Friday, February 10, 2006


In the past thirty years, there has been a dramatic shift in retirement funding. An employee could go to work for a company and remain there for an entire working career, and on retirement receive a monthly pension and health benefits, and no worries about the future. That system was called a defined benefit plan. The system now in place is called a defined contribution plan.

In the old system your retirement plan was administered by your company. You didn't have to worry about learning how to save and invest because making sure there was adequate funding was your employer's concern, not yours. All you had to do was put your time in 'til retirement, then sit back and collect your checks.

In the new system, the plan is administered by a third party, but you, the employee, are responsible for funding it. Now you not only have to set aside part of your current income for retirement, you also have to learn how to invest it. Otherwise you risk not having enough money when you retire.

Unfortunately, our educational system has not kept pace with the changes in retirement funding. Investing fundamentals are not taught at the high school level as they should be, and even college does not address investing fundamentals unless you take an economics course. When it comes to knowing what to do, you're pretty much on your own.

Depending on where you work, your defined contribution plan might be called a 401(k), 403(b), 457, or something else. The numbers refer to the part of the IRS code that covers the plan regulations. Although your employer may match all or part of your contribution amount, you probably won't receive the information you need to get the most out of your retirement plan.

What little education you're given comes from those selling the product.

Many plans are provided by insurance companies that charge very high fees and offer poor fund choices. Others have more reasonable fees and better choices, but that doesn't help much if you don't know how to use them.

The challenge before you is clear: you must make retirement savings a top priority and take charge of your future by becoming an educated investor.

A General Perspective on Saving and Investing for Retirement

While this book is about investing, a few comments about saving are in order because the two are so closely tied together. Before you can invest, you have to save. Your investment money can come from money you have put aside in your savings account, or it can bypass that and simply go directly to an investment from your wages. Saving is the real key to future wealth. No one is going to make you save, but no one is going to hand you a nice check every month after you retire either.

For some of you, serious saving may require a new perspective. Think for a minute about why you work. The answer is easy because the goals are readily apparent – you work so you can provide the necessities for yourself and your family, and earn enough to enjoy a better life.

Now, you have to add another goal that isn't quite as apparent: saving for a better life when you stop working. Saving for something so far away doesn't seem too important because more immediate goals appear to take priority. But preparing for that time is a very big part of your job now. You can't afford to ignore it.

Where do you think your income will come from after retirement? It will come from the money you have saved and the money you have invested. You have to save (pay yourself enough while you're working) to be able to support yourself after you no longer receive a check from someone else. Want to pay yourself well and enjoy a comfortable retirement? Then you have to continuously save and invest a portion of your earnings. With each paycheck, pay yourself first. Do it automatically and you won't even miss it.

How much will you need for your retirement nest egg? The general guideline is that you need to set aside 25 times the amount you plan to withdraw each year. This amount has a high probability of lasting 30 years without reducing the original principle.

This is where investing comes in. To accumulate what is needed is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.

The stock market has provided higher returns than savings accounts and bonds, but the reason is there is more risk involved. And the risk does show up—Investing is a bumpy road. Individual companies can go bankrupt and the stock market as a whole can crash as it has done several times. Also, the stock market can go a decade or more without providing the expected higher returns. It is important to understand this so you can make intelligent decisions about how much of your savings you are willing to expose to stock market risks.

The probability that the businesses you buy will reward you in the future is high. The value of all companies (the stock market) has an upward slope over time, but no one can guarantee the market or your investments will provide what they have in the past. On the other hand, you have to take some market risk to have a good chance of reaching your goals. The need to have enough money for retirement offsets the risk you have to take.

Remember, you'll need to accumulate total assets of about 25 times what you intend to withdraw in retirement. So, if you want to retire with an income of $40,000 a year at age 62, you need to accumulate one million dollars (today's dollars).

Assuming an average annual return of 8%, here is what you need to save each month starting at different ages in order to draw down that $40,000/year. Note that the 8% used is an attempt to represent a portfolio of approximately 75% stocks and 25% bonds. Since future market returns are unknown, the 8% and the associated savings/investing rates should be viewed only as an example. Actual returns will vary.

Beginning at age 22, you'll need to save $300 per month.
Wait 'til age 32, and you'll need to save $670 per month.
At age 42, you'll have to save $1,800 per month.

The catch is you can't get an 8% return on your money if you put it into a savings account. In the above example, if you start saving at age 22 but only earn a savings account rate of return, instead of $300, you'll have to set aside $1,000 per month. That's over 3 times more than if you invest some of your savings in the stock market. Also notice that waiting until age 32 requires you to save more than double the amount of age 22. Waiting until 42 requires six times the amount. These big increases are due to the power of compounding investment returns over longer time periods.

But wait, using the 22 year old as an example, what if it said instead of making 1 million over that 40 year period, you could make an additional $400,000 more using the same mix of investments, but with one very small adjustment—earn 9% instead of 8%. Wow, who would settle for 8% when they can get 9%? Well, many investors do exactly that. The adjustment needed to get the 9% is in the cost you pay for investing. It goes like this: no one actually receives all of what the market returns because you lose what you pay in costs. You can't control what the market returns, but you can control costs and there is a proven relationship between the costs you pay and the returns you get. If you pay 1% higher costs, you lose 1% in returns. And over time, that 1% can cost you $400,000.

The example demonstrates four things:

1. The need to take some stock market risk.
2. The big advantage of time and starting to save at a young age.
3. The power of compounding returns.
4. The relentless stranglehold costs have on returns.

Nothing can be guaranteed—risk is real. Smart investors do not forget this. And that is why they use every means at their disposal to minimize the elements of risk by investing in the most efficient way. The idea is to get the maximum return for the amount of risk taken and each dollar spent. Or actually, for each dollar unspent. That is what this book is all about.


In the coming pages, you will be introduced to an efficient, comprehensive and easy-to-understand investing strategy that is proven and backed by academic study. Over longer periods of time, this strategy will provide you with higher than average returns without large commitments of time or study. The fundamentals in this guide are relevant whether you use active funds or index funds.

The secret to investing and achieving higher than average returns is simply the elimination of mistakes most investors make. The stock market provides returns everyone hears about, but the truth is that investors as a group net substantially less than those returns.

With the aid of this guide, you will learn how to protect yourself from throwing away returns due to behavioral mistakes, unnecessary costs, and the more serious risk of bad advice. If you are considering an advisor, or already have one, you should find chapter 9 on evaluating and choosing an advisor very helpful.

The investment guide begins with an examination of the risks associated with investing. Then we move on to creating an investment portfolio that targets your goals and matches your desired risk exposure. And finally, in chapter 8, we cover the differences between active funds and index funds and how to use them in the most effective and efficient ways.

Throughout the guide you will find many links to additional information that you may want to explore. A glossary of investment terms is provided along with many additional links and references in the final chapter.

No matter if you manage your own investments or decide to hand the job to someone else, understanding essential investing principles is a must. With this book as your guide, you will gain the knowledge needed to learn and apply these essentials.

Taylor Larimore, Dean of the Vanguard Diehards as Money Magazine has named him, and one of the three authors of "The Bogleheads' Guide to Investing", has summed up the secret of successful investing in one concise sentence: The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course. The sentence is a true investing "gem."

Best wishes as you begin your journey along the pathway to investing success!

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