How to Invest by Burton Malkiel

From Burton Malkiel’s “A Random Walk Down Wall Street.”

What is the most important driver in the growth of your assets?

“The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline. Without a regular savings program, it doesn’t matter if you make 5 percent, 10 percent, or even 15 percent on your investment funds. The single most important thing you can do to achieve financial security is to begin a regular savings program and to start it as early as possible.” (p. 290)
“The only reliable route to a comfortable retirement is to build up a nest egg slowly and steadily. Yet few people follow this basic rule, and the savings of the typical American family are woefully inadequate.” (p. 290)

What is the most important investment decision you will make? Asset Allocation.

“The most important investment decision you will probably ever make concerns the balancing of asset categories (stocks, bonds, real estate, money-market securities, and so on) at different stages of your life.” (p. 347)
“According to Roger Ibbotson, who has spent a lifetime measuring returns from alternative portfolios, more than 90 percent of an investor’s total return is determined by the asset categories that are selected and their overall proportional representation. Less than 10 percent of investment success is determined by the specific stocks or mutual funds that an individual chooses.” (p. 344)

Asset Allocation should be based on your circumstances, age, and risk tolerance.

“Investment strategy needs to be keyed to one’s life cycle. A thirty-four-year-old and a sixty-eight-year-old saving for retirement should use different financial instruments to accomplish their goals.

The thirty-four-year-old—just beginning to enter the peak years of salaried earnings—can use wages to cover any losses from increased risk.

The sixty-eight-year-old—likely to depend on investment income to supplement or replace salary income—needs to constrain risk.

Even the same financial instrument can mean different things to different people depending on their capacity for risk. Although the thirty-four-year-old and the sixty-eight-year-old may both invest in a certificate of deposit, the younger may do so because of an attitudinal aversion to risk and the older because of a reduced capacity to accept risk. In the first case, one has more choice in how much risk to assume; in the second, one does not.” (p. 347)

Here are the 5 basic principles

“Before we can determine a rational basis for making asset-allocation decisions, certain principles must be kept firmly in mind. We’ve covered some of them implicitly in earlier chapters, but treating them explicitly here should prove very helpful. The key principles are:
1. History shows that risk and return are related.
2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return.
3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment.
4. Rebalancing can reduce risk and, in some circumstances, increase investment returns.
5. You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.”
“Although you may be tired of hearing that investment rewards can be increased only by the assumption of greater risk, no lesson is more important in investment management. This fundamental law of finance is supported by centuries of historical data.” (p. 349)

Make sure you understand your investment objectives.

Determining clear goals is a part of the investment process that too many people skip, with disastrous results. You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket. The securities markets are like a large restaurant with a variety of menu choices suitable for different tastes and needs. Just as there is no one food that is best for everyone, so there is no one investment that is best for all investors. We would all like to double our capital overnight, but how many of us can afford to see half our capital disintegrate just as quickly?
J. P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to the sleeping point.” He wasn’t kidding. Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. The decision is up to you. High investment rewards can only be achieved by accepting substantial risk. Finding your sleeping point is one of the most important investment steps you must take.” (p. 306)

Here is the Asset Allocation Malkiel suggests depending on your age.

Mid 20’s-
70%- Stocks (50% in US stocks, 50% in international stocks and emerging markets)
10%- REITS (portfolio of REIT’s
15%- Bonds and Bond Substitutes (no load high grade corporate bond fund, some Treasury inflation protected securities, foreign bonds, dividend growth stocks)
5% – Cash (money-market fund or short term bond fund (average maturity 1 to 1.5 years)

Late 30’s-40’s- 65% Stocks, 10% REITS, 20% Bonds and Bond Substitutes, 5% Cash.

Mid 50’s- 55% Stocks, 12.5% REITS, 27.5% Bonds and Bond Substitutes, 5% Cash.

Late 60’s- 40% Stocks, 15% REITS, 35% Bonds and Bond Substitutes, 10% Cash.

With respect to bond holdings, the guide recommends taxable bonds and bond substitutes. If, however you are in the highest tax bracket and live in a high-tax state such as New York and your bonds are held outside of your retirement plan, use tax-exempt money funds and bond funds tailored to your state so they they are exempt from both federal and state taxes.” (p. 365)

Although it doesn’t fit under the rubric of an index-fund portfolio, investors should consider putting part or all of the U.S. bond portfolio in Treasury inflation-protected securities. The U.S. Treasury I Savings Bonds were an excellent choice in 2022. The dividend growth and corporate bond funds are also exceptions since they are not standard index funds.” (p. 386)

“Bond and Bond substitutes: if bonds are held outside of tax-favored retirement plans, tax-exempt bonds should be used. The share of bond substitutes should be increased during periods of ultra-low interest rates” (p. 366)

Here are the specific Vanguard stocks, bonds, and REITs, Malkiel suggests.

Cash– Malkiel suggests Vanguard Prime Money Market Fund (VMMXX)

US Stocks– Malkiel suggests Vanguard’s Total Stock Market Index Fund (VTSAX)

International Stocks – Malkiel suggests Vanguard’s Developed Market Index Fund (VTMGX) and Vanguard’s Emerging Markets Index Fund (VEMBX).

REITS– Malkiel suggests buying Vanguard’s REIT Index Fund (VGSIX)

Bonds and Bonds Substitutes– Malkiel suggests Vanguard Long Term Corporate Bond Fund ETF (VCLT), Vanguards Emerging Market Government Bond Fund (VGAVX), and Vanguard Dividend Growth Fund (VDIGX).

A Specific Index-Fund Portfolio for investors in their mid 50’s by Malkiel

“The table shows the recommended percentages for those in their mid-fifties. Other can use exactly the same selections and simply change the weights to those appropriate for their specific age group. You may want to alter the percentages somewhat depending on your personal capacity for and attitude toward risk. Those willing to accept somewhat more risk in the hope of greater reward could increase the proportion of equities. Those who need a steady income for living expenses could increase their holdings of real estate equities and dividend growth stocks, because they provide somewhat larger current income.” (p. 385)

Stocks (55%)

27% Vanguard Total Stock Market Index Fund (VTSAX)
14% Vanguard Developed Market Index Fund (VTMGX)
14% Emerging International Markets Vanguard Emerging Markets Index Fund (VEMBX)

Real Estate Equities (12½%)

Vanguard REIT Index Fund (VGSLX)

Bonds and Bond Substitutes (27½%)

7½% U.S. Vanguard Long-term Corporate Bond Fund ETF (VCLT)
7½% Vanguard Emerging Markets Government Bond Fund (VGAVX)
12½% Vanguard Dividend Growth Fund (VDIGX)†

Cash (5%)

Vanguard Federal Money Market Fund (VMFXX) (“A short-term bond fund may be substituted for one of the money-market funds listed.)

“Remember also that I am assuming here that you hold most, if not all, of your securities in tax-advantaged retirement plans. Certainly all bonds should be held in such accounts. If bonds are held outside of retirement accounts, you may well prefer tax-exempt bonds rather than the taxable securities. Moreover, if your common stocks will be held in taxable accounts, you might consider tax-loss harvesting, covered below. Finally, note that I have given you a choice of index funds from different mutual-fund complexes.” (p. 386)

“Although it doesn’t fit under the rubric of an index-fund portfolio, investors should consider putting part or all of the U.S. bond portfolio in Treasury inflation-protected securities. The U.S. Treasury I Savings Bonds were an excellent choice in 2022. The dividend growth and corporate bond funds are also exceptions since they are not standard index funds.” (p. 386)

As investors age, what should they do?

As investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and bond substitutes such as dividend growth stocks during periods of ultra-low interest rates. The allocation is also increased to REITs that pay generous dividends. By the age of fifty-five, investors should start thinking about the transition to retirement and moving the portfolio toward income production. The proportion of bonds and bond substitutes increases, and the stock portfolio becomes more conservative and income-producing and less growth-oriented.”
“In retirement, a portfolio heavily weighted in a variety of bonds and bond substitutes is recommended. A general rule of thumb used to be that the proportion of bonds in one’s portfolio should equal one’s age. Nevertheless, even in one’s late sixties, I suggest that 40 percent of the portfolio be committed to ordinary common stocks and 15 percent to real estate equities (REITs) to give some income growth to cope with inflation. Indeed, since life expectancies have increased significantly since I first presented these asset allocations during the 1980s, I have increased the proportion of equities accordingly.” (p. 364)

What are the four Bonds I should consider?

“Bonds were a poor investment until the early 1980s because the interest rates they carried did not offer adequate inflation protection. But bond prices adjusted to give investors excellent returns over the next forty years. Moreover, bonds proved to be excellent diversifiers with low or negative correlation with common stocks from 1980 through 2021. In my view, there are four kinds of bond purchases that you may want to consider: (1) zero-coupon bonds (which allow you to lock in yields for a predetermined length of time); (2) no-load bond mutual funds (which permit you to buy shares in bond portfolios); (3) tax-exempt bonds and bond funds (for those in high tax brackets); and (4) U.S. Treasury inflation-protected securities (TIPS). But their attractiveness for investment varies considerably with market conditions. And with the low interest rates of the early 2020s, investors must approach the bond market with considerable caution.” (p. 313)

Zero-Coupon Bonds.

“These securities are called zero coupons or simply zeros because owners receive no periodic interest payments, as they do in a regular interest-coupon-paying bond. Instead, these securities are purchased at discounts from their face value (for example, 75 cents on the dollar) and gradually rise to their face or par values over the years. If held to maturity, the holder is paid the full stated amount of the bond. These securities are available on maturities ranging from a few months to over twenty years. They are excellent vehicles for putting money aside for required expenditures on specific future dates.” (p. 313)
“The principal attraction of zeros is that the purchaser is faced with no reinvestment risk. A zero-coupon Treasury bond guarantees an investor that his or her funds will be continuously reinvested at the yield-to-maturity rate. The main disadvantage of zeros is that the Internal Revenue Service requires that taxable investors declare annually as income a pro rata share of the dollar difference between the purchase price and the par value of the bond. This is not required, however, for investors who hold zeros in tax-deferred retirement plans.” (p. 314)
“Two warnings are in order. Some brokers will charge small investors fairly large commissions for the purchase of zero-coupon bonds in small denominations. In addition, you should know that redemption at face value is assured only if you hold the bonds to maturity. In the meantime, prices can be highly variable as interest rates change.” (p. 314)

No Load Bonds.

Open-end bond (mutual) funds give some of the long-term advantages of the zeros but are much easier and less costly to buy or sell. Those that I have listed in the Address Book all invest in long-term securities. Although there is no guarantee that you can reinvest your interest at constant rates, these funds do offer long-run stability of income and are particularly suitable for investors who plan to live off their interest income. Because bond markets tend to be at least as efficient as stock markets, I recommend low-expense bond index funds. Bond index funds and ETFs, which just buy and hold a broad variety of bonds, generally outperform actively managed bond funds. In no event should you ever buy a load fund with a commission fee. There’s no point in paying for something if you can get it free.” (p. 314)
“The Address Book lists several types of funds: those specializing in corporate bonds, those that buy a portfolio of GNMA mortgage-backed bonds, those investing in tax-exempt bonds (which I will discuss in the next section), as well as some riskier high-yield funds appropriate for investors willing to accept extra risk in return for higher expected returns.” (p. 315)

Tax-exempt Bonds.

“If you are in a high tax bracket, taxable money funds, zeros, and taxable bond funds may be suitable only within your retirement plan. Otherwise, you need the tax-exempt bonds issued by state and local governments and by various governmental authorities, such as port authorities or toll roads. The interest from these bonds doesn’t count as taxable income on your federal tax form, and bonds from the state in which you live are typically exempt from any state income taxes.”
“During 2021, good-quality long-term corporate bonds were yielding about 3 percent, and tax-exempt issues of comparable quality yielded about 2½ percent. Suppose your tax bracket (the rate at which your last dollar of income is taxed) is about 36 percent, including both federal and state taxes. The following table shows that the after-tax income is $58 higher on the tax-exempt security, which is clearly the better investment for a person in your tax bracket. Even if you are in a lower tax bracket, tax-exempts may still pay, depending on the exact yields available in the market when you make your purchase. Of course in 2021 neither bond provided a real return since the inflation rate was greater than 2½ percent.” (p. 315)
“For those in a high marginal tax bracket (the rate paid on the last dollar of income), there is a substantial tax advantage from municipal (tax-exempt) bonds. If you are in a high tax bracket, with little need for current income, you will prefer bonds that are tax-exempt and stocks that have low dividend yields but promise long-term capital gains (on which taxes do not have to be paid until gains are realized—perhaps never, if the stocks are part of a bequest). On the other hand, if you are in a low tax bracket and need high current income, you should prefer taxable bonds and high-dividend-paying common stocks so that you don’t have to incur the transactions charges involved in selling off shares periodically to meet income needs.” (p. 309)
“There is one nasty “heads I win, tails you lose” feature of bonds. If interest rates go up, the price of your bonds will go down. But if interest rates go down, the issuer can often “call” the bonds away from you (repay the debt early) and then issue new bonds at lower rates. To protect yourself, make sure that your long-term bonds have a ten-year call-protection provision that prevents the issuer from refunding the bonds at lower rates.”
“For some good tax-exempt bond funds, consult the list in the Address Book. If you have substantial funds to invest in tax-exempts, however, I see little reason for you to make your tax-exempt purchases through a fund and pay the management fees involved. If you confine your purchases to high-quality bonds, including those guaranteed by bond insurance, there is little need for you to diversify, and you’ll earn more interest. If you have just a few thousand dollars to invest, however, a fund will provide convenient liquidity and diversification. There are also funds that confine their purchases to the bonds of a single state so that you can avoid both state and federal income taxes.” (p. 316)

TIPS

“We know that unanticipated inflation is devastating to bondholders. Inflation tends to increase interest rates, and as they go up, bond prices fall. And there’s more bad news: Inflation also reduces the real value of a bond’s interest and principal payments. Now a lead shield is available to investors in the form of Treasury inflation-protected securities (TIPS). These securities are immune to the erosion of inflation if held to maturity and guarantee investors that their portfolios will retain their purchasing power. Long-term TIPS paid a basic interest rate of about 1 percent during the 2010s. But in contrast to old-fashioned Treasuries, the interest payment is based on a principal amount that rises with the consumer price index (CPI). If the price level were to rise 3 percent next year, the $1,000 face value of the bond would increase to $1,030 and the semiannual interest payment would increase as well. When the TIPS mature, the investor gets a principal payment equal to the inflation-adjusted face value at that time. Thus, TIPS provide a guaranteed real rate of return and a repayment of principal in an amount that preserves its real purchasing power.”
“No other financial instrument available today offers investors as reliable an inflation hedge. TIPS also are great portfolio diversifiers. When inflation accelerates, TIPS will offer higher nominal returns, whereas stock and bond prices are likely to fall. Thus, TIPS have low correlations with other assets and are uniquely effective diversifiers. They provide an effective insurance policy for the white-knuckle crowd.”
“TIPS do have a nasty tax feature, however, that limits their usefulness. Taxes on TIPS returns are due on both the coupon payment and the increase in principal amount reflecting inflation. The problem is that the Treasury does not pay out the increase in principal until maturity. If inflation were high enough, the small coupon payments might be insufficient to pay the taxes and the imbalance would worsen at higher rates of inflation. Thus, TIPS are far from ideal for taxable investors and are best used only in tax-advantaged retirement plans. As inflation began to accelerate during the early 2020s, the base yield on TIPS became negative. During late 2021, 10-year TIPS sold at a base rate of minus 1 percent, while the inflation rate had risen to about 6 percent.” (p. 317)

I-bonds

“U.S. Treasury I Bonds: The Best Alternative for Individuals There is an excellent alternative available for individual investors to standard TIPS: U.S. Treasury I Savings Bonds. The bonds pay a fixed rate for the life of the bond, plus the annualized CPI inflation rate, which is adjusted twice a year. These I Bonds paid a total interest rate of 7.12 in early 2022, well in excess of any other safe yield obtainable. The interest on an I Bond is deferred until the bond matures or is cashed in, and it is exempt from state and local income taxes. If you use the proceeds for qualified higher education expenses, the interest is exempt from federal taxes as well. The bonds mature in 30 years, but you can cash them in after one year (with a small penalty). After holding them for five years, there is no redemption penalty. The maximum purchase allowed is $10,000 each year for each social security recipient. Thus, a couple could purchase $20,000 of these I Bonds. In addition, one could obtain an extra $5,000 bond by using funds from an income tax refund. Available at the U.S. Treasury website (treasurydirect.gov), they are Uncle Sam’s best deal for risk-averse investors.” (p. 318)

Should you be a bond market junkie?

“Is the bond market immune to the maxim that investment risk and reward are related? Not at all! During most periods, so-called junk bonds (lower credit quality, higher-yielding bonds) have given investors a net rate of return up to 3 percentage points higher than the rate that could be earned on U.S. Treasury bonds. Thus, even if 1 percent of the lower-grade bonds defaulted on their interest and principal payments and produced a total loss, a diversified portfolio of low-quality bonds would still produce net returns higher than those available from Treasury bonds. Many investment advisers have therefore recommended well-diversified portfolios of high-yield bonds as sensible investments.”
“There is, however, another school of thought that advises investors to “just say no” to junk bonds. Most junk bonds have been issued as a result of a massive wave of corporate mergers, acquisitions, and leveraged (mainly debt-financed) buyouts. The junk-bond naysayers point out that lower credit bonds are most likely to be serviced in full only during good times in the economy. But watch out if the economy falters.”
“So what’s a thoughtful investor to do? The answer depends in part on how well you sleep at night when you assume substantial investment risk. High-yield or junk-bond portfolios are not for insomniacs. Even with diversification, there is substantial risk in these investments. Moreover, they are not for investors who depend solely on interest payments as their major source of income. And they are certainly not for any investors who do not adequately diversify their holdings. However, at least historically, the gross-yield premium from junk bonds has more than compensated for actual default experience.” (p. 318)

What about Foreign Bonds?

“There are many foreign countries whose bond yields are higher than those in the United States. This is particularly true in some emerging markets. Conventional wisdom has usually recommended against bonds from emerging markets, citing their high risk and poor quality. But many emerging economies have lower debt-to-GDP ratios and better government fiscal balances than are found in the developed world. The emerging economies are also growing faster. Hence, a diversified portfolio of higher-yielding foreign bonds, including those from emerging markets, can be a useful part of a fixed-income portfolio for risk-tolerant investors.” (p. 319)

What about bond substitutes for part of the aggregate bond portfolio during eras of financial repression?

“Low interest rates present a daunting challenge for bond investors. All the developed countries of the world are burdened with excessive amounts of debt. Like the United States, governments around the world are having an extraordinarily difficult time reining in entitlement programs in the face of aging populations.”
“The easier path for the U.S. and other governments is to keep interest rates artificially low as the real burden of the debt is reduced and the debt is restructured on the backs of the bondholders. We have seen this movie before. At the end of World War II, the United States deliberately kept interest rates at very low levels to help service the debt that had accumulated during the war. By doing so, the United States reduced its debt-to-GDP ratio from 122 percent in 1946 to 33 percent in 1980. But it was achieved at the expense of bondholders. This is what is meant by the term “financial repression.”
“One technique to deal with the problem is to use an equity dividend substitution strategy for some portion of what in normal times would have been a bond portfolio. Portfolios of relatively stable dividend growth stocks have yields much higher than the bonds of the same companies and allow the possibility of growth in the future. An example of the sort of company in such a portfolio is Verizon. Verizon’s 15-year bonds yielded about 3¼ percent in late 2021. Its common stock has a dividend yield of 4⅜ percent, and the dividend has been growing over time. Retired people who live off dividends and interest will be better rewarded with Verizon stock than with its bonds. And portfolios of dividend growth stocks may be no more volatile than an equivalent portfolio of bonds of the same companies. During periods of financial repression, the standard recommendations regarding bonds need to be fine-tuned and a partial substitution of stocks for bonds in that part of the portfolio designed for lower risk may be appropriate.” (p. 320)

Why should I buy international stocks?

“One of the biggest mistakes that investors make is to fail to obtain sufficient international diversification. The United States represents only about one-third of the world economy. To be sure, a U.S. total stock market fund does provide some global diversification because many of the multinational U.S. companies do a great deal of their business abroad. But the emerging markets of the world (such as China and India) have been growing much faster than the developed economies and are expected to continue to do so. Hence, in the recommendations that follow, I suggest that a substantial part of every portfolio be invested in emerging markets.”
“Emerging markets other than China tend to have younger populations than the developed world. Economies with younger populations tend to grow faster. Moreover, in 2022, they had more attractive valuations than those in the United States. We have pointed out that cyclically adjusted P/E ratios (CAPEs) tend to have predictable power in forecasting longer-run equity returns in developed markets. The relationship also holds in emerging markets. Emerging market CAPEs were less than half the level in the United States in 2022. Future long-run returns have tended to be generous when stocks could be bought at those valuations.” (p. 384)

Why should I buy a Total Market Index Fund over an S and P 500 index fund?

“Many people incorrectly equate indexing with a strategy of simply buying the S&P 500 Index. That is no longer the only game in town. The S&P 500 omits the thousands of small companies that are among the most dynamic in the economy. Thus, I believe that if an investor is to buy only one U.S. index fund, the best general U.S. index to emulate is one of the broader indexes such as the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI U.S. Broad Market Index—not the S&P 500. Ninety years of market history confirms that, in the aggregate, smaller stocks have tended to outperform larger ones. Over long periods of history, a portfolio of smaller stocks produced a rate of return of about 12 percent annually, whereas the returns from larger stocks (such as those in the S&P 500) were about 10 percent. Although the smaller stocks were riskier than the major blue chips, the point is that a well-diversified portfolio of small companies is likely to produce enhanced returns. For this reason, I favor investing in an index that contains a much broader representation of U.S. companies, including large numbers of the small dynamic companies that are likely to be in early stages of their growth cycles.”

Why should I buy Real Estate and REITS?

“Commercial real estate has been an unattainable investment for many individuals. Nevertheless, the returns from real estate have been quite generous, similar to those from common stocks. I’ll argue in Exercise 6 that individuals who can afford to buy their own homes are well advised to do so. I’ll also show that it is much easier today for individuals to invest in commercial real estate. I believe that real estate investment trusts (REITs) deserve a position in a well-diversified investment portfolio.” (p. 308)
“Remember Scarlett O’Hara? She was broke at the end of the Civil War, but she still had her beloved plantation, Tara. A good house on good land keeps its value no matter what happens to money. As long as the world’s population continues to grow, the demand for real estate will be among the most dependable inflation hedges.” (p. 311)
“Although the calculation is tricky, the long-run returns on residential real estate have been quite generous. We did have a bubble in single-family home prices during 2007 and 2008. By the second decade of the 2000s, however, home prices returned to “normal.” Again there was some froth in the market in 2021, as many people decided to leave crowded cities, but supply of new homes began to rise robustly. You should be aware that the real estate market is less efficient than the stock market. Hundreds of knowledgeable investors study the worth of every common stock. Only a handful of prospective buyers assess the worth of a particular property. Hence, individual pieces of property are not always appropriately priced. Finally, real estate returns seem to be higher than stock returns during periods when inflation is accelerating, but do less well during periods of disinflation. In sum, real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics.” (p. 311)
“The natural real estate investment for most people is the single-family home or the condominium. You have to live somewhere, and buying has several tax advantages over renting. Interest on up to $750,000 in mortgage debt on new home purchases was deductible from taxes in 2021, as were property taxes up to $10,000. Also, realized gains in the value of your house, up to $500,000 for married couples, are excluded from taxation. In addition, ownership of a house is a good way to force yourself to save, and a house provides enormous emotional satisfaction.”
“You may also wish to consider ownership of commercial real estate through the medium of real estate investment trusts (REITs, pronounced “reets”). Properties from apartment houses to office buildings and shopping malls have been packaged into REIT portfolios and managed by professional real estate operators. The REITs themselves are like any other common stock and are actively traded on the major stock exchanges. This has afforded an excellent opportunity for individuals to add commercial real estate to their investment portfolios.” (p. 311)
“You will also see that I have included real estate explicitly in my recommendations. I said earlier that everyone should attempt to own his or her own home. I believe that everyone should have substantial real estate holdings, and some part of one’s equity holdings should be in real estate investment trust (REIT) index mutual funds described in chapter 12.” (p. 365)
“If you want to move your portfolio toward terra firma, I strongly suggest you invest some of your assets in REITs. There are many reasons why they should play a role in your investment program. First, ownership of real estate has produced comparable rates of return to common stocks and good dividend yields. Equally important, real estate is an excellent vehicle to provide the benefits of diversification described in chapter 8. Real estate returns have often exhibited only a moderate correlation with other assets, thereby reducing the overall risk of an investment program. Moreover, real estate has been a dependable hedge against inflation.” (p. 312)
“As I argued in chapter 8, investors can reduce risk by diversifying internationally, by including asset classes such as real estate in the portfolio, and by placing some portion of their portfolio in bonds and bondlike securities, including Treasury inflation-protected securities. This is the basic lesson of modern portfolio theory. Thus, investors should not buy a U.S. stock-market index fund and hold no other securities. But this is not an argument against indexing because index funds currently exist that mimic the performance of various international indexes such as the Morgan Stanley Capital International (MSCI) index of European, Australasian, and Far Eastern (EAFE) securities, and the MSCI emerging-markets index. In addition, there are index funds holding real estate investment trusts (REITs) as well as corporate and government bonds.”

What about Gold?

“In previous editions of this book I took different positions on whether gold belongs in a well-diversified portfolio. At the start of the 1980s, as gold had risen in price past $800 an ounce, I took a quite negative view of gold. Twenty years later, at the start of the new millennium, with gold selling in the $200s, I became more positive. Today, with gold selling at over $1,800 an ounce, I find it hard to be enthusiastic. But there could be a modest role for gold in your portfolio. Returns from gold tend to be very little correlated with the returns from paper assets. Hence, even modest holdings (say, 5 percent of the portfolio) can help an investor reduce the variability of the total portfolio. And if high inflation were to be persistent, gold would likely produce acceptable returns. But prudence suggests—at best—a limited role for gold as a vehicle for obtaining broader diversification.” (p. 321)

Why do I need cash reserves?

I know that many brokers will tell you not to miss investing opportunities by sitting on your cash. “Cash is trash” is the mantra of the brokerage community. But everyone needs to keep some reserves in safe and liquid investments to pay for an unexpected medical bill or to provide a cushion during a time of unemployment.

Assuming that you are protected by medical and disability insurance at work, this reserve might be established to cover three months of living expenses. The cash reserve fund should be larger, the older you are, but could be smaller if you work in an in-demand profession and/or if you have large investable assets. Moreover, any large future expenditures (such as your daughter’s college tuition bill) should be funded with short-term investments (such as a bank certificate of deposit) whose maturity matches the date on which the funds will be needed.
Remember Murphy’s Law: What can go wrong will go wrong. And don’t forget O’Toole’s commentary: Murphy was an optimist. Bad things do happen to good people. Life is a risky proposition, and unexpected financial needs occur in everyone’s lifetime. The boiler tends to blow up just at the time that your family incurs whopping medical expenses. A job layoff happens just after your son has totaled the family car. And who knew that even “secure” jobs could disappear during the COVID-19 pandemic? That’s why every family needs a cash reserve as well as adequate insurance to cope with the catastrophes of life.” (p. 293)
“A reserve for any known future expenditure should be invested in a safe instrument whose maturity matches the date on which the funds will be needed. Suppose you have set aside money for junior’s tuition bills that will need to be paid at the end of one, two, and three years. One appropriate investment plan in this case would be to buy three bank CDs with maturities of one, two, and three years. Bank CDs are even safer than money funds, typically offer higher yields, and are an excellent medium for investors who can tie up their liquid funds for at least six months.” (p. 296)

How do you determine your risk tolerance?

“By far the biggest individual adjustment to the general guidelines suggested concerns your own attitude toward risk. It is for this reason that successful financial planning is more of an art than a science. General guidelines can be extremely helpful in determining what proportion of a person’s funds should be deployed among different asset categories. But the key to whether any recommended asset allocation works for you is whether you are able to sleep at night. Risk tolerance is an essential aspect of any financial plan, and only you can evaluate your attitude toward risk. You can take some comfort in the fact that the risk involved in investing in common stocks and long-term bonds is reduced the longer the time period over which you accumulate and hold your investments. But you must have the temperament to accept considerable short-term fluctuations in your portfolio’s value.”
“How did you feel when the market fell by almost 50 percent in 2008? How well did you sleep when the market dropped by a third in a month between February and March of 2020, including a 13 percent decline on a single day, March 16, 2020? If you panicked and became physically ill because a large proportion of your assets was invested in common stocks, then clearly you should pare down the stock portion of your portfolio. Thus, subjective considerations also play a major role in the asset allocations you can accept, and you may legitimately stray from those recommended here depending on your aversion to risk.” (p. 362)
“Those willing to accept somewhat more risk in the hope of greater reward could increase the proportion of equities. Those who need a steady income for living expenses could increase their holdings of real estate equities and dividend growth stocks, because they provide somewhat larger current income.” (p. 383)

The risk of holding stocks is less the longer you hold it. The risk of holding stocks is high if you only hold it for one year.

“What about investing in common stocks? Could it be that the risk of investing in stocks also decreases with the length of time they are held? The answer is a qualified yes. A substantial amount (but not all) of the risk of common-stock investment can be eliminated by adopting a program of long-term ownership, reinvesting dividends, and sticking to it through thick and thin (the buy-and-hold strategy discussed in earlier chapters). The figure on page 351 is worth a thousand words, so I can be brief in my explanation. If you held a diversified stock portfolio (such as the Standard & Poor’s 500-Stock Index) during the period from 1950 through 2020, you would have earned, on average, a quite generous return of about 10 percent.”
“But the range of outcomes is certainly far too wide for an investor who has trouble sleeping at night. In one year, the rate of return from a typical stock portfolio was more than 52 percent, whereas in another year it was negative by 37 percent. Clearly, there is no dependability of earning an adequate rate of return in any single year. A one-year U.S. Treasury security or a one-year government-guaranteed certificate of deposit is the investment for those who need the money next year.” (p. 351)
“But note how the picture changes if you held on to your common-stock investments for twenty-five years. Although there is some variability in the return achieved, depending on the exact twenty-five-year period in question, that variability is not large. On average, investments over all twenty-five-year periods covered by this figure have produced a rate of return of slightly more than 10 percent. This long-run expected rate of return was reduced by only about 4 percentage points if you happened to invest during the worst twenty-five-year period since 1950. It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.*” (p. 351)
“Over investment periods of twenty of thirty years, stocks have generally been the clear winners, as is shown in the table below. These data further support the advice that younger people should have a larger proportion of their assets in stocks than older people.”
I do not mean to argue that stocks are not risky over long holding periods. Certainly the variability of the final value of your portfolio does increase the longer you hold your stocks. And we know that investors have experienced decades during which common stocks have produced near-zero overall returns. But for investors whose holding periods can be measured in twenty-five years or more, and especially those who reinvest their dividends and even add to their holdings through dollar-cost averaging, common stocks are very likely to provide higher returns than are available from safe bonds and even safer government-guaranteed savings accounts.” (p. 352)

When should you be more aggressive?

“For those in their twenties, a very aggressive investment portfolio is recommended. At this age, there is lots of time to ride out the peaks and valleys of investment cycles, and you have a lifetime of earnings from employment ahead of you. The portfolio is not only heavy in common stocks but also contains a substantial proportion of international stocks, including the higher-risk emerging markets. As mentioned in chapter 8, one important advantage of international diversification is risk reduction. Plus, international diversification enables an investor to gain exposure to other growth areas in the world even as world markets become more closely correlated.” (p. 364)
“Tiffany B. is an ambitious, single twenty-six-year-old who recently completed an MBA at Stanford’s Graduate School of Business and has entered a training program at the Bank of America. She just inherited a $50,000 legacy from her grandmother’s estate. Her goal is to build a sizable portfolio that in later years could finance the purchase of a home and be available as a retirement nest egg. For Tiffany, one can safely recommend an aggressive portfolio. She has both the life expectancy and the earning power to maintain her standard of living in the face of any financial loss. Although her personality will determine the precise amount of risk exposure she is willing to undertake, it is clear that Tiffany’s portfolio belongs toward the far end of the risk-reward spectrum. Mildred’s portfolio of small-growth stocks would be far more appropriate for Tiffany than for a sixty-four-year-old widow who is unable to work.” (p. 360)

When should you be conservative?

“Finally, perhaps the most important reason for investors to become more conservative with age is that they have fewer years of paid labor ahead of them. Thus, they cannot count on salary income to sustain them if the stock market has a period of negative returns. Reverses in the stock market could then directly affect an individual’s standard of living, and the steadier—even if smaller—returns from bonds represent the more prudent investment stance. Hence, stocks should make up a smaller proportion of their assets.” (p. 352)
“As investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and bond substitutes such as dividend growth stocks during periods of ultra-low interest rates. The allocation is also increased to REITs that pay generous dividends. By the age of fifty-five, investors should start thinking about the transition to retirement and moving the portfolio toward income production. The proportion of bonds and bond substitutes increases, and the stock portfolio becomes more conservative and income-producing and less growth-oriented. In retirement, a portfolio heavily weighted in a variety of bonds and bond substitutes is recommended. A general rule of thumb used to be that the proportion of bonds in one’s portfolio should equal one’s age. Nevertheless, even in one’s late sixties, I suggest that 40 percent of the portfolio be committed to ordinary common stocks and 15 percent to real estate equities (REITs) to give some income growth to cope with inflation. Indeed, since life expectancies have increased significantly since I first presented these asset allocations during the 1980s, I have increased the proportion of equities accordingly.” (p. 364)
“Mildred G. is a recently widowed sixty-four-year-old. She has been forced to give up her job as a registered nurse because of increasingly severe arthritis. Her modest house in Homewood, Illinois, is still mortgaged. Although the mortgage was taken out at a relatively low rate, it involves substantial monthly payments. Apart from monthly Social Security checks, all Mildred has to live on are the earnings on a $250,000 insurance policy of which she is the beneficiary and a $50,000 portfolio of small-growth stocks accumulated by her late husband. It is clear that Mildred’s capacity to bear risk is severely constrained by her financial situation. She has neither the life expectancy nor the physical ability to earn income outside her portfolio. Moreover, she has substantial fixed expenditures on her mortgage. She would have no ability to recoup a loss on her portfolio. She needs a portfolio of safe investments that can generate substantial income. Bonds and high-dividend-paying stocks, as from an index fund of real estate investment trusts, are the kinds of investments that are suitable. Risky (often non-dividend-paying) stocks of small-growth companies—no matter how attractive their prices may be—do not belong in Mildred’s portfolio.” (p. 359)

Should you be dollar cost averaging?

“If, like most people, you will be building up your investment portfolio slowly over time with the accretion of yearly savings, you will be taking advantage of dollar-cost averaging. This technique is controversial, but it does help you avoid the risk of putting all your money in the stock or bond market at the wrong time. Don’t be alarmed by the fancy-sounding name. Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of some index mutual fund, at regular intervals—say, every month or quarter—over a long period of time. Periodic investments of equal dollar amounts in common stocks can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.” (p. 353)
“Dollar-cost averaging is not a panacea that eliminates the risk of investing in common stocks. It will not save your 401(k) plan from a devastating fall in value during a year such as 2008, because no plan can protect you from a punishing bear market. And you must have both the cash and the confidence to continue making the periodic investments even when the sky is the darkest. No matter how scary the financial news, no matter how difficult it is to see any signs of optimism, you must not interrupt the automatic-pilot nature of the program. Because if you do, you will lose the benefit of buying at least some of your shares after a sharp market decline when they are for sale at low prices.”
“Dollar-cost averaging will give you this bargain: Your average price per share will be lower than the average price at which you bought shares. Why? Because you’ll buy more shares at low prices and fewer at high prices. Some investment advisers are not fans of dollar-cost averaging, because the strategy is not optimal if the market does go straight up. (You would have been better off putting all $5,000 into the market at the beginning of the period.) But it does provide a reasonable insurance policy against poor future stock markets. And it does minimize the regret that inevitably follows if you were unlucky enough to have put all your money into the stock market during a peak period such as March of 2000 or October of 2007. To further illustrate the benefits of dollar-cost averaging, let’s move from a hypothetical to a real example. The following table shows the results (ignoring taxes) of a $500 initial investment made on January 1, 1978, and thereafter $100 per month, in the shares of the Vanguard 500 Index mutual fund. Less than $53,200 was committed to the program. The final value was over $1,460,000.” (p. 355)

Should I rebalance by portfolio?

“A very simple investment technique called rebalancing can reduce investment risk and, in some circumstances, even increase investment returns. The technique simply involves bringing the proportions of your assets devoted to different asset classes (e.g., stocks and bonds) back into the proportions suited to your age and your attitude toward and capacity for risk.” (p. 357)
“Suppose you decided that your portfolio ought to consist of 60 percent stocks and 40 percent bonds and at the start of your investment program you divided your funds in those proportions between those two asset classes. But after one year you discovered that your stocks had risen sharply while the bonds had fallen in price, so the portfolio was now 70 percent stocks and 30 percent bonds. A 70–30 mix would then appear to be a riskier allocation than the one most suitable for your risk tolerance. The rebalancing technique calls for selling some stocks (or equity mutual funds) and buying bonds to bring the allocation back to 60–40. The table below shows the results of a rebalancing strategy over the twenty years ending in December 2017. Every year (no more than once a year) the asset mix was brought back to the 60–40 initial allocation. Investments were made in low-cost index funds. The table shows that the volatility of the market value of the portfolio was markedly reduced by the rebalancing strategy. Moreover, rebalancing improved the average annual portfolio return. Without rebalancing, the portfolio returned 7.71 percent over the period. Rebalancing improved the annual rate of return to 7.83 percent with less volatility.” (p. 357)
“Rebalancing can often be accomplished by investing dividends or by allocating new deposits of cash into the asset classes that have become underweighted.” (p. 397)

What about Target Date and Life-Cycle Funds?

“Do you want to avoid the hassle of adjusting your portfolio as you age and rebalancing yearly as the proportions of your assets devoted to different asset classes vary with the ups and downs of the market? A new type of product has been developed during the 2000s just for those investors who want to set up a program and then forget about it. It is called the “life-cycle fund,” or “target date fund,” and it automatically does the rebalancing and moves to a safer asset allocation as you age. Life-cycle funds are particularly useful for IRAs, 401(k)s, and other non-taxable retirement plans. They can have adverse tax consequences when used in taxable accounts. You pick the particular life-cycle fund that is appropriate by picking a date when you expect to retire. For example, suppose you are forty years old in 2025, and you plan to retire at age seventy. You should then buy a life-cycle fund with a “target maturity 2055.” Subsequent contributions can be directed to the same fund. The fund will be rebalanced annually, and the equity mix will become more conservative over time.” (p. 368)
“The major mutual-fund complexes such as Vanguard, Fidelity, American Century, and T. Rowe Price all offer life-cycle funds. Details of the different maturities and the asset allocations offered may be found at the various company websites. When bond yields are extremely low, I tend to favor the life-cycle funds that are more aggressive—i.e., that start off with a larger allocation to equities and use fewer bonds. For those looking for the easiest way to manage their retirement monies, the automatic pilot aspect of life-cycle funds is a user-friendly feature. But before you sign up, check the fee schedule. Low fees mean more money in your pocket to enjoy a more comfortable retirement.” (p. 368)

Specific needs require dedicated specific assets.

“Always keep in mind: A specific need must be funded with specific assets dedicated to that need. Consider a young couple in their twenties attempting to build a retirement next egg. The advice in the life-cycle investment guide that follows is certainly appropriate to meet those long-term objectives.
But supposed that the couple expects to need a $50,000 down payment to purchase a house next year. That $50,000 to meet a specific need should be invested in a safe security, maturing when the money is required, such as a one-year certificate of deposit (CD). Similarly, if college tuitions will be needed in three, four, five, and six year, funds might be invested in zero-coupon securities of the appropriate maturity or in different CDs.” (p. 361)

Once I’m retired, how much can I withdraw?

“Many retirees will prefer to keep control of at least a portion of the assets they have saved for a retirement nest egg. Let’s suppose the assets are invested in accordance with the bottom pie chart shown on page 367, that is, a bit more than half in equities and the rest in income-producing investments. Now that you are ready to crack open the nest egg for living expenses in retirement, how much can you spend if you want to be sure that your money will last as long as you do? I suggested in previous editions that you use “the 4 percent solution.”† With interest rates as low as they are in 2022, a 3½ (or even a 3) percent rate is more likely to give you some assurance that you will not outlive your money. Under the “3½ percent solution,” you should spend no more than 3½ percent of the total value of your nest egg annually. At that rate the odds are good that you will not run out of money even if you live to a hundred. It is highly likely, too, that you will also be able to leave your heirs with a sum of money that has the same purchasing power as the total of your retirement nest egg. Under the 3½ percent rule, you would need $514,286 of savings to produce an income in retirement of $1,500 per month or $18,000 per year.” (p. 373)
“Why only 3½ percent? It is likely that a diversified portfolio of stocks and bonds will return more than 3½ percent in the years ahead. But there are two reasons to limit the take-out rate. First, you need to allow your monthly payments to grow over time at the rate of inflation. Second, you need to ensure that you could ride out several years of the inevitable bear markets that the stock market can suffer during certain periods.” (p. 373)
“There is a second reason to set the spending rate below the estimated rate of return for the whole fund. Actual returns from stocks and bonds vary considerably from year to year. Stock returns may average 6 percent, but in some years the return will be higher, whereas in other years it might be negative. Suppose you retired at age sixty-five and then encountered a bear market as severe as the one in 2008 and 2009, when stocks declined by about 50 percent. Had you withdrawn 6 percent annually, your savings could have been exhausted in less than ten years. But had you withdrawn only 3½ percent, you would be unlikely to run out of money even if you lived to a hundred. A conservative spending rate maximizes your chances of never running out of money. So if you are not retired, think hard about stashing away as much as you can so that later you can live comfortably even with a conservative withdrawal rate.”
“Three footnotes need to be added to our retirement rules. First, in order to smooth out your withdrawals over time, don’t just spend 3½ percent of whatever value your investment fund achieves at the start of each year. Since markets fluctuate, your spending will be far too uneven and undependable from year to year. My advice is to start out spending 3½ percent of your retirement fund and then let the amount you take out grow by 1½ percent per year. This will smooth out the amount of income you will have in retirement. Second, you will find that the interest income from your bonds and bond substitutes plus the dividends from your stocks are very likely to be less than the 3½ percent you wish to take out of your fund. So you will have to decide which of your assets to tap first. You should sell from the portion of your portfolio that has become overweighted relative to your target asset mix. Suppose that the stock market has rallied so sharply that an initial 50-50 portfolio has become lopsided with 60 percent stocks and 40 percent bonds. While you may be delighted that the stocks have done well, you should be concerned that the portfolio has become riskier. Take whatever extra moneys you need out of the stock portion of the portfolio, adjusting your asset allocation and producing needed income at the same time. Even if you don’t need to tap the portfolio for spending income, I would recommend rebalancing your portfolio annually so as to keep the risk level of the portfolio consistent with your tolerance for risk.”
“Third, develop a strategy of tapping assets so as to defer paying income taxes as long as possible. When you start taking federally mandated required minimum distributions from IRAs and 401(k)s, you will need to use these before tapping other accounts. In taxable accounts, you are already paying income taxes on the dividends, interest, and realized capital gains that your investments produce. Thus, you certainly should spend these moneys next (or even first if you have not yet reached the age of seventy and a half when withdrawals are required). Next, spend additional tax-deferred assets. If your bequests are likely to be to your heirs, spend Roth IRA assets last. There is no required withdrawal for these accounts, and these assets will keep accumulating earnings tax-free. In general, the last dollars you will want to spend are your Roth IRA dollars. No one can guarantee that the rules I have suggested will keep you from outliving your money. And depending on your health and other income and assets, you may well want to alter my rules in one direction or another. If you find yourself at age eighty, withdrawing 3½ percent each year and with a growing portfolio, either you have profound faith that medical science has finally discovered the Fountain of Youth, or you should consider loosening the purse strings.” (p. 375)

What about annuities?

Sturgeon’s Law, coined by the science fiction writer Theodore Sturgeon, states, “95 percent of everything you hear or read is crap.” That is certainly true in the investment world, but I sincerely believe that what you read here falls into the category of the other 5 percent. With respect to the advice regarding annuities, I suspect that the percentage of misinformation is closer to 99 percent. Your friendly annuity salesman will tell you that annuities are the only reasonable solution to the retirement investment problem. But many financial advisers are likely to say, “Don’t buy an annuity: You’ll lose all your money.” What’s an investor to make of such diametrically opposite advice?

Let’s first get straight what annuities are and describe their two basic types. An annuity is often called “long-life insurance.” Annuities are contracts made with an insurance company where the investor pays a sum of money to guarantee a series of periodic payments that will last as long as the annuitant lives. For example, during early 2022 a $1,000,000 premium for a fixed lifetime annuity would purchase an average annual income stream of about $61,250 for a sixty-five-year-old male. If a sixty-five-year-old couple retired and desired a joint and survivor option (that provided payments as long as either member of the couple was alive), the million dollars would provide fixed annual payments of about $51,500.

Of course, with any inflation, the purchasing power of those payments would tend to decrease over time. For that reason, many people prefer to purchase “variable annuities.” Variable annuities provide the possibility of rising payments over time, depending upon the type of investment assets (typically mutual funds) chosen by the annuitants. If the annuitant chooses common stocks, the payments will rise over time if the stock market does well, but they will fall if the stock market falters. Annuities can also be purchased with a guaranteed payment period. A twenty-year guaranteed period means that even if you die immediately after purchasing the annuity, your heirs will receive twenty years of payments. Of course, the annuitant will pay for that guarantee by accepting a substantial reduction in the dollar amount of the annual payments. The reduction for a seventy-year-old male is likely to be over 20 percent. Thus, if you are really bothered by the possibility of dying early and leaving nothing behind, it’s probably better to scale back the proportion of your retirement nest egg used for an annuity purchase.

Variable annuities provide one approach to addressing inflation risk. Another possibility is an annuity with an explicit inflation-adjustment factor. Such a guarantee will naturally lower the initial payment substantially. A sixty-five-year-old couple desiring a joint and survivor option would find that $1,000,000 would provide an initial annual payment of less than $40,000 per year.

Annuities have one substantial advantage over a strategy of investing your retirement nest egg yourself. The annuity guarantees that you will not outlive your money. If you are blessed with the good health to live well into your nineties, it is the insurance company that takes the risk that it has paid out to you far more than your original principal plus its investment earnings. Risk-averse investors should certainly consider putting some or even all of their accumulated savings into an annuity contract upon retirement.

What, then, are the disadvantages of annuities? There are four possible disadvantages. Annuitization is inconsistent with a bequest motive, it gives the annuitant an inflexible path of consumption, it can involve high transactions costs, and it can be tax inefficient.

1. Desire to Leave a Bequest. Suppose a retiree has saved a substantial nest egg and can live comfortably off the dividends and interest from the investments. While an even larger amount of yearly income could be provided by annuitization, there would be no money left over for bequests when the annuitant dies. Many individuals have a strong desire to be able to leave some funds for children, relatives, or eleemosynary institutions. Full annuitization is inconsistent with such bequest motives.

2. Flexibility of Consumption. Suppose a couple retires in good health at age sixty-five and purchases an annuity that pays a fixed sum each year as long as either partner is alive. Such a “joint life” annuity is a common way for couples to structure their retirement. But right after signing the contract with the insurance company, both husband and wife learn that they have incurable diseases that are highly likely to reduce the period each will survive to a precious few years. The couple might reasonably want to take the around-the-world trip they had always dreamed of. Annuitization gives them no flexibility to alter their path of consumption if circumstances change.

3. Annuities Can Be Costly. Many annuities, especially those sold by insurance agents, can be very costly. The purchaser pays not only the fees and expenses of the insurance company but also a sales commission for the selling agent. Some annuities can thus be very poor investments.

4. Annuities Can Be Tax Inefficient. While there are some advantages to fixed annuities relative to bonds in terms of tax deferral, variable annuities turn preferentially taxed capital gains into ordinary income subject to higher tax rates. Also, partial annuitization of retirement account assets does not offset the required minimum distributions (RMDs) you must take. If you annuitize 50 percent of your IRA, you still have to take RMDs on the other half. This is no problem if you are spending at least that total amount, but tax inefficient if you are not.

So what should smart investors do? Here are my rules: At least partial annuitization usually does make sense. It is the only no-risk way of ensuring that you will not outlive your income. Reputable companies offer annuities with low costs and no sales commissions. In order to make sensible decisions on annuities, you should do some comparison shopping on the Internet at http://www.valic.com. You will find considerable variation in rates from different providers.” (p. 370)

What if you have the itch to pick stocks?

“If you do want to pick stocks yourself, I strongly suggest a mixed strategy: Index the core of your portfolio, and try the stock-picking game for the money you can afford to put at somewhat greater risk. If the main part of your retirement funds is broadly indexed and your stocks are diversified with bonds and real estate, you can safely take a flyer on some individual stocks, knowing that your basic nest egg is reasonably secure.” (p. 390)
“Having been smitten with the gambling urge since childhood, I can well understand why many investors have a compulsion to try to pick the big winners on their own and a total lack of interest in a system that promises results merely equivalent to those in the market as a whole. The problem is that it takes a lot of work to do it yourself, and consistent winners are very rare. For those who regard investing as play, however, here is a sensible strategy that, at the very least, minimizes your risk.” (p 387)

Should I keep extra cash to buy the market when it comes down a lot?

“If possible, keep a small reserve (in a money fund) to take advantage of market declines and buy a few extra shares if the market is down sharply. I’m not suggesting for a minute that you try to forecast the market. However, it’s usually a good time to buy after the market has fallen out of bed. Just as hope and greed can sometimes feed on themselves to produce speculative bubbles, so do pessimism and despair react to produce market panics. The greatest market panics are just as unfounded as the most pathological speculative explosions. For the stock market as a whole (not for individual stocks), Newton’s law has always worked in reverse: What goes down has come back up.” (p. 354)

Other Quotes.

“Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. I boldly stated that buying and holding all the stocks in a broad stock-market average was likely to outperform professionally managed funds whose high expense charges and large trading costs detract substantially from investment returns.” (p. 17)

“If you want an easy, time-tested method to achieve superior investment results, you can stop reading here. The indexed mutual funds or ETFs that I have listed will provide broad diversification, tax efficiency, and low expenses. Even if you want to buy individual stocks, do what institutional investors are increasingly doing: Index the core of your portfolio along the lines suggested and then take active bets with extra funds. With a strong core of index funds, you can take these bets with much less risk than if the whole portfolio were actively managed. And even if you make some errors, they won’t prove fatal.” (p. 385)

“As a random walker on Wall Street, I am skeptical that anyone can predict the course of short-term stock-price movements, and perhaps we are better off for it.” (p. 343)

How to Invest by Burton Malkiel

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