To figure out the right mix for your retirement needs, start with a few simple questions. How long will the money stay invested? How much risk are you willing to take with your savings? How much growth do you need? “The only way to properly answer those questions is to put together a comprehensive financial plan that sets out your short- and long-term financial goals,” says Marc Lamontagne, a fee-only adviser with Ryan Lamontagne in Ottawa.

The biggest and most important question you’ll likely face is how to balance your risk with the amount of growth you need. Generally speaking, the longer your money is invested the more risk you can afford to take on. But how do you determine your tolerance for risk? “I like to use a questionnaire with my clients,” says Lamontagne. “It allows us to open up a discussion that allows us to gauge their risk tolerance. If they’re a couple and they each have a very different tolerance for risk, then I generally help them reach a compromise, keeping in mind that the compromise will allow both of them to reach their financial goals.”

To get the maximum return while taking the minimum amount of risk, it helps to think of your portfolio as being split into two parts: an equity portion comprised of stocks, and fixed income portion made up of bonds, GICs and savings accounts. Generally speaking, the higher the percentage in equities, the higher the risk.

Keep in mind that while stocks will earn you a higher return over the long run, their short-term performance is harder to predict. If you’re 30 and retirement is a long way away, you can take a few market crashes in stride and still come out ahead, so you can take on more risk. But if you’re getting close to retirement, you should probably decrease your stock holdings and go heavier on bonds, as they’re more predictable so you’ll suffer less damage from a market slump.

A good rule of thumb is to put a percentage in fixed income that is equal to your age. If you’re 40, for instance, you could put 40% in fixed income and 60% in stocks. If you’re 60, you could put 60% in fixed income and 40% in stocks. The exact proportions depend on your risk tolerance. You can also help insulate yourself from market declines by building up a pool of cash and GICs, or a short-term bond ladder. If you build up enough to fund three years’ worth of expenses, you won’t have to sell off stocks when the market is down.

Still, you don’t want to get too conservative: “If a retirement portfolio is to last you to age 90, it should not be invested only in cash and GICs,” says Norm Rothery, a chartered financial analyst and founder of StingyInvestor.com. “There should be a minimum 25% holding of equity—regardless of age. Such a portfolio actually has less risk than one invested 100% in fixed-income investments because it will protect you from the risk of inflation.”

Once you’ve established the right mix of equities and fixed income, then it’s time to choose your individual -investments. The -investment vehicles you pick depend on several factors, including the amount of time you want to spend on your portfolio. You can buy individual stocks and bonds, but this is best left to more experienced investors. Mutual funds and index funds are likely more convenient and practical.

If you’re a new investor, then a simple balanced mutual fund can be a great place to start. “They usually contain a conservative 60% equity and 40% fixed income mix all in one product,” says Rothery. Experienced investors who want a more hands-on -approach may also want to look at exchange traded funds (ETFs) or index mutual funds.

For a more detailed analysis of the right mix for you, consult a knowledgeable -adviser, who can help you pick the perfect investments for your particular situation and goals. Check back with your adviser regularly to ensure that your overall mix and risk level stay on track as your financial situation and time horizon changes.

The standard advice is to put Canadian stocks in non-registered accounts, and put fixed income investments, such as bonds and GICs, inside RRSPs and TFSAs. Tax rates are lower on the Canadian dividend income and capital gains you get from stocks than they are on the interest income you get from bonds and GICs, so keep your stocks outside your RRSP where taxes matter, and then hold your bonds and GICs inside.

U.S. equities are more complicated. Dividends from U.S. stocks are taxed in Canada at regular rates, just like interest income. But capital gains on U.S. stocks—which you trigger when you sell a stock at a profit—are taxed favorably just like capital gains on Canadian stocks. So it makes sense to hold U.S. stocks that pay little or no dividends inside your non-registered accounts alongside Canadian stocks. On the other hand, U.S. stocks that pay handsome dividends probably fit better in your RRSP.

There is an added U.S. tax wrinkle here: the Internal Revenue Service levies a 15% withholding tax on dividends on U.S. stocks held by foreign investors (these are deducted automatically). If a stock pays a 3% dividend, then, the withholding tax would reduce it to 2.55%.

Fortunately, if you hold U.S. stocks in non-registered accounts, you get a credit for the amount withheld that you can apply against Canadian income taxes, so in most cases that leaves you square—providing your Canadian tax rate is at least 15%.

In the case of RRSPs and other retirement accounts, Canada has a tax treaty with the U.S. that exempts you from the withholding tax. But if you hold U.S. stocks in a TFSA or an RESP, you’re dinged the 15% levy and you can’t get it back. As a result, you’re best off holding U.S. stocks that pay hefty dividends inside your RRSPs, and keeping them outside of your TFSAs and RESPs. Who knew?

Keep in mind that dividend withholding tax amounts and treatments vary among other countries, so don’t count on the advice for U.S. stocks applying to stocks from overseas.

Musson’s Mackenzie Ivy European Class Series A mutual fund is up 4.7% year-to-date (as of Nov. 7), almost 10 percentage points better than the benchmark MSCI Europe index in Canadian dollars, according to Morningstar. His strategy? Musson and co-manager Matt Moody look for companies with good competitive advantages, strong balance sheets, lots of free cash flow and reasonable valuations. About half have no debt.

Many are multinationals that benefit from better growth prospects beyond Europe. The fund has little exposure to banks, or companies located in the distressed European countries known as the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

Musson’s fund has invested in such companies as Hennes & Mauritz AB (H&M), a Swedish-based global clothing retailer with a reputation for low-priced fashion; William Morrison Supermarkets PLC, a U.K. food retailer known for creating market-like retail environments with reasonable prices; and Unilever NV, a Netherlands-based multinational with more than half its sales in emerging markets.

While Musson wants to remind investors that there are no guarantees when buying stocks, he does believe there are still some good opportunities among the less cyclical European equities, mainly in consumer products and health care. “As long as you’re careful, you have a long-term view and you know how to value a business, hopefully you’ll do well.”

However, Musson believes prices of many cyclical European stocks are overvalued, as they don’t fully reflect weak economic prospects yet. As a result, 16% of his fund is currently in cash. Musson has his eye on a number of top quality industrial stocks which he hopes to buy, “but only when we feel the price is right.”

The real question is whether prices are low enough yet. To deduce that, I like to turn to economist Robert Shiller’s price/earnings ratio (P/E) for the S&P 500 to value the general state of U.S. stock markets because it provides a useful long-term guidepost. Shiller’s P/E is the ratio between current prices and average earnings over the last 10 years, the idea being that you can get a better sense of the long-term trend via 10-year average earnings rather than by short-term figures.

The graph to the right shows the history of Shiller’s P/E for the S&P 500. You’ll notice that the ratio is currently 19.7, which is high compared to its historical norm of 16.4. As a result, U.S. stocks could still have farther to fall. The situation in Canada isn’t much better, with Canadian stocks at fairly high levels. Even worse, we tend to be more exposed to downturns, due to the cyclical nature of much of our economy.

Those with a more bullish bent will point out that stocks have traded at far higher levels in the past. Also, the huge earnings collapse of 2008 was unusual—the lower earnings over the last decade might provide an overly bearish reading. As a result, Shiller’s P/E could be somewhat inflated.

Nonetheless, I think stock markets as a whole are not overly cheap. (Thankfully there are still a few bargain stocks to be had.) I also don’t feel nearly fearful enough. As a result, I don’t expect to shift my asset allocation toward stocks at this point. I’ll wait for better valuations and a bit of stark terror before making any dramatic moves.

2. Practise your trading
Take advantage of the free seminars, videos and articles that discount brokerages offer to their clients. Rick Robertson, associate professor at the Ivey School of Business, recommends trying the trading simulators. These demos use play money, so you can learn to trade without risk. Stick with shares from large companies at first, and trade “board lots” of 100 shares each, as these are easier to buy and sell than odd lots of shares from small companies.

3. Time to buy
When you’re ready to buy, type in the ticker symbol of the company and specify the exchange it trades on. Select “buy” and “market order” to buy stocks at the current price, and enter the number of shares you want. An order preview will show you the estimated cost with the commission. Then you’ll get a confirmation with your order status so you can tell if the order was filled.

4. Understand the price
Stocks are quoted with two prices: the bid price and ask price. The bid price is the highest amount a buyer is willing to pay for a given stock, while the slightly higher ask price is the lowest amount a seller will accept. If a company’s stock is traded frequently, the difference (called the “bid-ask spread”) should be only a few cents. Remember that market orders will be filled at the current price, and since prices change every few seconds, your final cost may vary somewhat from the estimate.

5. Advanced orders
Once you’re fairly comfortable trading, you may want to explore more advanced options. A ‘limit order’ allows you to specify the price you’re willing to pay. For example, say you want to buy 100 shares of XYZ Corporation, but you don’t want to pay more than $20. If you place a limit order at that amount, it won’t be filled until the price drops to $20 or less. Similarly, a ‘stop loss order’ can be used to automatically sell your stock if it dips below a specified price, allowing you to lock in gains. But take the time to understand how stop loss orders work: if you’re not careful, your shares could be sold at bargain-basement prices if the market suddenly plunges.

But when it comes to investing, the possibilities are vast once your portfolio grows beyond $100,000. Problem is, much like Bertie Bott’s Every Flavour Beans (a devilish Harry Potter confection) the investing flavour you choose might wind up tasting like earwax. Alas!

That’s why the advice in Where to invest $10,000 still applies. If you aren’t intensely interested in the markets, you should probably stick with a good low-fee balanced mutual fund. After all, much like grilling a nice steak, if you poke and prod your portfolio too much then you’re likely to obtain less than desirable results.

But if vanilla really isn’t for you, let’s check out some other tasty ways to invest now that you have a more sizeable portfolio.

The lazy way to riches
In the “Where to invest $1,000” story, we introduced the idea of investing using passive index mutual funds such as the TD e-Series Funds, which rise and fall in tandem with the large market indexes. Long-time MoneySense readers will know that we call a portfolio of such funds a “Couch Potato portfolio,” as it’s so easy to execute, you rarely have to haul yourself up from the couch to tend to your investments. The goal is to take the returns the markets give you while keeping your investing costs as low as possible. This allows you to enjoy a big advantage versus high-priced fund managers who, far too often, fail to earn back the fees they charge investors.

Now that your portfolio is larger, we have some good news. You can implement the exact same strategy with a new type of fund that has even lower costs: the exchange-traded fund or ETF. These funds are much like index mutual funds in that they passively follow a market index such as the S&P 500, but instead of being sold like mutual funds, you buy them on the markets, just like a stock. The ETFs you choose depend on your investment goals, your time horizon and your tolerance for risk, but we find that plonking 40% of your money into a good bond fund, and spreading the remaining 60% among Canadian and U.S. stock funds is the simplest way to start. If you do it through ETFs, you can reduce your fees to very low levels. For example, if you use the iShares S&P/TSX60 ETF (XIU), the Vanguard Total Stock Market ETF (VTI), and the iShares DEX Universe Bond ETF (XBB) for the Canadian stock, U.S. stock, and Canadian bond components respectively, then the annual fee on your portfolio will be a minuscule 0.19% a year.

Just remember, because ETFs are traded like stocks, you do get dinged with a brokerage commission when you buy and sell them. The commissions can really add up for small portfolios but, by $100,000, the big Canadian discount brokers usually offer online trades for $9.95 a pop, or less.

Much of the appeal of Couch Potato investing lies in its simplicity, so you don’t want too many funds. Still, if you’re up for it, expanding beyond just U.S. and Canadian stocks is a sensible thing to do. As a result, I suggest the Global Couch Potato variant with international stocks added via the Vanguard FTSE All-World ex-US ETF (VEU). Here you’d put 40% of your portfolio in the XBB bond ETF, 20% in Canadian stocks via XIU, 20% in U.S. stocks via VTI, and the final 20% in international stocks via VEU.

Don’t want to go it alone? If the thought of opening a discount brokerage account and buying ETFs on your own fills you with fear and trepidation, don’t worry. You wouldn’t be the first to feel daunted by the task. I still remember that my first trade, back in the day when you had to phone a real trader, was rather nerve-wracking.

Besides, if you’d like a little guidance you’re in luck: when your portfolio moves above $100,000, advisers will start to take an interest. Problem is, their advice often comes at a steep price. To help you out, I’ve sleuthed out a few ways you can get the basics without spending an arm and a leg. You might not get expensive wine and cheese service, but you will get core asset allocation advice and a friendly hand to help you build a customized portfolio.

One good choice is to enlist the services of investment management firm Phillips, Hager & North. PH&N is the granddaddy in the field and it still represents good value. The firm offers a very broad line of low-fee funds and when you sign up directly with them, you can get a dedicated adviser, portfolio planning, and a long-term investment strategy. All of which is included in the already low cost of their funds.

Another option is Steadyhand, a new entrant run by PH&N alumni Tom Bradley. You get the benefits of his experience, but you also get advisers who are still hungry and thus likely to work harder for you than others who may have had a few too many ice cream cones. Portfolio strategy is included with the low cost of their funds, and Steadyhand’s fees fall as your portfolio grows. At $100,000 you already get a discount and there are more discounts to be had at higher levels. In a break from usual practice, their fees also decline based on how long you’ve held their funds.

Getting started with stocks
At the other end of the spectrum, you might want to take a more active approach and start picking your own stocks. While it might not be the right thing to do for many investors, it would be hypocritical of me if I didn’t say that it can be great for some.

If you’re just starting to buy your own stocks, I suggest moving slowly for the first few years. The experience will likely to be educational and you don’t want to make mistakes with the bulk of your money.

Thus at first you should keep the core part of your portfolio in a good low-fee balanced fund, or a Couch Potato portfolio, and then supplement that with a handful of stocks. Put at least 80% of your money in the core and at most 20% in individual stocks.

Which stocks should you start with? I suggest large Canadian dividend stocks, preferably in different industries. While you can go wrong with big dividend stocks—I’m looking at you Yellow Media—they’re generally less volatile than their smaller brethren. Large businesses with good credit ratings also tend to have more staying power than smaller outfits. To whet your appetite, I’ve highlighted five in 5 great stocks to start out with, which show promise at the moment.

Start slowly when learning the ropes to figure out if buying individual stocks is something you really want to do. As your portfolio and experience level increases, allocating more money directly to stocks becomes reasonable. Just be warned, successfully picking your own stocks is harder than it looks and requires a great deal of patience and discipline. But if you have some aptitude for it, the returns can be most gratifying.

Aside from picking up an infinitesimal amount of calculus, I met a fellow keener in class who had the investing bug. He rattled on and on about odd things called mutual funds and how you could make a potload of money from them. Naturally enough, I promptly forgot about funds for about a decade while exploring calculus a bit more. But I rediscovered them after I had amassed just over $10,000 by playing the part of Beaker to a series of lovable Dr. Honeydews in a variety of laboratories.

At the time, I felt that $10,000 was a tidy sum for a young fellow—enough to think about alternates to a bank account anyway. So after some pondering, I moved my grubstake into mutual funds. If only I knew then what I know now. But you can profit from my experience. Here’s what I’d tell a younger me about investing, if I had the chance.

The importance of fees
To begin with, there are only a few things that you can really control when heading to the market to make your fortune. It is important to realize that the market is just there. It doesn’t care if you make or lose money—and there are many ways to lose money.

That’s why you should launch your offensive for profits from a secure foundation. Instead of immediately seeking the very best opportunities, it can pay to aim to limit your losses. And it shouldn’t come as a surprise that fees are an important source of such losses. To make money from a small base it helps to be thrifty because many financial institutions seem to prey on the middle class and poor these days.

To highlight how important keeping costs down can be, let’s look at the miracle of compounded interest. The notion is simple. If you can grow your money—even at a low rate—over a long period, then you too can be rich as Croesus. More concretely, if you grow your $10,000 nest egg at 4% a year over 30 years, you’d have just over $32,400. Both higher rates of return and longer investment periods would improve your results considerably.

But unfortunately, all too many investors don’t realize that their funds charge annual fees—and the effect of those fees compounds too. A fund’s fee will rarely be highlighted as part of a sales pitch, but you can spot it in the fund’s prospectus, or you can look it up in your fund’s fact sheet online. It’s called a management expense ratio, or MER. Usually, if fees are mentioned, they’ll probably be referred to in some diminutive fashion. Something like: “It’s only 2%, just think about how much money you’ll make.”

It’s true that 2% doesn’t sound like a lot, but let’s say that you hold a mutual fund for 30 years and it earns 4% a year, on average, before fees. That means that almost half of all of your growth will be snatched back from you in fees. As a result, your $10,000 would grow to about $18,100, which is a good deal less than $32,400. That’s why it’s well worth your time to keep an eye on costs—after all, annual fund fees in Canada are often in the 2% to 3% range.

Three enemies of growth
Taxes are another bane to investors. Despite the government’s desperate need to fund new $400-million hockey arenas in Quebec and G8 gazebos in Ontario’s cottage country, I suggest structuring your affairs so as to minimise taxes as far as is both sensible and legal. For most people, the best way to pay less tax over the long run is to hold investments inside a Tax-Free Savings Account (TFSA) or an RRSP. Outside tax-sheltered accounts, taxes can act a bit like a 2% to 3% annual fee on stock returns over the very long term. Interest income from bonds and GICs is taxed at an even higher rate.

I hate to bring it up, but next I must address an even more insidious way that you can lose your hard-earned savings. It is called inflation. That’s the tendency of money to lose purchasing power over time and it is generally caused by the government printing too much currency. Inflation is the reason why ice cream cones cost 10 cents in the distant past whereas now they cost $3. These days inflation is running at 3.1% annually, which means that even if you avoid the risks of the market by stashing your cash under your mattress, you’re still losing 3.1% of your money’s value every year.

There’s one more threat to your growing portfolio: Your own behaviour. Specifically, it’s the tendency we have to buy high and sell low. Most people can sit in a savings account and sleep well at night. But they seem to lose their heads in the stock markets and it’s easy to see why. The markets gyrate and plunge frequently. In early 2009 many investors woke up to discover that their portfolios were only half as big as they were a couple of years earlier. Problem is, very few investors seem to dive in and actually buy low during such downturns. More commonly purchases are made after a good rally, and investments are sold after a big decline. As a result, history has shown that investors lose—very roughly—2% a year over the long term due to such behaviour.

So let’s do a rough summary: Fund fees might reduce your returns by 2.5% a year, taxes another 1%, say inflation nibbles off 3%, and bad timing another 2%. Gulp! Unless your money is earning an annual return of more than 7.5%, your savings could actually be shrinking. How can you avoid this nasty fate? By minimizing taxes, fees and bad timing.

So where should you invest? I’ve already suggested making use of TFSAs and RRSPs to reduce taxes, but what about fees and bad timing? The solution for the vast majority of investors is the humble low-fee balanced fund. It’s the unsung star of the investment world.

Balanced funds are a one-stop shopping experience for portfolios, and they hold a diversified selection of both stocks and bonds. Usually such funds invest about 60% in stocks and 40% in bonds, or equal amounts in both stocks and bonds.

Because balanced funds contain a big dollop of bonds, their returns tend to be much less volatile than those of stock funds. As a result, it is usually much easier to sleep well at night. You might lose a bit during market crashes, but the declines will be more palatable that those from stocks alone. History has shown that most investors handle balanced funds relatively well and don’t suffer too much from the buy-high, sell-low syndrome. That helps to minimize your losses from bad investing behaviour.

Even better, if you look for them, you can find excellent low-fee balanced funds in Canada. Because I know many people like to deal with their bank, I’ve picked a solid low-fee balanced fund for each of the big banks in 8 great funds to stash $10,000 in. I also included a couple of excellent funds from Calgary-based Mawer Investment Management. You can get both Mawer funds with a $5,000 initial investment through a discount broker, or wait until you have $50,000 and invest directly with Mawer to avoid the brokerage fees.

Much of that internal grappling comes from misunderstanding how the stock market really works. Couple that misunderstanding with our race to become rich, and we do everything wrong. We buy when our mutual funds are soaring, then we sell them or cease adding to them when they slump. We give up much of our gains to pricey fund managers, even though after fees, their funds trail the performance of cheaper investing options such as index funds. We’re confident we can predict where the market is going, though even the professionals have a terrible track record when it comes to forecasting the market’s ups and downs. In short, our greed and confidence can work against us, keeping us from realizing our true investing potential.

I can’t promise to collar your inner doppelganger, but I can help you understand how the stock market works—and how human emotions can sabotage the best-laid plans. Once you understand how your own all-too-human behaviour is affecting your investing, you’ll experience greater financial success.

When a 10% gain isn’t a 10% gain
Imagine a mutual fund that has averaged 10% a year over the past 20 years, after all fees and expenses. Some years, it might have lost money; other years it might have profited beyond expectation. It’s a roller coaster ride, right? But imagine, on average, that it gained 10% annually through all the bumps, rises, twists, and turns. If you found a thousand investors who had invested in that fund from 1990 to 2010, you would expect that each would have netted a 10% annual return.

But on average, they wouldn’t have made anything close to that, because most investors shoot themselves in the foot. When the fund has a couple of bad years, too many investors react by putting less money in the fund, or stopping their contributions entirely. They’re often prompted by their investment advisers, who say, “This fund hasn’t been doing well lately. Because we’re looking after your best interests, we’re going to move your money to another fund that is doing better at the moment.” And when the fund has a great year, most individual investors and financial advisers scramble to put more money in the fund, like feral cats around a fat salmon.

This behaviour is self-destructive. Investors sell or cease to buy after the fund has become cheap, and they buy like lunatics when the fund becomes expensive. If there weren’t so many people doing it, we would call it a “disorder” and name it after some dead Teutonic psychologist. This kind of behaviour ensures that investors will pay higher-than-average prices for their funds over time. Whether it’s an index fund or an actively managed mutual fund, most investors perform far worse than the funds they own—because they like to buy high, and they hate buying low. That’s a pity. And it can make the difference between retiring early and not retiring at all.

John Bogle, the founder of U.S. investment management giant The Vanguard Group, describes in his 2007 book, The Little Book of Common Sense Investing, that the average actively managed U.S. mutual fund reported a 10% annual gain from 1980 to 2005 after fees and expenses, but investors in those funds averaged just 7.3% over the same period. Their fear of low prices prevented them from buying when the funds were low, while their elation at high prices encouraged purchases when fund prices were high. Such bizarre behaviour has devastating financial consequences, as investors give away 2.7% annually because of their knee-jerking alter egos.

As this example shows, over a 25-year period, that’s a pretty expensive habit:

$50,000 invested at 10% a year for 25 years = $541,735.29
$50,000 invested at 7.3% a year for 25 years = $291,046.95
Cost of irrationality = $250,688.34

But what if you didn’t care what the stock market was doing?
As investors, you really don’t have to watch the stock market to see if it’s going up or down. In fact, if you bought an index fund for 25 years, with an equal dollar amount going into that fund each month (called “dollar-cost averaging”) and if that fund averaged 10% annually, you would have averaged 10% or more. Why more? If you put a regular $100 a month into a fund, that $100 would have bought fewer units of that fund when prices were high, but it would have bought more units of that fund when prices were lower.

Most investors don’t do that—they exhibit nutty behaviour
Combine the crazy behaviour of the average investor with the fees associated with actively managed mutual funds, and the average investor ends up with a puny portfolio compared with the disciplined investor, who puts in the same amount of money into index funds every month. The following table categorizes the behaviour of the two types of investors, assuming both will be working—and adding to their investments—for at least the next five years.

I’m not going to suggest that all index investors are evolved enough to ignore the market’s fearful roller coaster, while shunning the self-sabotage caused by fear and greed. But if you can learn to invest regularly in index funds and remain calm when the markets fly upward or downward, you’ll grow far wealthier. Below, you can see examples, based on actual U.S. returns between 1980 and 2005.

The figure on the left side ($84,909.01) is probably generous. The 10% annual return for the average actively managed fund has been historically overstated because it doesn’t include sales charges, adviser wrap fees, or the added liability of taxes in a non-registered account.

Disciplined index investors who don’t sabotage their accounts can end up with a portfolio that’s easily twice as large as that of the average investor over a 25-year period.

Small details like these can allow people with middle-class incomes to amass wealth more effectively than their high salaried neighbours—especially if the middle-class earners think twice about spending more than they can afford. Even if your neighbours invest twice as much as you each month, if they are average, they will buy actively managed mutual funds, and they will either chase hot performers or fail to stay committed to their investments when the markets fall. They’ll feel good about buying into the markets when they’re expensive, and they won’t be as keen to buy when they’re on sale.

I don’t want you to be like your neighbour. Avoid that kind of self-destructive behaviour and you’ll build more wealth.

It’s not timing the market that matters; it’s time in the market
There are smart people (and people who aren’t so smart) who mistakenly think they can jump in and out of the stock market at opportune moments. It seems simple. Get in before the market rises and get out before it drops. This is referred to as “market timing.” But most financial advisers have a better chance beating Roger Federer in a tennis match than effectively timing the market for your account.

Vanguard’s Bogle, who was named by Fortune magazine as one of the four investment giants of the 20th century, has this to say about market timing:

“After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”

When the markets go raving mad, jumping in and out can be tempting. But stock markets are highly irrational, and characterized by short-term swings. The stock market will often fly higher than most people expect during a euphoric phase, while plunging further than anticipated during times of economic duress.

Doing nothing but regularly putting money into an index fund might sound boring during a financial boom, and it might sound terrifying during a financial meltdown. But the vast majority of people (including professionals) who try jumping in and out of the stock market allow their emotional judgments to hurt their profits, as they often end up buying high and selling low.

What can you miss by guessing wrong?
Studies show that most market moves are like the flu you got last year, or the mysterious $10 bill you found in the pocket of your jeans. In each case, you don’t see it coming. Even when looking back at the stock market’s biggest historical returns, Jeremy Siegel, author of Stocks for the Long Run and professor of business at University of Pennsylvania’s Wharton School, suggests that there’s no rhyme or reason when it comes to market activity. He looked back at the biggest stock market moves since 1885 (focusing on trading sessions where the markets moved by 5% or more in a single day) and tried connecting each of them to a world event.

Seventy-five percent of the time, he couldn’t find logical explanations for such large stock market movements—and he had the luxury of looking back in time, and trying to match the market’s behaviour with historical world news. If a smart man like Siegel can’t make connections between world events and the stock market’s movements with the benefit of hindsight, then how is someone supposed to predict future movements based on economic events—or the prediction of events to come? It’s as improbable as guessing which of the moths frantically flying around your light bulb is going to be fried first.

If anyone ever convinces you to act on their short-term stock market prediction, it could end up being a very expensive mistake. Let’s look at the U.S. stock market from 1982 through December 2005 as an example.

During this time, the stock market averaged 10.6% annually. But if you didn’t have money in the stock market during the 10 best trading days, your average return would have dropped to 8.1%. If you missed the best 50 trading days, your average return would have been just 1.8%. Markets can move so unpredictably, and so quickly. If you take money out of the stock market for a day, a week, a month, or a year, you could miss the best trading days of the decade. You’ll never see them coming. They just happen. More importantly, as I said before, neither you nor your broker is going to be able to predict them.

Legendary investor and self-made billionaire Kenneth Fisher, who writes a column in Forbes magazine, had this to say, about market timing:

“Never forget how fast a market moves. Your annual return can come from just a few big moves. Do you know which days those will be? I sure don’t and I’ve been managing money for a third of a century.”

The easiest way to build a responsible, diversified, investment account is to invest regularly with stock and bond index funds. Many people view bonds as boring because they don’t produce the same kind of long-term returns that stocks do. But they don’t fall like stocks are apt to do either. They’re the steadier, slower, more dependable part of an investment portfolio. A responsible portfolio has a percentage allocated to the stock market and a percentage allocated to the bond market, with an increasing emphasis on bonds as the investor ages.

But when stocks start racing upward and everyone’s getting giddy on the profits they’re making, most people ignore their bonds (if they own any at all) and buy more stocks. Many financial advisers fall prey to the same weakness. But those ignoring their planned allocations between stocks and bonds set themselves up for disaster.

How can you ensure that you’re never a victim? It’s far easier than you might think. If you understand exactly what stocks are—and what you can expect from them—you’ll fortify your odds of success.

On stocks: What you really should have learned in school
The stock market is a collection of businesses. It isn’t just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in an equity index fund, you own something that’s as real as the land you’re standing on. You become an indirect owner of all kinds of industries and businesses, via the companies you own within your fund: land, buildings, brand names, machinery, transportation systems, and products, to name a few. Just understanding this key concept can give you a huge advantage as an investor.

Business earnings and stock price growth are two separate things, but over the long term they tend to reflect the same result. For example, if a business grew its profits by 1,000% over a 30-year period, we could expect the stock price of that business to appreciate similarly over the same period.

It’s the same for a stock market index. If the average company within an index grew by 1,000% over 30 years (that’s 8.32% annually) we could expect the stock market index to perform similarly. Long term, stock markets predictably reflect the fortunes of the businesses. But over shorter time periods, the stock market can be as irrational as a crazy dog on a leash. And it’s the crazy dog’s movements that can—if we let them—lure us closer to poverty than to wealth.

The stock market is a dog on a leash
I used to have a dog named Sue who behaved like we were feeding her rocket fuel instead of dog food. If you turned your back on her in the backyard, she’d enact a scene from the television show Prison Break, bounding over the five-foot-high fence in our yard and straining diplomatic relations between our family and those whose gardens she would destroy.

When I took her for extended runs in open fields, she was able to burn off some octane. I would run in a single direction while she darted upward, backward, right, then left. But collared by a very long rope, she couldn’t escape.

If I ran from the lake to the barn with Sue on a leash, and if it took me 10 minutes to get there, then any observer would realize it would take the dog 10 minutes to get there as well. True, the dog could bolt ahead or lag behind while sticking its nose in a gift left behind by another canine. But ultimately, she couldn’t cover the distance much slower or much faster than I did—because of the leash.

Now imagine a bunch of emotional gamblers who watch and bet money on leashed dogs. When a dog bursts ahead of its owner, the gamblers put money on that dog, betting that it will sprint far off into the distance. But the dog’s on a leash, so eventually it’s destined to either slow down or stop while the owner catches up.

But the gamblers don’t think about that. They ignore the leash and place presumptuous bets assuming that the dog will maintain its frenetic pace. Their greed wraps itself around their brains and squeezes. Without that cranial compression, they would see that the leashed dog couldn’t outpace its owner.

It sounds so obvious, doesn’t it? Now get this: the stock market is exactly like a dog on a leash. If the stock market races at twice the pace of business earnings for a few years, then it has to either wait for business earnings to catch up, or it will get choke-chained back in a hurry. But a rapidly rising stock market can cause people to forget that reality: they pile larger and larger sums into stocks with delusional confidence. I’ll use an individual stock to prove the point.

Coca-Cola bounds from its owner
From 1988 to 1998, the Coca-Cola Company increased its profits by 294%. During this short period (and yes, 10 years is a stock market blip) Coca-Cola’s stock price increased by 966%. Because it was rising rapidly, investors—including mutual fund managers—fell over themselves to buy Coca-Cola shares, pushing the share price even higher. Greed might be the greatest hallucinogenic known to humanity.

The dog (Coca-Cola’s stock) was racing ahead of its master (Coca-Cola’s business earnings). A rational share price increase must be in line with profits. If Coca-Cola’s business earnings increased by 294% from 1988 to 1998, we would assume that its stock price would grow by a percentage that was at least similar, maybe a little higher, and maybe a little lower. But Coca-Cola’s stock price growth of 966% was irrational.

Coca-Cola’s stock price vs. Coca-Cola’s earnings

Can you see what happened to the blazing Coca-Cola share price (in dark blue) when it got far ahead of Coca-Cola’s business profits (in light blue)? The dog eventually dropped back to meet its owner. After blazing ahead at 29% a year for a decade (from 1988 to 1998) Coca-Cola’s stock price eventually “heeled.” It had to. You can see in the chart that the stock price was lower in 2011 than it was in 1998. But, during the past 21 years, when were most people drunkenly pouring money into Coca-Cola shares? In the late 1990s. Why? Because the stock had been “performing well.” And most of those investors haven’t made a penny in profits over the last dozen years. Too many of them either sold or shunned the shares when the stock became cheaper in 2003 and 2004.

Ironically, a $10,000 investment in Coca-Cola stock in 1990 would have been worth nearly $100,000 by early 2011 (in U.S. dollars) with reinvested dividends. That’s an annualized return of about 11.5%. But few Coca-Cola shareholders earned anything close to that because of their giddy preference for rising prices and their fear of discounts.

I’m not suggesting that you should run out and buy Coca-Cola shares. What I am suggesting is that whether people invest in index funds, actively managed mutual funds or individual stocks, most investors significantly underperform the investment products they own.
If you can defeat that enemy in the mirror by investing regular monthly sums—or by increasing your contributions when the markets fall—you can make twice as much money as your neighbour, even if you own the exact same investments.

Excerpted with permission of the publisher John Wiley & Sons, Inc., from Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School by Andrew Hallam. Copyright © 2011 by John Wiley & Sons (Asia) Pte. Ltd. This book is available at all bookstores, online booksellers and from the Wiley website at www.wiley.ca or call 1-800-567-4797. More information at facebook.com/millionaireteacher.

]]> http://www.moneysense.ca/2011/10/03/the-enemy-in-the-mirror/feed/ 1