"How To Invest" seriesFIRST-TIME INVESTOR:GROW AND PROTECTYOUR MONEYPaul A. Merrimanwith Richard BuckREGALOeducate - empower
II First-Time Investor: Grow and Protect Your MoneyPublished by Regalo LLCCopyright 2012 Paul Merriman and Richard Buck.All rights reserved. Except as permitted under the United StatesCopyright Act of 1976, no part of this publication may be reproduced, ordistributed in any form or by any means, or stored in a database orretrieval system without prior written permission of the publisher, exceptby a reviewer who may quote brief passages in a review.ISBN-13: 978-1478206088ISBN-10: 147820608XThis publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is sold and otherwise distributed with theunderstanding that neither the authors nor publisher is engaged in renderinglegal, accounting, securities trading or other professional services. If legal adviceor other expert assistance is required, the services of a competent professionalperson should be sought. – From a Declaration of Principles Jointly Adapted by aCommittee of the American Bar Association and a Committee of Publishers andAssociationsTo contact Regalo LLC, please email us at [email protected] profits from the sale of this book – and all books in the "How ToInvest" series – are donated to educational non-profit organizations. Formore information, visit http://www.PaulMerriman.comCover Design by Anne Clark
First-Time Investor: Grow and Protect Your Money IIICONTENTSABOUT THE "HOW TO INVEST" SERIESVIIACKNOWLEDGEMENTSIXINTRODUCTIONXIWhat you will learnThree reasons the early years are crucialDouble your income in retirementBetter than winning the lotteryThe magic of an extra 1% returnPART 1: THE FOUNDATION FOR SUCCESSHabits that lead to big returnsThe guarantee that can break young investorsThe biggest mistake young investors makeInvest like a millionaireMutual funds: the bargain of a lifetimeHow to triple your income in retirementWhy you can’t trust Wall StreetWhy you shouldn’t trust your friends and neighborsThe single best source of investment advice1
IV First-Time Investor: Grow and Protect Your MoneyPART 2: BUILDING THE FOUNDATION FORLIFE-LONG RETURNS9Pay taxes now, later or neverThe guarantee of lower expensesHow much should you save?Stocks vs. bonds: A game changerHome sweet home, or make the world your oysterHow a lifetime vision changes your view of todayHow to turn 5,000 a year into a 10 million bonanzaPART 3: TAKING SMART RISKSThe guaranteed loss that could help you get richHow much risk should you take?Lower risk and higher returnsHow much will you make on your investments?How much should you allocate to stocks and to bonds?My formula for the best asset allocationWhen to make changes in your portfolio17PART 4: SELECTING THE BEST ASSET CLASSES25What cooking and investing have in commonLet equities be your engine of growthLittle things can make a big differenceInvest where others fear to treadThe expected returns of the best and worst mutual fundsThe surprising cost of investing in great companiesThe surprising advantage of adding international fundsDoes going for the gold make sense?The myths and realities of investing in high tech
First-Time Investor: Grow and Protect Your Money VPART 5: UNDERSTANDING MUTUAL FUNDS41How to select the best and forget about the restLoad vs. no load: The final answerPassively vs. actively managed funds: The final answerDiversification: The only free lunchMy favorite fund family for first-time investorsHow to pick the best funds at Vanguard and FidelityPros and cons of ETFsPros and cons of target-date retirement fundsPART 6: STUFF HAPPENS: EMERGENCIES53Prepare for the unexpectedWhere to invest emergency fundsPART 7: NO-NOS: DO NOT DO THESE!57Shortsighted investors pay a huge penaltyDon’t invest in insurance productsThe lure and risk of your company stockThe high risk of borrowing from your 401(k)The real cost of investment newslettersJust say no to market timingBeing the market is better than beating the marketIndex Funds: The near-perfect investmentPART 8: THINK ABOUT TAXESMaximizing tax sheltersMaximizing your 401(k) planMy recommendations for your 401(k)The remarkable Roth IRA and Roth 401(k)Choosing your IRA custodian65
VI First-Time Investor: Grow and Protect Your MoneyPART 9: FIXED-INCOME ASSET CLASSES71The time and place for bondsThe yin and yang of bondsThree reasons to own bond fundsWhen safety really countsShort-term bonds vs. long-term bondsShould you own international bonds?PART 10: BRING THE RIGHT FRIENDSTO YOUR INVESTMENT PARTY77Attitude is everythingKeep the faith about the future of capitalismNever give upNever lose your coolUse your common senseKnow exactly where you are goingGreed is not goodFear not, want notPART 11: WILL YOU BE A SUCCESSFUL INVESTOR?85APPENDIX89ABOUT THE AUTHORS95
First-Time Investor: Grow and Protect Your Money VIIABOUT THE "HOW TO INVEST" SERIESPaul Merriman's "How To Invest" series provides concise andtimeless information for a secure future and stress-free retirement.Each book addresses a specific audience or investor topic. Withalmost 50 years of experience as a nationally recognized authorityon mutual funds and retirement planning, Paul is committed tohelping people of all ages and incomes make the most of theirinvestments, with less risk and more peace of mind. All profitsfrom the sale of this series are donated to educational non-profitorganizations.The second book in the series will be: 101 Reasons I Don’t TrustStockbrokers (And You Shouldn’t Either)For articles, podcasts, updated fund recommendations and more,visit: www.PaulMerriman.com
VIII First-Time Investor: Grow and Protect Your Money
First-Time Investor: Grow and Protect Your Money IXACKNOWLEDGEMENTSOver the years I have learned about investing from many wisepeople (and a few foolish ones as well), and I am forever indebtedto them in more ways than I can say.I would be negligent if I didn't tell you that you would not havethis book in your possession without the patience and wisdom ofmy wife, Suzanne, and the creative, diligent work of Aysha Griffinand Richard Buck. If this book helps you, then you should bethankful that they are on my team.
X First-Time Investor: Grow and Protect Your Money
First-Time Investor: Grow and Protect Your Money XIINTRODUCTIONI want to congratulate you for taking the first steps toward financialsecurity and freedom in choosing to read this book. As a first-timeinvestor, the knowledge you have, the choices you make, and thehabits you establish now, will make an enormous difference in theyears ahead.In this book, I will walk you through the most important steps tobuild and maintain a successful investment portfolio. In plainlanguage, you will learn exactly what you need to do to set andmeet your financial goals. And, after reading this book, you willhave the confidence and understanding to know how to make thebest financial decisions for the rest of your life.Planning for the future can be challenging because, when you'reyoung, retirement seems far away and hard to imagine. But I canassure you that it will arrive. You will age. You will want to retire.And if you have a family, you will want to help ensure their future.In addition, you may want to leave a legacy to "give back" to thosewho have helped you or to support causes in which you believe.
XII First-Time Investor: Grow and Protect Your MoneyIf you invest wisely, you may be able to retire while your friendsare still chained to their jobs. That may sound unlikely during thesedifficult economic times, but it’s not magic, and it's not as difficultas you might think.Regardless of how much money you make, the crucial first step isto put aside a small amount on a consistent basis. You may be 23and have just landed your first job. Or you may be 40 and havedecided to finally get serious about investing. Whatever the case, ifyou are new to investing, this book is for you.If you diligently follow the advice you’ll find here, you’ll have ahigh probability of enjoying financial independence when yourworking years are over.In these pages you will learn: How investing really works Where you should get your information and place your trust How much risk you should take How to increase your returns without increasing your risk.You will also learn about the forces designed to rob you of yourhard-earned money and how to avoid becoming the prey ofslippery Wall Street salespeople as well as outright crooks and conartists.Most young investors think the lessons of sound investing don’treally matter until they have a lot of money. Many spend adecade or more making unsuitable investments, taking too muchrisk – or worse, not saving and investing at all.
First-Time Investor: Grow and Protect Your Money XIIIHowever, there are at least three reasons why the early years of aninvestment portfolio are extremely important:A. The much publicized “magic of compound interest” dictates thatevery dollar that you invest for 40 years will inevitably be worthmuch more than a dollar you invest for only 30 years or 20 years.B. Almost every beginning investor makes mistakes. But I don’tbelieve that they need to be painful or devastating mistakes. Youcan learn just as much from a 1,000 mistake when you’re young asyou can from a 50,000 mistake when you’re older. And the price ofthe lesson is much lower.C. The early years are the time you form the habits and attitudesthat separate the most successful investors from those who spendtheir lives talking about what they could have done, should havedone, and would have done differently.If you do the right things for the first 10 years of your workinglife, you can easily double your income in retirement.Of course nothing is guaranteed, and anything is possible.Win the lottery? It’s possible you will win the lottery, and a lot ofpeople who have neglected their finances believe that is their onlychance of success. I hope you won’t end up like them. In early 2012,the national lottery reached a record jackpot of 640 million. Threepeople split the pot. As one newspaper headline noted, that lotteryproduced three winners and more than 100 million losers. Thoseare not the kind of odds on which you should have to rely.Give your money to Wall Street? Wall Street brokers are eager tohelp you make more money. The system is organized so that WallStreet always makes money – and you might or might not. With the
XIV First-Time Investor: Grow and Protect Your Moneyknowledge you will find here, you will be far less likely to fall fortheir sophisticated sales pitches.As many wise people have said, investing is not a sprint but amarathon. I am not focused on getting good results for you in thenext month, the next year or even the next decade. I am focused onthe results that you will have for the rest of your life.If you do the right things from the start, the difference can behuge. And in this book I show you exactly how to do that, andwhy.Why should you listen to me? For more than 30 years I havespoken with thousands of investors of all ages and all levels ofwealth. I have made it my mission to reach as many people aspossible in order to help them be more successful investors. I havetaught tens of thousands of people at workshops, written hundredsof articles and several books. I have appeared on national andregional TV and radio, and I’ve recorded podcasts and DVDs andCDs, all in an effort to teach the sound principles you will findhere.I have now retired from Merriman Inc., the investment firm Ifounded in 1983. I represent no companies and have no investmentproducts or services to sell you. Both Richard Buck, my co-writer,and I intend to donate all profits from the sale of our books andproducts to scholarship funds and non-profit educationalorganizations. I am available to answer your questions and offermany more resources on my website, www.PaulMerriman.com.So, what do I mean by “huge” differences? I am about to show yousome numbers that I hope will get your attention. They show thelong-term differences that come from adding just one to sixpercentage points to your annual return.
First-Time Investor: Grow and Protect Your Money XVIn the following table I am assuming that for 40 years you save 5,000 a year, a total of 200,000 out of your pocket, and then youretire. This is theoretical, but it illustrates the point.Table 1 shows seven annual returns, from 4 percent to 10 percent.The lowest return is what you might expect to get in the long runfrom an ultra-conservative strategy investing in government bondsand certificates of deposit. The highest return is what you mightexpect from an all-stock portfolio.Table 1Results of 40 years of saving 5,000 annuallyat various rates of returnYour investments Your return Value after 40 years 200,0004% 475,128 200,0005% 603,999 200,0006% 773,810 200,0007% 998,176 200,0008% 1,295,282 200,0009% 1,689,412 200,00010% 2,292,963The point of this simple table is that small changes in your annualreturn can have a huge effect in your results over 40 years. Notice,for example, that by increasing your return from 9 percent to 10percent, you pick up an additional 603,551. That is three times thetotal of all the money you saved over the years!As you read about the various ways to increase your return inseemingly small increments, I hope you’ll remember how muchsmall changes add up over time.Your comments and questions are welcome. I can be reached viaemail at [email protected]
XVI First-Time Investor: Grow and Protect Your Money
1 THE FOUNDATION FOR SUCCESS1. Be different: Save money regularly.This is so obvious that I shouldn’t have to write it and youshouldn’t have to read it. But if you look around and seriouslyobserve your peers, you’ll see plenty of people who either don’tknow this or don’t care: To be an investor, you have to savemoney.Unless you come into a windfall inheritance, if you want to be aninvestor you will have to save money from your income. You willneed to do this every payday, every month, every year. Get in thishabit and you’re on your way. Ignore this, and the rest of what youread in this book won’t matter very much.
2 First-Time Investor: Grow and Protect Your Money2. Be even more different: Live below your means.I hate to saddle you with two pieces of bad news right off the bat,but you can’t follow my first piece of advice unless you spend lessthan you earn. The good news is that you can make this a habit,and eventually it will become second nature.Your friends may spend all the money they have and rack up bigdebts in order to spend even more, all in order to live a lifestylethey can’t afford. They will likely wind up with finances so fragilethat when a need comes along, they will have to either borrowmore money or sell the investments that are supposed to begrowing for the long term.3. Make your money work for you.There’s a terrible trend afoot in the land lately: Many young people,rightly observing the damage to their parents’ and grandparents’fortunes from what’s being called the Great Recession, have vowedto avoid that fate by shunning stocks and seeking guaranteedreturns.This happened after the stock market’s crash of 1929 and also after1932, 1974 and 1987. After each of these crashes, many investorswere unwilling to trust the market again for decades. During thosedecades, those spooked investors missed out on some of the mostproductive years in the market.So my advice to you is simple: Once you have saved money, don’tjust put it in the bank. Invest it is something that can grow overtime. That means owning something – most likely stocks of publiccompanies. When you put money in the bank or buy bonds or
First-Time Investor: Grow and Protect Your Money 3anything that’s “guaranteed,” you are letting your money work forsomebody else.Instead, I want your money to work hard for you, and that meansindirectly getting other people to work for you. How can you dothis, especially if you have only a small amount of money? That’swhat this book is about.4. Treat yourself like a millionaire.Should you own one stock or many? If you are a savvy investor,more is better. If you own only one stock, you are speculating,betting that you’ve chosen an Apple instead of an Enron. Themajority of individual stocks disappoint their early investors. Manypublic companies lose money, go out of business or just limp alonguntil some bigger company decides to buy them at a discount.If you own just one stock, you could lose most or all of yourinvestment. But there’s never been a case in which a broadlydiversified portfolio of stocks has become worthless. Millionairesinvest in 1,000 or more stocks. You should too, using mutual funds.5. Build your financial future with mutual funds.Unsophisticated investors buy stocks and bonds one by one,believing this will help them make higher returns. Some think thiswill help them understand what it means to own a stock or a bond.Others like to follow individual stocks on the Internet. The result,to put it bluntly, is almost always the same: They waste their timeand waste an opportunity.
4 First-Time Investor: Grow and Protect Your MoneyFor almost anything you might want to invest in, there’s at leastone mutual fund that will give you diversification, professionalmanagement and recordkeeping.Some investors shun mutual funds because they don’t want to paythe expenses. Here’s my answer to that: You’ll probably never meetanybody who is more expense-averse than I am. I hate paying evenone unnecessary dime in expenses. And virtually all my money isin mutual funds. In my view, mutual funds are the bargain of alifetime.6. Make a plan for your future.Think of investing as a long journey on which you are just settingout. Keep your destination – financial independence – in your mindall the time. You can get there. And when you do, it will be wortheverything you had to do along the way.A goal is a dream with a deadline, and I hope you will dream bigdreams.To see what’s possible, study the following table. It shows howmuch money (in today’s dollars) you could have available to spendevery year after you retire if you take the right steps now, and keeptaking them. Those numbers may seem mighty big, but I believethey are easily within your reach.7. Imagine 40 years of savvy investing.The following table takes up where Table 1 left off.
First-Time Investor: Grow and Protect Your Money 5Table 2Retirement income resulting from various rates of returnYour annual Yourinvestmentreturn 5,0004% 5,0005% 5,0006% 5,0007% 5,0008% 5,0009% 5,00010%Value after Your income in first40 yearsyear of retirement 475,128 603,999 773,810 998,176 1,295,282 1,689,412 2,292,963 19,005 24,160 30,952 39,927 51,811 67,576 91,719These figures assume you do the following:A. Invest 5,000 annually from age 25 through 64.B. Withdraw 4 percent for living expenses when you are 65.The point of this table is to illustrate the payoff you can have fromturning years of savvy investing into cash flow when you retire.Note the enormous differences in your payoff as you achievehigher returns. This is compelling evidence that small increases inreturn can add up to huge differences in your retirement lifestyle.8. Learn to recognize the siren song of Wall Street.Wall Street has a plan for your money, and it involves makingmoney – for businesses and individuals who may or may not be onyour side. There’s always a salesperson or broker who must bepaid as well as some firm that employs the broker. My definition ofWall Street includes the major financial media, as I have describedin detail in Chapter 3 of my book "Financial Fitness Forever". You
6 First-Time Investor: Grow and Protect Your Moneycan download this chapter for free when signing up at my website,http://www.PaulMerriman.com.In the view of Wall Street, if you end up making money, that’s fine.But your profits are a far lower priority. Sorry about that.In addition, I’ve seen time and again that no matter how you haveinvested your money, Wall Street always thinks you should dosomething different; that’s how they make money.You can’t be an investor without using the financial industry tosome extent. But you don’t have to buy high-cost, low-returnproducts. You don’t have to take Wall Street’s advice. Savvyinvestors should place their trust elsewhere.9. Learn to recognize the siren song of Main Street.Here I’m talking about your friends, relatives, colleagues andneighbors who like telling you about the great investments theyhave made. Recommendations from friends are great for choosingrestaurants, car mechanics and other businesses. But Main Street isnot the place to get investment advice.Your neighbors, relatives and friends are probably not trained inthe art and science of investing. They will never show you their fullfinancial records to demonstrate what they are bragging about, andthat means you have no way to know whether they are telling youthe truth, or whether they've had one success among many failures.Savvy investors should place their trust elsewhere.
First-Time Investor: Grow and Protect Your Money 710. Learn to appreciate the teachings of the academic community.There are many college and university professors who studyinvesting. In “Financial Fitness Forever,” I refer to them collectivelyas University Street. They don’t want to make a profit from you.They don’t care whether you think they’re smart. They just want tounderstand what really works to produce good investing results.Their motive is to impress their colleagues with their research,maybe gain tenure and be published.Most of what’s in this book is based on solid academic research andtime-tested results. University Street has found that investors dobest when they keep expenses low, diversify widely, accept thereturns of the market, pay attention to taxes and much more. Savvyinvestors place their trust in University Street. I hope you’ll beamong them.
8 First-Time Investor: Grow and Protect Your Money
First-Time Investor: Grow and Protect Your Money 9 2 BUILDING THE FOUNDATIONFOR LIFE-LONG RETURNS11. Pay attention to taxes.As a beginning investor, you are unlikely to be in a high taxbracket. You might think only wealthy people need to worry abouttaxes. But that would be a mistake. Taxes are inevitable, but youcan do a lot about them. In fact, you can eliminate almost 100percent of any taxes on your investment growth and income.Later in this book I’ll give you some specifics on how to legallyreduce your tax liabilities. For now I want to make the point that itreally matters what kind of accounts you have. Remember Table 1and Table 2, which show the hypothetical results of investing overa 40-year period? Those results assume that you achieved yourgains without paying taxes on them each year.
10 First-Time Investor: Grow and Protect Your MoneyIf you have to pay taxes as you go, you’ll wind up with a lot lessmoney for retirement.Here’s one example: If you achieved a long-term 10 percent returnbut had to pay taxes of 15 percent on your gains every year, yourafter-tax return would be only 8.5 percent. After 40 years, thatwould leave you with only about 1.5 million instead of 2.2million. (And you would still have taken all the risk of the strategythat produced the pretax 10 percent return.)12. Pay attention to expenses.Like taxes, the expenses you pay nibble away at your returns andthe gains you will have at retirement. You’ll encounter this pointagain and again in this book, and I hope the message sinks deepinside your mind.I’m always appalled at how casually investors agree to pay 1 to 1.5percentage points every year in expenses when they could veryeasily invest in essentially the same assets for one-tenth that cost.By the time you retire, this difference could easily rob you of 500,000 – more than twice your own total investments over 40years.13. Save 10 percent of your income if you can.Table 1 shows the power of long-term compounding. However, itmay be unrealistic in assuming a steady investment of 5,000 everyyear. When you’re 25, you may have a very hard time saving thatmuch. By the time you’re 55, you should be able to save a lot more.In the real world, you’ll almost certainly be able to reach your longterm goals if you get in the habit of saving 10 percent of your
First-Time Investor: Grow and Protect Your Money 11income each year – and if you invest that money wisely. Thatmeans 10 percent out of your own pocket, without counting taxbreaks or matching contributions from your employer. The firstpart, saving, is up to you. The second part, investing wisely, is whatyou will learn in this book.14. When you are young, invest in stocks.When there are decades left before you will need the money youinvest, you want that money to grow. No one can guarantee thereturn you will achieve from investing in stocks (using mutualfunds, of course). However, there is little evidence that you willachieve any significant growth if your money is in bonds orcertificates of deposit.It’s true that you can reduce your short-term risks by adding cashand bonds to your portfolio. But if you do that, you’ll reduce yourlong-term return in order to gain some short-term comfort. Ifyou’re young, that’s a poor bargain.Over the 86 years from 1926 through 2011, long-term governmentbonds provided a return of 5.7 percent. Meanwhile, the Standard &Poor's 500 Index returned 9.8 percent. That difference is muchgreater than it seems. Invested in bonds, 1 grew to 118 over thatvery long period. Invested in stocks, 1 grew to 3,100. Later in thisbook I’ll describe and recommend other types of stocks that didmuch better.15. Diversify your investments across many industries.Many people are tempted to concentrate their investments in a fewindustries they are sure will outperform the market. In the 1960s,
12 First-Time Investor: Grow and Protect Your Moneyatomic energy and airlines were seen as sure long-terminvestments. In the 1990s, many investors “knew” that technologycompanies were so promising that they abandoned common senseand put everything in that sector. I have a friend who knew thebanking business very well; just before that whole sector blew up in2008, he had the majority of his money in the stock of WashingtonMutual – and he kept it there while that company imploded andbecame nearly worthless.Don’t be like these people. If you diversify widely, at any givenmoment you’ll automatically have some of your money invested inwhatever part of the economy is going gangbusters. This willhappen automatically, and you won’t have to worry about it. Savvyinvestors diversify. You should too.16. Diversify your investments across many asset classes.In this book you will learn about a dozen or so important assetclasses. An asset class is a group of stocks with similarcharacteristics, such as large U.S. companies that are popular withinvestors. (I’ve just described the asset class known as U.S. largecap growth stocks.)At any moment, a few of these asset classes will be leading themarket and others will be languishing. Many “experts” on WallStreet and in the financial media will try to convince you theyknow which of these asset classes will do the best at any giventime. But they don’t and can’t know the unknowable.I’ve been paying close attention to these experts for half a century,and I haven’t found any whose predictions reliably pan out. Mybest advice is the same as in Item 15: Diversify.
First-Time Investor: Grow and Protect Your Money 1317. Diversify your investments geographically.The majority of the world’s stock market capital lies beyond theborders of the United States. In spite of that well-known fact, youwould be surprised how many U.S. investors believe all they needare companies based in their own country. Many advisorsencourage their clients to have most or all of their stockinvestments in U.S. companies, which are familiar and comfortable.All the research of which I am aware indicates that long-terminvestors have benefited from splitting their stock investmentsbetween U.S. and international funds. Sometimes internationalstocks do better than domestic stocks, and sometimes U.S. stockslead the way. Often they move up and down together, butsometimes their gains and losses offset each other, reducingvolatility (risk).There’s a whole world of opportunity waiting for you, and youshould take advantage of it. Based on historical returns and manyyears of working with clients and their portfolios, I recommendthat you split your stock investments 50/50 between companiesbased in the United States and ones based in other countries. Overlong periods, that combination increases return and reducesvolatility.18. Start thinking about retirement now.This may seem strange advice for somebody who may be 30 or 40years away from retirement, but I think it’s important. Think of itas advance planning on steroids.By the time you invest your first dollars toward retirement, youshould have at least a rough idea of how much money you’ll needto accumulate, and you should have chosen a distribution strategy.
14 First-Time Investor: Grow and Protect Your MoneyFor example you may determine that (in today’s dollars) you willneed 80,000 a year to live on and that you can expect half of thatfrom Social Security. That means your portfolio will need to “payyou” 40,000 a year for as long as you live. Using a conservative 4percent distribution assumption, that suggests you should have atleast 1 million in your portfolio when it comes time to retire.Table 3Total lifetime results of various rates of returnThe following table takes the set of calculations from Tables 1 and 2a step further, showing the potential results of various rates ofreturn during your life and after your life is over.YourinvestmentsYour pre- Yourretireme