Read an Excerpt

Chapter One

Successful Investing Is Easier Than You Think

Successful investing is not that difficult. It's just intimidating. Some people assume that you have to be rich or possess an important-sounding degree to accumulate wealth as an investor. They think you have to be able to understand all the topics covered in The Wall Street Journal--the ups and downs of the stock market, the interest-rate decisions of the Federal Reserve Board, corporate earnings announcements and dividend policies, economic indicators, and so forth. It's true that all of those things have meaning, but you don't have to follow them closely to invest well. Investing really is easier than most people think.

The purpose of this book is to give you the understanding you need to accomplish your financial goals through investing. Over the past 20 years, I've talked to tens of thousands of successful investors. They come from all backgrounds and all stages of life. Some are young; others are old. Some are experienced; others are beginners. Some have advanced degrees, while others never went to college.

Despite their differences, all the successful investors I've met share several traits, beginning with a very important one: They invest with confidence. Confident investors are people who make decisions based on their own personal financial situations, goals, and ability and willingness to take risks. They don't spend their lives haunted by the thought that somewhere out there is a get-rich scheme or investment gimmick that will lead them to a pot of gold.

The Environmental Forces Are with You

This is a great time in history to be an individualinvestor. There are a wide variety of investment vehicles, including thousands of mutual funds and thousands of individual securities. Educational material has never been more accessible, which means you'll have no trouble learning about the subject. If you have a computer, the Internet makes it easy to manage your investments at any time of day, no matter where you are. Finally, legislative changes have provided many attractive tax incentives for investors. Thanks to individual retirement accounts, 401(k) plans, and other tax-deferred savings vehicles, Americans get extra rewards when they put away money for their future.

Given all these factors, it's no wonder that millions of people have begun to invest for themselves in the last two decades. The explosion of awareness about investing among ordinary people is the most impressive thing I've witnessed in my 20 years in the business. The interest and knowledge are evident in the caliber of questions that Vanguard investors ask when they call our toll-free lines, in the letters I receive from shareholders, and in the questions people ask while making small talk with me at children's soccer games.

So today's environment offers great advantages--but investors must also steel themselves against two environmental challenges. The first one comes from the news media and all the others who make a living sharing their market wisdom with us. They all pay far too much attention to short-term events in the financial markets. In fact, news stories about the markets read a lot like the articles in the sports section. Who's ahead today? Who are the hot players with the golden touch? Who's going to have the best season? What's the best mutual fund this quarter? With so much excited commentary about every market move, it's no wonder that ordinary people sometimes feel intimidated or overwhelmed.

The second challenge comes from my own industry, sad to say. Remember, it's in the interest of many financial services companies to make you think that investing is difficult. They make money by selling investment products and advice. As you've no doubt noticed, there's no shortage of brokers, investment advisers, and financial planners eager to sign you on as a client and charge you for their services. There are financial professionals who want to make you think you can't make your own investment decisions. Don't believe them.

Your task is to recognize those environmental challenges and not to let them stop you from taking charge of your financial life. The reality is, you can succeed at accumulating wealth without spending every moment of your spare time trying to keep up with events. When you feel intimidated by the so-called experts, remember that they don't necessarily know more than you do. Indeed, we've all seen the headlines about financial hotshots who have lost millions and even billions of dollars through complicated trading schemes. What you don't see in the news are the countless stories of individual investors who are quietly and prudently amassing wealth through sensible and disciplined investment programs. They follow the four priorities of confident investors:

1. Do your homework.
2. Develop good habits.
3. Be skeptical of fads.
4. Keep learning about investing.

Do Your Homework

Building your confidence as an investor begins with developing some knowledge. Yes, you must be willing to put a little time into understanding the fundamentals of investing. But not much time! I'm talking about knowledge at a very basic level.

There's no need to read thick treatises on financial theory. You don't have to research any company's financial statements. You don't need to watch the nightly business news for the latest insights on why the markets did whatever they did, nor do you have to start each day knowing what happened in the Asian markets or in the Chicago futures pits in overnight trading. None of that is essential homework for individual investors.

But before you put your dollars anywhere, you do need some very fundamental knowledge. Right now I'm going to tell you what you need to know, but I will save the details for later.

You need to know a little about three different kinds of investments. You've heard of them: They are stocks, bonds, and cash. (Cash means not just money in your wallet, but ready stashes for it, like a bank savings account or a money market mutual fund.)

You need to know a little about some of the places to invest, including banks, mutual funds, and brokerage accounts. In this book, I'll focus on mutual funds because they are the best long-term investment vehicle for the bulk of your serious money.

You need to know what risk means. And here's a case where a lot of people think they already know all about it. But as we'll see, in investing the obvious risk isn't always the most dangerous one.

You need to know yourself as an investor. You can make all kinds of wise investments, with the very soundest long-term strategies, and still find yourself unable to sleep at night for worry when the markets are down. Life is too short for that! But there are many ways for you to invest at a level of risk you can live with, and I'll be discussing them later on in Chapter 11.

There Is No Free Lunch

The single question I've heard most from investors over the years is this one: "What should I invest in if I want to make a lot of money but I don't want to take a lot of risk?" There is no investment that fits that description. I always reply this way: "If you don't want to take risk, put your money in the bank. You cannot invest in the markets without taking on risk."

There is a risk/reward trade-off in every investment choice. If you want to reach for bigger returns, you must accept greater risks. Conversely, if you want to minimize your risk, you must plan for smaller returns. Think of it in terms of the old saying, "There is no free lunch." You must give up something to get something. What's important is to understand the risk you're taking on so you won't be surprised.

We're going to be discussing the risks of different types of investments, and I'll give you tips for checking out specific opportunities that come your way.

Develop Good Habits

The second key characteristic of successful investors is that they adopt good habits. You can start out with the very best investment plan possible and still end up disappointed if your own behavior undermines your plan. And the first, absolutely most important habit to develop is saving money. You simply cannot spend every penny you earn if you hope to accumulate wealth. The sooner you start saving, the better.

Because this topic is so important--and because saving money is difficult for so many people--I'm devoting Chapter 4 to it. In what follows in this chapter, we'll look at other good habits you'll need for managing your investments. But as you read them, keep in mind that your first priority is a disciplined saving program. Believe me--there is nothing that will put you on a sounder footing for success.

In managing your investments, what matters most is how much buying and selling you do. The choice is pretty simple: Either you are a buy-and-hold investor, or you are a trader. If you are a buy-and-hold investor, then once you have done your homework and set up an investment program, you just live your life. Yes, you'll want to monitor your investments on a regular basis, but you won't be inclined to make drastic changes unless something major happens to alter your circumstances, such as a marriage, a divorce, parenthood, or retirement.

Traders--even those who think they're being cautious--are risk takers. They believe they can turn quick profits or avoid big losses by pouncing on fleeting opportunities in the markets, buying and selling rapidly to stay just ahead of everybody else. So they pay a great deal of attention to deciding when to get into some investment and when to get out. They aim to invest when stock or bond prices are about to rise, and sell out when they think prices are about to fall. This approach is known as market-timing. Some people succeed at it in the short run, but it's extremely rare to hear of anyone winning at it over a period of years. Indeed, I've never heard of such a genius.

What makes the odds for market-timers so bad is something that few seem to think much about: the costs. You have to pay to trade, and then you have to pay taxes on any profit you make. Even if you are smart enough to beat the market, trading costs and taxes are likely to eat up your earnings over time. Many studies have shown that holding investments for the long term works far better than trying to time the market.

I'm a buy-and-hold investor myself, and so are all of the successful investors I know. I firmly believe that a buy-and-hold strategy is the best path to success. We'll come back to this topic later, but I want to be clear about my bias up front. Trading is really all about speculating, not investing. If you are a trader, this book isn't for you. Sell it to someone else--or better yet, set it aside. One day you will be ready to read it when you've found out for yourself that frequent trading doesn't work. Traders spend lots of time and effort on investments, but get back less than the buy-and-hold investor who simply goes about living life.

Another habit to cultivate is to resist keeping score too often. We're all susceptible to the temptation to check how our investments are doing at frequent intervals. Compulsive monitoring isn't worth the effort. It doesn't matter how your portfolio is doing from day to day or from week to week. Look at your balance every quarter if you must--once a year is often enough, in my view--but you shouldn't need to plan on more frequent checks. The danger in looking at your portfolio too often is that the short-term fluctuations will make you think that you have to take action when, in fact, almost always your best course is to sit tight.

We'll discuss other good investment habits later in this book, but these are the three most important ones:

• Save money.
• Be a buy-and-hold investor.
• Don't keep score too often.

Be Skeptical of Fads

Many businesses have an interest in getting you to make changes in your investment program--brokerages, fund firms seeking to get you to switch, gurus selling newsletters, books, and so on. If you are susceptible to the cold call from the stockbroker with a hot tip, pitches about the latest tax shelter, or the hype over last quarter's high-performing stock market sector, you can do a great deal of damage to your financial health.

I can't overemphasize the importance of avoiding fads. I've known many investors who have gone to great lengths to do their homework and learn what they need to do to be successful. And, sadly, I've seen a few who did all the right things for a time, only to turn around and make one major mistake. Fads can lead you into great errors, the kind that can wipe out gains achieved through years of patient investing. Successful investors understand that doing the right things is not the only key to success--you also have to avoid big mistakes.

The dot-com bubble is fresh in our minds today, but there are lots of examples. In the late 1960s and early 1970s, there was a lot of hoopla over the so-called Nifty Fifty--one-decision stocks that you could supposedly buy and safely hold forever. At the time, the 10 largest publicly traded U.S. companies were IBM, AT&T, General Motors, Eastman Kodak, Esso, Sears, Texaco, Xerox, General Electric, and Gulf. They were seen as one-decision stocks because they were world leaders with sustainable business advantages that seemingly would always dominate the market. I remember my parents giving me a single share of Eastman Kodak stock for my sixteenth birthday in July 1970 and telling me I would be able to hold it forever.

The Nifty Fifty fad lasted until the 1973-1974 bear market dragged the one-decision stocks down with all the rest. Today, only three of those former market titans rank among the largest-capitalization stocks in the United States. From July 1970 through 2001, 7 of the 10 companies underperformed the broad U.S. stock market. As for Kodak, it produced gains averaging 4.5% a year from 1970 to 2001. The diversified S&P 500 Index's return for that period averaged 12.8% a year, nearly three times more. The flaw in the Nifty Fifty fad lay in thinking that it was safe to pin all of one's hopes on any single stock or small group of stocks.

Keep Learning about Investing

Successful investors need to keep absorbing new information. This is just common sense. In any endeavor, whether it's parenting, a profession, or athletics, you must keep learning to stay up to speed. It's the same way with investing.

Your efforts don't need to be time-consuming. Devote a little bit of regular attention (or a regular bit of a little attention) to the markets and to your own investments. Look at the reports that you get on your investments. Pay periodic attention to magazines or local newspapers or national publications that cover business and investing news. I say periodic attention because it's misleading--and downright hazardous--to slavishly follow the movements of the markets or the fortunes of particular segments or companies on a daily, weekly, monthly, or even annual basis.

What you want to accomplish is threefold:

1. To deepen your understanding of what happens to your investments.
2. To protect yourself in case of developments that threaten your investments.
3. To keep abreast of new opportunities.

New investment opportunities will surface from time to time. You can distinguish the significant ones from the fads by taking a close look at the trade-offs. Should you be willing--as some investors were in the 1990s--to give up the diversification of a broadly based mutual fund in order to seek a higher return by sinking all of your money into one hot-performing stock? No way, and I'll explain why in Chapter 6. Should you be willing to give up the safety of a passbook savings account at the bank for a higher-yielding money market fund that invests in high-quality short-term commercial debt--as many investors have done in the last few decades? Sure.

Missing valuable new investment opportunities can hurt you--sometimes a little, sometimes a lot. The rise of money market instruments in the late 1970s is a perfect case in point. Money market funds revolutionized the financial industry because they offered market interest rates on very liquid high-quality securities. Investors who continued to keep their short-term savings in non-interest-bearing checking accounts after money market instruments became available missed an important opportunity to create more wealth for themselves.

Another example is index mutual funds, which weren't readily available to the public until 1976. Indexing is an investment strategy in which a fund seeks to mimic the behavior of a market index by holding all the securities in the index or a carefully chosen sample of them. That may sound less than exciting until you realize that index funds have a tremendous cost advantage that can mean greater profits for their investors. The trade-off is that, with an index fund, you will never "beat the market." It took decades for the news about index funds to sink in, but now millions of investors have realized that the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it. Investors who have ignored the opportunity to invest in index funds have done so to their detriment. We'll discuss indexing later in this book.

So there you have it. The four priorities of confident investors are: Do your homework, establish good habits, be skeptical about fads, and keep learning. By now, I hope you're thinking that this stuff isn't so difficult after all. Let's get on with the rest of the basics.

Basic Information

Every investor needs to know certain terms. Some of them are so basic that you're probably already familiar with them. Others may sound familiar, but in the financial world they take on a different meaning than the one you're used to. We've tried to avoid using investment industry jargon in this book, but there will be some terminology that gives you pause.

I don't want to interrupt the text to explain things you may already know. But it's important to be sure that you get the information you need. So I'll include Basic Information sidebars like this one along the way to make sure the terms we're using are clear. If you're already familiar with the terms, just skip these sidebars. At the end of the book, I've also included "Some Industry Jargon," an explanation of investment terms that you're likely to hear from investment providers.

This Basic Information sidebar will be the most basic. For starters, you should understand something about the risks and rewards of three fundamental asset classes--stocks, bonds, and cash investments. We'll discuss the asset classes in more detail further on in this book, but for now, an introduction is sufficient.

Asset Classes

Just to take care of this musty-sounding but essential term: An asset, as you know, is simply something of monetary value. In finance, the asset classes are types of investments that offer different combinations of risks and rewards.

Stocks

Stocks represent ownership. If you own a share of General Motors stock, then you are a part-owner of General Motors. That gives you the right to vote on certain policy issues, and it means that you share in the company's business results. If the company does well, you can benefit in two ways: (1) The value of your stock rises, so you could sell it at a profit if you wanted to, and (2) the company may decide to pass along profits to you and the other owners in the form of a dividend. On the other hand, if the company does poorly, your stock can fall in value and dividends can cease to flow. In the worst case, the company could go bankrupt and leave your stock utterly worthless.

What makes a company do well or poorly? There are many variables. A company with prudent management, a sound business strategy, and high-quality products or services that steadily sell is likely to do well. But other, external forces will also affect a company's prospects. These forces include interest rates and other economic factors, new technologies, competition, government regulation and legislation, and customer preferences. In addition to all those pragmatic influences, a company's stock can rise or fall due to investor sentiment--which is as changeable and as difficult to forecast as the weather. Add to that the fact that even the smartest company managers can make mistakes, and you'll see why many people view stocks as the riskiest investment.

Stocks are risky. As traders constantly second-guess each other about market trends and all the rest, stock prices jump around from day to day and month to month. Over long periods, though, stocks as a group have rewarded investors more than any other investment. Since 1926, stocks have provided average annual returns of 10.7% a year.

Bonds

A bond is essentially an IOU. When you buy a bond, you are lending your money to the issuer, typically a company or a government agency. The issuer is promising to pay you a stated amount of interest on the loan and to return the money at a certain time (the maturity date). When you buy a typical bond, you know in advance how much money you are going to receive in interest and when it is going to come; that's why bonds are called fixed income investments. (You'll often hear a bond's interest rate called the coupon--a term dating to when investors actually clipped coupons from paper bonds and presented them to get their interest.)

Though bondholders are creditors, rather than owners, they care about the soundness of the company or agency that issued the bond because that affects the prospects for payment. U.S. Treasury bonds are considered the safest investment in the world because they are backed by the full faith and credit of the United States government. Most established companies can be counted on to pay the interest on their bonds and repay the principal at maturity, no matter how their stock prices are faring.

Retirees who need a steady source of income tend to favor bond investments because of the periodic interest payments they provide. But you don't have to be a retiree to appreciate the stabilizing force that bonds can provide in an investment portfolio. As I'll explain later, many stock investors also hold bonds to help smooth out the inevitable fluctuations in the value of their overall investment portfolios.

But bonds do indeed have risks. The worst-case scenario is default: The bond issuer runs into trouble and can't pay you the promised interest or return your principal. Fortunately, defaults are relatively uncommon. A much more immediate risk involves bond prices. Existing bonds are constantly being traded on the market, and their value changes along with market interest rates. That's no problem for you if you don't need to sell your bond before its maturity date, but for those who do need to sell, the changing prices can result in losses. Also, if you invest in a bond mutual fund, your share price and the interest payments you receive will fluctuate along with the overall market and the fund's holdings.

Finally, there is the invisible risk of inflation. There have been periods when the interest paid on bonds did not keep up with rising prices, so that bond investors were steadily losing purchasing power.

Cash Investments

You may think of cash as the bills and change in your wallet, but it's something a little different in investing. Cash investments are very short-term IOUs issued by governments, corporations, banks, or other financial institutions. Money market mutual funds are one of the most popular forms of cash investments. Cash investments have been the least volatile of the three major asset classes historically, which means they are a safer choice than stocks or bonds if your biggest priority is not losing money. But they have also provided the lowest returns. Cash investments are said to have good liquidity because it's generally possible to withdraw one's cash immediately and without penalty, but their disadvantage is that they will provide a return that keeps you just about in line with or maybe slightly above inflation. While cash investments are a useful vehicle for emergency funds or money that will be needed just around the corner, they generally shouldn't serve as a large part of your long-term retirement account.

As you can see, there are trade-offs with each of the asset classes, so you'll always need to know what your objectives are before deciding how to invest. If you want to reach for the greater potential returns that are offered by stocks, you must be willing to accept their increased risk. If you want to opt for the greater safety of cash instruments, you must be willing to accept the lower returns they tend to provide.

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In a Nutshell

You can invest successfully and confidently if you establish four priorities:

1. Do your homework. Develop an understanding of investment basics, such as the notion of the risk/reward trade-off.
2. Develop good habits. Become a disciplined saver. Be a buy-and-hold investor. Resist the temptation to keep score too often.
3. Be skeptical of fads. If you abandon good habits in order to embrace fads, you can wipe out the gains of many years of patient investing.
4. Keep learning about investing. Keep abreast of new opportunities and protect yourself from developments that threaten your investments.

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