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Financial Peace University Lesson 9 – Of Mice and Mutual Funds

December 11, 2009 · Filed Under Financial Peace University · 7 Comments 

Understanding Investments

This week we listened to Dave Ramsey discuss various types of long-term investments.  For long-term wealth building, putting your money in a standard bank account is just not going to cut it.  You need to use some other vehicle that will outpace inflation and enable you to end up with more money than you start with.  If you don’t need access to your money for at least five years, then that money can be invested instead of just saved.

Keep it simple, stupid!

Besides the statement directly above, Ramsey provided a few more rules for investing:

  • Never invest purely for tax savings
  • Never invest using borrowed money (that certainly should not shock anyone!)

Diversification is the most important tip

Diversification means to “spread around” and it lowers your overall risk.  Ramsey presented an interesting example in the workbook.  Imagine two different investors.  The first puts $10,000 into a investment that earns 7% interest for 25 years.  The second puts $2,000 dollars into five different investments and earns the following returns over the 25 years: loses all $2,000, 0% (under mattress), 5%, 10%, 15%.  Maybe surprisingly, at the end of 25 years the second investor will have almost $59,000 more!!

A (very) basic primer on investments

Remember that all investments carry different degrees of risk and that as risk increases so does the potential rate of return.  Liquidity is the ease with which you can access your money (cash is very liquid while equity in a house is not very liquid at all).  Conversely to risk, as there is more liquidity, there is typically less potential return.  Finally, remember that there are two types of risk to consider for an investment – the investment risk itself (if I buy that Enron stock, is there a chance it will go down in value?) and inflation risk as it eats away at your money over time.

Different types of investments

Ramsey spent the remainder of the class touching on a few of the various types of investments out there.  I will just highlight some of those he mentioned.

  • Single Stocks – This is small piece of a company that you own.  You gain a return when the value of the company increases or when they pay you some of their profit (dividend).  These are extremely risky and should be kept to less than 10% of your net worth.  Ramsey does not own any individual stocks.
  • Bonds – This is debt that you lend to a company.  Your return is the interest rate that the company pays you and the fluctuation in the price of the bond.  Ramsey does not own any individual bonds either.
  • Mutual Funds – An investment where many people put money into a pool to buy a bunch of different stocks providing diversification.  The pool is is usually managed by a professional portfolio manager.  Mutual funds are a good long-term investment and Ramsey does own shares of a number of funds.
  • Rental Real Estate – This is a good investment (Ramsey does own paid-for rental real estate) but he suggests that you have a lot of cash before getting involved with real estate investing.  His recommendation is to buy slowly with cash only.  Also, a reminder from him is that your money is made at the purchase – so be patient and only buy big bargains.

Bad Investments

Ramsey does not recommend the following investment vehicles (in fact, he warns to stay far away from them):

  • Gold
  • Commodities & Futures
  • Day Trading
  • Viaticals

Dave’s suggested mutual fund portfolio

Ramsey suggested creating a diversified long-term portfolio by purchasing different mutual funds in the following proportions:

  • 25% Large-cap mutual funds (growth & income)
  • 25% Mid-cap mutual funds (growth)
  • 25% Small-cap mutual funds (aggressive growth)
  • 25% International mutual funds

“Cap” means the capitalization of a company which means how big the company is.  So, a large-cap mutual fund owns companies like IBM and/or GE.  By purchasing a few different mutual funds to create a similar portfolio, you are able to reduce your risk (relatively).  To recap: putting all your money into some shares in a single company is very risky, purchasing a mutual fund is much less risky, and purchasing a diversified set of multiple mutual funds is even less risky.  Again, the term “risky” is all relative as we have seen over the past year as all types of funds decreased in value.  So, remember that investing in stocks and mutual funds is a long-term endeavor!

A good tip or two

Ramsey concluded the class by giving out the following two tips:

  • If you don’t understand the workings of an investment well enough to be able to teach it to someone else, then you don’t understand it well enough to buy it!
  • Build wealth slowly – Don’t look for short-cuts; remember who wins in the tortoise and the hare story (hint – it’s the turtle).

One other point out of our discussion

Right at the end of class during our discussion, someone asked the following question – “When was this video made?” I couldn’t really hear what he asked and his comments after the question (everyone was starting to pack up and leave) during class, so I asked my wife. His point was to insinuate that Ramsey would have changed the video after what happened in the US stock market since late 2008. I remarked to her, “So he kinda missed the entire point of the lesson then?”

Here’s a reminder from me (not Dave Ramsey though he might say the same thing): You don’t change long-term strategy based on transient short-term events. Ramsey tried to explain this during class when he took a number of events that caused a significant market drop and showed that in almost every case the market had recovered within a year of the triggering event.  Remember, the market does go up and it does go down too; thus it is possible that your investments will also go down (not just up).  That is why it is important to view investing as a long-term process.  If you need that money in the near-term, the market is not a good place to put it (Remember the five-year rule).

Check out my previous FPU posts:

Repeat After Me: Do NOT Panic!

October 10, 2008 · Filed Under Investing · 6 Comments 

In case you haven’t noticed, the stock market hasn’t been doing so well lately.  And after another precipitous drop yesterday, a lot of people are very concerned.  So what is the best course of action to take under these current conditions?

There are two ways to look at the current situation

1. This is the end: the US economy is crumbling, the market will never recover, everyone will lose his/her job, and no one will have any money.

2. This is a painful but temporary disruption: things will be hard for a while but the market will eventually recover.  Start by looking at the history of the US stock market – it has always recovered in the past, right?  Isn’t the market higher than before The Great Depression, or the Savings & Loan Crisis, or the tech-market crash of the early 2000’s?

If you think the economy and the stock market will recover (eventually), then you should not do anything rash.  It’s time to take a deep breath (maybe even stop listening to all the talking heads screaming "PANIC!") and sit tight.

Remember, the goal is to buy low and sell high

If you were going to get out of the market, you should have already done it.  It’s too late to take action now – all you’d be doing is following the strategy of buying high and selling low.

If you are a long-term, buy and hold investor and you believe that #2 above is the current reality, then the best course of action is to do nothing. Actually, you might want to consider buying more now that stocks are "on sale."  As of this writing, the major US indices are all approximately 40% off of their recent highs of about a year ago.  If you believe they will recover, that sounds like a good bargain to me.

For a buy and hold investor, having an appropriate asset allocation is the best strategy to ride through situations like this, not jumping into and out of the market in an emotional frenzy.  In fact, if you still have a number of years before retirement, the current events might even be viewed as good for you.  I believe it was Alan Greenspan who stated in his book, The Age of Turbulence , that a prolonged recession early in a working career was actually good for building a comfortable retirement nest egg.  That person is able to purchase many more shares of stocks or mutual funds due to the lower prices and see them appreciate when the market finally recovers.

What is Warren Buffet doing?

Warren Buffet has a quote that I feel applies very well to the current situation:

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." Warren Buffet

It certainly seems that now is a time when everyone is fearful…and as you would expect, Buffet seems to be out buying (He recently invested $3 billion in GE , for instance).  Since his net worth exceeds most people’s by a few billion or so, I’d tend to follow his advice before that of all those on TV screaming about how bad everything is right now.

My disclaimer

Now, I certainly don’t know what the absolute best course of action is in the current economic climate (no one does).  But I will tell you that I am following the advice I put forth here (I’m not like one of the professional mutual fund managers who have their own money investing in index funds).  I have not removed any money from the market and, in fact, I just signed up to have Vanguard put a few hundred of my dollars into some of their index funds each month (and after reading about the 40% off sale…I’m very tempted to find some more money to put into mutual funds).

What about someone close to retirement?

Now, if you are close to retirement or in retirement and have all or most of your money in the stock market, then unfortunately I don’t have too much good advice for you.  After a disaster strikes is not the best time to create a strategy to deal with the disaster – it would have been much better to plan for a possible economic meltdown beforehand by diversifying your assets among stocks, bonds, cash, etc.

What to do now is a much tougher question for someone who needs the money sooner.   The real question is "what is the market going to do next?"  Is it going to go down more?  Are we at the bottom?  Will it recover and, if so, how quickly?  Unfortunately these are very difficult questions to answer (well, they’re easy to answer just not easy to answer correctly).  Whatever course of action you decide to follow, be cautious – if you get out now, make sure you don’t miss the market as it starts to go back up or you’ll be worse off than if you did nothing now.  It would be great if you could withdraw your money now and get back in at the bottom, but even the pros have a very, very hard time doing that.  In fact, if you were a good enough investor to be able to do that, you would have taken your money out of the market about a year ago.

Emotion does not mix with investing

I’m really sorry that I don’t have a good answer for you.  The one piece of advice I would give is do not panic or act out of emotion .  If you decide to pull your money out of the stock market, do so because you have calmly and rationally decided that is the best course of action and not because all the TV personalities are screaming "panic! calamity! sell!"

As for me (someone with a number of years before retirement), I think it’s time to follow Buffet’s advice and get a little greedy.

Photo Credits: nate steiner

Book Review: The Bogleheads’ Guide to Investing – Part 1

September 18, 2008 · Filed Under Book Reviews · 2 Comments 

By Taylor Larimore, Mel Lindauer, and Michael LeBoeuf

BFN Book Reviews

Here at BFN, I have been periodically reviewing personal finance books. In each review, I provide a brief overview of the book and the author(s), touch on the good and bad in the book, and give you my personal recommendation for whether you should borrow the book, buy the book, or neither. This is a fairly thick book with a lot of useful information so I am not going to be able to cover it in a single post. This will be Part 1 and Part 2 will follow soon after.

What is this book about?

Don’t be fooled by the title, though this is a book about investing, it contains much more than just investment advice. The authors do spend the bulk of their time discussing and educating the reader on the various aspects of investing. However, they also touch on other related topics such as financial lifestyle, insurance, estate planning, etc.

Who are the authors?

Not only are the authors "Bogleheads," but Taylor Larimore is actually the founder of the Bogleheads. Co-authors Mel Lindauer and Michael LeBoeuf also spend a lot of time reading and responding to posts on the Bogleheads forum hosted at . At this point, you might be asking, "What is a Boglehead? " (good question!) A Boglehead is a person who shares the investment philoshophy espoused by John Bogle, the founder of The Vanguard Group. In a nutshell, that philosophy is based on investing in a diversified manner with very low cost investments. (yes, that picture on the cover is John Bogle’s head)

What are the best parts of the book?

There is a great deal of useful and interesting information in this book. I really enjoyed reading it. I felt like I learned much about the stock market and especially mutual funds as a result. I’d heard how important mutual fund costs were to a portfolio, but really learned the "why" in this book. I can’t really go into too much detail on all of what they wrote in the book (it is going to take multiple posts as it is!), so I will present the information and you can check out the book if you want a more detailed treatment of each topic.

The authors start out by pointing out why investing is different than the rest of life by claiming that the following statements are NOT true for investing:

  • If you don’t know how to do something, hire an expert

  • You get what you pay for

  • If there’s a crisis, take action!

  • The best predictor of future performance is past performance

These are the investment principles that do work:

  • Choose a sound financial lifestyle – I covered their three financial lifestyles in a recent post.

  • Start early and invest regularly

  • Know what you’re buying

  • Preserve your buying power

  • Keep costs and taxes low

  • Diversify your stock portfolio

    • Diversify your stock risk with a bond portfolio

I thought it was a good idea for the authors to spend time discussing the importance of the extra-investing topics. Basically, the fundamental point is that the more you can do to free up money to invest, the more investment success you will have.

Chapters 1 & 2 focus on financial lifestyle and ways to spend less or make more money so you have more to invest. The following few chapters go into detail explaining what some of the common investments types are and how they work. These include various bonds (with an entire chapter on inflation protected bonds), mutual funds, ETFs, annuities, etc.

The investment part of the book starts in chapter 7. The authors, as you might expect, recommend using index funds as the core, if not the entirety, of your portfolio. The authors present the following list of why index funds are a great choice:

  • No sales commissions

  • Low operating expenses

    • A 1% difference makes an 18% difference in returns when compounded over 20 years

  • Many index funds are tax efficient

  • You don’t have to hire a money manager

  • Index funds are highly diversified and less risky than individual stocks

  • It doesn’t matter who manages the fund

  • Style drift and tracking errors aren’t a problem

Asset Allocation

Asset allocation is portrayed in this book as the cornerstone of successful investing. Some of the same theory is discussed in another book recently reviewed at BFN, The Intelligent Asset Allocator . The authors reference a 1986 study of pension plans by Brinson, Hood, & Beebower that found the following:

  • Allocation between stocks, bonds, and cash determined 93.6% of the variability of the studied pension plans’ returns
  • Manager’s attempts to actively manage their fund cost the average fund a 1.1% reduction in return compared to the indexes

Costs Matter

How is it possible that professional money managers actually cost their funds money, you ask? To borrow (and alter) a phrase, "It’s the costs, stupid!" The authors reference another study that found the expense ratio is the only reliable predictor of future mutual fund performance. Also, there are a number of hidden costs that investors never hear about in a mutual funds’ prospectus:

  • Hidden Transaction costs

  • Brokerage commissions

  • Soft dollar arrangements

  • Spread costs

  • Market impact costs

The investing takeaway from these chapters: buy a diversified mix of low-cost index funds in the context of an appropriate asset allocation. (you have to figure out your exact "appropriate" asset allocation yourself though there are some very general guidelines in the book)

That’s enough for one post

Ok, I’m stopping here for this post. I appreciate you sticking around as long as you did – and I’m only half way through the book! Update please check out part 2 of the review .

If you’re already sold on the book….

Want to borrow this book? Search your local library

Want your own copy? Buy this book now at

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Book Review: The Intelligent Asset Allocator

August 21, 2008 · Filed Under Book Reviews · Comment 

How to Build Your Portfolio to Maximize Returns and Minimize Risk

by William Bernstein, PhD, MD

BFN Book Reviews

Every Thursday I have been reviewing a personal finance book. I provide a brief overview of the book and the author, touch on the good and bad in the book, and finally, give you my personal recommendation for whether you should borrow the book, buy the book, or neither.

What is this book about?

As you probably have already figured out, this book is about investing and, specifically, asset allocation. The author discusses numerous investment concepts covering both theory and practical advice. Be warned, however, the information you read here will not be what you would hear from a typical financial advisor (well, maybe a fee-only one). The author presents this book as a guide to enable a normal person to construct and manage his/her own investment portfolio.

Who is the author?

William Bernstein is not a financial advisor or a wall street analyst. Instead, he is a neurologist. So, I’m not sure if that makes him less qualified or more qualified to write this book. He writes the book not as an expert in the field but as a person, probably like you and me, who desires to figure this investing stuff out for himself. Dismissing the typical wall-street wisdom and advice from self-serving brokers, his philosophy is that a normal person can do a good job of managing his/her own portfolio. Bernstein also maintains which provides investing and asset allocation resources.

What are the best parts of the book?

There is a great deal of theory in this book but it is also packed with really practical, useful information. Bernstein gives practical information and backs it up with statistical analysis. Here are some of the really valuable concepts that the author provided in this book (don’t worry – I won’t bother you with the statistics – you can read the book for that information)

  1. Effective portfolio diversification can increase return while reducing risk (diversification means creating a portfolio of multiple non-correlated or weakly correlated assets)
  2. Adding a small amount of stock to a bond portfolio increases return and reduces risk
  3. Adding a small amount of bonds to a stock portfolio significantly reduces risk while reducing return only slightly
  4. Favor short-term bonds (6 months to 5 years) rather than long term bonds
  5. Indexing is the best way to invest
    • One possible exception: Small-cap growth stocks
  6. Periodically re-balance your portfolio back to your target allocation
  7. Sticking to your target asset allocation through thick and thin is much more important than picking the right asset allocation
  8. Value investing typically returns more than growth investing (good companies make
  9. The market is not exactly a "random walk" – a good return this months means a slightly better than average chance of a good return next month.
  10. Dynamic asset allocation – changes in allocation that are purely market valuation driven are likely to increase return. Changes in response to economic or political conditions are a very bad idea.
  11. There are more expenses to an actively managed mutual fund than just the management expense fee disclosed in the prospectus:
    • Expense ratio
    • Commission ratio
    • Bid-Ask spread
    • Market-impact costs

The author also provides these key pieces of knowledge and advice as a final summary:

  1. Risk and reward are inextricably intertwined
  2. Those who do not learn from history are condemned to repeat it
  3. Portfolios behave differently than their constituent parts
  4. For a given degree of risk, there is a portfolio that will deliver the most return; this portfolio occupies the "efficient frontier" of portfolio compositions
  5. Focus on the behavior of your portfolio, not on its constituent parts
  6. Recognize the benefits of rebalancing (but not too often)
  7. The markets are smarter than you are; they are also smarter than the experts
  8. Know how expensive the tomatoes are (investigate Price/Earnings, Price/Book Value, Dividend yield)
  9. Good companies are usually bad stocks; bad companies are usually good stocks (Lowest P/E stocks typically outperform highest P/E stocks)
  10. In the long run, it is very hard to beat a low-expense index mutual fund.

In the interest of brevity, I won’t go into the detailed explanations of these concepts or his advice right now (Don’t worry, though, I plan on doing numerous posts on these investing concepts in the future).  If you’re intrigued by some of these concepts and more more information or you don’t believe the author and want the proof behind them, then you should grab a copy of the book and delve into it.

The three questions to ask yourself when determining asset allocation

The author shows you how to use your answers to these questions to determine a comfortable asset allocation:

  1. How many different asset classes do I want to own?
  2. How conventional of a portfolio do I want (how much difference from the S&P 500 can I tolerate?)
  3. How much risk do I want to take?

Besides the theory and concepts, there is also some very practical information

The author also describes various example asset allocations tailored to how many different types of asset classes you want to include in your portfolio. He also includes a table that lists actual mutual funds to use in your portfolios. He even divides this table into three sections describing which funds are best for tax-sheltered accounts, taxable accounts, and those that are acceptable for either type.

What is not-so-good about the book?

I did not find much bad information in this book. Actually, the biggest issue with the book is that there are a lot of statistics in it. That can be good or bad, depending on your perspective. If you don’t really enjoy reading a lot about the details of the numbers, then this book will be a tedious read for you. In fact, on Bernstein’s website, he notes that this book is "for the Sophisticated Investor" while his similar book, The Four Pillars of Investing , is "for the Liberal Arts Audience."

So what is my recommendation?

If you are not concerned with the mathematical details of why asset allocation and low-cost investing is important, then you probably don’t really need to read this book. Instead, you might want to read Paul Farrell’s The Lazy Person’s Guide to Investing. That book ascribes to the same investment philosophy. It will provide you with some practical examples of actual investment portfolios without bogging you down with all the theory and math.

If you are really interested in understanding why asset allocation is so important, then I think this is a good book to read. As I mentioned, this book contains some really useful and informative information covering both theory and practical advice. I have repeatedly mentioned that the book contains a lot of statistics, but don’t let that scare you. It’s not like this is a statistics textbook (and you can always skip a section or two if you want).

I would say that this is a good candidate for checking out from your local library. Borrow it, read it (maybe renew it), digest it, and become much more knowledgeable about what is important when constructing your portfolio and get inspired that you can do it yourself and do it well!

Want to borrow this book? Search your local library

Want your own copy? Buy this book now at

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Book Review: The Lazy Person’s Guide to Investing

August 7, 2008 · Filed Under Book Reviews · Comment 

A Book for Procrastinators, the Financially Challenged, and Everyone Who Worries About Dealing with Their Money

by Paul B. Farrell, JD, PhD

BFN Book Reviews

Over the years, I have found it tremendously helpful to see what other people with similar interests have been reading on the topics of personal finance. That is why I am periodically publishing my own reviews – to hopefully be helpful to others. I will provide a brief overview of the book and the author, touch on the good and bad in the book, and finally, give you my personal recommendation for whether you should borrow the book, buy the book, or neither.

What is this book about?

Click here to continue reading…

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