MONEY Ask the Expert

Investing in TIPS: Can Retirees Beat Inflation?

Q. Are TIPS a good investment for a retiree? — Rich Sherman

A. If your goal is to protect the value of your assets and your income from inflation over the course of a long retirement, then you should certainly consider TIPS, or Treasury Inflation Protected Securities.

But before you go stuffing your retirement portfolio with them — or more likely, TIPS funds — you first need to understand the type of the inflation risks you face in retirement. You’ll also want to keep in mind that you already have a very powerful inflation buffer in Social Security, as its payments are pegged to the inflation rate.

So as important as hedging your retirement portfolio against inflation is, you don’t want to overdo it.

Essentially, you need to guard against two forms of inflation during retirement. The first is what economists call expected inflation, or the steady rise in the price level that takes place over many years.

Hedging against this version of inflation is relatively straightforward: Keep a portion of your savings in investments that have the potential to generate returns several percentage points or more above the inflation rate over the long term.

Stocks are clearly one such investment, although mutual funds that invest in REITS and other real estate-related investments can also provide long-term inflation-beating returns. (Don’t forget that if you own a truly diversified portfolio of stocks, such as a total stock market index fund, you already have REITs in the mix.)

Related: Long-term investing — keep it simple

The second type of inflation you need to protect against is unexpected inflation. This is the kind that can flare up suddenly, like the oil-price shocks of the mid-1970s and early 1980s.

These spikes are usually relatively short-lived, so they’re not a major issue for people still investing for a retirement that’s decades down the road. But if you’re a retiree relying on your investments for current spending cash, even short spurts of inflation can make it more difficult to maintain your standard of living.

The issue is how to deal with this second inflation threat. Many advisers recommend investments like commodities or gold, which have the potential to generate lofty returns when unanticipated inflation takes off.

But Vanguard Investment Counseling and Research principal John Ameriks points out that these outsized returns aren’t a given. “There are many historical instances where you see high inflation and low commodity returns,” says Ameriks. Indeed, research shows that there’s roughly a 30% chance that commodities could post negative returns if inflation goes up.

TIPS, on the other hand, are uniquely suited for handling unexpected inflation. Unlike commodities or gold, which may be statistically likely to climb in value if inflation spikes, TIPS have been specifically designed to rise along with increases in the consumer price index.

Related: Are emerging market bond funds a safe haven?

That said, TIPS also have some drawbacks. They are bonds, so their value can fall if real interest rates rise. What’s more, demand for TIPS from investors seeking shelter from inflation has pushed their real yield, or their payout after inflation, close to or even below zero. Recently, for example, the real yield on 10-year TIPS was -0.53%.

Many advisers have pointed to TIPS’ negative real yields as a reason not to own them. But while investing in TIPS when their real yield is negative does mean you’ll earn less than the inflation rate, the principal value of the TIPS and the income they throw off will still rise if inflation picks up. Thus, by owning them you are still protecting yourself should inflation climb in the future or spike unexpectedly in the short-run.

Besides, it’s not as if regular Treasuries or other bonds will thrive if inflation heats up. Quite the opposite. Conventional 10-year Treasuries recently yielded about 2.03%. So if inflation exceeds that level over the next 10 years, regular 10-year Treasuries would generate a loss. And if inflation exceeds 2.56% — the recent difference between the -0.53% yield for 10-year TIPS and the 2.03% yield for 10-year nominal Treasuries — then TIPS will outperform regular, or nominal, Treasuries.

That’s why you really want to own both TIPS and regular Treasuries and other bonds. If inflation rises over time or just spikes for a shorter period at some point in the future, then TIPS could be the better performer. If inflation stays tame or becomes even more docile, then conventional bonds will generate better returns. By owning both, you’re hedging your bets.

You can argue about how much of a retiree’s bond stake should go to TIPS vs. nominal bonds. But if your retirement portfolio already includes some stocks to protect against expected inflation over the longer term, then devoting, say, 25% to 30% of your bond holdings to TIPS seems a reasonable way to guard against both expected and unexpected inflation.

Bottom line: Investing in TIPS is a reasonable way for you to protect your purchasing power in retirement. But do it in moderation. Because the more you focus your investing strategy toward dealing with one risk, the more vulnerable you are to others.

MONEY Ask the Expert

Long-Term Investing: Keep It Simple

Q. I have $12,000 that I’m ready to invest for a long term. But I’m not sure whether to buy regular mutual funds, index funds or a mix of both. What do you suggest? — Daniel, Sugarland, Texas

A. I believe that investors are generally better off when they keep things simple. So for that reason alone, I’d go with index funds.

You can make a very nice diversified portfolio for yourself by combining just two funds: a total stock market index fund and a total bond market index fund . That would give you a portfolio that covers all sectors of the U.S. stock market — large and small caps, value and growth shares, virtually every industry — as well as the entire investment-grade taxable bond market, including government and corporate bonds.

You would do just fine if you stopped there.

But if you want to add some exposure to foreign markets — which over the long run can reduce the volatility of your portfolio overall — you could also throw in a total international stock index fund . For guidance on how to divvy up your holdings between stocks and bonds, you can check out our Fix Your Mix asset allocation tool.

Simplicity aside, this approach offers another huge benefit: low annual expenses.

By sticking to diversified stock and bond index funds, you’ll likely pay yearly fees of less than 0.25% of the amount invested, in some cases less than half that figure. Regular, or actively managed, mutual funds on the other hand, often charge 1% of assets or more. And while there’s no guarantee that lower expenses leads to better performance, there’s plenty of evidence that’s the case, including this 2010 Morningstar study.

Oh, and there’s one more reason I prefer index funds: You know exactly what you’re getting. As their name implies, index funds track a particular index or stock market benchmark. The fund holds all, or in some cases a representative sample, of the stocks in the index and nothing more (except, perhaps, a smidgen of cash to accommodate redeeming shareholders).

Managers of actively managed funds, by contrast, have lots of wiggle room when it comes to investing.

So even though a fund may purport to specialize in, say, domestic large-cap value stocks, it’s not unusual to find a manager making forays into small-caps, growth stocks or even foreign shares in an attempt to juice returns. This sort of “adventurism” makes it harder to use actively managed funds as building blocks for a diversified portfolio in which you’re counting on each fund to play a specific role.

But as much as I believe index funds are the better choice, I don’t think you’d be jeopardizing your financial future by devoting a portion of your investing stash to actively managed funds. And if that’s the way you want to roll, you should have no trouble finding funds run by smart managers with solid long-term records who can do a credible job of investing your money.

In that case, you might employ a version of what’s known as a “core and explore” strategy: put most of your money into index funds and then round out your portfolio with some well-chosen actively managed funds.

Related: Mutual funds – a simple way to diversify your portfolio

How much of your dough goes into the core vs. explore is up to you. But to prevent any bad picks from undermining your portfolio’s overall performance, I’d recommend keeping the active portion of your holdings pretty small, say, 10% to 15%.

There’s one other thing you’ll want to be careful about if you decide to take this hybrid approach. Some advisers suggest using index funds in “efficient” markets like those for U.S. and developed country large-cap stocks and recommend actively managed funds for “inefficient” markets like those for small-caps and emerging market stocks. But identifying efficient vs. inefficient markets isn’t quite so simple, and finding active managers who consistently outperform is difficult in almost any market.

So I’d recommend that you get exposure to all markets with index funds and then add the actively managed funds you like even if it means you’ll have a bit of overlap in some areas.

I also suggest that as much as possible you go with actively managed funds that have reasonable expenses, as that should give those funds a better shot at competitive performance. You can find such funds, as well as all the index funds you’ll need, on our MONEY 50 list of recommended funds.

To sum up, I think most investors would be best served if they just stick with a straightforward portfolio of broad index funds.

Human nature being what it is, however, many people will give in to the urge to venture beyond the indexes for the thrill (even if only fleeting) of finding a fund that beats the market. If you’re one of those people, fine. Just don’t let yielding to that urge undermine your investing results.

MONEY

The other way to invest in a Roth IRA

My income is too high to contribute to either a deductible IRA or a Roth IRA. So am I better off investing in a nondeductible IRA or should I just invest my money in a regular taxable account? — Dennis, Cranston, R.I.

You’re giving up on the Roth IRA too easily.

Even if your income exceeds the Roth IRA income eligibility requirements — and I suggest you check out this calculator to verify whether that’s really the case — you can easily get around that hurdle: Simply open up a nondeductible IRA — which anyone under age 70½ with earned income can do — and then immediately convert the nondeductible IRA to a Roth IRA.

If you avail yourself of this option — colloquially known as a backdoor Roth IRA — before April 15th, you can make the contribution for the 2012 tax year. By doing that, you’ll still preserve the option of making a contribution for 2013 as well.

The maximum contribution for 2012 is $5,000 ($6,000 if you’re 50 or older), while the limit for 2013 is $5,500 ($6,500 if you’re 50 or older). So if you contribute for both years, you can get quite a nice sum into that Roth this year: as much $10,500 if you’re under 50, $12,500 otherwise.

Keep in mind that whenever you convert funds to a Roth, you must pay income tax on any portion of the converted amount that has yet to be taxed. This isn’t likely to be much of an issue if the only IRA you own is the nondeductible IRA you open and then convert.

Related: Your future self thinks you should save more

After all, you made your contribution in after-tax dollars, so those funds won’t be taxed again. The only tax bill you would incur is on investment gains, if any, that accumulate in your nondeductible IRA between the time you opened it and the conversion.

But if you also have money in other non-Roth IRAs — say, traditional deductible or nondeductible IRAs you opened years ago or a rollover IRA that holds money from a 401(k) with a previous employer — then you’ve got to consider the balances in those accounts when figuring the tax on the conversion.

For example, if you have $45,000 in an IRA rollover that consists totally of pre-tax dollars and you contribute $5,000 to a nondeductible IRA that you plan to convert, 90% ($45,000 in pretax dollars divided by your total IRA balance of $50,000), or $4,500, of your $5,000 conversion would be taxable. If your nondeductible IRA had investment earnings, those untaxed gains would have to be included in the calculation as well.

So if you were in, say, the 33% tax bracket, you would owe $1,485 in taxes on the conversion, which means you would effectively have to come up with $6,485 to get $5,000 into a Roth IRA.

But if you’re in this position — that is, you already have money in non-Roth IRAs andwant to get money into a Roth IRA but earn too much — there are two other maneuvers you may want to consider.

If you have a 401(k) plan through work and it accepts IRA rollover money (as most do) you could roll your IRA funds into the 401(k) and then convert your nondeductible IRA. Since you would have no other IRA money, you could convert your nondeductible IRA and avoid taxes (assuming your nondeductible IRA had no investment gains).

The other move you might consider is taking the money that you would have contributed to the nondeductible IRA and paid in taxes to convert that account ($6,485 in the example above) and use those funds to pay the tax to convert as much of the money in any existing IRAs as possible.

This would allow you to get more dough into a Roth than you could via the backdoor method, or nearly $20,000 assuming a 33% tax rate.

If you choose this last route, don’t forget that any pretax dollars you convert are considered taxable income. So moving more money into a Roth could push you into a higher tax bracket and boost your conversion tax bill.

Remember too that converting IRA funds to a Roth IRA — or contributing to a Roth IRA, for that matter — usually makes the most sense if you think you’ll face the same or higher tax rate when you withdraw the money as you did when converting.

That said, unless you’re absolutely sure you’ll face a lower tax rate in retirement, I think it’s a good idea to have at least some money in a Roth account if only to diversify your tax exposure.

Bottom line: if you would really rather invest money in a Roth IRA than a nondeductible IRA or a taxable account, you can easily do so. Okay, maybe “easily” is going too far. But you should definitely be able to pull it off.

MONEY Ask the Expert

Your Future Self Thinks You Should Save More for Retirement

From: faceretirement.merrilledge.com/

Q. How do I convince my spender husband that it makes sense to contribute more to his 401(k)? — G.L.

A. You’ve got a bit of an uphill battle for the simple reason that it’s a lot more fun to spend than save. Still, I have a suggestion that may be able to help you convince your hubby to rein in his free-spending ways and throw a few more bucks into the old retirement account: Introduce your husband to his future self.

How, you may ask, can you do that? Before I tell you, you first need to know why such a meeting might spur your husband to save more.

Ultimately, saving comes down to foregoing spending money today so you can spend it (plus however much it earns) later in life.

Problem is, research shows that the present day you doesn’t identify particularly well with the older you. Given that disconnect, you don’t have much of an incentive to abstain from spending and the pleasure it can bring today to make life better for this stranger in the future.

But apparently there’s a way to bridge the gap between our current and future selves.

Researchers at Stanford University conducted experiments in which they put two groups of students into virtual reality headgear and had them interact with realistic computer renderings of themselves. But one group was shown only images of themselves at their current age, while the other also saw age-morphed versions of how they may look in retirement.

When each group was later asked how much they would save for retirement, the ones who saw their older selves said they would save twice as much on average as the other group. Apparently they felt more of a bond with their future self and thus were more disposed to do something today to help that person.

You can do a somewhat similar experiment with your hubby. Just have him go to Merrill Edge Face Retirement and click on “Meet the Future You.” After entering his age and gender, he’ll be able to snap an online photo of himself (assuming his computer has a built-in camera) to which the site applies facial-aging software. He’ll then see a series of photos simulating what he might look like at different ages late in life.

The idea is that seeing a version of himself at, say 77, may make him think more seriously about the fact that he’ll still be around at that age and have to support himself in retirement.

The little factoids that accompany the photos at different ages — Cost of a new car in 2034: $62,000; Cost of living increase from 2012 to 2054: 307% — may also help drive home the point that he’ll need a sizable nest egg if he hopes to maintain his lifestyle in retirement.

Related: Take control of your spending

I’m not saying that going through this exercise — which, if only for kicks, you may want to try, too — will lead your husband to immediately boost his 401(k) contribution by 50%. But it could get you both talking about retirement and whether you’re adequately preparing for it.

Ideally, that discussion will lead you and your husband to take some other steps to advance your retirement planning. To get a sense of how you might actually live in retirement, you could check out Ready-2-Retire, a tool that allows you to sort through photos of different retirement activities (traveling, going back to school, etc.) and prioritize them based on how likely you are to engage in them. Once you have a decent idea of what kind of retirement lifestyle you aspire to, you can then go to a tool like our Retirement Planner to see how much you should be saving to achieve that goal.

See whether you’re saving enough

If after checking out these tools you find that your husband is actually putting away enough to assure you’ll both have a secure retirement, that’s great. You can both feel reassured about that.

But if it turns out that your husband really does need to save more, then having him meet a digital version of his future self maybe just the motivation he needs.

MONEY Ask the Expert

Reasons to Cut Back on Stocks in Retirement

Q. Why is the recommended mix of stocks and bonds any different at the beginning of my career than at the start of retirement? I don’t understand why I should reduce my exposure to stocks when I retire, as I’ll still have 30 years of investing ahead of me. — Gordon Groff, Lancaster, Pa.

A. You’re right. You should be investing for the long term — both during your career and after you retire. Still, there are some key differences between those two stages of life that argue for gradually scaling back on equities after you retire.

The single biggest difference is that you have a lot more flexibility during your career when it comes to retirement planning. For example, if you have the bulk of your retirement accounts in stocks and the market tanks, you’ve got plenty of options for rebuilding the value of those accounts.

With years of work still ahead of you, you can simply sit back and wait for the market to rebound and eventually climb to higher ground. Or you can pump up the amount you contribute to your retirement accounts, which will hasten the recovery of your balances.

If worse comes to worse, you can always postpone retirement for a year or two, which will give your nest egg a chance to grow through a combination of additional savings and a few extra years of investment returns.

But if your savings are heavily invested in stocks in retirement and the market takes a dive, you don’t have nearly as much wiggle room.

Unlike during your career when you’re still putting money into your 401(k), IRA or other accounts, you’ll be pulling money out of your nest egg once you retire. And that creates a very different dynamic.

Related: Retirement checkup for the new year

Specifically, the combination of investment losses from a market downturn, plus withdrawals from your account for retirement living expenses creates a double-whammy effect that can decimate the value of your portfolio and dramatically increase your chances of outliving your dough.

As a result, the same market meltdown that may be very unsettling during your career can be absolutely devastating after you’ve retired, perhaps even forcing you to radically scale back your standard of living to avoid running through your money too soon.

Here’s an example. Let’s say you retire at 65 with $500,000 in savings from which you plan to withdraw an initial 4%, or $20,000, that you will increase annually by the inflation rate to maintain your purchasing power. And let’s further assume that you would like your savings to support you at least 30 years.

If you plug that scenario into a good online retirement calculator, you’ll find that the chances of your nest egg lasting 30 years are roughly the same — just under 80% — whether you invest 80% of your savings in stocks and 20% in bonds or split it 50-50 between the two.

And although the calculator doesn’t show this, it’s also true that if all goes well and there are no major blowups in the market, the higher returns stocks can deliver might allow you to draw even more from your nest egg than had you gone with the 50-50 mix.

Related: Market timing — Not a good retirement strategy

The problem is what happens to those odds if things go badly. For example, if you had retired at the beginning of 2008 with 80% of your savings in stocks and 20% in bonds and embarked on the withdrawal scenario above, at the end of the first year of retirement the combination of a $20,000 withdrawal and a 30% investment loss would have left you with a nest egg worth roughly $340,000 — a 32% decline in a single year.

If you continued to withdraw $20,000 and increased annually for inflation of, say 3%, the chances of your savings lasting the next 29 years to age 95 would plummet from a little less than 80% to just under 40%.

By contrast, had you invested half your savings in stocks and half in bonds, the combination of your initial withdrawal and the market downturn would have left you with a nest egg worth a bit more than $400,000.

The probability of your money lasting to age 95 would decline. But since your nest egg wasn’t whacked as hard, the chances would drop to just over 50%.

Clearly, in both cases you would have to make some adjustments — going without an inflation increase for a few years, reducing your withdrawals outright or perhaps even taking on part-time work.

The difference is that with the more conservative portfolio, the compromises you would have to make to your retirement lifestyle wouldn’t have to be as severe. And you wouldn’t be as vulnerable to potential market setbacks in the future.

Now, does that mean that it can never make sense to invest somewhat aggressively in retirement? Of course not.

Related: Emergency funds: Risk versus returns

If income from Social Security and a traditional company pension covered all or nearly all of your annual expenses, then theoretically you may be able to invest quite heavily in stocks.

After all, if your retirement accounts suffered serious losses, you would still have enough income apart from savings withdrawals to maintain your lifestyle (although even then you would have to consider whether you would be emotionally okay watching your nest egg’s value decline by 30% or more).

Bottom line: If you’ll have lots of income flowing in throughout retirement from guaranteed sources — or your nest egg is so large or withdrawal rate so small that your chances of depleting it are truly minimal — then I suppose you could invest the same way late in life as you did at the beginning of your career. But if that’s not the case — and I suspect it’s not for most of us — the more prudent approach is to scale back your stock exposure as you near and enter retirement.

MONEY Ask the Expert

Retirement Savings Checkup for the New Year

Q. I save 15% of my salary each year in my 401(k), my company matches another 4.5% and I contribute the max to a Roth IRA. Am I doing enough to safely retire? — Dave K., Jacksonville Beach, Fla.

A. If you continue at the rate you’re saving, it’s hard to imagine you’ll come up short at retirement time. After all, you’re socking away money at more than double the rate of most 401(k) participants, plus you’re funding that Roth IRA.

But as important as diligent saving is, your savings rate alone can’t tell you whether you’re on track for a secure retirement. To know for sure, you’ve got to undertake a more comprehensive review of your retirement planning efforts.

You can do that by performing what I call my annual New Year’s Retirement-Planning Checkup. It consists of just three simple steps:

1. Figure the odds. There are so many unknowns and potential detours along the road to retirement — market setbacks, spates of unemployment, emergencies that drain savings — that you can never say that a secure retirement is a given.

Related: Take control of your spending

But by taking a look at where you stand now as well as the strategy you’re currently employing,you can get an estimate of the probability that you’ll be able to maintain an acceptable standard of living once you retire.

The easiest way to do such an assessment is to go to a robust online tool like our Retirement Planner or T. Rowe Price’s Retirement Income Calculator. You just plug in such information as how much you’ve already got tucked away in retirement accounts, the percentage of salary you’re saving now, how those savings are invested and the age at which you intend to retire, and you’ll get an immediate forecast of your chances of being able to retire on, say, 75% of your pre-retirement salary.

Aside from the obvious benefit of letting you know whether the path you’re on has a decent chance of leading to a comfy post-career life, this sort of evaluation has another advantage: by changing a few variables — your savings rate, how you invest, the age at which you retire, whether you work part-time in retirement — you can see how you might be able to increase your shot at a secure retirement.

This type of exercise is essential if you really want to know whether you’re making progress toward retirement. If you don’t feel confident doing this sort of number crunching on your own, then consider hiring a pro to guide you through the process. Just be sure to vet that adviser carefully.

2. Evaluate your portfolio. Although I’ve long noted that diligent saving is more crucial to retirement success than savvy investing, you nonetheless want to be sure you’re not undermining your savings effort with an inferior investment strategy.

Your first task on the investingfront is to makesure you’ve got a mix of stocks and bonds that’s appropriate given your age and risk tolerance.

Generally, the younger you are, the more of your retirement savings you’ll want to invest in stocks. As retirement nears and preserving your nest egg becomes a bigger priority than growing it, you’ll want to shift more toward bonds. There’s no single stocks-bonds blend that’s right for everyone.

As a starting point, you can check out the mix for a target-date retirement fund designed for someone your age. You can then see how such a blend might actually perform by going to Morningstar’s Asset Allocator tool. If you find that the mix you’re considering is too aggressive or too conservative, you can then adjust it.

You also want to be sure that your respective stock and bond holdings are properly diversified. In the case of stocks, for example, that means owning shares of both large and small companies as well as a broad range of industries. To gauge whether your portfolio is reasonably balanced compared with market benchmarks, plug your holdings into Morningstar’s Portfolio X-Ray tool.

Finally, take a hard look at what you’re shelling out in annual expenses.

Reducing the portion of your return that’s siphoned off by investment costs can have a big payoff. Lowering expenses from, say, 1.5% a year to 0.5% can increase the eventual size of your nest egg by roughly 20%. Fortunately, federal rules that went into effect in August make it much easier for 401(k) participants to see what they’re actually paying in fees and thus home in on the low-cost options in their plan’s investment roster.

3. Schedule updates. Once you’ve completed this checkup, you don’t need to fiddle with your retirement strategy every waking moment. Still, it is a good idea to check in occasionally just to be sure the plan you’ve put in place is working as expected.

So take a moment now to schedule a few specific times during the coming year — the end of a quarter, a birthday, wedding anniversary, whatever — when you can do quick re-assessment of where you stand and make tweaks if needed.

If you experience a significant change in your circumstances — say, moving to a new job or taking on a big new financial commitment — then you may very well want to perform a full-blown review.

Bottom line: There’s no way to eliminate uncertainty when it comes to retirement planning. But if you combine this sort of annual checkup with periodic monitoring throughout the year, you’ll dramatically improve your chances of getting, and staying, on the path to a secure retirement.

MONEY

Index Funds: A Simpler, Cheaper Way to Invest

I’m conflicted about whether I should invest in actively managed funds or index funds. Ideally, I’d prefer to keep things as simple and straightforward as possible. — Rusty, Albuquerque, N.M.

If you’re looking to keep things as uncomplicated and trouble free as possible — a perfectly reasonable goal, especially in these topsy turvy times — I don’t think there’s any doubt that index funds are the better choice.

In fact, even if simplicity isn’t an overriding concern, I still think you should consider keeping all, or at least most, of your savings in index funds that give you broad diversified exposure to the financial markets, or their ETF counterparts.

Why? Four reasons.

1. Greater certainty. One of the most valuable features about index funds is that you know exactly what you’re getting when you invest in one.

Want large-cap stocks? Fine, put your money in a Standard & Poor’s 500 index fund. Small caps? No problem, get a fund that tracks the Russell 2000 index or a similar benchmark for small companies.

Or you can make things really simple and invest in a total U.S. stock market index fund, in which case you get all U.S. stocks — large, small, value, growth, all industries — in a single fund. Throw in a total international stock index and a total U.S. bond market index fund, and you’ve got a fully diversified portfolio with just three funds.

You can build a portfolio using actively managed funds, but it requires more initial work and ongoing vigilance. The reason is that while you can get an idea of how an actively managed fund will invest based on its prospectus and its Morningstar category, the fund manager has wide leeway to stray from its specified strategy. And many often do.

During the go-go ’90s, for example, it wasn’t uncommon for value funds to juice their returns with growth-oriented tech stocks. To see if an actively managed fund has had a tendency to deviate from its stated investing style in recent years, you can plug its ticker symbol into the Quote box at the top of every Morningstar page and then click on the Portfolio tab.

So if you’re looking to build a portfolio that you can be sure will have specific types of stocks and bonds in specific proportions, you’ll have a much easier time doing so with index funds.

2. Lower costs. If keeping expenses down is a priority for you — and it should be — index funds are the hands down winner.

You can expect to pay roughly 1.5% or so a year on average for the typical stock fund and perhaps 0.75% or so for a bond fund. Index funds, by contrast, typically charge 0.25% to 0.5% a year, and by going to our MONEY 50 list of recommended funds you can find some that charge as little as 0.05%, or just $5 for each $10,000 invested.

To be fair, you can also find actively managed funds with fees considerably below the average. But you’re not going to find any with the razor-thin fees of index funds.

Related: What is the right mix of stocks and bonds for me?

Shelling out less in costs is a huge advantage, as every dollar of expenses is one less dollar of gross return that goes to you.

Over time, giving away more to fees can make a big difference. For example, if you invest $25,000 in two funds that both earn 7% annually before expenses and charge 1.5% a year and 0.25% respectively, after 20 years the fund with the lower fee tab will have an extra $19,000 or so.

3. Higher tax efficiency. In an attempt to deliver loftier gains to shareholders, many actively managed fund managers buy and sell shares frequently, hoping to rack up a profit or avoid a loss on each trade.

Even if that trading is successful after the costs it imposes, it can generate realized gains, which must be passed on to fund shareholders who must in turn pay taxes on them (assuming the fund is held in a taxable account).

If those gains are on shares held a year or less, they’re taxed at short-term capital gains rates, which today are taxed at a top rate of 35% versus a max of 15% for long-term capital gains.

Since index funds track a specific benchmark, such as the S&P 500 or Russell 2000, their selling is largely limited to getting rid of securities that leave the index or providing cash to redeeming shareholders, and even in those cases there are techniques managers can use to limit taxable gains.

The result is that index funds generate far fewer taxable realized gains.By deciding how long you’ll hold onto shares, you have more control over when you’re taxed and what rate you pay. If you want to compare the tax-efficiency of an index fund to an actively managed fund, check out the Tax tab on each fund’s Morningstar page.

4. Superior performance. If the three reasons I’ve already mentioned aren’t enough to bring you into the index camp, then this fourth one probably will: Over long periods, index funds tend to deliver higher returns than comparable actively managed funds.

Indeed, over the past 10 years, large-company index funds that track the S&P 500 or a similar index and small company index funds that mimic the Russell 2000 or other small-cap benchmark have beaten the average gain for comparable actively managed funds.

That said, over shorter spans it’s not uncommon for actively managed funds to post higher gains. And even over long periods, you’ll always be able to find some actively managed funds that due to the extraordinary skill of their managers or plain old luck have outgained index funds, although identifying such funds in advance is exceedingly difficult if not impossible.

Related: Why All-Cash Retirement Portfolios Can Be Risky, Too

The point, though, is that index funds’ lower fees and the fact their managers aren’t constantly buying and selling make it more likely that, on average, they’ll win out over actively managed funds in the long term.

Now, having made this case for index funds, I’d add that I don’t think you have to be such a purist that you sink every single cent you have into index portfolios. If you’re inclined to invest a portion of your money with a few managers who have solid long-term records and reasonable expenses, I don’t think you would jeopardize your financial future.

But if you want to keep things simple and straightforward and you want to increase your chances of earning competitive returns that will build your wealth over the long-term, I think your best shot is to create a diversified portfolio using broad-based index funds or ETFs as your building blocks.

MONEY

Retirement Investing in Uncertain Times

I’m 37, make $52,000 a year and have just begun putting money into a 401(k). With thirty years until retirement, I’m inclined to believe that a somewhat aggressive investing strategy will pay off in the long run. But given the immediate uncertainty in the economy and the market, am I better off investing in less risky funds in the short term? — Erik, Brooklyn, N.Y.

If you’re waiting for uncertainty, immediate or otherwise, to die down before you embark on your long-term investing strategy, you’re going to have a long wait. Things are never certain in the economy and the market.

Whether it’s concerns about the ability of a new Congress and a second Obama administration to get a handle on our massive budget deficit, worries about the effect Superstorm Sandy might have on future job growth, trepidation over the approaching fiscal cliff or anxiety stemming from the European debt crisis, uncertainty is a constant.

Or, to borrow a phrase from Gilda Radner’s classic Roseanne Roseannadanna character from the early days of Saturday Night Live: “It’s always something — if it ain’t one thing, it’s another.”

So the more important question you should be asking yourself is this: What kind of investor do you want to be, given that you’ll always have to deal with uncertainty? As I see it, you have two choices: you can be a reactive investor or a systematic investor.

Reactive investors spend most of their time figuring how to rejigger their investments to take advantage of new developments on the investing scene or to prevent those developments from hurting them.

Related: Worried about the Fiscal Cliff: Should I Sell?

If they see that inflation is ticking up or interest rates are starting to climb, they may shift money out of bonds and into gold or commodities. If they believe economic growth is weakening and the economy may be slipping into recession, they might get into defensive stocks or buy long-term bonds.

If you like making lots of moves with your investments, this is the right camp for you — for the reactive investor, investing is a never-ending guessing game. There will always be something going on in the economy or the markets that will catch your attention and require action.

The downside is that it’s tough — I would say virtually impossible — to make the right call consistently. Very often what seems like the obvious isn’t. Back in early 2009, for example, the last place most investors wanted to be was in stocks, which had just plummeted nearly 60% from their 2007 high. Moving to bonds or cash seemed a more prudent bet. Of course, we now know that since that low, stock prices have climbed more than 100%, while bonds gained about 28% and cash returned less than 1%.

A systematic investor, by contrast, starts with the premise that you can’t outguess the markets. The best you can do is set a strategy that will allow you to participate in the long-term upswing of stock prices, while hedging against the inevitable downturns by also holding some bonds and cash.

This type of investor doesn’t feel compelled to act every time a new piece of economic data flickers across his computer screen or a headline warns of impending doom.

Related: Retirement Savings: Quick Guide to How Much You’ll Need

Rather, the systematic investor realizes that one decision is key: determining the mix of stocks, bonds and cash that will give him a shot at reasonable returns while holding the risk of short-term setbacks to an acceptable level. Once he sets that mix, the systematic investor pretty much leaves it alone, except to rebalance periodically to bring the mix back to its original proportions.

If you prefer to be a reactive investor, I can’t offer you much advice. I don’t believe investors can consistently make the right moves in order to take advantage of market fluctuations. I think they’re more likely to end up hurting themselves.

No worries, though. There are plenty of brokers and other advisers out there all too willing to cater to the reactive investor’s need to act. In fact, the standard pitch from most of Wall Street and much of the financial services industry is that they know what moves to make, and for a price they’re willing to help you make the unending series of decisions you’ll face as a reactive investor.

If you want to join the systematic camp, however, then I suggest you stop obsessing about uncertainty and instead focus on creating a portfolio that makes sense for the long haul, in your case for someone with thirty or so years until retirement.

Related: Why There’s No Such Thing as Risk-Free Investing

Typically, retirement investors with that sort of time horizon invest between 70% and 90% of their savings in stocks with the rest in bonds, although the blend you choose should reflect how much you’re willing to see your account balance dip during market downturns. (To get a feel for the tradeoff between risk and return for different stocks-bonds mixes, you can check out Morningstar’s Asset Allocator tool.)

Of course, just because you arrive at the right mix doesn’t mean uncertainty will go away. It will always be there. But if you take the systematic approach, then at least you won’t have to react to it day after day after day.

MONEY

The Case for a Little Stock Market Optimism

Had you looked back in January to see how stocks did in the prior decade, you’d have been underwhelmed by annualized gains of just 3%.

Repeat that exercise today and you’ll get a decidedly brighter picture: The Dow has gained nearly 9% a year and the S&P 500 more than 8% now that the effects of the March 2000 to October 2002 bear market are more than a decade in the rearview mirror. That’s nearing the 9.8% historical average return of U.S. stocks.

No, this doesn’t erase the sting of the bursting of the tech bubble or the 2008 crash, nor does it mean you should put on rose-colored glasses as you read about 8% unemployment and a looming fiscal cliff. Nevertheless, the “lost decade” for stocks is no more.

So if the past wasn’t quite so bad, you ought to at least question the currently fashionable position that the future is really going to stink.

As governments worldwide struggle to pay down debt, the theory goes, economic activity and stock returns will be depressed for years. This is what bond guru Bill Gross and his colleagues at Pimco call “the new normal.”

Ben Inker, head of asset allocation at GMO, points out a problem with this assumption. “We don’t disagree when it comes to expectations for economic growth,” says Inker. “Where we disagree is whether the new normal has to have a bad impact on stock returns.”

Research by a team at the London Business School showing no relationship between how fast economies grow and how well stocks perform supports his view. Case in point: Since 1985, the U.S. economy grew less than a third as fast as China’s, yet American stocks gained more than twice as much as Chinese shares.

Related: Investing in China: Handle with Caution

Inker’s firm forecasts that over the next seven years, high-quality U.S. stocks should produce “real,” or inflation-adjusted, returns of 4.4% a year while foreign shares return 5%, based on factors including price/earning ratios. Again, that’s close to, though still less than, long-term averages.

Duncan Richardson, chief equity investment officer at Eaton Vance, argues the U.S. is “the most attractive major market when it comes to the fundamentals.”

What’s more, sentiment, as measured by money flowing into (or actually out of) stock funds, is as bad as it’s been in more than two decades. Most analysts believe that’s really a bullish sign.

Related: How do I make money investing?

This doesn’t mean it’s all smooth sailing ahead. Europe’s recession and China’s decelerating growth rate are cutting into U.S. corporate earnings this year. Profit growth for S&P 500 companies is expected to reaccelerate in 2013, but that assumes things don’t get worse from here.

So, yes, the risks are real, but the doom-and-gloom forecasts feel a bit overwrought.

MONEY

Higher Yields on Savings Accounts? It Will Be Awhile

The US Federal Reserve building is seen
The US Federal Reserve building is seen on August 9, 2011 in Washington, DC. New recession worries and market havoc posed the toughest challenge yet this year for the US Federal Reserve as its policy board met Tuesday holding a near-depleted box of stimulus tools. Economists said the Federal Open Market Committee (FOMC), meeting for the first time since its "QE2" asset purchase program ended in June, had few options to overcome stagnating growth and the growing pessimism that sent stock markets on their deepest plunge since the crisis of 2008. AFP PHOTO/KAREN BLEIER (Photo credit should read KAREN BLEIER/AFP/Getty Images) KAREN BLEIER—AFP/Getty Images

Waiting for higher yields on savings? Don’t hold your breath.

The Federal Reserve said in September it would buy $40 billion of mortgage-backed securities a month until the labor market rebounds. The goal: to free up banks to lend more.

It’s the Fed’s third attempt since 2008 to use this tactic, called quantitative easing.

Targeting the 8%-plus jobless rate, QE3, as it’s known, is likely to hold down mortgage rates which in October hit a 60-year low of 3.36%.

The Fed also plans to keep short-term rates near zero through mid-2015, so get used to current savings yields (recently averaging 0.12%).

And if you’re looking to beef up bond fund income, Morningstar Investment Management economist Francisco Torralba suggests short-term corporates, which yield about 2% today. Though the risk of inflation is low, he says, a spike would hit higher-yielding long-term bonds harder.

Related: Should I invest in bonds or in a bond mutual fund?

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