Bruce Wasserstein and Corporate Restructuring

In the mid-1980s, there was an avalanche of takeovers of underperforming companies, the targets of institutions and arbitrageurs who suspected that, with the help of plentiful leverage, they could increase corporate values by mobilizing assets. Often that term meant disposal of non-performing assets. In this earlier age of corporate restructuring, Bruce Wasserstein was an enfant terrible. M&A deals were being done at premiums of 3040% above market prices and Wasserstein would be in the middle designing strategies to make them happen.

This was also the heyday of shark repellents and poison pills. Often, the other side would be lawyers and PR people trying to set defenses against shareholders who had corporate control in mind, artfully removing shareholder rights whenever they might be exercised to change corporate control. But the SEC formed an advisory committee to evaluate many of these activities and concluded that the market mechanisms must be left unimpeded.

Wasserstein's youthful energy tapped intensity suited to the pulsing business of deals. Always very well prepared, he worked with arbitrageurs, lawyers, accountants and regulators to move business combinations forwards over institutions dedicated to thwart combinations, which, in the light of hindsight, seemed to favor one group of investors over another. He went on to found his own successful investment banking firm, his personality skills leading him on the correct path.

In his 1998 book Big Deal, Wasserstein surveys "the battle for control of America's leading corporations," including his own role in the past two decades or so. He describes five waves of mergers beginning in the mid-1800s: the first involved the building of the railroad empires; the second, in the 1920s, saw merger mania fueled by a frothy stock market and rapid industrial growth; the third happened during the go-go years of the 1960s and featured the rise of the conglomerate; the fourth occurred with the hostile takeovers of the 1980s, driven by names such as Icahn, Boesky and Milken; and finally, a fifth wave happening today. Wasserstein attributes the explosion of M&A activity at this turn of the century to the need for companies to reposition themselves in today's ever changing competitive environment:

Corporate Restructuring

One of the most high profile features of the business and investment worlds is corporate restructuring the mergers and acquisitions (M&A), leveraged buyouts, divestitures, spin-offs and the like that are contested in the ''market for corporate control." These recombinant techniques of corporate finance often have an impact on the financial markets far beyond the individual companies and sectors they involve and, in theory, all return real control of companies to shareholders. Virtually without exception, stock prices of participating companies rise in response to announcements of corporate restructuring. But are such events good for investors beyond the very short term?

The late 1990s have seen yet another wave of M&A activity. Indeed, the number and value of mega-mergers in 1998 set new records, a 50% increase on activity in 1997, itself a record year. This has reawakened the populist cry that such mergers do not create new wealth, that they merely represent the trading of existing assets rearranging the deck chairs on the Titanic. What is more, it is argued, the threat of takeover means that managements take too short-term a view, bolstering stock prices where possible, investing inadequately for the future and, where a company has been taken over in a leveraged buyout, perhaps burdening it with excessive debt.

On the other side of the debate, the primary argument in favor of M&A is that they are good for industrial efficiency: without the threat of their companies being taken over and, in all likelihood, the loss of their jobs, managers would act more in their own interests than those of the owners. In particular, this might imply an inefficient use of company resources, overinvestment, lower productivity and a general lack of concern about delivering shareholder value. Feeble supervision of corporations often leads to mismanagement, it is argued, and while increased shareholder activism is one option Certainly, a takeover bid is frequently beneficial to the shareholders of the target company in terms of immediate rises in the stock price (though acquisitions often have a negative effect on the profitability and stock price of the acquirer). And managements that resist takeover may be doing it for their own interests rather than those of their investors. Senior executives may use such bizarre devices as shark repellents and poison pills, which make it extremely costly for shareholders to replace the incumbent board of directors.

The next steps for investor relations are straightforward:

First, companies, funds and countries that wish to inform their constituency should maintain and publish FAQs (frequently asked questions), a common practice in industry. All questions with whatever favorable or unfavorable answer can be made available on a bulletin board. It is the next step to the ultimate in transparency, the ultimate being when the answers are created automatically regardless of the questions asked.

Second, companies should actively trade their own shares with open disclosure of transactions on an instantaneous basis. Companies would reveal their own interplay between business conditions, availability of capital and their assessment of prospects by their actions.

Third, and in the same vein, insiders would be encouraged to trade with no reservations on when, except that they would have to be identified as an insider.

Technology makes all these possible, and investor relations would be advanced, providing the user with live, real and significant information individually customized for each. It is possible today. But no one has done it.

Corporate governance: What Next?

Corporate governance is all about the relationship between investors and the companies in which they invest. But what does investor relations really mean? To the practitioner, it means a craft of communication striving to be a profession. To a shareholder receiving its output, it is a necessary way to understand markets and companies. To corporate officials, it is a convenience to fend off the time-consuming quest for information that is often a distraction from running a business. All these views are correct but they are far from the story of investor relations today.

An unprecedented eighteen-year bull market has multiplied all financial service tasks. Abby Joseph Cohen of Goldman Sachs notes that compensation for financial service workers has been the only area of wage inflation in the present business cycle. And many others note that financial assets are the only inflating assets in a deflationary economy. It is reasonable to look at the macro-influence of a bull market creating the need for ever more competent and ever more highly paid investor relations people. But that is not the whole story either.

At its base, investor relations is about communication of fact. Usually, it is what is today called "push" through releases, attractive venues and targeted sources. Investor meetings and lunches have given way to conference calls and internet group emails in turn to global videoconferences. Facts are still distilled by lawyers but, curiously, with the most important facts withheld during blackout periods when the most significant developments are taking place.

With computer databases and search capabilities, remarkable things can be done to turn masses of data into information. Most of the innovations have already taken place in the corporate world, especially in comparative retail sales. Now, they are finding their way into finance: for example, screening of the type used at www.fortuneinvestor.com can survey sixteen thousand securities on six hundred variables; and charts of historical activity on almost anything are available at www.bigcharts.com and www.yardeni.com. Hundreds of tools like these are converting the "push" from investor relations into a "pull" by users in control of what they want, what they do with it and the conclusions to be reached.

Investor persuasion is moving to the user through the empowerment of technology. The nub of judgment remains in an elusive corner of agency finance, behavioral sciences and computation. But each single user has access to machinery to do the chores, which is low-cost, readily available, global and instantaneous. Like Microsoft endorsing the internet, which may ultimately be its downfall, so the alert investor-relations person will provide these tools to make the user's job easier and better.

Understanding Corporate Governance

Shareholders demand high returns on their equity investments, while executives of public companies typically want a peaceful life with good remuneration and minimal outside intervention. These conflicting interests and how to achieve some kind of alignment between them to give corporate managers the incentives to act in the best interests of corporate owners are the central questions of corporate governance. They have become increasingly important in the 1990s as instead of choosing exit simply selling their holdings in underperforming companies investors are beginning to exercise their voice telling managements to change their ways.

In the 1980s, the most powerful external pressure on executives for stock market performance was the threat from corporate raiders, poised to bid for companies with underperforming shares. Latterly, challenges have come more from institutional investors, the activist shareholders who demand long-term value creation from the companies whose shares they own. This activism has been most dramatic in the United States, and has been supported by regulation: for example, the SEC has mandated the reporting of value creation in the proxy statement.

In the UK too, the pressures have shifted from the threat of takeovers to shareholder activism, often around the subject of top managers' pay and its weak relationship to corporate performance. For example, guidelines on remuneration published by the investing institutions' professional bodies (the National Association of Pension Funds and the Association of British Insurers) demand a clearer link between performance and pay. In turn, many UK companies now explicitly target the creation of shareholder value.

Understanding Counterpoint

If contrary thinking is so good, why doesn't everyone do it? In the first place, if everyone did it, then it would not work because there would be fewer panics and speculative orgies. Second, it can be very uncomfortable to be wrong and contrary at the same time: the humiliation of going against the crowd when the crowd is right and that can happen is devastating. And third, much of our training and socialization teaches us that the majority is right, or at least, Is contrarian strategy profitable? There is some indication that former loser stocks perform better than winners, but is this because they are riskier? And what about the transactions costs of a short-run contrarian strategy? The quantitative evidence on these questions, as in most investment documentation, seems to depend on the case the researcher wishes to support more than the case itself. Nowhere is the adage, "if you torture the data long enough, it will confess to anything," more clearly observed than in the examination of investment techniques. But a mixture of contrary instincts and investment skills seems to be a part of most investors we admire.

Finally, is contrarian strategy inconsistent with the concept of market efficiency (see Market Efficiency)? The efficient market hypothesis (EMH) in its strong form contends that security prices are always correctly assimilating information. Today, investors generally expect that the weak form of EMH is operative, which means that sometimes it is possible, with generally available information, to gain an advantage over other investors. Contrarians look for these small opportunities by noting where the consensus seems to be clustered and they examine the other, independent alternatives.

Contrary thinking can be a challenge to assumptions that are so deeply embedded in our understanding of the world that we often do not even realize they are there. Three contrary questions in particular may be helpful in guiding us to contrary answers. Contrarians should ask questions like these that are often not even being considered.

The first is, why do investment markets assume that growth should be the sole objective of economic enterprise? Primarily, because of a fifty-year expansion in bull markets, but in most cases, the pursuit of growth comes with the possibility of volatility and risk. Stability and survivability can also, under some conditions, be worthwhile objectives. Contrarians are likely to value these features, which are considered valueless by other investors. Corporate control through proxy voting, for example, is often considered valueless and even a potential conflict for a manager in his client relations. And yet, in a merger or acquisition environment, proxy power is quite valuable: some studies have estimated it at about 15% of total share price. Contrarians might be quicker to identify these underlying mispricings.

Second, we are raised on the notion of continuous time. Nobel Laureate Robert Merton (see Risk Management) wrote a fundamental text with that idea in the title. We learn that time is a horizontal axis on a time chart with each unit of time connected to its neighbor and all units of equal space and importance time is continuous, time flows, time moves on, time in any one period is connected with any other period, time reveals trends. But in the physical world, time may be discontinuous and unconnected with any other time period sometimes coming in bursts, separate packets of information, unique in themselves. And investment time could be like that: Humphrey Neill wrote "sudden events quickly crystallize opinion." Our assumptions about time having a root in the past leading to clues about the future may be wrong.

Third, there is the built-in notion of an equity premium. After a fifty-year period of expansion, we take it for granted that equities produce higher returns, and we think that this is because they have higher degrees of risk. Are we prepared for the time when risk produces lower returns for equities? Or that on closer examination, risk itself becomes something other than volatility but risk of loss and risk of being knocked out of the game?

Understanding Contrarian Investing

Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their intrinsic value (see Value Investing). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism

To a third group, contrarian investing is the reverse, a steadfast adherence to value- or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as "buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield."Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit. He uses traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the nifty fifty growth stock era of his apprenticeship in investments

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a herd or crowd, the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of the empty file drawer idea than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.

Predicting market

The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are pockets of predictability. This offers some hope to "disciplined" active managers if they can come up with innovative techniques to achieve superior long-term returns

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of nearly an eighteen-year bull market in equities by some counts, a fifty-year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see Value Investing).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see Initial Public Offerings), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, the quality stocks have done much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good if nothing happens or bad because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.

Bill Miller's Advices

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there and it is but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.
One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go technology stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.

Active Portfolio Management

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing buying diversified portfolios of all the securities in an asset class is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds ).

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments. These decisions, often referred to as market timing as investors try to reallocate between equities and bonds in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements. Then there is security selection picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.

Active investing involves being overweight in securities and sectors that you believe to be undervalued and underweight in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market. Compared with passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (. And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.

The right venue, the right style

It is an old adage of investment cynics that "managers do not pick markets, markets pick managers." This attitude suggests that brilliance is about evenly distributed, but that markets select their own heroes rather than vice versa.

With the construction of investment styles according to the radiation approaches I have described, that limitation is not quite true. Rather, managers can freely roam the world looking for an investment style that suits them a growth manager could have a period of successful investing in the United States, become a non-US manager, and then find a suitable venue in emerging markets: three investment lives all engaged in approximately the same principle. One can invest in all traditional ways and change location, or one can change investment techniques and invest in the same location.

How did you know a growth company in the 1945 and later period? I knew it when I saw it. When I see it again, now, in an emerging market, I say, "this company can compete on a world-wide basis, regardless of the fact that it is ... wherever."

The US style is now flexible, fast and fuzzy. The developed (ex-US) market style is structured, systematic and suited to individual customization. And despite the global economic crisis, emerging markets are the places where there is the greatest potential for growth if we hark back to the high-quality investment styles of yore.

Market students must look geographically outwards to see familiar, repeated patterns and inwards to see what is next.

Investing in US in 1970-1990

The post-World War II era and its corollary in other markets of the world ended after a generation, almost simultaneously, with academic studies on efficient markets achieving prominence in the United States. Firms capitalized on this phase shift by introducing index products and popularizing valuation shifts and new valuation techniques that are all price-related. As the dictum shifted to "buy low, sell high," it was characterized by the emergence of new investment folk heroes like Warren Buffett. A few firms, Batterymarch among them, popularized valuation techniques for institutional investors, giving voice to this newly emerged market style in the United States.

In Europe and Asia, internationally dominant companies, which looked very much like the nifty fifty, appeared popular for investing. Siemens, Hitachi, Sony, Philips, Bayer and their counterparts became components of more venturesome US institutional portfolios and appeared as the first equity holdings of some of the more fixed-income-oriented institutional holdings outside the United States.

And exactly the same pattern seen in the United States during 194570 was repeated, except in different places, in different markets.

Development institutions then shifted their attention from the devastated areas of World War II to the poorer countries suffering from population explosion. In many cases, these were agrarian-based economies with little ability to soften the shocks and cycles inherent in farming. These markets that had previously been worrying about subsistence began to establish the basis for market economies. Largely influenced by government programs, some of these countries began developing market structures.

Investing after WW2

Right after World War II, a widely anticipated global depression was expected a common occurrence after nearly every major world conflict. Surprisingly, in the United States, a major interest in equities prompted the success of a handful of companies that became known as the nifty fifty. These companies dominated in managerial skills, product R&D and financial resources. Investors remained skeptical about economic progress throughout this growth era, and markets faced the traditional wall of doubt, the trellis up which green investment ivy must climb.

''Buy high, sell higher" dominated investment styles over this period. Supply and demand for equities became the watchword more than underlying valuation. To adapt a phrase from a quantum physicist, "there appeared to be an underlying price spin tilted in the direction of the positive" other things being equal, something that had gone up would go up more. Another description might be the economics of increasing returns. Eventually, the era ended with the shock of 1967 and the subsequent decline of growth funds in the sharp market downturn in the United States during the 19734 period.

The developed (ex-US) markets essentially those of the advanced countries that were the major protagonists in World War II, whether victor or vanquished during this period were dominated by international reconstruction programs. The Marshall Plan in Europe and its counterpart under the administration of General MacArthur in Japan and Asia led the way. These programs were typically centered around infrastructure improvement and, with the exception of the UK, did not produce much in the way of private equity development until the second half of the period, when government programs became directly supportive of private development activities.

Style radiation

The spread of investment insights may be visualized as waves radiating outwards in concentric circles from pebbles falling into water. The source of these investment pebbles is the United States. The dynamic force behind the rise of post-World War II equity markets has been academic research coming out of US universities. The availability of cheap computer time, cheap graduate student labor and creative senior professors (six of whom have now received the Nobel Prize in Economics) has contributed to the development of concepts like the capital asset pricing model, the efficient market hypothesis and performance measurement, as well as the growth of derivatives markets.

Not every investment technique is appropriate at every place around the world at the same time. Ideas radiate, interfere with one another and produce new patterns, then reach the periphery at the same time as new stimuli occur at the origin. Technology and communications accelerate the speed of ideas radiating outwards until, finally, the impact reaches emerging markets. As the process is repeated, it is accelerated further.

We can divide the investment world into three parts the United States, developed (ex-US) markets and emerging markets. Most US institutional investors have dedicated teams covering each of these segments. In some cases, they have specialized teams within each team segmented by geography.

The investment world was reshaped immediately after World War II. In fact, if we go back farther, we can gauge the present long-wave bull market from the Battle of Midway in 1942. If we look at equity styles since then, we see that there have been two
major waves, each lasting one or two decades. And a third may have begun.

Paying down debt: the delicate dilemma

As we close our discussion of debt, we must address one of the more delicate dilemmas of modern marriage: how to handle debts each of you may have accumulated before the nuptials. Years ago, such a discussion hardly would have been necessary. People married young, well before they had accumulated significant debts—or assets, for that matter. Today, the opposite is often true. When people wed today, it may be after a decade or longer as professionals, plenty of time to borrow plenty of money. The same is true of people in second or third marriages. It would be hard to imagine people in that situation without some debt burden. When couples bring individual assets to the marital table, that’s a cause for joy. When the baggage includes debts, the issue is more complex and more volatile. Broadly, there are two approaches you can take to premarital debt. You may decide to reduce your debt as individuals, or you may elect to pay down premarital debt as a couple. Each approach brings advantages and disadvantages. Paying down premarital debt as individuals can prevent conflict, particularly if one party incurred substantially more debt than the other. With this approach, the partner with the smaller debt load doesn’t feel financially strapped by decisions made before the marriage. This approach also permits each spouse to maintain a significant level of independence. But there are disadvantages as well. For one, the debt might not be paid down as quickly or as efficiently as possible, because only one partner is focusing on it. In addition, that partner may feel resentment at being abandoned on Debt Island. That could promote continued use of debt, resulting in financial hardships and marital discord.
If you elect to pay down premarital debt as a couple, you can develop an efficient game plan that emphasizes quick payment of high-interest debt. You can get out of debt more quickly and focus on your goals as a couple. This joint process also implies regular communication about debt, an activity that will help you many times over.
The principal disadvantage to this approach is that the partner who kept the slate relatively debt-free may feel exploited; the good spending habits he or she developed might appear to have come to naught.
As we mentioned, this is a sensitive matter, and we don’t recommend one approach over the other. What we do recommend is talking about any premarital debt and developing a game plan that pays off all debts quickly while keeping both partners satisfied with the strategy.

Comfort Zone Investing Case Study

Michael and Susan have been saving for retirement for 10 years. They are a composite from interviews and people I have worked with during the past 21 years. Since Michael’s major promotion 10 years ago, they have invested about $50,000 a year. Prior to that, they had less than $10,000 in investments. Now, stockbrokers, realtors, insurance salespeople, venture capitalists, hedge fund vendors, and other investment product peddlers have their number and routinely call them. Michael and Susan have compiled investments worth $450,000 during the past 10 years: half in a 401(k) and half in an online brokerage account. Immediately, you might notice the math. If they have invested $50,000 a year for the past 10 years, achieving a zero total return on their money, they should have $500,000 in investments. You might do the math, but Michael and Susan have not. You would also think that Michael and Susan would be happy with the size of their nest egg. Sill in their mid-40s, they are in the top 1 percent of wealth in the world. But they are miserable. Michael losses sleep over his investments regularly. Though he works 60 hours a week, he finds time several months a year to shift between $100,000 and $300,000 from one investment fad to another, believing he will increase his returns and then be happier with his portfolio. Among the other high-income employees where he works, this is routine practice. In fact, the main non-work-related topic among these employees is investing. Though not one of them has ever calculated their annual returns, they all constantly chase high returns and lose sleep worrying about the market. Susan, a stay-at-home mom and part-time consultant, is equally unhappy with their investments. She wants Michael to work less, even take early retirement, and consult part-time so he does not miss his children’s childhood years. She is certain they were happier before Michael’s big promotion. She is angry that their portfolio is in constant flux. She has no understanding of why one year they seem to have all their money in small cap stocks, the next year in municipal bonds, then in tech stocks, and now in hedge funds. She is convinced that they are on the verge of losing it all any minute and she will have to go to work full-time. You might think the case of Michael and Susan is unusual. It is not. Studies by Dalbar Inc. and others show that as many as 90 percent of individual investors underperform stock market averages because they buy and sell too often. In fact, studies by Brad M. Barber, Terrance Odean, Moringstar, and others have shown that individual investors make returns about half as high as the stock market. During 1970-2000 period when the market made 12 percent a year, individual investors made 6 percent. Individuals even underperformed the bond market by a significant margin. However, hiring professional money management does not solve the problem. Studies by Mark Hulbert and others show that professional money managers also trade too often and underperform the stock market 80 percent of the time. Unfortunately, all these studies focus on investment return.

Investing is not about numbers

Few investors realize that investing is not a numbers game. Making buy-and-sell decisions based solely on price movements is a strong indication you are outside your comfort zone. Buy at 5 and sell at 10 or buy at 10 and sell at 5 is trouble both financially and emotionally. Buy-and-sell decisions need to be made on the basis of knowledge of who you are as an investor, a fundamental understanding of the investment, and a determination of whether the underlying fundamentals of the investment meet your investment needs. If a company or mutual fund is having a bad quarter or a bad year or a great quarter or a great year, you need to understand how it is reacting to that situation and if its reaction indicates that it fits your investment needs. Price movements are external factors that tell you little about the company, the mutual fund, or yourself.
An emotionally mature adult would not make personal relationship decisions based solely on external factors. If you are in a new romantic relationship and your lover’s mother suddenly dies, do you end the relationship immediately (sell) or watch how your lover reacts to the loss of a mother and watch how you react to your lover’s loss. If your lover then inherits half a million dollars, do you make a decision to marry (buy) or do you watch how your lover reacts to new wealth and how you react to your lover’s financial gain. In a romantic relationship, your goal is to build a long-term positive relationship. Breaking up or staying together based on external factors such as a death or inheritance is clearly immature. The internal factors, your lover’s emotional development and your own, are the real basis for judging the long-term potential for marriage or a parting. The internal factors, your emotional makeup and investment policy, and the company’s reaction to success or failure, are the real basis to determine buy-and-sell decisions.
Investing outside the comfort zone is exemplified by basing trading decisions solely on price. Other external factors also influence investors when they are outside their comfort zone.

Investing is not about numbers

Few investors realize that investing is not a numbers game. Making buy-and-sell decisions based solely on price movements is a strong indication you are outside your comfort zone. Buy at 5 and sell at 10 or buy at 10 and sell at 5 is trouble both financially and emotionally. Buy-and-sell decisions need to be made on the basis of knowledge of who you are as an investor, a fundamental understanding of the investment, and a determination of whether the underlying fundamentals of the investment meet your investment needs. If a company or mutual fund is having a bad quarter or a bad year or a great quarter or a great year, you need to understand how it is reacting to that situation and if its reaction indicates that it fits your investment needs. Price movements are external factors that tell you little about the company, the mutual fund, or yourself.
An emotionally mature adult would not make personal relationship decisions based solely on external factors. If you are in a new romantic relationship and your lover’s mother suddenly dies, do you end the relationship immediately (sell) or watch how your lover reacts to the loss of a mother and watch how you react to your lover’s loss. If your lover then inherits half a million dollars, do you make a decision to marry (buy) or do you watch how your lover reacts to new wealth and how you react to your lover’s financial gain. In a romantic relationship, your goal is to build a long-term positive relationship. Breaking up or staying together based on external factors such as a death or inheritance is clearly immature. The internal factors, your lover’s emotional development and your own, are the real basis for judging the long-term potential for marriage or a parting. The internal factors, your emotional makeup and investment policy, and the company’s reaction to success or failure, are the real basis to determine buy-and-sell decisions.
Investing outside the comfort zone is exemplified by basing trading decisions solely on price. Other external factors also influence investors when they are outside their comfort zone.

Comfort zone investing is…

Comfort zone investing consists of knowledge of how different investments affect your emotions, knowledge of who you are in relation to investments, and choosing investments that match your personality.
The comfort zone is tested most often by large increases and decreases
in investment values. Studies of stock investors show that most investors react to declines in stock values by holding on too long-hoping the price will
improve. Investors also sell winners too soon to lock-in profits, missing even greater gains, and avoid purchases of bargain stocks that have declined in price fearing the declines will continue indefinitely. The net result is individual and professional investors consistently fail to make even half the stock market averages.
Many studies describe these phenomena. These self-defeating behaviors are attributed to thinking patterns such as “loss aversion,” the “disposition effect,” and “mental accounting.” Unfortunately, the studies only describe the patterns and the resulting low returns. The studies do not tell you why you are reacting dysfunctionally nor how to act maturely.
The comfort zone has three elements:
self-knowledge, investment knowledge, and matching yourself to the proper investments. If any of these three elements is out of place, your reaction to your investments will be dysfunctional. If you are in the right investments, you will act maturely. For example, many investors think that investing is solely about numbers. Unfortunately, focusing on numbers ignores both who you are and the nature of investments.

Risk tolerance: The sales tool

Some investment promoters claim they have all this covered. They ask you a series of questions about your risk tolerance before they sell you their products:

• “If the market declines 25 percent in one year, will you take your money out?”
• “Are you able to keep the long-term in mind when markets

fluctuate or are you more comfortable with investments that do not fluctuate?”
These tests determine your so-called “risk tolerance.” Risk tolerance is your ability to handle volatility. Risk tolerance tests are supposed to match you to compatible investments. Unfortunately, they don’t. Risk tolerance is not a good measure of investment compatibility. At best, it measures a narrow aspect of your personality: your theoretical ability to handle volatility. Even if your broker happens to sell the product that is theoretically right for your risk profile and you buy it, studies show that how people think they will react under adverse market conditions and how they actually react are quite different. In fact, few of us know ourselves well enough to know how we would really react in future unknown situations. The real problem is that risk tolerance tests do not touch the crucial issues: who you are as an investor and how investments interact with your personality. For example, they do not address the issue of the adverse relationships you have with the investment seller and others. In fact, they disguise this issue. These tests lead you to believe that you and the salesperson have the same interest. The tests do not address the issue of overconfidence. Overconfident investors believe they have high risk tolerance when they do not. The tests do not address the issue of people pleasing. People pleasers are often aware that they have low risk tolerance but they buy high risk investments to make their broker or their coworkers happy. In fact, risk tolerance tests do not accurately address any of the issues that will lead you to purchase incompatible investments.
Risk tolerance tests are equally ineffective for average personalities and for extreme personalities such as workaholics, gamblers, and compulsive debtors. Extreme personalities typically have little or no self-knowledge. They will fill out risk profiles identical to those of average investors. Yet once sold an investment product, they will abuse it to a degree unimaginable by the average public. Risk tolerance tests do not pick up money addicts of any kind and lead to no help for these people or those affected by them.
While money addiction is more prevalent in our society than most people realize, the vast majority of investors suffer from less extreme forms of investment incompatibility. The more common symptoms include loss of sleep, irritability, unexplained anger or depression, random resentments, a sense that investing is meaningless, money arguments with a spouse or partner that neither can comprehend, a dim view of retirement possibilities, and a thousand forms of fear.
The major investment fears are that you do not have enough investments now, won’t have enough in the future, or will lose what you already have. Then these fears lead to further fears. If you don’t have enough savings, then how could you have enough money for travel, clothes, restaurants, a new car, a better house, a real life? Or you fear you cannot and will not ever grasp the mathematical complexities of compound interest and probability theory and you cannot trust those who do understand these concepts. Then there is the underlying fear that investing is irrational and no amount of study will help.
The premise of this book is that these feelings and fears are normal and healthy; understanding them and understanding the emotional hooks of different investments will lead to a greater sense of peace and contentment in your life. They don’t sell peace and contentment on Wall Street. You have to find it within yourself first and then look for the investments that enhance it, rather than disturb it.
When you know more about yourself and about the products that are out there, no risk tolerance tests with hidden agendas will sell you incompatible investments anymore. Investing will become an area of great satisfaction in your life.

Understanding investment compatibility

Investment compatibility becomes a possibility when you first admit that investing triggers difficult emotions. Try this series of questions and see if you relate to any part of the emotional dilemma:

• Have you ever found yourself losing sleep over the market, angry with your broker, unsatisfied with your returns, yet unable to pull out of the market?
• Are you jealous of your business associate who has turned it all over to a money manager and has no idea how he is doing?
• Does the woman across the street with her string of singlefamily houses irritate you?
• How did you react when that 35-year-old coworker retired?
• Do you value honesty yet find you have lied to several people about your investments and investment returns?
• Do you seek serenity over financial security?
• Will high returns bring you serenity or just increase your craving for more high returns?

The more you look at it, the more emotionally charged investing becomes. Financial advisors discuss risk as risk of losing money. Isn’t the real risk emotional? If you are not in the stock market, you risk being an outcast at the beach gatherings this summer. But if you are in the market, you risk losing sleep and losing time trying to keep up with how you are doing, how the market is doing, and how well everyone else is doing compared to how you are doing.
If you knew yourself better and knew more about the emotional aspects of different investments, investing would be more satisfying. Try this question. Is it easiest for you to trust people, financial markets, or the U.S. Treasury?
Those who have a hard time trusting people will find that turning their assets over to a money manager or a stockbroker creates fear. Many independent business people founded and built up their own businesses because they only really trust themselves. That is fine. If you are like that, yet you have turned your money over to a money manager, you will be uncomfortable even if the money manager produces outstanding financial results. You will be happier making all your own investment decisions even if it costs you money.
Some people cannot trust financial markets. Perhaps you saw your parents lose a fortune in stocks. In that case, you may be more comfortable receiving interest payments from Treasury bonds, even if you could make more money in stocks.

Investing triggers many emotions

To be comfortable saving for retirement and spending savings in retirement, your investments must satisfy both your financial and emotional needs. When your investments are lucrative, but you and your investments are not emotionally compatible, you will either get rid of them and look for something new and possibly more incompatible or stew in your misery. Yet it is difficult to even know what your needs are in this relationship. You are subject to great cultural pressure today to own U.S. stocks, especially the latest fad stocks. It is not just that everybody at the office claims to own them and is checking the results online all day. There are whole institutions devoted to this: CNBC, The Nightly Business News, The Wall Street Journal, a thousand Web sites, and chat rooms. The pressure to own stocks so you can converse about them is high. But are you happy with them? Is anybody happy with them? How many of your colleagues have stopped to ask what their emotional needs are in their investment relationships? Do they act like they know what their emotional needs are? Let’s return to the question that started this chapter and look at the emotional dilemma apart from the financial. What emotions are triggered by having to choose between retirement savings and vacations? Do you find yourself feeling guilty when you go to Hawaii instead of putting the money in an IRA? Or do you get depressed when you cannot go to Hawaii because all your extra savings are tied up in IRAs and other retirement plans?

How to Evaluate Whether Changes in the Budget Are Necessary?

If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.For example, if your actual utility bills are consistently greater than the amounts budgeted, then you need to either reduce your utility usage, if possible, or increase the amount budgeted for this item.When you increase planned spending, you will need to find items where you can make corresponding cuts to compensate for the increases. If you don’t, the amounts set aside for personal goals or savings will be reduced. There are certain expenditures over which you have some degree of control. These are your variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food are the most common areas of overspending, particularly when they involve eating out at restaurants. By contrast, fixed expenditures such as rent, mortgage payments, taxes, and insurance premiums cannot be easily trimmed without undue consequences. Deficit spending may be more difficult to remedy when you have already reduced many of your unnecessary and variable expenditures. It then becomes more difficult to cut essential spending items. If spending still exceeds income after revising spending amounts, you need to reevaluate your entire budget. Perhaps you have created too tight a straitjacket for yourself.Revise your goals and set aside amounts to attain them before allocating the rest of your income to your expenditures. You may need to prioritize your expenditures to see which are necessary and which can wait.
The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and set aside more of your money to savings. Following your budget will help you achieve what you want most from your resources.

How to Record Actual Income and Expenditures for the Period Budgeted?

Actual amounts earned and spent are not always the same as those projected. By recording the actual amounts and comparing them with the budgeted amounts, you can immediately see the differences, called variances. Spending more than a budgeted amount for one item can be offset by spending less than the budgeted amount for another item.
Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash. The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other assets in order to pay for the deficit spending.

How to Determine Whether There Is a Surplus or a Deficit?

If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts needed to fund personal goals added together equal the total expected expenditures. It is a good idea to incorporate goals into a budget so that monthly or periodic income is set aside to address them. When projected income exceeds projected expenditures, there will be additional amounts of cash, which can then be added to savings/investment plans or used to pay down liabilities.
When projected expenditures exceed projected income, there is a deficit. This means additional amounts will have to be withdrawn from savings/ investment plans to pay for these additional expenditures. In such a case, it may be necessary to review projected expenditures and reduce some of them, or look for ways to increase projected income.

Determine Your Financial Goals

In order to set aside money for your financial future, you need to estimate the expenditures that go toward your savings and investments. Financial goals vary from person to person over time. Some financial goals are:
• Saving for an emergency fund
• Increasing savings and investments
• Buying a new car
• Paying off a loan
• Buying a house
• Buying a larger house
• Saving to fund children’s education
• Providing retirement income
• Saving for annual vacations
Some of these are short-term goals while others are longer term. It is often easier to concentrate on the short-term goals and neglect longerterm goals. By assigning priorities to each of the goals and quantifying their cost, you can determine the amount of savings needed to fund them.

Determine Your Expected Expenditures

The second step is to estimate all expenditures during the period of the budget. Certain expenditures such as rent, mortgage, and auto loan payments are fixed in amount and do not vary from month to month, whereas other expenditures such as food, clothing, and utilities do vary in amount from month to month. Anticipating these variable expenditures with accuracy may be difficult. The purpose of budgeting is not to put you in a straitjacket in which you cannot maneuver. On the contrary, its purpose is to provide you with flexibility in your financial planning so you can achieve your financial goals.

How to Estimate Your Future Income?

Estimated income includes all anticipated receipts of money, such as future salary, estimated profits (or losses, which are deductions from income) from a business, bonuses, commissions, interest, dividends, rent, gains, tax refunds, loans, and other sources of income.
Wages, salary, and/or partnership/corporate income should be included net of payroll taxes. Payroll tax deductions can be shown in the income section or the expenditure section. Mr. X is expecting a 5 percent increase in salary for the coming year and Mrs. X expects her business income to be $36,000 for the coming year. The expected gross income for Mr. X is shown, along with the deductions withheld to give his net monthly income. Payroll tax withholdings are the amounts deducted by an employer from employees’ paychecks to pay their taxes. The amount of income earned and the number of exemptions filed by the employee on Form W-4 determines how much is withheld for federal income taxes. Self-employed workers receive income that is not subjected to payroll tax withholdings. This does not mean that they do not have to pay taxes on this income. The tax laws require such taxpayers to estimate their tax liability and pay it in quarterly installments by April 15, June 15, September 15, and January 15 for the tax year. The amount of these payments depends on a person’s total income from all sources, deductions, exemptions, and credits, which determine taxable income.
Mrs. X estimates that her monthly gross budgeted income will be $3,000.
Mrs. X would have to make quarterly estimated tax payments to the U.S. Treasury
on this business income and, depending on the requirements of the state
in which she lives, to the state as well. Income from sales commissions may be difficult to estimate, as they may
be irregular or seasonal. Being conservative by underestimating budgeted income may be prudent in order to avoid overspending and, consequently, having to dip into cash accounts.

Understanding Net Worth

Your net worth is the difference between the totals of your assets and liabilities. In other words, if you sold all your assets for the values stated and paid off all your debts, the amount left over would be your net worth. Your net worth should not be thought of as cash to be spent. Rather, it is a measure of a person’s financial position as of the date of the personal balance sheet. Can your net worth be a negative number? Yes, this is possible. If you have more debt than total assets, you are technically insolvent. A continuation of this position may make it difficult for you to pay off all your debts on a timely basis, which could necessitate a declaration of bankruptcy.

Understanding Liabilities

Begin by listing your most current debts, such as utility bills, telephone bills, and
others.Next, list the balances outstanding on your credit card debts and loans. For most people, a home mortgage is their largest single debt outstanding.The amount to include is not the original amount of the loan but the current outstanding balance. The reason is because a part of the monthly payments made to the lender over the duration of the mortgage reduce the outstanding balance of the loan. The current outstanding balance of the loan may be obtained directly from the lender or from mortgage statements from the lender. You can also determine the balance yourself. See the financial calculator in section 20, which explains how to determine your mortgage balance. Add up all the amounts owed to others and you have the total of your liabilities.

Understanding Assets

Assets are arranged in order of liquidity; that is, the ability to convert them into cash without losing much in the conversion. The most liquid are at the top of the list and include cash, checking accounts, money market securities, and money market mutual funds.
Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found in the financial pages of a newspaper or obtained from brokerage and mutual fund statements.
Determining the current value of pension funds may be more difficult if the pension fund provides amounts of future income to be received. This means that for this type of plan, you would need to determine the present value of the plan. The human resources or benefits department of your company can provide this information.
If the cash surrender values of your whole life insurance policies and annuities are not shown on the latest statements you receive, call your insurance agent for this information.
Your home is likely to be your largest asset, so its value should not be overinflated or underinflated. The figure that you are looking for is the current market value; that is, what someone would be willing to pay for your house. Generally, the cost of the property is not particularly relevant if you have owned your house for a long period of time. The most recent selling prices of houses similar to yours in your area are a good indicator of the likely market value of your house. Real estate brokers can also provide you with an estimate of the value of your house.
The value of cars can be obtained from used car price guides such as the N.A.D.A. Official Used Car Guide and the Kelley Blue Book (www.kbb.com). These guides can be found in most public libraries, or you can obtain the price of your car from your bank, which should have copies of these guides. Household furniture, clothing, and personal effects should be more conservatively valued so as not to overstate their value. In an actual sale of these items, you might get far less than the estimated values. Add the estimates of the value of all the items that you own and you will have the total of your assets.

Advisory services

Most mutual fund investors are self-directed: They educate themselves through books like this one, personal finance magazines and TV programs, and brochures and prospectuses offered by the fund companies. Then they make their fund selections and monitor the growth of their investments in order to make sure that they perform as expected. One reason for the popularity of mutual funds is that they lend themselves to just this kind of do-it-yourself investing. However, the bigger fund companies do offer free, personalized advisory services to their higher-dollar clients — especially those with assets of $500,000 or more. Most people who give advice are Certified Financial Planners (look for the CFP designation after their names). Their expertise covers asset allocation approaches, investment strategies, and economic and business trends, and they’re qualified to give specific recommendations on funds to consider. They may also talk about the tax implications of your investment.
If you are not (yet) a part of this investment stratosphere, you may be able to gain some of the same advice from a broker, accountant, insurance agent, or other professional. Be sure you understand exactly how your advisor derives his compensation. An advisor who receives a fee directly from you for his services — either in the form of a straight payment or as a percentage of the assets you invest — is likely to give relatively unbiased advice (how knowledgeable or helpful this guidance proves to be is another matter). On the other hand, advisors who receive all or part of their payments in the form of sales commissions may recommend that you buy the investment products from which they stand to benefit personally. A stockbroker may urge you to invest in stocks; an insurance agent may direct you toward insurance company products such as annuities. Before you buy into any sales pitch, carefully consider the source and what he or she has to gain from your investment.

Retirement-related services

Many fund firms offer retirement planning services. You may be able to consult a staff member who is familiar with retirement planning issues by telephone, or you may have access to retirement-planning brochures, worksheets, and other literature through the mail or online.
Typically, the retirement topics covered include the following:

• How to calculate the amount of money you can expect to require for a comfortable and secure retirement
• How much you need to save and invest each month in order to reach your retirement goals
• How your asset allocation should change over time as your investment time horizon and risk tolerance change
• The pros and cons of various kinds of tax-advantaged retirement accounts: IRAs, Roth IRAs, 401(k)s, Keogh plans, and so on
• Options for taking distributions from your retirement account

Social Security plays a role in retirement planning for most Americans. Despite concerns over the long-term viability of the government funding for Social Security, most people can expect to derive at least part of their retirement income from this source.
Your Social Security income will be based largely on how much money you’ve earned (and paid Social Security taxes on) throughout your life. To determine how much you’re probably going to receive from the government after retirement, request Form SSA-7004, the Personal Earnings and Benefit Estimate Statement, from the Social Security Administration, by calling toll-free 1-800-772-1213 or by logging onto their Web site at www.ssa.gov.
When you receive the statement (in four to six weeks), you can develop some perspective on your expected monthly Social Security payments — and how much more retirement income you’ll need to provide through your own savings and investments.

Check-writing

If you own shares in a bond fund, such as a money market fund, you probably have the option of writing checks against the money in your account on special checks from the fund company. (Check-writing is normally not an option with a stock fund.)
Most funds establish a minimum amount for the checks you write (typically $500), and you may have a small per-check charge. Writing a check can be a convenient way of redeeming shares.
When you write a check against a mutual fund, whether to raise some cash or to pay a bill, you are redeeming shares of your investment. Thus, you may be realizing capital gains or other profits, which subjects you to a tax liability at the end of the year. Don’t forget this potential for taxable profit when the time comes to perform your tax calculations.

Automatic investment and reinvestment plans

Most fund families make it easy to set up an automatic investment plan, which is an excellent way for you to develop a consistent practice of saving. When you opt for automatic contributions to an investment account, you can also take advantage of the benefits of dollar cost averaging.
Ask your fund company for information about how to establish an automatic investment plan. You determine the amount that you want to designate — $100, $300, $1,000 — and the sum automatically comes out of your bank account each month and is invested in the fund of your choice. Plan to complete an application form and send in a (voided) check from your bank account.
You can also have the dividends and capital gains income from your funds automatically reinvested, buying you additional shares. I strongly recommend reinvesting, because it allows you to enjoy the benefits of compounding.
Most fund families will allow you to have your dividend and capital gains income reinvested in a different fund, which can be an easy way of diversifying your portfolio. Suppose Jacob has $5,000 invested in an index fund — a conservative, low-cost form of stock investment. He can arrange to have the dividends and capital gains from this fund invested in the fund family’s Aggressive Growth fund. As this amount gradually builds up, the growing investment gives Jacob the opportunity to participate in the profit potential of a more risky and volatile but often lucrative sector of the stock market — without taking any money out of his lower risk index fund investment.

Online information and transactions

With the advent of the Internet, most mutual fund companies now offer the same information online that you receive in your printed account statements. In addition, you can access many other types of data and services online, which relieves much of the time and effort involved in doing research via multiple phone calls, letters, or office visits.
For example, at the Vanguard Web site (www.vanguard.com), you can find such information as

• Historical data on how particular funds have performed
• The largest stock or bond holdings of particular funds
• Specific data about your accounts

Most of the things you do over the phone, you can also do online. For example, you can make investment exchanges between funds, request redemptions, and buy shares.
You can also download application forms and fund prospectuses, plus you can locate other literature on Web sites. Typically, you can access marketing brochures, articles on retirement investing, and speeches by officials at the fund company. With each passing month, fund families are offering more and more interesting online perks. You can look forward to finding retirement calculators, reports on the economy, glossaries of investment terms, mini-courses on investment fundamentals, and other services.
Vanguard, for example, offers WebTurboTax tax-return software free to its online shareholders. Many fund Web sites feature message boards and chat rooms where you can share information and questions with other investors or with the company guru who can respond to your inquiries. The Resource Center at the back of this book lists some of the more useful mutual fund Web sites, including those sponsored by fund companies and those established by independent companies or organizations.

24-hour phone lines

You don’t need to wait for a quarterly statement to get answers about your mutual fund account. Today, most fund families make information about your account as near as your telephone.
Some major fund families offer 24-hour phone lines staffed by real human beings — a welcome convenience for the millions of investors who find themselves living such busy lives that the only time they have to check their investments may be at 11:00 on a Wednesday night or 8:30 Sunday morning. Other fund families have phone lines with live representatives only during business hours; however, they usually provide a 24-hour automated response phone system that gives you access to your account balance and the current NAV of your shares and enables you to make exchanges between funds simply by using your telephone keypad. Your own coded personal identification number (PIN) protects your privacy, so only you can access the account.
On occasion, you may need to open a mutual fund account in a hurry. For example, you may want to make a qualifying IRA deposit on April 15 so that you meet the annual deadline for saving on your taxes.
Many mutual fund companies are willing to let you open an account and make a deposit by phone, even without a completed application on file, provided you submit the application soon thereafter. Call the fund of your choice, explain the situation, and provide the information the company requests, including the number of your bank account where the necessary investment money is on deposit. Then have your bank wire the money to the fund.

Why most fund investors are dissatisfied with their account statements?

Dalbar says that most fund investors are dissatisfied with their account statements for several basic reasons:

• The statement provides too much information. Although investors need complete data on their accounts, a fine line exists between comprehensiveness and overkill. When too much information appears on the account statement, an investor may feel overwhelmed. Fund companies are beginning to refine and improve their presentation of information by selectively eliminating less-useful data and by making the data they retain easier to read through intelligent design and use of graphics. For example, many funds now show an investor’s current asset allocation percentages using a pie chart rather than simply listing a set of numbers.
• The report requires investors to translate tricky mathematical terminology. For example, some fund companies provide statistics like “average cost per share” (a number that may be useful when calculating the taxes due on mutual fund shares you’ve sold), but they don’t describe how it was derived. This lack of information forces you to figure it out yourself. The best account statements explain the source and meaning of every number presented.
• The statement overestimates the investor’s knowledge. Fund companies often use language that the typical investor doesn’t understand. The best account statements include a brief glossary with definitions of technical terms.

When you invest in a new fund, study the first account statement carefully. Make sure that you understand every piece of data it includes. If you don’t, call the fund company’s information line and ask the representative to walk you through the statement, number by number. Jot down notes as you go. And don’t be afraid to ask “silly questions”! Having read this blog, you know more than the average investor, so your questions are probably not foolish at all. After all, your money is at stake here — you deserve to know exactly what it’s doing.

Account statements

Although every mutual fund provides shareholders with periodic reports on their investments, the quality, understandability, and comprehensiveness of these reports vary widely. Most mutual fund families provide quarterly statements that let you know what your current investment balance is, how many shares you own in each fund you’ve invested in, and your current asset allocation (that is, what percentage of your money is invested in which types of funds). In addition, the statement lists the transactions on your account since the last statement — new share purchases and redemptions; switching of money from one fund to another; dividend reinvestments; capital gain distributions, and so on.
If you have more than one mutual fund investment with the same family, you typically receive a combined statement showing all of your holdings rather than a separate statement for each fund. You also get a year-end statement for tax purposes, which shows balances and account activity for the entire year. The account statements provided by most mutual fund companies provide the basics; only a few offer the luxuries. Dalbar, Inc., an independent financial research company located in Boston, has developed quality rankings for account statements from various mutual fund companies. According to Dalbar, the top account statements, in ranking order, come from the following fund companies:
_ The WM group of funds
_ Kemper Funds
_ Montgomery Funds
_ The Dreyfus family of funds
_ The MFS family of funds
Why did Dalbar rank the WM Funds at the top of its list? Beyond the basics, WM provides investors with such data as their beginning and ending account balance for the statement period, the total account value, and the total return percentage per fund.
For investors who participate in the company’s asset allocation advisory services program, WM Funds reports the total return on investors’ asset allocation portfolios — a collection of investments in various categories that shifts over time in response to changes in market and economic conditions. Eventually, WM hopes to provide investors with personalized returns under this program, showing total return on a shareholder’s own asset allocation account. Like most good fund companies, WM is constantly looking for ways to apply new information technology to communicate data to investors more quickly and usefully.

Understanding Basic Services from any mutual fund company

The basic services that you can expect from any mutual fund company include the following:

• Regular written reports on the performance of your investments
• 24-hour, toll-free customer service
• The ability to exchange money between funds in the same family with relative ease and at little or no cost
• The ability to make additional investments easily and quickly
• The choice between having dividends and capital gains paid directly to you or reinvested in additional mutual fund shares
• Check-writing capabilities
• Professional advisory services

Beyond these basics, however, more and more mutual fund families are offering services that go above and beyond the call of duty. For some investors, the variety and quality of shareholder services provided is an important factor in choosing a fund or fund family in which to invest. It’s also important to keep in mind that the quality of basic services varies from one fund company to another. For example, account statements highlight the differences among various companies’ approaches.

401(k)s

Like an IRA, a 401(k) account enables you to save and invest for retirement with no current taxation either on the money you set aside or on the profits that accumulate over the years. You pay taxes on the money in your account only when you withdraw it after retirement.
The main difference is that your employer must sponsor your 401(k) account. Most for-profit companies today offer 401(k) plans; in fact, the 401(k) plan has become the most common substitute for the traditional company-paid pension plan, which fewer and fewer firms now provide. As soon as you start any new job, ask about whether your employer offers a 401(k) plan and how you can begin to participate. Generally, this kind of plan is a wonderful deal for you. You can usually save any amount up to 10% or 15% of your salary, tax-free, with the money automatically deducted from your paycheck. (And,, this form of automatic saving is a great way to make regular investing a habit.)
Many employers match all or part of the employee contribution:
For example, if you set aside 10% of your weekly paycheck for your 401(k) account, your company may kick in half that amount on top of your own contribution. You can invest your 401(k) money in any investment vehicle offered by your employer. Most companies today make arrangements with large financial firms, including mutual fund companies, to provide an array of investment choices for their employees.
You’re likely to have stock funds, bond funds, money market funds, and other options to choose from, and you can divide your contributions among two or more fund types if you want. You receive regular statements about the growth of your account, just as with any mutual fund or brokerage account. If you leave your job, you will probably have the option of maintaining your 401(k) account, letting your money continue to grow tax-free until you retire. However, if you choose to receive the money in your account instead, you have to pay taxes and an IRS penalty on it — unless you roll your investment over into a rollover IRA, a new 401(k), or another type of tax-deferred account. Any fund company, broker, banker, or other financial professional can help you with the paperwork and other details.
A 403(b) is a similar type of account offered to employees of nonprofit organizations — schools, hospitals, and so on. If you have the option of participating in a 401(k) or 403(b) plan at your place of work, sign up as soon as you can. For almost every investor, these plans are a great way to grow your money tax-free, usually with help from your employer. Your 401(k) account can become the backbone of your savings plan for a happy and secure retirement.

SEP-IRAs

This is a special type of IRA for people who run their own small businesses (the acronym SEP stands for “self-employed person”). If you’re a freelancer, a temporary worker, or a selfemployed professional of any kind, look into a SEP-IRA account. This account enables you to invest up to 15% of your annual earnings in a retirement account free of current taxes — a significant advantage over the ordinary IRA. Another similar type of account is called the Keogh plan. The plan enables self-employed people to set aside even more tax-free income — usually up to 20% of your annual earnings — but the process involves a significant amount of paperwork, which may not sound particularly appealing to you.