You can't always trust your brain

Daniel Kahneman, psychologist and Nobel Prize winner, has gotten a lot of attention from his book,  Thinking, Fast and Slow, which lays out how our brains work. The Wall Street Journal's Diane Cole asked him to apply the thesis to money management.

Typically, Kahneman says, people rely on blink-of-an-eye judgments, driven by emotion and impulse, in navigating life—even when we should be thinking "slow," using reason, deliberation and logic to weigh our options.

WSJ: In your book, you discuss overconfidence as a common pitfall. What impact does that have? 

MR. KAHNEMAN: Overconfidence is everywhere. We all have clear and certain beliefs, and our certainty is not impaired by the fact that other people hold contradictory beliefs. We just think they are biased. When optimism and overconfidence come together, you get many mistakes. Optimistic estimates can in retrospect seem almost delusional. One example is that people end up paying about twice as much as they originally expected to pay for kitchen renovations.

WSJ: Any advice on how to avoid overconfidence in financial decisions? 

MR. KAHNEMAN: I don't think individuals should be in the business of picking individual stocks, because they will be taken advantage of. What happens is that when the market is doing well, it is populated by geniuses who think they can try it for themselves. It's natural and inevitable that this leads to overconfidence and foolish actions.

WSJ: Can people learn from errors of financial overconfidence? 

MR. KAHNEMAN: The first thing for people to know is to accept the limits of their knowledge. When you're young, you have time to make up for financial losses. But when you are older, it is a very concrete matter. You should be thinking about how much you need to spend every month. And many investment professionals are quite aware of that, so they steer people on a path toward diminishing risk, because those people don't have enough time to recover a loss.

You Wall Street tool, you

Whether you have $1,000 or $1 million in a mutual fund, you're a capitalist, Brett Arends writes in the Wall Street Journal. You're providing America's risk capital.

So how does Wall Street treat you?

To the barricades, I say!

According to Morningstar, the average money manager skims fees of 1.4% a year from your stock fund, and 1% from your bond fund. 

It may not sound like much, but it is. Especially these days, when returns are so low anyway.

Look at the cost over time. Consider someone who invested $1,000 every year for the past 30 years in a balanced portfolio of 60% U.S. stocks and 40% bonds. Today, after paying fees, he or she would have about $105,000. 

Sound good? Without those fees they'd have $137,000. Wall Street effectively pocketed the other $32,000. 

The picture is even starker than it looks. After all, you could have ended up with $54,000 just by keeping your money in risk-free Treasury bills. 

So your reward for risking your capital was a more modest $51,000. It should have been $83,000. But Wall Street pocketed nearly 40% of your return. 

Furthermore, the true picture on costs is surely much higher. Fees used to be even higher than today. And we're not even counting the extra hidden cost of trading expenses. 

Wall Street claims "management fees" are the price you pay for having them manage your risks. How'd that work out? In the 2008 crash, the average "actively managed" mutual fund actually did worse than an index fund. So much for that.

I'm gonna head down to Wall Street and camp out in the park and get free food and urinate on a shrub.

How to put money in the market

For years I had a set dollar amount automatically taken from my bank account and invested in mutual funds. It's called dollar cost averaging. When stocks are down, you get more shares. When they're up, you get fewer. Seems like a good way to buy low and sell high.

Well, someone did some research. If you have a pile of money -- which I didn't -- should you feed it into the market using dollar cost averaging or just pour it all in? Gregg S. Fisher, president of Gerstein Fisher, an independent investment advisory firm, says it might be smarter to dump a lump sum in the market all at once.

Perhaps contrary to what most investors would expect, our research revealed that the best performance consistently comes from Lump Sum Investing, with average annualized outperformance over DCA of nearly two percentage points over a period of 20 years.

There are variations on the theme.

The second-best performance came from the Momentum Dollar Cost Averaging strategy, whereby the monthly amount invested is ratcheted up on the heels of good market performance. Over the period we examined, this strategy achieved superior returns when compared to the basic DCA approach more than 50% of the time.  (More money is invested following a month of positive market returns; less following a month with negative returns.)

This market is so scary it might be best to use CCA -- closet cost averaging. Hide in there and cover your eyest.

How to panic wisely

Jeffrey Carter, an independent trader for several decades and former member of the CME Board of Directors -- that's a derivatives marketplace  -- offers some advice on investing in the post-downgrade market:

First, don’t call your broker when the market opens. He won’t know anymore than you. If you get through, they will parrot talking points given to them by their research department prepared last night. 

Second, don’t sell. That’s what the pros want you to do, panic. The end of the world isn’t near, although we are going to continue to go through some really rough patches. If you are looking at your retirement wilt away, don’t worry. Someday it will come back. I have seen my retirement funds get clocked several times, I am 49 and don’t plan on hanging it up for a minimum of 15 years anyway. 

Third, a lot of the selling today will come from funds that have to sell to raise cash for margin. They have to put up cash to hold positions-only way to raise it is sell. 

Fourth, this is not a stock picker’s paradise. If we have learned anything over the past two years is that no one single person can beat the market. You are much better off in a no load fund that replicates the S&P 500. It’s called the Efficient Market Hypothesis. Eugene Fama proposed it in 1962 at the University of Chicago, and there is enough research to prove it over the years. If you are inclined, sell any individual stocks you have, or focused funds you have tomorrow morning and roll them into a no load fund that replicates the S&P. Virtually every major mutual fund company has one. Your accounts value then won’t be beholden to a stock-but simply the broader market. Over time it tends to return 12%. 

Fifth, if you are out of work and panicked, I empathize with you. Take cash you have and bet on yourself. Start a business. Get any job. It will keep your mind off the ups and downs of the market and if you start generating some cash it will make you feel a lot better. 

Sixth, hold your elected officials feet to the fire. Write letters. There is only one way out of this mess. Cutting spending, and growing the economy. Too much spending and debt got us into this mess, less spending and growth can help get us out of it. Treasury Secretary Tim Geithner is a schmuck. He is a career bureaucrat and there is nothing we can do to get him out of there until November of 2012. To add insult to injury we will owe him a pension. The President is incommunicado since last Thursday. He is not deft when it comes to economics. He can get shown the door in November of 2012 too.

Should you buy gold?

Send yours to me.

You see the pitches constantly on TV. One thing that puzzles me is that they're always showing how high gold has risen in price. Shouldn't that be a signal to sell gold? As in, buy low, sell high?

Consumer Reports looked at one company, Goldline. Here's what it found:

Goldline's over-the-phone prices for bars and bullion coins (coins without collectible value) were on par with other dealers in May. Its online prices, however, were about 3 to 5 percent more. A Goldline rep told us that is because you have to pay by check or wire transfer when you buy by phone, which saves credit-card transaction fees.

But its prices for collectible coins are inflated. For instance, a four-piece Proof Gold Eagle coin set was selling for $5,924.63 on Goldline's website in May. The American Precious Metals Exchange offered the set at $3,295. A Goldline adviser recommended buying collectible coins because they're safe from confiscation. He also said you could sell them anonymously—you wouldn't have to report Social Security numbers to the government, as is done when buying most bullion. 

If you buy from Goldline you'll face several fees, starting with shipping costs. The company will also store bullion for you, at a cost of 0.75 percent of your gold's value annually. Goldline promises to buy it back for a 1 percent liquidation fee and about a 4 percent discount on gold's price that day.Consumers don't appear to have many complaints about Goldline. It has an A+ rating from the Better Business Bureau.

Bottom line:

Financial experts generally advise against holding physical gold and instead recommend buying shares of an exchange- traded fund that purchases gold for clients and stores it in a bank. Buying gold ETFs involves trading fees and annual expenses of about 0.4 percent.

There's nothing magical about gold, or any other investment? Remember when real estate was the thing? All investments should be made as part of a portfolio balanced according to your specific needs.

Why investors don't do as well as the market

In his book, Your Money, Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, the journalist Jason Zweig describes an experiment.

In the experiment, researchers flash two lights, one green and one red, onto a screen. Four out of five times, it’s green; the other time, the red light flashes. But the exact sequence is kept random.

When rewarded for correct picks, rats and pigeons quickly discover the best strategy is to always pick green, guaranteeing an 80 percent correct-pick rate.

Humans, however, tried to anticipate when the red light would come on. This misguided strategy, on average, leads people to pick the next flash accurately only 68 percent of the time.

Stranger still, humans persist in this behavior even when researchers tell them the flashing lights are random. And while rodents and birds quickly learn how to maximize their score, people often perform worse the longer they try to figure it out.

What does this mean for investors? Financial planner Stan Johnson:

Humans often see what they think are long-term trends but base their analysis on short-term data. Many credible studies show the average investor underperforms the market, some by as much as 6 percent per year, and this illustrates how it happens. Right after an investment generates strong returns, people tend to jump on the bandwagon. When an investment is struggling, people tend sell out and miss the recovery.

Be a bird brain.

Where the experts get their expertise

They come out like clockwork -- dozens of government and private economic reports, covering everything from bond sales to mortgage approvals, Russell Pearlman of Smart Money writes. Traders fixate on them, often enough to move the markets as they react to employment numbers or consumer-confidence surveys.

But the prediction game is shifting, he says, with a growing number of money managers searching for hidden nuggets that might offer insight into where the economy is headed and how fast.

Here are a few numbers the experts follow. These relate to employment. More at the link.

Hours Worked

Better than: number of people hired.

On the first Friday of each month, the nation learns (and agonizes over) how many people gained or lost a job in the previous month.

But many pros think another stat in the government jobs report -- average number of hours worked -- is more important. When business picks up, these pros explain, employers usually make existing workers log more hours before hiring new recruits.

Lately, the overall news hasn't been great: In November, Americans averaged 34.3 hours a week, still below the 35 hours when the recession started.

But the Bureau of Labor Statistics (bls.gov) also breaks down hours worked by industry, which can enable investors to get a jump on spotting a hot sector. In July 2009, for example, manufacturing workers began spending more time at the factory -- and manufacturing stocks proceeded to trounce the broader market.

Jolts

Better than: unemployment rate.

While the unemployment rate shows how many people aren't working, the Job Openings and Labor Turnover Survey shows how many are starting or leaving a job. According to the most recent data, 3.2% of American workers started a new job in October, while 3.1% left their job. In a fully healthy economy, a lot more people will be starting a job than leaving one. Still, the Jolts data currently paint a slightly more upbeat picture than the unemployment rate.

By watching this ebb and flow, some investors say they get a sense of the economy's health before the herd does. In the summer of 2007, for example, Jolts indicated that fewer people were starting jobs -- something some analysts now see as a premonition of the crash. Jared Franz, an economist at T. Rowe Price, says that these days he's "banging the table" about Jolts to T. Rowe's bond managers.

Playing games with index funds

Jason Zweig describes in The Wall Street Journal how your use of index funds get sabotaged by traders. I had no idea this was happening.

Index funds continue to make investing cheaper and easier than ever, he says. For investors in these low-cost, autopilot portfolios that dispense with stock pickers and passively replicate the holdings of a broad basket of stocks or bonds, the best is yet to be.

Here's the problem:

Until now, index funds have had an Achilles' heel. One factor that makes indexing "a horrendous idea," the renowned value investor Seth Klarman of Baupost Group argued earlier this year, is that hedge funds and others have long beaten the index funds to the punch on trades that the autopilot portfolios are forced to make.

Here's a solution:

New "investable" indexes, forthcoming early next year from the Center for Research in Security Prices at the University of Chicago, or CRSP, could reduce compulsory trading for any index funds that adopt them as a benchmark. Funds that trade less should have lower brokerage costs, lower tax bills and higher net returns. Better yet, it should be harder for outsiders to "front run" these improved indexes.

Here's how it works:

Consider an index fund that specializes in small stocks. If the shares of a little company in the fund take off, then the stock won't be small anymore—and the fund will have to sell it. Likewise, the firms that compile market benchmarks periodically add or delete stocks, forcing index funds to buy everything that is added and to sell everything that is deleted. 

CRSP's new family of indexes will tackle the poaching problem in several ways, says Lubos Pastor, a University of Chicago finance professor who helped design them. The boundaries between small, medium and large stocks will be set as proportions of the value of the total market, rather than as fixed dollar amounts or as an unchanging number of companies. Stocks will be "partially weighted," or shared, across different size indexes—so, as a company grows or shrinks, it doesn't have to be added or eliminated in one fell swoop. Any additions or deletions will be made in "packets," or gradual steps over time, and the days on which the substitutions take effect will be randomized.

Will those rising corporate profits do you any good?

Will they mean more jobs or more profits in your portfolio. Maybe not.

Corporate profits hit a new record in the third quarter of this year. But it was kind of a meaningless distinction, Justin Fox editorial director of the Harvard Business Review Group, writes.

In a growing economy, even a fitfully growing one, corporate profits should hit new records on a pretty regular basis. And indications are that inflation-adjusted corporate profits are probably still slightly below the levels of before the Great Recession.

It's easier and probably more meaningful to measure profits simply as a share of the economy, Fox says. You can divide by national income. Here's a chart, going back to 1947, of after-tax corporate profits as a share of national income.

 Fox:

You might not be able to tell this from the chart, but the third-quarter 2010 profit share, at 9.46%, is slightly below the peak of 9.58% in the third-quarter of 2006. But it's still quite high by historical standards.

There is annual data to 1929, and the only time besides 2006 and (one can predict with some confidence) this year when the profit share topped 9% was 1929, when it hit 9.9%. Approaching a record set in 1929 doesn't seem like an auspicious sign.

Because there is very little analysis of this, Fox did his own:

Pre-tax domestic nonfinancial corporate profits — a mouthful, but also seemingly a fair measure of the underlying health of business in America — are nowhere near record levels as a share of national income. They exceeded 15% of national income once in the late 1940s, and repeatedly topped 12% in the 1950s and 1960s; in the third quarter of this year, they were 7.03% of national income.

This might go some way toward explaining the seeming disconnect between booming corporate profits on the one hand and a very cranky business community on the other. For much of the business community, profits aren't that high by historical standards. These people have every right to be cranky.

Who is doing better?

Well, according to the BEA's data, financial industry profits and "rest of world" profits — that is, the money U.S.-based corporations make overseas — are relatively much higher now than they were in the 1950s or 1960s. And the taxes paid by corporations are much lower now than they were then, as a share of national income.

So the reason that corporate profits are near their all-time highs would appear to be that financial corporations (mainly big financial corporations) and multinationals are making lots of money and paying less of it out in taxes. Hmmmm.

 Hmmmm.

Will the election affect your investments?

I would have thought so, but the evidence indicates otherwise. Historical data shows that any impact political party changes in elections have had on short-term market returns have proven to be marginal, unpredictable, and not very statistically significant, says Gregg S. Fisher, president and chief investment officer of Gerstein Fisher, an independent financial advisory firm in New York City.

He writes in Forbes:

Election results are almost exactly 10 times less correlated to the S&P 500 than are five-year Treasury Bonds. If Congressional majorities were an investable asset, we would likely be looking to use them as a diversifying alternative asset class!

The S&P 500 has had positive returns 73% of the years in which Democrats controlled the House, vs. 68.2% of the years Republicans held the majority. The market as a whole had positive returns in 71.8% of the calendar years back to 1926, meaning the positive return percentage differences for each party represent only 1 or 2 years out of the decades each party has controlled the lower house of Congress. Likewise, the average return in "Democratic" years is 11.9%, while the mean in "Republican" House years is 11.5%--certainly not a statistically significant difference.

"Election results are indeed a factor in market return," Fisher says. "Significant, yes, but ultimately all but impossible to separate from every other economic, corporate, fundamental, global or psychological factor that influences the price of equities over the short run."

A sobering look at retirement

If you're depending on the stock market for your retirement nest egg, you need to consider the words of Rob Arnott at Research Affiliates, an investment management firm.

"I worry a lot about people reaching their golden years and discovering, 'Oh, I should've saved more,' and 'Oh, I don't qualify for Social Security any more because it's means tested'. We're headed for a retirement train wreck," he adds, "and it's going to get really ugly over the next 15 years." 

Here's why. The returns you will get from your stock funds can only come from four things: dividends, earnings growth, inflation and changes in valuation.

Using numbers from Research Affiliates, Brett Arends reports in The Wall Street Journal:

• Right now the dividend yield on U.S. stocks is about 2.2%, they note. Historically, earnings have only grown by a surprisingly low 1% a year in real, inflation-adjusted terms. Mr. Arnott tells me the average since 1900 is only about 1.2%, and in the last half century just 0.6%. Will we get more in the future? With the U.S. population ageing and heavily in debt? It's hard to imagine. Throw in a 2% inflation forecast–more on this later–and Research Affiliates forecasts a long-term return of 5.2%. 

• What about changes in valuation? Some generations are lucky. They invest in the stock market when it's depressed and shares are cheap in relation to earnings. This was the case in the 1930s and the 1970s. Then they retire and cash out when the market is booming and shares are expensive in relation to earnings–such as in the 1960s and 1990s. 

• People today are not so lucky. The stock market's latest rally has lifted shares already to pretty high levels in relation to average cyclically-adjusted earnings. This so-called "Shiller PE" (named after Yale professor Robert Shiller, who popularized the notion) has been an excellent indicator of market value. Right now it's at about 22–well above its historic average of 16. The only time the market has boomed from these levels, was in the late 1990s bubble–an atypical moment unlikely to be repeated any time soon.

What does this mean for your bottom line?

An investor with 60% of his portfolio in stocks and 40% in bonds, a standard, if conservative, allocation, can expect a weighted average return from here of only about 4.1%. Strip out 2% inflation and investors can only expect about 2.1%.

Someone who saves $10,000 a year for 30 years and invests the money at 5.5% a year will end up with $760,000. Someone who only manages to earn 2.5% on their investments: Just $420,000.

"Neither pension funds nor private investors seem to have fully absorbed the grim lessons of the past decade," Arends writes. "Returns are going to be much lower. People need to save more, much more, for their retirement. If the market rally this year has given them false hope, it will have turned out to be a curse more than a blessing."

You can read the report on which this article was based here.

Can you time the market?

The conventional wisdom is no, you can't. But that's not the whole story.

Writing in The Wall Street Journal, Brett Arrends takes aim at money managers who encourage you to stay in the market when things are bad: most gains come on just a few days, they argue, and you don't want to miss those.

True enough, but most losses also come on a few days, and you don't hear that side of it.

The best long-term study relating to this topic was conducted a few years ago by Javier Estrada, a finance professor at the IESE Business School at the University of Navarra in Spain. To find out how important those few "big days" are, he looked at nearly a century's worth of day-to-day moves on Wall Street and 14 other stock markets around the world, from England to Japan to Australia.

Yes, he found that if you missed the 10 best days you missed out on a lot of the gains. But he also found that if you managed to be out of the market on the 10 worst days, your profits went through the roof.

Over an investing period of about 40 years, he calculated, missing the 10 best days would have cost you about half your capital gains. But successfully avoiding the 10 worst days would have had an even bigger positive impact on your portfolio. Someone who avoided the 10 biggest slumps would have ended up with two and a half times the capital gains of someone who simply stayed in all the time.

What does this mean for you? It offers yet another argument in favor of investing for dividends, not simply for capital gains, Arends says.

Most of these "market timing" studies, including Mr. Estrada's, focus purely on stock market price movements. They ignore dividends. (The reason is technical. Reliable total return data is hard to find once you go back more than a few decades. And calculating the interaction between daily price movements and reinvested dividends is a heroic undertaking.) But the omission of dividends matters for shareholders. That's because dividends are likely to make up a significant bulk of your long-term returns.

One reliable way to time the market is through dollar cost averaging -- putting the same amount of dollars into the market each month. This means you're buying low and selling high.

Finding the right mix of investments

A key idea in putting together a portfolio of investments is to manage risk by having different types of investments that don't all move in the same direction at the same time. This is called correlation.

If your bonds and your stocks move in lockstep, what good is that?

Jonelle Marte explains in The Wall Street Journal how correlation is measured.

Correlation is determined by comparing the returns or general movements of two assets or products. Using what's called a regression analysis, an adviser produces a number, from 1 to negative 1, that displays how likely one asset is to move similarly to another.

A correlation close to zero means the performance of one asset has little or no connection to that of the other. A correlation of 1 is a perfect positive correlation, meaning the two assets always move in sync—in the same direction, and at a scale that doesn't vary. For instance, Asset A will always move at twice the magnitude of Asset B. A correlation of minus 1 is a perfect negative correlation. The assets move in opposite directions at a scale that doesn't vary.

Here is the strategy:

A key aim of asset allocation is to invest across a range of sectors, countries and asset classes that earn decent returns but are relatively uncorrelated. That way, if one asset in a portfolio suffers, the rest might be unaffected. For example, Treasury inflation-protected securities, or TIPS, usually move unrelated to the performance of the S&P 500.

You will likely need to get correlation data from a financial adviser, but here are two sources for ordinary folk:

Tools for individuals include assetcorrelation.com, which finds correlations between assets and between asset classes.

R-squared, a measure found on Morningstar.com, shows strength of correlations between funds and benchmark indexes, but not directions of movement. The scale ranges from 0 to 100.

Do you understand risk?

Several recent surveys of investor behavior in recent years have found that many people run from the market when it drops and dive in when it's up. In effect, they're selling low and buying high.

"To maximize returns, the ideal strategy is to buy stocks at a low price with the hope of selling them at a higher price," says Rui Yao, a University of Missouri assistant professor in the Personal Financial Planning department. "However, many investors seem to be unwilling to take risks when the market is at a low point and seem content to only invest when the market is at a high point."

Chuck Jaffe examines several types of risk, which he says many people don't understand.

• Purchasing-power risk: Most people who want to avoid risk actually mean they want to avoid loss. They remove everything from the market and put in their mattress, a piggy bank or a money-market fund—all providing roughly the same return these days.

While those methods protect against market risk, or the chance that, say, a double-dip recession or "flash crash" will drive down the value of any savings or investment holdings, they run the risk that inflation will outpace any asset growth.

• Interest-rate risk: This is a key factor in the current rate environment, where the Federal Reserve's main interest rate hovers near zero.

Investors face potential income declines when a bond or certificate of deposit matures and they need to reinvest the money at near-zero rates. By contrast, for investors who go chasing returns by using higher-yielding, longer-term securities, the potential arises to get stuck losing ground to inflation if the rate trend changes.

• "Shortfall risk": This is the possibility that someone won't have enough money to reach financial goals. Many investors take this risk when they are too conservative during troublesome market times or too aggressive when things are good.

Investors who went whole-hog into technology stocks during the dot-com bubble got hammered when it popped; today's sideline-sitter, conversely, might be missing out on low-priced stocks as they wait until they are more comfortable.

• Timing risk: This is not so much about when you are buying or selling as it is about your personal time horizon. To put it simply, the chance of stocks making money over the next 20 years is high; the prospects for the next 18 months are murky. If you need money at a certain time, this risk must be factored into your asset allocation.

"If the studies show anything, it is that investors definitely don't understand opportunity risk," Jaffe writes. "Consider this the greed factor, the chance of missing out. Opportunity risk runs against innate human psychology, as people perceive opportunities at just the wrong times. They will jump to buy when the market is at the end of a good run and hesitate when the market has fallen to lows that have put quality companies on sale."

Thinking about taxes when investing

I've always known that you need to be careful of mutual funds that are actively traded -- i.e., the more the manager buys and sells, the more taxes you might have to pay.

But there's more to taxes than that. In The Wall Street Journal, Carolyn Geer shows how you need to consider your mix of investment funds in light of future taxes. Here's one scenario to illustrate the point.

Say you and your spouse retire at 65 with $1 million—your entire savings—in a traditional IRA. Assume, too, you need $80,000 a year to live on, and together you receive $40,000 a year in Social Security benefits. Dean Barber, a financial adviser in Lenexa, Kan., says you would have to withdraw not just $40,000 a year but $70,000 a year from the IRA to meet living expenses. Why?

Not only would your IRA withdrawals be taxable, but they also would get included in your so-called "provisional income," which is used to figure what, if any, taxes you owe on your Social Security benefits. In this scenario, you would end up owing taxes on every dollar you took out of your IRA plus 85% of your Social Security benefits—the maximum percentage.

"That's really the current state of affairs for most people because they have piled most of their assets into the tax-deferred accounts," says Mr. Barber.

If instead you had $600,000 in the IRA and $400,000 in a taxable brokerage account, you could withdraw from the brokerage account just $40,000 a year in securities on which you don't have a net capital gain. That money wouldn't be taxable because it has already been taxed, and it wouldn't be included in your provisional income, so none of your Social Security benefits would be taxable either. In effect, you let the principal from the brokerage account feed your income needs for the first five years of retirement until you reach age 70½, when you are forced to start taking distributions from your IRA. This strategy would save you $150,000 in taxes over the five years.

Let's see, what could I do with $150k? Ms. Geer offers some advice (and I know the article is behind a paywall, if you're not a subscriber):

To get the most mileage out of your different accounts, fund them with investments that match their tax characteristics. For example, taxable accounts are a good place to hold tax-exempt municipal bonds and muni funds. Taxable bonds and bond funds work well in tax-deferred accounts. And actively traded stocks and actively managed stock funds make sense for Roth accounts where they can grow tax-free, especially if the top long-term capital-gains rate jumps from 15% to 20% next year as scheduled.

She suggests you may need professional advice on this. I know I do.

Don't follow the herd

"Human beings are hard-wired to run with the herd," Brett Arends writes in The Wall Street Journal. "For millions of years, when the herd stampeded, the smartest move wasn't the hang around and wait to see why. It was to run."

Over the past decade, however, if you had not followed the herd in the stock market, you would have done well. Arends cites some research from TrimTabs Investment Research showing that regular investors needlessly lost billions more than they should have on the stock market.

TrimTabs puts the losses at $39 billion. It calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171. The TrimTabs numbers show, instead, that over the past decade it was actually quite easy to time the market. All you had to do was buy when the public was selling, and sell when the public was buying.

It's just that simple.

Even during a flat decade, people could make money just by going against the herd. They didn't need to know anything else. They didn't need quantitative models, astrophysics Ph.D.s from M.I.T., inside information or privileged access. All that money spent on equity research? All you had to do was look at the latest numbers from the Investment Company Institute, showing whether the public was putting money into their stock-market funds or taking it out. And then do the opposite.

The way to do this automatically is through dollar cost average. That means you put a certain amount of dollars into the market regularly. When the market is down, your dollars buy more shares. When the market is up, you buy fewer. Automatically.

You first pick an asset allocation that works for you -- say, 60 percent stocks, 30 percent bonds, 10 percent cash. Then find a mutual fund that maintains this allocation -- look for one with low expenses, typically an index fund. Then have the mutual fund company automatically withdraw whatever amount of dollars you can afford each month.

Now you are buying low and selling high, while the herd is going over the cliff.

What are ETFs?

ETFs are "exchange traded funds," a rapidly growing form of investment that everyone should understand -- ETFs typically hold expenses down, which means more money in your pocket.

Somebody's catching on: new ETFs are appearing at a rate of one a day, according to Kiplinger. You can now choose from among 750 ETFs, and their total assets are approaching $1 trillion. 

Think of ETFs as a different way to do what mutual funds do. In fact, they're a lot like mutual funds. Kiplinger explains:

Typically, an ETF holds a basket of securities that track the performance of a specific stock index, bond index or other benchmark. So ETFs are much like traditional index mutual funds. ETFs cover all the stock, bond, real estate and other investments that make up complete portfolios. 

ETFs exist for every imaginable investment category -- from something as narrow as a single commodity (such as timber) or a single industry (such as health care) to something as broad as the complete domestic blue-chip stock market.

Here a few characteristics of these funds.

Minimum purchase. Traditional mutual funds come with investment minimums -- often $2,500 or more -- but you can buy ETFs for much less. For example, a share of SPY, an ETF that tracks the S&P 500, costs about $110. Many others sell for much less. Of course, you have to pay a brokerage commission when you purchase an ETF, so it would be expensive to buy a small number of shares.

 

Costs. Because most ETFs follow indexes or simply own the major companies in a particular sector, they are cheap to operate. They don’t have a large staff of managers and analysts, as do many actively managed mutual funds. So the expense ratio of a typical ETF that invests in large growing companies, such as iShares Russell 1000 Growth Index, is a mere 0.20%. That means for every $1,000 you have invested in the fund, you pay just $2 in expenses annually. Actively managed stock mutual funds usually charge more than 0.75%, and often well over 1%. Even traditional index funds usually charge more than ETFs. 

 

Taxes. ETFs are tax-friendly. That’s because ETFs have lower portfolio turnover than regular mutual funds and distribute fewer capital gains. (Many ETFs don’t pass along gains at all because they never change investments.) Although that doesn’t matter if you hold an ETF inside an IRA or 401(k), it will boost your return in a taxable account. 

 

Kiplinger has a lot more on ETFs, including how to buy them, here.

KISS: Keep It Simple, Sparky

If all the folderol of investing has you looking favorably on a Mason jar in the backyard, maybe you should look instead into a strategy advocated by Jonathan Burton, the Money & Investing editor at MarketWatch.

He explains it in The Wall Street Journal, which I realize is behind a paywall, but here it is.

All you need are three diversified index-tracking mutual funds or exchange-traded funds—one for U.S. stocks, one for international stocks and one for bonds. The portfolio must be rebalanced at least once a year to ensure that half of the money stays in stocks and half in bonds.

Duh, that's easy. He says:

It's boring and bland and won't score you any points at parties, but this bare-bones approach—call it the "Nifty 50/50 Portfolio"—has made almost as much money as a more aggressive, stock-heavy strategy over the past 25 years and topped it over the past decade. 

Duh, at parties just make something up. Burton uses a comparison of the KISS strategy with an 80/20 mix that commits 65% to U.S. stocks, 15% to international stocks and 20% to bonds. KISS wins over 10 and 15 years, but loses out over 25 to the tune of $10,000. However, he notes:

A difference of almost $10,000 is real money, but was it worth the risk? The 50/50 portfolio achieved 91% of the 80/20 portfolio's gain, but with just two-thirds of the volatility—not a bad trade-off.

In addition, if like many 401(k) investors you had diligently dropped $100 a month into the portfolio, the 50/50 mix would have achieved higher returns over both 10 and 15 years, and come within $1,350 of the riskier 80/20 portfolio over 25 years—essentially a tie.

So where do you go? Cheaper is better, of course. He points to:

At Vanguard Group, mutual funds that fit the bill include Vanguard Total Stock Market Index for U.S. stocks, Vanguard Total International Stock Index and Vanguard Total Bond Market Index. All three funds also have exchange-traded shares available.

Inexpensive choices from Fidelity Investments include Fidelity Spartan Total Market Index, Fidelity Spartan International Index and Fidelity U.S. Bond Index.

Other options among ETFs include iShares Dow Jones U.S. Index for U.S. stocks, iShares MSCI ACWI ex US Index for international stocks and iShares Barclays Aggregate Bond.

KISS me, baby.

Some investing advice for pessimists

Being pessimistic about investing has a lot going for it, especially these days. A lot of mental tricks can kick in when we're in the market, and they often come from too much optimism.

However, pessimists can hurt themselves, Colorado Springs, Colorado financial planner and CBS MoneyWatch blogger Allan Roth says. Here are two ways.

1. There’s a basic principle called loss aversion that influences our financial decisions: the high you get from winning isn’t as powerful as the low you feel from losing. This phenomenon is exacerbated for pessimists. “When losses happen, pessimists are miserable, and when gains happen, they’re not as happy as they think they will be,” says Dan Ariely, a professor of psychology and behavioral economics at Duke University and author of The Upside of Irrationality. Pessimists should try to view risk as the cost of doing business, and remind themselves that it makes sense to take some risk. For example, consider all the probabilities when investing for retirement: The odds of the stock market going nowhere for 30 years are fairly low, while the odds of money markets lagging inflation over the next 30 years are fairly high.

2. “If you tend to only see the negative, don’t look too frequently at your investments because you will only be miserable,” Ariely says. Even more important, don’t be reactive. It goes back to loss aversion: Be careful of doing something spur of the moment (like pulling all of your money out of the stock market) because you want to avoid the misery you fear is coming. “It’s good to evaluate, but don’t evaluate based on emotion,” he says, especially if you’re in a doom and gloom mood. Instead, take the long view. If the market has just crashed, for example, ask yourself: a year or two after a market crash, is it usually higher or lower?

Understanding investing isn't hard; it's understanding your own mind that's tough.