During our accumulation years, we do not need to pay much attention to yearly declines, because they are opportunities to add to the securities at low prices. Low prices and poorly performing markets are a friend to younger folks. They had best wish for good performance toward the end of their saving cycle. The pre retirees and retirees who will be or are drawing funds off each year want the opposite market behavior—a big difference. Since they are no longer putting money away, it is best for them to hope for steady, positive returns in the immediate future and most of the upcoming years. When they are older and less healthy, retirees usually use less money, unless they have to contend with inflation or have high medical expenses.

The young investor will make more money if reinvested income and dollar cost averaging are done at low prices rather than high prices. Rein-vestment is not as powerful a tool for retirees, because they most likely will be spending some income and gains each year. For them the principal needs to be an income-producing cash cow. The grave danger of changing from an accumulator to a spender mentality is that many do not do it quickly enough. One prospective client admitted she had gotten greedy. She said, “I saw everyone else throwing money into growth funds in January 2000, so I did too.” She lost 36 percent of her retirement a few months before exiting her company. This kind of postponement also hurt a client of mine who decided to stay 100 percent invested in stocks until the very end. He then retired. The month he transferred the 401(k) account to a rollover IRA, he had lost more than $30,000, about 12 percent of his account value. Some people think they need to ride the fastest horse in the race in order to win, and often they wind up losing at a time when they can least afford it.

You will learn in this book that investing, like life, is unpredictable, so your planning must be strategic in nature. And the best strategy is to maximize your greatest possibility of winning right from the get-go. That approach is not the same as trying to win the most. Many investors wrongly think, “I don’t have enough to keep up my lifestyle, so I’ll shoot for the highest pos-sible returns.” Poor investors seek the highest possible returns, while the great investors seek the highest probability of good returns.

I’m inviting you to use my experiences with retirement planning to bet-ter your own planning. The more self-sufficient you are, the less you need to depend on our government, and the more you have to share with those you love. The mistakes of others can be your least expensive lessons—les-sons you do not want to learn firsthand at a time when you can least afford the experience. As Laurence Peter said, “Experience is the worst teacher— it gives the test before explaining the lesson.”

Many popular investment books offer good information for people over fifty, but some of it is simplistic. One popular book by a well-meaning financial planner comes to mind. The chapter entitled “Keep Your Retirement Bucket Full While Drawing the Income You Need” includes a table showing how a sixty-five-year-old can remove 5.75 percent per year and still make 4.25 percent growth each year. The book does not explain the volatility of annual returns, but simply assumes the account will earn 10 percent year in and year out. The author seriously confuses the average return and the actual return when she makes her case for the continued growth of the retirement funds. Such books can greatly misinform readers about how money is made and can generate foolish expectations.

To be a little easier on my colleagues, I do believe some planners are often misled by the past performances of their own recommendations. The warning label “Past returns are no guarantee of future results” is as well heeded today as the ominous label on packs of cigarettes. I have heard that planners are saying, “Well, you can live off 10 percent per year, can’t you?” They neglect to add that there may be months or even years when 10 per-cent will be absurdly optimistic, and that the client may need to take noth-ing to save his account from a disaster. Using data from Ibbotson’s 2001 Yearbook, I calculated that from the beginning of 1968 to the end of 1977, $100,000 invested in the S&P 500 Index would have grown to $142,252. With a mere 3.6 percent average annual return, can you imagine what retirees got from their stock investments during that period? Very slim pick-ins. During that same period inflation averaged 6.24 percent, so subtracting that from the stock returns would have disheartened most investors as they saw their buying power shrink for ten years.

Some people say they will never retire, and they mean it honestly—but the truth is that almost all of us do. The harder the physical labor or the job stress, the more difficult work becomes as you age. Even those who know this still find that time creeps up on us, catching us off guard and slowing us down. If you say you will not retire, be sure it is not an excuse for not saving now. One soon-to-be retiree told me, “We had a great time; spent a lot of money traveling. Now I can barely afford to retire.”

Most financial planning advice is given to people who are staring into a rearview mirror. Thinking that good past performance of the stock market will continue, they underestimate how much must be saved. Any good truck driver will tell you it takes a long time to learn how to properly use rearview mirrors when going forward. One client called me because, he said, “for the last forty years I have had all my money in the bank and now I want to retire in five years. Shouldn’t I put everything into the stock mar-ket?” He finally had looked at the road and wanted to rush into the fastest lane instead of shifting down immediately.

Jeff Brown, syndicated columnist, wrote that a new survey done by Mathew Greenwald & Associates (for John Hancock) came to unfortunate conclusions regarding the average 401(k) investor. Of the eight hundred participants, “40 percent of those surveyed had no idea what returns to expect from stocks, bonds and other investments, and the remaining 60 percent, on average . . . over the next twenty years, expected stocks to return 19.3 percent a year, nearly double the 11 percent historical return.” My six-year-old daughter woke up one morning too tired to dress her self. She said to her mother, “Ma, you let me stay up too late.” Much like her, many people will wake up someday and point the finger at somebody else for their own poor choices. It is my hope that you are not among them.

The city I work in was the home of one of the larger corporate bankruptcies in U.S. history. By the end of 2000, corporate officers were sentenced to the tombs for misusing investors’ funds. Although the company did not initially do business unethically, the courts found that it eventually used money from new “investors” to pay off old ones until the entire thing collapsed. Much of the money lost belonged to thousands of retirees from across the country who parted with it for a promise of a steady 8 percent return. Bankruptcy trustee Richard C. Breeden, a former chairman of the SEC, estimated that investors would get back between 32 and 43 cents on every dollar invested, and no interest income while they waited. Some early investors actually had to return some of the money they received in years past. That surprised one retiree I spoke to who had to pay thousands of dollars.

A similar situation unraveling in the Western and Midwestern states as I write this book involves “promissory notes.” These securities guaranteed to pay the note holder 8 percent to 12 percent for nine months, and then return to the investor her full principal. Investor confidence was boosted when investors were told the short-term notes were on start-up companies backed by a foreign insurance company. They were sold by over 100 neighborhood insurance salespeople who got an 8 percent commission. Although some interest was paid, the notes came due but defaulted, and more than $300 million of invested dollars so far have disappeared. Insurance agents who did not have the proper training and licensing to sell securities broke state and federal securities laws. They now are facing stiff penalties. (Although there are many legitimate new investment vehicles, two causes for concern are the buying and selling of insurance policies and some ques-tionable investments offered on the Internet.)

Basically, households have three choices with regard to savings options:

1. Hold the liabilities of traditional intermediaries, such as banks, thrifts, and insurance companies. This means holding savings accounts, money market deposit accounts (MMDAs), and so forth.

2. Hold securities directly, such as stocks and bonds purchased directly through brokers and other intermediaries.

3. Hold securities indirectly, through mutual funds and pension funds.

Investors always have direct investing as an option, making their own buy and sell decisions, typically through a brokerage account. If you have enough money to invest, you could duplicate the last known portfolio holdings of any financial intermediary, such as a mutual fund. If you have the time and ability, you can make the ongoing decisions in terms of managing the portfolio. With direct investing, you make the decisions.

However, most investors lack the funds necessary to assemble a portfolio of 50 or 100 stocks, and many investors do not have adequate funds to immediately assemble what is generally agreed on in today’s world as a well-diversified portfolio—say 30 to 40 stocks. Furthermore, most investors do not have the time or expertise to manage a stock portfolio on an ongoing basis, making the necessary buy and sell decisions based on informed judgments.

A pronounced shift has occurred in these alternatives since World War II. Households have increasingly turned away from the direct holding of securities and of the liabilities of traditional intermediaries and toward indirect holdings of assets through pension funds and mutual funds. All we are talking about here is hiring a manager and an organization to do your investing for you. The investment company or pension fund owns a portfolio of securities, and thus the shareholders of the investment company or the beneficiaries of the pension fund indirectly own the portfolio of securities

Business generates some fantastic jargon, and I have made a promise to myself to avoid it at all costs. Occasionally it will be necessary to break the rule. Many years ago someone coined the phrase ‘vertical integration’. For the uninitiated ‘vertical integration’ relates to the idea that businesses can be more efficient (or make more money) if they own more and more of the processes between raw materials and the final product being delivered to the customer. In formal business-speak, this is ‘vertical integration within the supply chain’.

Large brewers are a good example of this phenomenon in action. First of all they take hops, barley, sugar and water, boil them up and produce a miraculous liquid called beer. Having done this they have a wide range of opportunities for vertically integrating their business to a point much closer to final customers enjoying a pint in the pub. The most obvious and successful way of achieving this involves owning the pub as well. That way they can ensure that all beer sold in the pub is their own (or products supplied by official partners), and they get to take the retail profit in addition to the wholesale profit. Large brewers developed such enthusiasm for this activity that eventually the Department of Trade and Industry had to intervene and tell them to stop. Some organizations were forced to sell hundreds of public houses because they had negatively affected all of the competition in certain regions. Vertical integration may be good for business but it is not always in the best interest of consumers.

If you own a successful pub there is a reasonable prospect that a brewery would be interested in buying it. Then they will vertically integrate their beer into your cellar. But it is not only brewers. Perhaps you have a small Who will buy your business? 15 local double-glazing business. The company that supplies your extruded PVC may well be interested in taking over your business. It can then join the brewers in their enjoyment of wholesale and retail profits. Does vertical integration make sense in your business sector? It depends, but a little logical thought should suggest a clear answer. If you own a newspaper shop it is unlikely that Mirror Group Newspapers will want to buy you out. Why? Isn’t the scenario similar to that of the brewers? Similar yes, but the difference lies with product exclusivity. If Mirror Group buys your shop and just sells its own newspapers, everyone who

U.S. households own numerous financial assets. They invested some $271 billion net in 2000 in financial assets, although this amount was down sharply from the $476 billion invested in 1999. On balance, households were net sellers of stocks and bonds held directly. However, they were net buyers of mutual funds.

Mutual funds are the quintessential asset for U.S. investors. In 1990, households owned 76 percent of all mutual fund assets. By 2000 they accounted for 80 percent of all mutual fund assets, and total mutual fund assets at that time totaled $7 trillion.

^[1] At the end of 2000, financial, business, and other organizations owned about 11 percent of mutual fund assets, and fiduciaries owned about 10 percent. Thus, households owned about 80 percent of all mutual fund assets.

Perhaps they are reassured by statements such as that made to a mutual fund industry gathering by Arthur Levitt when he was chairman of SEC and a well-known advocate for the rights and protection of individual investors: “You have earned the confidence of the American public—and you’ve done so without the safety net of federal insurance to protect investors from mistakes

How should investors make important investing decisions concerning mutual funds and the alternatives to mutual funds? We have now examined the many benefits of mutual funds and considered some of the potential problems that can arise when buying and owning them. We have also reviewed the three major alternatives to mutual funds that have recently emerged and captured some attention. Now we are ready to draw some conclusions.

We first examine the basic issue of how investors build wealth over time. This helps investors to better evaluate the role of any investment alternative they might be considering. We then review the overall case for mutual funds. They remain the major financial asset of choice for many investors, and this is not going to change anytime soon.

Mutual funds can be used effectively by many investors. The trick is knowing what investors can reasonably expect to accomplish with mutual funds. If investors understand the critical issues, and deal with them successfully, much can still be accomplished with mutual funds. We examine how index funds can be used successfully by almost all investors.

Regardless of the strong case for most investors to own index funds, many will continue to opt for actively managed funds. Therefore, we analyze some issues that investors need to carefully consider when choosing an actively managed fund.

Finally, we recognize the possibility that mutual funds might not be the best solution for some investors in today’s world. As we have seen, mutual funds have their problems. We review when and how to choose one of the three alternatives discussed in this book: ETFs, folios, and separately managed accounts.

Make no mistake, these alternatives are still small items relative to the assets invested in mutual funds. Most investors continue to use mutual funds to accomplish whatever goals they have set. Nevertheless, these alternatives have attracted considerable press attention and investor interest. Assets invested in them might in aggregate be small relative to mutual fund assets, but the growth rates for these assets in only a short time are quite high.

Investors are using these alternatives today for a variety of purposes. Smart investors will learn about them and decide how they might play a role in their investment situations.