, especially for higher-tax-bracket investors.  They don't have to be.  If you're concerned about the money you're investing outside of tax-sheltered retirement accounts, don't worry — I have a solution: See my recommended tax-friendly funds in Chapters 11 through 13. 
Chapter 3

Funding Your Financial Plans

In This Chapter

  Covering your bases before investing

  Meeting your goals with the help of mutual funds

In this chapter, I explain how to fit mutual funds into a thoughtful personal financial plan so the mutual funds you invest in and the other personal finance decisions you make help you achieve your goals. 

  One thing to remember before you dive in: Don't become obsessed with making, saving, and investing money that you neglect what money can't buy: your health, friends, family, and exploration of career options and hobbies. 

The Story of Justine and Max

Justine and Max, both in their 20s, recently married and excited about planning their life together, heard about a free financial-planning seminar taking place at a local hotel.  A financial planner taught the seminar.  One of his points was, "If you want to retire by the age of 65, you need to save at least 12 percent of your income every year between now and retirement . . .  the longer you wait to start saving, the more painful it'll be." 

For the couple, the seminar was a wake-up call.  On the drive home, they couldn't stop thinking and talking about their finances and their future.  Justine and Max had big plans: They wanted to buy a home, to send the not-yet-born kiddies to college, and to retire by age 65.  And so it was resolved: A serious investment program must begin right away.  Tomorrow, they'd fill out two applications for mutual fund companies that the financial planner had distributed to them. 

Within a week, they'd set up accounts in five different mutual funds at two firms.  No more paltry-return bank savings accounts — the funds they chose had been returning 10 or more percent per year!  Unlike most of their 20-something friends who didn't own funds or understand what funds were, they believed they were well on their way to realizing their dreams. 

  Although I have to admire Justine and Max's initiative (that's often the biggest hurdle to starting an investment program), I must point out the mistakes they made by investing in this fashion.  The funds themselves weren't poor choices — in fact, the funds they selected were solid: Each had competent managers, good historic performance, and reasonable fees.  Among the mistakes they made:

  They completely neglected investing in their employers' retirement savings plans.  They missed out on making tax-deductible contributions.  By investing in mutual funds outside of their employers' plans, they received no tax breaks. 

  They were steered into funds that didn't fit their goals.  They ended up with bond funds, which were okay funds as far as bond funds go.  But bond funds are designed to produce current income, not growth.  Justine and Max, looking to a retirement decades away, were trying to save and grow their money, not produce more current income. 

  To add tax insult to injury, the income generated by their bond funds was fully taxable because the funds were held outside of tax-sheltered retirement accounts.  The last thing Justine and Max needed was more taxable income, not because they were rolling in money — neither Justine nor Max had a high salary — but because, as a two-income couple, they already paid significant taxes. 

  They didn't adjust their spending habits to allow for their increased savings rate.  In their enthusiasm to get serious about their savings, they made this error — probably the biggest one of all.  Justine and Max thought they were saving more — 12 percent of their income was going into the mutual funds versus the 5 percent they'd been saving in a bank account.  However, as the months rolled by, their outstanding balances on credit cards grew.  In fact, when they started to invest in mutual funds, Justine and Max had $1,000 of revolving debt on a credit card at a 14 percent interest rate.  Six months later, this debt had grown to $2,000. 

The extra money for investment had to come from somewhere — and in Justine and Max's case, some of it was coming from building up their credit card debt.  But, because their investments were highly unlikely to return 14 percent per year, Justine and Max were actually losing money in the process. 

I tell the story of Justine and Max to caution you against buying mutual funds in haste or out of fear before you have your own financial goals in mind. 

Lining Up Your Ducks Before You Invest

  The single biggest mistake that mutual fund investors make is investing in funds before they're prepared — both financially and emotionally.  It's like trying to build the walls of a house without a proper foundation.  You have to get your financial ship in shape — sailing out of port with leaks in the hull is sure to lead to an early, unpleasant end to your journey.  And you have to figure out what you're trying to accomplish with your investing and what you're comfortable with. 

Throughout this book, I emphasize that mutual funds are specialized tools for specific jobs.  I don't want you to pick up a tool that you don't know how to use.  This section covers the most important financial steps for you to take before you invest so you get the most from your mutual fund investments. 

Pay off your consumer debts

Consumer debts include balances on credit cards and auto loans.  If you carry these types of debts, do not invest in mutual funds until these consumer debts are paid off.  I realize that investing money may make you feel like you're making progress; paying off debt, on the other hand, just feels like you're treading water.  Shatter this illusion.  Paying credit card interest at 14 or 18 percent while making an investment that generates only an 8 percent return isn't even treading water; it's sinking! 

  You won't be able to earn a consistently high enough rate of return in mutual funds to exceed the interest rate you're paying on consumer debt.  Although some financial gurus claim that they can make you 15 to 20 percent per year, they can't — not year after year.  Besides, in order to try and earn these high returns, you have to take great risk.  If you have consumer debt and little savings, you're not in a position to take that much risk. 

I go a step further on this issue: Not only should you delay any investing until your consumer debts are paid off, but also you should seriously consider tapping in to any existing savings (presuming you'd still have adequate emergency funds at your disposal) to pay off your debts. 

Review your insurance coverage

Saving and investing is psychologically rewarding and makes many people feel more secure.  But, ironically, even some good savers and investors are in precarious positions because they have major gaps in their insurance coverage.  Consider the following questions:

  Do you have adequate life insurance to provide for your dependents if you die? 

  Do you carry long-term disability insurance to replace your income in case a disability prevents you from working? 

  Do you have comprehensive health insurance coverage to pay for major medical expenses? 

  Have you purchased sufficient liability protection on your home and car to guard your assets against lawsuits? 

  Without adequate insurance coverage, a catastrophe could quickly wipe out your investments.  The point of insurance is to eliminate the financial downside of such a disaster and protect your assets. 

In reviewing your insurance, you may also discover unnecessary policies or ways to spend less on insurance, freeing up more money to invest in mutual funds.  See the latest edition of my book, Personal Finance For Dummies, 6th Edition (Wiley), to discover the best ways to buy insurance and whip all of your finances into shape. 

Figure out your financial goals

Mutual funds are goal-specific tools (see "Reaching Your Goals with Funds" later in this chapter), and humans are goal-driven animals, which is perhaps why the two make such a good match.  Most people find that saving money is easier when they save with a purpose or goal in mind — even if their goal is as undefined as a "rainy day."  Because mutual funds tend to be pretty specific in what they're designed to do, the more defined your goal, the more capable you are to make the most of your mutual fund money. 

Granted, your goals and needs will change over time, so these determinations don't have to be carved in stone.  But unless you have a general idea of what you're going to do with the savings down the road, you won't really be able to thoughtfully choose suitable mutual funds.  Common financial goals include saving for retirement, a home purchase, an emergency reserve, and stuff like that.  In the second half of this chapter, I talk more about the goals mutual funds can help you to accomplish. 

Another benefit of pondering your goals is that you better understand how much risk you need to take to accomplish your goals.  Seeing the amount you need to save to achieve your dreams may encourage you to invest in more growth-oriented funds.  Conversely, if you find that your nest egg is substantial, given what your aspirations are, you may scale back on the riskiness of your fund investments. 

Determine how much you're saving

Many folks don't know what their savings rate is.  By savings rate, I mean, over a calendar year, how did your spending compare with your income?  For example, if you earned $40,000 last year, and $38,000 of it got spent on taxes, food, clothing, rent, insurance, and other fun things, you saved $2,000.  Your savings rate then would be 5 percent ($2,000 of savings divided by your income of $40,000). 

If you already know that your rate is low, nonexistent, or negative, you can safely skip this step because you also already know that you need to save more.  But figuring out your savings rate can be a real eye-opener. 

Examine your spending and income

To save more, you must reduce your spending, increase your income, or both.  This isn't rocket science, but it's easier said than done. 

  For most people, reducing spending is the more feasible option.  But where do you begin?  First, figure out where your money is going.  You may have some general idea, but you need to have facts.  Get out your checkbook and debit card records, credit card bills, and any other documentation of your spending history and tally up how much you spend on dining out, operating your car(s), paying your taxes, and everything else.  When you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. 

Earning more income may help you save more to invest if you can get a higher-paying job or increase the number of hours you're willing to work.  Watch out, though: Many people's spending has a nasty habit of soaking up increases in income.  If you're already working many hours, tightening the belt on your spending is better for your emotional and social well-being. 

Maximize tax-deferred retirement account savings

Saving money is difficult for most people.  Don't make a tough job impossible by forsaking the terrific tax benefits that come from investing through retirement savings accounts.  Employer-based 401(k) and 403(b) retirement plans offer substantial tax benefits.  Contributions into these plans are generally federal- and state-tax-deductible.  And after the money is invested inside these plans, the growth on your contributions is tax-sheltered as well.  Furthermore, some employers will match a portion of your contributions. 

  Some investors make the common mistake of neglecting to take advantage of retirement accounts in their enthusiasm to invest in nonretirement accounts.  Doing so can cost you hundreds of thousands of dollars over the years.  Fund companies are happy to encourage this financially detrimental behavior, too.  They lure you into their funds without educating you about using your employer's retirement plan first because the more you invest through your employer's plan, the less you have available to separately invest in their funds. 

Prioritizing your financial goals

Only you know what's really most important to you and how to prioritize your goals.  And prioritize you must — because your desires outstrip your ability to save and accomplish your goals.  Now that doesn't mean that you can't fulfill your dreams.  With an average income, you can, with proper planning, achieve most of the financial goals identified throughout this chapter.  But you do have to be realistic about how many balls you can juggle at any one time. 

That may mean, for example, that you have to reduce your retirement plan contributions while you save for a down payment on a home.  Or that you have to downscale the size of your dream house a bit if you really want Junior to attend a pricey, private college. 

Again, you're the best person to decide what trade-offs to make.  However, because of the tax breaks that come with retirement account contributions, retirement funding should always be near the top of your priority list.  Remember: Making retirement account contributions reduces your tax bill, effectively giving you more dollars with which to accomplish your various goals. 

And, as suggested by its name, your emergency reserve fund should always be a top priority, especially if your income is unstable and/or you have no family to fall back on.  On the other hand, if you have a steady job and at least a few solvent family members, you can probably afford to build up this fund more slowly and in conjunction with other savings goals. 

Determine your tax bracket

When you're investing in mutual funds outside of tax-sheltered retirement accounts, the profits and distributions that your funds produce are subject to taxation.  So the type of fund that makes sense for you depends, at least partially, on your tax situation. 

  If you're in a high income tax bracket, give preference to mutual funds such as tax-free bond funds and stock funds with low levels of distributions (especially highly taxed short-term capital gains).  In other words, focus more on stock funds that derive more of their expected returns from appreciation rather than from taxable distributions.  If you're in a low bracket, avoid tax-free bond funds because you end up with a lower return than in taxable bond funds. ( In Part IV of this book, I explain how to select the best fund types to fit your tax status.) 

Assess the risk you're comfortable with

Think back over your investing career.  You may not be a star money manager, but you've already made some investing decisions.  For instance, leaving your excess money in a bank savings or checking account is a decision — it may indicate that you fear volatile investments. 

  How would you deal with an investment that dropped 10 to 50 percent in a year?  Some of the more aggressive mutual funds that specialize in volatile securities like growth stocks, small company stocks, emerging market stocks, and long-term and low-quality bonds can quickly fall.  If you can't stomach big waves in the financial markets, don't get in a small boat that you'll want to bail out of in a storm.  Selling after a large drop is the equivalent of jumping in to the frothing sea at the peak of a pounding storm. 

  You can invest in the riskier types of securities by selecting well-diversified mutual funds that mix a dash of aggressive securities with a healthy helping of more stable investments.  For example, you can purchase an international fund that invests the bulk of its money in companies of varying sizes in established economies and that has a small portion invested in riskier, emerging economies.  That would be safer than investing the same chunk in a fund that invests solely in small companies that are just in emerging countries. 

Review current investment holdings

Many people have a tendency to compartmentalize their investments: IRA money here, 401(k) there, brokerage account somewhere else.  Part of making sound investment decisions is to examine how the pieces fit together to make up the whole.  That's where jargon like asset allocation comes into play.  Asset allocation simply means how your investments are divvied up among the major types of securities or funds, such as money market, bond, United States (U.S.) stock, international stock, and so on. 

Another reason to review your current investments before you buy into new mutual funds is that some housecleaning may be in order.  You may discover holdings that don't fit with your objectives or tax situation.  Perhaps you'll decide to clear out some of the individual securities that you know you can't adequately follow and that clutter your life. 

Consider other "investment" possibilities

Mutual funds are a fine way to invest your money but hardly the only way.  You can also invest in real estate, invest in your own business or someone else's, or pay down mortgage debt more quickly.  Again, what makes sense for you depends on your goals and personal preferences.  If you dislike taking risks and detest volatile investments, paying down your mortgage may make better sense than investing in mutual funds. 

Reaching Your Goals with Funds

Mutual funds can help you achieve various financial goals.  The rest of this chapter gives an overview of some of these more common goals — saving for retirement, buying a home, paying for college costs, and so on — that you can tackle with the help of mutual funds.  For each goal, I discuss what kinds of funds are best suited to it and point you to the part of the book that discusses that kind of fund in greater detail. 

As you understand more about this process, notice that the time horizon of your goal — in other words, how much time you have between now and when you need the money — largely determines what kind of fund is appropriate:

  If you need to tap in to the money within two or three years or less, a money market or short-term bond fund may fit the bill. 

  If your time horizon falls between three and seven years, you want to focus on bond funds. 

  For long-term goals, seven or more years down the road, stock funds are probably your main ticket. 

But time horizon isn't the only issue.  Your tax bracket, for example, is another important consideration in mutual fund selection. ( See Chapter 10 for more about taxes.)  Other variables are goal specific, so take a closer look at the goals themselves.  Throughout the rest of this chapter, I also give you plenty of non-mutual-fund-related tips on how to tackle these goals.  Remember: Mutual funds are just part of the overall picture and a means to the end of achieving your goals. 

The financial pillow — an emergency reserve

  Before you save money toward goals, accumulate an amount of money equal to about three to six months of your household's living expenses.  This fund isn't for keeping up on the latest consumer technology gadgets.  It's for emergency purposes: for your living expenses when you're between jobs, for unexpected medical bills, for a last-minute plane ticket to visit an ailing relative.  Basically, it's a fund to cushion your fall when life unexpectedly trips you up.  Call it your pillow fund.  You'll be amazed how much of a stress reducer a pillow fund is. 

How much you save in this fund and how quickly you build it up depends on the stability of your income and the depth of your family support.  If your job is steady and your folks are still there for you, then you can keep the size of this fund on the smaller side.  On the other hand, if your income is erratic and you have no ties to benevolent family members, you may want to consider building up this fund to a year's worth of expenses. 

The ideal savings vehicle for your emergency reserve fund is a money market fund.  See Chapter 11 for an in-depth discussion of money market funds and a list of the best ones to choose from. 

The golden egg — investing for retirement

Uncle Sam gives major tax breaks for retirement account contributions.  This deal is one you can't afford to pass up.  The mistake that many people at all income levels make with retirement accounts is not taking advantage of them and delaying the age at which they start to sock money away.  The sooner you start to save, the less painful it is each year, because your contributions have more years to compound. 

Each decade you delay approximately doubles the percentage of your earnings that you should save to meet your goals.  For example, if saving 5 percent per year starting in your early 20s would get you to your retirement goal, waiting until your 30s may mean socking away 10 percent; waiting until your 40s, 20 percent; beyond that, the numbers get troubling. 

  Taking advantage of saving and investing in tax-deductible retirement accounts should be your number-one financial priority (unless you're still paying off high-interest consumer debt on credit cards or an auto loan). 

Retirement accounts should be called tax-reduction accounts.  If they were called that, people might be more excited about contributing to them.  For many people, avoiding higher taxes is the motivating force that opens the account and starts the contributions.  Suppose you're paying about 35 percent between federal and state income taxes on your last dollars of income (see Chapter 10 to determine your tax bracket).  For most of the retirement accounts described in this chapter, for every $1,000 you contribute, you save yourself about $350 in taxes in the year that you make the contribution.  You can invest this savings until it's taxed when withdrawn in retirement.  Some employers will match a portion of your contributions to company-sponsored plans, such as 401(k) plans — getting you extra dollars for free. 

On average, most people need about 70 to 80 percent of their annual preretirement income throughout retirement to maintain their standard of living.  If you haven't recently thought about what your retirement goals are, looked into what you can expect from Social Security (okay, cease the giggling), or calculated how much you should be saving for retirement, now's the time to do it.  My book, Personal Finance For Dummies, 6th Edition (Wiley), goes through all the necessary details and explains how to come up with more money to invest. 

When you earn employment income (or receive alimony), you have the option of putting money away in a retirement account that compounds without taxation until you withdraw the money.  With many retirement accounts, you can elect to use mutual funds as your retirement account investment option.  And if you have retirement money in some other investment option, you may be able to transfer it into a mutual fund company (see Chapter 16). 

  If you have access to more than one type of retirement account, prioritize which accounts to use by what they give you in return.  Your first contributions should be to employer-based plans that match your contributions.  After that, contribute to any other employer or self-employed plans that allow tax-deductible contributions.  If you've contributed the maximum possible to tax-deductible plans or don't have access to such plans, contribute to an IRA.  The following sections include the major types of accounts and explain how to determine whether you're eligible for them. 

401(k) plans

For-profit companies typically offer 401(k) plans, which typically allow you to save up to $16,500 per year (tax year 2010), $22,000 for those 50 and older.  Your contributions to a 401(k) are excluded from your reported income and are free from federal and state income taxes but not from FICA (Social Security) taxes. 

  Absolutely don't miss out on contributing to your employer's 401(k) plan if your employer matches a portion of your contributions.  Your company, for example, may match half of your first 6 percent of contributions (so you save a lot of taxes and get a bonus from the company).  Check with your company's benefits department for your plan's details. 

Smaller companies (those with fewer than 100 employees) can consider offering 401(k) plans, too.  In the past, administering a 401(k) was prohibitively expensive for smaller companies.  If your company is interested in this option, contact a mutual fund organization, such as T. Rowe Price, Vanguard, or Fidelity, or a discount brokerage house, such as Charles Schwab or TD Ameritrade. 

403(b) plans

Many nonprofit organizations offer 403(b) plans to their employees.  As with a 401(k), your contributions are federal- and state-tax-deductible.  The 403(b) plans often are referred to as tax-sheltered annuities, the name for insurance-company investments that satisfy the requirements for 403(b) plans.  No-load (commission-free) mutual funds can be used in 403(b) plans.  Check which mutual fund companies your employer offers you to invest through — I hope you have access to the better ones covered in Chapter 9. 

Employees of nonprofit organizations generally are allowed to contribute up to 20 percent or $16,500 of their salaries ($22,000 for those individuals 50 and older) — whichever is less.  Employees who have 15 or more years of service may be allowed to contribute more.  Ask your employee benefits department or the investment provider for the 403(b) plan (or your tax adviser) about eligibility requirements and details about your personal contribution limits. 

  If you work for a nonprofit or public-sector organization that doesn't offer this benefit, make a fuss and insist on it.  Nonprofit organizations have no excuse not to offer a 403(b) plan to their employees.  This type of plan includes virtually no out-of-pocket setup expenses or ongoing accounting fees like a 401(k) (see the preceding section).  The only requirement is that the organization must deduct the appropriate contribution from employees' paychecks and send the money to the investment company that handles the 403(b) plan. ( Some state and local governments offer plans that are quite similar to 403(b) plans and are known as Section 457 plans.) 

Small business plans

  If you're self-employed or a small business owner, you can establish your own retirement savings plans.  Simplified employee pension individual retirement account (SEP-IRA) plans require little paperwork to set up.  They allow you to sock away 20 percent of your self-employment income (business revenue minus expenses) up to a maximum of $49,000 per year.  Each year, you decide the amount you want to contribute — you have no minimums.  Your contributions to a SEP-IRA are deducted from your taxable income, saving you big-time on federal and state taxes.  As with other retirement plans, your money compounds without taxation until withdrawal. 

Keogh (profit sharing) plans are another retirement savings option for the self-employed.  They can and should be established through the no-load fund providers recommended in this book.  Keogh plans require a bit more paperwork to set up and administer than SEP-IRAs do. ( I show you the differences in Chapter 16.)  Keoghs now have the same contribution limits as SEP-IRAs — 20 percent of your self-employment income (revenue less your expenses), up to a maximum of $49,000 per year. 

  Keogh plans allow business owners to maximize the contributions to which they're entitled relative to employees in two ways:

  Keogh plans allow vesting schedules, which require employees to remain with the company a number of years before they earn the right to their retirement account balances.  If an employee leaves prior to being fully vested, the unvested balance reverts to the remaining plan participants. 

  Keogh plans allow for Social Security integration.  Integration effectively enables high-income earners (usually the owners) to receive larger percentage contributions for their accounts than the less highly compensated employees.  The logic behind this benefit is that Social Security taxes top out when you earn more than $106,800 (for tax year 2010).  Social Security integration allows you to make up for this ceiling. 

  When establishing your Keogh plan at a mutual fund or discount brokerage, ask what features its plans allow — especially if you have employees and are interested in vesting schedules and Social Security integration. 

Individual Retirement Accounts (IRAs)

Anyone with employment (or alimony) income can contribute to Individual Retirement Accounts (IRAs).  You may contribute up to $5,000 each year ($6,000 if you're age 50 and older) or the amount of your employment or alimony income if it's less than these amounts in a year.  If you're a nonworking spouse, you may be eligible to contribute into a spousal IRA. 

Your contributions to an IRA might be tax deductible.  For the tax year 2010, check out these eligibilities:

  If you're single and your adjusted gross income (AGI) is $56,000 or less for the year, you can deduct your IRA contribution. 

  If you're married and file your taxes jointly, you're entitled to a full IRA deduction if your AGI is $89,000 per year or less. 

If you make more than these amounts, you can take a full IRA deduction if you aren't an active participant in any retirement plan.  To know for certain whether you're an active participant is to look at the W-2 form that your employer sends you early in the year to file with your tax returns.  Little boxes indicate whether you're an active participant in a pension or deferred-compensation plan.  If either box is checked, you're an active participant. 

If you're a single-income earner with an AGI above $56,000 but below $66,000, or part of a couple with an AGI above $89,000 but below $109,000, you're eligible for a partial IRA deduction, even if you're an active participant.  The size of the IRA deduction that you may claim depends on where you fall in the income range.  For example, a single-income earner at $61,000 is entitled to half ($2,500) of the full IRA deduction (assuming they are under age 50) because his or her income falls halfway between $56,000 and $66,000. ( Note: These thresholds are for tax year 2010.  They'll increase in the tax years ahead.) 

If you yourself are not an active participant in a retirement, but your spouse is an active participant, then you may take a full IRA if your AGI is $167,000 or less.  A partial is allowed in this case if your AGI is between $167,000 to $177,000. 

  If you can't deduct your contribution to a standard IRA account, consider making a nondeductible contribution to a newer type of IRA account called the Roth IRA.  Single taxpayers with an AGI of $105,000 or less and joint filers with an AGI of $167,000 or less can contribute up to $5,000 per year to a Roth IRA ($6,000 for those individuals age 50 and older).  Although the contribution isn't deductible, earnings inside the account are shielded from taxes, and unlike a standard IRA, qualified withdrawals from the account, including investment earnings, are free from income tax. 

To make a qualified withdrawal from a Roth IRA, you must be at least 591//2 and have held the account for at least five years.  An exception to the age rule is made for first-time homebuyers, who are allowed to withdraw up to $10,000 toward the down payment on a principal residence. 

The white picket fence — saving for a home

A place to call your own is certainly the most tangible element of the American dream.  Not only does a home generally appreciate in value over the long term, but it also should keep you dry in a thunderstorm (assuming, of course, that you have a good roof!). 

To get the best mortgage terms for a house, you should aim for making a down payment of 20 percent of the purchase price. ( For a $250,000 home, that's $50,000.)  So unless you have some other sources available (such as a loan from your parents), you have some saving up to do. 

  If you're looking to buy a home soon, then a money market fund is the best place to store your down payment money (see Chapter 11).  If your target purchase date is in a few years, then consider a short-term bond fund (see Chapter 12).  In the rare case that you start saving a decade or more in advance, you can choose a balanced mix of stocks and bonds. 

The ivory tower — saving for college

A college education for the kiddies is certainly part of the American dream today — not surprising when you consider that a college degree has quickly replaced the high school diploma as the entrance bar to the U.S. job market.  Unfortunately, the financial services industry has fully exploited the opportunity to deepen parental anxiety over educational expenses.  Although mutual funds can help send your kids off to college, their specific role may be different from what you'd expect. 

Saving in your own name

  Few subject areas have more misinformation and bad advice than what is dished out on investing for your children's college expenses.  Too many investment firms publish free guides that contain poor advice and scare tactics.  Their basic premise is that, by the time your tyke reaches age 18 or so, college is going to cost more money than you could possibly imagine.  Thus, you'd better start saving a lot of money as soon as possible.  Otherwise, you'll have to look your 18-year-old in the eyes some day and say, "Sorry, we can't afford to send you to the college you have your heart set on." 

Yes, college is expensive, and it's not getting cheaper.  But what the financial services companies don't like to tell you is that you don't have to pay for all of it yourself.  Thanks to financial aid, most people don't.  By financial aid, I mean more than just grants and scholarships; I'm also talking about low-cost loans, which are by far and away the most common form of aid. 

  What's really sad about the scare tactics some investment companies use is that these tactics effectively encourage parents to establish investment accounts in their children's names.  The drawbacks for doing so are twofold:

Tips on how to afford college

So, how are you going to be able to afford sending your children to Prestige U. or even Budget Community College?  Gain financial aid and plug the gap between what college costs are and what you can afford with these tips:

Fund your retirement accounts first.  Self-centered as it may seem, you're really doing yourself and your kids a tremendous financial favor if you fully fund your retirement accounts before tucking away money for college.  First, you save yourself taxes.  As discussed in the section, "The golden egg — investing for retirement" earlier in this chapter, 401(k), 403(b), SEP-IRA, and Keogh plans give you an immediate tax deduction at the federal and state levels.  And after the money is inside these retirement accounts, it compounds without taxation over the years. 

Second, the more money you save and invest outside retirement accounts, the less financial aid (loans and grants) your child qualifies for.  Strange as it may seem, the financial aid system ignores 100 percent of the money you invest inside retirement accounts. 

Apply for financial aid.  College is expensive and, unless you're affluent, you and your child will need to borrow some money.  Consider these educational loans as investments in your family.  Much financial aid, including grants and loans, is available regardless of need, so don't make the mistake of not applying and researching. 

The financial aid system examines your income, assets and liabilities, number of children in college, and stuff like that.  Based on an analysis, the financial aid process may determine that you can afford to spend, for example, $17,000 per year on college for your child.  That doesn't mean that your child can only consider schools that cost up to that amount.  In fact, if your son or daughter desires to go to a $48,000-per-year private school, loans and grants may be able to cover the difference between what the financial aid system says you can afford and what the college costs.  If you don't apply for aid, you may never know what you and your child are missing out on. 

Investigate all your options.  In addition to financial aid, you may be able to use other sources to help pay college expenses.  If you're a homeowner, for example, you may be able to tap in to home equity.  The kids' grandparents also may be financially able to help out. ( It's better for the grandparents to hold the money themselves until it's needed.) 

Teach your children the value of working, saving, and investing.  If you're one of the fortunate few who can pay for the full cost of college yourself, more power to you.  But even if you can, you may not be doing as well by your children as you may like to believe.  When children set goals and find how to work, save, and make wise investments, these values pay dividends for a lifetime.  So does your spending time with your children instead of working so hard to try and save enough to pay for 100 percent of their college costs. 

Encourage your children to share in the cost of their education.  They can contribute in different ways, either upfront or by paying off some of the outstanding loans after they graduate.  Either way, your children will appreciate their education more. 

  You limit the amount of financial aid for which your child is eligible.  The financial aid system heavily penalizes money held in your child's name by assuming that about 20 percent of the money in your child's name (for example, in custodial accounts) should be used annually toward college costs.  By contrast, only 6 percent of the nonretirement money held in your name is considered available for college expenses annually. 

  You give your child free rein over your hard-earned investment.  When you place money in your child's name, he or she has a legal right to that money in most states at age 18 or 21.  That means that your 18- or 21-year-old could spend the money on an around-the-world junket, a new sports car, or anything else his or her young mind can dream up.  Because you have no way of knowing in advance how responsible your children will be when they reach ages 18 or 21, you're better off keeping money earmarked for their college educations out of their names. 

If you can and want to pay for the full cost of your child's education, you have an income tax incentive to put money in your child's name.  Under what's known as the kiddie tax system, income generated by investments held in your child's name is usually taxed at a lower rate than your own.  But remember that by saving money in a child's name, you're reducing that child's chances for financial aid.  That's why I say don't invest in your child's name unless you want to pay for your child's full college costs yourself. 

You get the benefits of tax-deferred growth and professional investment management by mutual fund companies through 529 plans.  You may derive some state tax perks as well using a 529 plan.  Because the money in 529 plans is earmarked for college, however, investing in these plans may have some negative consequences on college financial aid. 

Using mutual funds for college cost funding

To keep up with or stay ahead of college price increases (which are rising faster than overall inflation), you must invest for growth.  At the same time, you have to keep an eye on your time horizon; kids grow up fast (see "Reaching Your Goals with Funds" earlier in the chapter.) 

  The younger your child is, the more years you have before you need to tap the money and, therefore, the greater the risk.  A simple rule: Take a number between 30 (if you're aggressive) and 50 (if you're more conservative) and add that to your child's age.  Got that number?  That's the percentage you should put in bonds; the rest should go into stocks.  Be sure to continually adjust the mix as your child gets older. 

For a list of good stock and bond funds to invest in, see Chapters 11 and 12.  Pay particular attention to hybrid funds, which invest in both stocks and bonds and may already reflect your desired mix.  If you want to find out more about getting your finances in order and planning for college costs, read my book Personal Finance For Dummies, 6th Edition (Wiley). 
Part II

Evaluating Alternatives to Funds

In this part . . . 

This part covers alternatives to mutual funds.  Some folks consider picking their own stocks and bonds, whereas others want in on the new exchange-traded fund craze.  High rollers may look longingly at hedge funds or other managed money alternatives.  This part covers them all and more and explains the good and bad of each and when and how to use them. 
Chapter 4

Selecting Your Own Stocks and Bonds

In This Chapter

  Understanding the pros and cons of being your own investment manager

  Exploring how to pick your own stocks and bonds

Investing in stocks and bonds via mutual funds is one of several ways to tap in to stocks and bonds.  Some investors believe that they don't need mutual funds and that they should go and directly invest in their own stocks and bonds.  However, doing so is often much riskier than relying on mutual funds.  This chapter discusses why people choose their own stocks and bonds and what you need to do if you decide to do so. 

Choosing Your Own Stocks and Bonds

According to numerous books, newsletters, Web sites, and articles, mutual funds are not the place to be.  They're boring, conservative, and prone to mediocre returns.  According to the pronouncements of these gurus, you can get rich quick by investing in these individual stocks. 

Not only do these pundits say that investing in individual stocks provides Himalayan returns . . . 

"How we beat the stock market — and how you can, too.  23.4 percent annual return." —  subtitle of The Beardstown Ladies' Common-Sense Investment Guide

Novices can ". . .  nearly double the S&P 500 posting returns in excess of 20 percent per year . . .  you might be able to fish out greater than 30 percent per year on your own without assuming considerably greater risk." —  David and Tom Gardner, The Motley Fool Investment Guide

"Forget bonds . . .  real estate . . .  build a portfolio entirely of stocks.  Returns an annual average of 34 percent." —  Matt Seto, 17 years old, The Whiz Kid of Wall Street's Investment Guide

"I have been able to obtain fantastic returns on so many stock market plays: 260,000 percent annualized one-hour returns; 10,680 percent annualized in two days and so many more . . .  These trades are sort of like a magic trick.  At first it seems 'stupendous' — otherworldly.  But as you learn the trick, you say 'it's a piece of cake.'" —  Wade Cook, Stock Market Miracles

. . .  but they also say that anyone can do it with little effort . . . 

"It's not an exaggeration to say that fifth graders can wallop the market after one month of analysis.  You can too." —  The Motley Fool Investment Guide

"An amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage mutual funds, plus have fun in doing it." —  Peter Lynch, Beating the Street

Do the stock specialists' claims sound too good to be true?  Well, they are. 

Beware the claims of stock-picking gurus

It's easy to dismiss the outrageousness of the claims made by someone like Wade Cook in the previous section.  Even if you don't know that Cook was for many years in trouble with securities regulators and the courts (and is now serving prison time), your common sense tells you that five- and six-digit returns are well outside the realm of reasonable expectations for stock performance. 

But what about the more believable performance claims, in the range of 20 and 30 percent, that can so easily dupe an investor into thinking they're true — like the annualized return of 23.4 percent claimed by the Beardstown Ladies? 

  The Beardstown investment club's claim of 23.4 percent annualized returns made me suspicious.  Stocks historically return just 10 percent per year, yet this club, in its book, was claiming to ". . .  have been outperforming mutual funds and professional money managers 3 to 1."  When the club was unwilling to document its performance claims, I assumed they were false. 

Turns out its claims were indeed bogus.  Shane Tritsch, a reporter for Chicago magazine, wrote a piece entitled "Bull Marketing" in which he exposed gross inaccuracies in how the Beardstown investment club calculated its stock market returns.  Tritsch was tipped off to potential problems by a note that was added to the copyright page of the paperback edition of the Beardstown book that said that the club's 23.4 percent annualized returns were determined "by calculating the increase in their total club balance over time.  Because this increase includes the dues that the members pay regularly, this return may be different from the return that might be calculated for a mutual fund. . . ." 

May be different?  Indeed.  Translated, the disclosure was saying that the 23-plus percent returns were being goosed by including new investment principal (regular dues' payments).  Using documents from the investment club that were provided by a Wall Street Journal reporter, a senior research analyst named Jim Raker, from mutual fund publisher Morningstar, told me that he calculates that the investment club earned a return of a mere 9 percent per year — a far cry from the 23-plus percent returns claimed by the club. 

Even worse, though, is that the Beardstown investment club underperformed the market.  For the period in question (from 1983 to 1992), while the Beardstown club actually earned just 9 percent per year, the Standard & Poor's 500 index — the widely followed index for the U.S. stock market — returned about 16 percent.  In fact, if you'd invested in lower-risk bonds, you would've earned nearly 12 percent per year and still outperformed the stock picks of the Beardstown club! 

  Whenever an author, an investment newsletter, or an investment manager claims to have produced a particular rate of return, especially a market-beating return, I always ask for proof before I'm willing to put the claim in print myself.  Otherwise, how do I know whether the claims are real or advertising hype? 

As for Peter Lynch, who states in his book that an amateur stock picker can easily beat 95 percent of the pros, shame on him!  Widely regarded as one of the best mutual fund managers in his day, Lynch knows more than anyone how much hard work goes into beating the market.  In fact, during the years that Lynch piloted Fidelity's Magellan fund, he was known for his workaholic 70- and 80-hour workweeks.  He stated publicly that the primary reason he retired early was to spend more time with his family.  That leaves everyone else to question: He worked this hard to do something that he says amateurs can do with ease and that you, as an investor, don't really need his skills for? 

The notion that most average people and noninvestment professionals can invest in individual stocks with minimal effort and beat the best full-time, experienced money managers is, how should I say, ludicrous and absurd.  But it does seem to appeal to some people's egos — until the returns come in (or don't come in, as the case may be). 

Stock picking with Jim Cramer

If you ever watch CNBC, you've likely come across Jim Cramer, a former hedge fund manager, who now hosts an investment show at the network and operates a Web site among other endeavors.  If you've seen it, he yells and screams and jumps around while pounding on various sound-producing buttons. 

Cramer rose to fame through his strongly opinionated buy-and-sell recommendations on regular CNBC stock market programming and his supposed extraordinary investment returns from his days running a hedge fund bearing his name.  But there's a problem: Despite repeated requests from me, Cramer's former and current firms have been unable (and unwilling) to produce any independently audited tracking of Cramer's claimed returns. 

Compounding this lack of any proof is a uniformly poor to mediocre track record of his stock picks and pans in recent years.  Several independent tracking services have found that his stock market predictions have underperformed the broad market averages. ( Please see the "Guru Watch" section of my Web site, www.erictyson.com, for the details on Cramer and other investing pundits.) 

Also, I had no trouble finding numerous folks who shelled out $400 yearly for his online newsletter and were greatly disappointed.  One reader said, "I got caught up in watching his nightly show and then I paid for his Action Alerts service.  That service sends e-mail alerts every day telling you what to buy and sell.  Well after nine months, I lost a lot of money, and his portfolio is currently showing a 1.3% gain for the year to date (ever notice he doesn't mention that on his shows!).  I could've just purchased the S&P 500 and would be way ahead.  His trading ideas do not work, and his recommendations to not use mechanical stop loss trades have resulted in huge losses in my portfolio." 

Know the drawbacks of investing in individual securities

The stock-picking cheerleaders cite plenty of reasons and make hyped claims to get you to invest in individual stocks.  But they're loath to mention the drawbacks of selecting and trading individual securities.  You won't buy their books and newsletters or visit their Web sites if they can't promise you effortless riches, so you may not openly get the following information from the "stock-picking-is-easy" writers:

    Stock picking takes significant research time and expense.  Before buying an individual security (stock or bond), you should know a great deal about the company you're investing in.  Relevant questions that you need to answer include

• What products or services does the company sell? 

• What are the company's prospects for future growth and profitability? 

• How does the company's performance compare to its competitors' performances — both recently and over the long haul? 

• Are technological or other changes in the works that might harm or improve its business? 

• How much debt does the company have? 

You need to do your homework on these questions, not only before you make your initial investment, but also on a continuing basis as long as you hold an investment.  Gathering this information and accessing quality research on a company take time and money.  And you have to conduct this legwork for every company that you consider investing in.  That's how Lynch filled up his marathon workweeks as a fund manager. 

  Be honest with yourself.  If you're really going to research and monitor your individual securities, the extra work ultimately will take time away from other pursuits.  In worst-case situations, I've seen busy people spend almost as many hours on the weekend and in the evenings with their portfolios as they do with family and friends.  If you can really afford the time for this type of hobby, more power to you.  But remember, no one I know of has ever said on her deathbed, "I wish I had spent more time watching my investments."  You only get one chance to live your life — once squandered, your time is gone forever. 

  Stock trading incurs higher transaction costs.  Even when you use a discount broker (described in Chapter 9), the commissions you pay to buy or sell securities are higher (as a percentage of the amount invested) than what a fund company pays.  Note two exceptions to the rule that individual security purchases cost too much:

• You can purchase government bonds directly from the Federal Reserve without charge. 

• Deep-discount brokers (see Chapter 9) can be quite cheap for wealthy investors making large purchases. 

  Individual stocks offer less likelihood of diversification.  Unless you have several hundred thousand dollars to invest in dozens of different securities, you probably can't afford to develop a diversified portfolio.  For example, when investing in stocks, you should hold stock in companies belonging to different industries, in different companies within an industry, and so on.  Not properly diversifying adds to the risk of losing your shirt. 

  Individual stocks bring more accounting and bookkeeping chores.  When you invest in individual securities outside retirement accounts, you must keep track of your purchase and dividend history (if you reinvest them).  Every time you sell a specific security, you must report that transaction on your tax return. 

Even if you pay someone else to complete your tax return, you still have the hassle of keeping track of statements and receipts. ( On the plus side, however, you control selling decisions with individual securities; with funds, managers who trade can lead to capital gains distributions for you.  As I discuss in Chapter 10, you can select mutual funds that are tax friendly for your situation, including funds that are managed, so as to minimize or even eliminate capital gains distributions.) 

Understand the psychology of selecting stocks

Some folks just don't, won't, or can't enjoy having all their money tied up in mutual funds.  Some people say that funds are, well, kind of boring.  It's true that following the trials, tribulations, successes, and failures of a favorite company can provide you plenty of excitement (sometimes more than you want).  A fund, on the other hand, is a little more abstract.  You pour money into it and don't have specific corporate dramas to follow. 

Over the years, among investors who prefer to invest their portfolios in individual securities, I've noticed some common characteristics:

  The boaster: You enjoy going to parties and telling of your successes in the stock market.  Although the thought has never (hopefully) crossed your mind of sending copies of a brokerage statement to friends and relatives, you've been known on more than a few occasions to offer unsolicited stock tips and investment advice. 

  The controller: You hate delegating jobs to others, especially important ones, because no one does as good a job as you do.  Investing much or all of your money in mutual funds and leaving all the investment decisions to the fund manager won't make you a happy camper.  You may also believe that you can sidestep a market slide and get back in before prices skyrocket. 

  The free spirit: You're the type who says, "I don't care if there are trillions invested in mutual funds.  I don't care if everyone's using word processors rather than typewriters."  You like to be just a little bit different and independent. 

How to Pick Your Own Stocks and Bonds

  If you really want to invest in individual stocks and bonds, I suggest that you limit your purchase of individual securities to no more than 20 percent of the total money you've invested in stocks and bonds (including those you've invested in via mutual funds).  Be realistic as to why you're investing in them.  And before you plunk down too much money in stocks and bonds of your own choosing, remember the sage words of Jack Bogle, who's often called the mutual fund investor's best friend:

"Attempting to build an investment program around a handful of individual securities is, for all but the most exceptional investors, a fool's errand . . .  Specific stock bets should be made, if at all, in small portions, and more for the excitement of the game than for the profit." 

Yes, Bogle was the founder and former CEO of a large mutual fund company, Vanguard.  But, no, his comments aren't self-serving: Vanguard also operates a discount brokerage company that handles individual securities trades for customers who want to do them. 

  In the long haul, you're not going to earn higher returns than full-time professional money managers who invest in the securities of the same type and risk level that you are.  As with hiring a contractor for home remodeling, you need to do your homework to find good fund managers.  Even if you think that you can do as well as the best, remember that even superstar money managers like Peter Lynch have beaten the market averages by only a few percentage points per year. 

In my experience, more than a few otherwise smart, fun-loving people choose to invest in individual securities because they think that they're smarter or luckier than the rest.  If you're like most people, I can safely say that, in the long run, your individually selected stocks and bonds won't outperform those of a full-time investment professional. 

I've noticed a distinct contrast between the sexes on this issue (which is backed up by research).  Perhaps because of differences in how people are raised, testosterone levels, or whatever, men tend to have more of a problem taming their egos and admitting that they're better off turning the stock and bond selection over to a pro.  Maybe this trait is genetically linked to not wanting to ask for directions! 

  Before you set out to compete in the investment world, get smarter and wiser.  The latest edition of my book, Investing For Dummies (Wiley), explains how to analyze company financial statements and compare and select stocks and bonds as well as use the best investment research sources such as Value Line.  Also, don't overlook the opportunity to piggyback from all the research and knowledge of the best money managers.  By using the lists of best funds recommended in this book, you can use those funds' reports to figure out what stocks and bonds some of the most talented money managers in the world are buying. ( Note: The listing of a fund's portfolio still could be several months out of date because of the way funds issue their reports.) 

Should you join an investment club? 

Investment clubs are a little bit like having your own hands-on mutual fund.  Each club member chips in some money.  Then the group gets together for periodic meetings to discuss stocks and to make investment decisions. ( Although investment clubs could, of course, select other investments, such as bonds, most clubs choose stocks.) 

These groups can be valuable as an educational forum if you utilize good information sources.  If the group members are somewhat clueless and the meetings are rambling, these groups can end up degenerating into the blind leading the blind. 

Investment clubs may have social or hobby value (which are most clubs' major benefits), but they can hurt your checkbook more than they help:

The members of investment clubs are part-time amateurs.  You could end up making some poor decisions and losing money (or not making nearly as much as you would if you'd been in some good mutual funds). 

It's highly unlikely that everyone in the group is in the same tax situation.  Thus, the club's investments may work for some members' tax situations but not for others'. 

Beware of stockbrokers (and others trolling for prospective clients) who've been known to participate in investment clubs and volunteer as leaders.  Although their participation may be harmless, more often than not, these brokers have a hidden agenda to reel in new business clients. 

Consider forming a financial reading club and discussion group rather than an investment club.  You can get together and discuss financial periodicals, books, and investment strategies.  This way, you can advance your level of financial knowledge, find out about new resources from others, and enjoy the fun, camaraderie, and other benefits that come from doing things in a group. 

Better yet, join a bowling league or a softball team and leave the investing to fund managers! 
Chapter 5

Exchange-Traded Funds and Other Fund Lookalikes

In This Chapter

  Making sense of the hoopla of exchange-traded funds

  Understanding unit investment trusts

  Creating your own customized funds

The hallmarks of the investment and economic system are constant change, innovation, and choice.  Index mutual funds, which track a particular market index (see Chapter 10) and the best of which feature low costs, have been around for decades. 

Exchange-traded funds (ETFs) represent a twist on index funds — ETFs trade like stocks do and offer some potential advantages over funds.  However, some cheerleaders pitching ETFs gloss over drawbacks to ETFs and fail to disclose their agenda in promoting ETFs. 

Some other fund wannabes compete for your investment dollars too.  This chapter offers the straight scoop on these alternatives. 

Understanding Exchange-Traded Funds

For many years after their introduction in the 1970s, index mutual funds got little respect and money.  Various pundits and those folks with a vested financial interest in protecting the status quo, such as firms charging high fees for money management, heaped criticism on index funds. ( As I explain in Chapter 13, index funds replicate and track the performance of a particular market index, such as the Standard & Poor's 500 index of 500 large company U.S. stocks.)  Critics argued that index funds would produce sub-par returns.  Investors who've used index funds have been quite happy to experience their funds typically outperforming about 70 percent of the actively managed funds over extended time periods. 

In recent years, increasing numbers of financial firms have developed exchange-traded funds (ETFs).  Most ETFs are, essentially, index funds with one major difference: They trade like stocks on a stock exchange.  The first ETF was created and traded on the American Stock Exchange in 1993 and was known as a Spider. ( It tracked the Standard & Poor's 500 index.)  Now hundreds of ETFs trade comprising about $700 billion — a large sum indeed — but that's less than 7 percent of the total invested in mutual funds. 

Before you decide to invest in ETFs, take a moment to read this section.  It explains the advantages and disadvantages of investing in ETFs and helps you wade through the many ETFs to find the best one for you. 

Understanding ETF advantages

Like index funds, the promise of ETFs is low management fees.  I say promise because when evaluating ETFs, you must remember that the companies creating and selling ETFs, which are mostly large Wall Street investment firms, are doing it to make a nice profit for their firm.  Although the best index funds charge annual fees of less than 0.2 percent, the vast majority of ETFs actually charge fees much greater than that. 

Take a look at Table 5-1 for an analysis that I recently conducted of ETF expense ratios. 

Table 5-1 An Analysis of ETF Expense Ratios

---

Expense Ratio | Percentage of ETFs

0.60% and higher | 47%

0.50% to 0.59% | 14%

0.40% to 0.49% | 12%

0.30% to 0.39% | 7%

0.25% to 0.29% | 7%

0.20% to 0.24% | 6%

0.15% to 0.19% | 2%

0.10% to 0.14% | 4%

0.07% to 0.09% | 1%

  The vast majority of ETFs have expense ratios far higher than the best index funds.  I compare the best index funds with the best ETFs (which do have low expense ratios) in the section, "Identifying the best ETFs," later in this chapter. 

In addition to possible slightly lower expenses, the best ETFs have one possible additional advantage over traditional index funds: Because ETFs may not be forced to redeem shares to cash and recognize taxable gains (which can happen with an index fund), they may be tax friendlier for non-retirement account investors. ( Note: ETFs do have to sometimes sell and buy new holdings as adjustments are made to the underlying index that an ETF tracks.) 

If you can't meet the minimum investment amounts for index funds (which are typically several thousand dollars), you face no minimums when buying an ETF.  However, you must factor in the brokerage costs to buy and sell ETF shares through your favorite brokerage firm, and be sure that those fees don't greatly boost your costs.  For example, if you pay a $10 transaction fee through an online broker to buy $1,000 worth of an ETF, $10 may not sound like a lot but it represents 1.0 percent of your investment and wipes out the supposed cost advantage of investing in an ETF.  Because of the brokerage costs, ETFs aren't a good vehicle for investors who seek to make regular monthly investments. 

Eyeing ETF drawbacks

Meanwhile, some of the drawbacks to ETFs include the following:

  Three-day settlement waiting period: A possible disadvantage with ETFs is that like stocks, you have a three-day settlement process when selling shares.  So, for example, if you sell shares of an ETF on Monday, you won't have the proceeds to invest into a regular mutual fund until Thursday. ( This delay wouldn't be a problem if you're going back into another ETF or buying a stock — because a purchase order placed on Monday wouldn't settle until Thursday.)  If you're out of the market for several days, the market price can move significantly higher, wiping out any supposed savings from a low-expense ratio. 

  Potential fees for dividend and capital gain reinvestments: With a traditional mutual fund you can without cost reinvest dividend and capital gains distributions into more shares of the fund.  However, with an ETF, you may have to pay for this service, or it may not be available through the broker that you use. 

  Disproportionate amount of stocks: One problem with a number of the indexes that ETFs track (and with some index funds) is that certain stocks make up a disproportionately large share of the index.  For example, I don't care for the Standard & Poor's 500 index because each of the 500 stocks' composition in the index is driven by each stock's portion of total market value.  Check out Table 5-2 that shows the composition of the index at the end of 1999.  This list mostly represented a who's who of many overpriced technology stocks that subsequently got clobbered in the early 2000s bear market. 

Table 5-2 The Companies of the Standard & Poor's 500 Index at the End of 1999

---

Stock | Rank in Index | Market Value | Percent of Index

Microsoft Corp | 1 | 604,078 | 4.92%

General Electric | 2 | 507,734 | 4.14%

Cisco Systems | 3 | 366,481 | 2.99%

Wal-Mart Stores | 4 | 307,843 | 2.51%

Exxon Mobil | 5 | 278,218 | 2.27%

Intel Corp | 6 | 274,998 | 2.24%

Lucent Technologies | 7 | 234,982 | 1.91%

IBM | 8 | 194,447 | 1.58%

Citigroup Inc | 9 | 187,734 | 1.53%

America Online | 10 | 169,606 | 1.38%

  Invested segments too narrow: Many of the newer ETFs coming out invest in narrow segments, such as one specific industry or one foreign country.  As with sector mutual funds (see Chapter 13), such funds undermine the diversification value of fund investing and tend to have relatively high fees.  Morningstar, an investment research company, says, ". . .  ETFs offer new opportunities to sap returns by racking up transaction costs and/or chasing short-term trends." 

    Excessive risks and costs with leverage: In recent years, ETF issuers have come out with increasingly risky and costly ETFs.  One particular class of ETFs I especially dislike are so-called leveraged ETFs.  What these ETFs purport to do is magnify the move of a particular index — for example, the Standard & Poors 500 stock index — by double or triple.  So, a double-leveraged S&P 500 ETF is supposed to increase by 10 percent for every 5 percent increase in the S&P 500 index.  Inverse leveraged ETFs are supposed to move in the opposite direction of a given index.  So, for example, a double-leveraged inverse S&P 500 ETF is supposed to increase by 10 percent for every 5 percent decrease in the S&P 500 index. 

My investigations of whether the leveraged ETFs actually deliver on their objectives shows that they don't, not even close.  For example, in the two-year period ending in early 2010, one double-inverse S&P 500 ETF (brought to my attention by a reader who owned and asked me about it) fell by 43 percent, a period during which it should have increased about 28 percent because the S&P 500 index actually fell by 14 percent. 

Seeing the pros and cons of trading ETFs

One supposed advantage of trading ETFs is that, unlike the regular index mutual funds that I recommend in this book, you can trade (buy or sell) ETFs throughout the day when the stock market is open.  When you buy or sell an index mutual fund, your transaction occurs at the closing price on the day that you place the trade (if the trade is placed before the market closes). 

  Sure, the flexibility sounds alluring, but consider a few drawbacks:

  Timing your moves in and out of the stocks: Being able to trade in and out of an ETF during the trading day isn't a necessity, nor is it even a good practice.  In my experience of working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day.  In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that's far easier said than done. 

  Paying a brokerage commission every time you buy or sell shares: With no-load index funds, you generally don't pay fees to buy and sell.  But with ETFs, because you're actually placing a trade on a stock exchange, you pay a brokerage commission every time you trade.  For example, if you buy an ETF with a seemingly low expense ratio of 0.1 percent and you pay $10 to trade the ETF through an online broker, that's equal to paying two years' worth of management fees if you invest $5,000 in the ETF! 

  Figuring out if the current price on an ETF is above or below the actual value of the securities it holds: Because ETFs fluctuate in price based on supply and demand, when placing a trade during the trading day, you face the complication of trying to determine whether the current price on an ETF is above or below the actual value.  With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds. 

  Because ETFs trade like stocks, you can use limit order and stop loss orders as well as sell them short or trade them on margin.  I generally don't recommend these strategies for nonprofessional investors. 

Identifying the best ETFs

For the vast majority of investors, you don't need to complicate your lives by investing in ETFs.  Only use them if you're a more advanced investor who understands index funds and you have found a superior ETF to an index fund you're interested in. 

Beware of "financial advisers" in love with ETFs

I began work as a financial adviser in 1990.  I was just about the only practitioner at the time who worked solely on an hourly basis.  Most of the fee-based advisers at that time managed their client's portfolios by using mutual funds.  I was struck by the fact that many advisers didn't use or recommend low-cost index funds.  In speaking with some of these advisers, I got the sense that they were somewhat threatened by index funds because the investing process was so simplified that clients might question the value in paying the adviser an ongoing fee of about 1 percent to manage their money among funds. 

Interestingly, some advisers today boast that they use ETFs as the investment vehicle to manage their client's portfolio.  Ironically, they crow about the low cost of ETFs.  Why do some advisers now embrace and tout ETFs when they didn't advocate index funds?  ETFs are complicated and new enough that advisers feel safer using them and not worry about having clients feel that they could do this on their own.  Advisers who charge ongoing management fees while using ETFs aren't performing low-cost investment management.  If the ETFs they're using average about 0.5 percent in annual fees, paying the adviser 1 percent per year on top of that to shift your money around among various ETFs triples your costs!  See Chapter 24 for how to find a good adviser. 

  Be sure to check whether the ETF you're considering is selling at a premium or discount to its net asset value. ( You can find this information on the ETF provider's Web site after the market's close each business day.)  I strongly encourage you to employ the buy-and-hold mentality that I advocate throughout this book — don't hop in and out of ETFs.  You should also only buy the ETFs that track the broader market indexes and that have the lowest expense ratios.  Avoid those that track narrow industry groups or single, smaller countries.  See Chapters 11 through 15 for specific ETFs that I like for specific situations. 

  If you're truly interested in investing in ETFs and you're a more advanced investor, make sure that you know which funds are the best ETFs.  The best ETFs, like the best index funds, have low expense ratios.  My top picks among the leading providers of ETFs include the following:

  Vanguard: Historically, Vanguard has been the low-cost leader with index funds and now has the lowest cost with their ETFs as well.  If you're interested in finding out more about ETFs, be sure to examine Vanguard's ETFs.  Vanguard also offers the Admiral Share class for bigger balance customers ($100K+) of its index funds that match the low expense ratio on their ETFs. ( www.vanguard.com;  800-662-7447)

  Wisdom Tree: Developed by Wharton business professor Jeremy Siegel, this new family of indexes is weighted toward stocks paying higher dividends.  These ETFs have higher fees but offer a broad family of index choices for investors seeking higher-dividend-paying stocks.  Note: Other ETF providers do offer a number of value-oriented and higher-dividend-paying stock funds. ( www.wisdomtree.com;  866-909-9473)

Two additional and large providers of ETFs include the following firms (beware that many of their ETFs are pricey or too narrowly focused):

  iShares: BlackRock has competitive expense ratios on some domestic ETFs based on quality indexes, such as Russell, Morningstar, S&P, Lehman, Dow Jones, and so on. ( www.ishares.com;  800-474-2737)

  State Street Global Advisors: This group uses indexes from Dow Jones/Wilshire, S&P, Russell, and MSCI, among others. ( www.ssgafunds.com;  866-787-2257)

Mimicking Closed-End Funds: Unit Investment Trusts

Unit investment trusts (UITs) have much in common with closed-end funds (discussed in Chapter 2).  UITs take an amount of money (for example, $100 million) and buy a number of securities (such as 70 large-company United States stocks) that meet the objectives of the UIT.  Unlike a closed-end fund (and mutual funds in general), however, a UIT does not make any changes to its holdings over time — it simply holds the same, fixed portfolio.  This holding of a diversified portfolio can be advantageous because it reduces trading costs and possible tax bills. 

  With that said, UITs do suffer from the following major flaws:

  Significant upfront commissions: Brokers like to push UITs for the same reason that they like to pitch load mutual funds — for the juicy commission that they ultimately deduct upfront from your investment.  Commissions are usually around 5 percent, so for every $10,000 that you invest into a UIT, $500 goes out of your investment and into the broker's pocket.  Although UITs do have ongoing fees, their fees tend to be lower than those of most actively managed mutual funds — they're typically in the neighborhood of 0.2 percent per year.  As an alternative, you can buy excellent no-load funds (see Chapter 7), which, because you're buying the fund directly from an investment company and without the involvement of a broker, charge you no commission.  The best no-load funds also have reasonable management fees, and some charge even less than UITs charge (such as the index funds that I discuss in Chapter 10). 

  Lack of liquidity: Especially in the first few years after a particular UIT is issued, you won't readily find an active market in which you can easily sell your UIT.  In the event that you can find someone who's interested in buying a UIT that you're interested in selling, you may have to sell the UIT at a discount from its actual market value at the time. 

  Lack of ongoing management oversight: Because UITs buy and hold a fixed set of securities until the UIT is liquidated (years down the road), they're more likely to get stuck holding some securities that end up worthless.  For example, compared to the best bond mutual funds (see Chapter 12), bond UITs have had a greater tendency to end up holding bonds in companies that go bankrupt. 

Customizing Your Own Funds Online

On some Web sites, various services pitch that you can invest in a chosen basket of stocks for a low fee — and without the high taxes and high fees that come with mutual fund investing.  Like most political "Vote for me and not my opponent" ads, these services misrepresent both their own merits and the potential drawbacks of funds. 

These "create your own funds" services pitch their investment products as a superior alternative to mutual funds.  One such service calls its investment vehicles folios, charging you $29 per month ($290 if paid annually) to invest in folios, each of which can hold a few dozen stocks that are selected from the universe of stocks that this service makes available.  The fee covers trading in your folios that may only occur during two time windows each day that the stock market is open.  The folio service states that orders that are placed between 11 a.m. and 2 p.m. are processed starting at 2 p.m.; orders that are placed between 2 p.m. and 11 a.m. are processed starting at 11 a.m.

So, in addition to the burden of managing your own portfolio of stocks, you have virtually no control over the timing of your trades during the trading day. ( You can place traditional orders at whatever time the market is open but you'll be assessed an additional fee of $3 per trade.) 

The site also says, "Mutual funds impose fees that can be very high — and hard to calculate."  I agree with that statement.  However, without doing too much homework, an investor can easily avoid high-fee funds.  For example, an investor can invest in the best index funds for an annual fee of 0.2 percent per year or less.  Thus, an investor would need to have in excess of $150,000 invested through this folio service to come out ahead in terms of the explicit fees. 

In addition, you need to be aware of additional fees.  One folio service's Web site says (in fine print, of course) that it ". . .  does charge for certain special services and does receive payment for order flow."  You must be ready to shell out the dough if you

  Want to wire money out of your account — $30

  Need a copy of a prior statement or transaction — $10

  Hold any restricted securities (which are subject to SEC Rule 144) — $75

  Close out an account — $50

The site further warns, "Note: These are today's prices and fees, which are subject to change periodically." 

  You're simply not going to get the same level of service (and comfort) when dealing with a Web-site-based service as you do when dealing with the leading fund companies that I discuss in this book.  The companies that I recommend have trained representatives available by phone.  Understanding and evaluating the performance of self-created funds is difficult, and unlike mutual funds, these funds have no standards or easily accessible services that report and track the performance of your customized folio (see Chapter 17 for more information on adjusting your portfolio). 

It seems to me that folio services are geared toward those people who want to hold individual stocks, who trade a lot, and who seek to cap their annual trading costs.  Although I prefer investing in the best mutual funds, you can invest in stocks of your own choosing — as long as you do so with a long-term perspective.  But if you were going to simply buy and hold individual stocks, why would you want to pay a Web-site-based service $290 per year? 
Chapter 6

Hedge Funds and Other Managed Alternatives

In This Chapter

  Making sense of hedge funds

  Deciphering wrap or managed accounts

  Placing money with private money managers

Wealthier investors with large amounts to invest (typically well into the six figures) usually have more choices when it comes to investment vehicles.  Some financial advisers and money management firms pitch alternatives to mutual funds to these folks. 

The unbelievably wide variety of mutual funds enables you to invest in everything from short-term money market securities to corporate bonds, U.S. and international stocks, precious metals and other commodity companies, and even real estate funds.  Although funds can fill many investing needs — as I discuss in Chapter 1 — you may be interested in and benefit from directly investing in things such as real estate, your own business, and many other investments. 

During the early to mid 2000s, hedge funds were proliferating and promising high returns with less risk.  In the prior edition of this book, I warned readers, "As with all sales pitches, you must separate fact from fiction and hype."  This chapter can help you do just that if you're rolling in the dough.  Plenty of hedge fund investors got burned during the financial market turmoil in the late 2000s. 

Other types of privately managed investment accounts, such as wrap accounts, exist that have some things in common with mutual funds.  The following sections provide some background that you need to know if you're going to consider these fund alternatives. 

Hedge Funds: Extremes of Costs and Risks

Hedge funds, historically an investment reserved for big-ticket investors, are seemingly like mutual funds in that they typically invest in stocks and bonds.  They have the added glamour and allure, however, of taking significant risks and gambles with their investments.  Hedge funds may take risks by purchasing derivatives (see Chapter 2), or they may bet on the fall in price of particular securities by selling the securities short. ( When you short sell, you borrow a security from a broker, sell it, and then hope to buy it back later at a lower price.)  Some hedge funds even invest in other hedge funds. 

This section takes a closer look at hedge funds and gives you a clear idea of what hedge funds are and what you need to know and do before you consider investing in one. 

Getting the truth about hedge funds

In the prior edition of this book written in 2007, I warned, "Although hedge funds have recently been the buzz in some investment circles and some wealthier investors have been dropping money into them, they may not be the best choice for you.  Hedge funds are typically a far riskier investment than your typical mutual fund.  What's the hidden truth about these funds?  The following list highlights some of hedge fund's dangers:"

Hedge funds have a much higher risk than mutual funds

When a hedge fund manager bets right, he can produce high returns.  When he doesn't, however, the fund manager can have his head handed to him on an expensive silver platter.  With short selling, because the value of the security that was sold short can rise an unlimited amount, the potential loss from buying it back at a much higher price can be horrendous.  And even the most experienced investing professionals can also lose a pile of money in no time when they invest in derivatives.  Hedge fund managers have also been clobbered when a previously fast rising commodity like natural gas or copper futures plunges in value. 

A number of hedge funds have gone belly up when their managers guessed wrong.  In other words, their investments did so poorly that investors in the fund lost all their money.  As I discuss in Chapter 2, the odds of this happening with a mutual fund — particularly from one of the larger, more established companies — are nil. 

Hedge funds have much higher fees than mutual funds

Hedge funds charge an annual management fee of about 1 to 2 percent and a performance fee, which typically amounts to a whopping 20 percent of a fund's profits.  Veteran investment observer Jack Bogle said of hedge funds and the high fees that are extracted and paid to the hedge fund's managers (and not their customers), "Hedge funds are a compensation strategy not an investment strategy." 

Hedge funds aren't subject to the same regulatory scrutiny

A Forbes 2004 article on the hedge fund industry entitled "The Sleaziest Show On Earth" referred to the industry as, ". . .  a business rife with exorbitant fees, phony numbers, and outright thievery."  During the severe stock market decline in the late 2000s, many hedge funds did poorly, and some went under or were exposed to be fraudulent Ponzi schemes, the most notorious being the fund run by the now jailed Bernie Madoff. 

If that's still not enough to convince you from the perspective of one of the nation's best business magazines that caters to those affluent enough to invest in such funds, consider this: Forbes went on to say, "Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities, and most other investments.  Hedge funds aren't even required to keep audited books — and many don't.  These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors."  For more about insufficient regulatory oversight of hedge funds, please see the "Investigating hedge funds" section later in this chapter. 

Hedge funds have lower returns compared to mutual funds

Objective studies which I have seen, such as the one conducted by Princeton University's Burton Malkiel, present an unflattering perspective on hedge fund industry returns.  In short, hedge funds have produced lower average annual returns when compared with similar mutual funds. 

If you want riskier investments, you can find aggressive mutual funds, or you can buy mutual funds on margin through a brokerage account, meaning that you make a down payment but control a larger investment (such as when you purchase a home with a mortgage).  See Chapter 16 for more about the risks and rewards of buying on margin. 

Investigating hedge funds

Unfortunately, hedge funds aren't subject to the same regulatory scrutiny from the Securities and Exchange Commission (SEC) that mutual funds are.  However, if you go against my advice and consider investing in a hedge fund, I suggest that you adhere to the advice the SEC offers.  The following guidelines for evaluating hedge funds can help. 

Read all the important documents

Take the time to read the fund's prospectus or offering memorandum and all related materials.  Doing so discloses the fees, managers, and overall investment strategy. 

Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they're suitable to your personal investing goals, time horizons, and risk tolerance.  As with any investment, the higher the potential returns, the higher the risks you must assume. 

Understand how a fund's assets are valued

Funds of hedge funds and hedge funds may invest in highly illiquid securities (not easily and quickly converted into cash) that may be difficult to value.  Moreover, many hedge funds give themselves significant discretion in valuing securities.  You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources. 

Ask questions about fees

Fees impact your return on investment.  Hedge funds typically charge an asset management fee of 1 to 2 percent of assets, plus a performance fee of 20 percent of a hedge fund's profits.  A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return.  Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. 

These fees are charged in addition to any fees paid to the underlying hedge funds.  If you invest in hedge funds through a fund of hedge funds, you'll pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds. 

Understand any limitations on redeeming your shares

Hedge funds typically limit opportunities to redeem, or cash in, your shares (for example, to four times a year), and often impose a "lockup" period of one year or more, during which you can't cash in your shares. ( By contrast, mutual funds offer daily liquidity).  These should be disclosed in the hedge fund's prospectus. 

Research the backgrounds of hedge fund managers

Know with whom you're investing.  Make sure hedge fund managers are qualified to manage your money and find out whether they have a disciplinary history within the securities industry.  You can get this information (and more) by reviewing the adviser's Form ADV.  You can search for and view a firm's Form ADV by using the SEC's Investment Adviser Public Disclosure (IAPD) Web site (www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx). 

You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC's Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located.  If you don't find the investment adviser firm in the SEC's IAPD database, be sure to call your state securities regulator or search the NASD's BrokerCheck database for any information they may have. 

Don't be afraid to ask questions

You're entrusting your money to someone else.  You should know where your money is going, who is managing it, how it's being invested, how you can get it back, what protections are placed on your investment, and what your rights are as an investor. 

The SEC goes on to provide the following comments and suggested protections for those purchasing a hedge fund:

  Hedge fund investors don't receive all the federal and state law protections that commonly apply to most registered investments.  For example, you won't get the same level of disclosures from a hedge fund that you'll get from registered investments.  Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund.  You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities. 

  The SEC can take action against a hedge fund that defrauds investors and has brought a number of fraud cases involving hedge funds.  Commonly in these cases, hedge fund advisers misrepresented their experience and the fund's track record.  Other cases were classic "Ponzi schemes," where early investors were paid off to make the scheme look legitimate.  In some of the cases, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen.  That's why it's extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment. 

  If you encounter a problem with your hedge fund or fund of hedge funds, you can send your complaint by using the SEC's online complaint form at www.sec.gov/complaint.shtml. 

Wrap (Or Managed) Accounts: Hefty Fees

Brokerage firms (Prudential, Merrill Lynch, Salomon Smith Barney, PaineWebber, and Morgan Stanley Dean Witter) that used to sell investment products on commission now offer investment management services for an ongoing fee rather than commissions.  This change is an improvement for investors because it reduces some of the conflicts of interest caused by commissions. 

Wrap accounts, or managed accounts, go by a variety of names, but they're the same in one crucial way: For the privilege of investing your money through their chosen money managers, they charge you a percentage of the assets that they're managing for you.  These accounts are quite similar to mutual funds except that the accounts don't have the same regulatory and reporting requirements as do mutual funds. 

  Wrap accounts management expenses are high.  In fact, they're up to 2 to 3 percent per year of assets under management.  Remember that stocks have historically returned about 10 percent per year before taxes.  So if you're paying 2 to 3 percent per year to have the money managed in stocks, 20 to 30 percent of your return (before taxes) is siphoned off.  You pay a good chunk of money in taxes on your 10 percent return.  So a 2 to 3 percent wrap fee actually ends up depleting up to half of the profits that you get to keep after you pay taxes — ouch! 

  No-load (commission-free) mutual funds offer investors access to the nation's best investment managers for a fraction of the cost of wrap accounts.  You can invest in dozens of top-performing funds for an annual expense of 1 percent per year or less.  Many excellent funds are available for far less — 0.1 to 0.5 percent annually. 

So why do people invest through wrap accounts if they're such a poor investment?  Brokerage firms hoodwink investors into paying so much more for access to investment managers with clever marketing — slick, seductive, deceptive, misleading pitches. 

  The following are the key components of brokerage firms' pitch for wrap accounts — and then the real truth behind the pitch:

  "You're accessing investment managers who normally don't take money from small-fry investors like you."  Not a single study shows that the performance of money managers has anything to do with the minimum account size they handle.  Besides, no-load mutual funds hire many of the same managers who work at other money management firms.  In fact, Vanguard, the nation's largest exclusively load-free investment firm, contracts out to hire money managers who typically handle only multimillion-dollar private-client accounts to run many of their funds.  A number of other mutual funds are managed by private money managers who typically have high entrance requirements for their individual private clients. 

  "You'll earn a higher rate of return, so the fees are worth it."  Part of the bait brokers use to hook you into a wrap account is the wonderful rates of returns that these accounts supposedly generate.  You could've earned 18 to 25 percent per year, they say, had you invested with the "Star of Yesterday" investment management company.  The key word here is "could've."  History is history.  As I discuss in Chapter 7, in the money management business, many of yesterday's winners become either tomorrow's losers or its mediocre performers. 

You must also remember that, unlike mutual funds, whose performance records are audited by the SEC, wrap account performance records include marketing hype.  The SEC doesn't audit wrap accounts.  The most common ploy is showing the performance of only selected accounts — which turn out to be (you got it) only the ones that performed the best! 

The expenses you pay to have your investments managed have an enormous impact on the long-term growth of your money.  If you can have your money managed for 0.5 to 1 percent per year rather than 2 to 3 percent, you have an enormous performance advantage already. 

  "A wrap account is tailored to your personal needs."  Thousands of different mutual funds are available out there, covering every possible combination of investments and degree of risk.  You can find a mutual fund and develop a portfolio of funds that meets your objectives and risk tolerance.  Some wrap accounts have only funds that are managed by a particular brokerage firm, making it impossible for you to invest in the best from the universe of all funds. 

Moreover, if your portfolio ever begins to drift from your objectives, buying into a new mutual fund is much easier than ending a relationship with a broker who sold you the wrap account. 

  "There's little difference in cost between wrap accounts and mutual funds."  The worst and most inefficient mutual funds can have total costs approaching that of a typical wrap account.  But you're informed, right?  You're not going to invest in the highest-cost funds.  Chapters 11 through 14 detail which mutual funds offer both top performance and low cost. 

Private Money Managers: One-on-One

In the world of money management, added benefits — snob appeal and ego stroking for many — come with having your own private money manager.  First of all, you generally need big bucks, often $1 million or more, to gain entrance.  A private money management company allows you to sit down and visit with a personal representative and perhaps even the investment manager.  The company may lavish you with attention and glossy brochures.  You hear how your money not only receives individualized and personalized treatment but also how superb the investment manager's performance has been in prior years. 

Even if you have big bucks, you probably don't need a private money manager for two simple reasons:

  The best, average, and worst private money managers earn returns comparable to their counterparts in the mutual fund business.  And as I mention earlier in this chapter, some mutual fund firms contract out to or are themselves private money managers.  This gives you the best of both worlds: the SEC oversight of a mutual fund and access to some money managers that you may not otherwise be able to use. 

    You pay high fees to use these money manager's services.  One bank CEO, speaking at a banking conference about future sources of revenue growth, said private money management for the wealthy, along with the credit card business, are two "high-return, low-risk businesses" in the financial world.  Knowing that you're getting soaked with high fees like the average credit card customer shouldn't make you feel so special about having a private money manager! 

  If you're considering investing through private investment firms, make sure that you

  Ask to see independently audited rates of return.  Private managers' holdings and performances aren't subject to the same scrutiny and reporting as mutual funds are. 

  Check many references. 

  Compare the performance and costs of the private money manager with similar mutual funds in this book. 

For more ideas about evaluating money managers, see the criteria for selecting mutual funds in Chapter 7. 
Part III

Separating the Best from the Rest

In this part . . . 

In this part, I cover the difficult process of narrowing down the multitude of funds to the best funds for your situation.  I also discuss how to utilize fund company reports: prospectuses and annual reports.  In addition to explaining proven selection techniques, I name names and highlight the best firms with which to conduct your fund investing. 
Chapter 7

Finding the Best Funds

In This Chapter

  Keeping your investment from being whittled away by fees

  Looking at a fund's past and knowing how much risk a fund takes

  Getting to know the fund manager and fund family expertise

When you go camping in the wilderness, you can do a number of things to maximize your odds of happiness and success.  You can take maps and a GPS navigator to stay on course, good food to keep you nourished, proper clothing to stay dry and warm, and some first-aid stuff in case something awful happens, such as an outbreak of mosquitoes.  But no matter how much preparation you do, you still may not have the best of times.  You may get sick, trip over a rock and break your leg, or face inclement weather. 

And so it is with mutual funds.  Although funds can help you reach your financial goals, they come with no guarantees.  You can, however, use a number of simple, common-sense criteria to greatly increase your chances of investment success.  The issues in this chapter are the main ones you should consider when trying to separate the funds most likely to succeed from those most likely to perform poorly.  The mutual funds that I recommend in Chapters 11 through 14 meet these criteria. 

Evaluating Gain-Eating Costs

A survey conducted by the Investment Company Institute asked mutual fund buyers what information they reviewed about a fund before purchasing it.  Fifth on the list, mentioned by only 43 percent of the respondents, were fees and expenses.  Therefore, the majority of fund buyers surveyed — a whopping 57 percent — did not examine the fees and expenses for the funds that they bought. 

Additionally, only 27 percent of fund buyers surveyed bothered to look at how much of a load or sales charge was levied by the fund.  At the other end of the spectrum, past fund performance was the most cited information reviewed by fund buyers (with 75 percent considering). 

Such survey results don't surprise me.  I've witnessed investors looking first — and sometimes only — at the prior performance of a fund while completely ignoring fees.  Doing so is generally a major mistake. 

  The charges you pay to buy or sell a fund and the ongoing fund-operating expenses have a big impact on the rate of return you ultimately earn on your investments because fees are deducted from your investment returns.  All other things being equal, high fees and other expenses depress your returns.  You can and should examine a fund's expenses and fees before you buy into it.  In contrast, past performance is actually a relatively poor indicator of a fund's likely future returns. ( Later in this chapter, I discuss how many of yesterday's star funds turn into tomorrow's losers or mediocre performers.)  You just can't know what tomorrow will bring. 

Although you have no idea how much of a return you'll make, you can find out, before buying a fund, how much the fund has been charging in fees — both upfront (in the form of sales commissions) and ongoing (in the form of fund operating expenses).  Factor these known reductions in returns into your fund-buying decisions. 

Losing the load: Say no to commissions

When the Securities and Exchange Commission (SEC) deregulated brokers' commissions in 1975, the vast majority — more than 85 percent — of all mutual funds were sold through brokers.  The funds they sold are known as load funds.  Load simply means commission.  When you purchase a load fund through a broker (who often calls himself something other than a broker), the broker is paid a commission (typically ranging from 4 percent to 8.5 percent) out of the amount that you invest. 

Thanks in part to the deregulation of brokerage commissions and to the technological revolution that's taken place over recent decades, the growth of the no-load (commission-free) mutual fund industry took off.  Technology provided fund companies with a cost-effective way to handle thousands of accounts for folks like you who don't have millions of dollars to invest.  This fact also enabled fund companies to sell no-load funds directly to investors.  Today, no-load funds account for the majority of investors' mutual fund holdings. 

  Loads deducted from your investment money are an additional and unnecessary cost when you're in the market for the best mutual funds.  The best no-load funds are every bit as good, if not better, than the best load funds.  Today, you can stick with the no-load funds and keep more of your investment dollars working for you. 

Not surprisingly, those who have a vested interest in sales loads argue in favor of funds that carry sales loads.  Over the years, I've heard the content of these broker pitches through readers who write to me or visit my Web site and in counseling clients who came to me for advice. 

  Be wary of brokers or planners pitching house brands — for example, a Morgan Stanley broker recommending Morgan Stanley mutual funds.  The fund industry scandal in the early 2000s further shined the light on this problematic practice.  Salespeople often get higher commissions by pushing house brands. 

Refuting myths about loads

 Brokers have much to say about paying loads, and you should be aware of the arguments they use.  Here are a few examples:

  Don't concern yourself with commissions — I get paid by the mutual fund company.  It's true that the mutual fund company pays the broker's commission.  But where do you think this money comes from?  From your investment dollars — that's where.  Brokers like to imply that you're not effectively paying for the commission because it comes from the mutual fund company. 

  You get what you pay for — load funds have better fund managers.  Bunk!  Every objective study that I've seen shows that paying a load doesn't get you a better fund manager.  Remember, loads wind up in the pockets of the selling brokers and don't go toward the management of the fund. 

What the studies have shown is that on average load funds underperform no-loads.  Why?  It's simple: Those commissions paid to the brokers come out of the fund's returns, although you may not know that from a fund's published rankings.  Some published mutual fund rankings and ratings services completely ignore sales commissions in their calculations of funds' returns (see Chapter 20). 

  No-loads have higher ongoing fees.  Investment salespeople imply or state that no-loads have to make it up somewhere if they aren't charging you a sales commission.  Although this may sound logical, remember that sales commissions go to the broker, not toward the expenses of managing the fund.  Fact is, the reverse is true: Load funds, on average, have higher, not lower, annual operating expenses than no-load funds. 

All funds have to spend money to market themselves.  Load funds spend money to market themselves both to brokers and to the investing public like you and me.  And the better no-load companies, such as those recommended in Chapter 9, benefit from the thousands of investors who call, based on word-of-mouth or other recommendations (such as through this book!),  seeking to invest. 

  No-loads have hidden costs.  In this case, a half-truth doesn't make a whole.  Both no-load and load funds incur brokerage transaction costs when securities are bought and sold in the fund.  These costs aren't really "hidden."  They're disclosed in a fund's Statement of Additional Information (discussed in Chapter 8), which is part of the fund's prospectus; however, they're not included in the calculated annual operating costs for any type of mutual fund, either load or no-load. 

  No-loads are for do-it-yourself types.  People who need help buy load funds.  This either/or mentality is trumpeted not only by investment brokers but also by some financial writers and others in the media who sometimes parrot what brokers say to them.  If you need advice, you have options.  One alternative is to hire a financial adviser and pay a fee for her time to recommend specific no-load mutual funds.  No-loads are hardly just for do-it-yourself types (see Chapter 9 for the different types of advisers you may hire), although you can see from this book (after you finish reading it) that you have what it takes to just do it yourself. 

  I'll do a financial plan for you to determine your needs.  Try as they may, investment salespeople can't perform objective, conflict-free financial planning. ( You should never pay for a "financial plan" from an investment salesperson.)  The problem with sales loads is the power of self-interest (discussed in Chapter 9).  This issue is rarely talked about, but brokers' self-interest is even more important than the extra costs you pay.  When you buy a load fund through a salesperson, you miss out on the chance to objectively assess whether you should buy a mutual fund at all.  Maybe you'd be better off paying debts or investing in something entirely different.  But salespeople almost never advise you to pay off your credit cards or your mortgage — or to invest through your company's retirement plan — instead of buying an investment through them. 

I've seen too many people get into investments without understanding what they're buying and what the risks are.  People who sell mutual funds usually sell other investments, too.  And some of those other products — vehicles such as limited partnerships, cash-value life insurance, annuities, futures, and options — hold the allure (for the salespeople) of high commissions.  Salespeople tend to exaggerate the potential rewards and obscure the risks and drawbacks of what they sell and often don't take the time to educate investors. 

  I can get you those funds that you're interested in from the same no-load companies, such as Fidelity.  Brokers like to imply that they can sell you basically the same funds that you could buy on your own through no-load companies.  However, top no-load companies, such as Vanguard, for example, don't sell any load funds through brokers.  Fidelity sells a series of load funds, called Fidelity Advisor funds, through commission-based brokers.  These funds carry hefty upfront sales charges and/or much higher ongoing fees — up to a full 1 percent more per year — than their no-load counterparts. 

In recent years, increasing numbers of brokerage firms are offering their customers access to some no-load mutual funds through a service known as a wrap (or managed) account.  To get into these funds, you must agree to pay the brokerage firm an annual investment management fee on top of the fees the underlying mutual funds charge. ( I explain in Chapter 6 why high-fee wrap accounts aren't in your best interest.) 

  The no-loads won't call you to tell you when to get out of the market or switch funds.  True.  But far from being a disadvantage, not getting a call to switch funds is actually a plus.  Although mutual funds offer daily liquidity, funds are meant to be a longer-term investment. 

A broker who stands to gain financially when you trade is hard pressed to be a source of objective advice of when to trade funds. ( In Chapter 17, I explain how to evaluate whether to continue holding the funds you own by applying the criteria discussed in this chapter.) 

  No-loads are impersonal organizations.  When you call a no-load fund's toll-free number, you'll surely get a different representative every time.  Visiting a fund's Web site is even less personal.  If it's important for you to have a relationship with someone at these firms, however, some representatives give you their names and extensions (just ask) so you can reach them in the future. ( Higher balance customers at some fund companies can be assigned a dedicated representative, so inquire.) 

A broker can be a personal contact who asks you about your golf game, how your family is doing, and . . .  by the way . . . " What's the phone number of your rich Uncle Johnny?"  Independent financial counselors who charge a fee for their time can serve the same role.  Likewise, discount brokerage firms such as Charles Schwab, TD Ameritrade, and Fidelity maintain branch offices that offer a personal, local touch if you need and want it. 

Hidden loads in alphabet soup: ABCD shares

Over the years, investors have learned about the sales loads that are deducted from their investments in load mutual funds.  Perhaps you just discovered this yourself.  Well, the companies that specialize in selling load funds have, with the unwitting assistance of government regulators, developed various types of funds that make finding the load much harder. 

Just as some jewelers flog fake diamonds on late-night TV commercials, some brokers are selling funds that they call no-loads, when they're really not no-loads.  By any other name, these funds are load funds: The only difference is that, with these funds, someone has taken the time to hide the sales commission. 

For a given load fund, some fund companies have introduced different classes of shares, usually labeled by the letters A, B, C, or D. No matter what letter they slap onto it, remember that you're getting the same fund manager and the same fund.  The only difference is how much the company's charging you to own it. 

Shares with the traditional front-end load are usually sold as Class A shares.  Class B, C, and D shares are the classes that the mutual fund marketers deploy tricky techniques such as back-end loads or ongoing commissions known as 12b-1 fees.  These commissions often end up being more expensive than the old upfront loads. 

Take the back-end sales load, for example, which is the typical technique of Class B shares.  Instead of assessing a load when you purchase these shares, you're charged a load when you sell them.  But wait, the broker tells you, the more years you hold on to the shares, the lower the sales charge when you sell.  In fact, if you hold on to the shares long enough — usually five to seven years — the load disappears altogether.  This deal sounds a lot better than the Class A shares, which charge you an upfront load no matter what.  Not so fast.  The broker selling the Class B shares still gets a commission.  The company simply raises the fund's operating expenses (much higher than on Class A shares) and pays the broker commissions out of that.  One way or another, the broker gets his pound of flesh from your investment dollars. 

Remember: You can easily avoid these hidden loads.  Don't buy funds through salespeople.  Buy no-loads, such as those recommended in this book. 

Exposing loads

  The only way to be sure that a fund is truly no-load is to look at the prospectus for the fund.  Only there, in black and white and absent of all marketing hype, must the organization tell the truth about its sales charges and other fund fees. ( Check out Chapter 8.) 

Figure 7-1 is a sample of a typical fee table from a fund prospectus for a load fund.  Note that the Class A shares have an upfront 6.5 percent sales commission that's deducted when you invest your money. 

**Figure 7-1:** How to spot load funds. 

  The Class B shares don't have an upfront commission but instead have a deferred sales charge, which decreases over time.  However, note that this class can charge you up to an extra 1 percent per year (12b-1 marketing expense fees).  Class B shares in this example (as in most real cases) cost you more in the long run because you pay this cost each year as long as you own the fund.  Check out the "Hidden loads in alphabet soup: ABCD shares" sidebar earlier in this chapter for even more details on this game of hide the load. 

Considering a fund's operating expenses

One cost of fund ownership that you simply can't avoid is operating expenses.  Every mutual fund — load and no-load — has operational costs: paying the fund manager and research assistants, employing people to answer the phone lines and operate a Web site, printing and mailing prospectuses, buying technology equipment to track all those investments and customer-account balances, and so on. 

Running a fund business costs money!  Fund fees also include a profit for the fund company. ( The brokerage costs that a fund pays to buy and sell securities aren't included in a fund's operating expenses.  You can find this information in a fund's Statement of Additional Information, which I discuss in Chapter 8.) 

A fund's operating expenses are quoted as a percentage of the fund's assets or value.  The percentage represents an annual fee or charge.  In the case of load funds, this fee is in addition to the stated load.  You can find this number in the expenses section of a fund's prospectus, usually denoted by a line, such as Total Fund Operating Expenses.  Or you can call the mutual fund's toll-free number and ask a representative or dig for the information on most fund companies' Web sites.  I detail what the operating expenses are for the funds recommended in this book. 

Some people ask me how the expenses are charged and whether they're itemized on your fund statement.  The answer is that a fund's operating expenses are essentially invisible to you because they're deducted before you're paid any return.  Because these expenses are charged on a daily basis, you don't need to worry about trying to get out of a fund before these fees are deducted. 

  Although all funds must charge operating expenses, some funds charge much more than others.  By picking the right funds, you can minimize the operating expenses you pay.  And minimize them you should: Operating expenses come right out of your returns.  Higher expenses translate into a lower return to you. 

Expenses matter on all types of funds but more on some and less on others:

  Expenses are critical on money market mutual funds and are very important on bond funds.  These funds are buying securities that are so similar and so efficiently priced in the financial markets.  In other words, your expected returns from similar bond and money funds are largely driven by the size of a fund's operating expenses.  This fact has been especially true in recent years when interest rates have gotten low. 

  With stock funds, expenses are a less important (but still important) factor in picking a fund.  Don't forget that, over time, stocks have averaged returns of about 10 percent per year.  So, if one stock fund charges 1.5 percent more in operating expenses than another, you're giving up an extra 15 percent of your expected annual returns. 

Some people argue that stock funds that charge high expenses may be justified in doing so — if they're able to generate higher rates of return.  But there's no evidence that high-expense stock funds do generate higher returns.  In fact, funds with higher operating expenses, on average, tend to produce lower rates of return.  This makes sense because operating expenses are deducted from the returns that a fund generates. 

  But how high is high?  You should generally shun a money market or bond fund that charges more than 0.5 percent per year, a U.S. stock fund that charges more than 1 percent per year, or an international or specialty fund that charges more than 1.3 percent per year.  Steel yourself against clever marketing brochures and charming salespeople.  Read the fine print and walk the other way to a better fund if costs are too high. 

  If a given fund's expenses are much higher than its peers, one of two things is usually happening: Either the fund has little money under management — and therefore has a smaller group of investors to bear the management costs — or the fund owners are greedy.  Another possibility could be that the fund company is inefficiently managed. ( Maybe the company rents high-cost, big-city office space and its telephone reps spend half the day talking with friends!)  In any case, you don't want to be a shareholder of such a fund. 

  These high-expense funds have another insidious danger built in: In order to produce returns comparable to those of similar funds with lower costs, the manager of such a high-cost fund may take extra risks to overcome the performance drag of high expenses.  So on top of reducing a fund's returns, higher expenses may expose you to greater risk than you desire. 

In some cases, a fund (particularly a newer one that's trying to attract assets) will "reimburse" a portion of its expense ratio in order to show a lower cost.  But if (or when) the fund terminates this reimbursement, you're stuck owning shares in a fund that has higher costs than you intended to pay. 

  All mutual fund fees — both loads and operating expenses — are disclosed in a fund's prospectus, which is why obtaining a fund's prospectus before you buy it is so important.  Reviewing the prospectus is especially critical for funds pitched to you by brokers or by brokers who masquerade as "financial planners" and "consultants."  I tell you how to decipher a fund prospectus later in this chapter. 

Weighing Performance and Risk

Although a fund's performance, or its historic rate of return, is certainly an important factor to weigh when selecting a mutual fund, investors tend to overemphasize its importance.  Choosing funds on simplistic comparisons of performance numbers is dangerous. 

As all mutual fund materials are required to state, past performance is no guarantee of future results.  Analysis of historic mutual fund performance proves that some of yesterday's stars may turn into tomorrow's skid row bums (as I discuss in the next section, "Star today, also-ran tomorrow"). 

  Realize that funds with relatively high returns may achieve their results by taking on a lot of risk.  Those same funds often take the hardest fall during major market declines.  Remember that risk and return go hand in hand; you can't afford to look at return independent of the risk it took to get there.  Before you invest in a fund, make sure you're comfortable with the level of risk the fund is taking on. 

Star today, also-ran tomorrow

Some fund manager may have a fabulous quarter or year or two, ripping up the market with his little growth-stock fund.  Suddenly, his face is plastered across the financial magazines; he's hailed as the next investing genius, and then hundreds of millions and perhaps billions of new investor dollars come pouring into his fund. 

  Short-term (one year is a short time period) fund performance numbers don't mean much — luck can be just as big a factor as skill.  Also remember that earning much higher returns than other similar funds often means that the manager took a lot of risk.  The greater the short-term returns for that fund and manager, the greater the odds of sharp slump. 

The history of short-term mutual fund star funds confirms this: Of the number one top-performing stock and bond funds in each of the last 20 years, a whopping 80 percent of them subsequently performed worse than the average fund in their peer group over the next five to ten years!  Some of these former number one funds actually went on to become the worst-performing funds in their particular category. 

The following sections provide a historic sampling of the many examples of short-term stars becoming tomorrow's also-rans (and in some cases, downright losers). 

Fidelity Growth Strategies

Launched in 1991, Fidelity Growth Strategies invests in medium-size growth companies.  The fund performed a little better than the market averages in the early to mid-1990s, and then it dramatically outperformed its peer group in late 1990s. 

So, Fidelity promoted the heck out of the fund, and investors piled into it to the tune of nearly $10 billion in 1999.  And, Fidelity had some help from articles like the one that ran in the July 18, 1999, issue of The New York Times. 

In a positively glowing profile of the fund, and its manager, Erin Sullivan, the Times called Sullivan ". . .  the quintessential portfolio manager."  And it added in the following material, which caused investors to send Ms. Sullivan's fund their investment dollars:

"Ms. Sullivan, 29, has been in charge of the $5.96 billion Fidelity Aggressive Growth fund since April 1997.  In that time, the fund has posted total returns of 51.83 percent, annualized, versus 33.16 percent for the Standard & Poor's 500-stock index. . . .  This year through July 15, the fund was up 44.34 percent, nearly tripling the 15.4 percent gain of the S.& P. 500. 

Ms. Sullivan goes about her business with the self-assurance of a Harvard graduate, the analytical rigor of a math theoretician, and the vigor of a marathon runner, all of which she is.  But she has not entered a marathon race roughly since she took the reins of Aggressive Growth. ' It's hard to find time for anything else,' she said." 

Within months of the Times article, the fund's fortunes changed.  Overloaded with overpriced technology stocks, the fund plunged 84 percent in value from early 2000 to late 2002.  It was one of the worst performing funds of the decade just ended with its –9.9 percent per year annualized return. 

Van Wagoner Emerging Growth fund

With a mere three years of stellar returns under his belt, Garrett Van Wagoner, manager of the Govett Smaller Companies Fund, decided to cash in on his exploding popularity and start his own money management firm — Van Wagoner Capital Management.  Calling Van Wagoner the hottest small company stock picker around, several of the nation's largest financial magazines recommended investing in his new Emerging Growth fund.  Investor cash came flooding in — more than a billion dollars in the fund's first six months of existence. 

The Van Wagoner Emerging Growth fund (since renamed the Embarcadero Small Cap Growth fund) invests in high-flying smaller company growth stocks.  In its first full year of operations (1996), the fund posted a respectable total return of nearly 27 percent, placing it within the top 20 percent of funds within its peer group. 

In the next year, 1997, the fund dropped by 20 percent and dramatically underperformed its peer group and was among the worst of its peers.  Money flowed out, and the fund was largely ignored until 1999 when Van Wagoner piled into technology stocks, which were zooming to the moon.  In 1999, this fund produced a total return of a whopping 291 percent (making it the year's number one stock fund) while assets under management swelled from less than $200 million to nearly $1.5 billion! 

Investors who came to Van Wagoner's party in 1999 were subsequently treated to one of the greatest collapses in the history of the fund industry.  Following a drop of 20.9 percent in 2000, the fund posted horrendous losses in the next two years as well — losing 59.7 percent in 2001 and then 64.5 percent in 2002.  In fact, the poor investors who bought in at or near the top during late 1999 through early 2000 experienced a stomach-wrenching plunge of more than 90 percent through September 2002. ( The fund also had many horrendous years in the 2000s.)  See Table 7-1 for how this fund has performed versus its relevant index — the Russell 2000 Growth Index. 

Table 7-1 Comparing the Van Wagoner Emerging Growth Fund's Performance

---

Year | Van Wagoner Emerging Growth Fund Total Return | Russell 2000 Growth Index Total Return

2000 | –20.9% | –22.4%

2001 | –59.7% | –9.2%

2002 | –64.6% | –30.3%

2003 | 47.2% | 48.5%

2004 | –16.0% | 14.3%

2005 | –22.3% | 4.1%

2006 | 10.8% | 13.3%

2007 | –7.8% | 7.1%

2008 | –56.8% | -38.5%

2009 | 12.6% | 34.5%

Over the past decade, this fund has plunged in value by more than 94 percent!  If you invested $10,000 in this fund at its inception in 1996, your investment would've shrunk to $1,841; whereas, the same investment in its average peer would've grown to $22,383! 

Managers Intermediate Mortgage fund

Managed by portfolio manager Worth Bruntjen, Managers Intermediate Mortgage (MIM) was the darling of the moment for almost every mutual fund rating service in 1993. ( I talk about rating services in Chapter 20.)  It earned kudos because, in its seemingly boring investment universe — government-backed mortgage bonds — it produced an annual rate of return 3 percent higher than that of its peers (who came in it at just 10 percent per year) over the five-year period ending in 1993.  By earning 13 percent per year rather than 10 percent, MIM's performance was about 30 percent better than its peers. 

This fund received some of the highest ratings that most mutual fund rating companies allowed for performance, and, supposedly, MIM had "below average" risk.  It earned a coveted five-star rating from a leading mutual fund rating service.  When interest rates rose sharply in early 1994, the fund got clobbered.  It produced a total return of –22 percent in the first half of 1994.  This little six-month disaster was enough to bring the fund in dead last among 50 other mortgage bond funds for the five-year period ending June 30, 1994.  And the disaster wiped out the above-average returns that this fund had generated over the five previous years. 

  This fund was able to achieve its temporarily high returns by taking a ton of risk.  From where did all the danger come, you ask?  The fund invested in complex collateralized mortgage obligations (CMOs), which are pieces of a mortgage.  Buying CMOs is like buying chicken parts rather than a whole chicken at the supermarket.  A mortgage gets chopped into the different years of principal and/or interest repayments.  CMOs are incredibly complicated to understand, even if you surround yourself with computers and investment bankers. 

Forbes magazine, which had written a glowing article praising fund manager Bruntjen on January 17, 1994, admitted that its earlier enthusiasm had been excessive — a rare and honorable thing for a financial magazine to do.  Forbes said that the magazine had learned from the episode "not to be overly confident in historical statistics, especially those attached to complex investment products.  In this case, a volatility measure calculated from a mostly bullish period turned out to be meaningless during a period when the market turned bearish." 

Matterhorn Growth fund

This aggressive stock fund skyrocketed 184 percent in 1975 — the year following the end of one of the worst declines for the stock market since the Great Depression.  Since the 1970s, however, this fund has been in the doghouse.  It holds the dubious distinction of being the worst stock fund during the 1980s — one of the best decades ever for the stock market. 

As money poured out of the fund, its annual operating expenses as a percentage of assets ballooned in excess of 4 percent per year!  The fund was finally put out of its misery when it was merged into the CSI Equity fund in 2006. 

Apples to apples: Comparing performance numbers

Remember back in school when the teacher handed back exams and you were delighted to get a 92 (unless you're from an overachieving family)?  But then you found out that the average on the exam was a 95.  You still may have been pleased, but a lot of air was let out of your balloon. 

Mutual fund performance numbers are the same: They don't mean much until they're compared to the averages.  A 15 percent return sounds great until you find out that the return from the relevant index market average (that invests in similar securities) was 25 percent during the same period. 

The trick is picking the correct benchmark for comparison.  Dozens of market indexes and fund category averages measure various components of the market.  You always want to compare a fund's returns to its most appropriate benchmark.  Comparing the performance of an international stock fund to that of a U.S. stock market index isn't fair, just as comparing a sixth-grader's test results on a given test to those of a tenth-grader taking the same test is unfair. ( See Chapter 17 for a list of benchmarks and an explanation of what markets they measure.) 

  Context matters, and mutual fund companies realize this.  So in their marketing literature, fund companies usually compare their funds' returns to selected benchmarks.  Keep a wary eye on these comparisons.  In the great American advertising tradition, fund companies often pick benchmarks that make it easy for their funds to look good.  And in like manner, more than a few investment advisers who manage money do the same, as I discuss in Chapter 24. 

Here's an example of how a fund can make itself look a lot better than it really is. 

A number of years ago, the Strong Short-Term Bond Fund (subsequently acquired by Wells Fargo) ran ads claiming to be the number one, short-term bond fund. ( I'd show you the ad, but Strong refused to grant permission to reprint it.)  The ads featured a 12-month comparison graph that compared the Strong fund's yield to the average yield on other short-term bond funds.  The Strong Short-Term Bond Fund, according to the graph, consistently outperformed the competition by 2 to 2.5 percent! 

A bond fund must take a lot more risk to generate a dividend yield this much higher than the competition's.  You should also be suspicious of any bond fund claiming to be this good with an annual operating expense ratio of 0.8 percent.  With a yield and expenses that high (as I explain in Chapter 12), a fund has to take higher risks than supposedly comparable funds to make up for the drag of its expenses.  And if the fund's taking that much more risk, then it needs to be compared to its true competition — which, in Strong's case, are other funds whose investments take similarly high risks.  This fund isn't a bad fund, but it isn't nearly as good as the ad would've had you think. 

 This fund was on steroids!  The Strong Short-Term Bond Fund wasn't comparable to most other short-term bond funds because

  A high percentage of its bonds weren't high quality.  About 40 percent of its bonds were rated BBB or below. ( I explain bond credit-quality ratings in Chapter 12.) 

  Many of its bonds weren't short-term bonds.  The Strong Fund invested in mortgage bonds that are more like intermediate-term bonds. 

Strong's ad also claimed that its bond fund was ranked number one for the year.  If a fund takes more risk than the funds it compares itself to, then sure, during particular, brief periods, it can easily end up at the top of the performance charts.  But how strong of a long-term performer is this "number one" fund?  Over the five years before this ad ran, even including the year the ad was so proud of, Strong's fund had underperformed most short-term bond funds. 

Recognizing Manager Expertise

Much is made of who manages a specific mutual fund.  Although the expertise of the individual fund manager is important, a manager isn't an island unto himself (or herself — more women are becoming fund managers nowadays). ( And if the fund manager leaves or retires from the company, you're left holding the fund.)  Earlier in this chapter (see "Star today, also-ran tomorrow"), I explain how a star fund can flare for its moment of investor glory and then easily twinkle down to become just another average or worse-than-average fund.  Too many of us seem to want to believe that, in every field of endeavor — sports, entertainment, business — there are superhumans who can walk on water. 

  It's true that in the investment world some people shine at what they do.  But compared to other fields, the gap between the star investment manager and the average one, over long time periods, typically is small. 

If the stocks of large U.S. companies, for example, have increased an average of 13 percent per year over a decade, the money manager focusing on such securities may vault to star status if his fund earns 15 percent over the same time period.  Don't get me wrong: An extra 2 percent per year ain't nothin' to sneeze at — especially if you have millions invested.  But a 2 percent higher return is a lot smaller than what most people think they can achieve with the best investment managers. 

  Therefore, the resources and capabilities of the parent company should be equally important in your selection of which funds to invest in.  Different companies have different capabilities and levels of expertise with different types of funds.  In Chapters 11 through 14, I detail which firms have great reputations in various fund categories.  I also recommend individual funds from these various companies. 

  Avoid fund companies with little mutual fund management experience and success.  If you need surgery, you place your trust with a surgeon who's successfully performed the operation hundreds of times, not to a rookie who's only seen it on the local cable station.  Avoid novelty funds as well.  Mutual funds have been around for many decades.  Yet not a week goes by without some newfangled fund coming out with a new concept.  Most of these ideas come from the fund company's marketing department, which in some companies has too much clout.  Instead of coming up with investments that meet investors' needs, they come up with gimmicky funds that involve extra risk and that almost always cost extra in their high annual operating expenses. 
Chapter 8

Using Fund Publications

In This Chapter

  Understanding prospectuses and annual reports

  Checking out the Statement of Additional Information

Fund companies produce a lot of materials.  Even with the growth and usage of the Internet, plenty of paper and trees get trashed annually. 

While much of what funds publish isn't worth much of your time, some of it is and can address important questions you may have (or should have) about particular funds.  You can learn about fund fees (including so-called hidden brokerage costs), strategies, investment holdings, risks, to name just a few.  So, in this chapter, I walk you through three of the most important fund documents published for each and every mutual fund: the prospectus, annual report, and statement of additional information. 

Reading Prospectuses — the Important Stuff, Anyway

Securities laws require every fund to issue a prospectus, and the U.S. SEC reviews the details of every single one (which probably keeps plenty of coffee and eyeglass companies in business).  A prospectus is usually written and edited by an attorney who wouldn't know a lively and comprehensible sentence if it clobbered him on the head.  You can safely skip most of what's said in a prospectus, but be on the lookout for a few things you should check out. 

  The most valuable information — the fund's investment objectives, costs, and performance history — is summarized in the first few pages of the prospectus.  Read these.  Skip most of the rest.  The rest only tells you more than you could possibly want to know about how the fund is administered.  Do you really want to know whether employees are paid monthly or weekly?  Which brand of paper shredders they recently bought for the accounting department? 

If you find prospectuses to be positively lethal in their tediousness, let me suggest a friendlier alternative: Just jump ahead to the fund recommendations in Chapters 10 through 13 of this book.  I've already checked them out for you, and they meet the criteria for good funds that I list in this book.  However, if you're going to be assessing funds for purchase other than those presented in this book, you need to be able to read and understand a prospectus. 

In the pages that follow, I walk you through the more useful and relevant parts of a well-done prospectus for one of Vanguard's funds, the Wellington Fund.  This fund has been in existence for more than 80 years.  Consider that it was launched on July 1, 1929, right before the onset of the Great Depression.  So to say that it has stood the test of time and tough times would be an understatement!  Since its inception, the Wellington Fund has produced annualized returns of more than 8 percent per year, which demonstrates the value of diversification in stocks and bonds. ( Remember, the specifics about the fund have since changed, so be sure to get a new prospectus if you want to invest in the Wellington Fund.) 

Cover page

The prospectus is dated (see Figure 8-1) so that you know how recent its information is.  Don't sweat it if the prospectus is several months old; in general, fund companies update prospectuses annually. 

**Figure 8-1:** The Table of Contents shows you what's covered in the prospectus. 

Source: The Vanguard Group.  Reprinted with permission. 

The table of contents is a sure sign that the prospectus is too long — but then lawyers seldom use 1 word where 50 will do.  The table of contents helps you navigate the prospectus to find whatever information you want.  To illustrate here, I cover a portion of this prospectus (most of the good stuff is near the front). 

  Some prospectuses describe more than one fund in a particular fund family. ( This prospectus covers two different "Share Classes" — "Investor Shares" and "Admiral Shares," which are identical except that the Admiral Shares have far larger initial investment requirements and lower expenses.)  This practice can save a fund company printing and mailing charges when it has funds with very similar investment objectives and/or funds run by the same investment management team. 

Fund profile

The fund profile pages (beginning with Figure 8-2) contain a synopsis of the main attributes of the fund, such as a description of the fund's investment objectives and the strategies (the types of securities the fund invests in) that it employs to accomplish its objectives.  The Wellington Fund seeks current income from its investments and modest appreciation.  It invests the majority of its assets in stocks that pay decent dividends (for income as well as appreciation potential) and its remaining assets in high-quality bonds (for income). 

Thankfully, funds are required to present, in a standardized format, the costs that you'll incur for the privilege of owning a fund.  The first list of expenses shows the fees you pay when you buy and sell shares.  These fees are deducted at the time a transaction occurs; unfortunately, they're rarely itemized.  Because a no-load fund such as the Wellington Fund doesn't charge any sales commissions or redemption fees, you see the word None repeated throughout this section. 

Here, you also find a list of the main risks that come with investing in this fund.  All funds, especially those which invest in stocks and bonds (as this one does), come with risk.  Don't let this list scare you away — let it make you feel better.  You're hiring a knowledgeable and experienced fund manager who can do a much better job navigating these potential perils than you can. 

On the second page of the fund profile section, you find a description of the fund's performance chart and table (see Figure 8-3).  In the chart, you can see the yearly total return that an investor in this fund has earned over the past decade. ( Below the chart is a description of the best and worst quarters — three-month periods.)  Because this fund invests in a mixture of bonds and stocks, you shouldn't be surprised to see fluctuations — in some years, you see fairly large positive returns (in some cases, more than 20 percent), and in other years, you see a negative return.  The performance information also shows the impact of taxes (which assumes the deduction of taxes at the highest federal rates) and comparison of the fund's returns to relevant market indexes. 

**Figure 8-2:** The fund summary provides a digest of the fund's key features. 

Source: The Vanguard Group.  Reprinted with permission. 

**Figure 8-3:** The fund profile summarizes performance data. 

Source: The Vanguard Group.  Reprinted with permission. 

  If a so-called financial adviser pitches a fund, but you're not sure whether she gets paid for selling it to you, always get a prospectus and check out the fund expense section.  That way, you can see if commissions will erode your returns.  In this case, you'd see that if an adviser recommended this fund, she isn't paid any commission — a good sign. ( Refer to Chapter 7 for an example of a typical load-fund fee table.) 

Operating expenses are fees charged on a continuous basis by all mutual funds; they cover the expenses of running a fund and include the fund company's management fee — out of which it earns its profit.  In this case, they total a reasonable 0.34 percent (even less for the Admiral shares).  Because these fees are deducted from the fund's returns before your returns are paid to you, lower operating expenses translate into higher returns for you. 

In addition to showing you the fund expenses as a percentage of the amount an investor has in the fund, the prospectus also shows you the total expense dollars that an investor will incur over the years by investing a hypothetical amount ($10,000) in the fund. 

Other fund information

The next section of the prospectus (see Figure 8-4) presents you with a hodgepodge of facts about the fund, some of which may be important to you: who manages the fund, how long the fund has been in existence, what the fund's total assets are, what its minimum initial investment amount is, and how to purchase and redeem shares. 

Investment objectives and risks

This next section on investment strategies explains in detail what the fund is trying to accomplish and what risks the fund is subject to.  In Figures 8-5 through 8-7, I show you the first few pages of this section.  The Wellington Fund seeks both moderate growth of capital and current income.  It tries to accomplish these objectives by investing in stocks that pay decent dividends and bonds (fixed-income securities). ( The Plain Talk sections within this prospectus — see the shaded boxes — explain important fund-investing concepts.  The Plain Talk section isn't required, and you won't necessarily find it, or the equivalent, in every prospectus.) 

**Figure 8-4:** Important details about the fund. 

Source: The Vanguard Group.  Reprinted with permission. 

You can think of the investment policies or objectives as a broad set of rules or guidelines (for example, the major type of securities that the fund invests in) that the fund operates under when investing your money.  This hopefully protects you from most major surprises.  And if a fund violates these guidelines — for instance, if this fund puts all its money into international stocks — the SEC would spank, reprimand, and penalize Vanguard.  Unethical fund companies may be willing to pay this small price if they can seduce more people into their funds by showing higher returns that result from taking poorly disclosed risks. 

If you've taken the time to look at how much money this fund has made for investors, you owe it to yourself to understand this fund's risks, too.  This section of the prospectus does an excellent job of discussing the Wellington Fund's risks, using examples from past decades instead of just from recent years, which were generally good years for the financial markets. 

**Figure 8-5:** Investment objectives and risks. 

Source: The Vanguard Group.  Reprinted with permission. 

**Figure 8-6:** More investment objectives and risks. 

Source: The Vanguard Group.  Reprinted with permission. 

**Figure 8-7:** Still more investment objectives and risks. 

Source: The Vanguard Group.  Reprinted with permission. 

Investment adviser

This important section (see Figure 8-8) provides background about the investment adviser — the folks actually managing the investments of this fund.  You can read about the firm (in this case, it's an outside money management company — Wellington Management Company) who make the fund's investment decisions. 

Financial highlights

If you get a headache looking at all the numbers on financial pages, you're not alone.  Figure 8-9 looks frightening, but this table is just a yearly summary of the value of the fund's shares and the distributions the fund has made. ( I cover these subjects in detail in Chapters 17 and 18.) 

**Figure 8-8:** The investment adviser actually manages the fund's money. 

Source: The Vanguard Group.  Reprinted with permission. 

**Figure 8-9:** Financial highlights. 

Source: The Vanguard Group.  Reprinted with permission. 

The Net Asset Value (NAV) is the price per share of the fund.  Tracking this value provides an incomplete, terrible measure of what you would've earned in the fund.  Why?  Just look at the distributions section, which details all the money paid out to shareholders each year.  This fund has paid out total distributions (dividends and capital gains) of $9.63 per share over this five-year period.  This per-share figure is an enormous amount when you consider that the share price actually decreased from $30.54 to $28.99 during the period — a 5.1 percent decrease.  But if you add in the distributions to the change in share price, now you're talking about a 26.5 percent (or more) increase (if you'd reinvested these distributions, you would've had an even greater return). 

The Total Return represents what investors in the fund have earned historically.  The returns on this type of fund, which invests in stocks and bonds, bounce around from year to year.  You can see how the total investments (Net Assets) in the fund have changed over time.  Assets can increase from new money flowing into the fund as well as from an increase in the value of a fund's shares. 

  This section of a prospectus also shows you how a fund's annual operating expenses (Ratio of Total Expenses to Average Net Assets) have changed over time.  They should decrease when a fund is growing.  This fund's expense ratio of 0.29 percent in 2005 increased to 0.34 percent four years later.  If operating expenses are high (not in this case) and don't decrease, their persistent levels may signal a company that maximizes its profits because of the fund's popularity.  For funds that are only a few years old, expenses may remain higher because the fund is building its base of investors. ( The slight increase for this fund isn't significant and was due in part to the high return of the most recent year, which increased the fund manager's performance fee payments.) 

The line Ratio of Net Investment Income to Average Net Assets shows the annual dividends, or yield, that the fund has paid. ( This figure is especially important for retired people, who need income to live on.)  In this example, the downward trend merely reflects the overall decline in interest rates during the period.  If you looked at this ratio for a similar fund, you'd see the same trend for this period. 

The Turnover Rate tells you how much trading takes place in a fund.  Specifically, it measures the percentage of the portfolio's holdings that has been traded over the year:

  A low turnover number (less than 30 percent or so), such as the one for this fund, denotes a fund with more of a buy-and-hold strategy. 

  A high turnover number (100 percent plus) indicates a fund manager who does a lot of trading.  Rapid trading is costlier and riskier and may increase a fund's taxable distributions. 

Reviewing Annual Reports

Funds also produce annual reports that discuss how the fund's been doing and provide details on the specific investments that a fund holds.  Look at the annual report if, for instance, you want to know which countries an international fund is currently invested in. 

  You can get answers to questions like what countries a fund invests in by calling a fund's toll-free number or by hunting around on a fund company's Web site. ( Some fund companies enable you to access their fund's annual reports and prospectuses on their Web site.)  Some of the mutual fund information sources that I recommend in Chapter 20 also report this type of information. ( Or you could say, "Details, details.  Just suggest some funds to buy for different needs."  That's just what I do in Chapters 11 through 15.) 

In this section, I review the pages from the annual report on the Vanguard Wellington Fund — the same fund whose prospectus I introduce you to in the preceding section.  In addition to producing an annual report, each fund produces a semiannual report that (guess what?)  comes out halfway between annual reports.  The semiannual reports are usually a bit shorter than the full-year reports but contain the most up-to-date information on the fund's current investment holdings and performance. 

  When you call a fund company to ask for applications, specifically request a fund's recent annual or semiannual reports.  Unlike a prospectus, most funds don't automatically send you annual reports. ( And, of course, most fund companies provide these reports on their Web sites.) 

Chairman's letter and performance discussion

The Chairman's letter is supposed to explain how well the fund has performed recently and why (see Figure 8-10).  In far too many reports, the fund's chief executive uses his or her letter to the stockholders merely as an opportunity to overhype how well the fund has done — during good periods in the financial markets.  In tougher times, too many fund execs blame subpar performance on the market.  It's like fishing: On a successful day, you talk about your uncanny casting ability, your brilliant choice of lures, and your ability to keep still and quiet.  When you come home empty handed, the fish just weren't biting. 

**Figure 8-10:** President's letter. 

Source: The Vanguard Group.  Reprinted with permission. 

A good annual report like Vanguard's will detail the performance of the fund and compare it to relevant benchmarks and comparable funds.  You hope that your fund will meet or exceed the performance of comparable funds (and perhaps even of the benchmark, too) in most periods.  Don't worry if your fund periodically underperforms a little.  Especially with stock and bond funds, you invest for the long haul, not just for six months or a year. 

  Unfortunately, as I discuss earlier in this chapter, more than a few fund companies use benchmarks (indexes) as comparisons for their funds' performances so that their funds look as if they perform better than they really do.  This ruse is similar to a financially savvy adult like, say, me, comparing his mutual fund selection abilities to those of, say, a child.  I'm at something of an unfair advantage (at any rate, I'd better be).  As you review a fund's annual report, keep in mind this tendency of some funds to fudge comparisons.  In Chapter 17, I discuss ways you can make sure that you're comparing a fund's performance to an appropriate benchmark. 

In addition to discussing the fund's performance during the year, an annual report also covers how the overall financial markets were feeling.  If you're used to a steady diet of the daily news, an overview like this can help you to better see and understand the big picture (and maybe you won't be so shocked that one of your funds lost, say, 2 percent last year when you see that the benchmark index most relevant to that fund lost 5 percent). 

A good annual report is educational and honest.  As you can see, Vanguard's is both.  The report does a nice job of providing a historical context for understanding this fund's performance.  It also clearly explains that a surging stock market the past year propelled this fund's returns. 

The comparisons to competitors help you make sure that you're comparing your fund to the Wellington Fund's true peers — apples to apples.  These comparisons are even more valuable and useful when applied over longer periods (see Figure 8-11).  You can see how the Wellington Fund performed against its competitors ("average balanced fund") and the benchmark composite index.  The Wellington Fund handily beat the competition and the benchmark index. ( The "Composite Index" is a mythical investment, which has the advantage of not having any costs deducted from it.) 

  In the world of stocks and bonds, one year is too short a period to evaluate a fund.  In this section, the chairman also looks forward and prudently reminds you that the future will likely contain both good and bad periods. 

**Figure 8-11:** Long-term performance discussion. 

Source: The Vanguard Group.  Reprinted with permission. 

Investment adviser's thoughts

The "Advisor's Report" is where the portfolio managers of the fund (in this case, the Wellington Management Company) explain how the economic environment affected the fund's performance.  They also look ahead and discuss what the future may hold and what investment strategy they plan to take in the near future (see Figure 8-12).  I especially like how this report highlights not only their successes but also their less-than-stellar performers. 

**Figure 8-12:** Investment advisor's insights and reflections. 

Source: The Vanguard Group.  Reprinted with permission. 

Performance and its components

The performance page looks like a terrible overload of numbers, but it actually contains valuable information (see Figure 8-13). 

For example, this table shows you how the Wellington Fund has performed each year.  As you can see in the Cumulative Performance table, although the fund has produced an average annual return of 6.20 percent per year over the past ten years, its return varies much from year to year.  In 2008 (fiscal year, which in this case ends November 30), for instance, its return was –25.6 percent, but the return was 26.5 percent in 2009.  If a swing in returns such as this makes you reach for your motion sickness prescription, you'd better skip investing in the fund. 

  To earn better returns, you have to take risks. 

**Figure 8-13:** Total investment returns, year by year. 

Source: The Vanguard Group.  Reprinted with permission. 

Investment holdings

The Statement of Net Assets section lists every investment the fund owns.  Here's where you get the details that tell you exactly where your money is invested.  You can see here the incredible diversification your money gets in a mutual fund; you actually own a tiny sliver of each of these securities if you invest in this fund (see Figure 8-14).  For example, in this first section, you can see that this fund (as of November 30, 2009) was 65 percent invested in stocks, which are presented here by industry. 

**Figure 8-14:** Investment holdings of the fund. 

Source: The Vanguard Group.  Reprinted with permission. 

Reviewing a fund's specific investment holdings is important.  Sometimes, a fund's name is misleading relative to what the fund actually holds; often, the Objective section of a prospectus doesn't provide insight into important factors, such as the sizes of the companies that it owns. 

  For each security, you also can see how much each investment was worth at the end of the most recent year. ( Do you need to know, should you care, and will it be on the test?  No, no, and no!) 

Continuing on in the report, you see more of the investments that the fund owns.  Figure 8-15 shows you some of the bonds the fund owns.  These bonds are listed by issuer (government versus corporate) and the corporate bonds by industry and specific companies. 

**Figure 8-15:** Bond holdings of the fund. 

Source: The Vanguard Group.  Reprinted with permission. 

Investigating the Statement of Additional Information (SAI)

The brokerage fees that a fund pays to buy and sell securities for the fund are not included in the annual operating expense numbers that a fund reports.  Brokerage costs reduce a fund's returns just the same as a fund's operating expenses and are ultimately reflected in the fund's annual rate of return. 

Although fund brokerage costs are typically far less than the fund's operating expenses, funds that frequently trade or "turn over" their holdings can have significant brokerage expenses.  These costs are disclosed in a fund's Statement of Additional Information (SAI).  More trades mean more costs draining your returns, which may also lead to more taxable distributions.  Rest assured that the funds recommended in this book have relatively low overall expenses including brokerage fees. 

  In case you're curious, for the Vanguard Wellington fund, the brokerage expenses amount to about 0.07 percent annually — a small fraction of the funds' annual operating expense ratio. 
Chapter 9

Buying Funds from the Best Firms

In This Chapter

  Becoming familiar with the best and worst places to buy funds

  Letting discount brokers work for you

  Knowing when hiring an adviser is appropriate

Hundreds of investment companies offer thousands of fund options.  However, only a handful of these fund companies offer many top-notch funds, so in this chapter, I tell you which companies are the best places for your fund investing. 

  Some other good individual funds are run by companies not mentioned in this chapter. ( I recommend specific funds in Part IV of this book.)  In addition to recommending the best parent fund companies, I also recommend the best discount brokers.  Although these guys are slightly more expensive, discount brokers make buying the best funds from different fund companies and holding all the funds in a single account a lot easier. 

Finding the Best Buys

When studying the different mutual funds companies, you may see a lot of different funds.  Some are better than others.  Using the criteria in Chapter 7, this chapter presents the best buys.  In this section, I discuss the best companies through which to invest in funds directly.  Check out the Appendix for each company's contact information.  Note: In the fund company descriptions, I devote more space to those companies whose funds I recommend the most in this book.  Some good funds are offered by companies not on this short list — please see Chapters 11 through 14 for all the specific fund picks. 

The Vanguard Group

  The Vanguard Group is now the largest mutual fund company in America, having surpassed Fidelity.  Vanguard's significant growth since the early 1990s has been somewhat of a vindication for a company that was underrated for many years. ( At the time that I wrote the first edition of this book in 1994, I went on record as saying that Vanguard, overall, was the best mutual fund company around and wasn't getting the recognition it deserved.  My praise led some folks to ask whether I had a vested interest in praising Vanguard and the answer then is the same as today — no!) 

One of the reasons for Vanguard's underrating is the fact that its funds are almost never at the very tiptop of the performance charts for their respective categories.  As I discuss in Chapter 7, this sign is actually good, because many number-one-performing funds are rarely even above average over the long haul.  Although Vanguard offers a broad spectrum of funds in terms of risk, it doesn't take excessive risks with the funds it offers; thus, its funds rarely are ranked number one over short time periods. 

Because of Vanguard's unique shareholder-owned structure (see the nearby sidebar "Vanguard's roots: The Bogle difference"), the average operating-expense ratio of its funds — 0.22 percent per year for U.S. stock funds, 0.29 percent for international stock funds, and 0.14 percent for bond funds — is lower than that of any other fund family in the industry.  In fact, the average fund family's expense ratio is a whopping four times higher than Vanguard's.  Vanguard also offers its Admiral series of funds with lower expense ratios for higher balance customers and low-cost exchange-traded funds (see Chapter 5). 

A pioneer in the field, Vanguard was the first to offer to the public index funds, which are unmanaged portfolios of the securities that comprise a given market index.  Many fund companies have since added index funds to their lists of offerings.  But Vanguard is still the indexing leader with the broadest selection of index funds and the lowest operating expenses in the business. ( I talk more about the advantages of index funds in Chapter 10.) 

Vanguard's low expenses translate into superior performance.  Especially with money market and bond funds (markets in which even the best fund managers add relatively little value), Vanguard's funds are consistently near the head of the class. 

  Vanguard is best at funds appealing to safety-minded investors — those who want to invest in money market, bond, and conservative stock funds.  However, Vanguard also offers aggressive stock funds with solid performance and low-expense ratios (see Chapter 13 for the list).  In managing stock funds, where performance is supposed to be more closely tied to the genius of the fund manager, Vanguard's thriftiness enhances performance. 

Vanguard's roots: The Bogle difference

In the early 1970s when Vanguard was formed, John Bogle, its founder and former CEO, made the big decision that to this day clearly differentiates Vanguard from its competition: Vanguard distributes funds and provides shareholder administration on an at-cost basis — that is, with no markup. 

Bogle insisted that the management of most of the stock funds be contracted out to private money management firms, from whom Vanguard would negotiate the best deals.  Thus, Vanguard's mutual fund investors would own the management company.  Contrast this arrangement to that of traditional fund companies, in which the parent management company receives the profits from managing the funds. 

Bogle felt that this unique corporate structure ensured that fund shareholders would obtain the best deals possible on money managers. " Funds ought to be run for the benefit of shareholders, not for the fund managers," Bogle reasoned.  History has proven Bogle not only to be right but also to be a mutual fund investor's best advocate. 

Fidelity Investments

  Fidelity Investments is the second largest mutual fund company in America.  A mutual fund Goliath, Fidelity offers hundreds of funds.  As evidence of Fidelity's enormous buying power, representatives from dozens of companies visit its Boston offices every day.  Most mutual fund managers have to travel to the companies they're interested in researching; if you're a Fidelity mutual fund manager, however, many companies come to you. 

  Fidelity's roots trace back to the 1940s, when Edward C. Johnson II took over the then-fledgling Fidelity Fund from its president, who felt that he couldn't make enough money as the head of an investment fund!  Johnson's son, Ned (Edward C. Johnson III), assumed Fidelity's top position in 1972 and has clearly proven that you can make a truckload of money operating mutual funds: He's personally worth billions. 

If you're venturing to do business with Fidelity on your own, you have your work cut out for you.  One of the biggest problems novice investors have at Fidelity is discerning the good funds from the not-so-good ones. ( My book separates the best from the rest and highlights which Fidelity funds are worthy of your investment dollars.) 

  I specifically advise shunning the following types of funds at Fidelity:

  Bond funds: Relative to the best of the competition, Fidelity's bond funds charge higher operating expenses that depress an investor's returns. ( Note: For larger balance customers, Fidelity offers a decent series of bond funds known as Spartan funds that have lower operating expense ratios — see Chapter 11.) 

Funds with branch offices: Even better? 

Many mutual fund companies have their offices in one location.  If you happen to live in the town or city where they're located and want to do business with them, you can visit them in person.  However, odds are that, unless you maintain several homes, you won't be living near the fund companies with which you want to do your fund-investing business. 

Some fund companies, such as Fidelity, have greater numbers of branch offices, which are located primarily in densely populated and more affluent areas.  You may feel more comfortable dropping a check off or speaking to an investment representative face to face instead of being navigated through an automated voice message system or mouse-clicking through a Web site.  However, there's no sound financial reason that you need to go in person to a fund company —you can do everything you need to do by phone, mail, or computer. 

In most cases, you pay a cost for doing your fund investing through firms with branch offices.  Operating all those branch offices in areas where rent and employees don't come cheaply costs a good chunk of money.  Ultimately, firms that maintain a large branch network need to build these extra costs into their funds' fees.  Higher fees lower your investment returns. 

A counterargument that fund companies with many branch offices make is that if the branch offices succeed in enticing more investors to use the funds offered by the company, more total money is brought in.  Having more money under management helps to lower the average cost of managing each dollar invested. 

  Adviser funds: Fidelity sells this family of load funds through investment salespeople; these funds carry high sales loads or high ongoing fees. 

  Sector funds: You should also avoid Fidelity's sector funds (Select), which invest in just one industry — such as air transportation, insurance, or retailing.  These funds have rapid changeover of managers.  Being industry focused, these funds are poorly diversified (highly concentrated) and quite risky.  Fidelity, unfortunately, encourages a trader mentality with these funds. 

One of Fidelity's strengths is its local presence — it operates 100+ branch offices throughout the United States and staffs its phones 24 hours a day, 365 days a year. 

Dodge & Cox

Dodge & Cox is a San Francisco–based firm that has been in the fund business since the Great Depression.  It's best known for its conservatively managed funds with solid track records and modest fees. 

Unfortunately for new investors, from time to time, Dodge & Cox has closed some of its funds.  The company did so to keep funds from becoming too bloated with assets to manage, which could undermine the performance of those funds.  Thanks to the severe stock market decline in the late 2000s, all its funds were reopened and remain so as of this writing.  However, if any of its funds appeal to you, you should establish an account in case it shuts any of its funds again to new investors. 

Oakmark

Harris Associates, which has managed money since 1976, is the investment management company that oversees the management of Oakmark, this value-oriented Chicago-based family of funds. 

As with the Dodge & Cox funds (see the preceding section), a number of the best Oakmark funds have closed from time to time to new investors.  As of this writing, all its funds are open.  Be aware that when some of its funds have closed in the past, investors who establish accounts directly with Oakmark can still buy some of the closed funds. 

T. Rowe Price

Founded in 1937, T. Rowe Price is one of the oldest mutual fund companies — named after its founder, T. (Thomas) Rowe Price, who's generally credited with popularizing investing in growth-oriented companies.  The fund company has also been a fund pioneer in international investing. 

T. Rowe Price remained a small company for many years, focusing on its specialties of U.S. growth stocks and international funds.  That stance changed in recent decades as the company offered a comprehensive menu of different fund types.  It offers 401(k) retirement plans specifically for smaller companies.  The fund company also offers a series of lower cost money market and bond funds called Summit funds with a minimum initial investment of $25,000. 

TIAA-CREF

This nonprofit organization provides an array of investment services to education, hospitals, and other nonprofit organizations and offers a solid family of funds to the general public.  Its funds have low operating expense ratios and are conservatively managed. 

Headquartered in New York City, the company has major operations in Charlotte, North Carolina, and Denver, Colorado, as well as about 60 local offices.  The organization got its start in 1918 when Andrew Carnegie and his Carnegie Foundation established a pension system for professors.  Funding initially came from grants from the foundation and Carnegie Corporation of New York, and regular contributions from participating institutions and individuals.  Today, TIAA-CREF invests more than $400 billion on behalf of investors. 

  The funds' low minimums make them a good choice for investors with smaller sums to invest.  They have no-minimum-investment IRAs with no annual administrative fees. 

Other fund companies

With so many companies offering mutual funds, the number of them competing for your mutual fund dollars far exceeds those that are worthy of your consideration.  But here are some additional noteworthy fund companies:

  Artisan: This small family of well-managed stock funds is headquartered in Milwaukee, Wisconsin.  Unfortunately, as the popularity of some of its funds has grown over the years, some of them have closed.  As of this writing, the Artisan International Small Cap Fund, Artisan Mid Cap Fund, Artisan Mid Cap Value Fund, and Artisan Small Cap Value Fund are closed to new investors. 

  Harbor: Based in Toledo, Ohio, Harbor Funds contracts with outside money managers who manage money for affluent individuals and institutions.  Although Harbor fund managers don't take great risks, their funds are expected to — and are generally able to — outperform comparable market indexes. 

  Masters' Select: The investment advisory firm of Litman/Gregory, which manages money for affluent individuals and institutions, developed this unique and small family of funds in 1997.  Each of the funds within this family, which is based in Orinda, California, contracts out the actual management of the investment dollars to a handful of top fund managers. 

  USAA: Headquartered in San Antonio, Texas, USAA is a conservative family of efficiently managed mutual funds (and generally low-cost, high-quality insurance).  Although you (or a family member) need to be a military officer, enlistee, or military retiree to gain access to its homeowner and auto insurance, anyone can buy its mutual funds.  USAA also offers investors, with small amounts to invest (minimum of $50 monthly) and without several thousand dollars required to meet fund minimum requirements, the ability to invest via electronic monthly transfers.  For more info on USAA's funds, check out its Web site at www.usaa.com/inet/ent_utils/McStaticPages?key=investments_mutual_funds_main. 

  Hundreds of mutual fund companies offer thousands of funds.  Many aren't worth your consideration because they don't meet the common-sense selection criteria outlined in Chapter 7.  So if you're wondering why I didn't mention a particular fund family, it's probably because the record shows that its funds are high cost, low performance, managed in a schizophrenic fashion, or all of the above.  Check them out against the criteria in Chapter 7 to see for yourself. ( Note: In Part IV, where I recommend specific funds in varying fund categories, I also mention some other funds offered by companies that aren't specifically written up in this chapter.) 

One of the beauties of all the fund choices out there is that you don't have to settle for mediocre or inferior funds.  If you're wondering what to do with such funds that you already own, please read Chapter 17. 

Discount Brokers: Mutual Fund Supermarkets

For many years, you could only purchase no-load mutual funds directly from mutual fund companies.  If you wanted to buy some funds at, say, Vanguard, Oakmark, T. Rowe Price, and Dodge & Cox, you needed to call these four different companies and request each firm's application.  So you ended up filling out four different sets of forms and mailing them in with a separate check to each of the companies. 

Soon, you received separate statements from each of the four fund companies reporting how your investments were doing. ( Some fund companies make this even more of a paperwork nightmare by sending you a separate statement for each individual mutual fund that you buy through them.) 

Now suppose that you wanted to sell one of your T. Rowe Price funds and invest the proceeds at Oakmark.  Doing so was also a time-consuming pain in the posterior, because you had to contact T. Rowe Price to sell, wait days for it to send you a check for the sale's proceeds, and then send the money with instructions to Oakmark.  Shopping this way can be tedious.  Imagine wanting to make a salad and having to go to a lettuce farm, a tomato farm, and an onion farm to get the ingredients.  That's why we have supermarkets! 

In 1984, Charles Schwab came up with the idea to create a supermarket for mutual funds.  Charles Schwab is the discount broker pioneer who created the first mutual fund supermarket (which other discount brokers have since copied) where you can purchase hundreds of individual funds from dozens of fund companies — one-stop mutual fund shopping. 

The major benefit of such a service is that it greatly simplifies the paperwork involved in buying and selling different companies' mutual funds.  No matter how many mutual fund companies you want to invest in, you need to complete just one application for the discount broker.  And instead of getting a separate statement from each company, you get one statement from the discount broker that summarizes all your mutual fund holdings. ( Note: You still must maintain separate nonretirement and IRA accounts.) 

Moving from one company's fund into another's is generally a snap.  The discount broker can usually take care of all this with one phone call from you.  Come tax time, you receive just one 1099 statement summarizing your fund's taxable distributions to record on your tax return. 

  You weren't born yesterday, so you know that all this convenience must have a catch.  Here's a hint: Because discount brokers serve as intermediaries for the buying and selling of funds and the time and money spent sending you statements, they expect to make some money in return.  So guess what?  It costs you more to use a discount broker.  Discount brokers charge you a transaction fee whenever you buy or sell most of the better funds that they offer.  Leading discount brokers typically charge a flat fee of around $35. 

Buying direct versus discount brokers

Buying funds directly from fund companies versus buying funds through a discounter's mutual fund supermarket isn't inherently better.  For the most part, it's a trade-off that boils down to personal preference and individual circumstances. 

Why to buy funds direct

Many reasons exist to buy funds directly from the company.  Here are a few:

  You're thrifty.  And you can take that as a compliment.  Being vigilant about your investing costs boosts your returns.  By buying direct from no-load fund companies, you avoid the discount brokerage transaction costs. 

  You don't have much money to invest.  If you're investing less than $5,000 per fund, the minimum transaction fees of a discount broker will gobble up a large percentage of your investment.  You don't have to hassle with transaction fees when you buy direct from a no-load fund company. 

  You're content investing through one of the bigger fund companies with a broad array of good funds.  For example, if you deal directly with one mutual fund company that excels in all types of funds, you can minimize your fees and maximize your investment returns.  Given the breadth and depth of the bigger companies' fund selections, you should feel content centralizing your fund investments through one of the better companies.  However, if you sleep better at night investing through multiple fund companies' funds, I won't try to change your mind. 

  Given the fact that most of the major fund companies, such as Vanguard, Fidelity, and T. Rowe Price, have discount brokerage divisions offering mutual funds from companies other than their own, you could use one of these companies as your base and have the best of both worlds.  Suppose, for example, that you want to invest a large portion but not all your money in Fidelity funds.  By establishing a discount brokerage account at Fidelity, all your Fidelity fund purchases would be free of transaction fees; then through that same account, you could also buy other fund companies' funds. 

Why to buy through a discount broker

Here are the main reasons to go with a discount broker:

  You want to invest in funds from many fund companies.  In general, different fund companies excel in different types of investments: You may want to build a portfolio that draws on the specific talents of various companies.  Although you can buy directly through each individual fund company, the point eventually comes where the hassle and clutter just aren't worth it.  The one-stop shopping of a discount broker may well be worth the occasional transaction fee. 

  You hate paperwork.  For those of you out there whose disdain of paperwork is so intense that it keeps you from doing things that you're supposed to do, a discount broker is for you. 

  You want easy access to your money.  Some discount brokerage accounts offer such bells and whistles as debit cards and unlimited check-writing privileges, making it simple for you to tap in to your money. ( That can be a bad thing if this tempts you to spend your money!) 

  You want to buy into a high-minimum fund.  One unique feature available through some discount broker's fund services is the ability to purchase some funds that aren't normally available to smaller investors. 

    You want to buy funds on margin.  Another interesting but rarely used feature that comes with a brokerage account is that you can borrow on margin (take out a loan from the brokerage firm) against mutual funds and other securities (which are used as collateral) held in a nonretirement account.  Borrowing against your funds is generally lower cost than your other loan options, and it's potentially tax deductible.  That said, buying and holding funds on margin can be costly and risky, and you may be forced to sell some funds or add cash to your account if the value of your investments declines too much. 

  You have a way (that involves hassle) to buy and sell your funds and use a discounter but reduce the total transaction fees: Purchase your funds initially from the mutual fund company and then transfer the shares at no charge into a discount brokerage account.  Conversely, when you're ready to sell shares, you can transfer shares from the discounter to the mutual fund company before you're ready to sell. ( See Chapter 16 for details about transfer forms.) 

Debunking "No Transaction Fee" funds

After several years of distributing funds for all these different fund companies, discount brokers came up with another innovation.  Discount brokers were doing a lot for mutual fund companies (for instance, handling the purchase and sale of funds, as well as the ongoing account recordkeeping and reporting), but they weren't being paid for all their work. 

In 1992, Charles Schwab & Company negotiated to be paid an ongoing fee to service and handle customer accounts by some mutual fund companies.  Today, through Schwab and other discount brokers who replicated this service, you can purchase hundreds of funds without paying any transaction fees (that is, you pay the same cost as if you'd bought the funds through the mutual fund company itself).  These are called No Transaction Fee (NTF) funds. 

On the surface, this idea certainly sounds like a great deal for you — the mutual fund investor wanting to buy funds from various companies through a discount brokerage account.  You get access to many funds and one account statement without paying transaction fees. 

  The no-transaction fee fund is a case of something sounding much better than it really is.  Although some discount brokers say or imply that NTF funds are free, they're hardly free.  Discount brokers are able to waive the transaction costs only because the participating fund companies have agreed to foot the bill.  In a typical arrangement, the participating fund company shares a portion of its operating expense ratio with the discount broker handling the account.  But as you know if you read Chapter 7, annual operating expenses are drawn from the shareholders' investment dollars.  So in the end, you're still the one paying the transaction costs. 

As a group, NTF funds are inferior to the best no-load funds that you pay the discounters a transaction fee to purchase because NTF funds tend to

  Have higher operating expenses than non-NTF funds

  Be offered by smaller, less experienced fund companies who may be struggling to compete in the saturated mutual fund market

You'll notice that big, well-established fund companies (including the ones discussed earlier in this chapter, such as Vanguard, Fidelity, and T. Rowe Price) don't participate in NTF programs.  They don't have to; the demand for their funds is high even with transaction costs. 

  In their rush to sign up more NTF funds, some discounters have ignored the quality of the NTF funds they offer.  Some financial publications encourage and effectively endorse this lack of quality control by giving higher ratings (in articles purporting to review and rate various discount brokers) to those discounters offering more "free" funds to customers.  As with a restaurant meal, more isn't always better — quality counts as well! 

  Whenever you make a mutual fund investment decision through a discount broker, try not to be influenced by the prospect, or lack thereof, of a transaction fee.  In your efforts to avoid paying a small fee today, you can end up buying a fund with high ongoing fees and subpar performance.  If you're so concerned about paying additional fees, deal directly with mutual fund companies and bypass the discount brokers and their transaction fees. 

Using the best discount brokers

Although I've spoken of mutual fund companies and discount brokers as separate entities, the line between them has greatly blurred in recent years.  For example, Schwab started as a discount broker but later began selling its own mutual funds.  Other companies started selling mutual funds but have now moved into the discount brokerage business.  The most obvious example is Fidelity, which offers brokerage services through which you can trade individual securities or buy many non-Fidelity mutual funds. 

  Vanguard and T. Rowe Price have excellent discount brokerage divisions that offer an extensive array of funds from other leading fund companies and charge competitive transaction fees.  Vanguard charges $35 per trade and $3 for regularly scheduled dollar-cost averaging trades (minimum of $100); T. Rowe Price charges $35 per trade. 

  The discount brokerage services of Fidelity, Vanguard, or T. Rowe Price make a lot of sense if you plan on doing the bulk of your fund investing through their respective funds.  Remember, you only have to pay brokerage transaction fees on funds offered by other fund companies.  You won't pay for buying a Fidelity fund from Fidelity or a Vanguard fund from Vanguard or a T. Rowe Price fund from T. Rowe Price. 

If you're already wondering how to get in touch with the companies that I recommend in this chapter, check out the Appendix, which includes the phone numbers, Web sites, and mailing addresses for all these companies.  But before you put the cart before the horse, I strongly recommend that you at least read through Part IV of this book.  That's where I recommend specific funds and discuss how to assemble a top-notch portfolio of funds. 

Places to Pass By

  Don't base your investment decisions on your gut: Some mutual fund companies have plush offices and they charge relatively high fees for their funds (to pay for all their overhead costs) or sell poorly performing funds — or both.  What types of places are likely to make you feel comfortable but lead you astray?  Many people do their fund investing through a list of wrong places:

  The First Faithful Community Bank: Many people feel comfortable turning their money over to the friendly neighborhood banker.  You've done it for years with your checking and savings accounts.  The bank has an impressive-looking branch close to your home, complete with parking, security cameras, and a vault.  And then there's that FDIC insurance that guarantees your deposits.  So now that your bank offers mutual funds, you may feel comfortable taking advice from the "investment specialist" or "consultant" in the branch (and may erroneously believe that the funds it sells carry FDIC coverage). 

Well, the branch representative at your local bank is probably a broker who's earning commissions from the mutual funds he's selling you.  Bank funds generally charge sales commissions and higher operating expenses and generally have less-than-stellar performance relative to the best no-load funds.  And because banks are relatively new to the mutual fund game, the broker at your bank may have spent last year helping customers establish new checking accounts and may have little knowledge and experience with investments and mutual funds.  Remember, if he's working on commission, he's a salesperson, not an adviser.  And the funds he's selling are load funds.  You can do better. 

  Plunder and Pillage Brokerage Firm: Brokers work on commission, so they can and will sell load funds.  They may even try to hoodwink you into believing that they can do financial planning for you.  Don't believe it.  As I discuss in Chapter 7, purchasing a load fund has no real benefit; you have better alternatives. 

  Fred, the Friendly Financial Planner: You may have met Fred through a free seminar, adult education class, or a cold call that he made to you.  Fred may not really be a financial planner at all; instead, he could be a salesperson/broker who sells load funds. ( If you want to hire an objective planner or adviser for investing in funds, see the next section.) 

  Igor, Your Insurance Broker: Igor isn't just selling insurance anymore.  He now may sell mutual funds, as well, and may even call himself a financial consultant. ( See the preceding remarks for brokers.) 

  The Lutheran-Turkish-Irish-Americans-Graduated-from-Cornell-and-Now-Working-in-the-Music-Business Fund: Hoping to capitalize on the booming fund business, special interest groups everywhere have been jumping in to the fray with funds of their own.  Don't be surprised if your church, your alma mater, or your ethnic group makes a passionate pitch to pool your money with that of like-minded individuals in the hands of a manager who truly understands your background. 

Although something can possibly be said for group solidarity, I suggest leaving your nest egg alone.  Such special-interest funds carry loads and high operating fees and, because they have relatively little money to manage, are usually managed by money managers with little experience. 

Hiring an Adviser: The Good, Bad, and Ugly

Dealing directly with various fund companies or simply selecting funds from among the many offered through a discount brokerage service may seem overwhelming to you.  But don't hire an adviser until you've explored the real reasons why you want to hire help.  If you're like many people, you may hire an adviser for the wrong reason.  Or you'll hire the wrong type of adviser, an incompetent one, or one with major conflicts of interest.  Check out the following sections for the highlights of why you should and why you shouldn't hire an adviser for overall advice. 

The wrong reason to hire an adviser

Don't hire an adviser because of what I call the crystal ball phenomenon.  Although you know you're not a dummy, you may feel that you can't possibly make informed and intelligent investing decisions because you don't closely follow or even understand the financial markets and what makes them move.  Don't believe any advisor who claims he saw particular events (for example, the early 2000s bear market, the late 2000s financial crisis) coming in advance and perfectly positioned his clients' investment portfolio. 

  No one who you hire has a crystal ball.  No one can consistently predict future movements in the financial markets to know which types of investments will do well and which ones won't.  Investing intelligently in mutual funds isn't that complicated.  You bought this book, so read it, and you find out all you need to know to invest wisely in funds. 

The right reasons to hire an adviser

  Consider hiring an adviser if

  You're too busy to do your investing yourself. 

  You always put off investing because you don't enjoy doing it. 

  You're uncomfortable making investing decisions on your own. 

  You want a second opinion. 

  You need help establishing and prioritizing financial goals. 

Beware of conflicts of interest

  The field of investment and financial planning is booby-trapped with land mines awaiting the naive investor.  A particularly dangerous one is the enormous conflict of interest that's created when "advisers" sell products that bring them commissions. 

If a financial planner or financial consultant sells products and works on commission, he's a salesperson, not a planner — just as a person who makes money selling real estate is a real estate broker, not a housing consultant!  There's nothing wrong with salespeople — you just don't want one spouting suggestions when you're looking for objective investment and financial-planning advice. 

  Here are some of the problems created by commission-based advice:

  Investments that carry commissions can pit your interests against those of the broker selling them.  The bigger the commission on a particular investment product, the greater the incentive the broker/planner/adviser has to sell it to you. 

  Investments that carry commissions mean that you have fewer dollars working in the investments you buy.  Commissions are siphoned out of your investment dollars.  When it comes to returns, non-commission investments have a head start over commission ones. 

  Investments that carry the highest commissions also tend to be among the costliest and riskiest financial products available.  They're inferior products; that's why they need high commissions to motivate salespeople to sell them. 

  Planners who work on commission have an incentive to churn your investments.  Commissions are paid out whenever you buy or sell an investment (every time you make a trade).  So some commission-greedy brokers/planners encourage you to trade frequently, attributing the need to changes in the economy or the companies in which you've invested.  Not only does heavy trading fatten the broker/adviser's wallet at your expense, but also it's a proven loser as an investment strategy. ( See Chapter 10 for more about investment strategies and your portfolio.) 

  Planners who work on commission may not keep your overall financial needs in mind.  You may want to fund your employer-sponsored retirement plan or pay off your mortgage or credit card debt before you start investing.  The commission-based and money-managing planner has no incentive to recommend such strategies for you; that would give you less money to invest through them. 

  Planners who work on commission may create dependency.  They may try to make it all so complicated that you believe you can't possibly manage your finances or make major financial decisions without them. 

Your best options for help

You must do your homework before hiring any financial adviser.  First, find out as much as you can about the topic you need help with.  That way, if you do hire someone to help you make investment and other financial decisions, you're in a better position to evaluate his or her capabilities and expertise. 

Realizing that you need to hire someone to help you make and implement financial decisions can be a valuable insight.  Even if you have a modest income or modest assets, spending a few hours of your time and a few hundred dollars to hire a professional can be a good investment.  The services that advisers and planners offer, their fees, and their competence, however, vary tremendously. 

Financial advisers make money in one of three ways:

  From commissions based on sales of financial products

  From fees based on a percentage of your assets that they're investing

  From hourly consultation charges

If you read the preceding section, you already know why the first option is the least preferred choice. ( If you really want to or are forced to work with an investment broker who works on commission, be sure to read the last section in this chapter — "If you seek a salesperson.") 

  A generally better choice than a commission-based broker is a planner who works on a fee basis.  In other words, the planner is paid by fees from clients such as you, instead of from the investments and other financial products that he or she recommends that you buy.  This compensation system removes the incentive to sell you products with high commissions and churn your investments through a lot of transactions to generate more commissions.  However, this system still has potentially significant conflicts of interest. 

Many of the leading discount brokerage and mutual fund companies now offer advisory services (either in-house or through referrals), which typically perform mutual fund management for a percentage of assets under their care.  With their in-house asset management, you probably won't be able to get the hand-holding, handshakes, and eye-to-eye contact that you would by hiring a local financial-planning firm.  However, if you're looking at hiring a financial adviser, I encourage you to consider and interview the advisory divisions of the firms discussed in this chapter.  Just be sure to put them through the questions that I recommend in Chapter 24. 

  The most cost-effective method is to hire an adviser who charges an hourly fee and doesn't sell investment and other financial products.  Because he doesn't sell any financial products, his objectivity should be greater.  He doesn't perform money management, so he can help you get your financial house in order and make comprehensive financial decisions, including selecting good mutual funds. 

  Your primary concern in selecting a planner, hourly based or otherwise, is hiring one who's competent.  You can address this by checking references and discovering the difference between good and bad financial advice.  You have further risk if you and the adviser don't clearly define the work to be done and the approximate total cost before you begin.  Don't forget to set your parameters upfront. 

A drawback of an entirely different kind occurs when you don't follow through on your adviser's recommendations.  You paid for this work but didn't act on it: The potential benefit is lost.  If part of the reason that you're hiring an adviser in the first place is that you're too busy or not interested enough to make changes to your financial situation, then you should look for this support in the services you buy from the planner. 

  If you just need someone as a sounding board for ideas or to recommend some specific no-load mutual funds, hire an hourly based planner for one or two sessions of advice.  You save money by doing the legwork and implementation on your own.  Just make sure that the planner is willing to give you specific enough advice that you can implement it on your own.  Some planners charge for developing a financial plan and then will withhold specific investing advice and recommendations to create the need for you to hire them to do more, perhaps even to manage your money. 

If you have a lot of money that you want managed among a variety of mutual fund investments, you can hire a financial adviser who charges a percentage of your assets under management.  Some also offer financial-planning services.  Some just manage money in mutual funds and other investments. 

  In the chapters ahead, I give you enough information for you to make wise mutual fund investing decisions.  You owe it to yourself to read the rest of the book before deciding whether to hire financial help.  Also, be sure to pay extra close attention to Chapter 24, which covers the ten issues to consider and questions to ask when hiring an adviser to help with mutual fund investing. 

If you seek a salesperson

Despite the additional (and hence, avoidable) sales charges that apply when you purchase a load fund instead of a no-load fund, you may be forced to, or actually want to, buy a load fund through a salesperson working on commission.  Perhaps you work for an employer that set up a retirement plan with only load funds as the investment option.  Or your Uncle Ernie, who's a stockbroker, will put you in the family doghouse if you transfer your money out of his firm and into no-load funds.  Maybe you really trust your broker because of a long-standing and productive investment relationship (but ask yourself this: Is your success because of the broker or the financial markets?). 

Protect yourself

  If you're comfortable and willing to pay commissions from 4 percent up to as much as 8.5 percent to invest in mutual funds, you have a number of ways to protect your money and well-being when working with brokers:

  Be aware that you're working with a broker.  Unlike the real estate profession in which an employee's title — real estate broker or agent — clearly conveys how she makes her money, many investment salespeople today have labels that obscure what they do and how they make money.  Common misnomers include financial planner, financial consultant, or financial adviser as names for salespeople who used to be called stock, securities, or insurance brokers. 

  Make sure that you've already decided what money you want to invest and how it fits into your overall financial plans.  This point is one of the most important things for you to do first if you're going to invest through a commission-based investment salesperson.  Guard against being pushed into dollar amounts and/or investments that aren't part of your financial plan. 

Make sure you get the best funds

If you've optimized the structuring of your finances and you have a chunk of money that you're willing to pay as a sales charge to invest in load funds, make sure that you're getting the best funds for your investment dollars.  The criteria to use in selecting those load funds are no different from those used to select no-load funds:

  Invest in funds managed by mutual fund companies and portfolio managers that have track records of expertise that take a level of risk that fits your needs, and that charge reasonable annual operating expenses. 

  Pay attention to the annual operating expenses that both load and no-load funds charge.  These fees are deducted from your funds' returns in much the same way that IRS taxes are deducted from your paycheck, with one critical difference: Your pay stub shows how much you pay in taxes, whereas your mutual fund account statement doesn't show the fund's operating expense charges.  You need the prospectus for that, and even then it won't show you what you paid in dollars for that. 

    Never invest in a mutual fund without knowing all the charges — sales charges, annual operating expenses, and any annual maintenance or account fees.  You can find all these in a fund's prospectus (see Chapter 8 for the scoop on how to decipher a prospectus). 
Part IV

Crafting Your Fund Portfolio

In this part . . . 

You start building a portfolio of funds to help you meet your goals.  I explain the fundamentals of putting a portfolio together, including such concepts as asset allocation, buy and hold versus market timing, and selecting tax-appropriate funds.  I recommend the best money market, bond, and stock funds for the job.  And just to make sure that I don't leave you hanging, I pull it all together for you in a chapter that shows you how real people construct fund portfolios and fit funds into their overall financial plans.  The last chapter of this part walks you through the paperwork you need to fill out to build your fund portfolio. 
Chapter 10

Perfecting a Fund Portfolio

In This Chapter

  Creating the best mix of funds for your situation

  Understanding how taxes factor into selecting funds

  Recognizing wise and unwise fund investing strategies

  Executing your plan

Although portfolio usually describes a collection of funds, it doesn't have to.  For certain goals, one or two funds may be all that you need (for example, a short-term bond fund and a money market fund for a home down payment).  Even for a long-term goal, such as retirement, you may select just one fund; some mutual fund companies offer funds of funds, which, as the name suggests, are mutual funds comprised of other mutual funds. ( See Chapter 13 for details on such funds.)  And although a portfolio is sometimes held inside one account, it doesn't have to be.  The funds that make up your retirement portfolio, for example, could be in numerous accounts from different investment companies. 

This chapter shows you how to draw up a blueprint for your investing goals that includes all the key considerations, including asset allocation (how you divvy up your portfolio among different investments), tax implications (especially for portfolios held outside of tax-sheltered retirement accounts), and some mutual fund investing strategies.  I then help you execute your plan. 

Asset Allocation: An Investment Recipe

Asset allocation simply describes the proportion of different investment types (stocks, bonds, international investments, and so on) that make up your mutual fund portfolio.  So if someone asks, "What's your asset allocation?"  a typical response may be, "I have 60 percent in stocks, a third of which is in foreign stocks, and 40 percent in bonds." 

  You may hear a mutual fund nerd spout off about his allocation using more detailed terminology including large-cap and small-cap stocks, or between growth funds and value funds.  Don't worry about these terms for now. ( Check out Chapter 13 for more information about these terms.) 

Allocating to reduce your risks

You wouldn't have to worry about asset allocation if it weren't for a simple investment truth: The greater an investment's potential return, generally the greater the chance and magnitude of a short-term loss.  If there were no chance of loss, you could throw asset allocation out the window.  No matter what your savings goal, you could put all your money into stocks.  After all, in comparison to bonds and money market investments, stocks should give you the biggest long-term returns (see Chapter 1 for more details).  If you had no chance of loss when investing in stocks, every dollar you saved would go to creating wealth in stocks.  Your net worth would balloon. 

In the real world, stocks are a volatile investment.  Although providing the highest long-term gains, stocks also carry the greatest risk of short-term loss (compared with putting your money in bonds or money market accounts). 

  Asset allocation, then, is all about striking the right balance between your desire for higher returns and your ability to withstand a short-term loss.  All things being equal, all people prefer higher returns.  And although everyone has a different personality and temperament about accepting risk, your realistic ability to withstand a loss depends primarily on your time horizon. 

Looking toward your time horizon

The time horizon of a financial goal is the length of time between now and the time when you expect to need the money to accomplish that goal.  If you're currently 30 years old and want to retire by age 60, then the time horizon of your retirement investments is 30+ years from now (even though you'll begin to use some of your retirement money at age 60, some of it won't be spent until later in your retirement).  If you're saving to buy a home by the time you're 35 years old, then the time horizon of that goal is five years from now. 

The longer your time horizon, the more able you are to withstand the risk of a short-term loss.  For example, if you have a 30-year time horizon for retirement investments, then a short-term loss isn't a big deal — your investments have plenty of time to recover.  Thus, you probably want more of your retirement dollars in growth investments, such as stocks. 

Short-term goals

  Asset allocation for goals with short time horizons is quite simple:

  Less than two years: If you have less than two years, you're generally best off sticking to money market funds.  Stocks and bonds are volatile, and although you have the potential for earning higher returns in stocks and bonds, a money market fund offers the combination of terrific safety and some returns.  See Chapter 11 for more on money market funds. 

  Between three and seven years: If your time horizon is between three and seven years, then consider using shorter-term bond funds. ( If you have between two and three years, you can use both money market and short-term bond funds.)  When you're able to keep your money in an investment for several years, then the extra potential returns from low-risk bonds begin to outweigh the risk of short-term loss from possible bond market fluctuations.  See Chapter 12 for more on bond funds. 

  Seven or more years: If your time horizon is seven years or more, I think that you have a long enough time horizon to start investing in stocks as well as longer-term bonds. 

  Some market pundits and those involved with money management refer to extended periods such as the 2000s as the lost decade.  These people will point to a market index such as the Dow Jones Industrial Average and exclaim that from the end of 1999 through the end of 2009, that index of 30 large U.S. company stocks essentially treaded water and ended the decade at about the same level it began the decade.  This statement is highly misleading and inaccurate.  During that decade, numerous U.S. and foreign stock indexes posted healthy returns of between 5 and 10 percent annually.  Bond investors did well over that period as well.  And, you should also remember that these folks are overlooking the dividend payments stock investors earn and that are not reflected in the quoted level of a given market index.  While some commentators are simply ignorant of these facts, others, especially those managing money, selling newsletters, and advocating market timing, have an agenda to convince you that buying and holding don't work and that you need their services to time the market.  Please see the section "Timing versus buy-and-hold investing," later in this chapter, as well as Chapter 20, which discusses market forecasters. 

Retirement and other long-term goals

Long-term goals, such as retirement and college tuition, require more complex asset allocation decisions than those demanded by short-term goals.  If you plan to retire in your 60s, your retirement portfolio needs to fund your living expenses for 20 or more years.  That's a tall order.  Unless you have vast wealth in comparison to your spending desires, the money you've earmarked for retirement needs to work hard for you.  That's why you should heavily weight a portfolio that you're investing for your future retirement, particularly during your earlier working years, toward investments with appreciation potential like stocks. 

  Your current age and the number of years until you retire should be the biggest factors in your retirement asset allocation decision.  The younger you are and the more years you have before retirement, the more comfortable you should be with growth-oriented investments, such as stock funds. 

As you approach retirement age, however, you should gradually scale back the risk and volatility of your portfolio.  That's why, as you get older, bonds should become an increasingly bigger piece of your portfolio pie.  Although their returns are generally lower, bonds are less likely to suffer a sharp downswing in value that could derail your retirement plans. 

Table 10-1 in the next section lists some guidelines for allocating money you've earmarked for long-term purposes, such as retirement.  All you need to figure out is how old you are (I told you investing was easier than you thought!)  and the level of risk you're comfortable with. 

Factoring in your investment personality

In Table 10-1, I add a new variable to the asset allocation decision: your investment personality, or tolerance for risk.  Even if you and another investor are the same age, and you both have the same time horizon for your investments, you could very well have different tolerances or desires to accept and deal with risk.  Some people are more apt to lose sleep over their investments, just as some people are scared by roller coasters, whereas other people get a thrill from them. 

Table 10-1 Asset Allocation Guidelines for the Long Haul

---

Your Investment Attitude | Bond Allocation (%) | Stock Allocation (%)

Play it safe | Age | 100 – age

Middle of the road | Age – 10 | 110 – age

Aggressive | Age – 20 | 120 – age

Be honest with yourself and invest accordingly.  If you're able to accept who you are instead of fighting it, you'll be a happier and more successful investor.  Here's my advice for how to categorize yourself:

  Play it safe: Indicators of this investment personality include little or no experience or success investing in stocks or other growth investments, fear of the financial markets, and risk-averse behavior in other aspects of life.  You may desire to be conservative with your investments if you have enough saved to afford a lower rate of return on your investments. 

  Middle of the road: Indicators of this investment personality include some experience and success investing in stocks or other growth investments, and some comfort with risk-taking behavior in other aspects of one's life. 

  Aggressive: Indicators of this investment personality include past experience and success investing in stocks or other growth investments — and a healthy desire and comfort with sensible risk-taking behavior in other aspects of one's life.  You may also want to be more aggressive if you're behind in saving for retirement and you want your money to work as hard as possible for you. 

What does it all mean, you ask?  Consider this example.  According to Table 10-1, if you're 35 years old and don't like a lot of risk but recognize the value of striving for some growth to make your money work harder (a middle-of-the-road type), you should put 25 percent (35 – 10) into bonds and 75 percent (110 – 35) into stocks. 

Divvying up your stocks between home and abroad

Your next major asset allocation decision is to divvy up your stock investment money between U.S. and international stock funds.  This step is an important one for keeping your portfolio properly diversified.  Although some consider international markets risky, putting all your stock market money into just one country is even riskier, even if the country is relatively large and familiar, such as the United States. 

  When the U.S. market slumps, some markets do better.  Moreover, developing countries have the potential for greater economic growth and stock market returns than the U.S. market.  Here's the portion of your stock allocation that I recommend investing overseas, guided by your investment attitude:

  Play it safe: 20 percent

  Middle of the road: 33 percent

  Aggressive: 40 to 50 percent

So if you're a 35-year-old, middle-of-the-road type who's investing 75 percent of your portfolio in stocks, you'd then put 33 percent of that stock money into international stock funds.  Multiplying 33 percent by 75 percent works out to be about 25 percent of the entire portfolio.  So you'd put 25 percent in bonds, 50 percent in U.S. stocks, and 25 percent in international stocks. 

  Gradual change is better than abrupt change.  If you've had little or no experience or success investing in stocks, you're better to start with the play-it-safe allocation and then work your way to riskier allocations as you develop more comfort and knowledge. 

College savings goals

Be careful when investing money for your child's college education.  Doing so the wrong way can harm your child's chances of getting needed financial aid and increase your tax burden (see Chapter 3 for more information). 

The strategy for allocating money in a college savings portfolio can be similar to that used for retirement money.  Assuming that your child is young, the goal is relatively long term, so the portfolio should emphasize growth investments, such as stocks.  However, as the time horizon decreases, bonds should play a bigger role.  The big difference, of course, between investing for your retirement and investing for your child's college costs is that the time horizon for college depends not on your age, but on the age of the child for whom you're investing. 

  Here's my rule for investing college money for your kids.  To figure how much money you should put in bonds, take the following numbers:

  Play it safe: 60 + child's age

  Middle of the road: 45 + child's age

  Aggressive: 30 + child's age

The rest of your college investment should go into stocks (with at least a third in stocks overseas).  Use this rule to adjust the mix as your child gets older.  For example, suppose that you have a 5-year-old, and you want to follow a middle-of-the-road approach when investing her college money.  In this case, you could invest approximately 50 percent (45 + 5) in bonds, with the remaining 50 percent in stocks, one-third of which you'd invest overseas. 

Taxes: It's What You Keep That Matters

  Like asset allocation, tax implications are a fundamental consideration in portfolio construction.  When you're constructing a mutual fund portfolio outside of a tax-sheltered retirement account, Uncle Sam gets to grab a share of your returns.  Part of what makes up a mutual fund's returns are dividend distributions and capital gains, which are subject to taxation. 

For this reason, when you're investing outside of tax-sheltered retirement accounts, you must distinguish between pre-tax and post-tax returns.  Think of it as the business world difference between revenue and profit.  Revenue is what a business collects from selling products and services; profit is what a business gets to keep after paying all of its expenses, and in the end, that's what really matters to a business.  Likewise, your after-tax return, not your pre-tax return, should matter most to you when you invest your money. 

Unfortunately, all too many investors (and often their advisers) ignore the tax consequences and invest in ways that increase their tax burdens and lower their effective returns.  For example, when comparing two similar mutual funds, most people prefer a fund that earns returns of 13 percent per year on average to a fund that earns 12 percent.  But what if the 13 percent per year fund causes you to pay a lot more in taxes?  What if, after factoring in taxes, the 13 percent per year fund nets you just 9 percent, while the 12 percent per year fund nets you an effective 10 percent return? 

In the following sections, I help you plan how funds fit in your portfolio, given your current tax bracket, and how to ensure that the tax bite is as painless as possible.  Check out Chapter 18 for all the ins and outs of accounting for your funds when filing your tax return. 

Fitting funds to your tax bracket

Fortunately, you can pick your funds to minimize the federal and state governments' shares of your returns.  Some funds, for example, are managed to minimize highly taxed distributions, and certain government bond funds focus on investments that generate tax-free income. 

Understanding ordinary (marginal) income tax rates

To choose the right funds for your investment purposes, you must know your marginal tax rate, which is the rate you pay on the last dollar you earn.  For example, if you earned $50,000 last year, the marginal rate is the rate you paid on the dollar that brought you from $49,999 to $50,000.  The government charges you different tax rates for different parts of your annual income. 

You pay less tax on your first dollars of earnings and more tax on your last dollars of earnings.  For example, if you're single and your taxable income totaled $50,000 during 2010, you paid federal tax at the rate of 10 percent on the first $8,375 of taxable income, 15 percent on the income from $8,375 to $34,000, and 25 percent on income above $34,000 (see Table 10-2).  The rate you pay on those last dollars of income (25 percent) is your marginal rate. 

Your marginal tax rate allows you to quickly calculate how much tax you owe on additional salary and certain types of nonsalary income, such as

  Interest from taxable bonds

  Interest from taxable money market funds

  Short-term capital gains (that is, gains from investments sold after being held for one year or less)

Suppose that on top of your $50,000 salary you have some bond funds that pay taxable interest in a nonretirement account that distributed $1,000 of dividends.  Because you know your marginal tax rate — 25 percent — you know that Uncle Sam gets $250 of that $1,000 distribution ($1,000 × 25 percent).  Note that states generally also levy income taxes.  Table 10-2 shows federal tax rates for singles and for married couples filing jointly. 

Table 10-2 2010 Federal Income Tax Brackets and Rates

---

Singles' Taxable Income | Married-Filing-Jointly Taxable Income | Federal Tax Rate

Less than $8,375 | Less than $16,750 | 10%

$8,375 to $34,000 | $16,750 to $68,000 | 15%

$34,000 to $82,400 | $68,000 to $137,300 | 25%

$82,400 to $171,850 | $137,300 to $209,250  | 28%

$171,850 to $373,650 | $209,250 to $373,650 | 33%

More than $373,650 | More than $373,650 | 35%

Lower tax rates on stock dividends and long-term capital gains

In 2003, a major federal tax bill significantly lowered the tax rate applied to

  Dividends paid by corporations (domestic or foreign) on their stock

  Long-term capital gains (from profits on appreciated investments sold after being held for more than one year)

For those in the four highest federal income tax brackets listed in Table 10-2 (25, 28, 33, and 35 percent), the tax rate on stock dividends and long-term capital gains is just 15 percent.  And, get this, stock dividends and long-term capital gains are tax-free for taxpayers in the 10 and 15 percent federal income tax brackets! 

  Although the income paid on bond funds and money market funds is called a dividend, such income doesn't qualify for the new, lower federal income rates on stock dividends.  Dividend income that you receive from mutual funds holding stocks qualifies for the lower dividend tax rate. 

Minimizing your taxes on funds

Now that you're equipped with knowledge about your tax bracket and tax rates on various fund distributions (if you don't have a clue and skipped the preceding section, you may want to visit it before continuing here), the following sections enable you to understand how to select tax-friendly mutual funds when investing outside of retirement accounts. 

Use tax-free money market and bond funds

Certain kinds of money market and bond funds invest only in bonds issued by governments, and depending on the type of government entity they invest in, their dividends may not be subject to state and/or federal tax. 

Such funds are typically identified by the words Treasury or municipal in their fund titles:

  A Treasury fund buys federal-government-issued Treasury bonds (also called Treasuries), and its dividends — although federally taxable — are free of state taxes. 

  The dividends of a municipal bond fund, which invests in local and state government bonds, are free of federal tax, and if the fund's investments are limited to one state and you live in that state, the dividends are free of state taxes as well. 

Because Treasuries and municipal bonds aren't subject to complete taxation, the governments issuing these bonds can pay a lower rate of interest than, say, comparable corporate bonds (the dividends on which are fully taxable to bondholders).  Therefore, before taxes are taken into account, tax-free bond and money market funds yield less than their taxable equivalents. 

  However, after taxes are taken into account, you may find that with tax-free money market or bond funds, you come out ahead of comparable taxable funds if your tax bracket is high enough.  Because of the difference in taxes, the earnings from tax-free investments can end up being greater than what you're left with from comparable taxable investments.  If you're in the 28 percent federal bracket or higher (see Table 10-2), see Chapters 11 and 12 for details on tax-free money market and bond funds. 

  Don't buy tax-free funds inside retirement accounts.  Your returns inside a retirement account are already sheltered from taxation.  Ignore the taxability of funds and go for the highest yields. 

Invest in tax-friendly stock mutual funds

Unfortunately, stock mutual funds don't have a tax-free version like bond and money market funds do.  Unless they're held inside a retirement account, stock fund distributions are taxable.  However, as discussed in the previous sections, not all stock distributions and returns are treated equally from an income tax standpoint.  With stock funds, more than any other type of fund, investors often focus exclusively on the pre-tax historical return, ignoring the tax implications of their fund picks. 

You can invest in stock funds that are tax friendly — in other words, funds whose investing style keeps highly-taxed distributions to a minimum.  Here's how stock funds can minimize taxable distributions:

  Buy-and-hold investing: Dividends and capital gains are two types of stock fund distributions.  Capital gains distributions are generated when a fund manager sells a stock for a profit; that profit must then be given out to the shareholders annually.  Some fund managers engage in frequent trading, which can cause their funds to produce more distributions.  But other fund managers are buy-and-hold investors.  These managers tend to produce fewer capital gains distributions than their peers who trade frequently. 

  Index mutual funds and exchange-traded funds tend to produce fewer capital gains distributions because they hold their securities longer. ( For more on indexing, see "Fund Investing Strategies" later in this chapter, as well as Chapter 13 for more details on stock index funds.) 

  Long-term capital gains: Although no capital gains' distributions are best for minimizing taxes, a good manager ultimately sells some stocks at a profit when he sees better opportunities elsewhere.  When a fund manager does sell stocks at a profit, you pay a far lower tax rate when these realized gains are long term — from stocks held more than one year. ( See the section "Lower tax rates on stock dividends and long-term capital gains," earlier in this chapter.) 

  Offsetting gains with losses: If a fund manager sells some stock for a gain of $10,000 but sells other stock for a loss of $10,000, the capital gains net out to zero.  Some funds, managed specifically to minimize distributions, employ this offsetting technique to lower their capital gains.  I identify the best of these tax-managed stock funds in Chapter 13. 

Watch the calendar

  When purchasing stock mutual funds outside of tax-sheltered retirement accounts, consider the time of year at which you purchase shares in funds.  December is the most common month in which mutual funds make capital gains distributions.  Most funds also make a dividend distribution around that time as well. ( Dividends are also sometimes distributed at other times of the year, especially on bond funds.) 

  Don't invest in a fund just before it makes a large distribution.  You're not reaping any rewards from the capital gains distribution because, right after such a distribution, the fund's share price decreases to reflect the size of the payout.  You are, however, effectively making yourself liable for taxes on gains you didn't share in. 

When making purchases late in the year, find out whether and when the fund may make a significant capital gains and dividend distribution.  Fund companies can usually tell you, in advance of the actual capital gains and dividend distribution, approximately how much they expect the distribution to be. 

Fund Investing Strategies

In this section, I discuss some of the different investing strategies and philosophies that you can use to direct a mutual fund portfolio, and I also explain which ones are best for you and which ones to avoid.  Having an overarching strategy is vital for many reasons.  Without a clear plan and approach, you'll have less success, more anxiety, and more temptation to fall prey to sales pitches and unsound approaches. 

Timing versus buy-and-hold investing

Over the past two centuries, stocks have produced an average return of about 9 to 10 percent per year.  Some individual years are better, with stocks returning up to 20 or even 30 percent or more; other years are worse, with stocks losing 20 percent or more in value.  But when taken over a period of decades, the up years and the down years historically net out to returns of about 9 to 10 percent per year. 

Despite the long-term healthy returns stocks generally produce, it's disconcerting to some people to invest their money into something that can decline.  Many newsletters, advisers, and the like claim to predict the future movement of the financial markets.  On the basis of such predictions, these folks advocate timing the purchase and sale of securities, such as stocks, to maximize returns and minimize risks. 

  Although market timing sounds good in theory, a wealth of studies and evidence shows that market timing simply doesn't work in practice. ( In Chapter 20, I discuss the historically poor track record of investment newsletters that attempt market timing.)  In fact, those who try to time the markets inevitably do worse than those who simply buy and hold, because they too often miss the right times to buy and sell. 

Market timing is based on that age-old investment mantra, "Buy low, sell high."  It sounds so simple and logical; perhaps that's what makes it such an attractive concept.  One fundamental problem, however, destroys the logic: Recognizing a low or a high comes only with hindsight; market movements, especially in the short term, are unpredictable.  Telling someone to buy low and sell high is similar to telling someone that it's okay to drive his car if he expects not to have an accident and that he should stay out of his car if he expects to have an accident! 

If buying and holding had an investment mantra, it would be "Buy now, sell much later."  Instead of betting on short-term market movements, buy-and-hold investors do their homework and select solid funds and rely on long-term trends and aren't so concerned with when to get in and out of the market as much as how long they're actually in there.  Buy-and-hold investors know that if they hang in there through the inevitable tough times, the good years outnumber the bad, and they come out ahead. 

  Don't jump in and out of funds.  After you've bought into a decent fund, you have few good reasons to move out of it (see Chapter 17).  Not only does buy-and-hold investing offer better returns, but also it's less work and hassle. 

Active versus index fund managers

Unlike other mutual funds, in which the portfolio manager and a team of analysts scour the market for the best securities, an index fund manager passively invests to match the performance of an index.  Index funds are funds that can be (and, for the most part, are) managed by a computer, with intelligent human oversight.  An index fund manager invests the fund's assets so as to replicate an underlying index, such as Standard & Poor's 500 index — 500 large-company U.S. stocks.  An S&P 500 index fund generally buys and holds the same 500 stocks, and in the same approximate amounts, that comprise the S&P 500 Index. 

Index funds are underrated — they don't get the credit they deserve.  Index funds are a little bit like Jaime Escalante, that Garfield High School math teacher of poor children in the ghettos of Los Angeles (see the terrific movie, Stand and Deliver, about him).  In a school where kids often dropped out and were lucky to learn some algebra, Escalante got his kids to master calculus.  In fact, he got entire classes to work hard and pass the college advanced placement exam for calculus. ( The College Board that administers the AP test couldn't believe that so many kids from this school could pass this exam, so the kids were investigated for cheating — that's how Escalante's story was discovered, and he finally got credit for all the great work that he did.) 

Low-cost index funds work hard by keeping expenses low, staying invested, and holding on to a relatively fixed list of stocks.  So, like Escalante's kids, index funds are virtually guaranteed to be at the top of their class.  Over long periods (ten years or more), index funds outperform about three-quarters of their actively-managed peers investing in the same types of securities!  Most actively managed funds can't overcome the handicap of high operating expenses that pulls down their funds' rates of return.  Because significant ongoing research doesn't need to be conducted to identify companies to invest in, index funds can be run with far lower operating expenses. ( Please also see Chapter 5 for a discussion of the exchange-traded funds, which are index funds you can buy and sell on a stock exchange.) 

The average U.S. stock fund has an operating expense ratio of 1.5 percent per year. ( Some funds charge expenses as high as 2 percent or more per year.)  That being the case, a U.S. stock index fund with an expense ratio of just 0.2 percent per year has an average advantage of 1.3 percent per year.  A 1.3 percent difference may not seem like much, but in fact, the difference is significant.  Because stocks tend to return about 10 percent per year, you're throwing away about 13 percent of your expected stock fund returns when you buy a non-index fund.  If you factor in the taxes that you pay on your fund profits, these higher expenses gobble even more of your after-tax profits. 

  Another often overlooked drawback to actively managed stock funds: Your fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks.  An actively managed fund can easily underperform the overall market index that it's competing against.  An index fund, by definition, can't. 

Table 10-3 lists the worst-performing U.S. stock funds over the past decade.  Note how much worse these bowser funds performed versus the broad U.S. stock market index.  The past decade was one of the worst for U.S. stocks in history for sure, but you can clearly see that the worst funds underperformed relevant market indexes by about 12 to 30 percent per year over this decade long time span! 

Table 10-3 Worst Performing U.S. Stock Funds versus Market Indexes

---

Fund | Annualized Total Return

Embarcadero Absolute Return | –26.4% per year

Embarcadero Market Neutral | –19.2% per year

First American Mid Cap Select A | –15.5% per year

BlackRock Focus Growth A | –12.8% per year

Apex Mid Cap Growth | –11.9% per year

Stock Market Indexes | Annualized Total Return

Russell 2000 | +3.8% per year

DJ Wilshire 5000 Index | 0.0% per year

Source: Morningstar, Inc.

  When you invest in broadly diversified index funds, you never see your funds in the list of the top-performing funds — but then you never see your funds in the list of the worst-performing funds, either.  Don't overestimate your ability to pick in advance the few elite money managers who manage to beat the market averages by a few percentage points per year in the long run.  And then don't overestimate the pros' ability to consistently pick the right stocks. 

Index funds make sense for a portion of your investments, especially when investing in bonds and larger more-conservative stocks, where it's difficult for portfolio managers to beat the market.  Index funds also make sense for investors who are concerned that fund managers may make big mistakes and greatly underperform the market. 

As for how much you should use index versus actively managed funds, it's really a matter of personal taste.  If you're happy knowing that you can get the market rate of return and knowing that you can't underperform the market, you can index your entire portfolio.  On the other hand, if you enjoy the game of trying to pick the better managers and want the potential to earn better than the market level of returns, don't use index funds at all.  A happy medium is to do some of both. 

Putting Your Plans into Action

Constructing a mutual fund portfolio is a bit like constructing a house: There's a world of difference between designing a plan and executing it.  If you're the architect, your world is all clean lines on white paper.  But if you're the general contractor responsible for executing the plan, your circumstances are generally messier; you may face such challenges as inclement weather, unsuitable soil, and undependable construction workers. 

Like the contractor, you're bound to meet challenges in the execution of the plan — in your case, constructing a mutual fund portfolio instead of a house.  Some of these challenges come from the funds themselves; your personal circumstances are the source of others.  With patience, persistence, and a healthy helping of my advice, all are surmountable.  Investing in funds is much, much easier than building a house — which is why you can do it yourself if you so desire. 

Determining how many funds and families to use

Suppose that you've used the discussion earlier in this chapter to nail down an asset allocation for your retirement portfolio: 25 percent in bonds, 50 percent in domestic stocks, and 25 percent in international stocks.  That's all quite specific except for the fact that these percentages tell you nothing about how many funds and how many fund families you should use to meet these percentages. ( I introduce the concept of fund families in Chapter 2). 

  You could do all your investing through one family of funds, given the sheer number and quality of funds that the larger and better fund companies.  Centralizing your investments in one family saves on administrative hassles by cutting down on the number of applications to complete, envelopes to open, statements to file, tax statements to deal with, and so on.  Plus, you're more likely to find your way around better at a company that you spend more of your time interacting with.  Consider a good argument against investing through one family of funds, though: Even the best mutual fund companies don't offer the best of every type of fund.  By not spreading out your funds over different fund families to take advantage of their particular strengths, you may be sacrificing a little bit of return. 

Discount brokerage services offer some of the best of both approaches.  You get one-stop shopping and one statement for all your holdings, but you also have access to funds from many families.  The downside: You pay small transaction fees to purchase many of the better funds through discounters. ( I discuss discount brokerage services in detail in Chapter 9.) 

  You won't find one right answer to how many fund families to work with and whether to use a discount brokerage account.  Choose the approach that works best for your needs.  I use a combination of these approaches by maintaining accounts through a large mutual fund company while also using discount brokerage services to buy funds from some of the smaller fund families that are more of a hassle to work with.  This strategy allows me to maximize centralization while minimizing transaction fees. 

As for the number of individual funds to hold in your portfolio, again, there's no one correct answer.  The typical mutual fund is quite diversified to begin with, so you needn't invest in too many.  In fact, because some funds invest across different types of investments (known as hybrid funds) or even across other funds (known as funds of funds), you may be able to achieve your desired asset allocation by investing in just one fund. 

At a minimum, I recommend that you own enough funds so that you're able to diversify not only across the general investment types (stocks, bonds) that you've targeted but also across different types of securities within those larger categories — bonds of various maturity lengths, stocks of various-size companies. ( I explain these concepts in Chapters 12 and 13.) 

  As your savings allow, I generally recommend that you invest at least $3,000 to $5,000 per fund.  If you're investing outside of a retirement account, most of the better mutual funds require an initial investment of this magnitude anyway.  Inside a retirement account, you may invest less — typically only $500 or $1,000 per fund — to start.  However, because most retirement accounts annually ding you about $10 per fund as an account maintenance fee, you should aim to invest the higher amounts so you don't have your small investment devoured by high relative fees. ( A $10-per-year fee diminishes a $500 investment by 2 percent each year.)  Some fund companies waive this fee if you keep more than a certain amount — $5,000, for example — in their funds. 

  As you have larger sums to invest, it makes sense to use more funds.  Suppose that you have $300,000 and want to divide it equally among bonds, U.S. stocks, and international stocks.  You could put $100,000 into each of three funds: one bond fund, one U.S. stock fund, and one international stock fund.  But with that much money to invest, why not use at least two of each of the different types of funds?  That way, if the one international stock fund you've chosen does poorly, all of your money earmarked for overseas investing isn't doing poorly in that fund.  There's no reason that you can't use even three different funds within each category.  The more money you have, the more sense diversifying across two or three funds per category makes. 

And one more point: Don't invest in more funds than you have time to track.  If you can't find the time to read your funds' semiannual and annual reports, that's a sign that you have too many funds.  Extra diversification won't make up for a lack of monitoring. 

Matching fund allocation to your asset allocation

One thing that can trip up your asset allocation plans is the fact that mutual funds have their own asset allocations.  For example, a hybrid fund may invest 60 percent in stocks and 40 percent in bonds.  Perhaps you, on the other hand, want to invest 75 percent in stocks and 25 percent in bonds.  How the heck do you fit that kind of fund into your portfolio? 

  One option is to shun hybrid funds.  Take Thoreau's advice to simplify your (investing) life: Avoid funds that invest in different investment types.  Buy purebreds — stock funds that are 100 percent (or close to 100 percent) invested in stocks, bond funds that invest only in bonds, and international stock funds that are entirely invested overseas.  That way, your asset allocation calculations stay simple. 

Take the desired mix of the hypothetical 35-year-old from earlier in this chapter: 25 percent in bonds, 50 percent in U.S. stocks, and 25 percent in international stocks.  If she has $10,000 to invest and sticks to purebred funds, figuring out how much money to put into each kind of fund is a simple matter of multiplying the desired allocation percentage by the $10,000 total to invest.  In this case, she should put $2,500 in a pure bond fund (25 percent × $10,000), $5,000 in a U.S. stock fund, and $2,500 in an international stock fund. 

If that seems a little too easy, you're right.  Even if they label themselves as purebreds, plenty of mutual funds are given leeway in their charters to dabble in other investment types.  Read the annual report of some so-called U.S. stocks funds and you may find that up to 20 percent of their assets are invested in bonds or international stocks. 

Some hybrid funds are excellent funds, and eliminating them simply to avoid a math problem seems a bit silly.  Although I encourage you to focus on purebred funds, fitting a hybrid fund, or a hybrid disguised as a purebred, into your portfolio occasionally makes sense. 

Take the example of a 35-year-old investor — one who wants a portfolio of 25 percent bonds, 50 percent U.S. stocks, and 25 percent international stocks.  Suppose that she's picked out three funds she wants to buy: a U.S. stock fund (100 percent stocks), an international stock fund (100 percent international stocks), and a hybrid fund (60 percent U.S. stocks, 40 percent bonds).  Because the hybrid fund is the only one with bonds, the investor needs to figure out how much to put into the hybrid fund so that she ends up with about 25 percent (overall) in bonds.  Because 40 percent of the hybrid fund is invested in bonds, the arithmetic looks like this:

0.4 (40 percent) × Amount to be invested in fund = 0.25

Amount to be invested in fund = 0.25 ÷ 0.4

Amount to be invested in fund = 0.625 (or 62.5 percent)

I like nice, round numbers, so I rounded 62.5 off to 60.  Here's how much money she should put into each fund to get her desired investment mix:

60 percent hybrid fund (60 percent in U.S. stocks, 40 percent in bonds)

15 percent U.S. stock fund (100 percent in stocks)

25 percent international stock fund (100 percent in international stocks)

Allocating when you don't have much to allocate

If you're just starting out, you may have little money to allocate.  Here you've spent all this time exploring how to design a terrific portfolio, and then, thanks to minimum initial investment requirements, you may realize that you only have enough money to buy one of the five funds you've selected! 

  Fear not.  This problem has several answers:

  Buy a hybrid fund or a fund of funds (see Chapter 13) whose asset allocation is similar to your desired mix.  Don't sweat the fact that you can't find a fund with the exact mix you want.  For now, getting close is good enough.  When you're able to afford it, you can, if you so desire, move out of the hybrid fund and into the funds you originally chose. 

  Buy your desired funds — one at a time — as you're able to afford them.  I call this little trick diversifying over time, and it's perfectly legit. 

One twist on this strategy that tests and perhaps improves your mutual fund investing habits is to start by investing in the type of fund (bond or international stock, for example) that's currently doing the most poorly — that is, buy when shares are on sale.  Then the next year, add the fund type that's doing the most poorly at that time. ( Make sure to buy the better funds within the type that's doing poorly!) 

For more ideas, see Chapter 15 for sample portfolios for beginning investors. 

Investing large amounts: To lump or to average? 

Most people invest money as they save it.  If you're saving through a company retirement plan, such as a 401(k), this option is ideal: It happens automatically, and you're buying at different points in time, so even the world's unluckiest person gets to buy some funds at or near market bottoms. 

But what if you have what to you seems like a whole lot of money that's lollygagging around in a savings or money market fund?  Maybe it's just piled up because you're thrifty, or maybe you recently inherited money or received a windfall from work.  You're discovering more about how to invest this money, but after you decide what types of investments you'd like to purchase, you may be terrified at the thought of actually buying them. 

  Some people in this situation feel a sense of loss, failure, or even guilt for not making better use of the money than just letting it sit in a savings or money market account.  Always remember one important thing: At least you're earning a positive return in the bank or money fund, and it beats the heck out of rushing into an investment that you don't understand and in which you may lose 20 percent or more.  Of course, you have every reason to find the best parking spot that you can for your money. ( See Chapter 11 for recommendations of the best money market funds.) 

So how do you invest your lump?  One approach is to dollar-cost average it into the investments you've chosen.  This means that you invest your money in equal chunks regularly, such as once a month or per quarter.  For example, if you have $50,000 to invest and you want to invest it once per quarter over one year, you'd invest $12,500 per quarter until it's all invested.  Meanwhile, the money that's awaiting future investment happily continues accumulating interest in a good money market fund.  Take a look at the pros and cons of this method of investing a large sum:

  Thumbs up: The attraction of dollar-cost averaging is that it allows you to ease into riskier investments instead of jumping in all at once.  The benefit may be that, if the price of the investment drops after some of your initial purchases, you can buy some later at a lower price.  If you invest all your money at once and then the financial markets get walloped, it's human to think, "Why didn't I wait?" 

  History has proven that dollar-cost averaging is a great risk-reducing investment strategy.  If you'd used dollar-cost averaging during the worst decade for stock investors in the last century (1928 to 1938), you still would've averaged 7 percent per year in returns despite the Great Depression and a sagging stock market. 

  Thumbs down: The flip side of dollar-cost averaging is that if your investments do what they're supposed to and increase in value, you may wish that you'd invested your money faster.  Another possible drawback of dollar-cost averaging is that you may get cold feet continuing to put money in an investment that's dropping in value.  Some folks who are attracted to dollar-cost averaging are afraid to continue boarding what appears to be a sinking ship. 

Dollar-cost averaging also can cause headaches with your taxes when it's time to sell investments held outside retirement accounts.  If you buy an investment at many different times and prices, the accounting is muddied as you sell portions of the investment.  Also, remember to try not to purchase funds, particularly stock funds that have had a good year, late in the year because most of these funds distribute capital gains in December. 

  In my opinion, dollar-cost averaging is most valuable when the money you want to invest represents a large portion of your total assets and you can stick to a schedule.  Making it automatic is best so that you're less likely to chicken out and discontinue investing if your initial investment purchases have declined in value from when you bought them. 

Most mutual fund companies offer automatic exchange services.  Pick a time period that makes sense.  I like to do dollar-cost averaging once per quarter early in the quarter (the first of January, April, July, and October).  If you feel comfortable investing and want to get on with the program, averaging your money over one year is fine, but it's riskier.  If you have big bucks to invest and you're cautious, you may prefer to average the money over two to five years. ( In this case, you can use some CDs or Treasury bills as holding places in order to get a better return than on the money market fund.) 

Sorting through your existing investments

A final question that people who want to start a comprehensive mutual fund investment program, but who also have existing portfolios, frequently ask me is what to do with their existing investments.  Here are my thoughts:

  Keep the good nonfund investments.  Although I'm a fan of mutual funds, there's no compelling reason for you to invest all your money in funds.  If you enjoy investing in real estate or securities of your own choosing, go right ahead.  You may have inherited other assets that have done well over the long term, and you shouldn't rush into selling them, especially if prodded to do so by a self-serving investment advisor or broker.  Take your time and evaluate what you have.  You can account for these other investments when you tally up your asset allocation.  As for evaluating the mutual funds you may already own, see Chapter 17. 

  Get rid of high-fee, poorly performing investments.  As you understand more about the best mutual fund investments, you may come to realize by comparison how lousy some of your existing investments are.  I won't stand in your way of dumping them! 

  Pay attention to tax consequences.  When you're considering selling a nonretirement account investment, especially one that has appreciated considerably since its original purchase, be mindful of taxes.  Assets held for more than 12 months are eligible for the more favorable capital gains tax rates (see Chapter 10). 
Chapter 11

Money Market Funds: Beating the Bank

In This Chapter

  Distinguishing money market funds from other mutual funds

  Choosing the right fund for you

  Getting a glimpse of the best money market funds around

Back in the days when Richard Nixon was President, folks had hundreds of alternatives for safely investing their spare cash — they could schlep around and shop among banks, banks, and still more banks.  Although it may seem that safe-money investors had many alternatives, they really didn't.  As a result, yields weren't all that great compared with what a large institutional investor with millions of dollars to invest could obtain by purchasing ultrasafe short-term securities. 

Then in the early 1970s, money market mutual funds were born.  The concept was fairly simple.  The money market mutual fund invested in the same safe, higher-yielding financial instruments (which I discuss in the section "Grasping what money funds invest in," later in this chapter) that only those with big bucks could buy.  The money market fund then sells shares to investors who don't have vast sums to invest.  By pooling the money from thousands of investors, the fund offers investors a decent yield (after charging a reasonable fee to cover the operational expenses and make a profit).  In their first years of operation, these "people's" money funds had little cash flowing in.  By 1977, less than $4 billion were in money market funds.  But then interest rates rose sharply as inflation took hold.  Soon, bank depositors found that the rates of interest they could earn could rise no more, because banks were limited by federal regulations to paying 5 percent interest. 

As interest rates skyrocketed in the late 1970s and investors found that they could earn higher yields by switching from bank accounts to money market funds, money flooded into those funds.  Within just four years, money market fund assets mushroomed more than fiftyfold to $200 billion. ( Today, more than $1 trillion resides in retail money market funds.) 

Money Market Funds 101

Money market mutual funds are a large and unique part of the mutual fund industry's offering.  Money market funds are the only type of mutual fund whose share price doesn't fluctuate in value.  The share prices of stock and bond mutual funds fluctuate from day to day depending on how the stock and bond markets are doing.  Money market funds, in stark contrast, are locked in at $1 per share.  This section gives you the lowdown on these funds. 

Comparing money funds with bank accounts

You make money with money market funds by earning dividends, similar to the interest you earn on bank savings accounts.  However, the best money market mutual funds offer several significant benefits:

  Higher yields: What first attracted investors (including me as a young adult) to money market funds (back when interest rates zoomed up in the late 1970s and early 1980s) still holds true today.  The best money market mutual funds pay a higher yield than equivalent bank accounts, despite the deregulation of the banking industry. 

  Multiple tax flavors: Besides their lower rate of return, another problem with bank savings accounts is that they come in one tax flavor: taxable.  There's no such thing as a bank savings account that pays you tax-free interest.  Money market funds, however, come in a variety of tax-free versions, paying dividends free of federal or state tax or both.  So, if you're in a high federal or state (or both) income tax bracket, money funds offer you advantages that a bank savings account simply can't. 

  Check-writing privileges: Money market mutual funds allow you to write checks, without charge, against your account.  Most mutual fund companies require that the checks be written for larger amounts — typically at least $250 — and may limit the number that can be written per month.  They don't want you using these accounts to pay all your small household bills because checks cost money to process. 

  Convenient access to other mutual funds: After you've established a money market mutual fund at a particular fund company, investing in other funds offered by that company becomes a matter of placing a simple toll-free phone call or clicking your computer mouse. ( And, as I discuss in Chapter 9, if your chosen fund company has a discount brokerage division, you may also be able to invest in mutual funds from other parent companies.)  One centralized account eliminates the need to complete additional application forms every time and reduces the ongoing paperwork involved in tracking your funds.  Paperwork nirvana! 

How banks get away with paying less

How and why do banks continue to pay less interest than most money funds?  Two reasons:

Banks have a lot of overhead due to all the branch offices they operate. 

Banks know that they can get away with paying lower yields because many of their depositors, perhaps including you, believe that the FDIC insurance that comes with a bank account makes it safer than a money market mutual fund.  I dispel this myth in the section "I won't have FDIC insurance," later in the chapter. 

  No lines and traffic jams: Because you can invest and transact in mutual funds online, over the phone, and through the mail, you can save yourself considerable hassle.  Even though most banks are becoming more technologically savvy, some bank transactions, including opening an account, require you to drive to a bank branch.  When you deal with a fund, you've also eliminated the risk of being part of a crime scene, as numerous bank branches today still suffer from robberies and holdups. 

Sometimes, you get put on hold for a short time when you call a mutual fund company.  The better companies (the ones I recommend in this book) generally won't leave you hanging for more than 15 to 30 seconds.  If they do, please write me (you can drop me a note through my Web site at www.erictyson.com) and let me know so that together we can hassle them or delete them from the next edition! 

 Banks have developed money market deposit accounts (MMDAs) that are money fund wannabes.  Banks set the interest rate on MMDAs, and it's generally lower than what you can get from one of the better money market mutual funds.  Check writing on MMDAs, if it's available, is usually restricted to just a few checks monthly. 

As latecomers to the mutual fund business, some banks now offer real money market mutual funds, including tax-free money funds.  Again, the better money market mutual funds from mutual fund companies are generally superior (see my recommendations in the section "Finding the Recommended Funds," later in this chapter) to those offered by banks.  The reason: Most bank money market funds have higher operating expenses and hence lower yields than the best money funds offered by mutual fund companies. 

Finding uses for money funds

The best money market funds are the ideal substitute for a bank savings account — offering equivalent safety to a bank, but a much better yield.  Money market funds are well suited for some of the following purposes:

  Your emergency cash reserve: Money market funds are a good place to keep your emergency cash reserve.  Because you don't know what the future holds, you're wise to prepare for the unexpected — events such as job loss, unanticipated medical bills, or a leaky roof.  Three to six months' worth of living expenses is a good emergency reserve target for most people (for example, if you spend $3,000 in an average month, keep $9,000 to $18,000 reserved). 

You may be able to get by with just three months' living expenses if you have other accounts, such as a 401(k) or family members and close friends that you could tap for a loan.  Consider keeping up to one year's expenses handy if your income fluctuates wildly.  If your profession involves a high risk of job loss, and if finding another job could take a long time, you also need a significant cash safety net. 

  Short-term savings goals: If you're saving money for a big-ticket item that you hope to purchase within the next couple of years — whether it's a fishing boat or a down payment on a home — a money market fund is a terrific place to accumulate and grow the money.  With such a short time horizon, you can't afford to expose your money to the gyrations of stocks or longer-term bonds.  A money market fund offers not only a safe haven for your principal but also a yield that should keep you a step ahead of the inflation rate. 

  A parking spot for money awaiting investment: Suppose that you have a chunk of money that you want to invest for longer-term purposes but you don't want to invest it all at once for fear that you may buy into stocks and bonds just before a big drop.  A money market fund can be a friendly home to the money awaiting investment as you purchase into your chosen investment gradually over time. ( This technique is known as dollar-cost averaging, which I explain in Chapter 10.) 

  Personal checking accounts: You can use money market funds with no restrictions on check writing for household checking purposes.  Some discount brokerage services that offer accounts with a check-writing option downplay the fact that an investor is allowed to write an unlimited number of checks (in any amounts) on his or her account.  You can leave your bank altogether — some money funds even come with debit cards that you can use at bank ATMs for a nominal fee!  Later in this chapter (in the section "Finding the Recommended Funds"), I point out specific funds that offer unlimited check-writing privileges. 

  Business accounts: You can also open a money market fund for your business.  You can use this account for depositing checks received from customers and holding excess funds, as well as for paying bills by means of the check-writing feature.  Some money funds allow checks to be written for any amount, and such accounts can completely replace a bank checking account. 

  You can also establish direct deposit with most money market funds.  You can have your paycheck, monthly Social Security benefit check, or most other regular payments you receive from larger organizations zapped electronically into your money market mutual fund account. 

Refuting common concerns

Investors new to money market mutual funds sometimes worry about what they're getting themselves into.  It's good to be concerned and educated before you move your money into securities you've never invested in.  Most people don't worry about the money they keep in the bank.  They should — at least a little.  First of all, banks get burglarized and defrauded more than mutual funds! ( A thief created a bogus ID and visited five branches of my bank, posing as me, and succeeded in withdrawing $400 from my checking account.  The bank covered the loss, but I chose to take my business elsewhere.) 

 The biggest risk of keeping extra money in a bank savings account is that inflation erodes your money's purchasing power because of the paltry interest you're getting.  Remember: The FDIC insurance system is a government insurance system — not an ironclad, 100-percent safety guarantee.  This section presents the concerns that I hear about money market funds, and the reasons I think that you shouldn't worry about them. 

I won't have FDIC insurance

Some people are nervous about money market mutual funds because they aren't "insured." ( One exception: Government insurance covered money funds by during the late 2000s financial crisis.  See the sidebar: "The one year money market funds had insurance".)  Bank accounts, on the other hand, come with insurance that protects up to $250,000 you have deposited (assuming that your bank participates in the FDIC system).  So, if a bank with FDIC insurance fails because it lends too much money to people and companies that go bankrupt or abscond with the funds, you should get your money back, up to $250,000. 

But consider this: Part of the reason that money market funds aren't insured is that they don't really need to be.  Mutual fund companies can't fail because they have a dollar invested in securities for every dollar you deposit in their money funds.  Banks, on the other hand, are required to have available just 12 cents for every dollar you hand over to them; that's why they need insurance. 

The one year money market funds had insurance

During the height of the financial crisis in 2008, in early September 2008, the share price of a money market fund, the Reserve Primary Fund, fell below $1 per share, the normally fixed price for all money funds.  This fund actually declined 3 percent to $0.97 per share.  While 3 percent is a small decline, especially compared with declines in the stock market, investors in money market mutual funds have enjoyed and expect that the share price of their money funds would hold constant at $1 per share. ( Reserve lost some money on Lehman commercial paper that it owned that plunged in value when Lehman filed for bankruptcy.) 

To calm nervous investors, then U.S. Treasury Secretary Henry Paulson announced a new insurance plan, which covered money market fund asset balances investors had in money funds, on September 19, 2008.  A specific date was chosen as regulators didn't want investors, especially large institutional investors, continuing to move money around trying to game the system.  Some banks also complained that with insurance coverage instituted on money funds, bank depositors might move money from banks to the higher yielding money market funds.  If banks and money funds both had insurance, why leave your money in a lower yielding bank account? 

The new money market fund insurance program was not intended as a long-term or permanent change for the money market mutual fund business.  The insurance ended on September 18, 2009, one year after its inception. 

Historically, since their inception in 1972, money market funds have been extremely safe.  Only one other fund broke the buck (by 6 percent) and that was a fund run by and invested in only by a modest number of institutional investors.  Today, assets in all money funds (both retail and institutional) total more than $3 trillion.  Hundreds of trillions of dollars have flowed into and out of money funds over the decades without any retail investors losing principal. 

Rather than boosting yield by keeping their expenses low, some money funds venture into riskier debt to boost their fund's yields.  That's one of several reasons why I recommend that when you invest in money market funds, you do so with a larger and conservatively managed investment company that keeps expenses low, which is the only safe way to boost a money fund's yield.  These firms don't generally stretch for a little extra yield by taking silly risks, and in the highly unlikely event that they ever bought something problematic, they would surely make good on the $1 per share price. 

In the late 2000s, a couple dozen money fund owners have infused modest amounts of capital into their money funds to keep them from possibly breaking the buck when they held a security that may have had to be listed at a reduced value on the fund's books.  Taking such action requires U.S. Securities & Exchange Commission (SEC) approval.  Such requests have happened before, but their pace increased dramatically during the 2008 financial crisis.  Among fund companies having to take such action were Allianz, HSBC Holdings, Legg Mason, Northern Trust, Ridgewood Investments, SEI Investments, TD Ameritrade, and Wells Fargo. 

According to law professor and industry observer Mercer Bullard (who also was the technical reviewer for this edition of this book), the law is unclear as to whether fund companies ever need to disclose to their shareholders that they sought relief for their money funds and were blessed to do so by the SEC. 

It's possible that a money market fund's investments may decline slightly in value — thus reducing the share price of the money market fund below a dollar.  In a few cases, money market funds have held some securities that ended up tanking.  However, in each and every case (except for one, which I discuss next), the money market fund was bailed out — that is, cash was infused into the money fund by the mutual fund company, thus enabling the fund to maintain a price of $1 per share. 

One money market fund, however, did break the buck.  A newspaper article dramatically headlined, "Investors Stunned as a Money Fund Folds," went on to say, "The fund's collapse is the latest blunder to shake investors' confidence in the nation's mutual fund industry."  Although such hype may help to fill readers with anxiety (and perhaps sell more newspapers), it obscures several important facts.  This particular money fund didn't collapse; it was liquidated because its investors, who were all small banks, owned the fund, and they decided to disband it.  The fund didn't hold money from retail investors like you and me.  If it had, the fund company surely would've bailed it out, as other fund companies have done.  You should also know that only 6 percent of the investing banks' money was lost.  Hardly a collapse — and I doubt that anyone was stunned! 

 If you have more than $250,000 in one bank and that bank fails, you can lose the money over the $250,000 insurance limit.  I've seen more than a few cases where people had more than the insured amount— in one case, a person who came to me for advice had nearly $2 million — sitting in a bank account!  Now that's risk!  Since 1980, more than 3,000 banks have failed.  Because the government has taken a hard line on not going beyond the insurance limits in the 2000s, bank depositors have lost hundreds of millions of dollars. 

 Stick with larger mutual fund companies if you're worried about the lack of FDIC insurance.  They have the financial wherewithal and the most incentive to save a floundering money fund.  Fortunately, the larger fund companies have the best money funds anyway. 

The check may get lost or stolen

No one can legally cash a check made payable to you.  Don't mistakenly think that going to your local bank in person is safer — you could slip on some dog droppings or get carjacked. 

 If you're really concerned about the mail, use a fund company or discount broker with branch offices.  I don't recommend spending the extra money and time required to send your check by way of registered or certified mail.  You know if your check got there when you get the statement from the fund company processing the deposit. ( In those rare cases where a check does get lost, know that checks can be reissued.)  And when you're depositing a check made payable to you, be sure to endorse the check with the notation "for deposit only" along with your account number under your signature. 

When the bank or credit union may be better

Although I advocate use of the best money market funds, I realize that a bank or credit union savings account is sometimes the most practical place to keep your money.  Your local bank, for example, may appeal to you if you like being able to do business face to face.  Perhaps you operate a business where a lot of cash is processed; in this case, you can't beat the convenience and other services that a local bank offers.  And, if you have only $1,000 or $2,000 to invest, a bank savings account may be your better option; the best money market funds generally require a higher minimum initial investment. 

For investing short-term excess cash, you may first want to consider keeping it in your checking account.  This option may make financial sense if the extra money helps you avoid monthly service charges because your balance occasionally dips below the minimum.  In fact, keeping money in a separate savings account rather than in your checking account may not benefit you if service charges wipe out your interest earnings. 

Don't forget to shop around for the best deals on your checking account because minimum balance requirements, service fees, and interest rates vary.  Credit unions offer some of the best deals, although they usually don't offer extensive access to free ATMs.  The largest banks with the most ATM machines — you know, the ones that spend gobs of money on advertising jingles and billboards — usually offer the worst terms on checking and savings accounts. 

I may have trouble accessing my money

Although it may appear that you can't easily and quickly access your money market fund holdings, you can, in fact, efficiently tap your money market fund in a variety of ways (Note: You can use these methods at most fund companies, particularly the larger ones):

  Check writing: The most efficient way to access your money market fund is to write a check.  Suppose that you have an unexpectedly large expense that you can't afford to pay out of your bank checking account.  Just write a check on your money market mutual fund. 

  Electronic transfers: Another handy way to access your money (which may be useful if your money fund checkbook is hidden under a mountain of papers somewhere in the vicinity of your desk) is to call the fund company and ask it to have money sent electronically from your money market fund to your bank account or vice versa. ( Such transactions can also be done on some fund companies' Web sites.)  Or if you prefer, you can have the fund company mail you a check for your desired amount from your money fund. 

If you need money regularly sent from your money market fund to, say, your local bank checking account, you can set up an automatic withdrawal plan.  On a designated day of the month, your money market fund electronically sends money to your checking account. 

  Wiring: If you need cash in a flash, many money market funds offer the option of wiring money to and from your bank.  Both the money market fund and the bank usually assess a small charge for this service.  Most companies also send you money via an overnight express carrier, such as Federal Express, if you provide them with an account number. 

  Debit cards: Brokerage account money funds that offer debit cards allow access to your money through bank ATMs. 

Chapter 16 explains how to establish these account features.  Unlike when you visit a bank, you can't simply drop by the branch office of a mutual fund company and withdraw funds from your account.  They don't keep money in branch offices because they're not banks.  However, you can establish the preceding account features, if you didn't set them up when you originally set up your account, by mailing in a form or by visiting the fund's branch office. 

Grasping what money funds invest in

Under the Securities and Exchange Commission (SEC) regulations, money market funds can invest only in the most credit-worthy securities, and their investments must have an average maturity (when the short-term bonds pay off) of less than 60 days per new rules released by the SEC in 2010.  The short-term nature of these securities effectively eliminates the risk of money funds being sensitive to changes in (short-term) interest rates. 

The securities that money market funds use are extremely safe.  General-purpose money market funds invest in government-backed securities, bank certificates of deposits (CDs), and short-term corporate debt issued by the largest and most credit-worthy companies and the U.S. government (although that may not be much comfort to some of you).  The following sections explain the major types of securities that money funds hold. 

Commercial paper

Corporations, particularly large ones, often need to borrow money to help make their businesses grow and prosper.  In the past, most companies needing a short-term loan had to borrow money from a bank.  In recent decades, issuing short-term debt or IOUs — commercial paper — directly to interested investors has become easier.  Money market funds buy high-quality commercial paper that matures typically within 60 to 90 days and is issued by large companies (such as Boeing, Exxon Mobil, Hewlett-Packard, Home Depot, Microsoft, and Wal-Mart), banks, and foreign governments. 

If you had hundreds of thousands of dollars to invest, you could purchase commercial paper yourself instead of buying it indirectly through a money market fund.  If you do have a lot of money to invest, I don't recommend this approach.  You incur fees when you purchase commercial paper yourself, and you most likely lack the expertise to know how to evaluate credit risks and what a fair price to pay is.  The best money funds charge a small fee to do all this analysis for you, plus they offer perks, such as check-writing privileges. 

Certificates of deposit

You can go to your local bank and invest some money in a certificate of deposit (CD).  A CD is nothing more than a specific-term loan that you make to your banker — ranging anywhere from a month to some number of years. 

Money market funds can buy CDs as well.  The only difference is that they invest a lot more money — usually millions — in bank CDs.  Thus, they can command a higher interest rate than you can get on your own.  Money funds buy CDs that mature within a few months.  The money fund is only insured up to $250,000 per bank CD, just like the bank insurance that customers receive.  As with other money fund investments, the money fund does research to determine the credit quality of banks and other institutions that it invests in.  Remember that money funds' other investments aren't insured. 

Money market funds may hold some other types of CDs.  U.S. branches of foreign banks issue Yankee CDs.  Foreign banks or the foreign branches of U.S. banks issue Eurodollar CDs. 

Government debt

McDonald's has signs in many locations saying that billions and billions have been served.  Well, the federal government also serves up trillions and trillions — of dollars in debt, that is — in the form of Treasury securities.  A truckload of federal government debt is outstanding — about $12 trillion. 

Most money market funds invest a small portion of their money in Treasuries soon to mature.  Money funds also invest in short-term debt issued by government-affiliated agencies, such as the Federal Home Loan Bank, which provides funds to the nation's savings and loans. 

Government agency debt, which money funds also invest in, unlike Treasuries, isn't backed by the "full faith and credit of the U.S. government."  However, no federal agency has ever defaulted on its debt.  The folks back in Washington are certain to avoid the loss of faith in government-issued debt that would surely follow should such a default be allowed to occur. 

As I discuss in more detail later in the chapter, some money market funds specialize in certain types of government securities that distribute tax-free income to their investors.  Treasury money market funds, for example, buy Treasuries and pay dividends that are state-tax-free, but federally taxable.  State-specific municipal money market funds invest in debt issued by state and local governments in one state.  The dividends on state money funds are federal- and state-tax-free (if you're a resident of that state). 

Other types of securities

Other types of securities typically make up small portions of a money fund's holdings.  These types include the following:

  Repurchase agreements (repos) are overnight investments that money funds send to dealers (banks and investment banks' securities divisions), and the money fund receives Treasury securities overnight as collateral. 

  Bankers' acceptances are more complex: They're issued by banks guaranteeing corporation debt incurred from trade.  For example, if Sony sends televisions from overseas to the United States by freight but doesn't want to wait for its money until the ship comes in and the stores pay for the televisions, Sony can get paid right away by borrowing from a bank based on the expected delivery of the televisions.  The stores get the televisions and pay for them, and then Sony's loan gets repaid. 

Choosing a Great Money Market Fund

A money market fund is probably the easiest type of mutual fund to select.  To save you time and make you the most money, the following sections describe the major issues to consider when selecting money funds. 

Why yield and expenses go hand in hand

Within a given category of money market fund (general, Treasury, or municipal), money fund managers are investing in the same basic securities.  The market for these securities is pretty darned efficient, so superstar money fund managers may eke out an extra 0.1 percent of yield over their competitors but not much more. 

However, money funds can differ significantly from one another in yield due to expenses.  For money market funds more than for any other kind of fund, operating expenses are the single biggest determinant of return.  All other conditions being equal (which they usually are with money market funds), lower operating expenses translate into higher yields for you. 

 For money market funds, you shouldn't tolerate annual operating expenses greater than 0.5 percent.  Top quality funds charge 0.25 percent or less annually.  Remember, lower expenses don't mean that a fund company is cutting corners or providing poor service.  Lower expenses are possible in most cases because a fund company has been successful in attracting so much money to invest.  As I discuss in Chapter 12, fund companies with consistently low expenses on their money funds also generally offer good bond funds. 

Money funds 20 percent off! 

Some money market mutual funds aren't above resorting to the marketing tricks that retailers use.  Beware of money fund managers running specials or sales.  They try to lure investors by temporarily waiving (also known as absorbing) operating expenses.  These sales tricks create money fund yields that are a lot like muscles on steroids: artificially pumped up.  When the fund managers start thirsting for profits — and with time they will, because these aren't charities — they simply reinstate operating expenses, and then you can watch the air go out of the yield balloon.  Some bond mutual funds (see Chapter 12) engage in this deceptive practice as well. 

Some fund companies run sales because they know that a major portion of the fund buyers lured in won't bother leaving (or knowing) when the operating expenses are jacked up.  To get the highest long-term yield from money funds, you're best off sticking with funds that maintain everyday low prices for operating expenses.  You can ensure that your fund isn't running a special by asking what the current operating expense ratio is and whether the fund is waiving some portion of the expenses.  You may also discern this status by checking the annual operating expense ratio in the fund's prospectus (see Chapter 8). 

If you want to move your money to companies having specials and then move it back out when the special is over, you may come out a little ahead in your yield.  If you have a lot of money and don't mind paperwork, this strategy may be worth the bother.  But don't forget the value of your time, lost interest when a check is in the mail, and the chance that you may not stay on top of the fund's expense changes. 

Looking at your tax situation

 You've perhaps heard the expression, "It's not what you make; it's what you keep."  What you keep on your investment returns is what's left over after the federal and state governments take their cut of your investment profits.  If you're investing money held outside of a retirement account and you're in a high tax bracket (particularly the federal 28 percent or higher bracket), you may come out ahead by investing in tax-free money market funds instead of taxable ones.  If you're in a high-tax state, a state-specific money market fund (if a good one is available in your state) may be a sound move. ( See "Finding the Recommended Funds" section for specific fund recommendations.) 

 Tax-free refers to the taxability of the dividends paid by the fund.  Don't confuse this term with the effective tax deductions you get on contributions to a retirement account, such as a 401(k). 

Determining whether tax-free money market funds net you more

If you're in the highest federal tax brackets (see the federal tax rate chart in Chapter 10), you usually come out ahead in tax-free investments.  The only way to know is to crunch the numbers. 

In order to do the comparison properly, factor in federal as well as state taxes.  Suppose, for example, that you call Vanguard, which tells you that its Prime Money Market fund currently yields 2.0 percent.  The yield or dividend on this fund is fully taxable. 

Suppose further that you're a resident of California and that Vanguard's California Money Market fund currently yields 1.4 percent.  The California tax-free money market fund pays dividends that are free from federal and California state tax.  Thus, you get to keep all 1.4 percent that you earn.  The income you earn on the Prime Money Market, on the other hand, is taxed.  So here's how you compare the two:

yield on tax-free fund ÷ yield on taxable fund

.014 (1.4 percent) ÷ .02 (2.0 percent) = 0.70

In other words, the tax-free fund pays a yield of 70 percent of that on the taxable fund.  Thus, if you must pay more than 30 percent (1 – 0.70) in federal and California state tax, you net more in the tax-free fund.  If you do this analysis comparing some funds today, be aware that yields bounce around.  The difference in yields between tax-free and taxable funds widens and narrows a bit over time.  Instead of simply comparing the current yield on a tax-free versus a taxable money fund, compare the two funds' yields over the past year. 

One final and important point: Whenever a recession occurs, especially a severe one, some folks worry about the fiscal status of states that experience mushrooming deficits.  California, for sure, was in the news a lot with its ballooning deficits due to the painful, late 2000s recession.  Various commentators and talking heads referred to California as "bankrupt," which it most clearly was not.  While I don't have a crystal ball for California or any other state, I can tell you that such fears have come and gone in the past.  The conditions that lead to large budget deficits — declining tax revenue and rising state payments — inevitably reverse when the economy rebounds. 

If you worry about being in a state-specific money market or bond fund due to the economic health of your state, then you probably should go with a nationally diversified fund to ease your fears.  Either that, or tune out the fear-mongering talking heads (and visit my Web site at www.erictyson.com for an unbiased, level-headed view of recent news events). 

Deciding where you want your home base

Convenience is another important factor in choosing where to establish a money market fund.  For example, if you're planning on investing in stock and bond mutual funds at T. Rowe Price, that may be the best place for you to open up a money market fund as well.  Although you may get a slightly higher money market yield from another fund company, opening up a separate account may not be worth the administrative hassle, especially if you don't plan on keeping much cash in the money fund. 

 If you don't mind the extra paperwork, you can go for the extra yield.  Calculate (based on the yield difference) the costs of keeping a lower-yielding money fund.  Every tenth (0.1) of a percent per $10,000 invested costs you $10 in lost dividends annually. 

Keeping your investments close to home

Most mutual fund companies don't have local branch offices.  Generally, maintaining few offices helps fund companies keep their expenses low and their yields higher.  You may open and maintain your money market mutual fund through the fund's toll-free phone line, the mail, and the Internet. 

Except for psychological security, selecting a fund company with an office in your area doesn't offer much benefit.  But I don't want to downplay the importance of your emotional comfort level.  Fund providers Fidelity, Schwab, TIAA-CREF, and TD Ameritrade have larger branch networks.  Depending on where you live, you may be near one of the fund companies I recommend. ( See the Appendix.) 

Considering other issues

Most, but not all, money market funds offer other useful services, such as free check-writing privileges, fund exchange and redemption via telephone and the Internet, and automated, electronic exchange services with your bank account.  The fund companies I recommend generally offer these features, so these shouldn't be deciding factors when debating among fund options.  As I mention earlier in this chapter, most money funds require that you write checks for at least $250 or $500.  Some funds don't have this restriction, which may be important if you want to pay smaller bills out of the account. 

Another potentially important issue is the initial minimum investment required to open an account.  Most funds require a minimum investment of $3,000 or so, although some require heftier amounts.  If you drop below the minimum at most money market funds, it's no big deal, and no charge is assessed.  Some money funds do, however, charge small fees for use of certain features.  I discuss these fees in the next section. 

Finding the Recommended Funds

In this section, I recommend the best money market funds, based on the criteria I discuss in the previous section,.  Due to the financial crisis and severe recession in the late 2000s, short-term interest rates plummeted to near zero and continued that way into the new decade.  As a result, the yield on many money market funds was near or even at zero.  Many money funds had to absorb a portion of their fund's expenses so that the yield would not become negative.  Some money funds closed to new investors because allowing new investors would have driven a fund's yield down even further because the fund manager would be forced to buy lower yielding bonds.  Please see Chapter 12 for information on short-term bond funds as an alternative to low yielding money funds. 

Taxable money market funds

Money market funds that pay taxable dividends are appropriate for retirement account funds awaiting investment as well as nonretirement account money when you're not in a high federal tax bracket and not in a high state tax bracket.  Here are the best taxable money market funds to consider (call the fund companies for current yields):

   Vanguard's Prime Money Market (VMMXX) has an operating expense ratio of 0.25 percent per year.  Like most Vanguard funds, it requires $3,000 to open.  www.vanguard.com;  800-662-7447

  TIAA-CREF Money Market (TIAXX) has an annual expense ratio of 0.47 percent.  Minimum to open an account is $2,500.  www.tiaa-cref.org;  800-223-1200

   Fidelity Cash Reserves (FDRXX) has an operating expense ratio of 0.39 percent.  $2,500 minimum initial investment.  www.fidelity.com;  800-544-8888

   T. Rowe Price Summit Cash Reserves (TSCXX) has a minimum initial investment of $25,000 and an expense ratio of 0.47 percent per year.  If you're doing the bulk of your investing through a fund company other than heavyweights Vanguard or Fidelity, it's your call whether you should do your money fund investing there as well.  www.troweprice.com;  800-638-5660

U.S. Treasury money market funds

U.S. Treasury money market funds are appropriate if you're not in a high federal tax bracket but are in a high state tax bracket.  Check out these funds:

    Vanguard Admiral Treasury Money Market (VUSXX) has a slim 0.12 percent annual expense ratio.  Due to the very low yields on Treasury notes, this fund was closed to new investors in 2009. [ www.vanguard.com](http://www.vanguard.com);  800-662-7447

  USAA's Treasury Money Market (UATXX) has a 0.44 percent operating cost and a $3,000 minimum initial investment.  www.usaa.com;  800-531-8181

  Fidelity's Government Money Market (SPAXX) has an expense ratio of 0.45 percent.  This fund's minimum initial investment is $25,000 for nonretirement accounts.  This fund charges a $2 fee per check written (waived if your balance is greater than $50,000).  www.fidelity.com;  800-544-8888

 You can bypass Treasury money market funds and their operating fees by purchasing Treasury bills directly from your local Federal Reserve Bank for no fee.  Buying Treasuries direct especially makes sense during periods of low interest rates like we had in the late 2000s and into the new decade.  Although you save yourself expenses by going this route, you lose convenient access to your money.  You have no check-writing privileges: If you need to tap the Treasuries before they mature, it's a bit of an administrative hassle and will cost you a brokerage fee.  With Vanguard's expense ratios on their Treasury money funds, it costs you $12 per year with a $10,000 balance; $60 per year with a $50,000 balance. 

Municipal tax-free money market funds

Municipal (also known as muni) money market funds invest in short-term debt issued by state and local governments.  Dividends from municipal money funds are generally free of federal taxes.  Those investors who limit their investing to just one state are generally free of state taxes as well (provided you live in that state). 

You may be saying to yourself that state-specific muni funds are the way to go.  Not so fast.  You may not have to worry about shielding your dividends from state taxes if you live in a state that meets any of the following criteria:

  Doesn't impose any income tax, such as Florida (you lucky dog)

  Charges a lower income tax (less than 5 percent), such as Michigan

  Has a higher income tax but no decent state-specific money market funds to invest in

Understanding discount brokerage money fund options

As I discuss in Chapter 9, some discount brokers offer all-in-one accounts that combine unlimited check writing with investing.  These accounts can certainly reduce the paperwork in your life: Everything from your monthly bill payments to your mutual fund holdings is consolidated on one account statement. 

Comprehensive brokerage accounts are usually built around some kind of hub, a temporary holding place for the money that's waiting to be either spent or invested.  This part is the portion of the account you can write checks against, funnel dividends into, and purchase investments with.  You're usually given an option on how you want to hold this hub money.  Look at your options carefully, and don't make the mistake of leaving your money in the default option. 

With some all-in-one brokerage accounts, the hub may be called something like your core account.  Your first option for the core account may be to keep it in cash.  Although you do earn interest on it, that interest is fully taxable and offers a much lower yield than from a taxable money market fund. 

Especially if you're in a higher tax bracket, the better choice may be to use a municipal money market fund that pays federally tax-free dividends.  You also have the option to put your cash in a state-specific money market fund if you happen to live in a state in which the account provider offers such a fund: This strategy shields your dividends from state as well as federal taxes. 

Of course, money funds outside of the core options don't give you features such as unlimited check writing, but you may be able to get a higher yield.  You can always keep a small amount of money in one of the core options to cover any check-writing needs. 

If you live in any of those states and if you're in a high federal tax bracket, you may be better off with a national money market fund, whose dividends are free of federal but not state tax. ( Call the fund companies for current yields.)  Check out these funds:

   Vanguard Tax-Exempt Money Market (VMSXX) has a 0.17 percent annual expense ratio and requires a $3,000 minimum initial investment to open.  www.vanguard.com;  800-662-7447

  T. Rowe Price Summit Municipal Money Market (TRSXX) has a 0.47 percent annual expense ratio and requires a $25,000 minimum initial investment to open.  www.troweprice.com;  800-638-5660

  USAA Tax-Exempt Money Market (USEXX) has a 0.51 percent annual expense ratio and requires a $3,000 minimum initial investment to open.  www.usaa.com;  800-531-8181

 State-specific money market funds, whose dividends are free of both federal and state taxes if you live in the specified state, are appropriate when you're in a high federal and state tax bracket.  The major fund providers highlighted elsewhere in this chapter for having good money funds (Fidelity, USAA, Vanguard) offer competitive funds for states such as California, Florida, Massachusetts, Maine, New Jersey, New York, Ohio, Pennsylvania, and Virginia.  If you can't find a good state-specific money fund for your state or you're only in a high federal tax bracket, you need to use one of the nationwide muni money markets just described. 
Chapter 12

Bond Funds: When Boring Is Best

In This Chapter

  Defining bonds

  Knowing when and why to invest in bond funds

  Understanding how bond funds differ from one another

  Selecting short-, intermediate-, and long-term bond funds

  Considering CDs, GICs, and other alternatives to bond funds

Many investors, both novice and expert, think that the b in bonds is for boring.  And they're partly correct.  No one gets excited by bonds — unless she's an investment banker, money manager, or broker who deals in bonds and makes big bucks because of them. 

But take the time in this chapter to get the whole scoop on bonds.  They may seem boring, but they generally offer higher yields than bank and money market accounts with less volatility than stocks. 

Understanding Bonds

So what the heck is a bond?  Let me try to explain with an analogy.  If a money market fund is like a savings account, then a bond is similar to a certificate of deposit (CD).  With a five-year CD, for example, a bank agrees to pay you a predetermined annual rate of interest — say, 4.5 percent.  If all goes according to plan, at the end of five years of earning the 4.5 percent interest, you get back the principal that you originally invested. 

Bonds work about the same way, only instead of banks issuing them, corporations or governments issue them.  For example, you can purchase a bond, scheduled to mature five years from now, from a company such as Walmart.  A Walmart five-year bond may pay you, say, 6 percent.  As long as Walmart doesn't have a financial catastrophe, after five years of receiving interest payments (also known as the coupon rate) on the bond, Walmart returns your original investment to you. ( Note: Zero coupon bonds pay no interest but are sold at a discounted price to make up for it.) 

  The worst thing that can happen to your bond investment is that if Walmart filed bankruptcy, then you may not get back any of your original investment, let alone the remaining interest. 

You shouldn't let this unlikely but plausible scenario scare you away from bonds for these important reasons:

  Bonds can be safer than you think.  Many companies need to borrow money (and thus issue bonds) and are good credit risks.  If you own bonds in enough companies — say, in several hundred of them — and one or even a few of them unexpectedly take a fall, their default (failure to pay back interest or principal on time) affects only a sliver of your portfolio and wouldn't be a financial catastrophe.  A bond mutual fund and its management team can provide you a diversified portfolio of many bonds. 

  You're rewarded with higher interest rates than comparable bank investments.  The financial markets and those who participate in them — people like you and me — aren't dumb.  If you take extra risk and forsake FDIC insurance, you should receive a higher rate of interest investing in bonds.  Guess what?  Nervous Nellie savers who're comforted by the executive desks, the vault, the guard in the lobby, and the FDIC insurance logo at their local bank should remember that they're being paid less interest at the bank because of all those comforts. 

 If you like the government backing afforded by the FDIC program, you can replicate that protection in bond mutual funds that specialize in government-backed securities. ( See the section "Eyeing Recommended Bond Funds," later in this chapter.) 

In the last section of this chapter, "Exploring Alternatives to Bond Funds," I discuss some potentially higher yield alternatives to investing in bond funds.  There, you see that with those higher yields comes greater risk.  After all, there's no free lunch in the investing world. 

Sizing Up a Bond Fund's Personality

Bond funds aren't as complicated and unique as people, but they're certainly more complex than money market funds.  And thanks to some shady marketing practices by particular mutual fund companies and salespeople who sell funds, you have your work cut out for you in getting a handle on what many bond funds really are investing in and how they differ from their peers.  But don't worry: I explain these important details for the good funds that I recommend later in this chapter. 

 After you know four key facts about bond funds — maturity, credit rating, the different entities that issue bonds, and, therefore, the tax consequences on those bonds — you can put the four together to understand how mutual fund companies came up with so many different types of bond funds.  For example, you can buy a corporate intermediate-term high-yield (junk) bond fund or a long-term municipal bond fund.  In the following sections, you see the combinations are many. 

Maturity: Counting the years until you get your principal back

In everyday conversation, maturity refers to that quiet, blessed state of grace and wisdom that you develop as you get older (ahem).  But that's not the kind of maturity I'm talking about here.  Maturity, as it applies to bonds, simply refers to when the bond pays you back — it could be next year, 5 years from now, 30 years from now, or longer.  Maturity is the most important variable by which bonds, and therefore bond funds are differentiated and categorized. 

 You should care plenty about how long a bond takes to mature because a bond's maturity gives you a good (although far from perfect) sense of how volatile a bond will be if interest rates change (see Table 12-1).  If interest rates fall, bond prices rise. 

Table 12-1 Interest Rate Increases Depress Bond Prices

---

Bond Type | Price Change If Rates Suddenly Rise 1 Percent*

Short-term bond (2-year maturity) | –2 percent

Intermediate-term bond (7-year maturity) | –5 percent

Long-term bond (20-year maturity) | –10 percent

*Assumes that bonds are yielding approximately 7 percent.  If bonds were assumed to be yielding more, then a 1 percent increase in interest rates would have less of an impact.  For example, if interest rates are at 10 percent and rise to 11 percent, the price change of the 20-year bond is –8 percent. 

Bond funds are portfolios of dozens — and in some cases, hundreds — of individual bonds.  You won't need to know the maturity of every bond in a bond mutual fund.  A useful summarizing statistic to know for a bond fund is the average maturity of its bonds.  In their marketing literature and prospectuses, bond funds typically say something like, "The Turbocharged Intermediate-Term Bond Fund invests in high-quality bonds with an average maturity of 7 to 12 years." 

Bond funds usually place themselves into one of three maturity categories:

  Short-term bond funds: These funds concentrate their investments in bonds maturing in the next few years. 

  Intermediate-term bond funds: This category generally holds bonds that come due within five to ten years. 

  Long-term bond funds: These funds usually own bonds that mature in 15 to 20 years or so. 

 These definitions aren't hard and fast.  One long-term bond fund may have an average maturity of 14 years while another may have an average of 25 years. 

You can run into problems when one intermediate-term fund starts bragging that its returns are better than another's.  It's the old story of comparing apples to oranges.  When you find out that the braggart fund has an average maturity of 12 years and the other fund has a maturity of 7, then you know that the 12-year fund is using the "intermediate-term" label to make misleading comparisons.  The fact is, a fund with bonds maturing on average in 12 years should be generating higher returns than a fund with bonds maturing on average in 7 years.  The 12-year fund is also more volatile when interest rates change. 

The greater risk associated with longer term bonds, which suffer price declines greater than do short-term bonds when interest rates rise, often comes with greater compensation in the form of higher yields. 

 Most of the time, longer term bonds pay higher yields than do short-term bonds.  You can look at a chart of the current yield ("today") of bonds of varying length maturities, which is known as a yield curve.  Most of the time, this curve slopes upward (see Figure 12-1).  Many leading financial publications and Web sites carry a current chart of the yield curve. 

Duration: Measuring interest rate risk

 If you're trying to determine the sensitivity of bonds and bond funds to changes in interest rates, duration may be a more useful statistic than maturity.  A bond fund with a duration of ten years means that if interest rates rise by 1 percent, then the value of the bond fund should drop by 10 percent. ( Conversely, if rates fall 1 percent, the fund should rise 10 percent.) 

Trying to use average maturities to determine what impact a 1 percent rise or fall in interest rates will have on bond prices forces you to slog through all sorts of ugly calculations.  Duration is no fuss, no muss — and it gives you one big advantage, too.  Besides saving on number crunching, duration enables you to compare funds of differing maturities.  If a long-term bond fund has a duration of, say, 12 years, and an intermediate fund has a duration of 6 years, the long-term fund should be about twice as volatile to changes in interest rates. 

**Figure 12-1:** A yield curve chart. 

 Although duration is easier to work with and a better indicator than average maturity, you're more likely to hear about average maturity because a fund's duration isn't that easy to understand.  Mathematically, it represents the point at which a bondholder receives half (50 percent) of the present value of her total expected payments (interest plus payoff of principal at maturity) from a bond.  Present value adjusts future payments to reflect the fact that money received in the future has less value, primarily because of increases in the cost of living (inflation). 

If you know a bond fund's duration, which you can obtain from the fund company behind the bond fund you're interested in, you know almost all you need to know about its sensitivity to interest rates.  However, duration hasn't been a foolproof indicator: During particular periods when interest rates have risen, some funds have dropped more than the funds' durations predicted.  But bear in mind that some heavy investing in unusual securities (such as derivatives) was required to make duration unreliable — so the duration values of the better funds, which I recommend in this chapter, usually work just fine as a guide.  Also be aware that other factors — such as changes in the credit quality of the bonds in a fund — may affect the price changes of a bond fund over time. 

Credit quality: Determining whether bonds will pay you back

Bond funds also differ from one another in terms of the creditworthiness of the bonds that they hold.  That's just a fancy way of saying, "Hey, are they gonna stiff me or what?" 

Every year, bondholders get left holding nothing but the bag for billions of dollars when their bonds default.  You can avoid this fiasco by purchasing bonds that are unlikely to default, otherwise known as high-credit-quality bonds.  Credit rating agencies — Moody's, Standard & Poor's, Duff & Phelps, and so on — rate bonds based on credit quality and likelihood of default. 

The credit rating of a security depends on the company's (or the government entity's) ability to pay back its debt.  Bond credit ratings are usually done on some sort of a letter-grade scale: For example, in one rating system, AAA is the highest rating, with ratings descending through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on.  Funds that mostly invest in

  AAA and AA rated bonds are considered to be high-grade or high-credit-quality bond funds; bonds of this type have little chance of default.  These bonds are considered to be investment quality bonds. 

  A and BBB rated bonds are considered to be general bond funds (moderate-credit-quality).  Like AAA and AA rated bonds, these bonds are known as investment quality bonds. 

  BB or lower rated bonds are known as junk bond funds (or by their more marketable name, high-yield funds).  These funds expect to suffer more defaults — perhaps as many as a couple of percent of the total value of the bonds per year or more.  Unrated bonds have no credit rating because they haven't been analyzed or evaluated by a rating agency. 

 Lower quality bonds are able to attract bond investors by paying them a higher interest rate.  The lower the credit quality of a fund's holdings, the higher the yield you can expect a fund to pay (to hopefully more than offset the effect of potential defaults). 

Issuer: Knowing who you're lending to

Bond funds and the bonds that they hold also differ according to which type of entity is issuing them.  Here are the major options:

  Treasuries: These are IOUs from the biggest debtor of them all — the U.S. federal government.  Treasuries include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years).  All Treasuries pay interest that's state-tax-free but federally taxable. 

  Municipals: Munis are state and local government bonds that pay federally tax-free and state-tax-free interest to those who reside in the state of issue.  The governments that issue municipal bonds know that the investors who buy municipals don't have to pay most or any of the income tax that normally would be required on other bonds — which enables the issuing governments to attract buyers at a lower rate of interest.  Later in this chapter (in the section "How to obtain tax-free income"), I explain how to determine if you're in a high enough tax bracket to benefit from muni bonds. 

  Corporates: Issued by companies such as General Mills and Hewlett Packard, corporate bonds pay interest that's fully taxable. 

  Mortgages: You can actually get back some of the interest you're paying on your mortgage by purchasing a bond fund that holds it!  Some bond funds specialize in buying mortgages and collecting the interest payments.  The repayment of principal on these bonds is usually guaranteed at the bond's maturity by a government-sanctioned organization such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or the Federal National Mortgage Association (FNMA or Fannie Mae). 

  Convertibles: These are hybrid securities — bonds that you can convert into a preset number of shares of stock in the company that issued the bond.  Although these bonds do pay interest, their yield is lower than nonconvertible bonds because convertibles offer you the upside potential of being able to make more money if the underlying stock rises. 

  International bonds: Bond funds (and individual investors) can buy most of the preceding types of bonds from foreign issuers as well.  In fact, international corporate and government bonds are the primary bonds that foreign bond mutual funds may hold.  International bonds are riskier because their interest payments can be offset by currency price changes and may be riskier due to political instability and insufficient information. 

Management: Considering the passive or active type

Some bond funds are managed like an airplane on autopilot.  They stick to investing in a particular type of bond (such as high-grade corporate), with a target maturity (for example, an average of ten years).  Index funds that invest in a relatively fixed basket of bonds — so as to track a market index of bond prices — are good examples of this passive approach.  Exchange-traded funds (ETFs) of bonds are bond funds (generally index funds) that trade on a major stock exchange.  See Chapter 5 for more on ETFs. 

At the other end of the spectrum are aggressively managed funds.  Managers of these funds have significant freedom to purchase bonds that they think will perform best in the future.  For example, if a fund manager thinks that interest rates will rise, he'll buy shorter term bonds (remember that shorter term bonds are less sensitive to interest rate changes than longer term bonds) and keep more of a fund's assets in cash.  The fund manager may be willing to invest more in lower credit-quality bonds if he thinks that the economy is going to improve and that more companies will prosper and improve their credit standing. 

 Aggressively managed funds gamble.  If interest rates fall instead of rise, the fund manager who moved into shorter term bonds and cash suffers worse performance.  If interest rates fall because the economy sinks into recession, lower credit-quality bonds suffer from a higher default rate and depress the fund's performance even further. 

Some people think that predicting which direction interest rates and the economy are heading is fairly easy.  The truth is that economic predictions are difficult.  In fact, over long periods of time (ten or more years), meaningful predictions are almost impossible. 

 Investing some of your bond fund money in funds that try to be well positioned for changes in the economy and in interest rates may appear attractive.  But remember that if these fund managers are wrong, you can lose more money.  Over the long term, your best bet is efficiently managed funds that stick with a specific investment objective — such as holding intermediate-term, high-quality bonds — and don't try to time and predict the bond market. 

 Trying to beat the market can lead to getting beaten.  Some bond funds have fallen on their faces after risky investing strategies backfired (see Chapter 7).  Interestingly, bond funds that charge sales commissions (loads) and higher ongoing operating fees are the ones more likely to have blowups.  This may be because these fund managers are under more pressure to try and boost returns to make up for these higher fees. 

Inflation-indexed Treasury bonds

In 1997, the U.S. federal government introduced a new type of Treasury bond that's inflation proof: inflation-indexed Treasuries.  These new Treasury bonds were designed to better meet the needs of inflation-fearing investors. 

An investor with, say, $10,000 to invest could recently have purchased a ten-year, regular Treasury bond that yielded 4 percent interest, or about $400, annually.  Now, contrast this regular Treasury bond with its new inflation-indexed brethren.  The ten-year inflation-indexed bonds issued at the same time yielded about 1.5 percent.  Before you think that this low yield is a rip-off, know that this is a real (as in not affected or eroded by inflation) rate of return of 1.5 percent. 

The other portion of your return with these inflation-indexed bonds comes from the inflation adjustment to the $10,000 principal you invested.  The inflation portion of the return gets added back into principal.  So if inflation runs at, say, 2.5 percent, after one year of holding your inflation-indexed bond, your $10,000 of principal would increase to $10,250. 

So, no matter what happens with the rate of inflation, the investor who bought the inflation-indexed bond, in my example, always earns a 1.5 percent return above and beyond the rate of inflation.  If inflation leaps to 10, 12, or 14 percent, or more, as it did in the early 1980s, the holders of inflation-indexed Treasuries won't have the purchasing power of their principal or interest eroded by inflation.  Holders of regular Treasury bonds, however, won't be as fortunate because at a continued double-digit annual inflation rate, holders of these 4 percent yield bonds would have a negative real (after inflation) return. 

Because inflation-indexed Treasuries protect the investor from the ravages of inflation, they represent a less risky security.  In the investment world, lower risk usually translates into lower returns. 

Of course, the rate of inflation can and will change in the future.  For the ten-year bonds chosen in my example, inflation needs to exceed 2.5 percent per year for the holders of the inflation-indexed bonds to come out ahead of those holding the regular Treasury bonds.  If inflation were running at, say, 3 percent per year, the total return of inflation-indexed bonds would be 4.5 percent, exceeding the 4 percent on the regular Treasury bonds. 

Income-minded investors need to know that the inflation-indexed Treasuries only pay out the real return, which in the preceding example was just 1.5 percent.  The rest of the return, which is for increases in the cost of living, is added to the bond's principal.  Thus, relative to regular Treasury bonds, which pay out all their returns in interest, the inflation-indexed Treasuries pay significantly less interest.  Therefore, they don't make sense for nonretirement account investors who seek maximum income to live on. 

For recommended inflation-indexed Treasury funds, please see the "Eyeing Recommended Bond Funds" section, later in this chapter. ( Also know that regular bond fund managers may invest some of their fund's assets in inflation-indexed Treasuries if they appear attractive relative to other bonds.) 

Investing in Bond Funds

It's time to get down to how and why you might use bonds.  Bonds may be boring, but they can be more profitable for you than super-boring bank savings accounts and money market funds.  Bonds generally pay more than these investments because they involve more risk: You're purchasing an investment that's intended to be held for a longer period of time than savings accounts and money market funds. 

That doesn't mean that you have to hold a bond until it matures, because an active market for them does exist.  You can sell your bond to someone else in the bond market (which is exactly what a bond fund manager does if he wants out of a specific bond he holds in the bond fund).  You may receive more — or less — for the bond than you paid for it depending on what has happened in the financial markets since then. 

As I discuss earlier, in the section "Maturity: Counting the years until you get your principal back," bond funds are riskier than money market funds and savings accounts because their value can fall if interest rates rise.  However, bonds tend to be more stable in value than stocks (see Chapter 1). 

Why you might (and might not) want to invest in bond funds

Investing in bonds is a time-honored way to earn a better rate of return on money that you don't plan to use within at least the next couple of years.  As with other mutual funds, bond funds are completely liquid on a day's notice, but I advise you to view them as longer term investments.  Because their value fluctuates, you're more likely to lose money if you're forced to sell the bond fund sooner rather than later.  In the short term, the bond market can bounce every which way; in the longer term, you're more likely to receive your money back with interest. 

 Don't invest your emergency money in bond funds — use a money market fund instead (see Chapter 11).  You could receive less money from a bond fund (and could even lose money) if you need it in an emergency. 

Avoid using the check-writing option that comes with many bond funds.  Every time you sell shares in a bond fund (which is what you're doing when you write a check), this transaction must be reported on your annual income tax return.  When you write a check on a money market fund, by contrast, it isn't a so-called taxable event because a money fund has a fixed share price, so you're not considered to be adding to or subtracting from your taxable income when you sell these shares. 

Aren't higher interest rates better if you need income? 

In the early 2000s, after a multiyear drop, interest rates were at what seemed to be rock-bottom levels compared to those of earlier decades.  Intermediate-term bonds were yielding around 4 percent — about one-third of what rates had been in the early 1980s. 

Generally speaking, lower interest rates are great for the economy because they encourage consumers and businesses to borrow and spend more money.  But if you were a retiree trying to live off the income being produced by your bonds, low interest rates seemed like the worst of all possible economic worlds. 

For each $100,000 that a retiree invested in intermediate-term bonds, CDs, or whatever when interest rates were 12 percent, the retiree received $12,000 per year in interest or dividends.  A retiree purchasing intermediate-term bonds in the early to mid 2000s after the fall in interest rates, however, received two-thirds less dividend income because rates on the same bonds and CDs were just 4 percent.  So for every $100,000 invested, only $4,000 in dividend or interest income was paid. 

If you're trying to live off the income being produced by your investments, a 67 percent reduction in that income may cramp your lifestyle.  So higher interest rates are better if you're living off your investment income, right? 

Wrong! 

Never forget that the primary driver of interest rates is the expected future rate of inflation.  Interest rates were much higher in the early 1980s because the United States had double-digit inflation.  If the cost of living is increasing at the rate of 12 percent per year, why would you as an investor lend your money out (which is what you're doing when you purchase a bond or CD) at 4 percent?  Of course, you wouldn't lend money at that rate — which is exactly why interest rates were so high in the early 1980s. 

By the early 2000s, interest rates were low because the inflation dragon seemed to have been slain (and the economy was in a recession).  So the rate of interest that investors could earn by lending their money dropped accordingly.  Although low interest rates reduce the interest income, the corresponding low rate of inflation doesn't devour the purchasing power of your principal balance as quickly. 

So what's an investor to do if she lives off the income from her investments but can't generate enough income because present interest rates are too low?  A financially simple but psychologically difficult solution is to use up some of the principal to supplement the interest and dividend income.  In effect, this situation is what happens anyway when inflation is higher — the purchasing power of the principal erodes more quickly.  You also should educate yourself about the range of higher yielding (and quality) investment options available — this book helps you do just that. 

You also shouldn't put too much of your longer term investment money in bond funds (for example, your retirement money if you're a young adult with many decades until you would retire).  With the exception of those rare periods when interest rates drop significantly, bond funds won't produce the high returns that growth-oriented investments such as stocks, real estate, and your own business can. 

 Here are some common financial goals to which bond funds are well suited:

  A major purchase: But make sure that the purchase won't happen for at least two years, such as the purchase of a home.  Short-term bond funds should offer a higher yield than money market funds.  However, bond funds are a bit riskier, which is why you should have at least two years until you need the money to allow time for recovery from a dip in your bond fund account value. 

  Part of a long-term, diversified portfolio: Because stocks and bonds don't move in tandem, bonds can be a great way to hedge against declines in the stock market.  In fact, in a down economic environment, bonds may appreciate in value if inflation is declining.  Different types of bond funds (high-quality bonds and junk bonds, for example) typically don't move in tandem with each other either, so they can provide an additional level of diversification.  In Chapter 10, where I talk about asset allocation, I explain how to incorporate bonds into long-term portfolios for goals such as retirement. 

  Generating current income: If you're retired or not working, bonds are better than most other investments for producing a current income stream. 

How to pick a bond fund with an outcome you can enjoy

When comparing bond funds of a given type (for example, high-quality, short-term corporate bond funds), folks want to pick the one that's going to make the most money for them.  But be careful; some mutual fund companies exploit your desire for high returns.  These fund firms love to lure you into a bond fund by emphasizing high past performance and current yield, deflecting your attention away from the best predictor of bond fund performance: operating expenses. 

Don't overemphasize past performance

 A major mistake that novice bond fund investors make is to look at recent performance and assume that those are the returns they're going to get in the future.  Investing in bond funds based only on recent performance is tempting right after a period when interest rates have declined, because declines in interest rates pump up bond fund total returns.  Remember that an equal but opposite force is waiting to counteract pumped-up bond returns — bond prices fall when interest rates rise, which they eventually will. 

Don't get me wrong: Past performance is an important issue to consider.  But in order for performance numbers to be meaningful and useful, you must compare the same type of bond funds to each other (such as intermediate-term funds that invest exclusively in high-grade corporate bonds) and against the correct bond market index or benchmark (which I discuss in Chapter 17). 

Be careful with yield quotes

A bond fund's yield measures how much the fund is currently paying in dividends; it's quoted as a percentage of the fund's share price — say, 5.2 percent.  This statistic certainly seems like a valid one for comparing funds.  Unfortunately, some fund companies have abused it. 

 Don't confuse a bond fund's yield with its return.  Dividends are just one part of a fund's return, which also includes capital gain distributions and changes in the bond fund's share price.  Over a given period of time, a bond fund could have a positive yield but a negative overall return, particularly if interest rates have increased or the credit quality of bonds in its portfolio has deteriorated. 

Some unscrupulous fund companies try to obscure the difference between yield and return.  For example, consider an advertisement sent by the Fundamental U.S. Government Strategic Income Fund.  In huge type on the cover of this brochure, the fund boasted of its 11.66-percent yield, an impressive number because 30-year Treasury bonds were yielding less than 8 percent at the time.  One can only assume that the designers of this promo piece hoped that you wouldn't check out the back cover, where the small print stated that the fund's total return for the previous year was –15.7 percent. 

 Mutual fund companies can play a few games to fatten a fund's yield.  Such sleight of hand makes a fund's marketing department happy because higher yields make hawking the bond funds easier for salespeople.  But remember that yield-enhancing shenanigans can leave you disappointed when a bond fund fails to perform well after you buy it based on the allure of a swollen yield.  Here's what to watch out for:

  Lower quality: You may compare one short-term bond fund to another and discover, for example, that one pays 0.5 percent more and, therefore, looks better.  But, if you look a little further, you see that the higher yielding fund invests 20 percent of its assets in junk bonds (a BB or less credit-quality rating), whereas the other fund is fully invested in high-quality bonds (AAA and AA rated).  In other words, the junk bond fund isn't necessarily better; given the risk it's taking, it should be yielding more. 

  Lengthened maturities: Bond funds can usually increase their yield just by increasing maturity a bit. ( Insiders call this ploy going further out on the yield curve.)  So when comparing yields on different bond funds, be sure that you're comparing them for funds of similar maturity.  Even if they both call themselves "intermediate-term," if one bond fund invests in bonds maturing on average in seven years, while another fund is at ten years for its average maturity, comparing the two is a classic case of comparing apples to oranges.  Because longer term bonds usually have higher yields (due to increased risk), the ten-year average maturity fund should yield more than the seven-year average maturity fund. 

  Giving your money back without your knowledge: Some funds return a portion of your principal in the form of dividends.  This move artificially pumps up a fund's yield but depresses its total return.  Investors in this type of bond fund are rudely awakened when, after enjoying a healthy yield for a period of time, they examine the share price of their bond fund shares and find that they've declined in value. 

 When you compare bond funds to each other by using the information in the prospectuses (see Chapter 8), make sure that you compare their total return over time (in addition to making sure that the funds have comparable portfolios of bonds and similar durations). 

  Waiving of expenses: Some bond funds, particularly newer ones, waive a portion or even all of their operating expenses to temporarily inflate the fund's yield.  Yes, you can invest in a fund that's having a sale on its operating fees, but you also have the hassle of monitoring the fund to determine when the sale is over.  Bond funds engaging in expense waiving often end such sales quietly when the bond market is doing well.  Don't forget that if you sell a bond fund (held outside of a retirement account) that has appreciated in value, you owe taxes on your profits. 

Do focus on costs

Like money market funds, bond fund returns are extremely sensitive to costs.  After you've identified a particular type of bond fund to invest in, expenses — sales commissions and annual operating fees — should be your number-one criterion for comparing funds. 

 For bond funds, you should generally shun funds with operating expenses higher than 0.5 percent. 

The marketplace for bonds is fairly efficient.  For any two bond managers investing in a particular bond type — say, long-term municipal bonds — picking bonds that outperform the other's over time is difficult.  But if one of those bond funds charges lower fees than the other, that difference provides the low-fee fund with a big head start in the performance race. 

How bond funds calculate their yields

When you ask a mutual fund company for a bond fund's yield, make sure you understand the time period that the yield covers.  Fund companies are supposed to report the Securities and Exchange Commission (SEC) yield, which is a standard yield calculation that allows for fairer comparisons across bond funds.  The SEC yield reflects the bond fund's so-called yield to maturity.  This yield is the best to use when you compare funds because it captures the effective rate of interest an investor will receive going forward. 

Funds also calculate a yield that only looks at the recently distributed dividends relative to the share price of the fund.  Funds can pump up this number by purchasing particular types of bonds.  For just that reason, yield based on recently distributed dividends isn't nearly as useful a yield number to look at (although some brokers who sell bond funds love to use it because they push funds that are pumping up their yields). 

 You can earn a higher return from a bond fund by investing in funds that

  Hold longer term bonds

  Hold lower credit-quality bonds

  Have lower operating expenses

Please note that the first two ways of earning a higher bond fund yield — using longer term and lower credit-quality bonds — increase the risk that you're exposed to.  Stick with no-load funds that have low annual operating expenses as a risk-free way to boost your expected bond fund returns. 

How to obtain tax-free income

Just as money market funds can produce taxable or tax-free dividends (see Chapter 11), so too can bond funds.  In order to produce tax-free income, a bond fund invests in municipal bonds (also called muni bonds or munis) issued by state or local governments. 

As long as you live in the United States, generally, municipal bond fund dividends are federally tax-free to you.  Funds that specialize in muni bonds issued just in your state pay dividend income that's typically free of your state's taxes as well. 

 When you're investing in bonds inside retirement accounts, use taxable bonds.  If you're investing in bonds outside retirement accounts, the choice between taxable versus tax-free depends on your tax bracket.  If you're in a high tax bracket (28 percent or higher for federal) and you want to invest in bonds outside of tax-sheltered retirement accounts, you may do better in a muni fund than in a bond fund that pays taxable dividends (see Chapter 10 to determine your tax bracket). 

Eyeing Recommended Bond Funds

If you've read through this chapter, you now know more about bond funds than you probably ever imagined possible, so now it's time to get down to brass tacks: selecting bond funds for a variety of investing needs. 

Using the logic laid out earlier in this chapter, I present you with a menu of choices.  Although thousands of bond funds are available — few are left to consider after you eliminate the high-cost ones (loads and ongoing fees), low-performance funds (which are often the just-mentioned high-cost funds), and funds managed by fund companies and managers with minimal experience investing in bonds. 

I've done the winnowing for you, and the funds I present in the sections that follow are the best of the best for meeting specific needs.  I've organized the funds by the average maturity and duration of the bonds that they invest in, as well as by the taxability of the dividends that they pay. 

 Use the following funds only if you have sufficient money in your emergency reserve (see Chapter 3).  If you're investing money for longer term purposes, particularly retirement, come up with an overall plan for allocating your money among a variety of different funds, including stock and bond funds.  For more on allocating your money, be sure to read Chapter 10. 

Short-term bond funds

Short-term bond funds, if they live up to their name, invest in short-term bonds (which mature in a few years or less).  Of all bond funds, these are the least sensitive to interest rate fluctuations.  Their stability makes them the most appropriate bond funds for money on which you want to earn a better rate of return than a money market fund could produce for you.  But with short-term bond funds, you also have to tolerate the risk of losing a few percent in principal value if overall interest rates rise. 

Even lower fees: High-balance funds and exchange-traded funds

Throughout this chapter, I highlight the best bond funds.  Among other positive attributes, those funds have low fees.  That said, you may be able to lower your bond fund fees even further in two additional ways.  Some mutual fund companies will offer a lower fee version of a given bond fund to investors who are able to invest a larger amount into the fund. 

For example, many Vanguard bond funds now offer "Admiral" versions with even lower operating expenses (and thus higher yields) for big balance customers.  For example, Vanguard's Short-Term Investment-Grade Admiral shares (VFSUX), which sports a $100,000 minimum to invest, have an expense ratio of just 0.14 percent.  The regular share class, which has a $3,000 minimum, has an expense ratio of 0.26 percent.  You may qualify to convert your regular shares (also known as "Investor" shares) in Short-Term Investment-Grade into Admiral shares if you've been a longer term customer but lack $100,000.  If you've held the Investor shares at least ten years, you need a balance of $50,000.  Where relevant in this chapter, I note attractive options for high-balance investors. 

Another potentially attractive and low-cost option is exchange-traded funds (ETFs).  However, as I discuss in Chapter 5, don't get blindly suckered into the pitch that ETFs are universally superior due to low costs.  The vast majority of ETFs have higher costs than the best mutual funds recommended in this book.  Interestingly and perhaps not surprisingly, the best bond ETFs come from Vanguard and where appropriate, I recommend some of their ETFs in this chapter. 

Short-term bonds work well for investing money to afford major purchases that you expect to make in a few years, such as a home, a car, or a portion of your retirement account investments that you expect to tap in the near future. 

Taxable short-term bond funds

Bond funds that pay taxable dividends are appropriate for nonretirement accounts if you're not in a high tax bracket (no more than 28 percent federal) and for investing inside retirement accounts. ( Call the fund companies for current yields.) 

 Vanguard Short-Term Investment-Grade (VFSTX) invests the bulk of its portfolio in high- and moderate-quality, short-term corporate bonds. ( The average credit rating is AA.)  Typically, it keeps a small portion in U.S. Treasuries.  It may even stray a bit overseas and invest several percent of the fund's assets in promising foreign bonds.  This fund maintains an average maturity of two to three years, and duration currently is two years. 

Robert Auwaerter has managed Vanguard's Short-Term Corporate fund since the early 1980s.  Gregory Nassour, who had been an investment manager since 1994, was added as co-manager in 2008.  All told, this fund invests in more than 1,000 bonds. ( Imagine having to keep track of all of them on your own!)  This fund's operating expense ratio is just 0.26 percent (0.14 percent for its Admiral share class discussed in the adjacent sidebar).  It has a $3,000 minimum. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

Vanguard offers an ETF similar to this fund: Short-Term Corporate Bond ETF (VCSH).  It's expense ratio is just 0.15 percent. 

U.S. Treasury short-term bond funds

U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) or if you're not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher).  I don't recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. ( Call the fund companies for current yields.) 

 Vanguard Short-Term Treasury (VFISX) invests in U.S. Treasuries maturing within two to three years — you can't get much safer than that.  Duration currently is two years.  This fund has been managed by David Glocke since 2000, who has been an investment manager since 1991.  Although the fund has that lean Vanguard expense ratio of 0.22 percent annually (0.12 percent for the Admiral share class), don't forget that you can buy Treasuries direct from your local Federal Reserve Bank if you don't need liquidity.  The minimum initial investment is $3,000. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

Municipal tax-free short-term bond funds

Short-term bond funds that are free of both federal and state taxes are scarce.  However, some good short-term funds are free of federal, but not state, taxes.  These are generally appropriate if you're in a higher federal bracket (more than 28 percent) but in a low state bracket (less than 5 percent). 

If you live in a state with high taxes, consider a state money market fund, which I cover in Chapter 11. ( Call the fund companies for current yields.) 

 Vanguard Short-Term Tax-Exempt (VWSTX) invests in the crème de la crème of the federally tax-free muni bonds issued by state and local governments around the country. ( Its average credit rating is AA.)  The fund's average maturity ranges from one to two years, and duration is about one year. 

Vanguard Limited-Term Tax-Exempt (VMLTX) does just what the short-term fund does (and has the same manager), except that it does it a while longer.  This fund's average muni bond matures in two to five years (with a duration of about three years), although its average credit rating is a respectable AA. 

Both the short-term and limited-term funds have a miserly annual operating expense ratio of 0.20 percent and require a $3,000 minimum initial investment.  Admiral shares, with a 0.12 percent expense ratio, are available for both these funds. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

Intermediate-term bond funds

Intermediate-term bond funds hold bonds that typically mature within a decade or so.  They're more volatile than shorter term bonds but should be more rewarding.  The longer you can own an intermediate-term bond fund, the more likely you are to earn a higher return on it than on a short-term fund, unless interest rates keep rising over many years. 

You shouldn't purchase an intermediate-term fund unless you expect to hold it for a minimum of three to five years — or longer, if you can.  Therefore, the money you put into this type of fund should be money that you don't expect to use during that period. ( Call the fund companies for current yields.) 

Taxable intermediate-term bond funds

If you invest in these funds in a nonretirement account, be sure that you're not in a high tax bracket — more than 28 percent federal. 

 Dodge & Cox Income (DODIX) is run by a conservative management team at an old San Francisco investment firm that has been managing money for private accounts since 1930 and running mutual funds since 1931.  This fund, which focuses on government securities and high-grade corporate debt, has an average bond credit rating of AA, an average maturity of five to ten years, and a duration of about four to five years.  This fund is team managed with the managers having an average tenure of about 14 years.  The operating expense ratio is a reasonable 0.43 percent: $2,500 is the minimum initial investment ($1,000 for retirement accounts).   800-621-3979. 

  Harbor Bond (HABDX) is a more aggressive intermediate-term bond fund.  The fund invests mostly in corporate bonds, as well as in mortgage bonds with average maturities of up to ten years (duration is about five years), depending on fund manager William Gross's outlook for inflation and the economy. 

Gross, who's managed this fund since 1987, has three plus decades of experience managing money in the bond market.  He makes relatively wide swings in strategy and, during periods of rising interest rates, has bulked up the fund with money market securities to protect principal.  At times, Gross has also ventured small portions of the fund into foreign bonds, junk bonds, and even a sprinkling of derivatives such as futures and options to slightly leverage returns. ( The fund has an average credit rating of AA.)  Despite its aggressiveness, the fund has had low volatility.  Although this fund's expense ratio is a tad on the high side (0.57 percent), Gross has delivered high enough long-term returns to justify the slightly higher costs.  The minimum initial investment is just $1,000.   800-422-1050. 

 Vanguard Total Bond Market Index (VBMFX) is an index fund that tracks the index of the entire bond market, the Lehman Brothers Aggregate Bond Index.  The fund is managed Kenneth Volpert, Gregory Davis, and a computer.  It uses a sampling to mirror the index so it doesn't actually invest in every bond in the index.  Investment-grade corporate bonds and mortgages make up the majority of the fund's investments; the rest are U.S. government and agency securities.  The fund's average maturity is about seven years, with a duration of about five years. ( Average bond credit rating is AA.)  Annual operating expenses are a paltry 0.22 percent (0.14 percent for Admiral shares). ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)  You need a $3,000 minimum initial investment to open.   800-662-7447. 

Vanguard Total Bond Market ETF (BND) is an ETF similar to this fund.  Its expense ratio is 0.14 percent. 

 Vanguard GNMA (VFIIX) invests in residential mortgages that people just like you take out when they purchase a home and borrow money from a bank.  Like other GNMA funds, this one has very low credit risk. ( Its average credit rating is AAA.)  Why?  Because the principal and interest on GNMAs is guaranteed by the U.S. government.  All GNMA funds have prepayment risk. ( If interest rates fall, mortgage holders refinance.)  But this GNMA fund has less risk than most because it minimizes the purchase of mortgage bonds that were issued at higher interest rates — and are, therefore, more likely to be refinanced and paid back early. 

This fund is managed by Thomas Pappas at Wellington Management, a private money management firm that Vanguard uses for some of its other funds.  GNMA doesn't invest in some of the more exotic mortgage securities and derivatives that are abused by other firms' bond funds.  Like all other bond funds, this one has interest rate risk, though it's comparable to other intermediate-term bond funds despite the longer maturity of most of this fund's holdings.  Duration is generally around four years, and the fund's yearly operating expense ratio is 0.23 percent: $3,000 is the minimum initial investment. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

Vanguard Mortgage-Backed Securities ETF (VMBS) is an ETF similar to this fund.  Its operating expense ratio is 0.15 percent. 

 Vanguard High Yield Corporate (VWEHX) invests in lower quality (junk) corporate bonds.  These pay more and are for more aggressive investors stretching for greater yield.  Intermediate-term junk bonds are volatile: They not only are interest rate sensitive, but also they're susceptible to changes in the economy.  For example, this fund lost more than 10 percent of its principal value in 1989, 1990, and 1994 and more than 25 percent in 2008. ( Dividends payments, of course, mitigated some of this principal erosion.) 

Unlike other high-yield funds, this fund invests little (if any) of its funds in lower rated junk bonds; it invests in the best of the junk (its average credit rating is BB).  The average maturity of this fund is seven years, with a duration of five years.  Michael Hong, who has been an investment manager since 1997, at Wellington Management has managed this fund since 2008.  The fund has been around since 1978 — a degree of longevity that makes it one of the longest and best-performing junk bond funds.  Yearly operating expenses are 0.32 percent: $3,000 is the minimum initial investment. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

U.S. Treasury intermediate-term bond funds

U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) and if you're not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher).  I don't recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. ( Call the fund company for current yields.) 

 Vanguard Intermediate-Term Treasury (VFITX) invests in U.S. Treasuries maturing in five to ten years. ( See the description for the short-term U.S. Treasury funds for minimum initial investment and expense ratio.)   800-662-7447. 

Vanguard Inflation-Protected Securities (VIPSX) fund is a new breed of fund, which I cover in the "Inflation-indexed Treasury bonds" section in this chapter.  With a low operating expense ratio of 0.25 percent (0.12 for the Admiral share class), this fund is a good one for inflation-skittish investors to consider.  It has a $3,000 minimum initial investment. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

Municipal tax-free intermediate-term bond funds

Consider federally tax-free bond funds if you're in a high federal bracket (28 percent and up) but a relatively low state bracket (less than 5 percent). ( Call the fund company for current yields.) 

If you're in the market for a state and federally tax-free bond fund, the problem is that the ones available (and there aren't all that many) have high expenses.  High expenses are always a problem but are especially so in a low interest rate environment (like has been around for years) because little of a fund's yield will be left to pay out.  So, if you're in high federal (28 percent and up) and high state (5 percent or higher) tax brackets, you're better off using the nationwide Vanguard municipal bond fund that I describe at the end of this section. 

 Fidelity Intermediate Municipal Income (FLTMX) invests in high-credit-quality (average rating is A) municipal bonds that generally mature within ten years.  This fund's average maturity is usually around eight years, with a duration of about five to six years.  The expense ratio is a competitive 0.38 percent, and the minimum initial investment is $10,000.   800-544-8888. 

 Vanguard Intermediate-Term Tax-Exempt (VWITX) does what Vanguard's short-term muni funds do, except that it invests in slightly longer term muni bonds. ( Duration is generally about six years, and the average credit rating is AA.)  The annual operating expense ratio is a mere 0.20 percent (0.12 for the Admiral share class); $3,000 is the minimum initial investment.  Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.   800-662-7447. 

Long-term bond funds

Long-term bond funds are the most aggressive and volatile bond funds around.  If interest rates on long-term bonds increase substantially, the principal value of your investment could decline 10 percent or more. 

Long-term bond funds generally are used for retirement investing in one of two situations:

  For investors not expecting to tap their investment money — ideally — for a decade or more

  For investors wanting to maximize current dividend income and who are willing to tolerate volatility

 Don't use these funds for investing money that you plan to use within the next five years, because a bond market drop could leave your portfolio with a bit of a hangover. ( Use intermediate-term and short-term bond funds instead.)  And don't use the taxable funds in a nonretirement account if you're in a high tax bracket — especially higher than 28 percent federal. ( Call the fund companies for current yields.) 

Taxable long-term bond funds

Bond funds that pay taxable dividends are appropriate for nonretirement accounts if you're not in a high tax bracket (no more than 28 percent federal) and for investing inside retirement accounts. ( Call the fund companies for current yields.) 

 Vanguard Long-Term Investment-Grade (VWESX) is comprised mostly of high-grade corporate bonds, but it sometimes holds around 10 percent in Treasuries and foreign and convertible bonds. ( Average credit rating is A.) Long-term bonds such as these (the fund's average maturity is 20+ years, with a duration of 10+ years) can produce wide swings in volatility.  For example, this fund lost more than 12 percent of its principal value in 1999, its worst year in a generation.  The dividends of 6.3 percent paid that year brought the fund back to produce a total return of –6.2 percent.  Wellington Management's Lucius Hill has managed the fund since 2008, and he has been an investment manager since 1993.  Wellington itself has managed this fund since its inception in 1973.  It has an annual operating expense ratio of 0.28 percent (0.16 percent for Admiral shares), with a $3,000 minimum initial investment. ( Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.)   800-662-7447. 

An ETF version of this fund is available and is called Vanguard Long-Term Corporate Bond ETF (VCLT).  Its expense ratio is 0.15 percent. 

U.S. Treasury long-term bond funds

U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) and if you're not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher).  I don't recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. ( Call the fund companies for current yields.) 

  Vanguard Long-Term Treasury (VUSTX) invests in U.S. Treasuries with average maturities around 20 years.  Duration is about 12 years. ( See the description in the section "U.S. Treasury short-term bond funds" for minimum initial investment and expense ratio.)  Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.   800-662-7447. 

Municipal tax-free long-term bond funds

Consider federally tax-free bond funds if you're in a high federal bracket (28 percent and up) but a relatively low state bracket (less than 5 percent). ( Call the fund company for current yields.) 

 Vanguard Long-Term Tax-Exempt (VWLTX) does what Vanguard's short-term muni funds do, except that it invests in long-term muni bonds. ( The average credit rating is AA.)  This fund has an operating expense ratio of 0.20 percent.  This fund has a $3,000 minimum initial investment.  Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard's Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.   800-662-7447. 

 State and federally tax-free bond funds may be appropriate if you're in high federal (28 percent and up) and high state (5 percent or higher) tax brackets.  The fund providers Fidelity, T. Rowe Price, and Vanguard offer competitive funds for states such as California, Connecticut, Florida, Maine, Maryland, Michigan, Minnesota, New Jersey, New York, Ohio, and Pennsylvania.  If you can't find a good state-specific bond fund for your state, or if you're only in a high federal tax bracket, use the nationwide Vanguard Municipal bond funds I describe in this section. ( Call the fund companies for current yields.) 

Exploring Alternatives to Bond Funds

Bond mutual funds are just one way to lend your money and get paid a decent yield.  In the following sections, I discuss the advantages and disadvantages of other alternatives, some of which have acronyms that you can impress your friends and family with — or confirm that you're an investments geek.  Regardless of which investment type(s) you end up purchasing, do your big-picture thinking first: What do you plan to use the money for down the road?  How much risk are you willing and able to take?  What's your tax situation? 

Most of these bond fund alternatives have one thing in common: They offer psychological solace to those who can't stomach fluctuations in the value of their investments.  After I tell you more about these alternatives (including information that you're not likely to hear in a marketing pitch from the company or person who's trying to sell you on them), low-cost bond funds may look more attractive. 

Certificates of deposit

For many decades, bank certificates of deposit (CDs) have been the safe investment of choice for folks with some extra cash that they don't need in the near term.  The attraction is that you get a higher rate of return on a CD than on a bank savings account or money market fund.  And unlike a bond fund, a CD's principal value doesn't fluctuate.  Of course, you also enjoy the peace of mind afforded by the government's FDIC insurance program. 

 All these advantages of CDs aren't nearly as attractive as they may seem on the surface.  I start with the FDIC insurance issue.  Bonds and bond mutual funds aren't FDIC-insured.  The lack of this insurance, however, shouldn't trouble you on high-quality bonds because these bonds rarely default.  Even if a fund held a bond that defaulted, it probably would be a tiny fraction (less than 1 percent) of the value of the fund, so it would have little overall impact. 

You may believe that there's no chance you'll lose money on a CD — but banks have failed and will continue to fail.  Although you're insured for $100,000 in a bank, if the bank crashes, you'll likely wait a while to get your money back — and you'll probably have to settle for less interest than you expected, too. 

 Here's another myth about CDs: The principal value of your CD doesn't fluctuate.  Sure it does; you just don't see the fluctuations!  Just as the market value of a bond drops when interest rates rise, so too does the "market value" of a CD — and for the same reasons.  At higher interest rates, investors expect a discounted price on fixed-interest-rate CDs because they always have the alternative of purchasing a new CD at the higher prevailing rates.  Some CDs are actually bought and sold among investors — on what's known as a secondary market — and they trade and behave just like bonds. 

So a lot of those advantages CDs seem to have aren't as impressive as some may believe.  In fact, compared to bonds, CDs have a number of drawbacks:

  Early withdrawal penalties: Money in a CD isn't accessible unless you pay a fairly big penalty — typically, six months' interest.  With a no-load (commission-free) bond fund, if you need some or all of your money next month, next week, or even tomorrow, you can access it without penalty. 

  Restricted tax options: Another seldom-noted drawback of CDs is that they come in only one tax flavor — taxable.  Bonds, on the other hand, come both in tax-free (federal and/or state) and taxable flavors.  So if you're a higher tax-bracket investor, bonds offer you tax-friendly options that CDs can't. 

  Lower yield: For a comparable maturity, CDs yield less than a high-quality bond.  Often, the yield difference is 1 percent or more.  If you don't shop around — if you lazily purchase CDs from the bank that you use for your checking account, for example — you may be sacrificing 2 percent or more in yield. 

Don't forget about the unfriendly forces of inflation and taxes.  They may gobble up all the yield that your CD is paying, thus leaving you no real growth on your investment.  An extra percentage point or two from a bond can make a big difference in the long term. 

 You'll earn more over the years and have better access to your money in bond funds than in CDs.  And bond funds make particular sense if you're in a higher tax bracket and would benefit from tax-free income on your investments.  If you're not in a high tax bracket and you get gloomy whenever your bond fund's value dips, then consider CDs. 

 CDs may make the most sense if you know, for example, that you can invest your money for one year, after which you'll need the money for some purchase you expect to make.  Just make sure that you shop around to get the best interest rate.  If what attracts you to CDs is the U.S. government backing that comes with FDIC insurance, consider Treasuries, which are government-backed bonds.  Treasuries often pay more interest than the better CDs available. 

Individual bonds

Maybe you've had thoughts like these:

  Why buy a bond fund and pay all those ongoing management fees, year after year, when I can buy high-rated bonds that pay a higher yield than that fund I'm looking at? 

  I can create my own portfolio of bonds and purchase bonds with different maturities.  That way, I'm not gambling on where interest rates are headed, and I won't lose principal as I may in a bond fund. 

Or more likely, you've listened to a broker — who was trying to sell individual bonds to you — make these sorts of remarks.  Does the purchase of individual bonds make sense for you?  Although the decision depends on several factors, I can safely say that most types of individual bonds probably are not for you. ( Treasuries that you can buy directly from a local Federal Reserve Bank without charge are notable exceptions to my comments that follow.) 

Here are some solid reasons why a good bond mutual fund beats individual bonds:

  Mutual funds allow for better diversification.  You don't want to put all your investment money into a small number of bonds of companies in the same industry or that mature at the same time.  Building a diversified bond portfolio with individual issues is difficult unless you have a hefty chunk (at least several hundred thousand dollars) that you desire to invest in bonds. 

  You want to save on commissions.  If you purchase individual bonds through a broker, you're going to pay a commission.  In most cases, it's hidden; the broker quotes you a bond price that includes the commission.  Even if you go through a discount broker, transaction fees take a healthy bite out of your investment.  The smaller the amount invested, the bigger the bite.  On a $1,000 bond, the fee can equal up to 5 percent. 

  Adjusting bond holdings as percentage of your portfolio is easy.  Good investment management includes monitoring and adjusting your overall bond/stock mix.  Adding to or subtracting from your bond holdings by using individual bonds, however, can be inconvenient and costly. 

  Life's too short.  Do you really want to research bonds?  You have better things to do with your time.  Bonds and the companies that stand behind them aren't that simple to understand.  For example, did you know that some bonds can be "called" before their maturity date?  Companies often do this to save money if interest rates drop significantly.  After you purchase a bond, you need to do the same things that a good bond fund manager would need to do, such as tracking the issuer's creditworthiness and monitoring other important financial developments. 

 In terms of costs, you can purchase terrific bond funds with yearly operating expense ratios of just 0.2 percent (or less).  And remember, a bond mutual fund provides you tons of diversification and professional management so that you can spend your time doing activities you're good at and enjoy.  You can increase your diversification by purchasing bond funds with different maturity objectives (short, intermediate, and long) or an index bond fund that covers the range. 

If you already own individual bonds and they fit your financial objectives and tax situation, you can hold them until maturity because you've already incurred a commission (which some brokers instead call a markup) when they were purchased; selling them now would just create an additional fee.  When the bond(s) mature(s), think about moving the proceeds into bond funds if you want to continue owning bonds. 

  Don't mistakenly think that your current individual bonds are paying the same yield as when they were originally issued. ( That yield is the number listed on your brokerage account statement in the name of the bond.)  As the market level of interest rates changes, the actual yield of your bonds fluctuates to rise and fall with the market level of rates.  So if rates have fallen since you bought your bonds, the value of those bonds has increased — which in turn reduces the effective yield that you're currently earning. 

Guaranteed-investment contracts

Guaranteed-investment contracts (GICs) are sold and backed by an insurance company.  Typically, they quote you a rate of return projected one or a few years forward.  So, like that of a CD, a GIC's return is always positive and certain.  With a GIC, you experience none of the uncertainty that you normally face with a bond fund that fluctuates in value with changing interest rates and other economic upheavals. 

The attraction of GICs is that your account value doesn't fluctuate (at least, not that you can see).  For people who panic the moment a bond fund's value slips, GICs soothe the nerves.  And they usually provide a higher yield than a money market or savings account. 

As a rule, the insurance company invests GIC money mostly in bonds and usually a small portion in stocks.  The difference between the amount these investments generate for the insurer and the amount they pay in interest is profit to the insurer.  The yield is usually comparable to that of a bond fund.  Typically, once a year, you'll receive a new statement showing that your GIC is worth more — thanks to the newly added interest. 

Some employers offer GICs in their retirement savings plans as a butt-covering option or because an insurance company is involved in the company's retirement plan.  More and more companies are eliminating GICs as investment options because of the greater awareness about GICs' drawbacks.  First, insurance companies (like banks) have failed and will continue to fail.  Although failed insurers almost always get bailed out — usually through a merger into a healthy company — you can take a haircut on the promised interest rate if your GIC is with a failed insurance company.  Second, by having a return guaranteed in advance, you pay for the peace of mind in the form of lower long-term returns. 

Mortgages

Another way that you can invest your money for greater dividend income is to lend your money via mortgages and second mortgages.  Mortgage brokers often arrange these "deals."  They appeal to investors who don't like the volatility of the stock and bond markets.  With a mortgage, you don't have to look up the value every day in the newspaper; a mortgage seems safer because you can't watch your principal fluctuate in value. 

 What's amazing is that people who invest in these types of mortgages don't realize that they're getting a relatively high interest rate only because they are accepting relatively high risk.  The risk is that the borrower can default, which would leave you holding the bag.  More specifically, you could get stuck with a property that you may need to foreclose on.  And if you don't hold the first mortgage, you're not first in line with a claim on the property. 

 If a property buyer could obtain a mortgage through a conventional bank, he would.  Banks offer the lowest interest rates.  So if a mortgage broker is offering you a deal to lend your money at 12 percent when the going bank rate is, say, 8 percent, that means you'll be lending money to people who the bank considers high risk.  If a bank, with its vast assets on hand, isn't willing to lend money to somebody, ask yourself whether you should.  Mortgage investments also carry interest rate risk: If you need to "sell" the mortgage early, you'll probably have to discount it, perhaps substantially if interest rates have increased since you purchased it. 

 If you're willing to lend your money to borrowers who carry a relatively high risk of defaulting, check out high-yield bond funds, which I discuss earlier in the chapter (under "Taxable intermediate-term bond funds").  With such funds, you at least diversify your money across many borrowers, and you benefit from the professional review and due diligence of the fund management team.  If the normal volatility of a bond fund's principal value makes you queasy, then don't follow your investments so closely! 

When you're selling some real estate and are willing to act as the bank and provide the financing to the buyer in the form of a first mortgage, consider that a viable investment.  Be careful to check the borrower's credit, employment, and income situation; get a large down payment (at least 20 percent); and try not to lend so much money that it represents more than, say, 10 percent of your total investments. 

Exchange-traded bond funds

In 2007, Vanguard launched four different bond ETFs:

  Total bond market ETF

  Short-term bond ETF

  Intermediate-term bond ETF

  Long-term bond ETF

These funds track respective Lehman Brothers bond indexes.  The expense ratio of these new ETFs is 0.11 percent.  Check out Chapter 5 for more information on ETFs. 
Chapter 13

Stock Funds: Meeting Your Longer Term Needs

In This Chapter

  Growing your money in the stock market

  Investing in stocks through mutual funds

  Getting some stock fund recommendations

Most stock market investors who don't manage money for a living and who make money do so not because they're pouring over daily market commentaries or are luckier or more clairvoyant than anyone else.  They make money by simply being patient and using three simple investment methods:

  Invest in a diversified portfolio of stocks. 

  Continue to save money and add to investments. 

  Don't try to time the market. 

A small number of extraordinary investors — Warren Buffett being a famous one who's frequently in the news — generate exceptional returns.  Buffett and these other elite investors do the above three things and have a talent for identifying and investing in undervalued businesses before most others see that value.  The good news for you is that you can earn handsome long-term stock market returns without having Buffett's talent. ( And, you can some fun and make more money investing with the best fund managers who are able to post above-average, long-term returns.) 

People who get soaked in the stock market are those who make easily avoidable mistakes.  An investment mistake is a bad decision that you could've or should've avoided, either because better options were available, or because the odds were heavily stacked against you making money.  Investment mistakes result from the following:

  Not understanding risk and how to minimize it

  Ignoring taxes and how investments fit into overall financial plans

  Paying unnecessary and exorbitant commissions and fees

  Surrendering to a sales pitch (or salesperson)

  Trading in and out of the market

Give up the search for a secret code — there isn't one.  Focus on avoiding major gaffes. 

The stock market isn't the place to invest money that you need to tap in the near future (certainly not money you need to use within the next five years).  If your stock holdings take a dive, you don't want to be forced to sell when your investments have lost value.  So come along for the ride — but only if you can stay for a while! 

The Stock Market Grows Your Money

Stocks represent a share of ownership in a company and its profits (see Chapter 1).  As companies (and economies in general) grow and expand, stocks enable investors to share in that growth and success.  Over the last two centuries, investors holding diversified stock portfolios earned a rate of return averaging about 9 to 10 percent per year, which ended up being about 6 to 7 percent higher than the rate of inflation.  Earning such returns may not seem like much (especially in a world with gurus and brokers claiming returns of 20 percent, 50 percent, or more per year).  But don't forget the power of compounding: At 9 to 10 percent per year, your invested dollars doubles about every seven to eight years.  The purchasing power of your money growing 6 to 7 percent more per year than the rate of inflation doubles about every 10 to 12 years. 

Contrast this return with bond and money market investments, which have historically returned just a percent or two per year over the rate of inflation.  At these rates of return, the purchasing power of your invested money takes several decades or more to double. 

 Your investment's return relative to the rate of inflation determines the growth in purchasing power of your portfolio.  What's called the real growth rate on your investments is the rate of return your investments earn per year minus the yearly rate of inflation.  If the cost of living is increasing at 3 percent per year and your money is invested in a bank savings account paying you 3 percent per year, you're treading water — your real rate of return is zero. ( When you invest money outside of a tax-sheltered retirement account, you end up paying taxes on your returns, which could lead to a negative real "growth" in your money's purchasing power!) 

Be patient

The 9 to 10 percent annual historic return in stocks (quoted in the preceding section) isn't guaranteed to be the same in the future.  Consider some of the unexpected storms that hammered the stock market over the past 110 or so years (see Table 13-1). 

Table 13-1 Great Plunges (20 Percent or More) in the

Dow Jones Industrial Average Index of

Large-Company Stocks

---

Years | Percent Decline* | Years | Percent Decline*

1890–1896 | 47% | 1961–1962 | 27%

1899–1900 | 32% | 1966 | 25%

1901–1903 | 46% | 1968–1970 | 36%

1906–1907 | 49% | 1973–1974 | 45%

1909–1914 | 29% | 1976–1978 | 27%

1916–1917 | 40% | 1981–1982 | 24%

1919–1921 | 47% | 1987 | 36%

1929–1932 | 89% | 1998 | 20%

1937–1942 | 52% | 2000–2003 | 40%

1946–1949 | 24% | 2007–2009 | 55%

*The returns that stock market investors earned during these periods differ slightly from the above figures, which ignore dividends paid by stocks that mitigate some of the above declines.  The returns also ignore changes in the cost of living, which normally increase over time and make these drops seem even worse.  The Great Depression is the exception to that rule: The cost of living decreased then. 

As you see in Table 13-1, the stock market can sometimes take a beating.  But before you let the chart convince you to avoid the stock market, look at the time periods during which those great plunges occurred — notice how relatively short most of them are.  During the last century, major stock market declines have lasted less than two years on average.  Some of the 20-percent-plus declines lasted less than one year.  The longest declines (1890–1896, 1909–1914, 1929–1932, 1937–1942, 1946–1949, and 2000–2003) lasted from three to six years. 

Also remember that these declines are from an absolute peak to an absolute bottom.  While we all know folks who don't seem to be possess good luck, no investor invests all their money at a precise peak of the stock market — and then would be hapless enough to sell at the exact bottom! 

Table 13-1 tells less than half the story.  True, the stock market can suffer major losses.  But over the long haul, stocks make more money than they lose.  That's how they end up with that 9 to 10 percent average annual long-term return I've been telling you about.  Stock market crashes may be dramatic, but consider the powerful advances in Table 13-2 that have happened after big market declines. 

Table 13-2 Great Surges in the Dow Jones Industrial Average

after Major Market Declines

---

Years | Percent Increase

1896–1899 | 173%

1914–1916 | 114%

1932–1937 | 372%

1942–1946 | 129%

1949–1956 | 222%

1962–1966 | 86%

1970–1973 | 67%

1974–1976 | 76%

1987–1998 | 450%

2003–2007 | 98%

2009-2010* | 71%

*Increase may continue and add to the stated number

 In each and every one of the cases, subsequent stock market increases more than made up for the previous declines.  In other words, wait long enough, and time will bail you out! ( Hence, why stocks are for long-term investors and long-term goals.)  If you're going to invest in stocks, you must have the time on your side to wait out a major market decline.  If you don't, you face the risk of selling your stocks for a loss.  Don't keep your emergency money in stocks.  Only invest money that you don't plan on using for at least five years — preferably ten or more. 

Add regularly to your stock investments

 Although the stock market may be able to double the purchasing power of your money on average every 10 to 12 years, the real key to creating wealth with stocks is investing in them regularly.  Put $1,000 into stocks, and seven years later, you'll probably have $2,000.  But if you put $1,000 into stocks every year for seven years, you end up with nearly $9,500 — that's nearly five times more.  Remember the power of combining these two simple but powerful financial concepts: Regular savings and investing in growth-oriented investments lead to simply amazing long-term results. 

Another advantage of buying in regular chunks (some call this dollar-cost averaging, a subject I cover in Chapter 10) is that it softens the blow of a major decline.  Why?  Because you can make some of your stock investments as the market is heading south; perhaps you may even buy at or near the bottom.  After the market rebounds, you show a profit on some of those last purchases you made, which helps soothe the rest of your portfolio — as well as your bad feelings about the decline.  If you used dollar-cost averaging during the worst decade for stock investors last century (1928–1938), you still averaged 7 percent per year in returns despite the Great Depression and a sagging stock market. 

Using Mutual Funds to Invest in Stocks

The best stock funds offer you diversification and a low-cost way to hire a professional money manager.  In Chapter 4, I discuss at length why purchasing individual stocks on your own doesn't make good financial sense. ( If you haven't read Chapter 4 yet and you believe that buying individual stocks is the best route for you to take, please read it.) 

Reducing risk and increasing returns

When you invest in stocks, you expose yourself to risk.  But that doesn't mean that you can't work to minimize unnecessary risk.  One of the most effective risk-reduction techniques is diversification — owning numerous stocks in many industries to minimize the damage of any one stock's decline.  Diversification is one reason why mutual funds are a proven way to own stocks. 

 Unless you have a lot of money to invest, you can only cost-effectively afford to buy a handful of individual stocks.  If you end up with a lemon in your portfolio, it can devastate the returns of your better-performing stocks.  Companies go bankrupt.  Even those that survive a rough period can see their stock prices plummet by huge amounts — 80 percent or more — and sometimes in a matter of weeks or months. 

Even during the 1990s bull market (a bull market is one in which stock prices are rising; its opposite is a bear market), certain individual stocks took it on the chin.  A good example is Iomega, a darling of Internet message boards in the mid-1990s.  After zooming to more than $135 per share in 1996, it plunged and languished below $5 per share (adjusting for splits).  It was finally acquired by EMC for just under $4 per share

Of course, owning any stock in a company that goes bankrupt and stays that way means that you lose 100 percent of your investment.  If this stock represents, say, 20 percent of your holdings, the rest of your stock selections must increase about 25 percent in value just to get your portfolio back to even. 

 Stock mutual funds reduce your risk by investing in many stocks, often 50 or more.  If a fund holds 50 stocks and one drops to zero, you lose only 2 percent of the value of the fund if the stock was an average holding.  If the fund holds 100 stocks, you lose 1 percent, and a 200-stock fund loses only 0.5 percent if one stock goes under.  And don't forget another advantage of stock mutual funds: A good fund manager is more likely to sidestep investment disasters than you are. 

Another way that stock funds reduce risk (and thus their volatility) is by investing in different types of stocks across various industries.  Some funds also invest in both U.S. and international stocks. 

Different types of stocks don't always move in tandem.  So if smaller company stocks are being beaten up, large-company stocks may be faring better.  If growth companies are sluggish, value companies may be in vogue.  If U.S. stocks are in the tank, international ones may not be. ( I discuss these different types of stock funds later in this chapter.) 

 You can diversify into various types of stocks by purchasing several stock funds, each of which focuses on different types of stocks.  This diversification has two potential advantages.  First, not all your money is riding in one stock fund and with one fund manager.  Second, each of the different fund managers can focus on and track particular stock investing opportunities. 

Making money: How funds do it

When you invest in stock funds, you can make money in three — count 'em, three — ways:

  Dividends: Some stocks pay dividends.  Many companies make profits and pay out some of these profits to shareholders in the form of dividends.  Dividends are taxed at a far lower income tax rate than ordinary income. ( Find the lowdown on fund investments and taxes in Chapter 18.)  As a mutual fund investor, you can choose to receive your fund's dividends as cash or reinvest them by purchasing more shares in the mutual fund. 

 Unless you need the income to live on (if, for example, you're retired), reinvest your dividends into buying more shares in the fund.  If you do this outside of a retirement account, keep a record of those reinvestments because those additional purchases should be factored into the tax calculations you make when you sell the shares. 

  Capital gains distributions: When a fund manager sells stocks for more than she paid for them, the resulting profits, known as capital gains, must be netted against losses and paid out to the fund's shareholders.  As with dividends, your capital gains distributions can be reinvested back into the fund.  Gains from stock held for more than one year are known as long-term capital gains and are taxed at a much lower rate than your regular income (see Chapter 18). 

  Appreciation: The fund manager isn't going to sell all the stocks that have gone up in value.  Thus, the price per share of the fund should increase (unless the fund manager made poor picks or the market as a whole is doing poorly) to reflect the gains in unsold stocks.  For you, these profits are on paper until you sell the fund and lock them in.  Of course, if a fund's stocks decline in value, the share price depreciates.  Hold the fund for more than one year and you qualify for low long-term capital gains tax rates when you sell. 

If you add together dividends, capital gains distributions, and appreciation, you arrive at the total return of a fund.  Stocks (and the funds that invest in them) differ in the proportions that make up their total returns, particularly with respect to dividends. 

Seeing your stock fund choices

Stock mutual funds, as their name implies, invest in stocks.  These funds are often referred to as equity funds.  Equity (not to be confused with equity in real estate) is another word for stocks. 

Stock funds and the stocks that they invest in usually are classified into particular categories based on the types of stocks they focus on.  Categorizing stock funds often is tidier in theory than in practice, though, because some funds invest in an eclectic mix of stocks.  Funds and the stocks that they hold differ from one another in three major ways:

  Size of the company: You can purchase stock in small, medium, and large companies.  The size of a company is defined by the total market value (capitalization) of its outstanding stock.  Small companies are generally defined as those that have total market capitalization of less than $2 billion.  Medium-sized companies have market values between $2 billion and $10 billion.  Large-capitalization companies have market values greater than $10 billion.  These dollar amounts are somewhat arbitrary. ( Note: The term capitalization is routinely shortened to cap, as in small-cap company or large-cap stock.) 

What do all those other names mean? 

If small and large, value and growth, U.S. and international haven't created enough mind-numbing combinations of stock fund options, here are a few more names that you'll come across. 

Start with all the variations on growth.  Aggressive growth funds are, well, more aggressive than the other growth funds.  Not only does an aggressive growth fund tend to invest in the most growth-oriented companies, but also the fund may engage in riskier investing practices, such as making major shifts in strategy and trading in and out of stocks frequently (turning over the fund's investments several times or more during the year). 

Then consider growth-and-income funds and equity-income funds.  Both of these fund types invest in stocks (equities) that pay decent dividends, thus offering the investor the potential for growth and income.  Growth-and-income and equity-income are basically one and the same.  The only real difference between them is trivial: Equity-income funds tend to pay slightly higher dividends (although some growth-and-income funds have higher dividends than equity-income funds!).  They may pay higher dividends because they invest a small portion of their portfolios in higher-dividend securities, such as bonds and convertible bonds. 

Income funds tend to invest a healthy portion (but by no means all) of their money in higher-yielding stocks.  Bonds usually make up the other portion of income funds.  As I explain later in this chapter, other fund names (such as balanced funds) designate those funds investing in both stocks and bonds.  Income funds are really quite similar to some balanced funds. 

The term international typically means that a fund can invest anywhere in the world except the U.S. The term worldwide or global generally implies that a fund can invest anywhere in the world, including the U.S. I generally recommend avoiding worldwide or global funds that have just one manager for three reasons:

It's difficult for a fund manager to thoroughly follow the companies and financial markets across a truly global investment landscape. ( It's hard enough to follow either solely U.S. or solely international markets.) 

Most of these funds charge high operating expenses — often well in excess of 1 percent per year — that drag down investors' returns. 

The proportion of U.S. and foreign stocks within a global fund may vary a lot, which can make it difficult for you to have a set long-term allocation between foreign and domestic stocks. 

Don't get bogged down in the names of funds.  Remember that funds sometimes have misleading names and don't necessarily do what their names may imply.  What matter are the fund's investment strategies and typical investments.  I tell you what these strategies are for the funds I recommend in this book, and I show you how to combine great funds together into a portfolio in Chapter 15. 

Why should you care what size companies a fund holds?  Because smaller companies behave differently than larger companies do.  Historically, smaller companies pay lower dividends (yields) or none at all, but may appreciate more.  Their share prices, although more volatile, tend to produce greater total returns.  Larger companies' stocks tend to pay greater dividends and on average are less volatile, but they produce slightly lower total returns than small-company stocks.  Medium-sized companies, as you may suspect, fall between the two.  Investing in companies of varying sizes can generally reduce a portfolio's risk and volatility. 

  Growth or value: Stock fund managers and their funds are further categorized by whether investments are made in growth or value stocks. 

• Growth stocks are public companies that are experiencing rapidly expanding revenues and profits and whose stocks are relatively costly in relation to the assets and profits of the company.  These firms tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay low dividends. 

• Value stocks are public companies that are priced cheaply in relation to the company's assets and profits.  Such a company could possibly be a growth company, but that's unlikely because growth company stocks tend to sell at a premium compared to what the company's assets are worth. 

  Geography: Stocks and the companies that issue them are further categorized by the location of their main operations and headquarters.  Is a company based in the United States or overseas?  Funds that specialize in U.S. stocks are (surprise, surprise) called U.S. stock funds; those focusing internationally are typically called "international" or "overseas" funds. 

By putting together two or three of these major classifications, you can start to appreciate all those silly and lengthy names that mutual fund companies give to their stock funds.  You can have funds that focus on large-company value stocks or small-company growth stocks.  These categories can be further subdivided into more fund types by adding in U.S., international, and worldwide funds.  For example, you can have international stock funds focusing on small-company stocks or growth stocks. 

The Best Stock Funds

Using the selection criteria outlined in Chapter 7, the following sections describe the best stock funds worthy of your consideration.  The recommended funds differ from one another primarily in terms of the types of stocks they invest in.  Keep in mind as you read through these funds that they also differ from each other in their tax friendliness (see Chapter 10).  If you're investing inside a retirement account, you don't need to bother with this issue. 

Because stock funds are used for longer-term purposes, the subject of stock funds usually raises another important issue: How do you divvy up your loot into the different types of investments for purposes of diversification and to make your money grow?  Chapter 10 also answers that question. 

Mixing it up: Recommended hybrid funds

Hybrid funds invest in a mixture of different types of securities.  Most commonly, they invest in both bonds and stocks.  These funds are usually less risky and less volatile than funds that invest exclusively in stocks; in an economic downturn, bonds usually hold up better in value than stocks do. 

 Hybrid funds make it easier for investors who're skittish about investing in stocks to hold stocks while they avoid the high volatility that normally comes with pure stock funds.  You could place 60 percent of your investment moneys into a pure stock fund and the other 40 percent into a pure bond fund — but you can do just that by investing in one hybrid fund that has the same overall 60/40 mix.  Because bonds and stocks often don't fluctuate in unison, movements of one can offset those of the other.  Hybrid funds are excellent choices for retirement account investing, particularly when an investor doesn't have much money to start with. 

Hybrid mutual funds come in two flavors:

  Balanced funds: Balanced funds try to maintain a fairly constant percentage of investment in stocks and bonds.  For example, a balanced fund's objective may be to keep 60 percent of its investments in stocks and 40 percent in bonds. ( Some balanced funds are exceptions to this rule and will, like asset allocation funds, adjust their mix over time.) 

  Asset allocation funds: These funds adjust the mix of different investments according to the portfolio manager's economic expectations.  Essentially, the fund manager keeps an eye on the big picture — watching both the stock and bond markets — and moves money between them in an attempt to get the best value.  For example, if the manager thinks stocks are highly valued and bonds are not, he may move more money into bonds and out of stocks. 

 You should note, however, that most managers have been unable to beat the market averages by shifting money around instead of staying put in sensible investments. ( See Chapter 10 for more on index funds.) 

One of the brighter spots on the mutual fund landscape is the best mutual funds that invest in a variety of different funds offered by their parent companies.  They're known as funds of funds, and they're the ultimate couch-potato way to invest!  Later in this section, I discuss specific best funds of funds. 

 Because hybrid funds hold taxable bonds and, therefore, pay decent dividends, they aren't appropriate for many investors who're purchasing funds outside tax-sheltered retirement accounts.  If you're in a higher tax bracket (federal 28 percent and higher), bonds that you hold outside a retirement account should probably be tax-free.  With the exception of the Vanguard Tax-Managed Balanced Fund (see the sidebar, "A tax-friendly hybrid"), you should avoid the hybrid funds if you're in this situation.  Buy separate tax-friendly stock funds (which I cover later this chapter) and tax-free bond funds (see Chapter 12). 

The following sections describe some terrific hybrid funds.  They're loosely ordered from those that generally take less risk to those that take more.  Higher risk hybrid funds tend to hold greater positions in stocks and/or make wider swings and changes in their investments and strategies over time. 

Vanguard Wellesley Income

 The Vanguard Wellesley Income is among the most conservative and income oriented of the hybrids.  This fund typically has about 60 percent of its assets in high-quality bonds, with the remaining assets in high-yielding, large-company stocks.  Since its inception in 1970, the majority of this fund's returns have come from dividends.  Like many of the other conservative Vanguard funds, this one is managed by Wellington Management and the duo of John Keogh and Michael Reckmeyer, who have more than five decades of investment experience between them. 

This fund is ideal for people who've either retired or are on the verge of retiring — or anyone else who wants a high rate of current income but also wants/has some potential for growth from their investments.  Its stocks are value oriented and among the more stable of stocks.  Its high-quality bonds, which tend to be intermediate term, also don't go through the gyrations that junk bonds do.  Expense ratio is 0.31 percent (0.21 percent for the Admiral share class which requires a $100,000 minimum).  Minimum initial investment is $3,000.  The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

Vanguard's funds of funds

  A fund of funds is simply a mutual fund that invests in other individual mutual funds.  Although the concept isn't new, it's become increasingly attractive to investors who either are overwhelmed by the number of fund choices out there or who want to diversify.  Vanguard offers some excellent funds of funds. 

Begun in 1985 — and thus the oldest of the funds of funds — the Vanguard Star fund is diversified across 11 different Vanguard funds: 6 U.S. stocks, 2 foreign stocks, and 3 bonds.  Its targeted asset allocation is about 65 percent in stocks and 35 percent in bonds.  The Star fund's diversification comes cheap: The expense ratio of the underlying funds is 0.32 percent. ( There's no additional charge for packaging them together.)  The initial investment requirement is just $1,000. 

A tax-friendly hybrid

Vanguard Tax-Managed Balanced is the one hybrid fund that's tax friendly enough to be considered for investments held outside tax-sheltered retirement accounts.  Why?  Because the bonds that it holds (typically half of this fund's investments) are federally tax-free municipal bonds.  Be forewarned, though, that this fund has a steep initial minimum of $10,000 and is intended for investors who can hold the fund for at least five years.  Otherwise, a 1 percent transaction fee is charged against your sale proceeds and paid into the fund.  The fund's annual expense ratio is a mere 0.15 percent. 

The bond portion of the portfolio is composed of high-quality and generally intermediate term municipal bonds.  The stocks in this fund try to replicate the Russell 1000 index of the 1,000 largest company stocks in the United States, although the fund emphasizes stocks with lower dividends to reduce taxable distributions.  Selling of stocks with capital gains is also minimized to reduce those taxable distributions as well. 

Because this fund shuns dividend paying stocks, it's not a good choice for conservative, value-oriented investors seeking current investment income on which to live. 

If you live in a high-tax state, instead of buying this Vanguard fund, you may be better off buying a state and federally tax-free municipal bond fund, if a good one's available for your state (see Chapter 12 to find out), and pairing it with a tax-friendly stock fund.  Contact Vanguard investor and client information at (800) 662-7447. 

Realizing that in the case of asset allocation, one size doesn't fit all, Vanguard introduced the LifeStrategy series of funds in 1994.  Although each of the four LifeStrategy funds draws from numerous Vanguard stock and bond funds, they differentiate themselves by their target asset allocations.  The LifeStrategy Income fund, the most conservative of the bunch, has 70 to 80 percent in bonds and 20 to 30 percent in stocks, whereas the LifeStrategy Growth portfolio, at the other end of the risk spectrum, invests 80 to 90 percent in stocks and 10 to 20 percent in bonds.  The asset allocations of the LifeStrategy Conservative Growth and the LifeStrategy Moderate Growth funds fall somewhere in between. ( If you want a fund that gradually scales back its risk as you get closer to retirement, take a look at Vanguard's Target Retirement fund series.) 

By relying more heavily on index funds than the Star fund does, the LifeStrategy funds come through with an even lower average expense ratio of 0.22 percent.  Minimum initial investment is $3,000, and these funds charge a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

 The Dodge & Cox Balanced fund is one of the oldest and best-balanced funds, having started in 1931.  Like Dodge & Cox itself, this fund is conservatively run, investing primarily in medium- and large-company U.S. value stocks and high-quality, intermediate-term bonds.  Typically, it invests about 60 to as much as 70 percent in stocks and the rest in bonds. 

This fund has always been managed by using a team approach, so if you like to be able to rattle off the name of a star fund manager who's investing your money, this fund isn't for you (although you can impress others by saying that the minimum account size that Dodge & Cox normally accepts is several million dollars).  This fund has a low 0.53 percent expense ratio. 

Vanguard Wellington

 The Vanguard Wellington is the oldest hybrid fund: It dates back to the summer of 1929 (which means that it even survived the Great Depression!).  This fund typically invests about 60 to 65 percent in larger company value-oriented stocks, with the remainder in high-quality, intermediate- to longer-term bonds.  In recent years, approximately 10 to 15 percent of this fund's stocks were overseas. 

This fund is co-managed by Wellington Management's Edward Bousa and John Keogh, who together have more than 55 years of investment management experience.  The fund's expense ratio is 0.35 percent (0.23 for Admiral shares that require a $100,000 minimum).  Minimum initial investment is $10,000.  The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

Fidelity Puritan

 One of the company's oldest funds (it began in 1947), the Fidelity Puritan fund is co-managed by Ramin Arani and George Fischer, who have a combined four decades with Fidelity in investment research and management.  Puritan typically has about 60 percent in stocks that tend to be large company and value oriented.  In recent years, the fund has been investing about 10 percent of its stock allocation overseas. 

Most of the bonds are intermediate term, and a modest portion of them are junk bonds.  The expense ratio is 0.67 percent.  Minimum initial investment is $2,500.  The fund charges a $12 annual low-balance fee for nonretirement account balances below $2,000.   800-544-8888. 

Fidelity's Freedom funds of funds

Fidelity offers 12 Freedom funds of funds: Freedom Income, Freedom 2000, Freedom 2005, Freedom 2010, Freedom 2015, Freedom 2020, Freedom 2025, Freedom 2030, Freedom 2035, Freedom 2040, Freedom 2045, and Freedom 2050.  The Freedom Income fund is the most conservative, targeting 40 percent of its assets to fixed income funds, 40 percent to money market funds, and 20 percent to equity funds.  At the other end of the scale is the Freedom 2050 fund, the most aggressive, with about 90 percent of its assets in equity funds and 10 percent in fixed-income funds.  The asset allocations of the other funds fall between these extremes. ( The higher the number in the fund title, which is theoretically the customer's approximate retirement date, the greater its percentage of stock funds.) 

All the Freedom Funds draw from a fixed pool of Fidelity funds, such as Capital & Income, Strategic Real Return, Investment Grade Bond, Blue Chip Growth, Disciplined Equity, Equity-Income, Growth Company, Large Cap Value, Diversified International, and Fidelity Overseas. 

The combined operating expenses of the underlying funds within the Freedom Funds typically ranges from 0.7 to 0.8 percent.  The Fidelity Freedom funds charge a $12 annual low-balance fee for nonretirement account balances below $2,000.   800-544-8888. 

T. Rowe Price offerings

 T. Rowe Price Balanced invests mainly in large-company stocks within the United States and has about one-quarter of its stocks overseas and 10 to 15 percent of its bonds in junk.  The expense ratio is 0.69 percent.  T. Rowe Price Personal Strategy Balanced is another fine hybrid fund, which typically holds 60 percent stocks of companies of varying sizes and has 20 to 25 percent of its stocks overseas.  The expense ratio is 0.86 percent.  Minimum initial investment for both of these funds is $2,500 ($1,000 for retirement accounts). 

T. Rowe Price also has a series of target-date retirement funds, with names such as T. Rowe Price Retirement 2040, that are funds of funds.  On the conservative end of the spectrum, it has T. Rowe Price Retirement Income and T. Rowe Price Retirement 2005, with expense ratios around 0.6 percent.  At the most aggressive end of the spectrum, it has T. Rowe Price Retirement 2055, with an expense ratio of 0.79 percent.  These funds gradually reduce their stock exposure and risk as you near the retirement date in the fund's name.   800-638-5660. 

Letting computers do the heavy lifting: Recommended index funds

Index funds are passively managed — that means an index fund's money is invested, using computer modeling, to simply track the performance of a particular market index, such as the Standard & Poor's 500.  When you buy into an index fund, you give up the possibility of outperforming the market, but you also guarantee that you won't much underperform the market either. 

Beating the market is extremely difficult; most actively managed funds are unable to do it.  The best index funds, however, have an advantage — the lowest operating expenses in the business.  In Chapter 10, I further discuss the virtues of index funds and the role they should play in your portfolio. 

Exchange-traded funds (ETFs) are index funds that are the newer kids on the block.  ETFs trade on a stock exchange, and the best of them have low expense ratios like Vanguard's index funds.  In fact, many of the best ETFs come from Vanguard.  Where relevant, I have included recommended stock ETFs in this chapter.  For more information about ETFs, including their pros and cons, please see Chapter 5. 

Vanguard's index funds are generally the best stock index funds available.  John C. Bogle, Vanguard's founder and former CEO, was the first person to take the idea of indexing to the mutual fund investing public; he's been a tireless crusader for index funds ever since.  Today, Vanguard continues to be the index fund leader with the lowest operating expenses (which directly translates into higher index fund returns) and the biggest index fund selection around. 

The flagship of Vanguard's index fleet, the Vanguard Index 500 fund invests to replicate the performance of the popular stock market index — the Standard & Poor's 500 index — which tracks the stocks of 500 large companies in the United States.  These 500 stocks typically account for about three-quarters of the total value of stocks outstanding in the U.S. market.  I don't enthusiastically recommend this fund because you miss out on medium- and smaller-sized companies.  Also, because it's weighted by the market value of the stocks in its index, you end up over-investing in sectors of the market (for example, technology stocks in the late 1990s and financial services stocks in the mid-2000s) that are bloated and due for a more substantial correction.  The expense ratio on this fund is a razor-thin 0.18 percent, and if you invest $100,000 in the fund, you can use the Admiral share class with its ultra-low 0.09 percent expense ratio. 

 A more diversified and tax-friendlier fund than Vanguard's Index 500 is the Vanguard Total Stock Market Index, which replicates the performance of the MSCI US Broad Market Index, comprising 99.5 percent or more of the total market capitalization of all of the U.S. common stocks regularly traded on the New York and American Stock Exchanges, and the NASDAQ over-the-counter market.  This index comprises the entire U.S. market of large-, medium-, and small-company stocks.  This fund, which holds more than 3,400 stocks, also has a wafer-thin expense ratio of 0.18 percent and also offers Admiral shares with a 0.09 percent expense ratio. 

Value-oriented indexes generally are a little less volatile, produce more dividend income, and offer slightly higher long-term total returns.  Among U.S. index funds and exchange-traded funds I like is iShares Russell 1000 Value ETF, which invests in large cap U.S. stocks.  For smaller cap stocks, check out iShares Russell 2000 Value ETF, Vanguard Small Cap Value Index fund, and Vanguard Small Cap Value ETF. 

Taxes on stock funds

For mutual funds held outside of retirement accounts, you have to pay income tax on dividends and capital gains that are distributed.  Stock dividends and long-term capital gains are taxed at far lower income tax rates relative to ordinary income (see Chapter 10).  If your circumstances lead you to have money that you want to invest in stock funds outside of retirement accounts, by all means do it.  But pay close attention to the taxable distributions that funds make (especially short-term capital gains distributions that aren't eligible for the lower tax rates). ( I've indicated in this chapter which funds are tax friendly.) 

In addition to the tax-friendly index and stock funds I note in the chapter, also check out the Vanguard Tax-Managed Capital Appreciation fund, which invests in the universe of the 1,000 largest company stocks in the U.S. stock market. ( Vanguard actually selects and samples from among the 1,000 companies.)  This fund seeks to minimize capital gains distributions by holding on to appreciating stock and, if it needs to sell some stocks at a profit, offsetting those sales by selling other stocks at a loss.  Vanguard also offers a Tax-Managed Growth and Income fund, Tax-Managed Small-Cap fund, and a Tax-Managed International fund. 

You shouldn't go into the Vanguard Tax-Managed funds unless you plan to hold your investment for five years because you'll get clipped with a transaction fee of 1 percent for such an early exit.  The minimum initial investment is a hefty $10,000. 

  Vanguard Total International Stock Index seeks to replicate a combination of two international indexes: the Morgan Stanley Capital International Index (which is comprised of established economies) and the Select Emerging Markets Index.  This fund is actually a fund of funds, as it includes Vanguard's index funds for Europe, the Pacific, and Emerging Markets.  At 0.34 percent, this fund's expense ratio is a bargain for an international fund. 

Vanguard FTSE All-World ex-US ETF is also a solid core international fund worth considering. 

For nonretirement accounts, the minimum initial purchase for Vanguard index funds is $3,000.  Vanguard's index funds charge a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

Keeping it local: Recommended U.S.-focused stock funds

 This section focuses on the better actively managed funds that invest primarily in the U.S. stock market.  I say primarily because some "U.S." funds venture into overseas investments.  The only way to know for sure where a fund is currently invested (or where the fund may invest in the future) is to ask.  You can start by calling the toll-free number of the mutual fund company that you're interested in.  You can also read the fund's annual report (which I explain how to do in Chapter 8).  A prospectus, unfortunately, won't give you anything beyond the general parameters that guide the range of investments: It won't tell you what the fund is currently investing in or has invested in. 

Of all the different types of funds offered, U.S. stock funds are the largest category.  To see the forest amidst the trees, remember the classifications I cover earlier in the chapter.  Stock funds differ mainly in terms of the size of the companies they focus on and whether those companies are considered "growth" or "value" companies. 

 I highly recommend another of the fine but few funds offered by Dodge & Cox, the Dodge & Cox Stock fund, which focuses on large- and medium-company value stocks, including about 10 to 20 percent in foreign shares. 

Unlike most U.S. stock funds today, this fund does little trading, often less than 15 percent of its portfolio annually.  Like the Dodge & Cox Balanced Fund, this fund is managed by a team and doesn't try to time the markets.  Its annual expense ratio is a low 0.52 percent. 

Fairholme Fund

You may think that a fund that was started in late 1999, right before the peak of a long bull market and just before U.S. stocks in general suffered their worst decade was destined for trouble.  But, you'd be wrong in the case of the Fairholme Fund.  Fund managers Bruce Berkowitz and Charles Fernandez scour the world stock markets for undervalued stocks, primarily in medium- and larger size companies.  This firm started out in the private money management business — Fairholme Capital Management — in 1997, which required a $1 million initial investment.  The Fairholme fund's expense ratio is 1 percent.  Initial minimum investment is $2,500; $1,000 for retirement accounts.   866-202-2263. 

Fidelity Low-Priced Stock

 The Fidelity Low-Priced Stock fund specializes in investing in small- and medium-company value stocks.  As of this writing, about one-third of its stocks are overseas.  As you may guess from its name, it buys stocks that have low share prices.  Lower priced stocks tend to coincide with smaller companies, but not always: The price per share of a stock may bear little resemblance to the size of the issuing company because companies can "split" their stock and issue more shares, which cuts the price per share.  This fund has been managed since its inception in 1989 by Joel Tillinghast, an amazing run given the turnover of managers at many funds, especially at Fidelity.  Annual operating expenses are 1 percent.  The minimum initial investment requirement is $2,500 for all accounts.   800-544-8888. 

Sequoia

A conservatively managed fund with a long history (dating back to 1970) of success, Sequoia got a boost from Warren Buffett who closed an investment fund in 1969 and recommended that investors invest with the newly formed Sequoia, which was managed by Bill Ruane. 

The fund generally focuses on larger company stocks.  This fund is co-managed by Robert Goldfarb and David Poppe.  Its expense ratio is 1 percent.  Minimum initial investment is $5,000, $2,500 for retirement accounts.   800-686-6884. 

Vanguard Primecap

 Vanguard Primecap is one of the few growth-oriented stock funds that doesn't trade its portfolios heavily, trading typically less than 20 percent of its fund per year.  It invests in companies of all sizes and even invests a small portion overseas.  This fund has been managed since its inception by Howard Schow and Theo Kolokotrones of Primecap Management, a Southern California investment management company.  Joel Fried was added as a co-manager in 1993; several additional co-managers were added in recent years.  The expense ratio for this reasonably tax-friendly fund is a competitive 0.49 percent. ( Note: This fund is currently closed to new investors.)  Although this fund is closed, you can, however, still tap in to the investment expertise of Primecap Management through the Primecap Odyssey Growth fund ($2,000 minimum, 0.73 percent expense ratio).   800-662-7447 for Vanguard;  800-729-2307 for Odyssey. 

Vanguard Selected Value

James Barrow and Mike Giambrone, who have nearly six decades of investment management experience between them, are principals in the money management firm of Barrow, Hanley, Mewhinney, & Strauss, which have managed most of this fund since 1999.  A portion of this fund has also managed by Donald Smith & Company since 2005.  Vanguard Selected Value focuses on mid-size value stocks and invests a small portion overseas.  The fund's expense ratio is a low 0.45 percent.  Unfortunately, Vanguard raised the minimum investment amount on this excellent fund to $25,000, so those with smaller balances to invest will need to look elsewhere.   800-662-7447. 

Vanguard Strategic Equity

Using models honed by Gus Sauter and Joel Dickson of Vanguard's Quantitative Equity Group, this fund has invested in small- and medium-sized U.S. companies since 1995.  This fund, too, has a higher minimum: $10,000.  Expenses are a low 0.30 percent.   800-662-7447. 

Being worldly: Recommended international funds

As I discuss in Part I, for diversification and growth potential, funds that invest overseas should be part of an investor's stock fund holdings.  Normally, you can tell you're looking at a fund that focuses its investments overseas if its name contains words such as international, global, worldwide, or world. 

 Generally, you should avoid foreign funds that invest in just one country.  As with investing in a sector fund that specializes in a particular industry, this lack of diversification defeats the whole purpose of investing in funds.  Funds that focus on specific regions, such as Southeast Asia, are better but are generally problematic because of poor diversification and higher expenses than other, more-diversified international funds. 

 In addition to the risks normally inherent in stock fund investing, international securities and funds are also influenced by changes in the value of foreign currencies relative to the U.S. dollar.  If the dollar declines in value, the value of foreign stock funds goes up.  Some foreign stock funds hedge against currency changes.  Although hedging helps to reduce volatility a bit, it costs money to do, so I wouldn't worry about it if I were you.  Remember, you're investing in stock funds for the long haul.  And in the long haul, your international stock funds' performance will largely be driven by the returns generated on foreign stock exchanges, not currency price changes. 

The following sections offer my picks for diversified international funds that may meet your needs.  Compared to U.S. funds, fewer established international funds exist, and they tend to have higher annual expense ratios.  So I've listed fewer options for you. ( Don't forget the Vanguard Total International Stock Index fund and the Vanguard Tax-Managed International fund, which I discuss earlier in this chapter.) 

Vanguard International Growth

 The Vanguard International Growth fund invests primarily in large companies with growth potential, mainly in established countries.  It also invests a modest 15 to 20 percent in emerging markets. 

International Growth is primarily managed by London-headquartered Schroder Capital Management, which has research offices around the world focused on specific countries and has managed this fund since its inception in 1981.  In 2003, James Anderson of Baillie Gifford was added to manage a portion of this large fund.  This fund has an expense ratio of 0.53 percent and has been reasonably tax friendly.  Initial minimum investment is $3,000 (Admiral shares of this fund have a $100,000 minimum and levy 0.34 percent in annual expenses).  The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

Dodge & Cox International

This excellent private money management firm also offers a handful of excellent mutual funds and manages the Dodge & Cox International fund, a foreign stock offering, which focuses on larger company, value-oriented stocks.  The fund is managed by a team of investment managers, most of whom have been with the firm for 20+ years.  Expenses are a low 0.64 percent.  Minimum initial investment is $1,000 for retirement accounts; $2,500 for other accounts.   800-621-3979. 

Masters' Select International Equity

 Like a fund of funds, Masters' Select International Equity has some of the best fund managers each managing a portion of fund.  Some of these top fund managers manage funds that are closed to new investors.  Although each manager has a somewhat different investment orientation, collectively this fund invests in foreign companies of all sizes, including those in emerging markets. 

Masters' Select International's expenses are 1.07 percent. ( Unfortunately this fund is closed to new investors.)  If you sell shares in this fund within six months of purchase, you must pay a 2 percent redemption fee.  Minimum initial investment is $10,000 ($1,000 for retirement accounts).   800-960-0188. 

Expanding your horizon: Recommended global stock funds

A select number of stock funds invest globally (overseas as well as in the United States) and do so well and cost-effectively; I detail those funds in this section. 

Oakmark Global

 The Oakmark Global fund invests in an eclectic mix of companies worldwide.  Oakmark is one of a very short list of fund firms that has successfully managed a global stock mutual fund.  While the fund commenced operations in 1999, fund manager Clyde McGregor has been with the Oakmark Funds parent company (Harris Associates) since 1981 and co-manager Robert Taylor has been with Harris since 1994.  Together, McGregor and Taylor have five decades of experience in money management.  While expenses are a little high at 1.23 percent.  Minimum initial investment for all account types is $1,000.   800-625-6275. 

T. Rowe Price Spectrum Growth

 T. Rowe Price offers a number of good stock funds, both U.S. and international, and the Spectrum Growth fund of funds offers a simplified way to invest in them.  The U.S. stock funds in this fund cover the entire range of company sizes.  Spectrum Growth also invests about 25 percent of its assets overseas. 

This fund of funds is managed by regular meetings of a committee made up of fund managers within the company.  Slight changes in allocations among the different funds are made based on expectations of how particular types of stocks (for example, growth versus value, larger versus smaller company) will fare in the future.  The expense ratio of the funds in this fund come to about 0.82 percent, and the company doesn't charge an additional fee for the fund's packaging.  Minimum initial investment is $2,500 ($1,000 for retirement accounts).   800-638-5660. 

Tweedy Browne Global Value

 Tweedy Browne Global Value invests in value stocks of companies of all sizes worldwide, primarily in established countries.  Although it can invest in the United States, its U.S. holdings are generally 10 to 15 percent of the fund.  The parent company has an excellent reputation, managing money privately since the 1920s; this fund itself has been in existence since 1993 and has done well.  Operating expenses, consistently lowering as the fund grows in size, are still a bit on the high side at 1.4 percent.  Initial minimum investment is $2,500 ($500 for retirement accounts).   800-432-4789. 

Vanguard Global Equity

This excellent fund is co-managed by three leading private money management firms: Marathon Asset Management, Acadian Asset Management, and AllianceBernstein.  U.S. stocks currently comprise about 40 percent of the fund.  The expense ratio of 0.47 is low for a global fund.  Minimum initial investment is $3,000.  The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 
Chapter 14

Specialty Funds: One of a Kind

In This Chapter

  Looking into real estate investment trust (REIT) funds

  Getting the scoop on precious metals and commodities funds

  Reviewing utility funds

  Doing good with socially responsible and market neutral funds

In the other chapters in this part of the book, I explain the three major types of funds: money market, bond, and stock.  Specialty funds, which tend to be stock funds, are often known as sector funds because they tend to invest in securities in specific industries.  But, as you see in this chapter, some specialty funds hold securities in a variety of industries but engage in unusual strategies that separate them from their peers. 

In addition to real estate and precious metals funds, other types of sector-focused funds I discuss in this chapter are commodity funds, and utility funds, which are popular with some investors who want more conservative stock investments.  In addition, I cover specialty funds that engage in unusual strategies and invest in a wide range of industries — socially responsible funds and market neutral funds. 

Sector Funds: Should You or Shouldn't You Invest in Them? 

 In most cases, you should avoid specialty or sector funds.  Investing in stocks of a single industry defeats a major purpose of investing in mutual funds — you give up the benefits of diversification.  Also, just because the fund may from time to time be dedicated to a hot sector (a sector fund or two is often at the top of short-term performance charts), you can't assume that the fund will pick the right stocks within that sector. 

Another good reason to avoid sector funds is that they tend to carry much higher fees than other mutual funds do.  Many sector funds also tend to have high rates of trading or turnover of their investment holdings.  Investors holding these funds outside of retirement accounts may have to turn over a tidy portion of their returns to the IRS. 

 The only types of specialty funds that may make sense for a small portion (10 percent or less) of your investment portfolio are funds that invest in real estate or precious metals.  These types of funds can help diversify your portfolio because they can do better during times of higher inflation — which often depresses general bond and stock prices.  Don't feel obligated to invest in these sector funds, however, because diversified stock funds tend to hold some of these specialty investments. 

Landlording Made Easy: Real Estate Investment Trust (REIT) Funds

Do you want to invest in real estate without the hassle of being a landlord?  Invest in real estate investment trusts (REITs), which are stocks of companies that invest in real estate.  These funds typically invest in properties, such as apartment buildings, shopping centers, and other rental properties.  Of course, evaluating REIT stocks is a hassle, but you can always (you guessed it) invest in a mutual fund of REITs! 

 REITs are small-company stocks and usually pay decent dividends.  Sorry, but these dividends aren't eligible for the lower dividend tax rates for other stock funds.  As such, REITs aren't appropriate for higher-tax-bracket investors investing money outside of retirement accounts.  Most of the larger, diversified U.S. stock funds that I recommend in Chapter 13 have a small portion of their fund's assets invested in REITs, so you'll have some exposure to this sector without investing in a REIT-focused fund. 

 Here are some solid REIT funds from which to choose:

  Cohen & Steers Realty Shares has been managed by Martin Cohen and Robert Steers since the fund began in 1991. ( Two additional comanagers have recently been added.)  The minimum initial investment is steep at $10,000.  Discounters also may offer it without transaction charges.  Annual operating expenses are 1.00 percent.   800-437-9912. 

  Fidelity Real Estate Investment, the oldest REIT mutual fund, is managed by Steven Buller, who's been with Fidelity since 1992 and managed this fund since 1998.  This fund has expenses of 0.92 percent per year.  Initial minimum investment is $2,500 ($500 for retirement accounts).   800-544-8888. 

  T. Rowe Price Real Estate has been managed since its inception by portfolio manager David Lee.  0.75 percent, $2,500 minimum ($1,000 for retirement accounts).   800-638-5660. 

  Vanguard REIT Index, yet another of Vanguard's long line of index funds, has minimal expenses of just 0.21 percent.  Although this fund will never be a star in its category, its low expenses should ensure its long-term success.  Minimum investment amount is $3,000.  The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

Profiting from What Everyone Needs: Utility Funds

Utility funds tend to attract older folks who want to earn good dividends and not have the risk of most stock investments.  And that's what utility funds are good for.  But this once-staid industry has been shaken up by increased competition. 

 In a sense, utility funds are superfluous.  Most diversified stock funds contain some utilities, and those investors who want income can focus on better income-producing funds, such as Wellesley Income in the hybrid group and the value-oriented stock funds that I discuss in Chapter 13. 

Arming for Armageddon: Precious Metals Funds

Gold and silver have been used by many civilizations as mediums of exchange because these metals have unique physical properties and rarity.  These precious metals are used not only in jewelry but also in less frivolous applications, such as manufacturing. 

With a paper-based currency, such as the U.S. dollar, the government can always print more currency to pay off its debts.  This process of casually printing more and more currency can lead to a currency's devaluation — and to inflation. 

Holdings of gold and silver can provide a so-called hedge against inflation.  In the United States during the late 1970s and early 1980s, inflation rose dramatically.  This rise depressed stocks and bonds.  Gold and silver, however, soared in value, rising more than 500 percent (even after adjusting for inflation) from 1972 to 1981. 

Over the long term, however, precious metals are lousy investments.  They don't pay any dividends, and their price increases just keep you up with, but not ahead of, increases in the cost of living.  Although investing in precious metals is better than keeping cash in a piggy bank or stuffed in a mattress, it's historically not been as good as bonds, stocks, and real estate. 

 Don't purchase precious metals futures contracts.  Futures aren't investments; they're short-term gambles on which way prices of an underlying investment (in this case, gold or silver) may head over a short period of time (see Chapter 1).  You also should stay away from firms and shops that sell coins and bullion (not the soup, but bars of gold or silver).  Even if you can find a legitimate firm (which isn't an easy task), storing and insuring gold and silver are costly.  You don't get good value for your money. 

 Gold and silver can help to diversify a portfolio, but if you want to invest in precious metals, you're wise to do so through mutual funds.  For more information about determining how these types of funds may fit with the rest of your investments and how to buy them, be sure to read Chapter 12. 

 Vanguard Precious Metals and Mining fund, like most gold and precious metals funds, invests in mining companies' stocks worldwide because many are outside the United States in countries such as South Africa and Australia.  This fund, which also invests in other metals such as platinum and nickel, has one of the best track records among precious metals funds and has been around since 1984.  Annual operating expenses for this tax-friendly fund are 0.40 percent.  At the time this book went to press, this fund was closed but will likely reopen, probably when this market sector isn't overheated as it has been recently.  Minimum initial investment is $3,000.  The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard's Web site for electronic delivery of statements and fund reports.   800-662-7447. 

 If you expect high inflation or if you just want an inflation hedge in case you expect the end of civilization, you could invest in a gold and precious metals fund.  But these funds have wild swings and aren't for the faint of heart or for the majority of your portfolio.  To illustrate why, consider this: In 1993, the Vanguard Precious Metals and Mining fund rocketed up 93 percent, whereas in 1997, it lost almost 39 percent.  From 2000 through 2007, it increased in value more than 600 percent!  But, then in 2008, this fund lost a whopping 56 percent.  In 2009, it jumped 76.5 percent.  For an alternative, less volatile (and lower return) inflation hedge, consider investing in inflation-protected Treasury bonds (which I discuss in Chapter 12). 

Commodity Funds

Precious metals are but one type of commodity.  The major commodities that trade include energy commodities (such as oil, gasoline, and natural gas), grains and other agriculture commodities, industrial metals (such as titanium, aluminum, stainless steel, nickel, and copper), and livestock. 

A number of mutual funds invest so as to track or beat various broadly diversified commodity indexes.  Here are the notable attributes of commodities as an investment class:

  Modest returns: Long-term commodity returns are comparable to those on bonds but certainly less than stocks. 

  High volatility: Commodities tend to be at least as volatile as stock prices without offering as high long-term returns. 

  Diversification value: Historically, commodities have posted their best returns when stocks and bonds have done poorly.  For example, this situation happened during a portion of the 1970s, when commodities did well during times of increasing inflation.  Thus, commodities add some diversification to a portfolio. 

 Plenty of poor commodity funds, including exchange-traded funds, are out there.  In addition to high fees, funds in this space are often plagued by poor long-term returns due to excessive risk taking that doesn't pan out. 

Commodity funds should never be used for more than a small portion (say, 10 percent) of your portfolio, you should primarily use them for their diversification value.  Because of their volatility, commodity funds are best used over several or more years, as you would use a stock fund. 

 Here's a short list of some of the better commodity funds available:

  Credit Suisse Commodity Real Return Strategy

  Fidelity Global Commodities

  Harbor Commodity Real Return Strategy

  PIMCO Commodity Real Return Strategy

Hedging: Market Neutral (Long-Short) Funds

In Chapter 6, I discuss hedge funds.  As I have in prior editions of this book, I warn investors about the many dangers of such funds, which lure investors with the promise of expected high returns and the possibility of doing well even when the stock market is doing poorly.  Many hedge funds sell stocks short — a strategy that makes money when stock prices fall, but that typically leads to losing money.  Often overlooked are the high fees, big risks, and relatively poor to mediocre long-term performance of most hedge funds. 

The mutual fund industry developed market neutral funds, also known as long-short funds, as yet another answer to investor fears about falling stock market prices.  A typical market neutral fund invests in stocks, which its fund manager believes will rise in value, but also shorts some stocks that the fund manager thinks will fall in value. ( When you sell short, you borrow a security from a broker, sell it, and then hope to buy it back later at a lower price.)  Supposedly, such funds shine during a volatile market because plenty of stocks should be rising and falling, and a smart manager, so the theory goes, should be able to invest in those that will rise and short those that will fall. 

Well, this category of funds has generally failed to deliver for investors, which is why I haven't recommended these funds in prior editions of this book.  Consider the following issues with market neutral funds:

  High expenses: The average expense ratio is a whopping 2.07 percent.  One reason is the high costs involved in short selling.  Paying more than 2 percent per year in fees is a major drag on your potential long-term returns. 

  Lack of track records: Of the 235 funds engaging in this strategy, only 65 have a five-year track record, only 19 have 10-year track records, and only 8 have 15-year track records. 

  Mediocre returns: In the five-year period ending April 7, 2010, which includes a fairly volatile period of rising and falling markets, the average market neutral fund posted an annual average return of just 1.9 percent.  Over this same period, diversified funds generally returned double to triple that amount. 

 If you're skittish about investing in stocks, then you need to develop an overall investment plan which includes holding a diversified portfolio.  Ultimately, if you're uncomfortable putting any money in stocks, then don't do so.  Investing in funds that short stocks is even more dangerous and risky. 

Matching Morals to Investments: Socially Responsible Funds

Socially responsible mutual funds appeal to investors who want to marry their investments to their social principles and avoid supporting causes that they feel are harmful.  These funds attempt to look at more than a company's bottom line before deciding to commit their investors' capital.  Many of these funds consider such factors as environmental protection, equal employment opportunity, the manner in which a company's employees are treated, and the level of honesty that a company displays in its advertising. 

I can certainly understand the desire to put your money where your mouth is; unfortunately, socially responsible funds fail to bridge the gap between theory and practice.  If you blindly plunk down your money on such a fund, you may be disappointed with what you're actually getting.  Bear with me as I explain. 

Evil is in the eye of the beholder

The biggest problem is that the term socially responsible has different meanings for different people.  Sure, most socially conscious investors can agree on some industries as being "bad."  The tobacco industry, associated with hundreds of thousands of deaths and billions of dollars of healthcare costs, is an obvious example, and socially responsible funds avoid them.  But most industries aren't so easy to agree on. 

For example, McDonald's is the world's largest fast-food (hamburger) company, as well as a stock that some socially responsible funds hold.  McDonald's is deemed socially responsible because of its support for children's charities, participation in recycling programs, hiring and promotion of women and minorities, and purchase of hundreds of millions of dollars in goods and services from woman- and minority-owned businesses. 

But how socially responsible is a company whose business depends on beef?  It's certainly not the best for people's health, and raising cattle is tremendously land and water intensive.  Moreover, some may also question the screening and awarding of contracts based on gender and ethnicity.  Others may blame McDonald's for running small local restaurants out of business and contributing to the sterile strip-mall culture of our communities. 

Or consider Toys "R" Us, the giant toy retailer and another stock that's widely held by socially responsible funds for many of the same reasons that McDonald's is.  But this company sells widely criticized violent video games that keep kids away from homework.  Thus, some investors might consider Toys "R" Us a socially irresponsible company — and that's before you consider the heaps of plastic (made from petroleum) and the drive toward overconsumption that the toy industry generates. 

Pick any company, put it under a magnifying glass, and you can find practices that are objectionable to somebody's (perhaps your) moral consciousness.  Of course, that's a poor argument for throwing in the towel.  I'm simply warning you that you may be hard-pressed to find a fund manager whose definition of social responsibility is closely enough aligned to yours.  A mutual fund, by its very nature, is trying to please thousands of individual investors.  That's a tall order when you throw moral consciousness into the picture. 

 Even if you can agree on what's socially irresponsible (such as selling tobacco products), funds aren't always as clean as you'd think or hope.  We live in a global economy where it's increasingly difficult to define a company's sphere of influence.  Although a socially responsible fund may choose to avoid tobacco manufacturers, it may invest in retailers that sell tobacco products, or the paper supplier to the tobacco manufacturer, or the advertising agency that helps pitch tobacco to consumers. 

Ways to express your social concerns

Some funds that aren't labeled "socially responsible" still meet many investors' definitions of socially responsible.  These other funds usually carry lower fees and produce better returns.  For example, GNMA bond funds invest in mortgages that allow people to purchase their own homes.  Municipal bond funds buy bonds issued by local governments to fund projects that most would consider good — such as building public transportation, libraries, and schools.  See Chapter 10 for my specific bond fund recommendations. 

 If you consider investing in socially responsible funds, look well beyond a fund's marketing materials.  When you find a socially responsible fund that interests you, call the fund company and ask it to send you a recent report that lists the specific investments that the fund owns.  Otherwise, you may be blissfully ignorant, but not as socially responsible as you may like to believe. 

You can always consider alternative methods of effecting social change, such as through volunteer work and donations to causes that you support.  You can also exercise a means of change that people the world over are dying for, a means that is guaranteed to all U.S. citizens by the Constitution and is exercised today by only a minority of American adults — the right to voice your opinion and vote. 
Chapter 15

Working It Out: Sample Portfolios

In This Chapter

  Establishing your financial goals

  Handling life changes

  Managing a windfall

  Following a prescribed investment pattern

This chapter is where the rubber hits the road.  If you read the other chapters in this part of the book, where I discuss the details of money market, bond, and stock funds and everything in between, the concepts and individual funds may be swirling around your brain like random pieces of paper in a city alley during a windstorm. ( Chapter 10 covers several important investment selection topics as well, including asset allocation.  If you haven't read that chapter, please do so now — otherwise, you may be less able to make use of the guidance in this chapter.) 

In this chapter, I talk through some real live cases. ( Of course, the names and details have been changed to protect the innocent!)  This chapter should bring a lot of things together for you; I at least hope that it calms the whirlwind. 

My goal in going through these cases is to illustrate useful ways to think about investing in funds and to provide you with ideas and specific solutions to investment situations.  You may think that you'll benefit most from reading only those cases that seem closest to your current situation, but I encourage you to read as many cases as your time allows — perhaps even all of them.  Each situation raises somewhat different issues, and your life and your investing needs will change in the years ahead. 

Don't worry if your circumstances don't perfectly match one of these cases; in fact, it probably won't be a complete match.  After all, you're uniquely you.  However, the principles illustrated here are general enough to be tailored to just about anyone's specific situation. 

Throughout these cases, I explain

  How your investing decisions fit within the context of your overall finances

  How to consider the tax impact of your investing decisions

  How to recognize situations in which you may need to make other financial moves prior to (and maybe even instead of) investing in mutual funds

 Determine where you stand with regard to your own important financial goals, such as retirement planning (the fund-related ins and outs of which I cover in Chapter 3), before you put together your investment portfolio.  The examples in this chapter are arranged from the simpler cases to the more complex. 

Getting Started

If you're just starting to get your financial goals together, you're hardly alone.  If you're still in school or otherwise new to the working world, good for you if you want to get on the right investing road now!  Regardless of your age, though, remember that it's never too late.  Just get started. 

Starting from square one: Melinda

Melinda is in her 20s, works as an architect, earns decent money, lives in New Jersey, and has no debt and no savings yet because she just started her first job.  Financially speaking, she's a blank slate, but because she made a New Year's resolution to get her finances in order, she wants to do something. 

Her employer offers her health and disability insurance and a profit-sharing retirement plan, which only her firm may contribute to, but to which small contributions have been made in the past.  She wants to invest in mutual funds but doesn't want hassle in either paperwork or complications on an ongoing basis. 

On a monthly basis, she figures that she can save $600.  She wants to invest for growth.  With her money earmarked for long-term future needs, such as retirement, she sees no need to invest conservatively (even though she does want some of her investments more conservatively invested).  She's in the 28 percent federal tax bracket now, but as her experience in her field increases, she expects to earn more. 

 Recommendations: Melinda should consider investing $5,000 annually in a Roth IRA (see Chapter 3).  In her case, a regular IRA contribution won't be tax deductible because her employer offers a retirement plan under which she's considered covered and because she earns more than is allowed to make a tax-deductible contribution to a regular IRA. 

Melinda could invest in a fund of funds, such as Vanguard LifeStrategy Growth, Fidelity Freedom 2050, or T. Rowe Price Spectrum Growth (all covered in Chapter 13), which all offer the simplicity of one-stop shopping and reduced annual account fees. 

Like everyone else, Melinda should have an emergency source of cash.  Although the mutual funds that she's investing in outside her retirement account are liquid and can be sold any day, she runs a risk that an unexpected emergency could force her to sell when the markets are hung over. 

With family to borrow from if needed, she could make do with, say, a cushion equal to three months' living expenses.  She could even postpone building an emergency fund until after she funds her IRA. ( Normally, I'd recommend establishing the emergency fund first, but because she has family she can borrow from, I believe that it's okay to go for the long-term tax benefits of funding the IRA account.)  Because she won't keep a large emergency balance, she could keep her emergency fund in her local bank account, especially if the balance helps keep her checking account fees down.  Given her current tax bracket, if Melinda wanted a money market mutual fund, she could invest in a taxable fund, such as Fidelity Cash Reserves or others described in Chapter 11. 

For longer term growth, Melinda could invest her monthly savings as follows:

60–70 percent in Vanguard Total Stock Market Index

30–40 percent in Vanguard Total International Stock Index

(These funds are reasonably tax friendly, which is important because she's investing outside a retirement account and is in a reasonably high tax bracket.) 

 These funds generally make low taxable distributions and make especially low distributions, such as short-term capital gains, that are highly taxed.  They require a $3,000 minimum initial investment, so Melinda needs to save the minimum before she can invest.  After the minimum is met and invested in each fund, she can have money deducted electronically from her checking account and invested in these mutual funds. 

Silencing student loans: Stacey the student

Stacey is a 25-year-old graduate student in psychology with three years to go before she gets her well-deserved degree.  She's hoping that all this education will fetch her a solid income when she finally gets out of school. 

Her current income amounts to about $19,000 per year.  She's also sitting under $25,000 of student debt from her undergraduate days.  Both of her loans are in deferment, so she's not obligated to make payments until she finishes graduate school: One is incurring interest at 7 percent per year; the other is subsidized (the government is paying the interest until she gets out of school). 

Fortunately, Stacey has the starving-student-thing down cold.  She's so savvy at living cheap that despite her low income she has an extra $150 to play with at the end of every month. ( Stacey has an emergency reserve already in place.) 

Stacey wants to be debt-free sooner, so her first instinct is to use that money to start paying down those student loans.  But Stacey is also excited about investing for her future.  Because half of her student loan interest is subsidized, she's wondering if she'd come out ahead by using her extra money to open and invest in an IRA account. 

 Recommendations: Stacey should be proud of herself.  Living below her means on such a small income, as well as thinking about her financial future, is commendable.  She's asking good questions.  Her decision comes down to a comparison of the student loan interest rate to the potential return of her IRA investments.  Because she'll be investing for retirement, which is decades away for a 25-year-old, Stacey's time horizon is long enough to focus largely or almost entirely on stocks.  As I discuss in Chapter 1, stocks historically have returned about 9 to 10 percent per year.  Measured against the 7 percent interest she's paying on her unsubsidized student loan, Stacey can perhaps come out a little ahead by holding off on student loan payments and investing in stocks through an IRA account. ( She can deduct up to $2,500 per year in student loan interest on her tax return; her investment returns would ultimately be taxed). 

 I say that it's really Stacey's call as to which option — paying down the 7 interest student loan or investing in good stock mutual funds through an IRA — makes her feel more comfortable.  Financially, the choice is a tossup.  It's worth noting, however, that the annual savings of 7 percent that comes from paying down the student loan is a sure thing, whereas the stock market annual average returns of 9 to 10 percent are an expectation and in no way guaranteed.  For this reason, I'd be inclined to pay down the student loans at 7 percent. 

Getting started with just $50 per month

Although most mutual funds' minimum initial investment amount of a couple of thousand dollars is quite small compared to that of private money managers, who have six-figure to several-million-dollar entrance requirements, the amount may still loom large if you're just starting to save and invest.  You want to get on with the program, and you don't want to risk giving in to the temptation to spend your savings if they're sitting around in your bank account until you can save enough for high-fund minimums. 

Here's a way around the problem.  Some fund companies (for example, TIAA-CREF and T. Rowe Price) allow you to invest in their funds without meeting the minimum initial investment requirements as long as you enroll in an automatic investment program.  You can do the trick with these by having a small amount per month deducted from your bank account and sent electronically to the fund company.  Call the fund family's toll-free number to see if it offers an automatic investment plan for a fund you're interested in. 

Also remember that fund retirement account minimums are significantly lower — often as low as $50 per month, some even less.  A final strategy is to save for several months until you have enough for some of the funds recommended in Chapters 11, 12, and 13 that have lower minimums. 

If Stacey decides to go the IRA route, because she has such a long time horizon, her fund(s) should focus almost entirely on stocks.  Ideally, her fund(s) should be diversified across large-, medium-, and small-company stocks as well as international investments.  Stacey's situation is ideally suited for a fund of funds (such as the ones I recommend to Melinda in the preceding section).  Alternatively, if she wants to get going with investing $150 per month and not wait to save enough to meet a fund's minimum, she could invest monthly in an automatic investment plan (AIP) through a company such as TIAA-CREF or T. Rowe Price that waives fund minimums if you sign up for an AIP (see the sidebar "Getting started with just $50 per month"). 

Living month to month with debt: Mobile Mark

Mark is a 42-year-old renter who says that he has no desire to own a home.  He doesn't want the feeling of being tied down in case he ever wants to move — something he's done a lot of over the years.  Currently, he lives in California.  Feeling that he's hitting middle age, Mark wants to start socking away money regularly into investments.  He has a large folder filled with mutual fund ads and prospectuses but finds most of the material confusing and intimidating.  He has about $5,000 in a bank IRA invested in a certificate of deposit. 

Mark feels insecure living month to month and being so dependent on his paycheck.  One of the reasons he's feeling some financial pressure is that, in addition to his monthly rent, he has an auto loan payment of about $300 per month and total credit card debt of $6,000.  He also doesn't have any family he can depend on for money in an emergency. 

 Recommendations: Although Mark has the best of intentions, he's a good example of someone who's managed to get his financial priorities out of order.  Mark's best and most appropriate investment now is to pay off his credit card and auto loan debt and forget about fund investing for a while.  These debts have interest rates of 10 to 15 percent, and paying them off is actually his best investment. 

Like millions of others, Mark got into these debts because credit is so easily available and encouraged in our society.  Such easy access to borrowing has encouraged Mark to spend more than he's been earning.  Thus, one of the first things he should do is figure just where his money goes in a typical month.  By using his credit card statement, checkbook register, and memory of items he's bought with cash, Mark can determine how much he's spending on food, clothing, transportation, and so on.  He needs to make some tough decisions about which expenditures he'll cut so that he can pay off his debts. 

Like Melinda (the 20-something architect in the first example), Mark should also build an emergency reserve.  If he ever loses his job, becomes disabled, or whatever, he'd be in real financial trouble.  Mark has no family to help him in a financial pinch, and he's close to the limits of debt allowed on his credit cards.  Because he often draws his checking account balance down to a few hundred dollars when he pays his monthly bills, building up his reserve in his checking or savings account to minimize monthly service charges makes the most sense for him now.  Recently, Mark eliminated about $100 per year in service charges by switching to a bank that waives these fees if he direct deposits his paycheck. 

By mainly going on a strict financial program — which included sacrifices such as dumping his expensive new car and moving so that he could walk or bike to work — within three years, Mark became debt-free and accumulated several thousand dollars in his local bank.  Now he's ready to invest in mutual funds. 

 Because his employer offers no retirement savings programs, Mark should annually contribute $5,000 to an individual retirement account (IRA).  Mark doesn't want investments that can get clobbered: He thinks that he's been late to the saving game and doesn't want to add insult to injury by losing his shirt in his first investments.  Being a conservative sort, Mark thinks that Vanguard makes sense for him.  For his IRA, he can divide his money between a hybrid fund, such as Vanguard Wellington (70 percent), and an international stock fund, such as Vanguard International Growth (30 percent).  In addition to his new $5,000 contribution, Mark also should transfer his $5,000 bank CD IRA into these funds.  In the event that he isn't eligible for a tax deduction on a regular IRA, he should definitely fund a Roth IRA. 

Now debt-free, Mark thinks that he can invest about $400 per month in addition to his annual IRA contribution.  His income is moderate, so he's in the 28 percent federal tax bracket.  He wants diversification, but he doesn't have a lot of money to start his investing program.  He has set up an automatic investment plan whereby each month the $400 is invested in the T. Rowe Price Personal Strategy Balanced or T. Rowe Price Retirement 2035 ($50 per month minimum with an automatic investment plan). 

Competing goals: Gina and George

George works as a software engineer, and his wife Gina works as a paralegal.  They live in Virginia, are in their 30s, and have about $20,000 in a savings account, to which they currently add about $1,000 per month.  This money is tentatively earmarked for a home purchase that they expect to make in the next few years.  They figure they need a total of $40,000 for a down payment and closing costs; they're in no hurry to buy because they plan to relocate after they have children in order to be closer to family. ( The allure of free baby-sitting is just too powerful a draw!) 

Justifiably, they're pleased with their ability to save money — but they're also disappointed with themselves for leaving so much money earning so little interest in a bank.  They figure that they need to be serious about investments because they want to retire by age 60, and they recognize that kids cost money. 

George's company, although growing rapidly, doesn't offer a pension plan.  In fact, the only benefits his company does offer are health insurance and a 401(k) plan that George isn't contributing to because plan participants can't borrow against their balances.  Gina's employer offers health insurance, $50,000 of life insurance, and disability insurance — but, like George's employer, Gina's employer doesn't offer a retirement savings plan. 

 Recommendations: Deciding between saving for a home or funding a retirement account and immediately reducing one's taxes is often a difficult choice.  In George and Gina's case, however, they can and should do some of both.  At a minimum, George can save 10 percent of his income in his company's 401(k) plan.  Wanting to be somewhat aggressive and considering his age, George could invest about 80 percent in stock funds with the balance in bonds among his 401(k) plan's mutual fund investment options. 

Here are his 401(k) plan options and how he should invest:

0 percent in the money market fund option

20 percent in Vanguard Total Bond Market Index

20 percent in Fidelity Contrafund

25 percent in Dodge & Cox Stock

35 percent in Oakmark International

0 percent in a so-called guaranteed investment contract (GIC) that isn't a mutual fund but a fixed-return insurance contract (see the sidebar on "Investing money in company-sponsored retirement plans" for a discussion of these investment options)

If George contributes the maximum amount through his employer's 401(k) and he and Gina still want to invest more in retirement accounts, they can invest $5,000 each, per year, into an IRA. 

 Gina shouldn't worry that, if she and George divorce, George would get all the money in his 401(k) plan.  As with nonretirement account assets, these assets can be split between a divorcing husband and wife.  A more significant concern would occur if, say, George is an isolated dunce and refuses to talk to Gina about the investment of this money for their retirement and makes some not-so-smart moves, such as frequently jumping from one fund to another. ( Try discussing this issue with your spouse.  If you don't get anywhere with your spouse, pay a visit to your local marriage counselor.) 

What about their $20,000 that's sitting in a bank savings account?  They should move it, especially because George is a fan of USAA, having benefited from their terrific insurance programs as a member of a military family.  Initially, he and Gina can establish a tax-free money market fund, such as the USAA VA Money Market fund, as an emergency reserve. 

Because they don't plan to need the down payment money for the home for another three to five years, they can invest some of their savings — perhaps as much as half — in the USAA Tax-Exempt Intermediate-Term Bond fund.  Even though they'll pick up a little more yield, they need to know that the bond fund share price declines if interest rates rise. ( For that weighty subject, see Chapter 12.) 

George should get some disability insurance to protect his income. ( It turns out that his employer offers a cost-effective group coverage plan.)  Before Gina becomes pregnant, George and Gina should also purchase some term life insurance. 

Investing money in company-sponsored retirement plans

In some company-sponsored plans, such as 401(k)s, you're limited to the predetermined investment options your employer offers.  In most plans, the mutual funds are decent and make you happy that you didn't have to do the research.  Plans differ in the specific options they offer, but these basic choices are common:

Money market funds: These funds offer safety of principal because they don't fluctuate in value.  But you run the risk that your investment won't keep up with or stay ahead of inflation and taxes (which are due upon withdrawal of your money from the retirement account).  In most cases, skip this option. 

If you use the borrowing feature that some retirement plans allow, you may need to keep money in the money market investment option.  For regular contributions coming out of your paycheck, money funds make little sense. 

Bond mutual funds: This option pays higher yields than money funds but carries greater risk because the value can fall if interest rates increase.  However, bonds tend to be more stable in value than stocks.  Aggressive, younger investors should keep a minimum amount of money in these funds, whereas older folks who want to invest more conservatively may want to invest more money this way. 

Guaranteed-investment contracts (GICs): Backed by an insurance company that typically quotes you an interest rate a little lower than on bond funds, GICs have no volatility (that you can see).  The insurance company, however, normally invests your money mostly in bonds and a bit in stocks.  GICs are generally better than keeping your retirement money in a money market or savings account, both of which usually pay a couple of percent less in yield (see Chapter 11). 

Balanced mutual funds: Invest in a mixture primarily of stocks and bonds.  This one-stop shopping concept makes investing easier and smoothes out fluctuations in the value of your investments — funds investing exclusively in stocks or bonds make for a rougher ride.  These funds are solid options and can be used for the majority of your retirement plan contributions. 

Stock mutual funds: Invest in stocks, which usually provide greater long-term growth potential but also wider fluctuations in value from year to year.  Some companies offer a number of different stock funds, including those investing overseas.  Unless you plan to borrow (if your plan allows) against your funds — for example, for a home purchase — you probably should have a healthy helping of stock funds. 

Employee Stock Ownership Plans (ESOPs): Offer employees the option of investing in their company's stock (not all companies make these plans available).  Generally, I'd avoid this option because your future income and other employee benefits are already riding on the company's success.  If the company hits the skids, you may lose your job and your benefits.  You certainly don't want the value of your retirement account to depend on the same factors.  If you expect your company to conquer the competition, though, investing a portion of your retirement account is fine if you're a risk-seeking sort — but no more than 25 percent.  If you can buy the stock at a discount compared to its current market value, that's so much the better. 

 If George and Gina had little or no money saved and couldn't save for both the home and get the tax benefits of their retirement account contributions, they'd have a tougher choice.  They should make their decision based on how important the home purchase is to them.  Doing some of both (saving for the home and in the retirement accounts) is good, but the option of not using the retirement account and putting all their savings into the home down payment "account" is fine, too. 

Wanting lots and lotsa money: Pat and Chris

Pat and Chris earn good money, are in their 40s, and live in South Dakota.  Pat is self-employed and wants to sock away as much as possible in a retirement savings plan.  He figures that he can invest at least 10 percent of his income.  Chris works for the government, which offers a retirement plan with the following options: a money market fund, a government (big surprise!)  bond fund, and a stock fund that invests in large-company U.S. stocks only. 

Pat and Chris want diversification and are willing to invest aggressively.  They want convenience, and they're willing to pay for it.  In addition to Pat's retirement plan, they want and are able to save additional money to invest for other purposes, such as Chris's dreams of buying a small business and investing in real estate.  They currently own a home that has a mortgage that could easily be supported by one of their incomes.  Neither depends on the other's income. 

Pat also has an $8,000 IRA account, which is currently divided between a Class B growth stock fund and a Class A total return bond fund (both load funds).  Pat hasn't contributed to the IRA for six years now.  He also owns a universal life insurance plan, which he bought from the same broker who sold him the load mutual funds.  He bought the life insurance plan five years ago when he no longer could make tax-deductible contributions to his IRA; the life insurance plan is better than an IRA, according to Pat's broker, because he can borrow from it.  The broker told Pat last week that his life insurance plan is "paid up" (he need not put any more money into the plan to pay for the $20,000 of life insurance coverage) and has a cash value of $3,300, although he'd lose $1,200 (due to surrender charges) if he cashed it in now. 

 Recommendations: First, Pat should get rid of his load mutual funds and his current broker.  The broker has sold Pat crummy mutual funds.  The funds have high fees and dismal performance relative to their peers.  He could transfer his fund monies into something like Vanguard Star. 

Pat doesn't need life insurance because no one depends on Pat's income.  Besides, it's a lousy investment. ( For the compelling reasons why you're better off not using life insurance for investing, see Chapter 1.)  Pat should dump the life insurance and either take the proceeds or roll them over into a variable annuity (which I explain later in this chapter). 

Pat can establish a Keogh retirement savings plan and stash away up to 20 percent of his net self-employment income per year (See Chapter 3 for more on Keoghs).  He could establish his Keogh plan through a discount brokerage account that offers him access to a variety of funds from many firms.  Over the years, he could divide up his Keogh money as follows:

15 percent in Dodge & Cox Income or Harbor Bond

15 percent in Vanguard Total Bond Market Index

10 percent in Vanguard Total Stock Market Index

10 percent in Fairholme

20 percent in T. Rowe Price Spectrum Growth

15 percent in Oakmark Global

15 percent in Vanguard Total International Stock Index

 Because Chris doesn't have international stock funds as an investment option, Pat can invest more in these than he normally should if he were investing on his own.  In Chris's retirement plan, contributions could be allocated this way: approximately one-third into the bond fund and the remainder in the stock fund. 

As for accumulating money for Chris to purchase a small business or to invest in real estate, Pat and Chris should establish a tax-free money market fund, such as the Vanguard Tax-Exempt Money Market fund, for this purpose.  As could George and Gina earlier in this chapter, Pat and Chris can invest in a short- to intermediate-term tax-free bond fund if they anticipate not using this money for at least several years and want potential higher returns. 

Changing Goals and Starting Over

Life changes, so your investing needs may change as well.  If you have existing investments, some may no longer make sense for your present situation.  Perhaps your investment mix is too conservative, too aggressive, too taxing, or too cumbersome given your new responsibilities.  Or maybe you've been through a major life change that's causing you to reevaluate or begin to take charge of your investments.  The following sections offer some examples sure to stimulate your thinking about an investing makeover. 

Funding education: The Waltons

One of the biggest life changes that makes many adults think more about investing is the arrival of a child or two.  And after contemplating all the fear-mongering ads and articles about how they're going to need a gazillion dollars to send their little bundles of joy off to college in 18 years, many a parent goes about investing in the wrong way. 

The Waltons — Bill, 42, and Carol, 41, along with their two children, Ted, 3, and Alice, 5 — live in the suburbs of Chicago in a home with a white picket fence and a dog and cat.  They own a home with a mortgage of $150,000 outstanding.  Their household income is modest because they both teach. 

The Waltons have $40,000 in five individual securities in a brokerage account they inherited two years ago.  They also have $20,000 in two of that same brokerage firm's limited partnerships, now worth less than half of what they paid for them years ago.  Bill and Carol prefer safer investments that don't fluctuate violently in value. 

They have $25,000 invested in IRAs within a load domestic stock fund and $10,000 in a load foreign stock fund outside an IRA.  Bill hasn't been pleased with the foreign fund, and Carol is concerned about supporting foreign countries when so many Americans are without jobs.  Both of them like conservative, easy-to-understand investments and hate paperwork.  They also have $10,000 apiece in custodial accounts for each of the kids, which Bill's dad has contributed for their educational expenses.  Bill's dad wants to continue contributing money for the kids' college expenses. 

Bill just took a new job with a university that offers a 403(b) retirement savings plan, which he can get with many of the major mutual fund companies.  He wasn't saving through his old employer's 403(b) plan because, with the kids, they spend all their incomes.  Carol's employer doesn't have a retirement savings plan. 

 Recommendations: First, Bill should be taking advantage of his employer's 403(b) plan.  Though he may think that he can't afford to, he really can.  If need be, he should dump the individual securities and use that money to help meet living expenses while he has money deducted from his paycheck for the tax-deductible 403(b) account. ( Always consider the tax consequences if you consider selling securities held outside of a retirement account.  In the Waltons' case, these securities have only been held for a couple of years and were worth approximately the amount of their tax cost basis — see Chapter 18 for more on tax basis.) 

TIAA-CREF would be a fine choice for Bill's 403(b).  He could allocate his money as follows:

100 percent in Fidelity Freedom 2030 or Fidelity Freedom 2035 (fund of funds)

or

100 percent in Vanguard LifeStrategy Moderate Growth (fund of funds)

Bill and Carol could hold onto their load domestic stock fund investment that they have in their IRAs: This fund has a solid track record and reasonable annual fees of 0.7 percent.  Its only drawback is its sales load of 5.75 percent, which is water under the bridge for Bill and Carol because it was deducted when they first bought this fund. 

Their foreign stock fund isn't a good fund and has high ongoing management fees.  They should dump this fund and invest the proceeds in some better and more diversified international stock funds, such as those in Chapter 13.  And regarding Carol's concerns about supporting foreign companies, many companies today have operations worldwide.  If she's strongly against investing overseas, I suppose that she can choose not to invest her IRA money overseas, but her portfolio will likely be more volatile and less profitable in the long run.  Foreign stocks don't always move in lock step with domestic ones, and some foreign economies are growing at a faster rate than our economy. 

 Regarding custodial accounts, Bill and Carol need to remember that the amount of financial aid their kids will qualify for decreases as more money is saved in the children's names.  Bill's dad should hold on to the money himself or give it to Bill and Carol. ( This latter option has the added benefit of increasing Bill's ability to fund his 403(b) account and take advantage of the tax breaks it offers.)  Bill and Carol (and you as well, if you have children) should read Chapter 3, which has important information you should know before you invest in funds for college. 

The limited partnerships are bad news.  Bill and Carol should wait them out until they're liquidated and then transfer the money into some good no-load mutual funds. 

Rolling over (but not playing dead): Cathy

It's a surprise to her as much as it is to her friends and family: Cathy has a new job.  Although she was happily employed for many years with a respected software company, she got smitten with the entrepreneurial bug and signed on with a well-funded start-up software company.  Her 401(k) plan investment of about $100,000 is invested in the stock of her previous employer.  The company is waiting for Cathy's instructions for dealing with the money.  It's been nine months since she got sucked into the vortex of the insane hours of a start-up company. 

Nearing 40, tired but invigorated from those long days at her new company, Cathy has resolved to make some decisions about where to invest this money.  She's comfortable investing the money fairly quickly after she thinks she has a plan.  Cathy wants to invest somewhat aggressively: Although she enjoys working hard, she happily imagines a time when she doesn't need to work at all.  She likes the idea of diversifying her investments across a few different fund families.  She also wants to minimize her paperwork by setting up as few accounts as possible while at the same time minimizing transaction fees. 

 Recommendations: Cathy should sell her stock through her old employer and transfer cash.  This sale will save on brokerage commissions.  Having her retirement money in one company's stock like this is risky. 

For the best of both worlds, Cathy can establish an IRA through Vanguard's brokerage divisions, which would give her access to all the great Vanguard funds, plus access for a small fee to non-Vanguard funds.  She could invest the money as follows:

20 percent in Vanguard Total Bond Market Index

30 percent in Vanguard Total Stock Market Index

10 percent in Vanguard Selected Value or Fairholme or Sequoia

10 percent in Primecap Odyssey Growth

10 percent in Oakmark Global or Tweedy Browne Global Value

10 percent in Vanguard Total International Stock Index

10 percent in Masters' Select International or Dodge & Cox International

Wishing for higher interest rates: Nell, the near retiree

Nell is a social worker.  Now 59 and single, she wants to plan for a comfortable retirement.  In addition to owning her home without a mortgage, she has $225,000 currently invested as follows:

$60,000 in a bank money market account

$110,000 in Treasury bills that mature this month

$55,000 in an insurance annuity that's invested in a "guaranteed investment contract" through her employer's nonprofit retirement savings 403(b) plan

Nell currently earns $40,000 per year and has received pay increases over the years that keep pace with inflation.  She has $300 per month deducted from her paycheck for the annuity plan.  Her employer allows investments in the retirement plan through almost any insurance company or mutual fund company she chooses.  She's also saving about $800 per month in her bank account.  She hates to waste money on anything, and she doesn't mind some paperwork. 

Nell is concerned about outliving her money; she doesn't plan to work past age 65.  She's terrified of investments that can decrease in value, and she knows a friend who lost thousands of dollars in the stock market.  She says that her CDs and Treasuries were terrific in the 1980s when she was earning 10 percent or more on her money.  She's concerned now, though.  She keeps reading and hearing that many large, reputable companies are laying off thousands of workers, but the stock market seems to be once again rising to high levels.  She wishes that interest rates would rise again. 

 Recommendations: First, Nell should stop wishing for higher interest rates.  Interest rates are primarily driven by inflation, and high inflation erodes the purchasing power of one's money (see Chapter 12).  The problem here is that Nell's portfolio is poorly diversified.  All her money is in fixed-income (lending) investments that offer no real potential for growth and no real protection against further increases in the cost of living. 

Even though she's planning to retire in six years, she's certainly not going to use or need all of her savings in the first few years of retirement.  She won't use some of her money until her 70s and 80s.  Thus, she should invest some money in investments that have growth potential. 

Nell also could and should invest more through her employer's retirement savings plan because she's saving so much outside that plan and already has a large emergency reserve.  In fact, she should invest the maximum amount allowed under her employer's plan: 20 percent of her salary.  She also can do better to invest in no-load funds for her 403(b) plan instead of through an insurance annuity, which carries higher fees.  Vanguard and its hybrid funds (which are far less volatile because they invest in many different types of securities) are logical choices for her to use for her 403(b).  I'd recommend the following investment mix for Nell's 403(b):

25 percent in Vanguard Wellesley Income

25 percent in Vanguard Star

25 percent in Vanguard Wellington

25 percent in Vanguard LifeStrategy Moderate Growth

In addition to putting future money into these mutual funds, Nell should also decide whether she wants to transfer her existing annuity money into these funds as well.  First, she should check her annuity account statement to see whether the insurance company would assess a penalty for transferring her balance. ( Many insurance companies charge these penalties to make up for the commissions they have to pay to insurance agents for selling the annuities.) 

If the penalty is high, she might delay the transfer a few years: These penalties tend to dissipate over time (because the insurer has use of your money long enough to compensate for the agent's commission).  If, however, the annuity is a subpar performer (a likelihood, given its high fees), she may want to go ahead with the transfer despite a current penalty. ( See Chapter 16 for how to do proper transfers.) 

With the $170,000 in money outside of her retirement accounts, Nell can gradually invest (perhaps once per quarter over two years) a good portion of this money into a mix of funds that, overall, is more conservative than the mix she's using for her 403(b).  She can be more conservative because she'd likely tap the nonretirement money first in the future.  She should reserve $25,000 in Vanguard's U.S. Treasury money market fund, which pays more than her bank account.  Nell wants to have her emergency reserve in an investment that's government backed. 

Nell can use taxable funds for the other $145,000 because

  She's in a low-to-moderate tax bracket. 

  She's nearing retirement. 

  Investing solely in tax-friendly funds wouldn't meet her needs. ( The stock funds would have to be growth oriented — increasing the risk beyond Nell's comfort level.) 

I recommend that she invest the money as follows:

25 percent in Vanguard Total Bond Market Index

20 percent in Vanguard Wellington

25 percent in Fidelity Freedom 2020

20 percent in T. Rowe Price Retirement 2020

10 percent in Fidelity Puritan

 If you're older than Nell, you can use a similar but more conservative mix of funds.  For example, if you're in your 70s, for the 403(b), you could substitute the Vanguard LifeStrategy Income fund in place of the LifeStrategy Moderate Growth fund and invest 40 percent in that fund and 20 percent each in the other three funds (Wellesley Income, Star, and Wellington).  For the nonretirement money, you could shift the Fidelity Puritan money to the Vanguard Total Bond Market Index fund. 

Lovin' retirement: Noel and Patricia

Noel and Patricia, both age 65, are retired, healthy, and enjoying their long days unfettered by the obligations of work.  They take long road trips together to pursue their hobbies.  Noel is an avid fisherman, and Patricia is a wildlife photographer. 

Together, they want about $4,500 per month to live on.  Social Security provides $2,000 per month, and Noel's pension plan kicks in another $1,500 per month.  That leaves an extra $1,000 per month that must come from their $400,000 nest egg, currently comprised of

$260,000 in bank CDs

$40,000 in a money market

$100,000 in IRAs, most of it in hybrid funds and bonds

They are in a low tax bracket. 

Noel and Patricia have an outstanding $50,000 mortgage at 7 percent interest. 

 Recommendations: A good portfolio for a retiree must not only provide an income for today's expenses but also protect income for the years down the road.  Noel and Patricia are managing to get by on the current income from their investments.  However, with only 10 percent of their nest egg invested for growth in stocks, they've left themselves quite exposed to the ravages of inflation.  Their retirement could easily last another 25+ years.  Unless they allocate their assets more aggressively, their nest egg may not last that long. 

They can accomplish all their goals if they're able to boost their portfolio's total average annual returns from 6 percent to 8 percent. ( You have to crunch some numbers to figure out where you stand in terms of retirement planning; see Chapter 3.)  Averaging 8 percent annual returns shouldn't prove difficult; Noel and Patricia can boost their stock allocation to about 50 percent. 

First, however, when the CDs mature, Noel and Patricia should go ahead and pay off the remaining $50,000 of their mortgage.  Even if they invested a bigger portion of their portfolio in potentially higher returning investments such as stocks, they can't easily expect to get an overall return that much better than 7 percent, the interest rate they're currently paying on the mortgage.  True, the tax deductibility of mortgage interest effectively reduces that interest rate a bit, but don't forget that they must pay income tax on investment dividends and profits as well as on retirement account withdrawals, which effectively reduces the rate of return on their investments. 

The dreaded d's: Downsizing, divorce, disability, and death

Life isn't always what we hope it'll be.  Sometimes it changes suddenly.  You lose your job, your health, or a loved one.  Everyone reacts differently to these events.  Some maintain a balanced and positive perspective.  Others get depressed, panic, and make rash decisions.  If you're making financial decisions that you haven't had to make before, you owe it to yourself to be educated about your options and the pros and cons of each.  Be especially careful about hiring financial help because you're in danger of being too dependent and blindly following advice. 

The only step you should rush to take is to raise an emergency reserve if you need one.  Be careful about selling investments that show a profit, which could boost your tax bill.  In one case, a client I had just started working with got laid off.  From his perspective, the layoff came out of nowhere; it was a complete shock.  He was married, and he and his wife were raising their two children.  They were heavily in debt, having stretched to buy the most expensive home they could afford and having leased two expensive cars.  They had decent savings, but all their money was in the stock market.  Luckily for them, this scenario occurred when the market was doing well.  His first move was to sell some of their stock to raise cash to tide them over if finding a job took a while.  This move made sense and was all that he needed to do immediately.  The rest of their investments could be left alone. 

As evidenced by their current investment choices, Noel and Patricia are conservative, safety-minded investors.  And although they could be more aggressive, Noel and Patricia can't be too aggressive, given their ages.  Thus, paying off their mortgage, which carries a 7 percent interest rate, makes good sense.  In addition to the psychological satisfaction of owning their home free and clear, by eliminating their monthly mortgage payment, Noel and Patricia will reduce their cost of living, taking pressure off their need to generate as much current investment income. 

They can also afford to move quite a bit of money out of their money market fund into better yielding bond funds; $9,000 in the money market, enough to cover six months of expenses together with their Social Security and pension checks, is plenty. 

So, after paying off the mortgage and withdrawing cash from the money market, they'll have $241,000 to invest in funds in a nonretirement account.  They could invest it as follows:

20 percent in Dodge & Cox Income or Vanguard Total Bond Market Index

20 percent in Vanguard Wellesley

20 percent in T. Rowe Price Balanced

40 percent in Vanguard LifeStrategy Conservative Growth

Noel and Patricia need about $1,000 per month from this money, which works out to $12,000 per year on $241,000 invested in nonretirement accounts and $100,000 invested in IRAs.  To get $12,000 per year from $341,000, those investments would need to produce an income of about 3.5 percent per year.  The preceding mix of funds recently yielded about 3 percent, so they would need to use a small amount of principal to reach their annual income goal.  For more details about how to plan retirement withdrawals to make your money last, please see my newly coauthored book, Personal Finance for Seniors For Dummies (Wiley). 

With their IRAs, they could keep their financial affairs really simple and use a fund of funds, such as Vanguard's LifeStrategy Moderate Growth. 

Dealing with a Mountain of Moola

Sometimes the financial forces are with you, and money pours your way.  Hopefully, this windfall happens for good reasons instead of due to a negative event.  Regardless, a pile of money may overwhelm you.  The good news is that a lump sum gives you more financial options.  The following sections describe the ways a couple of people handled their sudden wealth. 

He's in the money: Cash-rich Chuck

Chuck is a successful Pennsylvania entrepreneur in his late 30s.  Starting from scratch, he opened a restaurant eight years ago.  Today, he's reaping the fruits of his labor.  After several relocations and remodels, Chuck has built himself quite an operation, with 40 employees on the payroll.  It's difficult for him to believe, but his restaurant's profit is now running at around $500,000 per year.  Not surprisingly, money has been piling up at a fast rate.  He now has about $800,000 resting in his business bank checking account paying next to no interest. 

He owns a home with a mortgage of about $250,000 but has no money in retirement savings plans.  Chuck doesn't want to set up a retirement savings plan at his company because he'd have to make contributions for all of his employees in a plan such as an SEP-IRA or a Keogh (which I cover in Chapter 3). 

Chuck has been planning to open another location.  He figures that a second location will cost around $400,000, but, as he says, "You just never know with construction work what the total tab may be."  He considers himself a conservative investor. 

 Recommendations: The first thing Chuck should do is get his pile of money out of the bank and into a safer investment.  Bank accounts are federally insured only up to $250,000 — so if his bank fails (and banks have and will continue to fail), he'll have a lot to cry over.  Besides, money market funds pay much better interest than his checking account does. 

Chuck has several options for investing his excess money.  The first is to pay for the cost of a second location: With his savings, he can likely buy a second location with cash.  But he faces a couple of drawbacks to using too much or all of his cash on a second location:

  The issue of liquidity: You can't write checks on a piece of real estate (unless you establish a home equity line of credit). 

  The issue of diversification: If he doesn't use all his savings on a second location, he can invest in things other than his business. 

Another option for Chuck is to pay off his home mortgage.  Yes, he gets a decent tax deduction for his mortgage interest on Schedule A of his Form 1040 — although some of the tax write-off is lost because of his high income.  However, because Chuck has all this extra cash, paying off the mortgage saves interest dollars.  That would leave $550,000 in his money fund. 

 If he paid down his mortgage and didn't want to pay all cash for his second restaurant location, he could take out a business loan.  However, that loan would likely be at a higher interest rate than the rate he pays on a mortgage for his home (because banks consider small-business loans riskier).  Because some of the home mortgage interest isn't tax-deductible, the options are close to a financial wash in Chuck's case.  So he could pay off the mortgage and perhaps use some of his remaining money to pay for part of the second location, and the rest could be financed with a business loan. 

He should keep a good cushion — say, around $200,000 — for operating purposes for his business. ( A bank line of credit may be useful to line up as well).  Some entrepreneurs, including those who've gone on to achieve great success, have violated these principles — and more — by not only pouring all their savings into their business but also by borrowing heavily.  I say: To each his own.  There's nothing wrong with going for it if you're willing and able to accept the financial consequences.  However, if the going gets tough and you don't have a safety net (such as family members who could help with a small short-term loan), you could get wiped out. 

Because Chuck uses his current bank account for keeping his excess cash as well as for check writing, he could establish a tax-free money market fund with check-writing privileges.  Some brokerage accounts, such as those offered by discount brokers (such as Fidelity, Vanguard, and TD Ameritrade), offer unlimited check writing. ( See Chapter 11 for more on money funds.)  Beyond the money market fund, Chuck could begin to invest some money ($100,000 to $200,000) in reasonably tax-friendly mutual funds through Vanguard:

20 percent in Vanguard PA Long-Term Tax-Exempt

35 percent in Vanguard Tax-Managed Capital Appreciation

15 percent in Vanguard Tax-Managed Small-Cap

15 percent in Vanguard Tax-Managed International

15 percent in Vanguard Total International Stock Index

 In place of the previously mentioned stock funds, Chuck could use some exchange-traded funds (ETFs).  For example, in place of the two domestic stock funds, he could invest in Vanguard's Total Stock Market ETF.  In place of the foreign stock funds, he could use Vanguard's FTSE All-World ex-U.S. ETF. 

Inheritances: Loaded Liz

About a year ago, Liz, who's in her 40s, received a significant inheritance.  She received about $600,000; $150,000 of this sum was a portfolio of individual large-company, higher yielding stocks, and the balance came as cash.  The stock portfolio is being managed by an out-of-state adviser, who charges 1.5 percent per year as an advisory fee and places trades through a brokerage firm.  Despite the fact that the portfolio usually has only about eight stocks in it, trade confirmations come in about once per month. 

Liz currently is a college professor and makes about $50,000 per year.  She has approximately $40,000 invested in the TIAA-CREF retirement plan, with 80 percent in the plan's bond fund and 20 percent in its stock fund.  She's saving and investing about $400 per month in the plan because that's the amount she can afford.  Liz also has $110,000 in a bank IRA CD that will mature soon. 

Liz currently owns a home and is happy with it.  It has a mortgage of about $90,000 at a fixed rate of 7 percent.  She wants to retire early, perhaps before age 60, so that she can travel and see the world.  She's wary of risk and gets queasy over volatile investments, but she's open to different types of funds.  She likes to use many different companies but doesn't want the headache of a ton of paperwork.  Liz prefers doing business over the phone and through the mail because she's too busy to go to an office. 

  Recommendations: First, Liz should maximize her retirement contributions even though she thinks that she's saving all that she can afford.  She has all this extra money now that she could draw upon and use to supplement her reduced take-home pay if maximizing her retirement contributions doesn't leave enough to live on. 

This extra cash also affords Liz another good move — getting rid of the mortgage.  It's costing her 7 percent interest pre-tax (around 5 percent after tax write-offs), and she'd have to take a fair amount of risk with her investments to better this rate of return. 

Liz also needs to invest her money more aggressively, particularly inside her retirement accounts.  All of her IRA and 80 percent of her employer's retirement plan money are in fixed-income investments.  In the TIAA-CREF plan, she can invest 30 percent in the bond fund, 40 percent in its stock fund, and 30 percent in its global equities fund. 

She could transfer her IRA account to a discount broker and invest it as follows:

40 percent in Vanguard Star

20 percent in Fidelity Freedom 2030

20 percent in T. Rowe Price Spectrum Growth

10 percent in Vanguard Total Stock Market Index or ETF

10 percent in Dodge & Cox International or Masters' Select International

After paying down the mortgage and keeping an emergency reserve of $40,000, as well as another $70,000 for remodeling, Liz would have $250,000 in cash plus the stocks.  She should sell the stocks because their dividend income is taxable and she's paying 1.5 percent per year (plus commissions) to have her account managed.  The account has underperformed the S & P 500 by an average of 3 percent per year over the past five years.  She could transfer these shares to Vanguard's discount brokerage division and then sell them there to save on commissions as well as to have money at Vanguard to invest in its funds.  Then Liz could invest the remaining $400,000 once per quarter over the next two to three years as follows:

20 percent Vanguard Intermediate-Term Tax-Exempt

40 percent Vanguard Tax-Managed Balanced

25 percent in Vanguard Total Stock Market Index or ETF

15 percent in Tweedy Browne Global Value or Oakmark Global

Getting Unstuck . . . 

Some people feel overwhelmed when they're making investing decisions.  If you're one of those people — and if you're willing to pay the price and put in the hours to interview and select the right person and firm — you can hire a financial adviser (see Chapter 24).  But if you're not willing to put in that time and money, don't worry — you can still keep things simple (without sacrificing quality).  Table 15-1 can help you establish and maintain a simple, yet solid, mutual fund portfolio by using funds of funds (which I discuss in Chapter 13). 

Table 15-1 assumes that you're investing money for retirement and that you're willing to take on a moderate level of risk. ( Remember that, because funds of funds hold thousands of individual securities, they're more than diverse enough to be used "exclusively.")  When investing money in a retirement account (or if you're not concerned about taxable distributions, in a nonretirement account), use the recommended mix of funds for your age in the second column.  When investing retirement money that happens to be in a nonretirement account, you can avoid taxable distributions by using the recommended selection of funds for your age in the third column. 

Table 15-1 Eric's Keep-It-Simple Portfolio

---

Your Age | Suggested Vanguard Funds | Tax-Friendly Vanguard Fund Mix*

Less than 36 | 100% LifeStrategy Growth | 54% Total Stock Market Index26% Total International Stock Index20% Intermediate-Term Tax-Exempt

36–45 | 50% LifeStrategy Growth50% LifeStrategy Moderate Growth | 47% Total Stock Market Index23% Total International Stock Index30% Intermediate-Term Tax-Exempt

46–55 | 100% LifeStrategy Moderate Growth | 40% Total Stock Market Index20% Total International Stock Index40% Intermediate-Term Tax-Exempt

56–65 | 50% LifeStrategy Moderate Growth50% LifeStrategy Conservative Growth | 33% Total Stock Market Index17% Total International Stock Index50% Intermediate-Term Tax-Exempt

66–75 | 100% LifeStrategy Conservative Growth | 27% Total Stock Market Index13% Total International Stock Index60% Intermediate-Term Tax-Exempt

76–85 | 50% LifeStrategy Conservative Growth50% LifeStrategy Income | 20% Total Stock Market Index10% Total International Stock Index70% Intermediate-Term Tax-Exempt

86 or more | 100% LifeStrategy Income | 13% Total Stock Market Index7% Total International Stock Index80% Intermediate-Term Tax-Exempt

* If you live in California, Florida, Massachusetts, New Jersey, New York, Ohio, or Pennsylvania, you can substitute the state-specific Vanguard bond fund appropriate for your state in place of the Intermediate-Term Tax-Exempt fund.  Although the state-specific bond funds are more volatile because they invest in longer term bonds, they pay slightly higher yields. 

* If you prefer to use the Vanguard Tax-Managed funds that I discuss in Chapter 13, simply substitute 67 percent Tax-Managed Capital Appreciation and 33 percent Tax-Managed Small Capitalization for Total Stock Market Index; and Tax-Managed International for Total International Stock Index. 

* If you're investing larger balances and understand ETFs (see Chapter 5), you could use Vanguard's Total Stock Market Index ETF in place of the domestic stock funds in the table and Vanguard's FTSE All-World ex-US ETF in place of the foreign stock funds. 
Chapter 16

Applications, Transfers, and Other Useful Forms

In This Chapter

  Explaining application basics

  Understanding nonretirement and retirement account forms

  Establishing an automatic investment program

  Asking for help

When you invest money, completing forms is unfortunately a requirement.  But don't despair.  If you truly detest paperwork and mailing things, you'll be happy to know that you can now complete many application forms online.  In this chapter, I explain how to fill out fund application and transfer forms. 

Although the subject of this chapter may seem mundane, I explain some extra-nifty things that perhaps you didn't know you could do with fund investing.  And, unlike dealing with IRS tax forms year after year, fund paperwork isn't unpleasant to deal with.  You won't have much (if any) ongoing paperwork to do, except for filing the taxes owed on mutual fund distributions held outside of retirement accounts (the subject of Chapter 18). 

Taking the Nonretirement Account Route

As I discuss in Chapter 9, you can purchase most of the excellent mutual funds that I recommend in this book either directly from the mutual fund company responsible for them or through a discount brokerage firm.  Though you see many similarities between mutual fund company and discount broker applications, you also see that brokerage account applications are a different type of animal than mutual fund company applications.  I show you how to handle both in this chapter. 

Filling in the blanks: Application basics

In years past, prospective customers called the fund company on its toll-free number and said, "Please send me your account application materials for your (fill-in-the blank) fund."  Several days later, a packet arrived in the mailbox with enough density and heft to make a great flyswatter!  Most of the content was marketing propaganda to convince people to send gobs of money.  You had to hunt around for the document that said something like Account Registration Form or New Account Application or Application. 

Thanks to the Internet, now you can open fund accounts online.  In the past, although various fund companies allowed you to access and download account application forms on their Web sites, you still had to print the application, sign it, and drop it in the mail.  But today, electronic signatures exist.  E-signatures, as they're commonly referred to, are now legally equal to traditional pen-and-ink signatures on paper forms.  You don't literally sign a form using your computer; you're simply assigned a code that serves as your very own e-signature.  Fund companies ensure your account's security by requiring your Web browser to use sophisticated encryption technology and by mailing another code to the address that you provide in your application. 

 Here are the potential benefits of completing an account application online:

  You can get your new account open much faster, which may come in handy when you face a deadline for opening a particular type of account (such as a retirement account). 

  You can save time completing forms through the same company.  Most of the better fund-company Web sites remember your information when you've completed one form, which allows them to precomplete common portions of new forms when you come back to open more new accounts. 

The following sections explain and show you how to complete the important portions of a typical new account application for a nonretirement account (I discuss the nuances of retirement account applications later in the chapter). 

Account registration

In the account registration section (which usually comes first on an account application), you're asked to choose the appropriate box and enter the name of the individual or organization that's registering the account.  Here are the common types of account registrations:

  Individual or Joint Account: Choose this option if you're opening the account for yourself or jointly for yourself and someone else.  Joint tenants with rights of survivorship is generally the default classification for jointly registered accounts and establishes the following conditions:

• The person you've jointly registered the account with can do everything that you can do on the account, such as calling and inquiring about account balances, performing transactions, and writing checks.  Neither party needs the other's permission (although it's possible to establish the account so that both signatures are required for check writing). 

• Each account holder has an equal interest in the account. 

• If you should die, the entire account balance goes to the other person registered on the account without the hassles and expense of going through probate. 

A rarely used option is to register the account as tenants in common.  To arrange a tenancy in common, you can have a legal document drawn up specifying that each tenant owns a certain percentage of the account.  Unlike shares of ownership for joint tenants with rights of survivorship, the shares for tenants in common need not be equal.  If you die, the account is restricted; your share of the account is distributed to the person whom you designated to receive it, and the surviving account holder is required to set up a new account for his share. 

 If you go to the trouble of setting up the account registration as tenants in common, just write in the margin in this section of the form that you want the account set up this way or attach a short letter that presents the same request.  The fund company doesn't want or need to see the legal document (which you should keep with your will) or other important personal financial documents. 

  Gift or Transfer to Minor: Use this section if you want to open (register) an account in your child's name.  As the parent, you're the custodian, your child the minor.  Your state's name is requested in this section because two different sets of laws govern custodial accounts: the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA).  States allow one or the other.  Your child is legally entitled to the money in the account when she reaches the so-called age of majority (which is, depending on the state, between 18 and 21).  Read Chapter 3 before putting money into an account in your child's name because there are drawbacks. 

  Trust: Generally, you know if you have a trust because you're either the one who sets it up or you're the recipient of assets that are part of a trust.  There are many types of trusts.  For example, some folks, by the time they get older, have set up a living trust that allows their assets to pass directly to heirs without going through probate.  If you have a trust agreement, provide the pertinent details at this point in the form. 

  Corporation, Partnership, or Other Entity: If you want to open a mutual fund account for your corporation or local Rotary Club, use this section.  You need a taxpayer ID number.  If your organization doesn't have one, call the IRS at 800-829-3676 (800-TAX-FORM) and request Form SS-4, or visit its Web site at www.irs.gov. 

Your personal information

This part's easy.  You may be wondering why some fund companies ask for your phone numbers, the name of your employer, and your occupation.  The company wants your phone numbers so it can call you regarding account issues.  The rest of this information is partly required by fund regulators and partly just desired by the fund company for its own market research; it wants to know about the people who invest in each of its specific types of funds.  If you want to maintain your privacy, you can skip the employment stuff, and the fund company will still happily open your account. 

Your investment

The investment section is where you tell 'em which fund you want.  But be careful in this section.  Most account applications offer a menu of fund choices, so you need to double-check that you've selected the fund that you have your heart set on. 

 To ensure that the money is deposited into the correct fund, check the account statement that you receive when you open your account.  Although it doesn't happen often, fund companies (and you!)  occasionally make mistakes. 

Your method of payment

After you open an account, you're faced with the task of getting money into your new account in order to buy some mutual funds.  You can put money into your account by mailing the fund company a check, having funds electronically transferred from an existing bank account, or transferring funds from an account you previously opened at the fund company. 

Generally, you need to send a check to open a mutual fund account.  If this is the case, make the check payable to the fund (if the company numbers its funds, include the fund number next to the fund company name).  Don't worry about someone stealing the check or a mail thief cashing it (remember that you make the check payable to the fund). 

 After you open a money market fund account, you can do exchanges into other accounts by telephone.  Exchanges save you the hassle of filling out more application forms every time you open new funds at the same company (although different account types, such as IRAs, do require separate account applications).  Make sure that you have another source of cash during the time it takes for the fund company to open your money fund and send your first check.  Sometimes people send in almost all their money and then, in a few days, they wish that they'd kept some back. 

Dividend and capital gains payment options

Most mutual funds make dividend and capital gains payments.  If you're not living off this income, it's usually best to reinvest these payments by purchasing more shares in the fund.  To reinvest, just check the box indicating that you want to have the fund's dividend and capital gains reinvested.  This strategy eliminates the hassle of receiving and cashing checks often and then figuring out where to invest the money (but it doesn't change the taxability of a fund's distributions). 

On the other hand, if you're retired, for example, you may want the distributions on your fund sent to you so that you can spend it on early-bird restaurant specials.  Most fund companies offer you the option of having the money from distributions sent to you as a check through the mail.  Or, even better, the fund can electronically transfer the money to your bank account.  This method gets you the money quicker and requires less mail to open and fewer checks to sign and schlep to the bank. 

Wiring and automatic investment options

You're not required to have wiring and automatic investment options on an account.  Wire redemption allows you to request that money be wired to your bank account.  Use this feature if you might unexpectedly need money fast.  Your mutual fund and your bank may charge for wiring services, though, so don't use wiring as your regular way to move money to and from your bank. 

If you want to make regular deposits into one of your fund accounts, you can select an automatic investment plan, which authorizes the fund to instruct your bank to send a fixed amount on a particular day of the month (or some other time period).  You can do the same in reverse by withdrawing money on a regular schedule, too.  The minimum amount should be stated on the form. 

Special purchases and redemptions is an electronic funds transfer — it's like a paperless, electronic check that allows you to move money back and forth between your bank and mutual fund accounts.  This process usually takes a full two days to complete because, like a check, the transaction is cleared through the Automated Clearing House (wiring can typically be done the same day or next day).  The fund and the bank shouldn't charge for the service because it's just like a check (which means that it costs less than wiring). 

 To establish these additional services, remember to attach a preprinted deposit slip or blank check (write "VOID" in large letters across the front of the check so that no one else can use it). 

Check-writing option

Check writing is a useful feature to sign up for on a money market fund.  But most money funds limit check writing to amounts of $250 or more. 

 I don't recommend establishing check writing for bond funds because each time you write a check on a bond fund, you must report the transaction on your annual tax return (because the price of the bond fund fluctuates, you'll be selling at different prices than you bought).  Keep enough cash in your money fund and write your checks from there. 

Opening multiple fund accounts quickly

Some of the larger fund companies have a number of good funds, so you may want to invest in multiple funds at one company.  Through a comprehensive account application form, most fund companies let you invest in multiple funds without having to complete a mountain of paperwork.  However, not all fund companies offer these comprehensive account application forms.  You're supposed to fill out a separate application for each fund you plan to invest in, but you don't need to.  Avoid this paperwork nightmare in several ways:

Establish a money market fund first.  Then you may do exchanges by phone into any other funds you want.  When you call to order the money fund materials, ask for the prospectuses for the other funds that you're interested in.  When you do telephone exchanges, fund companies are required by the SEC to ask if you've received the prospectus before they'll allow an exchange. 

Attach a separate piece of paper to one application with instructions to the fund company to open "identically registered accounts in the following funds" (but first make sure the company allows this shortcut).  Next to each fund name, list the amount you want to invest.  Don't forget to sign the page and attach your check. 

Open a discount brokerage account through a firm that allows telephone exchanges (see the "Buying in to discount brokerage accounts" section). 

Buying in to discount brokerage accounts

As I discuss in Chapter 9, discount brokerage firms and the discount brokerage divisions of fund companies offer you the opportunity, through a single account, to invest in hundreds of funds from many fund companies.  Brokerage firms are different from mutual fund companies.  The first difference is that brokerage accounts allow you to hold and trade individual securities, such as stocks and bonds.  This feature is handy if you hold individual securities and want them in the same account as your mutual fund. 

 Another difference is that, in addition to offering mutual funds, brokerage accounts allow you to invest in riskier types of securities and engage in riskier investing strategies.  Many brokerage firms, for example, allow investing in options (see Chapter 1), which are volatile, short-term, gambling-type instruments.  Keep your distance. 

Most of the sections on a typical brokerage application are the same as those on a mutual fund application, which I describe in the "Filling in the blanks: Application basics" section, earlier in the chapter.  The following sections explain the main differences that may give you cause for pause. 

Borrowing money so you can invest: Margin accounts

Brokers offer (and sometimes encourage) margin trading.  Just as you can purchase a home and borrow some money to finance the purchase when you can't afford to pay all cash, you can do the same with your investments.  When you buy a home, most banks require that you make a 10 to 20 percent down payment on the purchase price.  When you invest in a brokerage account, you need to make a 50 percent down payment. 

 Buying investments on margin isn't something I recommend because

  You pay interest.  Although the rate is competitive — nothing approaching the worst credit cards — it still isn't cheap.  Typically, the rate is a bit more than you'd pay on a fixed-rate mortgage on your home. 

  If your investments fall significantly in value (25 to 30 percent), you get a margin call, which means that you need to add more cash to your account.  If you can't or don't add more money to your account, you must sell some investments to raise the cash.  Of course, if your securities' prices increase in value, you earn money not only on the down payment you invested but also on the borrowed money invested. ( That's called leverage.) 

  You can't invest on margin in retirement accounts, which is where you should be doing most of your investing (because of the tax benefits). 

Borrowing on margin can be useful as a short-term source of money.  Suppose you need more short-term cash than you have in a money fund.  Instead of selling your investments, just borrow against them with a margin loan.  This move makes sense especially if you'd have to pay a lot of tax on profits were you to sell appreciated investments. 

Getting personal

Brokerage applications ask for financial information that most people consider to be confidential, such as your driver's license number, income, and net worth. " Why," you may rightfully ask, "are they being so nosy?  Do they really need to know this stuff?" 

All brokerage firms ask for this kind of information (although different firms ask different questions) because of the so-called know-your-customer rule imposed by regulators.  Because brokerage accounts allow you to do some risky stuff, regulators believe that brokerage firms should make at least a modest effort to determine whether their clients know enough and have a sufficient financial cushion to make riskier financial investments. 

 Make your paperwork go faster and your investing less dangerous and skip this!  If you're not signing up for the risky account features, such as margin and options trading, the brokerage firm doesn't need to know this info. 

Accessing your cash: Checks and debit cards

Some brokerage accounts offer additional features, such as check writing and a debit card, that allow more convenient ways for you to access the money in your account.  The only challenge is that you may have to request a different application for the special type of account that offers these features. 

 Debit cards look just like credit cards and are accepted by retailers the same way as credit cards.  But, when you use your debit card, the money is generally sucked out of your account within a day or two.  Using debit cards instead of credit cards may simplify your financial life by saving you from writing a check every month to pay your credit card bill.  However, you give up the float — the free use, until the credit card bill is due, of the money that you owe — because debit cards quickly deduct the money owed from your account.  You may also use your debit card to obtain cash from ATMs. 

As with a money market mutual fund account, you may obtain checks to write against the money market fund balance in your brokerage account.  Don't forget to complete the signature card for check writing. 

Some brokerage accounts come with even more features that make organizing your finances easier, such as unlimited check writing and a bill payment service.  These services cost more money, and you may have to put more money into your account, pay a monthly service fee, and/or pay an annual account fee if you don't place a specified minimum number of trades per year. 

Transferring your dough into a new brokerage account

You may have cash, securities, and most mutual funds transferred into a new brokerage account that you establish. ( If you haven't opened an account yet, you also need to complete an account application form.)  All you need is an account transfer form for the brokerage firm into which you're transferring the assets.  Using one of these forms saves you the hassle of contacting brokerage firms, banks, and other mutual fund companies from which you want to move your money.  Using this form also saves you the bother and risk of taking possession of these assets.  The following sections contain the info you need to know to complete a typical brokerage account transfer form. 

Information about your (new) brokerage account

Your new brokerage firm needs to know into which account you want your assets transferred, so in this section you fill in your name as you have it on your account application or as it's currently listed on your account, if it's already open.  If you're sending your account application with this transfer form, you won't have an account number yet, so just write NEW in the space for your account number. 

Information about the account you're transferring

Here, you write the name of the brokerage, bank, or fund company that holds the assets you want to transfer and enter the account number of your account there.  You may see the phrase Title of account; this simply means your name as it appears on the account you're transferring. 

Brokerage account transfers

 In this section, you indicate whether you want to transfer your entire brokerage account — which makes your administrative life easier by eliminating an account — or only a part of it. ( Another advantage of closing accounts at firms such as Prudential, Merrill Lynch, and so on is that they generally charge an annual account fee.) 

If you're doing a partial transfer, you generally just list the assets that you want to transfer — for example, IBM stock — and the number of shares, such as "50" or "All."  With partial transfers that include the transfer of mutual funds, you may have to go through the hassle of completing a transfer form for each company whose funds you're moving.  You may have to list these funds in a separate section. 

 You generally won't be able to transfer (into your new brokerage account) mutual funds that are unique (or proprietary) to the brokerage firm you're leaving.  Funds that can't be transferred typically include funds such as Prudential, Merrill Lynch, and so on.  If there are no adverse tax consequences, you're better off selling these funds and transferring the cash proceeds.  Check out Chapter 17, which walks you through the issues to consider if you're debating whether to hold or sell a fund. 

If you bought some of those awful limited partnerships, check with the discount brokerage firm to which you're transferring your account to see if it'll be able to hold them.  Discounters will likely charge you a fee ($25 to $50) to hold LPs, but many of the lousy firms that sold them to you in the first place also charge you for the privilege of keeping your account open with them.  If the costs are about the same, I'd move the LPs to your new account to cut down on account clutter.  Another alternative is to speak with the branch manager of the firm that sold them to you and ask that it waives the annual account fee for continuing to hold your LPs there. 

Mutual fund transfer forms

As I explain in the last section, you can only transfer certain companies' funds into a brokerage account.  For each fund you're transferring, you typically list the fund name, your account number, and the amount of shares you want transferred or sold. 

  If you're transferring the fund as is instead of selling it, tell the new firm whether you want the fund's dividends and capital gains distributions reinvested.  Unless you need this money to live on, I'd reinvest it. 

Bank, savings and loan, or credit union transfers

A potential complication occurs when you're transferring money from a certificate of deposit.  In that case, send in this form several weeks before the CD is set to mature. 

 If you're like most people and do things at the last minute, you may not think about transferring a CD until the bank notifies you by mail days before it's due to mature.  Here's a simple way around your inability to get the transfer paperwork in on time: Instruct your bank to place the proceeds from the CD into a money market or savings account when the CD matures.  Then you can have the proceeds from the CD transferred whenever you like. 

Attach your account statement! 

Don't forget to attach a copy of a recent statement of the account you're transferring as well as your account application if you haven't previously opened an account.  At this point . . .  you're done!  Mail the completed application in the company's postage-paid envelope, and the transfer should go smoothly.  If you have problems, see Chapter 19 for solutions. 

Preparing for Leisure: Retirement Accounts

The applications for retirement accounts pose new challenges.  But, remember that it will be worth the effort: Otherwise, how will you pay for dentures and your annual AARP membership?  The first part of these applications is just like a nonretirement account application, except that it's easier to fill out.  Retirement accounts are only registered in one person's name: You can't have jointly registered retirement accounts.  Because mutual fund company retirement account forms are so similar to brokerage account retirement forms, I cover only the differences here. 

Retirement account applications

Individual Retirement Accounts (IRAs) are among the most common accounts you may use at a mutual fund company.  This section explains what you need to know to complete an IRA application.  I also discuss the unique features of the other common retirement accounts — SEP-IRAs and Keoghs, which are used for the self-employed and small business owners. ( For a detailed explanation of the various types of retirement accounts, see Chapter 3.) 

 If you plan to transfer money from a retirement account held elsewhere into the one you're opening, before you start, pay attention to two details:

  Make sure that the retirement account type you're opening (such as a SEP-IRA) matches the type you're transferring from (unless you're moving money from a 401(k) plan, in which case you'd be sending that money into an IRA because you can't open a 401(k) as an individual). 

  If you want to transfer individual securities from a brokerage account, you need a brokerage account application for the type of retirement account you're opening, not a mutual fund account application. 

Register for an account

 Account registration is an easy section to fill out — but make sure that, if you're transferring IRA money from another firm into your mutual fund IRA, you list your name exactly as it appears on the account you're transferring.  Otherwise, the firm that has your IRA may make a fuss, causing delays and making you complete yet more forms.  Note: Some applications ask for your employer info.  You don't have to provide this if you don't want to. 

Choose your investment method

With an IRA, you can fund your account through three methods:

  Annual contribution: Select this option if you're opening up a new IRA with money previously held outside any kind of retirement account.  You must specify which kind of fund(s) you want to buy, how much you'll be contributing (in 2010, up to $5,000; $6,000 if you're age 50 and older), which kind of IRA you want to open (traditional or Roth), and which tax year you're making your contributions.  You have until the time you file your tax return (the deadline is April 15) to make a contribution for the previous year. 

   Transfer from an existing IRA: If you want to move an IRA from another investment firm or bank into your new mutual fund IRA, select this option.  You also need to complete an IRA transfer form (which I explain in the "What to do before transferring accounts" section).  This option is the best way to move an existing IRA because it presents the least hassle and the fewest possibilities of a tax screw-up. 

   Rollovers: Withdrawing the money from another IRA and sending it yourself to the new account isn't a good way to transfer your IRA.  The big danger is that if you don't get the funds back into the new account within 60 days, you'll owe megataxes (income tax plus penalties). 

Retirement plan applications for the self-employed and small business: SEP-IRAs and Keoghs

If you're self-employed or a small business owner, consider opening a SEP-IRA or Keogh plan.  Most self-employed people can generally make larger tax-deductible contributions into these accounts than they can into a regular IRA. ( I discuss the pros, cons, and contribution limitations of SEP-IRAs and Keoghs in Chapter 3.) 

SEP-IRA applications are virtually identical to IRA applications, so just follow the instructions for the IRA applications in the section "Retirement account applications" (in fact, some firms use the same application form).  At those firms that use SEP-IRA applications that differ from IRA applications, you may see references to "Employer Contribution" as the main difference.  If you're the business owner, you, as the self-employed person, are your own employer.  If you have other employees, they may be eligible for SEP-IRA contributions under your plan (the maximum waiting period is three years of service — a year of service is a year in which an employee earns $550).  When employees become eligible for contributions, you set up accounts for them (with their names on them) — they don't establish accounts on their own. 

Keogh account applications are more complicated.  You must complete more paperwork, particularly if you set up the combined profit-sharing and money purchase pension plans that I explain in Chapter 4. 

A few items appear on a Keogh application that you won't find on an IRA application.  First, you must supply an employer tax identification number.  If your business has obtained a tax identification number from the IRS, plug that in.  Otherwise, most small business owners use their Social Security numbers.  You also need the name(s) of the plan administrator, the person(s) responsible for determining which employees are eligible in the plan, making contributions into the accounts, and other tasks.  If you're a sole proprietor, you're the administrator.  In larger businesses, the administrator is the business owner(s). 

The Keogh plan documents also ask whether your company operates, for tax purposes, on a calendar year (which ends on December 31) or a fiscal year (which has some other end date for the year).  Employees are eligible to participate after they've completed two years of service.  Different plans define a year of service differently, but most use 500 or 1,000 hours as the threshold. 

If you're rolling over money from an employer-sponsored plan, such as a 401(k), you can select the option that's labeled something like Traditional Rollover IRA.  Tax advisers usually recommend that money coming from your employer's plan should go into a rollover account.  This choice allows you to someday transfer the money back into another employer's plan.  Of course, you can choose investments in your IRA, so this may sound like a silly reason to use a rollover IRA.  An advantage to establishing a contributory IRA, instead, is that you can add to it with future IRA contributions.  You can also merge it with other IRAs. 

  Don't request that your employer issue you a check because your employer must withhold 20 percent for taxes.  If you want to roll the full amount over — a wise move — you must come up with the missing 20 percent when you deposit the money into your IRA.  Otherwise, you owe tax and penalties on it.  Establish your IRA and then instruct your employer to send your money directly to that account. 

Select your account service options

Most companies allow you to pick and choose from various service options that come with your IRA.  Some of them, such as telephone/computer exchange, are automatically available with your account unless you specify otherwise.  You can usually also set up an automatic investment plan; contributions to your IRA can be regularly deducted from either your bank checking account or your paycheck itself.  Such plans generally have lower minimum initial investment requirements. 

Designate your beneficiaries

In the beneficiaries section, you specify who gets all this retirement money if you work yourself into an early grave or haven't spent all of it by the time you go.  In most cases, people name their spouses, kids, parents, or siblings.  You may also list organizations such as charities that you want to receive some of your money; providing their tax identification number and address is a good idea (just include this info on a separate piece of paper). 

If your children are under 18, they don't have access to the money.  A guardian who you identify through your will controls the money.  If you die without a will, the courts will assign a guardian.  Your primary beneficiaries are first in line for the money, but if they've all crossed the finish line by the time you do, your contingent beneficiaries receive the money. 

What to do before transferring accounts

If you have money in a retirement account in a bank, brokerage firm, other mutual fund company, or in a previous employer's retirement plan, you can transfer it to the mutual fund(s) of your choice.  Here's a list of steps for transferring a retirement account.  Note: If you're doing a rollover from an employer plan, please heed the differences indicated:

1.  Decide where you want to move the account. 

See Chapter 9 for help with this decision. 

2.  Obtain an account application and asset transfer form. 

Call the toll-free number of the firm you're transferring the money to (or visit its Web site) and ask for an account application and asset transfer form for the type of account you're transferring to — for example, an IRA, SEP-IRA, Keogh, or 403(b). 

You can tell which account type you currently have by looking at a recent account statement; the account type is given near the top of the form or in the section with your name and address.  If you can't figure it out on a cryptic statement, call the firm that currently holds the account and ask a representative which type of account you have (just be sure to have your account number handy when you call). 

3.  Figure out which securities you want to transfer and which you need to liquidate. 

Transferring existing investments in your account to a new investment firm can cause glitches because not all securities may be transferable.  If you're transferring cash (money market assets) or securities that trade on any of the major stock exchanges, transferring isn't a problem. 

 If you own publicly traded securities, it's often better to transfer them as is to your new investment firm, especially if the new firm offers discount brokerage services. ( The alternative is to sell them through the firm you're leaving, which may cost you more.) 

If you own mutual funds unique to the institution you're leaving, check with your new firm to see whether it can accept them.  If not, you need to contact the firm that currently holds them to sell them. 

4. ( Optional) Let the firm from which you're transferring the money know that you're doing so. 

(You don't need to worry about this step if you're rolling money out of an employer plan.)  If the place you're transferring from doesn't assign a specific person to your account, you definitely should skip this step.  If you're moving your investments from a brokerage firm where you've dealt with a particular broker, though, the decision is more difficult.  Most people feel obligated to let their rep know about the transfer. 

 In my experience, calling your representative with the bad news is usually a mistake.  Brokers or others who have a direct financial stake in your decision to move your money will try to sell you on staying.  Some may try to make you feel guilty, and badger you.  The more that you feel personally obligated to continue doing business with a broker, the more likely it is that your personal relationship is getting in the way of your financial goals.  Instead, write a letter if you want to let them know you're moving your account.  It may seem the coward's way out, but writing usually makes your departure easier on both sides.  With a letter, you can polish your explanation, and you don't run as much risk of putting the broker on the defensive.  Just say that you've chosen to self-direct your investments. 

But then again, telling an investment firm that its charges are too high or that it sold you a bunch of lousy investments that it misrepresented to you may help the firm to improve in the future.  Don't fret this decision too much.  Do what's best for you and what you're comfortable with. 

Establishing retirement accounts quickly

Okay, so you procrastinate — you're human.  Perhaps it's April 14 or 15, and you want to establish an IRA, but you need to do it, like, now.  You don't have time to call a toll-free number, wait for days to get the application in the mail, and then wait even more days until the fund company receives your check.  All isn't lost; get yourself out of your pickle in several proven ways:

Visit a branch office.  Companies such as Fidelity and TD Ameritrade have numerous branch offices.  Call them to find the location of the one nearest you.  You may also be near other companies' main offices.  Check the Appendix of this book for contact information.  And believe it or not, some branch offices are kept open late on tax day. ( Some larger firms even keep some of their branches open until midnight.) 

Visit a Web site.  Most fund companies provide downloadable account applications on the Internet — and increasing numbers of fund providers allow you to complete these applications online using e-signatures (which I discuss in the section "Filling in the blanks: Application basics").  Most likely, however, you'll have to print and mail a form.  And to get your money into your newly opened account, you need to wire or electronically transfer funds (or employ one of the other strategies that I discuss in this sidebar). 

Use an express mail service.  Although not a low-cost option, if you have a chunk of money at stake, an overnight express mail service may be worth the cost and save you the time of going to a branch office. 

Go to your local bank.  Establish your retirement account in a savings or money market type of account at the bank.  Later, when the dust settles and you have breathing room, call your favorite fund company for its application and transfer forms to move the money. 

Bank employees will more than likely try to talk you into a CD or one of the mutual funds that they sell.  Skip the CD, because you're looking for a short-term and flexible parking place for your retirement contribution.  Bank mutual funds tend to be commission-based (load) funds and aren't among the best choices. 

File for a tax extension.  If you're opening a non-IRA retirement account, such as an SEP-IRA or a Keogh, consider buying yourself more time by filing for an extension.  Although you must still pay any outstanding tax owed by the April 15 deadline, filing for an extension by using IRS Form 4868 gets you six more months (until October 15) to file your Form 1040 and establish and fund your retirement accounts. ( Note: This extension doesn't apply to normal IRAs; for those, April 15 is the absolute deadline.) 

If you're self-employed, be aware that you need to file the paperwork for a Keogh retirement account by December 31 — no extensions are allowed (although, as with other retirement accounts, you do have until the time you file your tax forms to fund the Keogh).  You can use the strategies I discuss in this sidebar to get the job done by year's end. 

Filling out transfer forms

Transferring retirement accounts generally isn't too difficult.  In most cases, all you need to do is complete a transfer form.  You can use a mutual fund transfer form to move money that's in a bank account, in another mutual fund, or in a brokerage account.  You may only use this form to move investment money that you want liquidated and converted to cash prior to transfer. 

 You'll probably need to use one of these retirement account transfer forms for each investment company or bank you're transferring IRA money out of.  If you're transferring individual securities (for example, stocks or bonds) or want brokerage account features, you need a brokerage account transfer form (and brokerage application forms).  The following sections detail the unique features that you should know about when completing a transfer form. 

Account ownership and address

Be sure to list your name and address as it appears on the account you're transferring (look at a recent statement for that account).  A discrepancy between the two accounts often leads to an incomplete transfer. 

 If you're transferring an IRA, look at a statement for the account you're transferring and see which type of IRA you have.  If you can't figure it out, either call that company and ask which of the three types you have or just leave it blank, send it to the mutual fund, and let it figure it out from the statement for the account that you're transferring! 

Where the retirement account funds will be invested

On most applications, you simply list the funds that you want the transferred money invested in and the percentage of the money that is to go into each (the percentages must total 100 percent).  If you want to divvy up the money into more funds than the form allows space for, list the additional funds on a separate piece of paper and attach that sheet to the form. 

Account being transferred

In this section of the transfer form, you tell the fund company where the account you want to transfer is currently held.  If it's in another fund, list the name of the fund (if you're transferring more than one fund from the same company, just squeeze those names into the space provided).  If it's money in a CD that you're moving, try to send your transfer form several weeks before the CD is scheduled to mature. 

 If you don't get around to sending the form until right before your CD matures, buy yourself more time by directing your bank to place the CD proceeds into a money market or savings type account from which you then can do the transfer. 

List the firm where your account is currently being held.  You may see the term custodian, which is simply the term for the company holding your IRA — for example, First Low Interest Bank & Trust or Prune Your Assets Brokerage.  Some transfer forms ask for a specific department or person who handles account transfers at your old firm.  You probably won't have a clue as to which person or department has this responsibility.  If you don't, you can call the company and try to find out.  My advice: Don't bother.  Most funds don't burden you with having to find this information out — the funds should already know from other transfers that they've done with that firm.  If they don't, let them do the work to find out. 

 List the mailing address and phone number of the company where your account is currently held, and also list your account number there.  Attach a copy of the statement for the account that you want to move.  If you don't know the phone number, don't worry — it isn't critical. 

Authorization to transfer your account

It's a pain, but some firms that you're transferring out of may require that you burn a chunk of your day to go get your signature guaranteed at your local bank (a notary doesn't do this).  Fortunately, most companies don't require this effort — but the only way to know for certain is to call and ask. 

Investing on Autopilot

You may have noticed if you were reading earlier in this chapter that I mention that some mutual fund applications include sections that allow you to establish an automatic investment program.  This program allows the fund to electronically transfer money from your bank account at predetermined times.  You'll probably need to complete a separate form to establish this service if your fund company doesn't have this option listed on its original application, you didn't fill out that part when you opened the account, or you're investing through a discount brokerage firm. ( See the explanation in "Filling in the blanks: Application basics" earlier in this chapter.) 

If you have a pile of money sitting in a money market fund and you want to ease it (dollar-cost averaging) into mutual funds, you can use the services most fund companies and discount brokers offer for this purpose.  They may have separate forms to fill out or, even better, some companies allow you to establish this service by phone after your money fund account is open. ( See Chapter 10 for a discussion of the pros and cons of dollar-cost averaging.) 

 If you're investing outside a retirement account into fund(s) at different points in time, here's a hint: For tax recordkeeping purposes, save your statements that detail all the purchases in your accounts. ( Most mutual fund companies also provide year-end summary statements that show all the transactions you made throughout the year.) 

If you don't save your statements, it won't be the end of the world — as long as you're investing through most of the larger and better fund companies, which are able to tell you your average cost per share when you need to sell.  Average cost isn't the only or even necessarily the most advantageous method for you to use in determining your cost basis (see Chapter 18). 

Finding Help for a Overwhelmed Brain

If you get stuck or can't deal with filling out forms — not even with the comfort and solace you get from this book — you have two safety nets:

  Call the fund company or discount broker and ask for help. ( The number is usually listed at the top of the first page of the application.)  Providing assistance is one of the many tasks those phone reps are paid to do.  If you get someone who's impatient or incompetent, simply call back, and you'll get someone else. ( Should this happen with the companies recommended in this book, please let me know!) 

 If you're dealing with a problem that can't be solved during the first phone call and you're working with a representative on it, jot down the person's name and extension number.  And don't forget to ask which office location he's in.  Some of the larger fund companies route their toll-free calls to various offices, so you may not know where your call has ended up unless you ask. 

  Visit a branch office.  Accessibility is one of the reasons that branch offices exist.  Some companies have them; others don't (see Chapter 9). 
Part V

Keeping Current and Informed

In this part . . . 

In this part, I explain how to evaluate the performance of your funds, how to decide when to sell, how to understand tax forms that your mutual fund companies send you, and how to fix the rare but downright aggravating technical glitches and problems that you may encounter.  And, to help you keep current with the latest mutual funds news, I cover fund ratings systems and forecasters and how to use your computer to research and manage your mutual fund portfolio. 
Chapter 17

Evaluating Your Funds and Adjusting Your Portfolio

In This Chapter

  Understanding the finer points of fund statements

  Translating discount brokerage firm statements

  Figuring your funds' performance

  Deciding whether to sell, hold, or buy more of a fund

  Fine-tuning your portfolio as you get older

After you've explored different funds, filled out the application forms, and mailed your money, the hard part is over.  Congratulations!  You've accomplished what millions of people are still thinking about but haven't gotten off their blessed behinds to do (probably because they haven't read this book yet). 

Now that you've started investing in funds (or even if you've been doing so for years), of course, you want to know how your funds are doing — specifically, you want to know how much return your funds are generating.  You may also be interested in evaluating funds you already owned before you and I met, wondering if your prior holdings are greyhounds or basset hounds. 

In this chapter, I explain how to evaluate the performance of your funds and decide what to do with them over time.  I also explain why most of the statements you get from fund companies make your head spin and leave you clueless as to how you're doing. 

Deciphering Your Fund Statement

Every mutual fund company has its own statement design.  But they all report the same types of information, usually in columns.  The following sections present the type of entries you find on typical fund company statements, along with my short explanations of what they all mean. 

Trade date or date of transaction

The trade date (or date of transaction) is the date that the mutual fund company processed your transaction.  For example, if you mailed a check as an initial deposit with your account application, you can see which date the company actually received and processed your check.  If the fund company receives your deposit by 4 p.m. EST, it will generally purchase shares that same day in the bond and/or stock funds that you intended the check for. 

  Money market funds work a little differently than bond and stock funds.  Money market fund deposits don't start earning interest until the day after the company receives your money.  The delay is due to the fact that the fund company must convert your money into federal funds. 

Transaction description

In the transaction description column, you find a brief blurb about what was actually done or transacted.  In this column, you're likely to see a few things:

  Annual maintenance fee charge: You may see this entry, although not necessarily. ( Try to pay these fees outside the account so that more of your money continues compounding inside the retirement account.) 

  Asset transfer: This term refers to a transfer of money into your retirement account from another investment company or bank. 

  Capital gains reinvest: Funds may pay capital gains, and you can choose to reinvest those into purchasing more shares in the fund.  In order to satisfy the IRS, capital gains are specified, for example, as short-term capital gains or long-term capital gains, for which different tax rates apply. ( See Chapter 18 for the reasons the IRS cares, and the consequences for your tax return.  And check out the "Capital gains distributions" section later in this chapter for more on the subject.) 

  Check-writing redemption: On the statement for a money market fund, you may see such entries to show the deduction of a check that has cleared your account (should you use the option of writing checks that draw from the fund — like a checking account). 

  Contribution: Often, new purchases for retirement accounts are referred to as a contribution (such as 2010 IRA contribution). 

  Dividend reinvestment: This term simply means that the fund paid a dividend that you reinvested by purchasing more shares of that same fund in your account. ( See details in the section "Dividends" later in the chapter if you're not sure what a dividend is.) 

  Income dividend cash: If you so desire, you may receive your dividends as cash — the fund company can send a check to you, or it can electronically deposit the money into your bank checking account. 

  Phone exchange from so-and-so fund: For example, if you moved money into a fund from your U.S. Treasury money market fund by phone, this item may read phone exchange from U.S.T. money fund. 

  Purchase or purchase by check: If you mailed a deposit, you may see this notation. 

Dollar amount

The dollar amount column simply shows the actual dollar value of the transaction.  If you sent a $5,000 deposit, look to make sure that the correct amount was credited to your account.  Fund companies calculate and credit the appropriate amount of dividends and capital gains to your account.  There's really no need to check these distributions.  At any rate, I'm not aware of a fund company making a mistake with these, other than possibly a delay (a few days beyond the promised deadline) in crediting shareholder accounts. 

Share price or price per share

The share price (or price per share) column shows the price per share that the transaction was conducted at.  When you're dealing with a no-load (commission-free) fund, such as those that I recommend in this book, you get the same price that everyone else who bought or sold shares that day received.  Money market funds maintain a level price of $1 per share. 

  If you're concerned that a load was charged, check with the company to see the buy (bid) price and sell (asked) price on the day you did a purchase transaction.  If a load wasn't charged, these two prices should be identical.  If a load was charged, the buy price is higher than the sell price, and the purchase on your statement was done at the buy price. 

Share amount or shares transacted

The share amount (or shares transacted) column simply shows the number of shares purchased or sold in the particular transaction.  The number of shares is arrived at by default: The fund company takes the dollar amount of the transaction and divides it by the price per share on the date of the transaction. 

For example, a $5,000 investment in a bond fund at $20 per share gets you 250 shares.  You detail-oriented types will be happy to know that fund companies usually go out to three decimal places in figuring shares. 

Shares owned or share balance

If money was added to or subtracted from your account, the share balance changes by the amount of shares purchased or redeemed and listed in the prior section, "Share amount or shares transacted." 

  In one unusual instance, the number of shares in an account changes even though no transactions have occurred: when a fund splits.  If it splits 2 for 1, for example, you receive two shares for every one that you own.  This split doesn't increase the worth of the investments you own; the price per share in a 2-for-1 split is cut by 50 percent. 

Why do funds split?  It's a gimmick.  In the world of individual securities, stock splits are often associated with successful, growing companies; likewise, mutual fund splits are usually trying to cash in on positive connotations.  The fund company wants potential buyers to think that the fund has done so well that the company has split its shares in order to reduce the price; that way, new investors won't think that they're paying a high price.  But the high price doesn't matter because fund minimum investment requirements, not the share price, determine whether you can afford to invest in a fund. ( Reverse splits can be done as well to boost a laggard fund's price per share.) 

  Some exchange-traded funds (ETFs) have split, which may make some sense.  The reason is that ETFs trade on a stock exchange, so if an ETF's share price has risen too high, it may actually keep buyers with small amounts to invest from being able to buy some shares. ( See Chapter 5 for details on ETFs.) 

Account value

Typically, on a different part of the account statement separate from the line-by-line listing of your transactions, fund companies show the total account value or market value of your fund shares as of a particular day — usually at the end of a given month.  This value results from multiplying the price per share by the total number of shares that you own. 

  Four out of five fund investors care about total account value more than the other totals (at least, according to my scientific surveys of fund investors that I work with!).  So you'd think that the fund companies would list on your statement how this value has changed over time.  Well, many don't, and that's one of the reasons why examining your account statement is a lousy way to track your fund's performance over time. 

Some fund companies show how your current account value compares to the value when your last statement was issued.  This comparison sheds some useful light on your account's performance, but it still doesn't tell you how you've done over longer time periods (since you originally invested, for example).  See the later section, "Assessing Your Funds' Returns," for how to determine your funds' performance. 

Interpreting Discount Brokerage Firm Statements

Discount brokerage statements may look a bit different from those that mutual fund companies produce.  In a discount brokerage statement, the portfolio overview (summary of the value of each fund holding) and the transaction details are usually listed in separate sections.  This section breaks down a typical brokerage firm statement. 

Portfolio overview

A portfolio overview section on a brokerage account statement lists funds from your various fund companies.  As on a mutual fund statement, the number of shares (quantity), price per share (latest price), and market value of the funds held as of the statement date are listed. 

  Brokerage statements may use terms like long, which simply means that you bought shares and you're holding those shares. ( You may — although I don't recommend it — actually short shares held in nonretirement brokerage accounts.  Shorting shares simply means that you sell the shares first, hope that they decline in value, and then buy them back.)  You may also see the term cash or the letter C associated with your fund holdings.  These items mean that this fund is a cash holding (as opposed to one purchased with borrowed money). 

Account transaction details

An account transaction details section, which summarizes any transactions occurring on your fund holdings since the last statement, often confuses people because transactions seem to be repeated.  The apparent repetition occurs because of the silly accounting system of debits and credits that brokerage firms use. 

For example, you might see a line item for one of your funds that shows that 5.953 shares of the fund were purchased at $9.80 per share for a total purchase of $58.34.  Where did this odd amount of money come from for the purchase?  The next line on the statement tells you the fund paid a dividend of $58.34.  It'd be logical and more understandable if these two lines were reversed, wouldn't it?  First the money comes in, and then it's reinvested into purchasing more shares! 

Assessing Your Funds' Returns

Probably the single most important issue that fund investors care about — how much or little they're making on their investments — isn't easy to figure from those blasted statements that fund companies send you.  That is, it isn't easy to figure unless you know the tricks regarding what to look for and what to ignore. 

  If you've just started investing in funds — or even if you've held funds a long time — you need to realize that what happens to the value of your stock and bond funds in the short term is largely a matter of luck.  Don't get depressed if your fund or funds drop in value the day after you buy them or even over the first three or six months.  When you invest in bond and stock funds, you should focus on returns produced over longer periods — periods of at least one year and preferably longer. 

Getting a panoramic view: Total return

The total return of a fund is the percentage change in the overall value of your investment over a specified period.  For example, a fund may tell you that its total return during the year that just ended December 31 was 15 percent.  Therefore, if you invested $10,000 in the fund on the last day of December of the prior year, your investment is worth $11,500 after the year just ended. 

This section explains the three components that make up the total return on a fund: dividends, capital gains distributions, and share price changes.  These are the three ways you can make money in a mutual fund. 

Dividends

Dividends are income paid by investments.  Both bonds and stocks can pay dividends.  As I explain in Chapter 12, bond fund dividends (which come from the interest paid by bonds) tend to be higher than stock fund dividends.  When a dividend distribution is made, you can receive it as cash (which is good if you need money to live on) or reinvest it into more shares in the fund.  In either case, the share price of the fund drops by an amount that exactly offsets the payout.  So if you're hoping to strike it rich by buying into funds just before their dividends are paid, don't bother.  All you may accomplish is increasing your income tax bill! 

  If you hold your mutual fund outside a retirement account, the dividend distributions are taxable income (unless they come from a tax-free municipal bond fund).  When you're ready to buy into a fund outside a retirement account that pays a decent dividend, you may want to check to see when the fund is next scheduled to pay it out.  For funds that pay quarterly taxable dividends (such as balanced or hybrid funds), you may want to avoid buying in the weeks just prior to a distribution (which is usually late in each calendar quarter). 

Capital gains distributions

When a stock or bond mutual fund manager sells a security in the fund, any gain realized from that sale (the difference between the sale price and the purchase price) must be distributed to fund shareholders as a capital gain. ( Gains offset by losses — so called net gains — are what actually get distributed.)  Typically, funds make one annual capital gains distribution in December.  Some funds make two per year, typically making the other one mid-year. 

As with a dividend distribution, you can receive your capital gains distribution as cash or use it to buy more shares in the fund.  In either case, the share price of the fund drops by an amount to exactly offset the distribution. 

For funds held outside retirement accounts, all capital gains distributions are taxable.  As with dividends, capital gains are taxable whether or not you reinvest them into additional shares in the fund. 

  Before you invest in bond and stock funds outside retirement accounts, determine when capital gains are distributed if you want to avoid investing in a fund that's about to make a capital gains distribution. ( Stock funds that appreciated greatly during the year and that do significant trading are most likely to make larger capital gains distributions.  Money funds don't ever make these distributions.)  Investing in a fund that will make a distribution soon increases your current-year tax liability for investments made outside retirement accounts.  About a month before the distribution, fund companies should be able to estimate the size of the distribution. 

Share price changes

You also make money with a mutual fund when the share price increases.  This occurrence is just like investing in a stock or piece of real estate.  If your fund is worth more today than when you bought it, you have made a profit (on paper, at least).  To realize — or lock in — this profit, you need to sell your shares in the fund.  A fund's share price increases if the securities that the fund has invested in have appreciated in value. 

Tallying the total return

After you've seen all the different components of total return, you're ready to add them all up.  For each of the major types of funds that I discuss in this book, Table 17-1 presents a simple summary of where you can expect most of your returns to come from over the long term.  The funds are ordered in the table from those with the lowest expected total returns and share price volatility to those with the highest. 

Table 17-1 Components of a Fund's Returns

---

Funds | Dividends  | + | Capital Gains  | + | Share Price Changes  | = | Total Return

Money market funds | All returns come from dividends

|  |

None

|  |

None

|  |

Lowest expected returns but principal risk is nil

Shorter term bond funds | Moderate

|  |

Low

|  |

Low

|  |

Expect better than money funds but more volatility

Longer term bond funds | High

|  |

Low to moderate

|  |

Low to moderate

|  |

Expect better than short-term bonds but with greater volatility

Stock funds  | None to moderate depending on stock types

|  |

Low to high depending on trading patterns of fund manager

|  |

Low to high

|  |

Highest expected returns but most volatile

Focusing on the misleading share price

You probably know someone who's always glued to his computer screen or favorite wireless mobile device to check on the share prices of individual stocks and how much they've gone up or down. 

Unfortunately, mutual fund share prices are also reported on various financial Web sites and through other media outlets.  I say "unfortunately" because all too many fund investors, perhaps taking a cue from individual-stock owners, look to daily or other short-term-oriented sources of fund pricing information. 

If you follow the price changes in your fund(s) every day, week, month, or other time period, you won't know how your fund is doing.  Referring to Table 17-1, you can see that share price is but one of the three components that make up your total return.  And to make matters worse for the share-price hawks, another one of the three components — dividends — directly affects share price.  When a fund makes a distribution to you, you get more shares of the fund.  But distributions create an accounting problem because they reduce the share price of a fund by the exact amount of the distribution.  Therefore, over time, following just the share price of your fund doesn't tell you how much money you've made or lost. 

  The only way to figure out exactly how much you've made or lost on your investment is to compare the total value of your fund holdings today to the total dollar amount you originally invested.  If you've invested chunks of money at various points in time, this exercise becomes much more complicated. ( Some of the investment software I recommend in Chapter 21 can help if you want your computer to crunch the numbers.  Frankly, though, you have easier, less time-consuming ways to get a sense of how you're doing.) 

How often should I check on my funds? 

I recommend that you don't track the share prices of your funds every day.  It's time consuming and nerve-racking and can make you lose sight of the long term.  Worse, you'll be more likely to panic when times get tough.  A weekly, monthly, or even quarterly check-in is more than frequent enough to follow your funds.  I know many successful investors who check on their funds' performance twice or even just once a year. 

If you do check your funds more often, one day, usually soon after you talk with a friend and mention how pleased you are with your fund's returns, you'll receive a rude awakening. " It dropped $1.21 per share!"  That's what one of my clients said to me after noticing the price of one of her international stock funds in December.  Guess what?  The fund made a distribution that reduced the price per share but increased the number of shares.  So she wasn't losing money after all. 

If you follow your funds through the daily newspaper and you see such a large price drop, look again to see if any special letters are printed after the fund's name, such as x, which indicates that a fund paid its dividend, and e for payment of a capital gains distribution. 

Figuring total return

As I mention in the "Account value" section earlier in the chapter, fund companies make determining your total return in the fund from the information they provide on their statements almost impossible for you. 

  Regardless of the time period over which you're trying to determine your funds' total return, here are the simplest ways to figure total return without getting a headache:

  Call the fund company's toll-free number or visit its Web site.  The telephone representatives can provide you with the total return for your funds for various lengths of time (such as for the last three months, the last six months, the last year, the last three years, and so on).  Most fund companies post similar information on their Web sites as well. 

  Examine the fund's annual and semiannual reports.  These reports provide total return numbers. 

  Keep a file folder with your investment statements.  That way, you can look up the amount you originally invested in a fund and compare it to updated market values on new statements you receive.  You can make a handwritten table or enter the figures in the software I describe in Chapter 21. 

  Check fund information services and periodicals.  Fund information services and financial magazines and newspapers carry total return data at particular times during the year.  Some, such as The Wall Street Journal, carry this information daily.  See my favorite Web sites in Chapter 21. 

If you've made numerous purchases in a fund, you may want to know your effective rate of return when you also factor in the timing and size of each purchase.  The only way to make this calculation is with software.  However, you don't need to know the exact rate of return for your overall purchases in order to successfully evaluate your fund investments.  Comparing your funds' performance over various time periods to relevant performance benchmarks is sufficient. ( I explain how to do just that in the next section.) 

  Examining online charts of mutual fund prices over time on financial Web sites provides an inaccurate picture of a fund's total return.  The reason is that most online charting services fail to correct for the effect of fund distributions (for example, capital gains and dividends).  Take a simple example of a fund that begins the year at $20 per share and in late December is at $22 per share.  Thus, it has increased 10 percent.  However, further suppose it makes a distribution of $2 per share and thus ends the year at $20 per share.  With an online chart, it would appear that the fund dropped sharply at year-end and provided no return for the year when in fact shareholders were rewarded with a 10 percent return. ( Charts on fund company sites that show the change in value of an investment in a particular fund correct for this problem and do accurately show the returns of a fund over time.) 

Which total return figures are best for the long term? 

Fund companies typically report fund total returns in one of two ways.  The absolute return measures the total percentage increase from the beginning to the end of the time period being looked at.  The annualized return measures the average increase per year during the specified time period.  Over a five-year period, for example, the absolute return of the Blue Chip Stock fund may be 98 percent, which translates to an annualized return of about 14.6 percent. 

Don't be fooled by a more impressive-sounding absolute return.  Remember, both numbers are measuring the same real return.  Beware of fund companies that exploit the eye-catching qualities of absolute return numbers to make themselves look good in their marketing literature: 200 percent, 300 percent!  Sounds spectacular, but it doesn't mean anything unless the time period and the performance of comparable funds and benchmarks are taken into account.  If the time period is long enough, just about any fund's absolute return figure, especially if it's for a stock fund, is impressive looking, even if it's actually below average. 

Annualized return numbers are much more useful for comparative purposes.  Because a time factor — per year — is built in to the number, a glance at the annualized return gives you a much better idea of how a fund has performed and a much easier time comparing that performance to similar funds for similar time periods. 

Assessing your funds' performance

Whenever you examine your funds' returns, compare those returns to appropriate benchmark indexes.  Although many stock market investors may have been happy to earn about 10 percent a year with their investments during the 1980s and 1990s, they really shouldn't have been because the market averages or benchmark indexes were generating about 15 percent per year. 

  You should compare each mutual fund to the most appropriate benchmark given the types of securities that a fund invests in.  For the bond and stock funds that I recommend in Chapters 12, 13, and 14, I provide descriptions of the types of securities that each fund invests in.  The following sections offer a brief rundown of the benchmark indexes you'll find useful. ( I present benchmarks for the types of funds most people use for longer term purposes, such as retirement account investing.) 

Don't get too focused on performance comparisons.  Indexes don't incur expenses that an actual mutual fund does although, as you may know, expenses among funds vary tremendously.  Remember all the other criteria — such as the fees and expenses and the fund company's and manager's expertise — that you should evaluate when you consider a fund's chances for generating healthy returns in the years ahead (see Chapter 7). 

Bond benchmarks

A number of bond indexes exist (see Table 17-2) that differ from one another mainly in the maturity of the bonds that they invest in; for example, short-term, intermediate-term, and long-term indexes. 

Table 17-2 Bond Indexes

---

Year | Barclays Short-Term Bond Index | Barclays Intermediate-Term Bond Index | Barclays Long-Term Bond Index | Barclays U.S. GNMA Index | Barclays High Yield (Junk Bond) Index

2000 | 8.9% | 12.4% | 16.2% | 11.1% | –5.9%

2001 | 9.0% | 8.8% | 7.3% | 8.2% | 5.3%

2002 | 8.1% | 13.0% | 14.8% | 8.7% | –1.4%

2003 | 3.4% | 6.0% | 5.9% | 2.9% | 29.0%

2004 | 1.9% | 5.3% | 8.6% | 4.4% | 11.1%

2005 | 1.4% | 1.8% | 5.3% | 3.2% | 2.7%

2006 | 4.2% | 3.8% | 2.7% | 4.6% | 11.9%

2007 | 6.1% | 5.0% | 3.6% | 7.0% | 1.9%

2008 | –1.1% | –4.7% | –3.9% | 7.9% | –26.2%

2009 | 13.5% | 19.0% | 16.8% | 5.4% | 58.2%

5-year annualized average | 4.8% | 4.7% | 4.5% | 6.0% | 7.8%

10-year annualized average | 5.9% | 7.0% | 7.5% | 6.3% | 7.4%

Many more specialized indexes exist than those listed in Table 17-2; for example, indexes for municipal bonds, treasury bonds, and so on.  So if you're looking at these different types of funds, take a look in the fund's annual report to see which index it compares the fund's performance to.  But don't assume that it's using the most comparable index. 

U.S. stock benchmarks

The major U.S. stock indexes (see Table 17-3) are distinguished by the size of the companies (large, small, all sizes, and so on) whose stock they're tracking.  The Standard & Poor's 500 index tracks the stock prices of 500 large-company stocks on the U.S. stock exchanges.  These 500 stocks account for more than 70 percent of the total market value of all stocks traded in the United States.  The MSCI 1750 index tracks 1,750 smaller company U.S. stocks.  The MSCI Broad Market index tracks all stocks of all sizes on the major U.S. stock exchanges. 

Table 17-3 U.S. Stock Indexes

---

Year | Standard & Poor's 500 Index | MSCI U.S. Small Cap 1750 Index | MSCI Broad Market Index

2000 | –9.1%

|  |

2001 | –11.9%

|  |

2002 | –22.1%

|  |

2003 | 28.7%

|  |

2004 | 10.9%

|  |

2005 | 4.9% | 7.5% | 6.4%

2006 | 15.8% | 15.8% | 15.7%

2007 | 5.5% | 1.2% | 5.6%

2008 | –37.0% | –36.2% | –37.0%

2009 | 26.5% | 36.1% | 28.8%

5-year annualized average | 0.4% | 1.8% | 1.0%

10-year annualized average | -0.9% | n/a | n/a

  If you're evaluating the performance of a fund that invests solely in U.S. stocks, make sure to choose the index that comes closest to representing the types of stocks that the fund invests in.  Also, remember to examine a stock fund's international holdings.  Suppose, for example, that a particular stock fund typically invests 80 percent in U.S. stocks of all sizes and 20 percent in the larger, established countries overseas.  You can create your own benchmark index by multiplying the returns of the MSCI Broad Market index by 80 percent and the Morgan Stanley EAFE international index (which I discuss in the next section) by 20 percent, and then adding them together. 

International stock benchmarks

When you invest in funds that invest overseas, you should use a comparative index that tracks the performance of international stock markets.  The Morgan Stanley EAFE (which stands for Europe, Australia, and Far East) index tracks the performance of the more established countries' stock markets.  Morgan Stanley also has an index that tracks the performance of the emerging markets in Southeast Asia and Latin America (see Table 17-4). 

Table 17-4 International Stock Indexes

---

Year | Morgan Stanley EAFE | Emerging Markets

2000 | –14.2% | –31.8%

2001 | –21.4% | –4.9%

2002 | –15.9% | –8.0%

2003 | 38.6% | 51.6%

2004 | 20.3% | 26.7%

2005 | 13.5% | 32.8%

2006 | 26.3% | 29.7%

2007 | 11.2% | 39.4%

2008 | –43.4% | –53.3%

2009 | 31.8% | 78.5%

5-year average | 4.0% | 15.9%

10-year average | 1.6% | 10.1%

You should know that emerging markets are volatile and risky.  As I discuss in Chapter 13, diversified international funds that invest in both established and emerging markets offer a smoother ride for investors who want some exposure to emerging markets.  More-diversified funds also aren't as constraining on a fund manager who believes, for example, that emerging markets are overpriced. 

If you do invest in the more diversified international funds that place some of their assets in emerging markets, remember that it's not fair to compare the performance of those funds solely to the EAFE index.  So how do you fairly compare the performance of this type of fund?  Well, if an international fund typically invests about 20 percent in emerging markets, then multiply the EAFE return in the table by 80 percent and add to that 20 percent of the Emerging Markets index return.  For 2009, for example: 0.318(0.8) + 0.785(0.2) = 0.411, or 41.1 percent.  With this computation formula, you can see how any international fund that invested in emerging markets in 2009 couldn't help but look good in comparison to the EAFE index. ( The numbers in Table 17-4 also suggest why you shouldn't be too impressed with an emerging markets fund that boasted of a 60 percent return in 2009 — if it did, it was well below average!) 

  The hard part is finding out the percentage of assets a fund typically has invested in emerging markets.  Some international funds don't report the total of their investments in emerging markets.  For the international funds I recommend in Chapter 13, I provide some general idea of the portion they've invested in emerging markets.  Also, you can peek at a fund's recent annual or semiannual report, in which the fund managers detail investments held for each country. 

Deciding Whether to Sell, Hold, or Buy More

  Investors often ask me, "How do I know when I should sell a fund?"  The answer is relatively simple: Sell only if a fund is no longer meeting the common-sense criteria (which I outline in Chapter 7) for picking a good fund in the first place.  Stick by your fund like a loyal friend as long as it is

  Generating decent returns relative to appropriate benchmarks and the competition

(Even one or two years of slight underperformance are okay if the fund's five- and ten-year numbers are still comparatively good.) 

  Not raising the fees that it charges and not charging more than the best of the competition

  Still managed by a competent fund manager

The only other reason to sell a fund is if your circumstances change.  For example, suppose that you're 50 years old, and you inherit a big pot of money.  You hadn't been planning to retire early, but with oodles of money suddenly at your disposal, maybe now you're thinking that early retirement isn't such a bad idea after all.  This change in circumstances may cause you to tweak your portfolio so that you have more income-producing investments and fewer growth investments. 

This section deals with two special situations that require further thought and reflection: down markets and the acquisition of your funds by another company. 

Handling bear markets

  No one enjoys losing money.  Most people find it unpleasant and at times stressful.  If you follow my advice in the rest of this book, you know that I advocate building a diversified portfolio of funds and investing for the long term, not tomorrow.  Eventually, you'll suffer a down period.  Anyone who was investing in the early 2000s and late 2000s understands firsthand that stocks and stock mutual funds can drop significantly.  So for handling such bear (down) markets in your funds, here is my advice:

  Don't watch your funds too closely.  Tracking your fund's prices daily or even weekly is sure to make you a nervous wreck if you're doing so because you fear a market slide.  Don't dwell on daily news reports of the latest stock market gyrations.  Remember that you're investing for future years, not next week and next month. 

  See the glass as half full, not half empty.  When certain types of funds that you own decline in value, don't get depressed.  If you're still feeding new money into purchases (or perhaps reinvesting distributions), remind yourself that your next purchases will be at lower prices.  If you're retired and not making more purchases, you surely have the wisdom that good days and periods follow difficult ones.  Be patient for improvement. 

  Look at your portfolio's performance, not individual funds.  The whole point of diversifying is so that some of your funds may go up while others are down.  So, when some of your funds do decline, remember to assess the performance of your entire portfolio, and you may be pleasantly surprised that things aren't as bad as you may have thought. 

  Buy value (and different assets) if you dislike volatility.  Stock funds that focus on value-oriented stocks (please see Chapter 13) tend to be less volatile.  You can also dampen the gyrations in your portfolio by investing in different types of assets (bonds, real estate, and so on). 

Dealing with fund company consolidations

The fund industry is increasingly competitive, and some fund companies (usually those of the larger variety) swallow other (usually smaller) fund companies.  Such mergers can lead to problems, but you can steer clear of them:

  Financial firms, including fund companies, have been known to put deposits into the wrong account or to lose track of certain accounts altogether.  During the transition period, be vigilant about ensuring that your account information, including recent transactions and current balances, is correct. 

  The new parent company in a merger may jack up fees or make other unfavorable changes to your fund.  Use the straightforward criteria that I outline earlier in this section to determine what you should do post-merger. 

Tweaking and Rebalancing Your Portfolio

  Over longer periods of time, you may need to occasionally adjust your portfolio to keep your investment mix in line with your desires.  Unless you experience a major change in your circumstances, I advocate adjusting your investment mix every three to five years (see Chapter 10).  Suppose that at the age of 40, you invest about 80 percent of your retirement money in stock funds with the balance in bonds.  By the age of 45, you find that the stock funds now comprise an even larger percentage (maybe 85 percent) of your investments because they've appreciated more than the bond funds have.  You are also appreciating (in age, that is) and should in fact be reducing your stock allocation as you get older. 

Using the asset allocation guidelines in Chapter 10, you decide that at the age of 45, you now want to have about 75 percent of your money in stock funds.  The solution is simple: Sell enough of your stock funds to reduce your stock holdings to 75 percent of the total and invest the proceeds in the bond funds.  Don't forget to factor in the tax consequences when you contemplate the sale of funds held outside retirement accounts (see Chapter 18). 

  Trying to time and trade the markets to buy at lows and sell at highs rarely works in the short term and never works in the long term.  If you do a decent job upfront of picking good fund companies and funds to invest in, you should have fewer changes to make over the long haul. 

If you have a good set of funds, keep feeding money into them as your savings allows.  As your portfolio value grows, add a new fund or two to broaden your overall mix.  Holding a couple (or several) of each different type of fund makes a lot of sense. ( I cover the common sense of fund diversification in much depth in Chapter 10.)  Don't end up with 50 funds though — you won't keep up with what they're doing and reviewing their reports. 
Chapter 18

The Taxing Side of Mutual Funds

In This Chapter

  Checking out Form 1099-DIV and distributions from mutual funds

  Understanding the issues of selling funds

  Browsing Form 1099-R and retirement fund withdrawals

You invest in mutual funds to make money.  But guess who starts licking his chops when he hears about money being made?  That's right: good ol' Uncle Sam.  And state governments, too. ( In Chapter 17, I explain the different ways that mutual funds can make you money: either through distributions (capital gains and dividends) or through appreciation.  If the fund that made the money is being held outside a tax-sheltered retirement account, federal and state governments will demand a portion of your fund's distributions and of your profits when you sell shares in a fund for more than you paid for them.) 

Once each year, the mutual fund companies or brokerage firms where you're holding funds send you one or more tax forms that tell you how much taxable money you made on your mutual funds held outside of retirement accounts. ( Remember, you don't need to file anything with funds held inside retirement accounts.)  Come April (or whenever you get around to completing your tax returns), you must transfer the information on these fund-provided tax forms to your income tax return, where you calculate how much tax you actually owe on the money you made from your mutual funds. 

If you cringed when you read the words tax forms, you've obviously battled these ugly beasts.  I sometimes wonder if the people who write tax forms come from another planet — that would perhaps explain their use of what appears to be a nonhuman form of communication.  But don't despair.  I devote this entire chapter to helping you interpret the hieroglyphics on these sometimes intimidating documents. 

Just for toughing out this chapter, you get a few rewards.  I show you how to use a fund's tax forms to help you discover whether your mutual fund money is being invested in the most tax-friendly way.  I also give you some tips on reducing your tax bill if you have to sell some mutual funds. 

Mutual Fund Distributions Form: 1099-DIV

If you're an employee of a company, you're probably familiar with IRS Form W-2, that little piece of paper that comes in late January or early February and sums up the amount of money your employer paid you over the previous year.  You're required to report this income on your income tax return. 

Form 1099-DIV is similar to a W-2, but instead of reporting income from an employer, it reports income from mutual funds that you hold outside of retirement accounts.  By income, I mean capital gains and dividend distributions, which I explain in Chapter 17. 

Like the W-2, Form 1099-DIV should arrive in your mailbox in late January or early February.  You should get one for every nonretirement account you held money in during the tax year.  Call the responsible company if you don't get one for an account that you think you should. ( And if you're tired of receiving these forms from so many fund companies, visit Chapter 9, where I explain the paperwork-friendly benefits of consolidating your mutual fund holdings into a discount brokerage account.) 

  Also like the W-2, a copy of each of your 1099-DIVs is sent to the IRS and your state authorities, so don't get any ideas about fudging the information on your tax return. 

Figure 18-1 is a sample Form 1099-DIV, which I use to walk you through the form.  First, notice that the distributions are divided into various boxes. ( Actually, most mutual fund companies display this information in columns, but they're still called boxes.)  This division is done because different parts of your distributions are taxed at different rates, and the IRS wants to know what is what. 

Jump in to these boxes and see what you find.  In the following sections, I discuss the boxes that pertain to mutual funds. 

**Figure 18-1:** Form 1099-DIV reports dividends and capital gains your funds paid. 

Box 1a: Total ordinary dividends

All types of mutual funds pay dividends, which account for all of a money market's return, most of a bond fund's return, and part of a stock fund's return.  Thanks to tax laws passed in 2003, dividends paid by stocks are taxed at the same reduced tax rate that applies to long-term capital gains, which I discuss in just a bit.  Stock dividends are termed qualified dividends and reported in Box 1b (discussed in the next section).  Thus, Box 1a only includes dividends from taxable money market and bonds that are held by mutual funds. 

Untrue to its name, however, ordinary dividends also include short-term capital gains distributions — profits from securities that the mutual fund bought and sold within a year.  These short-term capital gains are lumped together with your dividend income because they're both taxed at your ordinary income tax rate. 

  The distributions reported as ordinary dividends are taxed at your highest possible rate: up to 35 percent on your federal income tax return depending on your annual income.  If you're in a higher tax bracket, you don't want to see big ordinary dividends.  You'd be better off with investments that don't produce so much taxable income. ( Chapters 11 and 12 explain how to select tax-friendly money market and bond funds.)  For stock mutual funds, if you're seeing big ordinary dividends, your fund must be making a lot of short-term trades.  Outside of retirement accounts, regardless of your tax bracket, you have no reason to own mutual funds that generate a lot of short-term capital gains.  Chapter 13 gives recommendations for tax-friendly stock funds. 

Box 1b: Qualified dividends

Qualified dividends include dividends paid by corporations to their stockholders (stock dividends).  If you're in the 10 or 15 percent federal income tax bracket, qualified (stock) dividends are tax-free — a 0 percent tax rate!  For those in the higher federal tax brackets, the qualified dividend tax rate is 15 percent. 

Box 2a: Total capital gains distributions

Because short-term capital gains are reported in Box 1a, this box would be more appropriately called "Long-term capital gains distributions," which are profits from securities sold more than 12 months after their purchase.  Long-term capital gains are taxed at a lower rate than regular income, taxable money market and bond dividends, and short-term capital gains.  The federal tax rate on long-term gains is 15 percent for those in an ordinary tax bracket of 25 percent or higher and long-term capital gains are tax-free for those in the 10 or 15 percent ordinary tax brackets. 

  You can count the lower tax rate on long-term capital gains as one more benefit of the buy-and-hold investing strategy (see Chapter 10).  Not only does this strategy typically generate higher returns than short-term trading, but also for investments held outside of retirement accounts, it's gentler on your tax bill.  The tax relief and the potential for higher returns are why mutual funds that tend to buy and hold their securities are preferable for nonretirement accounts. 

Box 3: Nondividend distributions

You rarely see numbers in the nondividend distributions section of Form 1099-DIV.  This box is where funds report if they made distributions during the year that repaid a shareholder's original investment.  Like the principal returned to you if a bond or CD you've invested in matures, this chunk of money isn't taxable. 

  For shares held outside of retirement accounts, these nondividend distributions factor into your computation of the gain or loss when the shares are sold.  For purposes of calculating any gain, if and when you sell these shares, you must subtract nondividend distributions from the amount you originally paid for these shares. 

Box 4: Federal income tax withheld

  If your funds report that federal income tax was withheld, that can be bad news.  It means that you're being subjected to the dreaded backup withholding.  If you don't report all your mutual fund dividend income (or don't furnish the fund company with your Social Security number), your future mutual fund dividend income is subject to backup withholding of 28 percent!  To add insult to injury, in the not-too-distant future, you'll receive a nasty notice from the IRS listing the dividends you didn't report.  You end up owing interest and penalties. 

Find out right away what's going on here.  Either you or the IRS could've made a mistake.  Perhaps you didn't provide a correct Social Security number or you've been negligent in reporting your previously earned taxable income to the IRS.  Fix this problem as soon as you can.  Call the IRS at (800) 829-1040. 

Don't despair about the tax that your fund withheld.  The withholding wasn't for nothing — you'll receive credit for it when you complete your Form 1040 on the line "Federal income tax withheld." 

Box 6: Foreign tax paid

If you invest in an international mutual fund, the fund may end up paying foreign taxes on some of its dividends.  The foreign taxes paid by the fund are listed on Form 1099-DIV because the IRS allows you two ways to get some of this money back.  You can choose one of the following:

  Deduct the foreign tax you paid on Schedule A (the "Other taxes" line), as long as you have enough deductions to itemize on Schedule A.

  Claim a credit on Form 1040 ("Foreign tax credit" line). 

Because a credit is a dollar-for-dollar reduction in the tax that you owe, the latter move may save you more taxes — but it may also be more of a headache because you may need to complete another IRS form, Form 1116, which is a doozy.  However, if the total foreign taxes you pay are $300 or less ($600 or less for a married couple filing jointly), you can claim the credit directly on Form 1040 without having to fill out Form 1116. 

Get out last year's tax return

With all the fuss and muss over mutual fund distributions, you should note how the rest of your nonmutual-fund investments are positioned.  Although taxes aren't everything, you may be paying much more than you need to. 

Look at your Form 1040 to see how much taxable interest income you had to pay tax on.  On Forms 1040 and 1040A, this figure goes on line 8a.  If you filed 1040EZ (don't you just love that name?),  the figure goes on line 2. 

Now find out the rate of interest (percent yield) paid that generated this interest income.  If it came from money in a bank account, odds are quite good that you could be earning more in a money market mutual fund (see Chapter 11). 

When You Sell Your Mutual Fund Shares

Besides distributions, the other way to make money with a mutual fund is through appreciation.  If the price of your shares moves higher than the price at which you bought them, your investment has appreciated.  Your profit is the difference between the amount you paid for the investment and the amount the investment is currently worth.  For investments held outside of retirement accounts, that profit is taxable. 

However, you don't actually owe any tax on the appreciation until you sell the shares and lock up your profit.  Then you must report that profit on that year's tax return and pay capital gains tax on it.  Conversely, when you sell a fund investment at a loss, it's generally tax deductible.  You should understand the tax consequences of selling your fund shares and always factor taxes into your selling decisions. 

What's confusing to some people about this talk of capital gains and losses is that each year your fund(s) may have been paying you capital gains distributions (see the preceding section) which you also owed tax on.  So you may rightfully be thinking, "Hey!  I'm being taxed twice!" 

It's true that you're being taxed twice but not on the same profits.  You see, the profits the fund distributed, which resulted from the fund manager selling securities in his fund at a profit, are different from those profits that you realize by selling your shares. 

  You have no control over fund distributions.  They happen at regular intervals — at least once a year — whether you like it or not, and you must pay taxes on them when they occur from nonretirement account holdings.  Taxes on fund appreciation, on the other hand, can be indefinitely delayed if you choose.  As long as you hold the investment and don't sell it, the federal and state governments can't get their hands on the profit — one more advantage of buy-and-hold investing.  In fact, if you hold an appreciated asset outside of retirement accounts, that asset can be transferred at your death to your heirs, and the capital gain is eliminated for tax purposes.  Of course, the other way to avoid taxes on mutual fund profits is to hold them inside retirement accounts; then you don't owe taxes at all (until, of course, you start taking retirement withdrawals). 

Introducing the "basis" basics

Suppose that you sell a mutual fund.  In order to compute the taxable capital gain or the deductible capital loss, you have to compute your fund's tax basis.  Basis is the tax system's way of measuring the amount you originally paid for your investment(s) in a mutual fund.  I say investments (plural) because you may not have made all your purchases in a fund at once; you may have reinvested your dividends or capital gains into buying more shares or simply bought shares at different times by sending the fund company additional money.  For example, if you purchase 100 shares of the It's Gotta Rise mutual fund at $20 per share, your cost basis is $2,000, or $20 per share.  Simple enough. 

But now suppose that this fund pays a dividend of $1 per share (so that you get $100 in dividends for your 100 shares) and suppose further that you choose to reinvest this dividend into purchasing more shares of the mutual fund.  The price of shares has gone up to $25 per share since your original purchase, so the reinvested $100 buys you four new shares.  You now own 104 shares, which, at $25 per share, are worth $2,600. 

But what's your basis now?  Your basis is your original investment ($2,000) plus subsequent investments ($100) for a total of $2,100.  Thus, if you sold all your shares at $25 per share, you'd have a taxable profit of $500 (current value of $2,600 less $2,100 — the total amount invested or basis). 

  For recordkeeping purposes, save your statements detailing the purchases in your accounts.  Most mutual fund companies provide year-end summary statements that show all transactions throughout the year.  Thanks to their computer systems, fund companies also should be able to tell you your average cost per share when you need to sell your shares.  As I discuss in the following sections, using the average cost method isn't necessarily the optimal method to minimize your taxes. 

Accounting for your basis

If you understand the concept of basis for your fund investments (see the preceding section), you can put that understanding to work.  Here I introduce you to the different ways that taxpayers commonly use (and that the IRS approves) to calculate a basis when selling nonretirement account mutual fund investments. 

If you sell all your shares of a particular mutual fund that you hold outside a retirement account at once, you can ignore this issue. ( After reading through the accounting options that the IRS offers, you'll probably feel that you have more incentive to sell all your shares in a fund at once!) 

  Be aware that after you elect one of the following tax accounting methods for selling shares in a particular fund, you can't change to another method for the sale of the remaining shares.  Regardless of the method you choose, your mutual fund capital gains and capital losses are recorded on Schedule D of IRS Form 1040. 

  Regardless of which tax cost accounting method you choose for your fund sales, be careful not to overpay your capital gains tax when completing your annual tax return.  Remember that the maximum tax rate for long-term capital gains (investments held more than 12 months) is 15 percent (tax-free if you're in the 10 or 15 percent federal tax bracket).  Be sure to complete all the relevant portions of IRS Form 1040 Schedule D.

Specific identification method

The first fund basis option that the IRS allows you to use when you sell a portion of the shares of a fund is the specific identification method.  Here's how it works.  Suppose that you own 200 shares of Global Interactive Couch Potato fund (you laugh — but there really was a fund with a name similar to this!),  and you want to sell 100 shares.  Suppose further that you bought 100 of these shares ten years ago at $10 per share and then another 100 shares two years ago for $40 per share. ( To keep this example simple, I'm assuming that you didn't make any other purchases from reinvestment of capital gains or dividends.)  Today, the fund is worth $50 per share. ( Being a couch potato has its rewards!) 

Which 100 shares should you sell?  The IRS gives you a choice.  You can identify the specific shares that you sell.  With your Global Interactive Couch Potato shares, you may opt to sell the last or most recent 100 shares you bought — or some combination of shares from each purchase that totals 100. ( Selling the most recent shares will minimize your tax bill because you purchased these shares at a higher price.)  If you sell this way, you must identify the specific shares you want the fund company (or broker holding the shares) to sell.  To identify the 100 shares to be sold, use either or both of the following ways:

  Original date of purchase

  Cost when you bought the shares

  You may wonder how the IRS knows whether you specified shares before you sold them.  Get this: The IRS doesn't know.  But if you're audited, the IRS will ask for proof that you identified the shares to be sold before you sold them.  It's best to put your sales request to the fund company in writing and keep a copy for your tax files. 

  Although you can save taxes today if you specify selling the shares that you bought later at a higher price, don't forget (the IRS won't let you) that when you finally sell the other shares, you owe taxes on the larger profit.  The longer you expect to hold these other shares, the greater your chances of earning more money when you sell (and thus owing more in taxes).  Of course, you always run the risk that Congress raises tax rates in the future or that your particular tax rate rises. 

The "first-in-first-out" method

Another method of accounting for which shares are sold is the method the IRS forces you to use if you don't specify before the sale which shares you want to sell: the first-in-first-out (FIFO) method.  FIFO means that the first shares you sell are simply the first shares that you bought.  Not surprisingly, because most stock funds appreciate over time, the FIFO method leads to paying more taxes sooner.  In the case of the Global Interactive Couch Potato fund, FIFO considers that the 100 shares sold are the 100 that you bought ten years ago at the bargain-basement price of $10 per share. 

The average cost method

Had enough of fund accounting?  Well, unfortunately, we're not done yet.  The IRS, believe it or not, allows you yet another fund accounting method: the average cost method.  If you bought shares in chunks over time and/or reinvested the fund distributions (such as from dividends) into more shares of the fund, then tracking and figuring which shares you're selling could be a real headache.  So the IRS allows you to take an average cost for all the shares you bought over time. 

If you sell all your shares of a fund at once, you use the average cost basis method.  You may also prefer this method when you sell a portion of a fund that you hold.  Because many fund companies calculate this number for you, you can save time and possible fees paid to a tax preparer to crunch the numbers. 

Deciding when to take your tax lumps or deductions

If funds held outside of retirement accounts increase in value, you won't want to sell them because of the tax bite.  If, on the other hand, they decline in value, you may not know whether to sell them and, thus, lock in your losses.  So how do you decide what to do and what role taxes should play in your decisions?  As I discuss in Chapter 17, several issues can factor into your decision to sell a fund or hold on to it.  Taxes are an important consideration.  So, what do you need to know about them? 

Cashing in long-term gains and keeping taxes low

You do need to realize that taxes are important, but don't let them keep you from doing something you really want to do.  Suppose, for example, that you need money to buy a home or take a long-postponed vacation — and selling some mutual funds is your only source of money for this purpose.  I say go for it.  Even if you have to pay state as well as federal taxes totaling, say, 20 percent of the profit, you'll have a lot left over.  Before you sell, however, do some rough figuring to make sure that you have enough money to accomplish your goal.  Remember, you pay far lower tax rates when selling at a profit if you've held the fund for more than one year. 

If you hold a number of funds, give preference to selling your largest holdings (that is, the ones with the largest total market value) with the smallest capital gains.  If you have some funds that have profits and some with losses, you can sell some of each, subject to IRS rules, in order to offset the profits with the losses. 

Selling for tax deductions and the famous wash sale rule

Some tax advisers advocate doing year-end tax-loss selling.  The logic goes something like this: If you hold a mutual fund that has declined in value and you hold that fund outside a retirement account, you should sell it, take the tax write-off, and then buy the fund (or something similar) back. ( In fact, you can employ this strategy at any point during the year, not just at year's end.) 

  I don't think that selling solely for taking a tax loss is worth the trouble, particularly if you plan on holding the repurchased shares for a long time.  Remember that by selling and buying back the shares, you've lowered your basis, which increases the taxable profit after you sell the repurchased shares (assuming, of course, that they appreciate).  To find out about your basis, see the section "Introducing the 'basis' basics," earlier in this chapter. 

Plus, if you sell a fund for a tax loss and buy back shares in that same fund within 30 days of the sale, you can't deduct the loss because you violated the wash sale rule.  The IRS won't allow deduction of a loss for a fund sale if you buy that same fund back within 30 days.  As long as you wait 31 or more days, you won't violate the wash sale rule.  If you're selling a mutual fund and want to reinvest that money soon, you can easily sidestep this rule simply by purchasing a fund similar to the one you're selling. 

  Try not to have net losses (losses plus gains) that exceed $3,000 in one year.  You can't claim more than $3,000 in net short-term or long-term losses in any one year.  If you sell funds with net losses that total more than $3,000 in a year, you must carry the excess losses over to future tax years.  This situation not only creates more tax paperwork, but also it delays taking the tax deduction. 

Looking at fund sales reports: Form 1099-B

When you sell shares in a mutual fund, you receive Form 1099-B early in the following year.  This document is fairly useless because it doesn't calculate the cost basis of the shares that you sold.  Its primary value to you is that it nicely summarizes all the transactions that you need to account for on your annual tax return.  This form, which is also sent to the IRS, serves to notify the tax authorities of which investments you sold so that they can check your tax return to see if you report the transaction. 

  If some of the sales listed on your Form 1099-B are from check-writing redemptions, stop writing checks on those funds!  Keep enough stashed in a money market fund and write checks only from that type of account.  Money market fund sales aren't tax reportable because a money fund's share price doesn't change.  Thus, you get fewer tax headaches! 

Getting help: When you don't know how much you paid for a fund

When you sell a mutual fund that you've owned for a long time (or that someone gave you), you may have no idea of its original cost (also known as its cost basis). 

If you can't find that original statement, start by calling the firm where you bought the investment.  Whether it's a mutual fund company or brokerage firm, it should be able to send you copies of old account statements.  You may have to pay a small fee for this service.  Also, increasing numbers of investment firms (particularly mutual fund companies) automatically calculate and report cost-basis information on investments that you sell.  Generally, the cost basis they calculate is the average cost for the shares that you purchased. 

For a small fee, the research firm of Prudential American Securities may be able to help you figure out how much you originally paid for your funds.  Contact the firm at (626) 795-5831 or online at www.securities-pricing.com. 

Retirement Fund Withdrawals and Form 1099-R

Someday, hopefully not before you retire, you'll need or want to start enjoying all the money that you've socked away into great mutual funds inside your tax-sheltered retirement accounts.  The following sections explain what you need to know and consider before taking money out of your mutual fund retirement accounts. 

Minimizing taxes and avoiding penalties

Although many different types of retirement accounts exist (IRAs, SEP-IRAs, Keoghs, 401(k)s, 403(b)s, and so on), as well as many tax laws governing each, the IRS has declared one rule that makes understanding taxes on withdrawals a little easier.  All retirement accounts allow you to begin withdrawing money, without penalty, after age 591//2. ( Why they didn't use a round number like 60 is beyond me.) 

  If you withdraw money from your retirement accounts prior to age 591//2, in addition to paying current income tax on the distribution, you also must pay penalties — 10 percent of the amount of the taxable distribution at the federal level and whatever penalties your state charges. ( You compute the penalty on Form 5329 — "Additional Taxes on Qualified Plans [Including IRAs] and Other Tax-Favored Accounts.") 

Exceptions to the early withdrawal penalty do exist: You're allowed to make penalty-free withdrawals before the age of 591//2 if any of the following conditions apply:

  You've stopped working after you reach age 55 (whether by retirement or termination). 

  The withdrawal was mandated by a qualified domestic relations court order. 

  You have deductible medical expenses in excess of 7.5 percent of your adjusted gross income. 

Early retirement account distributions are also exempted from a penalty if they're paid because of death or disability, paid over your life expectancy, or rolled over to an IRA.  Withdrawing money from an IRA for a first-time home purchase (up to $10,000) or higher education expenses is also permitted. 

Issues to consider before making retirement account withdrawals

Generally speaking, most people are better off postponing withdrawals from retirement accounts until they need the money.  But don't delay if waiting means that you must scrimp and cut corners — especially if you have the money to use and enjoy. 

Suppose that you retire at age 60.  In addition to money inside your retirement accounts, you have money available outside as well.  If you can, you're generally better off using the money outside of retirement accounts before you start to tap the retirement account money. 

If you're not wealthy, odds are good that you'll need (and want) to start drawing on your retirement account soon after you retire.  By all means, do it.  But have you figured out how long your nest egg will last and how much you can afford to withdraw?  Most folks haven't.  It's worth taking the time to figure how much of your money you can afford to draw on per year, even if you think that you have enough.  Many good savers have a hard time spending and enjoying their money in retirement.  Knowing how much you can safely use may help you loosen your purse strings. 

One danger of leaving your money to compound inside your retirement accounts for a long time — after you're retired — is that the IRS requires you to start making withdrawals by April 1 of the year following the year you reach age 701//2.  If you don't, you pay a whopping 50 percent penalty on the amount that you should've taken out but didn't. ( Note: This requirement doesn't apply to the new Roth IRAs.) 

It's possible that because of your delay in taking the money out — and the fact that it'll have more time to compound and grow — you may need to withdraw a hefty chunk each year.  Doing so could push you into higher tax brackets in those years that you're forced to make larger withdrawals. 

If you want to plan how to withdraw money from your retirement accounts in order to meet your needs and minimize your taxes, some of the larger mutual fund companies that I recommend in this book have resources that can help you do the calculations.  You can also hire a tax adviser to help.  If you have a lot of money in retirement accounts, as well as the luxury of not needing the money until you're well into retirement, tax planning will likely be worth your time and money. 

Of course, you pay current income taxes, both federal and state, when you withdraw money that hasn't previously been taxed from retirement accounts.  The one exception is for withdrawing money early from the new Roth IRA accounts for a home purchase — in this case, you don't owe any income tax on the withdrawn investment earnings as long as you meet eligibility requirements. 

Making sense of Form 1099-R for IRAs

If you receive a distribution from your mutual fund IRA, the mutual fund company or brokerage firm where you hold your funds will report the distribution on Form 1099-R (see Figure 18-2).  These distributions are taxable unless you made nondeductible contributions to the IRA (a situation I cover momentarily). 

**Figure 18-2:** Here's where funds report your retirement plan distributions. 

Here's a rundown of the relevant boxes on your 1099-R:

  Box 1, Gross distribution: The amount of money that you withdrew from your IRA.  Make sure that this figure is correct: Check to see if it matches the amount withdrawn on your IRA account statement.  This amount is fully taxable if you've never made a nondeductible contribution to an IRA — that's an IRA contribution in which you didn't take a tax deduction and, therefore, filed Form 8606 ("Nondeductible IRA Contributions, Distributions and Basis"). 

    Box 2a, Taxable amount: The taxable amount of the IRA distribution.  However, the payer of an IRA distribution doesn't have enough information to compute whether your entire IRA distribution is completely taxable or not.  Therefore, if you simply enter this amount on your tax return as being fully taxable, you'll overpay on your taxes if you've made nondeductible contributions to your IRA.  If you made nondeductible contributions, compute the nontaxable portion of your distribution on Form 8606, which you need to attach to your annual tax return. 

Withdrawing from non-IRA accounts

Retirement account withdrawals from non-IRA accounts — such as 401(k), SEP-IRA, or Keogh plans — are taxed depending on whether you receive them in the form of an annuity (paid over your lifetime) or a lump sum.  The amount you fill in on your 1040 tax return is reported on a 1099-R that you receive from your employer or another custodian of your plan, which may include an investment company, such as a mutual fund company or discount broker. 

If you made nondeductible contributions to your retirement plan or contributions that were then added to your taxable income on your W-2, you aren't taxed when withdrawing these contributions because you've already paid tax on that money.  The rest of the amount you receive is taxable. 

Understanding form 1099-R for non-IRAs

You report non-IRA retirement account distributions on Form 1099-R, which is the same one you use to report IRA distributions.  Sometimes people panic when they receive a 1099-R, and they intend to rollover their retirement account money into a fund from, say, their employer's retirement plan after they leave their job.  Don't worry.  You received this form because you did do a legal rollover and, therefore, won't be subjected to the tax normally levied on distributions. 

The following list highlights how some of the other boxes on distributions for non-IRA retirement accounts come into play:

  Box 3: If the distribution is a lump sum and you were a participant in the plan before 1974, this amount qualifies for capital gain treatment. 

  Box 4: This box indicates federal income tax withheld. ( You get credit for this amount when you file your tax return.) 

  Box 5: Your after-tax contribution is entered here. 

  Box 6: Securities in your employer's company that you received are listed here.  This amount isn't taxable until the securities are sold. 

  Box 7: Your employer enters a code that explains the type of distribution you're receiving and why you're receiving it. ( See the back side of your Form 1099-R for an explanation of the code.) 

  Box 8: If you have an entry here, seek tax advice. 

  Box 9a: This amount is your share of a distribution if there are several beneficiaries. 
Chapter 19

Common Fund Problems and How to Fix Them

In This Chapter

  Dealing with fund company representatives

  Moving money into and out of funds

  Fixing paperwork, online snafus, and other problems

Established fund companies and discount brokerages have hundreds and, in some cases, thousands of telephone representatives who field phone calls and process stuff you send them in the mail.  Most of the bigger and better companies recommended in this book do a good job of training their employees, so you should receive competent assistance.  But keep in mind that these people are human — that is, not perfect.  Some are more competent and service-oriented than others at getting the job done right the first time with the proper attitude.  Although I can't guarantee that this chapter is a page turner, it can help bail you out and soothe your nerves when you just don't know how to get a problem fixed. 

Playing the Telephone Game

  When you call fund companies to ask a question or express a concern, you may end up speaking with someone who doesn't know how to fix your problem, gives you the runaround, or worse — gives you incorrect information.  Here's what you can do to ensure that you get accurate solutions:

  Know the representatives' limitations.  Fund company reps are there to provide assistance.  Don't depend on them for tax advice. ( Most of the larger fund companies have retirement account specialists who have more detailed knowledge about tax issues relating to those accounts.) 

  Talk to someone else.  If you don't get clear answers or answers that you're satisfied with, don't hesitate to ask for a supervisor.  Or you can simply call back on the toll-free line, and you're sure to get another rep.  This method is a proven way to get a second opinion to make sure that the first person knew what he was talking about. 

  Take names and notes for thorny problems.  If you're dealing with a problem that could cost you big bucks if not properly solved, take notes of your conversation.  Write down the name of the representative you spoke to, the office she's located in, and her telephone extension.  That way, you have some proof of your good efforts to fix things when you need to complain to or are summoned by a higher authority (for example, a supervisor, the IRS, and so on).  E-mail or a written letter can be effective ways to document your problems and concerns, although some companies don't provide e-mail addresses. 

  Visit the fund company's Web site.  The larger fund companies have extensive Web sites that are equipped with good search capabilities. ( See the Appendix for the addresses of the fund companies.) 

Trouble-Shooting Bungled Transactions

With all the sound-alike fund names, you can mistakenly have your money deposited into the wrong fund at some firms.  That's why it's a good idea to look at the statement that confirms your purchase to verify that the deposit amount and the fund into which the money was deposited are both correct. 

If the fund company makes a mistake, it should cheerfully fix the problem. ( It may need to do a bit of research first.)  It should be willing to credit the correct amount to the fund you requested as of the date the money was originally received. 

  With increasing numbers of fund investors conducting transactions online, I'm hearing about more problems with such trades.  Don't get me wrong — trading online is a fine thing to do, and the vast majority of transactions occur without a hitch.  However, accidentally duplicating an online trade is a good example of a common mistake. 

  If you make a mistake trading online (or by phone), get on the phone and request help.  Ask for a supervisor if frontline employees are unhelpful.  Don't accept a response such as, "We can't correct online trades." 

Specifying Funds to Buy at Discount Brokers

When you invest through most mutual fund companies, their account application and other forms allow you to indicate what fund(s) you want to make your deposit into.  Not so at discount brokerage firms. 

  If you want your deposit to a discount brokerage to be immediately invested into a particular fund or funds, write your instructions and send them with your deposit.  For example, if you mail $5,000 for an IRA deposit to a discount brokerage firm and you want the money divided between, say, the Fairholme Fund (FAIRX) and the Dodge & Cox International fund (DODFX), Figure 19-1 shows you how to word the letter. 

**Figure 19-1:** A sample letter to specify funds with discount brokers. 

Note the last sentence in the figure is a reference about what to do with dividends and capital gains distributions.  Try to be as precise as possible with the fund names.  The ultimate in precision for a broker is the fund's unique, five-letter trading symbol (three letters for exchange-traded funds). 

Making Deposits in a Flash

Maybe you have an account open and just need to feed it in a hurry.  Most often, this situation happens when you need to fund a retirement account, but it may also happen if you're on the verge of overdrawing a money market account due to outstanding checks and withdrawals. 

  If you need to make a deposit in a flash, you basically have the three following options:

  Write a check.  You can stop by and deposit it at the company's local branch office if you're dealing with a company with a branch location near you. 

  Wire the money from your bank account.  If the fund company isn't in your neighborhood, don't despair.  However, note that wiring usually costs money on both ends. 

After you've set up the wiring feature on your fund account (see Chapter 16), call your fund company to see what information you need to provide to your bank in order for the wire to be correctly sent.  This usually includes

• The name of the bank your fund uses for wires

• The bank's identification number (the nine-digit ABA number)

• The title and account number of the fund company's account at that bank

• Your name as it appears on your fund account

• The name of the fund account

• Your own account number

  If you don't have the wiring feature set up on your account, establishing this feature takes some time because you must request, fill out, and mail a special form. 

  Electronically transfer the funds.  Electronic funds transfer, which is like a paperless check, usually takes a day longer than a wire, but it's free.  Simply call your fund company and say how much money you want to move.  As with wiring, if you don't have this feature set up, you can establish it by requesting and filling out a form from the fund company. 

Verifying Receipt of Deposits

When you send money to a fund company, how do you know if the fund company received your money?  Unlike when you use a bank ATM, you won't get a deposit slip with your transaction — at least, not right away.  Fund companies mail you a statement (usually the day after they receive and process the deposit) that shows you the transaction.  You can keep a log of deposits on paper or with a computer program and check them off when you receive the deposit statement, once a month, or quarterly. 

If you can't wait for the mail, you can call the fund company's toll-free number and verify receipt over the phone.  Many fund companies have secure Web sites and automated phone systems that allow you to check on stuff like this quickly, without waiting for a live person to talk to. 

Transferring Money Quickly

For nonretirement accounts, if you have a money market fund with check-writing privileges, writing a check to get money is quick and simple and costs nothing.  Another option, which you can use on all types of accounts, is to call the fund company and request a telephone redemption.  The day after the next financial market close, a check should be cut and mailed to you.  If you need the check faster than the mail service can get it to you, you can provide your express mail company (for example, FedEx, UPS, or DHL) account number.  Some fund companies also allow you to pick up redemption checks at their headquarters.  Call to see whether they provide this service. 

Banks and other recipients of checks from your account may annoy you by placing a hold for a number of days on the funds from your checks.  For checks that you write yourself, the hold is understandable because the check recipient has no way of knowing whether the money will be in the account when the check is ready to clear.  But if the check was issued by the fund company, then the money has already been taken from your account, so the check is almost as good as cash to recipients — they just need to wait a couple of days for receipt of the funds. 

  Banks normally place up to a five-day hold on out-of-state checks. ( Odds are that your fund company clears checks through an out-of-state bank.)  If a bank doesn't make the money available to you quickly, ask to speak to the branch manager or some other higher-up.  Gently remind him that you can move your bank accounts to a less bureaucratic bank. 

Wiring and electronic funds transfers are other alternatives that you may prefer because you don't need to wait for a paper check to clear.  If you just realized that you need money to close on a home purchase tomorrow, these are your best bets.  See the section "Making Deposits in a Flash" earlier in this chapter for how these services work. 

For retirement account withdrawals, you need to make requests in writing.  Perhaps you need to withdraw money before the end of December to meet the IRS's mandatory withdrawal requirements after age 701//2.  The good news here is that you don't need to have received the funds before the end of the year.  As long as the distribution is made by the end of December, the IRS will be satisfied. 

Losing Checks in the Mail

  Checks and other stuff can get lost in the mail.  If you wrote a check and made it payable to the fund company, you don't need to stop payment.  If you're depositing checks with your fund company that someone else wrote to you, the check's issuer may want to stop payment when you report to it that the check is lost and you want it reissued, if it's concerned that you might cash it. 

A bigger pain is having to redo a bunch of account applications that you may have sent with the check(s).  If you are completing a pile of applications and transfer forms, you may want to keep copies.  Or, you investigate if the fund company allows you to complete forms through its Web site. 

Registered mail and certified mail don't eliminate the problem of lost mail.  They just indicate whether the mail was received.  Don't waste the money or the time needed to go to the post office to use these extra mail services. 

Changing Options after Opening Your Account

Perhaps now you wish you had check writing on your money market fund.  Or you want to establish a regular monthly investment plan so that money is sent electronically from your bank account to some funds.  How do you add these features after you've opened an account? 

Although you can add some features over the phone, you can only set up most features, particularly the ones that require your signature — such as check writing — through short forms that you request by phone. ( Some fund companies allow you to add these account features via their Web sites, as I discuss in Chapter 16.)  You can change previously established options, such as reinvestment of dividends, over the phone or via the fund company's Web site. 

Changing the registration of your accounts is more of a pain.  A letter is generally required, for example, if you marry and change your name or want to add your spouse to the account.  A signature guarantee may be required — these guarantees are provided by banks and brokerage firms.  Don't confuse this requirement with getting something notarized, which is different. 

Making Sense of Your Statements and Profits

Can't understand your fund statement?  Don't know how much money your fund is making for you?  Welcome to a large and nonexclusive club.  See Chapter 17 for the full scoop. 

  If you want a tax, financial, or legal adviser — or a savvy relative — to help you keep an eye on your investments, you can ask that she be listed on your account as an interested party to receive duplicate statements.  Simply write to the fund company and include the accounts you want the interested party to receive statements for and provide that person's name and mailing address. 

Changing Addresses

Normally, fund companies require that you make a change of address in writing, but over time more fund companies are establishing security procedures that allow you to make a change of address by phone or via a Web site.  The safeguards include a requirement that you prove that you're who you say you are on the phone (give your mother's maiden name and all that).  The fund companies also mail confirmations of the changed address to both old and new addresses and don't allow money to be transferred out to the address for, say, 15 days to give the mail sufficient time to deliver confirmation of the address change to both the new and old addresses. 

Finding Funds You Forgot to Move

Every year, people literally throw away hundreds of millions of dollars in investments, including investments in mutual funds.  You may have done this if you've moved around a lot without systematically sending changes of address to fund companies and placing mail-forwarding orders with the post office.  After fund companies try for a long time to send mail to your old address, they eventually throw in the towel, and your account becomes dormant.  No more statements are sent for a number of years, after which time your account is considered abandoned! 

By law, the mutual fund company must transfer your abandoned money to the treasurer's office (called escheatment, for you Trivial Pursuit or game show buffs) of the state in which the fund company does business or the state in which the last registered address appeared on your account.  This transfer may happen from within a few years to more than a decade after the fund company loses contact with you.  If you don't claim the money within a certain number of years after that, the state gets to keep it. 

  If you vaguely recall that you had funds with a particular fund company way back when, call the company.  You don't need to remember the specific funds you invested in.  By using your name, Social Security number, old mailing addresses, and personal stuff like that, the fund company's computer system can find your accounts and determine whether they were turned over to the state.  You can also try contacting the state treasurer's office in the states in which you've lived to see whether they have any of your abandoned accounts. ( You can do this as well for recently deceased relatives in the event you're concerned that you may have overlooked some of their accounts.)  If you find your accounts, please write to me in care of the publisher and let me know — these successes make me happy! 

Untangling Account Transfer Snags

Transferring accounts from one investment firm or bank to another can be a big pain.  Even obtaining the correct transfer paperwork and completing it are challenges — that's why I detail how to do these steps in Chapter 16. 

  Problems happen most often with retirement accounts and with brokerage account transfers.  Some firms are reluctant to give up your money, and so they drag their feet, doing everything they can to make your life and the lives of employees who transfer accounts at your new investment company a nightmare.  The biggest culprits are the supposed "full-service" brokerage firms that employ commission-based brokers.  They've lost a lot of money flowing out to no-load and discount brokers' mutual funds, and they do what they can to hang on.  The unfortunate reality is that they'll cheerfully set up a new account to accept your money on a moment's notice, but they'll drag their feet, sometimes for months, when it comes time to relinquish your money. 

  Don't let this foot dragging on the part of brokerage firms deter you from moving your money to a better investment firm.  Remember that the transfer should, under securities industry regulations, be done within 30 days.  If it's not, hammer the villains!  Should the transfer not be complete within a month, get in touch with your new investment firm to determine what the problem is.  If your old company isn't cooperating, a call to a manager there may help get the ball rolling.  To light a fire under his behind, tell the manager at the old firm that you'll be sending letters to the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) if he doesn't complete your transfer within the next week.  Then do it. 

In addition to uncooperative brokers, certain assets present problems with transfers.  If you purchase any house-branded mutual funds at commission-based brokerage firms, in addition to buying into what's likely a relatively mediocre family of funds, you also can't transfer their funds as they are.  You must first have them liquidated through the broker whose name is on them so that the cash proceeds can be transferred.  Most annuities work the same way. 

  Transfer individual securities, such as stocks and bonds, to a discount broker.  That way, if you later decide to sell them, you save on commission charges.  Limited partnerships generally can't be liquidated, and everybody levies fees to hold them — another reason not to buy them in the first place.  If you want less account clutter, transfer these to the discount broker you're otherwise going to be using. 

Eliminating Marketing Solicitations

  If you do business with many companies and their marketing folks are driving you batty, call your fund companies and ask them to code your account on their advanced computer systems so that you won't receive anything other than statements and reports on your funds.  Fund companies are required under SEC regulations to honor such a request.  Fund companies are happy to oblige — they don't want irritated customers. 

As for all the other junk mail you get, send a request not to receive junk mail (including your name, complete home address) to the Direct Marketing Association, Mail Preference Service, P.O. Box 643, Carmel, NY 10512.  You can also complete the form on the association's Web site at www.dmachoice.org. 

  Some fund companies and brokers may call you at home soliciting your purchase of investments.  They tend to focus on people with large cash balances sitting in their accounts.  To stop any type of sellers from calling you in the future, you have the Do Not Call Registry on your side.  Register for free either online at www.donotcall.gov or call (888) 382-1222 from the number you want to register. 

Digging Out from under the Statements

If you're being buried in paperwork from statements and transaction confirmations from too many fund companies, consider consolidating your fund holdings through a discount broker.  Trade-offs do exist — you pay more in fees for the convenience that these accounts offer (see Chapter 9).  Some fund companies also have ways to consolidate statements, but you may have to specifically request this service for your statements. 

  If you truly abhor getting paper statements in the mail, increasing numbers of fund firms allow you to "turn off" receiving such clutter and view your statements online.  Visit your favorite fund company Web sites for details. 

Getting Older Account Statements

Perhaps, for reasons of nostalgia or taxes, you need copies of a statement that's more than a year old.  Most companies should have no problem providing it (and some have Web sites allowing you to retrieve such history).  Some smaller companies may, however, charge you something like $10 per fund per year requested.  So be choosy.  The main reason you'd request a statement is to research how much you originally invested in a mutual fund held outside of a retirement account.  If you sold or are thinking about selling shares of the fund, you may have to figure out the fund's cost basis for tax reporting purposes (see Chapter 18).  In the future, be sure to keep your statements so you don't need to ask for copies. 

  If you're going to sell all the shares that you hold in a fund, check to see if your firm can report the average cost of the shares sold.  If its accounting system can do this, you're golden, and you don't need to bother with getting the old statements. 
Chapter 20

Fund Ratings and Forecasters

In This Chapter

  Steering clear of the lousy newsletters

  Getting investment information from the best sources

My father loves data and analyzing it.  He likes figuring out how things work.  Before he retired, he was a mechanical engineer. ( Impressively, he worked his entire career in one field.)  He loves making charts and graphs.  During the months that I wrote the first edition of this book, he was poring over a veritable truckload of data and information on mutual funds and investing. 

So I wrote this chapter for people like my dad.  Even if you're not an engineer by training, there may be a bit of a data lover in you.  The challenge as you navigate the landscape of mutual fund data, newsletters, references, and gurus is discerning the good from the merely mediocre — as well as the downright useless and dangerous information and advice.  Unfortunately, more of the latter are out there waiting to trip you up. 

Avoiding the Bad Stuff

I start with the bad stuff because so much bad investment advice is out there, and odds are good that you may currently be using some of it or thinking of using it, or it may be pitched to you in the future.  Finding out the tricks of the trade enables you to better identify the good stuff.  But if you're pressed for time and can't bear to see the ugly side of the investment newsletter business, skip ahead to the good sources that I recommend later in this chapter. ( I cover software and Web sites in Chapter 21.) 

  Newsletters cost you time and money.  Don't use newsletters for predictive advice.  If these prognosticators were that smart about the future of financial markets, they'd be successful money managers making a lot more money.  The only types of publications you should consider subscribing to are those that offer research and information rather than predictions. ( I discuss those publications in the "Getting In on the Good Stuff" section in this chapter.) 

Looking into market timing and crystal balls

  Market timing — even in the form of slick, professional-looking packaging and claims — is a losing proposition.  Many fund investors believe that they can increase their chances of success if they follow the predictions of certain gurus.  Gurus often say (or imply) that they can tell you when you should be in or out of the markets or particular investments.  Whenever a prognosticator near you treats you to such "wisdom," just repeat after me:

"No one can predict the future." 

"No one can predict the future." 

"No one can predict the future." 

If you can remember this one simple fact — a fact supported by mountains of evidence and plenty of good, old-fashioned common sense — you'll dramatically increase your chances for successful investing in funds, and you will decrease the odds of making major mistakes.  And you'll have a much clearer vision about which resources to use for further reading and research about funds.  As I explain in Chapter 10, the strategy of market timing is doomed to failure in the long run. 

Take a look at the performance track record of investment newsletters.  According to The Hulbert Financial Digest (see the next section), which looks at risk as well as return, only a few newsletters have managed to keep ahead of the market averages over the past 15 years.  And these newsletters only managed to do so by a small margin (and that doesn't take into account the cost of subscribing to a newsletter).  The worst investment newsletters, on the other hand, have underperformed the market averages by dozens of percentage points: Some would've even caused you to lose money during time periods when the financial markets performed extraordinarily well. 

Of course, you'd never know about newsletters' dismal performances if all you ever listened to were the claims made by newsletter writers themselves.  Most claim that they told their loyal followers to sell everything just before the last dozen times that the stock market plunged.  They also usually go on to proclaim that they advocated buying at every bottom in the market. 

  Newsletter writers don't know anything that isn't already reflected in the prices of securities.  If newsletter writers did have a knack for unearthing information that no one else typically knew, they'd be too busy investing their own money and making millions off their predictions to waste their time publishing a newsletter. 

Keeping them honest and providing new fodder: The Hulbert Financial Digest

Mark Hulbert started a useful business in the 1980s.  Almost every investment newsletter was making outrageous claims about the success of its previous predictions.  But how could you, the potential new subscriber, know whether a newsletter was telling the truth or blowing smoke?  Answer: You couldn't. 

Not until Mark Hulbert came along, that is.  He tracks the actual performance of the newsletters' investment picks.  He tracks each newsletter's recommendations.  So, over time, Hulbert knows exactly how the newsletters' picks have done. 

Has The Hulbert Financial Digest stopped the outrageous claims of the investment newsletters?  No, but the claims seem to be slowly getting more accurate, thanks to Hulbert's influence.  The problem is that people still believe the marketing hype of the newsletters and never bother to check with Hulbert's service. 

  Hulbert's service has created another problem, however.  Many newsletters can claim to be number one by selecting short time periods when they actually were number one, even though they've underperformed the rest of the time.  And some falsely lay claim to the number one status by simply comparing their performance to all those that are worse, while ignoring the ones that perform better! 

Using bogus rankings, token awards, and mystery testimonials

Newsletters also cite rankings from other organizations (such as Timer's Digest) in their efforts to justify their claims of numero uno status.  Given enough time periods and categories of newsletters, many newsletter writers can claim the coveted number one spot at some time or another. 

  Newsletters also refer to awards they've won from the Newsletter Publisher's Association (NPA).  My advice: Ignore NPA awards.  They're meaningless.  They have nothing to do with the performance of a newsletter's advice.  And because the NPA is an association made up of the newsletters themselves, they're just giving themselves a pat on the back!  Not a very objective way to dole out awards, eh? ( The association isn't very large and is always doling out awards, which doesn't hurt newsletter writers' chances of winning, either.) 

And, of course, you have the inevitable customer testimonials.  Curiously, though, testimonials almost always parrot the promotional material for the newsletter, and they never include the person's name.  All they provide are the person's initials, such as B.S., and good old B.S.'s home, such as Brooklyn, N.Y. Some of these testimonials are made up — so they really are B.S.! 

Pitching a product: Filler and ads in newsletter form

  Many newsletter writers publish newsletters as a means of drawing people into their money management business.  For some, that's the only reason they produce the newsletter.  So they don't really want to teach you too much about investing; they want to convince you that your money is best off in their hands — which means that their articles are usually trying to tell you that investing is complicated and market timing is everything. 

Some newsletters that are already short on content plug their money management service right in the newsletter.  One monthly newsletter that sells for more than $100 per year publishes issues that are 80 percent filler; performance numbers for funds are an example of this filler.  In the four pages of articles in the typical newsletter, readers often confront a plug for the editor's money management business because (according to him) a newsletter's advice can't substitute for the daily oversight of your portfolio. 

Don't believe it.  Of course, this claim isn't what they told you in their marketing materials to get you to subscribe to the newsletter.  What the newsletter should've said (and what would've been accurate) is that the editor nets a lot less profit by selling a newsletter than he does by landing another client for his money management business. 

Investing newsletter Hall of Shame

The following sections reveal some of the many examples of the really heavy stuff that gets shoveled by some of these folks to sell you on their investment newsletters.  All the examples are drawn from real-world newsletters.  However, I've modified the names to keep you focused on the types of misleading practices that marketing newsletters engage in instead of having you focus on the particular scoundrels behind each of these disreputable newsletters. 

Dwayne Dweeb's Personal Finance

  Dwayne Dweeb's newsletter marketing materials issue the following proclamation about Dweeb, a veteran newsletter writer: "A Millionaire Maker Outsmarts the Market.  Again."  In a glossy, multipage brochure, Dweeb is said to have "the highest IQ of them all . . .  somewhere between Einstein, Mother Theresa, and an IBM mainframe." ( I'm not making this up!) 

His literature goes on to say: "The reason he can expand your money by 30 percent to 50 percent a year is sheer mental horsepower."  You're also told that his newsletter is rated number one by "both of the major rating services."  Dweeb's materials assert that he's developed a brilliant and totally awesome proprietary model, which he calls the "Numero Uno Indicator."  His claim is that this model has predicted the last 28 (count 'em, 28) upturns in the market in a row without a single miss.  The odds of doing this, according to Dweeb, are more than 268 million to 1! 

But wait, it gets better.  The ad goes on to claim that Dweeb's "Numero Uno Indicator" market timing system could've turned a $10,000 investment into $39.1 million in 12 years.  That would be a return of 390,000 percent! 

Does this claim sound too good to be true?  You got it.  This outrageous claim, if not purely fabricated, was based on backtesting, looking back over historical returns and creating "what if" scenarios.  In other words, Dweeb didn't turn anyone's $10,000 into $39.1 million.  Much too late after that ad appeared, the Securities and Exchange Commission (SEC) finally charged Dweeb with false advertising.  Dweeb settled out of court, and a $60,000 fine was imposed. 

Here's the real scoop on Dweeb's investing ability.  In 1991, Dweeb established a mutual fund.  Over the next decade, this fund was one of the worst growth stock funds around.  His fund underperformed about 90 percent of its peers. 

Harry Hacker's Mutual Fund Investing

  Steer clear of anyone who claims to be "America's #1 Mutual Fund Adviser."  I remember Hacker's name as if it were my own, because for a while, it seemed, once a month I'd receive a glossy color brochure more than 20 pages long from him in the mail.  Like Dweeb (see the preceding section), Hacker claimed to have been rated number one by Hulbert.  Hulbert responds, "It is a fabrication.  Mutual Fund Investing is not now, nor has it ever been, rated number one by my digest."  Hulbert was so incensed by Hacker's claim that he devoted an entire column, appropriately entitled "Lies and near lies" to setting the record straight in Forbes magazine. 

Mutual confusion: Misuse of fund ratings

Rating mutual funds has become a national obsession.  When you check out business and financial publications, be cautious about fund ratings.  Whether they're letter grades (ranging from "A" for best to an "F" for worst or a number system, fund ratings purport to rank how good particular funds are.  The most common mistake investors make in using even the better mutual fund publications is focusing too much on the ranking of specific funds. 

Dan Wiener, editor of The Independent Adviser for Vanguard Investors newsletter (discussed in the next section of this chapter), did an interesting analysis of four major financial magazines lists of best funds.  Amazingly, more than 80 percent of the chosen funds appeared on just one of the four lists and not even one fund made it on all four lists.  Clearly, different publications have widely varying criteria. 

The problem with many fund-rating systems is that they're based on history and overweight the most recent performance of funds.  The mutual fund landscape is littered with plenty of funds that were yesterday's stars that have become today's losers and has-beens (see Chapter 7).  A problematic fund rating system is one that

Ignores the risk of a fund and its costs

Gives costs little weighting to these two important factors

Soon after Hulbert's scathing column about Hacker appeared in Forbes, in Hacker's next mailing he changed his tune a bit.  His newer marketing materials displayed a colorful chart showing that his stock and bond fund picks returned 1,517 percent over a 15-year period — for a nearly 20 percent annualized rate of return, which would've put him in an exclusive league with the like of investing legend Warren Buffett.  This return would imply that his advice had beaten the average stock fund, which over the same time period returned just 14.7 percent per year, and the average bond fund, at 9.1 percent per year, by some distance significantly greater than a country mile. 

Hulbert's tracking of Hacker's recommendations clearly shows that Hacker's portfolio returns fell well below the market averages. 

Getting In on the Good Stuff

  If you want to read more about investments, by all means read more.  But read useful information.  Most of the better financial magazines and newspapers, for example, cost a fraction of the newsletters' prices, and provide more useful information. 

Many of the major financial publications — Barron's, Business Week, Forbes, Fortune, Kiplinger's Personal Finance, SmartMoney, and The Wall Street Journal — do annual mutual fund roundups.  Most newspapers and many large news magazines provide fund coverage as well.  Some good newsletters are available, too. 

Morningstar Mutual Funds

If you want a snapshot summary of a lot of data, as well as some thoughtful analysis about a fund you're considering investing in or currently own, Morningstar can't be beat.  Most of the information summarized on its pages comes from a fund's prospectus and semiannual reports.  Some of the data it provides for funds may take you hours to calculate and may require a sophisticated computer software program. 

Morningstar Mutual Funds covers load funds (funds that carry commissions) as well as no-load funds.  As I explain in Chapter 7, loads are an additional cost to buy funds that brokers sell.  If you have load funds that you want to evaluate, Morningstar Mutual Funds can help. 

  A one-year, Web-based subscription costs $179. ( See Chapter 21 for details on the Morningstar Web site and software offerings.)  In the sections that follow, I highlight the more pertinent information in an individual Morningstar bond fund and stock fund report. 

Reading a Morningstar bond fund report

In this section, I highlight some of the more useful features to examine for bond funds that you may be considering. 

  Quote: This section presents a data dump of all sorts of information for the fund over more than the past decade.  Here you can see how the total return, performance versus benchmarks, dividend (income), capital gains, the fund's annual operating expenses, and trading (turnover rate) have varied over the years. 

  Management: This section highlights the fund's managers and notes the date the manager(s) started managing the particular fund as well as their investment management experience. 

  Strategy: This section provides a summary of the general investment objectives and limitations that a fund subjects itself to. 

  Performance: The first section displays the total amount that investors made or lost (from dividends, capital gains, and share price changes) for each quarter over the past seven years.  This section can give you a sense of the likely volatility of an investment in the fund. ( Remember, though, that this is history, and the future will differ.)  If you get queasy looking at these numbers, don't invest. 

  The second section — the trailing returns — shows annualized total return information over longer time periods. ( Total return numbers don't account for loads, but you're not going to pay any anyway, are you?)  The fund's returns are also compared to benchmark indexes, which in some cases aren't so comparable. ( See Chapter 17 for more background on benchmarks.) 

  Portfolio: This data is summarized from a fund's most recent reporting.  Detailed are the total number of securities this fund holds and the listing of the top 25 holdings. 

• The Investment Style box shows you which types of bonds the fund mainly holds at the moment (in this case, high-quality, intermediate-term bonds).  Measures of interest rate sensitivity — average maturity and duration (both of which I explain in Chapter 12) — are provided here, as well as the average credit quality of the fund's bonds. 

• Sector Weightings quantifies the fund's current holdings of the major types of bonds.  Asset Allocation details the fund's recent holdings of cash, bonds, and other securities.  This section is worth looking at to determine whether a fund really is what it says it is. 

• The Bond Quality section highlights the fund's holdings by the credit rating of the bonds it is invested in (see Chapter 12). 

  Fund Analysis: Each fund at Morningstar is assigned an analyst.  Analysts use available information, as well as interviews with fund company managers (and others), to summarize the fund strategies.  This section is usually well worth reading, especially if you're not a numbers kind of person. 

    Rating and Risk: Without a doubt, this section is the most overused and abused part of a Morningstar report.  Funds are given ratings, based on past performance and volatility, from one (worst) to five (best) stars.  The folks at Morningstar say that "funds with 3, 4, and 5 stars often make the most sense for many investors."  I think that says it well — you can't really say much more about the star rating system than that.  More stars are not necessarily better than fewer and vice versa. 

Here you see more details for the determination of the ranking and the way the fund rates over different periods. 

All sorts of other quantitative measurements of risk are presented here.  One of the more useful is beta, which helps you calibrate the volatility of a fund compared to relevant benchmarks.  The overall bond market benchmark is assigned a beta of 1.00.  Thus, a fund with a beta of 1.2 implies that it's 20 percent more volatile on average (perhaps because it invests in longer term bonds or lower credit-quality bonds). 

    Tax Analysis: This section provides some insightful measures of a fund's tax efficiency or tax friendliness.  If you're investing in a fund inside a retirement account, ignore this section.  If you're investing outside a retirement account, the tax-adjusted return column shows what your effective return would've been in this fund over various periods if all the dividend and capital gains distributions that a fund makes were taxed at the highest applicable federal tax rate and then reinvested in the fund. 

Potential Capital Gains Exposure measures how much, if any, unrealized profit exists.  The larger the number here, the greater the potential risk of larger distributions in the future, particularly for funds that trade a lot (that is, that have a high turnover), as this one does. 

  Purchase Information: Here's where you see how to get in touch with the fund, how much is required as a minimum investment, and so on. 

Reviewing a Morningstar stock fund report

Morningstar's stock fund reports carry much of the same types of information that its bond fund reports contain.  I won't repeat my explanations of the same sections I cover for a bond fund report. ( To see what I'd be repeating if I did talk about it here, skip back to the preceding section.)  The sections of a stock fund report that significantly differ from a bond fund page include

  Quote: Stock funds, of course, have different benchmark indexes suitable for comparison purposes. 

  Portfolio: The summary of a fund's holdings is the most important area of difference between a stock fund report and a bond fund report.  That's no surprise, though, because stocks are quite different from bonds. 

Similar to the bond fund report, the stock fund page notes the total number of securities that it holds.  A list of the top 25 securities, along with what portion each stock comprises of the fund's assets and its recent return and price-earnings ratio, also shows up here. 

• Investment Style classifies a fund's current stock holdings based on the size of the company, as well as on whether those stocks tend to be growth, value, or both. ( I cover the difference among these various types of stocks in Chapter 13.)  The page also presents a variety of statistical measures for the stocks that the fund holds.  For example, you can see the average rate of growth in the earnings of the companies that this fund invests in and how that rate compares to that of other funds in its category. 

• Asset Allocation is also useful because it indicates whether a fund is holding major cash positions and whether it invests in securities other than stocks.  Market Cap shows how the fund is allocating its holdings among stocks of companies of varying sizes.  Sector Weightings breaks down a fund's stock holdings by industry and compares the fund's holdings to those of a relevant index. 

No-Load Fund Analyst

  Those people who enjoy doing more reading about funds and the financial markets should consider the No-Load Fund Analyst newsletter, which tracks a much smaller universe of the better no-load funds than Morningstar does.  This monthly publication provides commentary and analysis of trends in the economy, happenings in the fund industry, and fund manager interviews and profiles.  In an industry in which many publications claim that they can double your money in a snap if you become a subscriber, the No-Load Fund Analyst is a breath of fresh air — it includes no hype or inflated marketing claims. 

Personal interviews and the tracking of individual fund managers are unique and valuable aspects of this publication, which tries to identify talented fund managers at some of the smaller, lesser known funds.  These funds, of course, are riskier to invest in.  Also, because the No-Load Fund Analyst recommends funds in numerous fund families, as an investor you must be willing to deal with many fund companies or establish an account at a discount brokerage firm (see Chapter 9).  The editors' primary business has been their investment management company.  They manage money for institutions and wealthy individuals in mutual funds — their minimum account size for new clients is $3 million. 

The No-Load Fund Analyst also follows and discusses closed-end mutual funds, which I cover in Chapter 2.  An annual subscription to the No-Load Fund Analyst costs $600.  For $50, you can obtain a sample issue by calling (800) 776-9555 or visiting its Web site at www.nlfa.com. 

The Independent Adviser for Vanguard Investors

As you may have guessed from its name, the Independent Adviser for Vanguard Investors is a useful publication that focuses exclusively on Vanguard's extensive family of mutual funds (and now exchange-traded funds).  Editor Dan Wiener, who's a former financial journalist, also operates a money management business. 

What I really like is that Wiener does his research and homework.  He's adept at sifting through the large number of Vanguard funds and highlighting those that do the best and are likely to continue performing well.  That said, he isn't like many other newsletter writers who make predictions about the stock market and economy.  He also shies away from making major shifts in his suggested holdings — he's much more of a buy-and-hold investor.  This newsletter costs $99.95 for the first year, and you can order by calling (800) 211-7641 or going to the Web site at www.adviseronline.com. 

EricTyson.com

Drop on by and visit my Web site — www.erictyson.com — where I digest and summarize what the best newsletters and other resources highlighted in this chapter are saying now.  I also discuss current economic news, books worth reading, and prominent gurus, among other topics. 
Chapter 21

Harnessing Your Computer's Power

In This Chapter

  Finding your way around mutual funds with software

  Locating the best mutual fund Web sites

When you invest your money, especially in mutual funds, having a computer at your disposal to make wise investing decisions and to manage your portfolio is not necessary nor is it advantageous.  In fact, the use of a computer when investing may prove detrimental to your investing success.  Why? 

My experience with counseling clients, reading letters and e-mails from readers and visitors to my Web site, and instructing students in my courses is that heavy computer users tend to focus too much on daily price changes and the short-term news and, thus, they trade too much — losing sight of the important bigger-picture issues.  So if you're not online yet or don't own a computer to play around with investing software or Internet sites, don't be sad.  If you decide to spend money on a computer or you already own one but don't know how it can help you invest in funds, this chapter assists you with finding out how to put it to work. 

I divide this chapter into two parts — software and Web sites.  Some of the stuff I discuss does some of both categories.  Those that do are generally placed in the category that they do more of. 

Using Computer Software

Most software reviewers can agree that good software must be easy to use.  Software that helps you make mutual fund and other investing decisions must also provide well-founded advice and information.  Not all of it does. 

Knowing which software is best for you depends on your goals and level of investment expertise.  The financial software in the marketplace today can help you with a variety of activities that range from simply tabulating your mutual fund's values and getting current prices to researching investment choices.  You can even execute fund trades on your computer. 

As I discuss later in this chapter (see the section, "Entering Cyberspace: Internet Sites"), thanks to technological advances, Web sites are offering features that were once the exclusive domain of software programs.  Before you rush out to purchase a specific software program to accomplish a certain task, check to see what the Internet has to offer in that area. 

Getting-and-staying-organized software

Checkbook software programs, such as Quicken, help with checkbook accounting, expense tracking, and bill paying.  But checkbook software is also useful for keeping track of your mutual fund investments.  By remembering your original purchase price, as well as factoring in dividend and capital gains distributions, checkbook software automatically calculates your current rate of return, both annualized and cumulative, for each individual fund, as well as for your entire portfolio. 

However — and this is a big however — in order for software to keep track of your returns, you must plug in all your transactions, distributions, and share price changes when you receive your account statements.  If you have a lot of funds at different accounts, this process could be tedious, depending on how much you like detail work.  Some (primarily) larger investment companies allow you to download your account statement details directly into your software program.  But even this procedure usually requires you to work with the downloaded transactions and assign them to appropriate categories. 

  Software can be useful if you have accounts at numerous investment firms and want to keep tabs on your various accounts and overall performance.  But remember that consolidating your investments at a larger mutual fund company or through a discount brokerage account can accomplish the same goals for you — without your having to invest hours in studying software and entering data. 

Also keep in mind that one of the most attractive features of checkbook software — its ability to track your cost basis — is irrelevant for funds held in retirement accounts. ( See Chapter 18 for more information on cost basis as used for tax purposes.)  Most mutual fund companies in this day and age track your cost basis for you, too. 

Accessing investment research software

Investment research software packages usually separate investment beginners (and others who don't want to spend a lot of time managing their money) from those who enjoy wallowing in data and conducting primary research.  The best reason to use research software is to access quality information in a way that may be more cost-effective than doing so through traditional channels.  Research software may allow you to peruse more information more efficiently. 

  Although these packages can be cost-effective, they're still expensive.  Don't jump in to one of these programs until you've done a careful comparison between the information it offers and the data you need.  Most investment software packages offer more raw data than you can ever use. 

Mutual fund data hounds delight in the software products that Morningstar offers.  However, if you're an investing and mutual fund novice, don't expect an easy time working with these sometimes jargon-laden and costly packages.  Also expect to invest several hours of your time to figure out how to work with a program. ( Morningstar offers more affordable and scaled-down information through its Web site, which I discuss later in this chapter.)  Here's my take on Morningstar's mutual fund software:

  Principia Mutual Funds: This software provides most of the data that's provided on Morningstar's fund reports, which I discuss in Chapter 20.  You can search and screen for funds that meet the specific criteria that you enter into the program.  The program also comes with a feature called the Portfolio Developer, which allows you to gather a portfolio of funds and then view a pie chart of that particular portfolio's asset allocation.  A subscription is $675 a year.  Call (877) 586-5405 for more info. 

  Principia Mutual Funds Advanced: The ultimate for the mutual fund data junkie, its interface is similar to Principia Mutual Funds', but you get more historical data and features.  All the data available on Morningstar's reports comes with this program, and then some.  For example, each fund has an archive of all the analyst's reviews of that fund.  The program also lets you print these reports on your own printer.  The Portfolio Developer allows you to track the performance of your mutual fund portfolio over time.  The price for Morningstar's first-class ticket is steep: An annual subscription is $1,220.  Call (877) 586-5405 for more information. 

Before plunging in to the data jungle, be honest about your reasons for doing research.  Some investors fool themselves into believing that their research will help them beat the markets.  As I say many times in this book, though, few of even the so-called professional investors ever beat the markets. 

Entering Cyberspace: Internet Sites

The Internet is a vast network of computers all over the world that share information.  Just about anyone can plug in to the Internet right from home — all you need is a personal computer and a connection.  Fund investors online have some of the following possible benefits:

  Quick access to info: The Internet can give you faster access to important resources than traditional channels allow.  Before the Internet, investors had only one way to get their hands on, say, a fund prospectus: Call the folks at the fund company, give them an address, and wait up to a week for the mailman to deliver the goods.  With Internet access, you can log on to the fund company's Web site and view the prospectus immediately, and even print it, if you want to.  The same goes for annual reports, account applications, research reports, account statements, and so on. 

  Interactive features: The best Internet sites are similar to software programs in that they're interactive.  The phenomenon of retirement-planning calculators is a good example.  The best online calculators ask you questions, you plug in the answers, and on your computer screen you see your personalized plan calculated for you, complete with graphs and charts — sure beats slugging it out with a calculator and pencil over a fill-in-the-blank retirement-planning workbook. 

  Up-to-date info: Information on the Internet can be kept up-to-date, even up-to-the-minute.  Larger companies have entire staffs that are responsible for keeping their Web sites current.  If a prospectus is revised or a new tax law affects a retirement-planning calculation, a well-maintained Web site can reflect these changes the next time you log on.  This advantage is one over the traditional print medium and software programs. 

  Of course, every coin has a flip side.  The Internet has introduced plenty of hazards for mutual fund investors to be concerned about, but here, to steer clear of the pitfalls, I give you a few tips:

  Free information, at a price: After you've paid your toll to get on the Information Superhighway, many things that you find there have the illusion of being free.  Don't be fooled.  Somebody has to pay to put that info on the Internet, and nine times out of ten it's a company that's trying to sell you stuff that you're better off not buying.  Before you trust a Web site with information on mutual funds, find out who's paying the bucks for the site to be there. ( See the sidebar, "Who's footing the bill?") 

  Minutia to fixate on: An advantage of the Internet — its capability to keep information up-to-date — is also its Achilles' heel.  Too many Internet sites get so focused on the short term that they lose sight of the big picture.  For example, many Web sites center on up-to-the-minute investment price quotes and late-breaking financial news: This type of information doesn't serve a healthy, long-term investment strategy perspective.  Don't let the Internet distract you from your focus on the investment horizon.  Don't be as enamored with the Internet's up-to-the-minute update ability as most Web sites seem to be. 

  Too many "experts": Message boards and chat rooms are a unique aspect of the Internet.  The way that these mediums can facilitate communication between people in various towns, cities, and states is potentially exciting.  But message boards and chat rooms are dangerous places to tread for the naive and too trustful.  Remember, you don't have to take an entrance exam or have a license requirement for joining a chat room or posting a message on an electronic bulletin board.  The anonymity makes pretending to be someone you're not easy.  Therefore, participate cautiously.  Never trust any advice you get from a chat room or message board without verifying it through a reliable independent source.  And never share confidential personal or financial details online. 

  Information overload: The possibilities on the Internet are so endless that they can be overwhelming, and the easiest way to find bad advice is to be unsure about what you're looking for in the first place.  Knowing what information you want before you start searching pays.  If you enter a vague term into an Internet search engine — say, "mutual funds" — you'll probably end up more lost than you were to begin with.  If, on the other hand, you enter a specific term — such as TIAA-CREF mutual funds — you'll probably find the information you're looking for. 

  That said, let me speed up your search for good resources on the Internet by recommending what I think are the best mutual fund Web sites out there.  You'll recognize some of the names behind these sites because they're companies I recommend throughout the book.  Not surprisingly, the organizations that demonstrate excellence offline seem to be the ones that do best online as well. 

Who's footing the bill? 

You need to know that the Internet is primarily funded by companies' marketing departments.  Of course, nothing is intrinsically wrong with this arrangement; magazine articles and television programs are also paid for with advertising dollars.  What's problematic about the Internet, however, is that the line between advertising and content is much fuzzier and more blurred than in other mediums.  In fact, some Web sites obscure the difference between content and advertising in a manner that could be called deliberate. 

For example, consider a Web site that hypes itself as the "best independent mutual fund resource" and even goes on to boldly declare that "Content is what makes us different."  However, this content, such as the text that appears in the site's "Expert's Corner," turns out to be nothing more than thinly veiled marketing fodder from financial newsletter writers who are intent on selling you a subscription to their wares. 

So how can you tell whether the objective content you're reading on the Web is really just a paid advertisement?  Begin by thoroughly checking out the fine print.  In the preceding example, I found this little disclaimer in the corner: "These articles are sponsored by the featured experts. . . ."  Sponsored means that the "experts" (newsletter writers) were paying to put their articles on the Web site. 

If the Web page has a button that reads something like About Us, click it.  Sometimes you can get information on who's sponsoring the site.  Also click any buttons that say something such as For Clients Only or How to Join Us.  You may discover that the site only mentions fund companies that pay a fee to be represented. 

Keep an eye out for advertisements that spill over into the content when you read articles on independent sites.  For example, if an article recommends a fund company whose advertisement appears at the top of the page, consider surfing elsewhere. 

If you can't find out who's behind a particular site, don't trust it.  A Web site that has nothing to hide has no reason to be evasive.  To be safe, stick with sites that are totally upfront about who's paying for them.  A site whose Web address is www.fundcompanyxyz.com is obviously not trying to fool anybody. 

Investment Company Institute

The Investment Company Institute (ICI) is the investment companies' trade association; it includes mostly mutual funds but also closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  This site has a wealth of industry data that's of greater use to financial professionals who enjoy wallowing around such numbers.  Check it out online at www.ici.org. 

  Be forewarned, however, that the educational materials on this site won't show you to avoid load funds or other high-cost investments, such as most UITs — some ICI members sell them, so telling you to avoid these investments would be self-detrimental. 

Morningstar.com

Morningstar's site (www.morningstar.com) is one of the better mutual fund Web resources.  You find Morningstar's well-known research reports on individual funds, which feature long-term performance data and graphs, risk ratings, manager profiles, information on fees, and a list of discount brokers who sell the fund.  Surprisingly, considering that Morningstar was built on the basis of research and no advertising, the mutual fund companies with their banner advertisements at the top of every page pay for this Web site. 

The site also features articles on advanced concepts of fund investing and developments in the fund industry.  For $179 per year, a premium membership gives you online access to more fund information and tools. 

T. Rowe Price

On this site (www.troweprice.com), you can find some of the best retirement-planning tools available — for individuals saving for retirement, as well as for those already in or near retirement.  Interactive worksheets can help you determine which type of IRA may be best for you to invest through. 

This site also has a good selection of articles on various fund-investing topics as well as interviews with leading fund managers at the company.  Should you invest in any of T. Rowe Price's solid mutual funds, the Web site provides convenient access to your account information. 

Securities and Exchange Commission

Although the government's Securities and Exchange Commission (SEC) Web site is far from being the most user-friendly one, it contains a truckload of the required documents that all funds must file with this agency, whose purpose is to oversee the investment industry.  The EDGAR database enables you to access documents that mutual funds have filed with the SEC at www.sec.gov/edgar/searchedgar/webusers.htm. 

To look at a particular fund's documents on file with the SEC, simply choose the general-purpose search option for companies and other filers.  The site then provides a few different ways to search, but the easiest is to enter as much of the fund's name as possible — don't use abbreviations or acronyms — in the company-name search box.  If the fund name you provide is associated with more than one particular fund (for example, if you simply type Vanguard), a list of choices appears from which you can choose.  After you narrow it down to the particular fund you're looking for, you get a laundry list of all the documents that the fund has filed with the SEC in recent years. ( The most recent filings will be at the top of the screen.) 

Vanguard.com

Among the fund company Web sites that I've examined, Vanguard's (www.vanguard.com) is unsurpassed.  In addition to housing an extensive online library of brochures on important fund-investing topics, this site also boasts numerous planning tools.  For example, you can calculate how much to save for retirement or determine whether to convert your regular IRA into a Roth IRA. 

Vanguard's Web site also enables you, if you so desire, to track and manage your investments in one central location.  You can buy and sell mutual funds from hundreds of fund companies, stocks, bonds, and many more investments all in one account. 
Part VI

The Part of Tens

In this part . . . 

Why include lists of ten-somethings?  Why not?  Life is all about priorities, and more than ten of anything is too many to remember.  Fewer than ten leaves you with that empty feeling you have after eating a hearty plate of bean sprouts for lunch.  So — ten it is.  Like Goldilocks, here you get just the right amount of information about some important fund concepts and concerns. 
Chapter 22

Ten Common Fund-Investing Mistakes and How to Avoid Them

In This Chapter

  Designing the right plan for you

  Keeping taxes and fund fees in mind

  Staying away from shady advisers and market predictors

From getting your finances in order to selecting funds to maintaining your portfolio over time, various potholes and dangers can get in your way.  This chapter highlights the ten most common fund-investing mistakes you're likely to make and how you can sidestep them. 

Lacking an Overall Plan

Just as you shouldn't build a house without an overall plan, you shouldn't start buying funds until you have your arms and mind wrapped around a sound financial plan.  The plan doesn't have to be a fancy, professionally or computer-generated one, but it should include the basics:

  Proper insurance coverage, like health, disability, auto, home, excess liability if you hold sufficient assets, and life insurance if others depend on your income

  A plan for paying off consumer debt on credit cards and auto loans, if you have any

  Savings goals for retirement, buying a home, starting a business, putting your kids through college, and anything else your heart desires

  An overall asset allocation — what portion of your money should be invested in different assets, such as stocks (foreign versus domestic), bonds, and so on

Failing to Examine Sales Charges and Expenses

Would you ever buy a car without considering its sticker price?  How about checking out the car's safety record and insurance costs?  Mutual funds are like cars in one respect — you should check under the hood before you buy.  But the good news is that fund fees are actually a lot easier to comprehend compared to the various car costs. 

Before you consider buying any mutual fund, be sure you understand precisely any sales charges as well as the fund's ongoing operating expense ratio.  Over the long term, a fund's fees are one of the biggest (and most predictable) determinants of the fund's likely future returns.  This point is especially true with boring old money market and conservative bond and stock funds.  Please see Chapter 7 for more on fees. 

Chasing Past Performance

Before anyone hires a job applicant, he likes to know that person's track record.  Ditto for professional sports teams seeking new players.  Of course, when hiring a money manager, which is what you're doing when you invest in a mutual fund, you should examine that manager's prior experience.  However, many investors simply throw money at funds currently posting high returns without thoroughly examining a fund manager's experience. 

More often than not, current hot funds cool off (especially as small funds get larger and market conditions change), and many underperform in the future.  The reason is quite simple: The market forces that lead to the relatively brief period of high performance inevitably change.  Peruse Chapter 7 for how to avoid tomorrow's losers and maximize your chances of picking a consistent winner. 

Ignoring Tax Issues

Do you know your current federal and state income tax brackets?  When a particular type of stock or bond fund makes a dividend or capital gains distribution, do you know what rate of tax you'll pay on that? 

Many fund investors aren't well informed when it comes to the tax consequences of their fund purchases and sales.  Although you don't want the tax tail to wag the fund selection dog, you should know how taxes work on your funds and which funds fit best for your tax situation.  See Chapter 10. 

Getting Duped by "Advisers"

Some people want to hire a financial adviser to help them navigate financial choices.  But many so-called financial consultants or advisers have serious conflicts of interest.  Their recommendations and objectivity are tainted by commissions earned from products that they sell or from their money-management services. 

If you seek to hire a financial planner/adviser, it's a good rule of thumb to hire someone who's selling his time and nothing else.  If what you're really looking for is someone to manage your money, seek out a money manager.  See Chapter 24. 

Falling Prey to the Collection Syndrome

Some people buy mutual funds the way they build a clothing collection.  Visits to different stores and articles recommending specific items lead to purchases.  Before you know it, you may own numerous funds that don't really go together well. 

This mismatching is another reason you should develop your overall plan first.  For example, after you decide that you're going to invest, say, 20 percent of your retirement plan money into international stock funds, then you can set out to identify and then invest that amount of money into your chosen foreign funds.  Check out Chapter 10, which provides a guide to putting together a sound portfolio that matches your needs. 

Trying to Time the Market's Movements

Just as no one enjoys losing a game, who wants to invest in a fund only to see it fall in value?  Sometimes, though, that may happen even though you've done your homework and selected a good fund. 

Stock and bond funds fluctuate in value, and you must accept that inevitability when you invest.  Some people like examining pricing charts online to guess when a fund is about to turn around and increase in value.  Don't waste your time on such unproductive and time-consuming endeavors.  Identify good funds, buy into them over time, and don't jump in and out. 

Following Prognosticators' Predictions

Don't make the mistake of believing that some supposed expert bold enough to make financial market forecasts on television, on radio, or in print actually has any proven talent to do so.  Such blustery babblings are merely for the publicity of a given firm or individual. 

Your long-term goals and desire or lack thereof to accept risk and volatility in your investments should drive your fund selection.  Please read Chapter 20 to discover how to use information, not predictions, in building a winning fund portfolio. 

Being Swayed by Major News Events

You're human and have emotions.  September 11, 2001, was a horrible day for Americans (and many other people around the world) that caused some people to panic and sell investments when the financial markets reopened.  Similar emotions and reactions happened during the 2008 financial crisis/panic.  Wars, oil price spikes, large corporate layoffs, the latest retail sales and consumer confidence reports, and Federal Reserve meetings and interest rate changes are but a few of the news reports that can move the markets. 

Don't make your investing decisions based on the news of the day.  The only action you should consider taking if doom and gloom are in the air is to consider using some of your spare cash and buying when a sale is going on. 

Comparing Your Funds Unfairly

While teaching adult courses and working with clients as a counselor, I've witnessed many people who were disenchanted with otherwise good funds.  Often this effect was the result of their knowledge that other funds, often seeming similar on the surface, were doing better.  Perceptions changed when these people found out that the other funds weren't holding the same types of securities and that their funds were actually doing fine compared with a relevant market index (see Chapter 17). 

Don't be quick to assume that your funds aren't doing well simply because they've gone down recently or are producing lower returns than some other funds.  Compare them fairly over a long enough period (years, not months or weeks) and then decide. 
Chapter 23

Ten Fund-Investing Fears to Conquer

In This Chapter

  Avoiding the tendency to predict (and the anxiety that comes with it)

  Learning to relax and watch your investments grow over time

Experiencing the worries that I identify in this chapter is a sign that you're a normal person.  But these concerns are also something I want you to overcome.  When you do, you're well on your way to avoiding common painful and costly fund-investing blunders and oversights. 

Investing with Little Money

You have to start somewhere.  People with less to invest actually benefit more from mutual funds than investors with heftier balances (although those investors benefit a lot as well).  With just several hundred or a few thousand dollars to invest, you can't diversify well or avoid commissions that gobble a significant percentage of what you have to invest when you buy individual securities.  By investing in mutual funds, you can invest efficiently. 

If you invest money for the longer term, especially inside retirement accounts, start with a hybrid fund or a fund of funds.  Some of these funds have low minimum initial investment requirements of $1,000, and they'll go even lower — $50 — if you sign up for an automatic investment plan that regularly makes electronic withdrawals from your bank account. ( See the examples in Chapter 15.)  Invest just $1,000 today in good mutual funds and add just $50 per month.  With funds that average a 10 percent annual return, in 20 years you'll have about $44,000!  Invest over 40 years, and you'll have about $336,000.  If you can manage $100 per month rather than $50, you'll have about $82,000 in 20 years and $628,000 in 40 years! 

Investing in Uninsured Funds

Lack of insurance (think FDIC on bank accounts) isn't what makes funds risky.  Mutual fund risks are driven by the price changes of the securities, such as bonds and stocks, that they invest in.  Unlike banks and insurance companies, mutual funds can't go bankrupt (see Chapter 2).  Funds that invest in municipal bonds may have insurance against the default of the bonds.  Otherwise, insurance isn't necessary or available for funds. 

Don't overlook other not-so-obvious types of risk.  Bank accounts don't carry the price risk, or volatility that bond and stock mutual funds do.  However, bank accounts are exposed to the risk that the value of your money may not grow fast enough to keep ahead of inflation and taxes. 

  If you don't like significant volatility, even with money you've earmarked for long-term purposes, invest more of your money in balanced or hybrid funds.  These funds tend to mask the volatility of their individual stock and bond components because they're all mixed together (see Chapter 13). 

Rising Interest Rates

After a lengthy period of declining and stable interest rates, speculation inevitably surfaces about when interest rates will rise.  This spooks not only some bond investors but also stock investors.  Rates rarely rise when they're widely expected to and even when they do rise, it's nearly impossible to know how significantly rates will increase and what, if any, impact that will have on the bond and stock markets. 

  The financial markets tend to lead these sorts of economic changes.  The stock market, for example, often peaks six months to a year before the economy does.  Conversely, stock prices usually head back up in advance and in anticipation of an actual economic recovery.  Interest rates and bond prices typically have the same kind of interaction.  For example, by the time everyone's talking about the damage to the bond market from rising interest rates, the bond market has usually hit bottom. 

Missing High Returns from Stocks

Perhaps you've read about how investment legends like Peter Lynch and Warren Buffett make wise stock picks, so you figure that if you do what they do, you can, too. ( After all, numerous books out there say that you can.)  Nothing personal, but it isn't going to happen.  You're probably a part-time amateur, at best.  If you enjoy playing pickup basketball games, it'd be fun, if somewhat humbling, to play against greats like Kobe Bryant and Lebron James.  But I assume that you'd play these stars for the fun of it instead of in an expectation or vain hope of beating them.  Buying individual stocks is the same — don't do it thinking that you'll beat the better mutual fund managers. 

  Don't fool yourself into thinking that you're an expert just because you know more than most people about a particular industry or company.  Many others have this knowledge, and if you have truly inside information that a company is about to be acquired, for example, and you invest your money based on this insider knowledge, you can end up with a large fine or jail sentence or both. ( See Chapter 4 for a thorough discussion about investing in stocks of your own choosing.) 

Waiting to Get a Handle on the Economy

Although I don't advocate sticking your head in the sand, the big-picture economic issues such as interest rates, employment, corporate profits, trade agreements, and tax and budget reform are well beyond your (or, really, anyone else's) ability to accurately forecast.  Besides, investors' expectations are already generally reflected in the prices of securities in the financial markets. 

  Read about, listen to, and absorb what's going on in the world.  But don't use this noise of the day to help make your investing decisions.  You should determine your investment portfolio by considering your financial situation, your personal goals, and your plans for the future (see Chapter 10). 

Buying the Best-Performing Funds

Most people want to jump on board the winning bandwagon.  But the best performers all too often turn into tomorrow's mediocre or loser funds (see Chapter 7).  Look at what happened in the early 2000s to the high-flying funds that focused on technology and Internet stocks during the late 1990s.  The same thing happened with the seemingly unstoppable financial companies in the late 2000s. 

  The types of securities that do best inevitably change course.  You may actually increase your chances of fund-investing success by minimizing exposure to recent hot performers and investing more into fund types that are currently depressed but otherwise fundamentally sound. 

Waiting for an Ideal Buying Opportunity

Some stock market investors like the idea of waiting for a big drop before they start investing.  This strategy seems logical, especially coming on the heels of years of advancing prices or if a major decline happened in the recent past.  It also fits the philosophy of buying when prices are discounted.  The problem is, how do you know when the decline is over?  A 10 percent drop?  How about after 20 or 30 percent?  If you're waiting for a 20 percent drop and the market only drops 15 percent before it then rises 100 percent over the coming years, you'll miss out.  If you're waiting for a 40 percent decline, will you really have the courage to invest if that happens? 

  Especially if you're just starting to save and invest money, invest regularly so that, if prices drop, you'll buy some at lower prices.  That way, if prices don't decline, you won't miss out on the advance.  If you have a large amount of money awaiting investment, move it gradually (dollar-cost averaging) — a portion every month or quarter over a year or two into different types of funds (see Chapter 10). 

Obsessing Over Your Funds

There's a big difference between monitoring and obsessing.  You don't need to follow the daily price changes of your mutual funds, which is an incomplete and often misleading way to discern the amount of return from your fund.  In addition to share price changes, you must take into account dividend and capital gains distributions when you calculate a fund's performance (see Chapter 17). 

  Tracking and hovering over your funds increases your chances of panicking and making emotionally based decisions.  The investors I know who bail out when prices are down almost always are the ones who follow prices too closely.  Keep your sights on the big picture — why you bought the fund in the first place and what financial goal you're trying to fulfill.  To reduce your risk and sleep soundly at night, diversify. 

Thinking You've Made a Bad Decision

Don't be so hard on yourself.  Invest in the funds that I recommend in this book and use good selection criteria in picking funds on your own.  Then, if one of your funds goes down, the decline is — 99 times out of 100 — because the types of securities it focuses on (for example, bonds, United States stocks, or international stocks) are down. 

  If, for example, your fund is down about 5 percent over the past year, find out how similar funds have done over the same time period.  If the average comparable fund is down more than 5 percent, you have cause to be happy; if comparable funds are up an average of 20 percent, you have reason to worry.  See Chapter 17 for some ground rules for deciding whether to dump or hold a laggard fund. 

Lacking in Performance

Stop looking at fund performance top-ten lists.  Most of these lists completely ignore risk.  Many of these lists rank funds based on short time periods.  The funds on top are constantly changing.  And no one knows which ones will be on next year's top-ten list. 

  If a fund is taking so much risk that it's in the top-ten list, then such a status also means that it's risky enough to end up in the bottom-ten list someday. ( See the examples in Chapter 7.)  The categories that are used in these types of lists are also flawed, because many of the funds aren't really comparable.  Read Chapter 17 to find out appropriate ways to evaluate and track the performance of your funds. 
Chapter 24

Ten Tips for Hiring a Financial Adviser

In This Chapter

  Knowing what services to expect and how much you pay

  Hiring someone you can count on

Hundreds of millions of people worldwide have successfully invested in mutual funds on their own.  Investing in mutual funds isn't difficult; common sense and an ounce of financial sense are all you need. 

  You have no compelling reason to hire a financial adviser in order to invest in mutual funds.  So if you jumped to this chapter first, stop!  I recommend that you march back to the earlier chapters.  You'll be better able to understand this chapter after you've read the ones that come before it, not to mention the fact that you'll be improving your ability to save yourself possibly thousands of dollars in financial advisory fees.  But if you've arrived here because you just don't want to deal with handling fund-investing or financial-planning decisions on your own, keep on keepin' on. 

Communicator or Obfuscator? 

In your preliminary meetings with a financial adviser, develop a sense and opinion about the person's ability to clearly communicate with you.  Take your time and speak with prospective advisers before deciding whom to hire.  Don't rush yourself or allow an adviser to pressure you into making a decision before you're ready and comfortable. 

Consider these questions: Does he clearly and patiently explain things or use a lot of jargon and talk down to you?  Is he forthright and candid or evasive? 

Financial Planner or Money Manager? 

As you search for help, you'll confront a variety of people who call themselves "advisers" and who're eager to assist you with investing and other financial matters.  People who claim to be advisers but who derive commissions from the products that they sell are salespeople (Chapter 9).  Keep this warning in mind as you consider the different types of people you could hire:

  Financial planner: True financial planners generally provide objective help with issues, such as retirement planning, using and paying off debt, investing, insurance, and even real estate.  The charge for these services should be a fee based on the time involved.  A good planner should help restructure your financial situation before your money gets invested in funds.  If a planner provides specific fund recommendations, implement them on your own and save yourself ongoing advisory fees. 

  Money managers: Money managers or financial advisers who perform money management invest your money and charge you a fee — usually expressed as a percentage of assets under management (that's the money you turn over to them to manage).  Some advisers only do money management, but increasing numbers of financial planners offer money-management services as well.  Using money managers can make sense for people who've finished their planning and need someone to help manage their money.  Money managers argue that, because they devote themselves full time to investing, they're more adept at it. 

  Planner/money managers may be reluctant to recommend — and, in fact, have an incentive to ignore — strategies that deplete the money you have to invest.  The more you have to invest with them, the greater the fees they earn.  All the following financial moves result in less money that you can invest, so planners/money managers may not recommend these often-advisable paths:

  Paying down debt of all types, such as credit cards, auto loans, mortgages, business loans, and the like

  Maximizing saving through your employer's retirement savings plan(s)

  Purchasing real estate — either through buying a primary home or investing in rental property

  Buying and investing in your own business or someone else's privately held business

  Another problem with planners who also manage money is that they may be short on specific advice in the planning process.  Sadly, I've seen cases in which people paid planners thousands of dollars for a largely boilerplate, computer-generated financial plan and received little, if any, specific financial planning and investment advice.  If you want to invest in no-load funds, the planner should willingly and happily provide specific fund recommendations and help you build a portfolio for the fee that you pay her. 

Market Timing and Active Management? 

Much of what you're paying a planner for is the time spent reviewing your financial situation and matching your needs and goals to a suitable portfolio of funds.  If your needs and situation are relatively stable and you do your homework right the first time and select good mutual funds, you shouldn't need to make frequent changes to your portfolio. 

  If anything, constant tinkering with a portfolio tends to lower returns.  In Chapter 20, I cover this same issue on the perils of blindly following some newsletters' and gurus' timing advice to switch into this fund and out of that one.  Trading in nonretirement accounts also increases your tax burden. 

Who's in Control? 

If you hire a money manager, you should consider if the manager requires that you turn control of the account over to him.  Specifically, you'll sign or initial a form, as shown in Figure 24-1.  Here's the outline of the form:

  Line 1: Grants the adviser authority to execute trades in your account — otherwise known as granting a limited power of attorney. 

  Line 2: Gives your adviser power to move money out of your account.  I recommend against giving your adviser this power unless you need to withdraw money from your account frequently and find it more necessary to have your adviser do it for you. 

  Line 3: Allows your adviser to deduct his ongoing fees from the account.  Definitely do not allow this deduction to be taken from retirement accounts because it diminishes the amount of money that you have compounding tax deferred. ( But, unless you're already well into retirement and taking plan distributions, paying fees from your retirement account may be okay — you're paying with before-tax dollars that would otherwise be withdrawn and taxed.)  For nonretirement accounts, it's up to you, although many advisers insist on this feature to make collecting their fees easier. 

  Line 4: Requests the brokerage firm to send duplicate copies of your account statements and trade confirmations to your adviser.  That's acceptable and to be expected. 

**Figure 24-1:** Initialing this section gives the adviser control over investing your funds. 

Almost all money managers manage money on what's called a discretionary basis — they make decisions to buy and sell funds without your prior approval.  In other words, you're turning control over to them.  You find out about transactions after they've occurred, usually when you receive the trade confirmations in the mail and through your monthly or quarterly statement. 

  At a minimum, before you turn control over to the money manager, make sure that you discuss your investment objectives with him.  These overall goals should drive the way he manages your money. 

Fees: What's Your Advice Going to Cost? 

If you hire a planner on an hourly basis, expect to pay at least $100 per hour — you can easily pay more; planners with the $300+ per-hour billing rates tend to work exclusively with affluent clients. 

Fee-based money managers work on an entirely different basis.  See this fee schedule example:

Amount You Invest Fee Percentage Annual Fee

$1,000,000 1.10% $11,000

$2,000,000 1.00% $20,000

$5,000,000 0.90% $45,000

  What's amazing to me about this type of fee schedule is that, although the percentage charge declines slightly as the amount you invest increases, look at how the total charges increase.  This firm sends the same quarterly reports out to the client with $5 million invested, who pays $45,000 per year, as it does to the client with $1,000,000 invested, who pays $11,000 per year for the same service.  Advisers' fees are often negotiable.  The more you have to invest, the greater your ability should be to negotiate lower fees. 

  Also, ask what sort of transaction and other fees you have to pay in addition to the advisory fee paid to the money manager.  Most money managers ask that you establish an account at one of the discount brokerage firms, such as Schwab, Fidelity, TD Ameritrade, or with a mutual fund company.  Ask who they use and why.  If you're going to consider hiring a mutual fund money manager, add up all the costs.  Table 24-1 helps you do the job. 

Table 24-1 Adding Up All the Costs

---

Cost | Annual Percentage of Your Assets

Money manager's fee | For example, 1.0%

Operating fees on mutual funds invested in (Don't let the adviser say that she can't figure this amount because the funds she uses vary over time — she can base the calculation on her current portfolio or the amount she used over the past year.)  | For example, 1.0%

Transaction and other fees (Your adviser can convert these dollar expenses to a percentage.)  | For example, 0.2%

Total | For example, 2.2%

  Over the long haul, a diversified portfolio that's primarily invested in stocks has usually returned around 9 to 10 percent annually.  If you're paying a total of 2.5 percent to have your money managed, you're giving away 25 to 28 percent of your expected return.  And don't forget, because the IRS sure won't, that you'll owe taxes on your nonretirement account profits, so you're giving away an even greater percentage of your after-tax returns. 

How Do You Make Investing Decisions? 

Throughout this book, I discuss the good and bad ways people can and have invested in mutual funds over the years (Chapter 7, in particular).  The process isn't rocket science — it can be as simple as picking any other product or service.  You want value — where can you invest in funds that meet your needs and that are managed by a fund company and fund managers that have good track records and that charge competitive fees.  Most advisers try to factor their economic expectations and prognostications into their investment strategies.  But this is much easier said than done. 

  The fundamental problem with some money managers is they try to convince you that they have a crystal ball.  Specifically, some claim (explicitly or implicitly) that they can time the markets, that they'll get you out of the market before it falls and put your money back in time for the next rise.  Over long time periods, beating the markets is virtually impossible, even for acknowledged experts (see Chapter 20).  Great investors, such as Warren Buffett and Peter Lynch, say you can't time the markets.  Believe 'em! 

What's Your Track Record? 

  Mutual fund companies must have their performance records audited and reviewed by the United States (U.S.) Securities and Exchange Commission (SEC).  Most also provide an independent auditor's report.  Private money managers face no such SEC requirement.  Few provide independent audits.  Of course, you really want to know the performance facts about the money manager who you're considering for ongoing management of your funds.  What rate of return has he earned year by year?  How has he done in up and down markets?  How much risk has he taken, and how have his funds performed versus comparable benchmarks (see Chapter 17)?  These are important questions.  Getting objective and meaningful answers from most investment advisers who manage money on an ongoing basis is difficult. 

  Money managers play a number of marketing games to pump themselves up.  If all the money managers are telling the truth, 99 percent of them have beaten the market averages, avoided major market plunges over the years, and just happened to be in the best-performing funds last year.  Money managers pump up their supposed past performance to seduce you into turning your money over to them through common marketing ploys:

  Select accounts: If you can get the money manager to give you performance numbers and charts, too often an asterisk refers you to some microscopic footnote somewhere.  If you have a magnifying glass handy, you can see that the asterisk states something like select or sample accounts.  What this term means, and what they should've said instead is "We picked the accounts where we did best, used the performance numbers from those, and ignored the rest." ( Interestingly, using smaller type in this way is a violation of SEC regulations.)  Advisory firms also may select the time periods when they look best.  Finally, and most flagrantly, some firms simply make up the numbers (such as Bernie Madoff did). 

  Free services: Some money managers will produce performance numbers that imply that they're giving their services away.  Remember, money managers charge a fee (a percentage of assets) for their services — they are required to show your returns net of fees [or after fees have been deducted] to clearly show the amount that, as an investor using their services, would've made.  Because most money managers place their fund trades through discount brokers who charge transaction fees, they must deduct these fees from returns as well. 

  Bogus benchmarks: Some money managers make their performance numbers higher than they really are; some also try to make themselves look good in relation to the overall market by comparing their performance numbers to inappropriate benchmarks.  For example, money managers who invest worldwide (including in international stocks) may compare their investment performance only to the lowest-returning U.S.-based indexes. 

  Switching into (yesterday's) stars: Money managers don't want to send out updates that show that they're sitting on yesterday's losers and missed out on yesterday's winners.  So guess what?  They may sell the losers and buy into yesterday's winners, creating the illusion that they're more on top of the market than they are. ( Some newsletters also engage in this practice.)  This strategy, known as window dressing, is potentially dangerous because they may be making a bad situation worse by selling funds that have already declined and buying into others after they've soared (not to mention possibly increasing transaction and tax costs). 

What Are Your Qualifications and Training? 

An adviser should have experience in the investing or financial services field — generally, the more the better.  But also look for someone with intelligence and ethics who has good communication skills. 

Check out credentials but don't be overly impressed by some, such as the CFP (Certified Financial Planning) degree.  Too many planners with this "credential," which you can largely earn by taking a self-study course at home and then an exam, sell financial products.  Other common credentials include

  CFA (Chartered Financial Analyst): This credential means that the adviser knows how to analyze securities and investments and the fundamentals of portfolio management. 

  MBA (Master of Business Administration): An adviser with an MBA should've had coursework dealing with investments and finance.  Find out where he earned the MBA and check out the school's reputation. 

  PFS (Personal Financial Specialist): A PFS is a credential conferred on accountants who pass an exam similar to the CFP. 

  CLU (Chartered Life Underwriter) and ChFC (Chartered Financial Consultant): These credentials are for insurance and carry little, if any, value in advising on mutual funds.  These credentials may be a red flag that you're dealing with a salesperson or with someone who knows more about insurance than investments. 

The term Registered Investment Adviser denotes that the adviser is registered with the SEC; it means nothing as a professional credential. ( Smaller advisory firms with assets under management of less than $25 million generally register with state regulatory agencies.)  The SEC doesn't require a test; however, it does require that the adviser file Form ADV, also known as the Uniform Application for Investment Adviser Registration.  This document asks for specific information from investment advisers, such as a breakdown of the sources of their income, relationships and affiliations with other companies, each adviser's educational and employment history, the types of securities the firm recommends, and the firm's fee schedule. ( Many states require passing a securities exam, such as a Series 2, 63, or 65.) 

  In a pitch over the phone or in marketing materials sent by mail, an adviser may gloss over or avoid certain issues.  Although it's possible for an adviser to lie on Form ADV, it's likely that an adviser will be more truthful on this form than in marketing materials.  Ask the adviser to send you a copy of his Form ADV, or visit the SEC Web site at www.sec.gov.  You can also call them at (202) 551-8090 or fax your request to (202) 777-1027. 

What Are Your References? 

  Ask other people about how the adviser benefited them.  This process is one way to verify the rates of return the adviser may claim (although you're smart enough to recognize that the adviser will refer you to the clients who've done the best with her).  Also ask about the adviser's strengths and weaknesses. 

Virtually all money managers offer a free introductory consultation if you meet their minimum investment requirements.  Planners who work on commission also tend to offer free sessions.  So the "free" consultation ends up being a sales pitch to convince you to buy certain products or services. 

Busy advisers who charge by the hour usually can't afford to burn their time for a free in-person session, especially a lengthy one.  Don't let this deter you; this fee is probably a good sign.  These advisers should be willing, however, to spend a modest amount of time in person or on the phone answering background questions free of charge.  They should also send background materials and provide references if you ask. 

Do You Carry Liability Insurance? 

Some advisers may be surprised by the question of liability insurance or may think that you're a problem customer looking for a lawsuit.  On the other hand, if your adviser gets you into some disasters, you'll be happy you have the insurance coverage.  Financial planners and money managers should carry liability insurance (sometimes called errors and omission insurance).  This coverage provides you (and the adviser) with protection in case a major mistake is made for which the adviser is liable. 
Appendix

Recommended Fund Companies and Discount Brokers

Artisan Funds

800-344-1770 www.artisanfunds.com

Cohen & Steers Capital Management Inc.

800-330-7348 www.cohenandsteers.com

Dodge & Cox Funds

800-621-3979 www.dodgeandcox.com

The Fairholme Fund

866-202-2263 www.fairholmefunds.com

Fidelity Brokerage

800-544-6666 www.fidelity.com

Fidelity Funds

800-343-3548 www.fidelity.com

Harbor Funds

800-422-1050 www.harborfunds.com

Masters' Select Funds

800-960-0188 www.mastersselect.com

The Oakmark Funds

800-625-6275 www.oakmark.com

Sequoia Fund

800-686-6884 <http://www.sequoiafund.com>

T. Rowe Price Brokerage

800-225-7720 www.troweprice.com

T. Rowe Price Funds

800-638-5660 www.troweprice.com

TD Ameritrade

800-454-9272 www.tdameritrade.com

TIAA-CREF

800-223-1200 www.tiaa-cref.org

Tweedy, Browne Funds

800-432-4789 www.tweedybrowne.com

USAA Funds

800-382-8722 www.usaa.com

Value Line Funds

800-223-0818 www.vlfunds.com

Vanguard Brokerage

800-992-8327 www.vanguard.com

The Vanguard Group

800-662-7447 www.vanguard.com

# Personal Finance Bundle For Dummies®

**Table of Contents**

Personal Finance Bundle For Dummies

> Personal Finance For Dummies
>
>> Table of Contents
>> 
>> Introduction
>> 
>> Chapter 1: Improving Your Financial Literacy
>> 
>> Chapter 2: Measuring Your Financial Health
>> 
>> Chapter 3: Managing Where Your Money Goes
>> 
>> Chapter 4: Establishing and Achieving Goals
>> 
>> Chapter 5: Dealing with Debt
>> 
>> Chapter 6: Reducing Your Spending
>> 
>> Chapter 7: Trimming Your Taxes
>> 
>> Chapter 8: Considering Important Investment Concepts
>> 
>> Chapter 9: Understanding Your Investment Choices
>> 
>> Chapter 10: Investing in Funds
>> 
>> Chapter 11: Investing in Retirement Accounts
>> 
>> Chapter 12: Investing in Taxable Accounts
>> 
>> Chapter 13: Investing for Educational Expenses
>> 
>> Chapter 14: Investing in Real Estate: Your Home and Beyond
>> 
>> Chapter 15: Insurance: Getting What You Need at the Best Price
>> 
>> Chapter 16: Insurance on You: Life, Disability, and Health
>> 
>> Chapter 17: Covering Your Assets
>> 
>> Chapter 18: Working with Financial Planners
>> 
>> Chapter 19: Using a Computer to Manage Your Money
>> 
>> Chapter 20: On Air and in Print
>> 
>> Chapter 21: Survival Guide for Ten Life Changes
>> 
>> Chapter 22: Ten Tactics to Thwart Identity Theft and Fraud
>> 
>> Chapter 22: Ten Tactics to Thwart Identity Theft and Fraud
> 
> Investing For Dummies
>
>> Table of Contents
>> 
>> Introduction
>> 
>> Chapter 1: Exploring Your Investment Choices
>> 
>> Chapter 2: Weighing Risks and Returns
>> 
>> Chapter 3: Getting Your Financial House in Order before You Invest
>> 
>> Chapter 4: The Workings of Stock and Bond Markets
>> 
>> Chapter 5: Building Wealth with Stocks
>> 
>> Chapter 6: Investigating and Purchasing Individual Stocks
>> 
>> Chapter 7: Exploring Bonds and Other Lending Investments
>> 
>> Chapter 8: Mastering Mutual Funds
>> 
>> Chapter 9: Choosing a Brokerage Firm
>> 
>> Chapter 10: Investing in a Home
>> 
>> Chapter 11: Investing in Real Estate
>> 
>> Chapter 12: Real Estate Financing and Deal Making
>> 
>> Chapter 13: Assessing Your Appetite for Small Business
>> 
>> Chapter 14: Starting and Running a Small Business
>> 
>> Chapter 15: Purchasing a Small Business
>> 
>> Chapter 16: Selecting Investing Resources Wisely
>> 
>> Chapter 17: Perusing Periodicals, Radio, and Television
>> 
>> Chapter 18: Selecting the Best Investment Books
>> 
>> Chapter 19: Investigating Internet and Software Resources
>> 
>> Chapter 20: Ten Investing Obstacles to Conquer
>> 
>> Chapter 21: Ten Things to Consider When Weighing an Investment Sale
>> 
>> Chapter 22: Ten Tips for Investing in a Down Market
> 
> Mutual Funds For Dummies
>
>> Table of Contents
>> 
>> Introduction
>> 
>> Chapter 1: Making More Money, Taking Less Risk
>> 
>> Chapter 2: Mutual Funds: Pros and Cons
>> 
>> Chapter 3: Funding Your Financial Plans
>> 
>> Chapter 4: Selecting Your Own Stocks and Bonds
>> 
>> Chapter 5: Exchange-Traded Funds and Other Fund Lookalikes
>> 
>> Chapter 6: Hedge Funds and Other Managed Alternatives
>> 
>> Chapter 7: Finding the Best Funds
>> 
>> Chapter 8: Using Fund Publications
>> 
>> Chapter 9: Buying Funds from the Best Firms
>> 
>> Chapter 10: Perfecting a Fund Portfolio
>> 
>> Chapter 11: Money Market Funds: Beating the Bank
>> 
>> Chapter 12: Bond Funds: When Boring Is Best
>> 
>> Chapter 13: Stock Funds: Meeting Your Longer Term Needs
>> 
>> Chapter 14: Specialty Funds: One of a Kind
>> 
>> Chapter 15: Working It Out: Sample Portfolios
>> 
>> Chapter 16: Applications, Transfers, and Other Useful Forms
>> 
>> Chapter 17: Evaluating Your Funds and Adjusting Your Portfolio
>> 
>> Chapter 18: The Taxing Side of Mutual Funds
>> 
>> Chapter 19: Common Fund Problems and How to Fix Them
>> 
>> Chapter 20: Fund Ratings and Forecasters
>> 
>> Chapter 21: Harnessing Your Computer's Power
>> 
>> Chapter 22: Ten Common Fund-Investing Mistakes and How to Avoid Them
>> 
>> Chapter 23: Ten Fund-Investing Fears to Conquer
>> 
>> Chapter 24: Ten Tips for Hiring a Financial Adviser
