MONEY target date funds

Target-Date Funds Try Timing the Market

Managers of target-date retirement funds seek to boost returns with tactical moves. Will their bets blow up?

Mutual fund companies are trying to juice returns of target-date funds by giving their managers more leeway to make tactical bets on stock and bond markets, even though this could increase the volatility and risk of the widely held retirement funds.

It’s an important shift for the $651 billion sector known for its set-it-and-forget-it approach to investing. Target-date funds typically adjust their mix of holdings to become more conservative over time, according to fixed schedules known as “glide paths.”

The funds take their names from the year in which participating investors plan to retire, and they are often used as a default investment choice by employees who are automatically enrolled in their company 401(k) plans. Their assets have grown exponentially.

The funds’ goal is to reduce the risk investors take when they keep too much of their money in more volatile investments as they approach retirement, or when they follow their worst buy-high, sell-low instincts and trade too often in retirement accounts.

So a move by firms like BlackRock Inc., Fidelity Investments and others to let fund managers add their own judgment to pre-set glide paths is significant. The risk is that their bets could blow up and work against the long-term strategy—hurting workers who think their retirement accounts are locked into safe and automatic plans.

Fund sponsors say they aren’t putting core strategies in danger—many only allow a shift in the asset allocation of 5% in one direction or another—and say they actually can reduce risk by freeing managers to make obvious calls.

“Having a little leeway to adjust gives you more tools,” said Daniel Oldroyd, portfolio manager for JPMorgan Chase & Co’s SmartRetirement funds, which have had tactical management since they were introduced in 2006.

GROWING TACTICAL APPROACH

BlackRock last month introduced new target-date options, called Lifepath Dynamic, that allow managers to tinker with the glide path-led portfolios every six months based on market conditions.

Last summer, market leader Fidelity gave managers of its Pyramis Lifecycle strategies—used in the largest 401(k) plans—a similar ability to tweak the mix of assets they hold.

Now it is mulling making the same move in its more broadly held Fidelity target-fund series, said Bruce Herring, chief investment officer of Fidelity’s Global Asset Allocation division.

Legg Mason Inc says it will start selling target-date portfolios for 401(k) accounts within a few months whose allocations can be shifted by roughly a percentage point in a typical month.

EARLY BETS PAYING OFF

So far, some of the early tactical target-date plays have paid off. Those funds that gave their managers latitude on average beat 61% of their peers over five years, according to a recent study by Morningstar analyst Janet Yang. Over the same five years, funds that held their managers to strict glide paths underperformed.

But the newness of the funds means they have not been tested fully by a market downturn.

“So far it’s worked, but we don’t have a full market cycle,” Yang cautioned.

The idea of putting human judgment into target-date funds raises issues similar to the long-running debate over whether active fund managers can consistently outperform passive index products, said Brooks Herman, head of research at BrightScope, based in San Diego, which tracks retirement assets.

“It’s great if you get it right, it stings when you don’t. And, it’s really hard to get it right year after year after year,” he said.

MONEY Ask the Expert

Can I Diversify My Portfolio With One ETF Rather than Four?

Q: Does investing in a “total stock market index fund” give you diversified exposure to large-, medium-, and small-sized companies? Or do I need to invest in separate mutual funds for my large- and small-company stocks? — Toby, Davis Junction, IL

A: No, you don’t need separate funds. The Vanguard Total Stock Market ETF VANGUARD INDEX FDS TOTAL STOCK MARKET ETF VTI 0.6166% is designed to give you exposure to a broad cross-section of different types of domestic equities in a single exchange-traded fund.

Its portfolio breaks down like this: around 72% is invested in large companies, a little less than 20% is in medium-sized businesses, about 6% is in small-company shares, and 3% is in so-called micro-cap stocks.

Now, you can achieve similar diversification by allocating your dollars into a collection of more narrowly constructed funds that focus on industry-leading large companies or quick-growing but volatile small companies.

For instance, you could pick up Money 50 funds Schwab S&P 500 Index SCHWAB CAPITAL TST S&P 500IDX SEL SWPPX 0.6365% , with iShares Core S&P Mid-Cap ISHARES TRUST REG. SHS S&P MIDCAP 400 IDX ON IJH 0.3439% and iShares Core S&P Small Cap ISHARES TRUST CORE S&P SMALL-CAP ETF IJR 0.8074% . (Although, if you’re not careful, you might end up with more exposure to smaller companies than you want. About 30% of IJR’s portfolio is in micro-cap stocks.)

All things being equal, says BKD Wealth Advisors’ portfolio manager Nick Withrow, you’re better off going with the one fund than three or four.

For one thing, each fund comes with its own expenses. If VTI dovetails with your risk tolerance, then you’ve taken care of your domestic stock portfolio at a measly cost of 0.05% of assets annually. That’s marginally cheaper, by about 0.06 percentage points, than buying a host of exchange-traded funds that collectively approximate VTI’s portfolio, says Withrow.

But there’s another reason — you.

Basically, you don’t want to get into the business of buying and selling ETFs to try and time the market. And you’re much less likely to get into that expensive habit if you buy-and-hold one fund, rather than picking three or four.

“The more choices an investor has, the more apt he or she is to feel that they have to do something,” says Withrow. “The idea of simplicity, especially with a buy-and-hold attitude, goes a long way.”

Of course, one total market exchange-traded fund doesn’t mean your portfolio is complete. Don’t forget about foreign equities or, you know, bonds. But when it comes to U.S. stocks, one cheap total market ETF (like VTI) is particularly useful.

MONEY Portfolios

The One Thing You Have to Know to Invest on Your Own

You don't need pricey money managers to help you buy low and sell high.

With the 4th of July on the way, the editors here at Money.com asked me to think about what it takes to become an independent investor.

I’ll take “independent” to mean something that most people with a 401(k) or an individual retirement account can realistically do. I’m not talking about sitting at your desk all day trading your own portfolio of stocks. In fact, the way I think about independence, you’ll want to automate about 99% of the investment decisions in your portfolio — specifically, which individual stocks and bonds to hold. The independence that matters has nothing to do with security selection. It’s about cutting out costly middlemen, from advisers who help you select investments, to the managers who pick the securities inside the mutual funds you may hold.

The rewards to doing this are significant. A high-cost mutual fund may shave 1% or more off of your investments each year, which can easily add up to six figures in fees and foregone gains over a lifetime as an investor. Eliminating layers of management also means you are less exposed to the quirky risks someone else might take with your money.

You don’t need a lot of time or expertise to pick these middleman-free investments. You can build a portfolio that holds a diversified slice of stocks and bonds with just three index mutual funds, portfolios that mimic the composition of the overall market at very low cost. If stocks rise 8% in a year, you’ll earn 8% or very close to it. You very likely have index options in your 401(k) plan—if not, say something to your HR manager!—and index funds are easy to buy in an IRA.

Below is what that portfolio might look like. You can adjust the split depending on you appetite for risk, but the one below is a good starting point for many long-term investors saving for retirement. (The less you can stand to lose, the more you’d add to the bond fund.)

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In contrast to typical funds, this portfolio will cost you less than 0.1% of assets per year, and will get with three easy decisions exposure to literally thousands of stocks. You can choose index funds from our Money 50 list of recommended funds.

It’s easy to say that anyone can do this, of course. But I think a lot of people lean on investment middlemen because they aren’t sure they know enough about investing to do it themselves, and even if they want to learn, they aren’t sure which knowledge really matters. There’s so much you could dive into: stock sectors, “P/E” ratios, the January effect, EPS growth, upside earnings surprises, etc., and etc.

So here’s the one thing I think you have to understand to be a competent, on-you-own investor: Where the return on your investments really comes from. And the answer is that, for stocks, it comes from two sources. You own businesses, and you are taking a risk to do so.

Beginners are often introduced to the market with the old saying, “buy low and sell high.” This isn’t wrong (doing it the other way sure won’t feel good), but it’s not at all helpful. It makes investing sound a like a game of wits against other investors — first you figure out when a stock is too low, and then sell it when somebody else is willing to buy it for more than its worth. That’s hard, and you have to learn a lot about companies, accounting and human psychology to even attempt it. The whole edifice of the middleman money management business is built on the fact that most people believe they can’t do this themselves, or don’t want to.

But to be a buy-and-hold index investor, you can throw out “buy low/sell high” and the game-playing thinking that tends to go with it. This isn’t about finding a greater fool to buy your stock further down the road. Owning stocks gives you a claim on the earnings of companies. As an owner, you make money over time either because you are being paid a dividend out of profits, or because profits are being reinvested in the business to make it more valuable. Index funds give you a share in the future profits of the America’s, or the world’s, public companies. It’s almost as simple as that. Almost.

The other, crucial part of the equation is that the earnings of companies are uncertain and so are the cash flows shareholders will get. Stock investors get no promises that a company will ever earn enough to produce a dividend. Investors typically bake that risk into the market price of stocks, so that they can hope to be compensated with a higher return than they’d get on bonds. Historically, stocks have earned about 4.5 percentage points per year above bonds. Stock investors have on average been paid for risk — but that doesn’t mean you’ll always get paid for risk. Case in point: The nearly 50% loss investors took on blue chip stocks in the wake of the financial crisis.

If you get that, you have the baseline knowledge you need to build a diversified portfolio and stick with it. The potential for loss is built into stock investing and you only make money if you are willing to live that. The rest is (usually expensive) fiddling around the edges.

MONEY Markets

The Real Reason You Should Care About Insider Trading

Martha Stewart leaving court after conviction
Businesswoman Martha Stewart, 62 leaves federal court in New York City on March 5, 2004. Stewart was found guilty on all counts over a suspicious stock sale. Jeff Christensen—Reuters

A new study suggests insider trading is even more rampant than anyone thought. But it's not so obvious why individuals should be concerned.

Between Michael Lewis’s takedown of high-frequency traders in Flash Boys and a new study finding that one in four M&A deals are preceded by insider trading, Wall Street’s public image is looking more “sell” than “buy” these days.

But how much does insider trading actually harm the average Joe? Even if Gordon Gekkos are running amok, do cheaters pose a real threat to those who play by the rules? The answer might surprise you.

1. Insider trading won’t hurt you if you don’t trade. Just like front-running high-frequency traders, those who trade on secret information are unlikely to hurt the portfolios of buy-and-hold investors, says Rick Ferri, founder of Portfolio Solutions.

In theory, an individual who frequently trades could be unlucky and end up buying or selling just as market-riggers are doing the opposite. But holding a diversified portfolio of stocks over long periods of time dilutes that damage; if you hold an index fund for a decade, you’d likely lose no more than pennies from trading inequities, says Ferri. “Getting upset about insider trading is like getting upset about the NFL draft,” says Ferri. “It makes for juicy headlines, but unless you’re a professional, it’s not really going to affect you.”

2. Insider trading could even help you. The presence of cheaters in the market could, coincidentally, benefit uninformed investors who just happen to land on the right side of a trade, says Santa Clara University finance professor Meir Statman, who has studied investor perceptions of insider trading. Let’s say you need to sell a stock in a company to free up cash, says Statman: If that happens to coincide with an insider trading-driven run-up before the company announces a merger or acquisition, you could actually win out.

3. Nevertheless, these cheaters are destroying the American Dream. Pundits have used the points above to argue that insider trading should be legalized. But the so-called “victimless crime” claims at least one victim, says Statman: confidence in the market. “A belief in fair play is part of good American culture,” says Statman. “The stock market is supposed to be an emblem of the American Dream: the belief that if you work hard and do your research, you’ll be rewarded. It’s not supposed to feel like the lottery.”

In his research, Statman has found that people living in economies riddled with more corruption, like India and Italy, are twice as likely as Americans to deem insider trading acceptable.

insider
Meir Statman, “Is It Fair? Perceptions of Fair Investment Behavior across Countries,” Journal of Investment Consulting, 2011.

There are a few key takeaways: If we want to keep our markets fair, it’s important that cheaters are caught and punished. But news headlines shouldn’t prevent you from investing, as long as you do it wisely — with diversified index funds and minimal trading. “Trading is like going into the jungle,” says Statman.

“There will always be beasts who are larger than you and thus able to devour you,” he says. “So go in as rarely as possible.”

MONEY Ask the Expert

What’s the Right Way to Expand My Portfolio In My 20s?

A financial pro gives a young investor some advice on the smartest ways to gain exposure to the market.

Q: I am in my early 20s and am looking to expand my investment portfolio. I currently have a small 401(k) and an S&P 500 index fund. Should I keep building up my index fund or start diversifying into something with a higher return potential? — Caroline, California

A: Participating in a 401(k) and investing in an S&P 500 index fund are a good start in your early 20s, notes Jim Ludwick, president of MainStreet Financial Planning.

Index funds — which simply buy and hold all the stocks in a market index such as the S&P 500 — aren’t as flashy as actively managed portfolios, where stock pickers can choose only those shares that they think are promising. However, index funds are a simple and inexpensive way to gain exposure to the market.

And there are years, depending on the market, where they can produce some sizeable gains. For instance, in 2013, the Vanguard 500 index fund, which tracks the S&P 500 index, returned more than 32%. That’s around three times the long-term average annual gain for stocks.

However, index funds are only as diverse as the market they track. So a good way to expand at this point would be to invest in other index funds that go beyond the S&P 500 index of U.S. blue chip stocks. An index fund that tracks the Russell 2000 index, for example, would give you exposure to shares of faster-growing small U.S. companies which your existing portfolio lacks.

You can add a Russell 2000 index fund to your mix to complement the S&P 500 fund, which gives you exposure just to large domestic companies.

Or for simplicity, you could trade in your S&P 500 fund for a so-called total market index fund, which in a single portfolio gives exposure to both large and small U.S. firms. “Expanding into a whole market index,” Ludwick notes, “is a very effective way to do it.”

Ludwick further highlighted the importance of investing in overseas markets for those seeking to expand and diversify. He noted that the Vanguard FTSE All-World ex.-U.S. ETF (ticker: VEU), which tracks stock markets outside the U.S., would be a good, low-cost complement to your U.S. holdings.

When investing in index funds, it’s important to comparison shop among vendors — Vanguard, Fidelity, Charles Schwab, iShares, SPDR all offer index products — for fees. Keep in mind that the expenses you pay are deducted from the market returns the fund generates, so the less a fund charges in fees, the more of its returns you get to keep.

Beyond index funds, you could branch out into actively managed portfolios. Studies have shown that over the long run, the majority of actively managed funds trail the basic indexes. Ludwick says active management is effective only in niche markets. That’s where the “insight really pays off,” he says.

However, as with all funds, the lower you can keep the fees, the better off you’re likely to be in the long run.

MONEY 401(k)s

Do I Really Need Foreign Stocks in My 401(k)?

Foreign stocks are supposed be a great way to diversify and get better returns. But these days? Not so much.

It’s long been a basic rule of retirement planning—allocate a portion of your 401(k) or IRA to international stocks for better diversification and long-term growth. But I’m not really sure those reasons hold up any more.

Better diversification? Take a look at the top holdings of your domestic large-cap or index stock fund. You’ll find huge multinationals that do tons of business overseas—Apple, Exxon, General Electric. Investing abroad and at home are close to being the same thing, as we saw during the financial crisis in 2008, when all our developed global markets fell together.

As for growth, we’ve been told to look to the booming emerging markets—only they don’t seem to be emerging much lately. Even as the U.S. stock indexes have been reaching all-time highs, the MSCI emerging markets benchmark has had three consecutive sell-offs in 2012, 2013 and 2014, missing out on a huge recovery. That’s diversification, but not in the direction I want for my SEP-IRA that I’m trying to figure out how to invest. (See “My 6 % Mistake: When You’ve Saved Too Little For Retirement.”)

Some market watchers have pointed out that after two decades, the countries that were once defined as emerging—China, Brazil, Turkey, South Korea—are now in fact mature, middle-income economies. If you’re looking for high-octane growth, you should really be considering “frontier” markets, funds that invest in tiny countries like Nigeria and Qatar.

That’s all well and good. But when it comes to Nigeria, I don’t really feel confident investing in a country where 200 schoolgirls get kidnapped and can’t be found. As for Qatar, it’s awfully exposed to unrest in the Middle East. (Dubai shares just tumbled, triggered by escalating violence in the Iraq.)

Twenty years ago, I was more than game for emerging markets and loved getting the prospectus statements for funds listing then exotic-sounding companies like Telefonas de Mexico and Petrobras. But I just don’t think I have the stomach, or the long time horizon, for it anymore.

My new skittishness around international stocks may be signaling a bigger shift in my investing style from growth to value, the gist of which is this: since you can’t always predict which stocks will grow, the best thing you can do is to focus on price. Quite simply, value investors don’t want to pay more for a stock than it is intrinsically worth. (Growth investors, by contrast, are willing to spend up for what they expect will be larger earnings increases.) By acquiring stocks at a discount to their value, investors hope profit when Wall Street eventually recognizes their worth and avoid overpriced stocks that are doomed to fall.

As Benjamin Graham, the father of value investing, wrote in his 1949 classic, “The Intelligent Investor,” “The habit of relating what is paid to what is being offered is an invaluable trait in an investment.” (Warren Buffett, among many others, consider “The Intelligent Investor” to be the investing bible. ) “For 99 issues out of 100 we could say that at some price they are cheap enough to buy and some other price they would be so dear that they should be sold,” Graham also wrote. And he famously advised that people should buy stocks the way they buy their groceries, not the way they buy their perfume, a lesson in price sensitivity that I immediately understand and agree with.

Looking at the international question through a value vs. growth lens, my choice is seems more clear—at least on one level. If emerging markets are down, now is probably a good time to buy. But the biggest single country exposure in the MSCI Emerging Markets Index is China, at 17%, and it might be on the brink of a major bubble.

It seems a bargain-hunting investing approach isn’t always that much safer, and I’m wondering if it might be worth paying more at times to avoid obvious trouble. Still, I’ve only just discovered my inner value investor. I’m going to keep reading Benjamin Graham and will let you know.

Ruth Davis Konigsberg, a fortysomething journalist and consultant to Arden Asset Management, writes weekly about retirement planning.

MONEY funds

3 Bad Reasons We Pay So Much For Mutual Funds

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Why do investors let active managers reel in their assets? Getty Images

The numbers say that cheap index funds are your best bet. So why are people still willing to pay fund managers so much?

Every time the market makes a big turn, this happens: A bunch of money managers previously hailed as brilliant get caught betting the wrong way. This time it’s hedge fund managers making “macro” bets. For example, the $13 billion fund run by Paul Tudor Jones is down 4.4%, according to the Wall Street Journal, while the general stock market is up 5.4% and bonds are up 3.4%.

Meanwhile, in the prosaic world of mutual funds available to you and me, the evidence is overwhelming that most managers can’t beat the market. Over the past five years, according to S&P Dow Jones Indices, about 73% of blue chip stock funds trailed the S&P 500 index. You can buy a passive S&P 500-tracking index fund for almost nothing—as little as 0.05% of asset per year—and get roughly all of the market’s return. Funds that instead use human being to pick stocks often charge 1% to 1.4%, for worse results.

In a post on his Pragmatic Capitalist blog, Cullen Roche wonders why people keep buying these funds that cost more and deliver less. His explanations sound right—you should read them—and boil down to people being poorly informed and too emotional about investing. Not everyone knows how hard it is to beat the market, and the ones who do are overconfident about their ability to do better.

But I’d like to propose a few more reasons people like active funds, which go beyond overoptimism. I’m not advocating for these active approaches. In each case, if this why you use active funds, I’ll suggest an alternative way of coming at the problem.

1) Using an active fund as a de facto financial adviser.

Many if not most fund managers these days are “closet indexers,” meaning they stick pretty close to a stock benchmark like the S&P 500, with just a few deviations they hope will goose performance enough to justify their fees. But there is a subset of managers with a broader mandate. They mix up U.S. stocks, foreign stocks, bonds and other assets. Some, like the popular T. Rowe Price and Fidelity “target-date” funds, shift among these assets according to a pre-set formula based on their investors planned age of retirement. Others move around based on their views about whether, say, U.S. stocks look expensive or cheap. But in either case, their investors may not really be coming to them for market-beating stock picks. They are using those funds to help find the right split among stocks and bonds.

In other words, these funds are stand-ins for the financial advisers who help people set up their portfolios. The advice isn’t personal, but really good personal advice is hard to get if you don’t already have a big portfolio.

The better alternative: Buy a target date fund that uses cheap index funds instead. Or an index-based “balanced fund” with about 60% in stocks and 40% in bonds. Even if that’s not quite the optimal mix, the advantage of low fees is often more important. Or you can build your own cheap three fund portfolio using the index funds on the Money 50 recommended list.

If what you really want is a fund manager who knows when to get you out of stocks before they drop, well, the truth is neither fund managers nor advisers are likely to time these turns consistently well. Investors who want to preserve capital in bear markets are better off just dialing back their stock exposure as a matter of policy.

2) Going active to get a tilt.

Not everyone wants exactly the level of risk the stock market delivers. Investors willing to live with more volatility to get a higher return might, for example, want to add more small companies to their portfolio. Likewise, there is some evidence that a bias toward value stocks can deliver better returns over the long run. For a long time, buying an active mutual fund was really the simplest way for most people to get a slightly different mix of risk and return characteristics than the market offered.

Those days are over. You can buy an index-based exchange-traded fund to capture almost any slice of the market or stylistic tilt. I’m skeptical of whether most of these funds are worth the bother, but many are cheaper and more reliable than pure active funds.

3) That enterprising feeling.

I’ve been a convinced indexer for so long that sometimes I forget how cynical the approach can sound to the uninitiated. You’re just tossing your money into the market and betting that on average it works out. Mutual fund managers, on the other hand, say they are scouring companies’ “fundamentals,”and “kicking the tires,” and “thinking of ourselves as owners of businesses.” (Never mind that for many fund managers holding a stock for a year is what counts as a long-run strategy.) At first blush, this doesn’t only sound like a smart way to make money… it sounds like the right thing to do. A way to be a good steward of wealth and to help build the American economy. I’m often struck by how people seem to admire Warren Buffett not only as a smart businessman with a rare stock picking ability, but as a kind of spirit guide. Not for nothing is his annual shareholder meeting called the Woodstock of Capitalism.

Roche has what I think is a deep insight that might make you think differently about this. The money you put into equities via your 401(k) or IRA isn’t really “investing,” just saving with more risk and an incrementally better expected return than bonds. That’s because you aren’t handing any funding to the company, but buying an old claim on it from someone else.

…the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO).

Whether you buy an active fund or an index fund, you’ll be at a pretty distant remove from the companies you indirectly own. On average, you won’t have much chance of a big return, and some tire kicking here and there won’t add a lot of value. There’s nothing wrong with that. Most of us don’t have the time or the interest to be even part-time entrepreneurs. There’s no shame—and a lot of gain to be had—in keeping it cheap and simple and moving on.

MONEY Portfolios

Alex, I’ll Take “How to Invest Like a Jeopardy Champ” for $1000

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Host of Jeopardy! Alex Trebek and contestant Arthur Chu. courtesy of Jeopardy

Controversial Jeopardy champion Arthur Chu talks with MONEY about risk-taking, his long-term goals, and why he isn't in the market for a shiny convertible.

Earlier this year, Arthur Chu won a staggering 11 games on Jeopardy, nearly $300,000 in prize money, and the unofficial title of “Jeopardy Villain.”

Chu upset some gameshow purists with his counter-intuitive tactics. For instance, he relied on game theory to outmatch his opponents. Chu would often skip around from category to category and select the most valuable answers first. Fans who were used to contestants staying in one category, and starting with the least valuable answers, chafed at his approach. (Although Chu is hardly Jeopardy’s first unconventional player.)

A few months after his epic run, Chu had to figure out what to do with his winnings, and how to adjust to life with a lot more money in the bank.

The 30-year-old voice-over artist and actor lives in Broadview Heights, Ohio, and recently spoke with MONEY.

(The interview has been edited.)

Viewers seemed to view you as a risky player, but you’ve maintained that your strategy was risk-averse. How so?

For some reason, probably because Jeopardy consistently refers to its points as “dollars,” people don’t get the most fundamental rule of how Jeopardy works — the points you earn in the game are NOT dollars. They only turn into money if you win the game, if after Final Jeopardy you’re in first place. If you aren’t in first place, all your points disappear, your total is completely erased and you either get the 2nd-place $2,000 or 3rd-place $1,000 consolation prize and go home.

The expected value of winning the game versus losing is immense. Not one single dollar in your stack is worth anything if you lose. And yet people do irrational stuff all the time like make bets that ensure they’ll still “have something” if they lose the bet, even though if you lose the game “having something” and “having $0″ are completely equivalent — you get the same consolation prize either way.

So imagine if you had some bizarre contract where if your investment portfolio hit a certain value by a certain time limit, you get to keep the money. But if it’s below that value all the money is taken away. Do you see how this would be different from normal investing? How “low-risk” moves would actually be very high-risk moves — the “safer” your portfolio is, the higher the risk that you won’t hit your target and win the game, and all your money will vanish?

Speaking of risk, how do you view risk in your own portfolio?

When all I had was a small amount of savings I was invested conservatively to make sure that our total funds wouldn’t dip too low in case we needed them — specifically the Vanguard LifeStrategy Conservative Growth Fund (VSCGX).

Now that I have a much bigger stack I’m sitting on and the capacity to absorb more downside risk I have it all invested aggressively in Vanguard’s Target Date 2050 Retirement Fund (VFIFX.) I’m trying to keep everything as automated as possible so that managing money can be one less drain on my thoughts and energy among all the other stuff I have to do.

What’s your long-term investing strategy? Do you own actively managed funds?

As long as I’ve been into investing I’ve been an indexer. I’ve absorbed the gospel of A Random Walk Down Wall Street, I follow the Bogleheads forum, I’m invested in Vanguard, all of that stuff.

I’ve yet to see a compelling, rational argument that says you come out ahead with active investing — at least not without a lot more research and a lot more savvy that I really want to put into it. (You have to be able, as a non-financial professional yourself, to identify the managers you trust to give you above-market returns — and not just above-market returns but returns that are enough above market to justify the cut they take. I’ve yet to see a reliable method for doing this.)

What goals will your winnings allow you to achieve?

It’s not really buying stuff that matters most to me — the single thing I value most that’s most irreplaceable is my time. A nine-to-five job, while it comes with a lot of perks and a lot of security, takes the lion’s share of the hours in the day away from me and puts them toward something I’d rather not be doing. To be able to live a life basically like the one I have now but to have that time freed up — that’s worth more than any car or any cruise.

What does all of this money buy you?

The main thing it buys is a feeling of peace. I have no intention of quitting my job in the near future but just knowing that you don’t need a job is profoundly freeing.

Knowing that I could buy almost anything I wanted if I really wanted to is profoundly freeing — and, paradoxically, having this knowledge means I no longer think about things I want but can’t have nearly as much. When the thing that you’d be trading off for the lust-inspiring luxury is tangible — when I know that I’d be trading, say, six months of not having to work for a shiny new convertible — it puts things in perspective and helps push away the need to lust over such things.

MONEY Warren Buffett

One Weird Trick That Will Help You Beat the Market Like Warren

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Warren Buffett Ben Baker—Redux

Here's a no-brainer way to win with "Warren" stocks. It won't do you any good now, but it would have been brilliant in 1993.

My story, Inside Buffett’s Brain, is about the search by financial economists and money managers for persistent patterns in stock returns. Some of these patterns might help to explain why a handful of money managers, including Buffett, have done so well. The story is about more than Buffett, though. The hunt through past market data for potentially winning strategies is a big business, and has fueled the growth of exchange-traded funds (ETFs). So a word of warning is in order.

Here’s the result of astoundingly simple Buffett-cloning strategy I put together, inspired by a “modest proposal” from Vanguard’s Joel Dickson. All you have to do buy stocks with tickers beginning with the letters in “Warren.” (You have double up on the “r” stocks, natch.)

Winning with Warren NEW

This likely “works” in part because it’s an equal-weight index—meaning each stock in the W.A.R.R.E.N. portfolio is held in the same proportion. Traditional indexes like the S&P 500 are “capitalization weighted,” meaning they give more weight to the biggest companies in the market. Because smaller stocks have outperformed in recent years, equally weighted indexes have done pretty well compared to traditional indexes in the period in question.

So you might find out that you can also beat the market with an equally weighted basket of stocks whose tickers begin with the letters in your name too. Just cross your fingers and hope the trend doesn’t reverse in favor of blue chips.

Another reason why this trick worked is that it picks from among current S&P 500 names, which means the stocks on the list are already in a sense known winners. Companies that used to be small and then graduated to the S&P 500 are on list, and companies that used to be big and then got small or disappeared aren’t on the list. But you couldn’t know which companies those were in 1993.

This is obviously dopey, and no way to run your money. (And the ideas I wrote about are much, much more sophisticated than this.) But there’s a serious point here. ETFs are a great way to buy cheap, reliable exposure to the stock market. But these days most ETFs track not a simple well-known benchmark, but a custom index built upon rules which, if followed, are thought to give investors an edge. For example there are indexes which tilt toward companies with better-than-average sales, or which specialize in certain sectors or investment themes.

These indexes often have really impressive past performance. In theory. Based on “back tests” of market data, from before the index was actually in operation.

And of course they do. Today indexes are often created with an ETF launch in mind. So there’s not much point in building an index and marketing it if you don’t know that the strategy has already won. Unfortunately, knowing what’s already worked in the past doesn’t mean you know what will work in the future.

In fact, investors in new indexes are likely to be disappointed. Samuel Lee, an ETF strategist at Morningstar, explains that in any group of past winning strategies, a high number will have won just through sheer luck. The future average performance of those strategies is almost certain to decay. Because luck runs out.

MONEY Investing

Winning at Investing Made Simple

Served on a silver platter: the right portfolio strategy and investing well for retirement. illustration: tavis coburn

Here are just a few of the ways Wall Street pros try to eke out an edge in the market. You can’t do any of them:

With a subscription to the Bloomberg online news service (price: about $20,000 a year), traders can instantly see anything from the location of oil tankers around the globe to supply-chain maps of a company’s vendors and customers.

Hedge fund managers who invest in drug and technology companies tap into “expert networks” of executives and scientists paid for their specialized knowledge. In some cases, it’s been charged, traders have also illegally gotten inside information through these contacts.

Half of stock trades are made by automated “high-frequency” programs; it takes 7/10,000ths of a second to buy or sell on the New York Stock Exchange, says the Tabb Group, down from a horse-and-buggy 10 seconds eight years ago.

You can’t get a jump on this crowd. You can’t even compete with them. Chances are, the professional managers you hire via a mutual fund, for 1% of assets or more per year, won’t be able to stay ahead either.

In October, Ray Dalio, one of the most successful hedge fund managers in the world, told a conference audience that “going forward, most investors are not going to be able to produce alpha.” “Alpha” is finance jargon for outperforming the market after accounting for risk. In truth, the search for alpha has always been something of a snipe hunt; the word was first used in a 1967 article that showed that most mutual funds didn’t deliver it, especially after subtracting fees.

Two things have changed since then: More pros admit the alpha game is over, and perhaps more important for you, investing has never been better for those willing to stop playing. In the words of Tadas Viskanta, editor of the finance blog Abnormal Returns, there’s wisdom in reaching for “investment mediocrity.”

Today, just as in 1967, most professionals can’t beat an index that tracks the stock market. “The paradox,” says Viskanta, “is that the less effort you put in, the better off you are.” And recently, he notes, perfect mediocrity has grown more attainable, as index-based investing has moved steadily closer to free.

For as little as 0.04% of assets per year — that’s $4 for every $10,000 you’ve invested — and often with no broker commission, you can buy an exchange-traded fund, or ETF, that follows most of the U.S. stock market and delivers its return.

This year’s Investor’s Guide starts from the idea that index funds and a buy-and-hold stance should be the default approach for long-term wealth builders. With that in mind, MONEY has rebuilt our basic investing tool set: Our list of recommended funds is now the MONEY 50, streamlined from 70. Not all the funds are index trackers, but the core choices are low-cost, highly diversified portfolios for the long run. For many investors, a portfolio balanced among one broad U.S. stock fund, an international fund, and one or two bond funds is all you need. The MONEY 50 makes building that portfolio easy.

Yet even if you decide to stick with a simplified strategy, that doesn’t mean every investment puzzle you’ll face has been solved. The stories in this guide will help you think through your approach to the three biggest questions you still face as you save for retirement.

Question No. 1: Buy and hold what exactly?

You can build a simple portfolio for any level of risk. Stretching for high returns? You could put all your money in the Schwab U.S. Broad Market SCHWAB STRATEGIC T US BROAD MKT ETF SCHB 0.6675% , or crank up risk and return potential further by adding funds like Vanguard Small-Cap VANGUARD INDEX FDS VANGUARD SMALL-CAP ETF VB 0.5378% or Vanguard FTSE Emerging Markets VANGUARD INTL EQUI FTSE EMERGING MARKETS VWO 1.1478% . Need safety? Stash more in Vanguard Total Bond Market VANGUARD BD IDX FD TOTAL BOND MARKET BND 0.0728% or iShares Barclays TIPS Bond ISHARES BARCLAYS TIPS BOND FUND TIP -0.0354% to add inflation protection.

These funds make security selection automatic, but they don’t help at all with the question of how much risk you want to take. The standard rule of thumb says you should start out with a high allocation to equities and gradually “glide” that down as you age. These days fund companies often focus less on their stock-picking prowess and more on designing all-in-one “target date” funds that do this asset allocating for you. Yet as you’ll see in “How much should you hold in stocks?,” the theory and practice of lifetime asset allocation are all over the map.

Question No. 2: What if high stock and bond returns are really over?

If you’re a just-own-the-market purist, you don’t ask if stocks are cheap or expensive. You assume it’s too hard to outwit the hive-mind intelligence of the crowd. Over the short run that’s almost certainly true. But there’s evidence that the price of stocks relative to measures of their value like earnings and assets can provide a clue about returns over the course of a decade.

Stocks are now priced at about 21 times the five-year average of their earnings. According to research from the Leuthold Group advisory firm, when the market’s price-to-earnings ratio is between 20 and 25, over the next 10 years stocks have delivered an annualized return of only 3% after accounting for inflation.

Combine that with a gloomy outlook for bonds. Current yields are an indicator of future returns, and with the 10-year Treasury at 2.8%, you may be lucky to carve out 1% after inflation. “Stocks, Bonds? In 2014, Think Cash,” will help you think through your strategy so that you can thrive in a world where today’s high-asset prices could repress tomorrow’s returns.

Question No. 3: Can I ever do better?

Maybe. Even some advocates of index investing say there may be ways to outperform. But the extra bump doesn’t come from tearing into company balance sheets or, as famed Fidelity manager Peter Lynch used to say, “buying what you know.” It comes from “tilting” a portfolio of hundreds of securities to take advantage of anomalies that have shown up in historical stock returns.

One is the value effect, the tendency of stocks with low prices relative to their earnings or asset value to outperform over time. Likewise, there seems to be a small-company premium. For a shot at earning these boosts, you don’t buy a portfolio of 40 or 50 small-caps or bargain stocks. Instead, you buy an index or index-like fund that gives more weight to such shares.

You’ll need nerve: Larry Swedroe of Buckingham Asset Management, who recommends tilting, says the strategy trailed the S&P 500 badly in the late 1990s; in the past decade, though, an index of small value stocks earned an extra 2% annualized. “You have to be able to live through it,” he says.

“The New Faces of Stock Picking” profiles a pioneer in low-cost, tilted portfolios as well as other quantitatively driven thinkers searching for ways investors can carve out advantages. Instead of hunting for the inside scoop, they crunch data and use insights into investors’ behavioral blind spots. A caution: Now that star fund managers have faded, Wall Street is cranking out lots of ETFs. For every robust new idea, there’s likely to be a dozen more that are nothing but savvy marketing tied to a hot short-term trend.

Investing may be simple now, but you’ll still need the discipline not to chase the latest market beater, plus the patience to stick to a long-term strategy even when it’s out of favor. Simple? Yes, but not always easy.

OWN THE WORLD, FOR NEXT TO NOTHING

You can build a solid portfolio with just three investments. Here are examples using ETFs and index mutual funds:

The ETF route:

Schwab U.S. Aggregate Bond SCHWAB STRATEGIC T US AGGREGATE BD ETF SCHZ 0.0997% : 40%
Schwab U.S. Broad Market: SCHWAB STRATEGIC T US BROAD MKT ETF SCHB 0.6675% 40%
Schwab International Equity: SCHWAB STRATEGIC T INTL EQUITY ETF SCHF 0.5629% 20%

The index fund route:

Vanguard Total Stock Market Index: VANGUARD INDEX FDS TOTAL STK MARKET PORTFOLIO VTSMX 0.6237% 40%
Vanguard Total Bond Market Index: VANGUARD BD IDX FD TOTAL BOND MARKET BND 0.0728% 40%
Vanguard Tax Managed International VANGUARD TAX MANAG DEVELOPED MKTS INDEX FD INV VDVIX 0.5192% : 20%

Either way you go, your costs will be far, far less than most active fund managers charge…

Annual fee:

ETF portfolio: 0.05%
Index fund portfolio: 0.08%
Three average active funds: 1.22%

… and you’ll be diversified across the globe.

Number of stocks:

ETF portfolio: 3,144
Index fund portfolio: 4,823
Three average active funds: 289

SOURCE: Morningstar

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