beginning investing seminar

8/3/2019 Beginning Investing Seminar

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Beginning Investing Seminar!

LESSON 1

Introduction

Financial independence. Ah, yes.

Has a nice ring to it, doesn't it? To be a person of independent means,to live on one's investments, to retire, to retire early. To one person,financial independence may mean just enough cash coming in tosupport a beach bum lifestyle, to another it may mean a $2 millionportfolio that supports round-the-world cruises and his-and-her golfcarts. Whatever it means to you, this seminar can be the first stepdown the road to your financially secure future. We will teach you howto save, what to do with your savings, and how to outperform morethan 75% of professional mutual fund managers (surprisingly, it's notthat hard!). Along the way we'll try to point out which side roads aredead ends and which detours might lead to washed-out bridges.

Seminar Roadmap

We're glad you've made the decision to join us as we tackle the

mysteries of the investment world together. Here's what we haveplanned:

In Lessons 1 and 2 you will learn why it really pays to save andinvest and how to start getting your financial house in order.(Sharpen your pencils!) You'll also begin to get a littleperspective on what to expect from investing.

Lessons 3 and 4 teach you what kinds of investments are mostappropriate for beginning investors and help you decide which isbest for you.

Lessons 5 and 6 take some of the mystery out of investingaccounts such as IRAs and brokerage accounts.

Lesson 7 teaches you how to ride out the inevitable storms inthe marketplace.


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Lesson 8 looks at where you can go from here and gives you alist of resources you can use to continue your investingeducation.

The seminar is designed to get you started on a lifetime of investingwith a simple plan that will work reasonably well for most people. It'snot a cram course in all aspects investing, and it won't immediatelyturn you into a financial whiz. But when we finish, you will be on theroad to a lifetime of successful investing. Where you go from there isup to you.

What Is an Online Seminar Anyway?

Just to be sure everyone is clear on the concept, here's how thisseminar works. It's self-paced, which means you can bear down and

complete it in a day or two, or you can take a few months. We'veparked all the lessons and homework assignments in one area whereyou can access them at any time. Each lesson is broken down intoconvenient sections focusing on some key points with links to placeson the Web (including the Motley Fool site) where you can go for morein-depth treatment of topics that are of particular interest to you.

There's a lot of homework. Sorry, but no pain, no gain! The homeworkis where you'll take what each lesson teaches and apply it to your ownspecific situation. What you get out of this seminar will depend largely

on what you put into it.

Step One Is Saving Money

Easier said than done, eh? It's that old conflict between immediategratification and delayed gratification. Immediate gratification is fun,but delayed gratification is far more satisfying over the long run. Youmay have to trust us for a while on that one, but once you try it, Ithink you'll agree.

The thing about investing in the stock market is that it supercharges

your savings. Over the last 75 years, the market has returned anaverage of 11% per year. (Savings accounts, bonds, etc., cycle around3% to 7% annually. We will use 5% as a representative rate.) So let'ssee what that supercharged stock market rate does for delayedgratification:

In 10 years, a $300 DVD player will be worth... nothing. It will


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probably be taking up space in your basement while youdownload movies from the 'Net. If you keep the old VCR and putthat $300 in a bank account, in 10 years you'll have a grand

total of $488 (assuming a 5% annual interest rate). Not anexciting prospect? OK, put the $300 in the stock market andearn an average of 11% a year for the next 10 years and you'llhave $851. (And yes, that will buy more than a newer modelDVD player.)

In 20 years, the $2,000 you might have spent on a trip toCancun could be worth $5,300 in a bank or $16,000 in the stockmarket.

In 30 years, $4,000 for that titanium bike you covet could beworth $17,000 in a savings account or $91,000 in the stockmarket.

More to the point, $2,000 invested every year in a Roth IRA over a 40-year career earning the average annual market return of 11% willbecome over a million bucks (tax free!). In a savings account at 5%,it's just $240,000.

It comes down to a simple trade-off: Do you want to have stuff now ormoney (and maybe even better stuff!) later? (We call this the "Stockvs. Stuff" dilemma.) You can buy stuff or you can put that moneyaway and watch it grow. The big payoff comes to those who are willing

to take on a certain amount of risk (more about that in a later lesson)and put some of their savings in the stock market rather than optingfor the safe, boring interest a savings account offers. So how can wedo that? We're glad you asked! Read on.

Step Two Is Investing It Foolishly

Here are the returns investors have historically received for differenttypes of investments, with inflation included for context:

1926-2000

Investment Average Annual Return

S&P 500 11%

Small company stocks 12%

U.S. Treasury Bills (short-term) 4%

U.S. Treasury Long-Term Bonds 5%

U.S. Treasury Mid-Term Bonds 5%

Inflation 3%

Notice one thing. The top two categories, each a different segment of


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the stock market, have returned farmore than the fixed-rateinvestments. Government bonds and bank accounts are risk-free. Youknow you will get back what you invested (your principal), plus a small

guaranteed return (interest). Stocks are riskier. Not only do they nothave a guaranteed return, but you aren't even guaranteed to get youroriginal investment back. So why do people invest in stocks? Investorstake on the additional risk because they know there is the possibility ofearning far more than they could with a risk-free investment like cashor bonds. And that's the secret -- that's why the Fool is a proudproponent of informed participation in the U.S. stock market. It comesdown to one thing: The market is where you make the most moneyover the long term.

The Power of Compounding

When asked what was the most powerful force in the universe, AlbertEinstein is reported to have said, "compound interest." Investing, andthen reinvesting your returns year after year, does astonishing thingsto your balance. Check out this table to see how much more you mightearn when you reinvest your profits year after year.

But Fools aren't that fond of interest per se. We prefer to participate inthe growth of the stock market, which over the last 75 years hasaveraged a return of 11% per year. (That return was quite a bit higher

in the '80s and '90s, but we'll use the more conservative long-termrate for our examples.) Interest-paying bank accounts and bonds can'tcompete with stocks over the long term. (Here's a nifty table thatdemonstrates just how much difference a higher growth rate makesover time.)

How fast your cash piles up depends on three factors: time, growthrate, and savings:

Time: You have very little control over this. About all you can dois adjust your plans to give your investments more time to grow.

So don't put off learning about and starting investing. It's nevertoo early and rarely too late to begin!

Growth rate: We'll tackle this in an upcoming lesson. When youfinish this seminar, you will know how to match the growth rateof the market (which will beat most mutual funds andprofessional money managers).

Savings: This is the one factor you can control most easily. In
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the next lesson, we will look for ways to wring more money outof your (yeah, yeah, we know) already impossibly tight budget.If you need motivation, check out our "Power of Saving" table.

What We've Covered So Far

We introduced the topic of financial independence and describedwhat you should expect to get out of this seminar.

We discussed the importance of saving and offered someexamples of how not buying some stuff today can lead to piles ofwealth tomorrow.

We helped you set some expectations by showing you thereturns of stocks and bonds over the last 75 years. The mainpoint: For long-term investments, stocks are the best place tobe.

We rhapsodized over the power of compounding, illustrating howmodest amounts of money can grow to large amounts over time.

Lesson Resources

Table illustrating the power of compounding. Table illustrating the power of growth.

Table illustrating the power of saving.

For further study, may we recommend a few books that many of us

have found both useful and inspiring? You don't have to read themnow -- it's not like we haven't given you enough to do. But you mightwant to keep them in mind for after the seminar.

The Millionaire Next Doorby Thomas J. Stanley & William D.Danko

Learn to Earn by Peter Lynch

Homework

You've managed to make it through the first lesson, but now it's time

to reallystart learning by putting what you've learned into action.Then, we're going to take a little time to examine the consequences ofchoosing to spend money on stuff vs. investing in stock. All togethernow, "Stuff vs. Stock!"

Assignment 1:
http://www.fool.com/seminars/partners/resources/beginvest/savingtable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/CompoundTable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/GrowthTable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/SavingTable.htmhttp://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=1563523302http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=0684811634http://www.fool.com/seminars/partners/resources/beginvest/savingtable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/CompoundTable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/GrowthTable.htmhttp://www.fool.com/seminars/partners/resources/beginvest/SavingTable.htmhttp://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=1563523302http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=0684811634


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Part 1: Walk around your house, condo, apartment, log cabin,houseboat, or whatever dwelling unit you call home, and make a list ofpurchases you made several years ago that you really just don't need

or could have done without. Now write down the cost and, if possible,the year you bought that unloved, unused item. Remember, Fools lookat stock investing over the long haul, so try to avoid purchases madewithin the last year.

Your list may look something like this:

Mondo-screen TV (for watching PBS, of course!) -- $500 inOctober 1998

Lunch every day at McTaco Hut when leftovers would do --$1,495 every year for the last five years

Shoes, way too many shoes! -- $200 every year for the last 10years! (No snickering! Some of us just like shoes!)

Let's start looking at the choice we didn't make when we bought ourTV. We didn't choose to buy stock in Cisco or eBay or Kodak. So, let'ssee... how many shares of Cisco could we have bought three years agowith our $500, and what would those shares be worth today?

Stroll over to the Historical Quotes page at Yahoo! to determine howmany shares your $500 would have bought at the beginning of 1998and the value of those shares today. Using our example, at thebeginning of 1998 you could have bought Cisco Systems for about$9.68 per share. Ballparking it is fine for this exercise, so let's call it aneven $10 per share. With our $500, we could have purchasedapproximately 50 shares of Cisco (ignoring commissions -- about $10at a discount broker). In late February 2001 (when this lesson wasbeing prepared), Cisco traded at around $26 per share. So 50 shares x$26 = $1,300 that could have been sitting nicely in our brokerageaccount. But it's not. It's sitting in the living room. Just curious -- arethose Frasierreruns really better on a $1,300 TV? (What, it's not highdefinition?)

(Note that the historical price for Cisco has been adjusted forsubsequent stock splits. In reality, your $500 would have boughtabout nine shares at $58.06 per share, but the stock has split sixshares for one since that time, so your nine shares would now be 54shares. When you look up historical stock prices, you usually get "split-adjusted" prices that reflect splits and can therefore be compared
http://chart.yahoo.com/thttp://chart.yahoo.com/t


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directly with today's price. If the Cisco price weren't split-adjusted, itwould look like the stock had actually fallen in value from $58 to about$26, when instead it rose from roughly $10 to $26. If this talk about

stock splits is confusing you, don't worry about it and move on. It's notcritical to master now.)

Now take your list and run that Cisco exercise for each purchase andsee what that purchase would be worth today if you had insteadinvested in a favorite company. Or, if you don't have any favoritecompanies, just multiply the purchase price by 11% (the stockmarket's average return) for each year:

$500 x 1.11 = $555

$555 x 1.11 = $616

$616 x 1.11 = $684

Next time you're thinking about whipping out your credit card to buysomething, remember that stuff loses value, but stocks often gainvalue. Stuff vs. stock. Fool, put the credit card down and step awayfrom the store! 'Nuff said.

Assignment 2:

We're going to start a project here that you will use throughout theseminar, so write neatly and put some thought into it. This is wherewe get personal. What are your savings goals? Need a down paymenton a house? College tuition for your little ones? Planning a trip toAustralia in a year or two? Thinking about retirement?

Part 1: List your goals. All of them. Be realistic, but be ambitious. Alsowrite down how many years you have until the expense hits andapproximately how much money you think you will need. Don't worryabout how to reach the goals yet -- just get them down on paper.

Make a chart like this:

Time Left

Goal Cost to Save

Trip to Europe $10,000 3 years

College for Kenny $5,000 per year/4 years 6 years

Retirement $1,000,000 portfolio 30 years


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This homework has no wrong answers. It comes straight from yourown experience and your life. But teachers should never assign workthey wouldn't do themselves, so I've volunteered my life as an open

book so that you can see just how one goes about doing theseassignments. Here are my answers:

Example Homework Answers

Assignment 1:

OK, here's my list. It's embarrassing, but I'll share it.

Glass-topped dining table, 1996 -- $250. This could have been a goodpurchase -- I bought it from a classified ad in the paper, so at least I

didn't pay full price. But I hated it within a week (glass is cold and loudand usually covered with fingerprints) and, more important, I had aperfectly good oak table.

In 1996, I wasn't a very sophisticated investor. Suppose I hadinvested that $250 in the S&P index using S&P Depositary Receipts(SPY) (more about them in a later lesson).

Bopping over to quote.fool.com and entering SPY in the quote box, Isee that shares are selling for $135.50. Checking Historical Quotes andpicking a random day in March of 1996, I see that SPYs sold foraround $67.50 a share -- exactly half! Hey, I didn't plan it that way.So my $250 would be worth $500 bucks.

I sold the table and four chairs at a garage sale last summer for $35.

Some others: Bike in January 1994 for $300. Entering GE (for GeneralElectric) in the quote box gives me a quote for today of $47. Clickingon "Historical Quotes" for Jan. 9, 1994, tells me I could have boughtGE at around $9, giving me 33 shares for my $300. So 33 sharesbought in 1994 times today's price of $47 = $1,551. Whoa!

Health Rider (remember them?). Christmas 1995. $400. I actuallybought Iomega stock at that time at (split-adjusted) $3.80. Today,IOM sells for $4.15, a 16% increase in five years. I would have beenbetter off in a bank CD. Oh, well, you can't win them all.

Assignment 2:
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Goal Cost When needed

----------------------------------------------------

Trip to Europe $10,000 3-5 years

College for Kenny $5,000/yr x 4 4 years

Retirement $1,000,000 portfolio 15 years

New roof $3,000 1 year

SUV, used $18,000 2 years

As we go through the lessons, we will be refining that list and workingon ways to reach our goals. I can tell you right now that the SUV willbe partly financed, even though I know it would be better to pay cash!

We all know that no plan is perfect, but not planning is a disaster. Getstarted!


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LESSON 2

Welcome back! Now that you've started thinking about your goals, thenext step is to get your financial house in order and learn aboutinvestments appropriate for beginners. This short seminar will be amere moment in your financial life, and you will notend the seminarwith absolutely, perfectly completed financial plans. That said, youabsolutely, definitely willknow how to define your goals, compareinvestment types, and make investment decisions.

It's time to put your financial house in order. This may seem like ahopeless task, but that's not so, not even a little bit! OK, maybe a littlebit, but you can break this task down into manageable steps by askingyourself three easy questions:

Where am I? What do I want?

How will I get it?

Where Am I?

Before you jump into the stock market, it is vitally important to takestock of your personal financial situation. You need to know how youcurrently spend your money, and how much (if anything) you owe.Once you nail down how you spend your monthly cash, you can makeyour own "stuff vs. stock" decisions to increase the money available tospend on stock. We have a detailed homework exercise (somehow youknew that, didn't you?) that will guide you through that process. Butfirst, let's do some hard thinking.

What Do I Want? (Stuff vs. Stock)

A house to call your very own? Enough wealth that you can pursuework you enjoy, regardless of the pay? Are you saving for a car, a tripto Cancun, a chalet in the Swiss Alps? Perhaps you just want to feel incontrol of your money. (Remember, we're only covering things thatmoney can buy. Eternal love is a worthy goal, but that's another


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seminar.) Grab your list of personal goals from Lesson 1's homeworkand let's refine it a bit.

Are your goals realistic? ($1 million in three years won't cut it unlessyou are pretty close already!) Now, which of those goals are really

important to you? Do you really want a Ferrari andan SUV? Go for theattainable, but set your sights high.

How Will I Get It?

Someone's going to end up living in your dream home, Fool. To makesure it's you, you need to free up some cash to save and invest. Butfirst, use that cash to pay down high-interest credit card debt and anyother consumer debt before you start investing. Debt is the biggestthief of investment capital we know of. It's really the opposite ofinvesting, sucking your money into a black hole that often just getsbigger and deeper. Here are a few suggestions on how to approachdebt and interest.

Scrape up cash everywhere you can. This is where today's homeworkcomes in. The Foolish Cash Uses Tally helps you see where yourmoney is going: $1,000 on shoes last year? $2,000 on eating out? Afamily can do that easily these days. Single? What's your bar bill?Everyone has their pleasures, and pleasures are a great source forcash to invest. You don't have to give them up, but you do have tothink about them seriously. Some might just be reduced instead of

eliminated. Ask yourself how important that morning latte is. Maybeskip the grande mochas for a month and buy a couple of shares ofStarbucks instead.

Finally, if you aren't satisfied with how much you can put away, canyou increase your income? Get a part-time job? Get a better-payingjob, or at least a raise? Maybe it's time to dust off the resume or go foradditional training. One thing is certain: You won't reach those goals ifyou don't plan for them and put that plan into action.

Your Savings Options

OK, by the time you've finished all your homework, you'll be paying offyour debts at a furious rate, and you'll have a general idea of howmuch cold, hard cash you can free up for investing. The next step is tostart thinking about where to put that money. We'll get into specificaccounts and investments in later lessons, but first, let's think aboutdifferent types of savings.
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Not all savings are alike. You need to treat short-term and long-termsavings very differently if you expect the money to be there when youneed it. Here's one way to define the appropriate investment types foryour personal schedule.

Time Frame Investments to Consider

Short-term

(up to 3 years)

Risk-free investments

Mid-term

(3-10 years)

Mix of risk-free investments and

stocks

Long-term

(more than 10 years)

Stocks

Short-term expenses are major expenses planned for the next three

years -- a down payment on a house, that family reunion cruise,perhaps college tuition. Short-term money should also include an"emergency fund," in case you ever find yourself sans paycheck. Asingle person with generous parents will need less in emergency cashthan a single parent of three small children, but a cautious benchmarkwould be three to six months of living expenses.

The onlyappropriate investment for short-term money is one thatdoes not risk your capital such as bank savings accounts andcertificates of deposit (CDs), money market accounts, or short-termbonds that mature when you expect to need the cash.

Money for mid-term goals can be in risk-free accounts or stocks (or acombination of the two), depending on how much time you have andhow much risk you are comfortable with. As the time for theexpenditure draws near, you simply switch cash from stocks to a risk-free investment. So if Junior is 15, the cash for his freshman yearcollege tuition might get moved out of stocks and into a bond thatmatures in three years. Of course, you have some flexibility here. Lotsof folks will leave the money in the market until Junior is dragging hisfootlocker down the stairs, but we don't advise taking chances with

essential expenses. You could get hit with another year like 2000 andfind your tuition fund 20% short. Years like that aren't predictable, butthey hit often enough to keep us on our toes and out of the marketwith our must-have money.

For long-term money, such as retirement savings, we think that thereis only one good place: stocks held directly or through a mutual fund.If you are in doubt about this, revisit Lesson 1.


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Setting Expectations

It's one thing to have a plan. But carrying through with it can be easiersaid than done. As you begin actually investing, you may find thatsome unexpected developments set your heart beating faster. Be

prepared with some perspective. Here's what you can expect from thestock market:

Volatility:

Stocks can zip up or down quickly. You'll have some down daysand even some down years.

The stock market might not gain much new ground for severalyears -- that's happened before.

Over the short term, anything can happen. But over the longterm, the stock market has steadily advanced (just not in astraight line).

Mistakes:

Don't expect to have a pristine trading record. You'll makemistakes. Even the best investors have made a bunch ofmistakes -- and not just in their early years.

Expect to sell some stocks too soon and some too late. Expect tobuy some that you never should have bought. Expect to miss outon some great bargains because you waited too long.

The upside of mistakes is that you can learn from them. Takethe time to reflect on your decisions and purchases and learnfrom any regrettable moves.

Success:

If you keep reading and thinking and questioning and learningthroughout your investing career, you're likely to get better at itas time goes by.

If you find great companies and remain invested in them for aslong as they remain great companies (ideally, decades), youshould profit handsomely.

Remember not to judge your results on a short-term basis. Realsuccess is measured over years or decades, not weeks ormonths.

Remember that you needn't charge full-blast into stockinvesting. You can ease into it. You can move some of your


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money into stocks incrementally. Only do what you'recomfortable doing.

Don't Panic

During market downswings, many investors get anxious, wonderingwhether they should follow the crowd and bail out on some of theirinvestments. This is often the worst time to sell. Here are somepointers on the fine art of avoiding panic.

People tend to panic...

When the market tanks

When a stock they own tanks When people around them are panicking

None of these are particularly good reasons for panicking. Here's whenyou might have cause for concern, though:

When you don't know why you own the stocks you own. Ifyou have no clue why you ever bought shares of Rubber ChickenCatering Co. (ticker: CHEWY), you'll have a lot of troubledetermining when it's the right time to sell. Did CHEWY sharesjust take a nosedive? It might be due to some fleeting marketmisunderstanding, in which case you should hang on. Or it mightbe due to some serious trouble at the firm. An informed investor

should have a good handle on her investments. (Don't worry. Wecan help you learn how to evaluate companies.)

When you don't understand the long-term upward trend

of the market. From decade to decade, stocks in greatcompanies and the market as a whole tend to rise in value. Tokeep your blood pressure down during market slumps, remindyourself of this.

When you have a short time horizon. If your moolah isinvested in stocks for just a few months, then go ahead andbegin hyperventilating right now. Anything can happen in theshort term. Even stock in wonderful companies can temporarilyfreefall. As we mentioned earlier, any money you expect to needwithin the next five (if not 10 or more) years should be out ofstocks and perhaps in CDs or money market funds.

When you haven't learned that it's the percentage of the

market drop that counts, not the points. A 100-point dropwas a big deal when the Dow was at 1,000. But when the Dow isat 10,000, 100 points is just 1%.


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When your investing is mostly influenced by fear andgreed. Don't be one of those people who eagerly snap up sharesof companies they've never heard of, on a hot stock tip, only toquickly unload at the first sign of trouble. All that trading willonly make your broker rich.

Well-informed Fools will rarely panic. Expect occasional market slumpsand surges. Read up on investing. The more you learn, the less you'llpanic. (If you're like us, you may find yourself licking your chops atsome falling stock prices, as they present good buying opportunities.)

What We've Covered

Let's do a quick review of how you will get your financial house inorder. So far you are:

Tallying your current uses of cash Making some "stock vs. stuff" decisions to free up cash

Managing your necessary debt to pay the lowest interest ratespossible, thus freeing up more cash for investing/debt payoff

Using this cash to pay off high-interest debt (if you have any),pay off any other consumer debt, and start building up savings

Defining your savings goals

Defining the timeframe in which you expect to need yoursavings.

Preparing to invest while developing realistic expectations, so

that you keep your wits about you through market ups anddowns.

Lesson Resources

Foolish Cash Uses Tally (i.e. Budget) Quick Tips on Paying Down Credit Card Debt

Additional Resources

The Motley Fool's Investing Basics The 13 Steps to Investing Foolishly

The Motley Fool's Credit Card Debt area

Homework

You're getting a lot of homework for this lesson, but fortunately, this isa self-paced seminar. You don't need to finish it all overnight.
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Definitely get started now, though. Begin analyzing your spending andmaking some decisions. Take all the time you need to really thinkthrough how you want to change your spending habits and what youwant your goals to be. You need to have your goals and plan in placebefore you start investing, but not before you start learning about

investing. Start the saving process now -- and keep it up for the restof your life.

Assignment 1:Get started on your Foolish Cash Uses Tally (i.e. budget). This can looklike a painful and boring exercise, but you'll probably find yourselfsurprised by how worthwhile it is. (And it's not thatpainful, either.) Itshould actually be eye opening, if not fascinating, to see where yourdollars really go.

Assignment 2:We've shared our "stuff vs. stock" thinking to help you examine yourpast spending decisions. Make a list of stuff that you might be able todo without in order to free up cash for investing in stock.

Assignment 3:If you have debt, what's your plan for paying it off? Formulate a step-by-step plan and write it down. Then stick to it.

Sample Homework Answers

Assignment 1:As with most of our assignments in this seminar, there's no right orwrong answer. For the first assignment, consider it completed if you'vebroken out and tallied several months' worth (ideally three to sixmonths) of expenses. Once you've done that, you'll want to startthinking of ways to reduce some expenses in order to generateadditional funds for savings and investments.

Make sure you include your cash expenses in your calculations. Forabout a month, keep a 3x5 index card or a small notebook with you atall times. Any time you make a cash purchase, record it. This istedious, but you only have to do it once. Set up general categories forthe items on which you spend money (newspapers, movies, coffee,breakfast, lunch, dinner, groceries, gas) and then tally the spendingwithin each category.

Assignment 2:Getting Foolish with your money means making better choices. It does
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notmean living your life in a dank basement eating cold soup! It justmeans making some adjustments in your spending habits and focusingon long-term plans as well as today's needs and desires. Here's howI've been maintaining a happy lifestyle while socking away somesavings:

I'd been paying $48 for my monthly haircut (a sorta fancy place,right near my home). I've now found a new place (definitely nofrills, right near my gym) that only charges $15! That's $396 insavings for my Roth IRA (or 20% of my annual contribution),and my hair still looks great!

I generally walk to work (which I love!), but on cold or rainydays I drive in and park for $8.50 a day. I spent about $300doing this last year. Recently, I looked into the schedule of thebus that goes right past my home, and it turns out it stops oneblock from my office, which is even closer than the garage. I'llsave around $250 in parking expenses this year.

I bought new golf clubs last year, and still have the used set Istarted with. They're sitting in my hall closet. Since they wereused when I got them, I'll probably only be able to get about$75 for them, but that's still stuff out and stock in, and that's thedirection I want to go.

So, my quality of life is just as good, I'm a little more than one-third of

the way toward my annual Roth IRA contribution, and I haven't cut outany fun at all!

Assignment 3:On a sheet of paper, list every creditor, outstanding balance, interestrate, and minimum monthly payment, and for those debts with a fixedterm (mortgage, student loan, car loan), also list the date you'rescheduled to complete your payments.

Use this "Tips on Paying Down Credit Card Debt" link to see if you canreduce the interest rates that you pay on any of your debt. This won'treduce the principal balance that you owe, but it will help you to payless interest on that balance, which means you will end up paying lessto the creditor.

Rank the debt in the order in which you want to pay it off. Debt withthe highest interest rate comes first. Maintain the minimum paymentson all your debt, but focus any payments beyond those on the creditor
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charging you the highest interest rate. When this debt is paid, movedown your list to the debt with the next highest interest rate. Whenyou have paid off your high-interest debt, start pouring this moneyinto your investments! (Low-interest mortgage and student loan debtshould not keep you from investing.) This assumes that you do not

have any pressing debt, such as overdue utilities, which would takeprecedence.

Paying down one debt at a time (while remaining current on all bills)can make the task of eliminating all your debt more manageable.


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LESSON 3

So far you've seen the value and importance of defining your goalsand designing a financial plan to reach them. In this lesson, we look atwhat should certainly be the first stop for all investors -- aninvestment that, for most investors, could also be the last. We're goingto give you the one-stop shop for a lifetime of successful investing, theclosest thing yet devised for getting the full value of the stock marketinto every man, woman, or child's investment account. We present toyou... index investing.

In 1975, a man named John Bogle presented a then-radical idea to the

board of directors of the newly formed Vanguard Group (a mutual fundcompany). He suggested creating an extremely low-cost mutual fundthat would not even attemptto beat the returns of the entire stockmarket (as measured by Standard & Poor's 500 index). Instead ofhiring expensive well-dressed managers to actively buy and sell stocks-- trying to guess where the market was going or which companieswere better buys at one moment, and which were overpriced atanother -- this mutual fund would simply buy all the stocks in the S&P500. That way, investors could participate in the successes and failuresof the 500 biggest companies in America. Since the S&P 500 index is

widely regarded as "the market," an investor in this index fund wouldautomatically match the market's return.

In case you're curious, the S&P 500 includes companies such as AOLTime Warner, Boeing, Cisco, Coors, Disney, Exxon Mobil, Ford,Gateway, Gillette, Hershey, Intel, Johnson & Johnson, LockheedMartin, Marriott, McDonald's, Motorola, Oracle, PepsiCo, Pfizer,Safeway, Sara Lee, Schwab, Sears, Texas Instruments, Toys R Us,Wal-Mart, Walgreen, Waste Management, Wells Fargo, Wrigley, Xerox,and Yahoo! And that's just a small part of its holdings. Most majorAmerican companies that you can think of are part of this massive

index.

Let's back up a second now in case we're getting ahead of anyone.Whenever you read or hear the words "index fund," what's beingdiscussed is a mutual fund that buys just the stocks that are listed byan established stock market index. What's an index? It's a list ofcompanies that represent some aspect of the market. An index could


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attempt to measure the whole market, some part of the market, aspecific industry, or a foreign market, but it's always a group ofcompanies with something in common.

The index's value is generally the average value of these companies.

When the average value of the companies in the index goes up, theindex goes up by the same amount. When the average value of thecompanies goes down, the index goes down by the same amount. (Itcan get more complicated than that, but essentially the value of theindex rises and falls with the value of the companies that comprise theindex.) So when you hear that the Dow gained 120 points, or 1.2%,that means that the average of the prices of the 30 companies thatmake up the Dow Jones Industrial Average went up 1.2%.

To back up further still, let's make sure everyone understands thatmutual funds are companies set up to receive investors' money, andthen having received it, to make investments with that money. Whenyou buy shares in a mutual fund, you are a shareholder -- an owner --of that fund, but you are also an indirect owner of the companies thatthe fund has invested in. If you buy an index fund, you own a piece ofevery company that makes up your fund's index. So if you buy evenone share of the Vanguard 500 Index Fund, for example, you own atiny piece of the 500 of the largest companies in the U.S.

Now, onward!

The Vanguard S&P 500 index fund chugged along for years, spawningan occasional competitor and getting modest attention, but eventuallyit dawned on the industry that John Bogle was really on to something-- especially since most actively managed funds continued to lose tothe overall market year after year. Then, in 1993, the American StockExchange introduced a new kind of index investment. Now known asexchange traded funds (ETFs), or index shares, this approach to indexinvesting works much like a mutual fund, except that the shares aretraded on an exchange just like stocks or closed-end mutual funds Anindex share represents partial ownership of a huge block of stock thatduplicates the composition of a particular market index. Instead ofowning a share of a company or a mutual fund, you own a share ofthat block of stock (known as a "depositary receipt").

Like the first index fund, the first index share was based on the S&P500 index. Dubbed SPDRs (for S&P Depositary Receipts), they quicklybecame known as Spiders and trade on the American Stock Exchange
http://www.amex.com/indexshares/index_shares_over.stmhttp://www.amex.com/indexshares/index_shares_over.stm


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under the ticker symbol SPY. Today there are dozens of index sharesavailable, and more are planned.

Index shares can be purchased from any broker just like stock. Theyhave ticker symbols so that you can easily get quotes on their value

and see their performance history. (Index funds have tickers, too, butthey can be harder to find.) Once purchased, index shares functionjust like shares in an index fund -- you own both the index share, and,indirectly, a small piece of every company in that index. Their pricerises and falls with their index. We will refer to both index funds andindex shares as "index investments," and in a later lesson we willdiscuss the pros and cons of each.

The crucial thing that distinguishes an index investment from amanaged mutual fund is that the index investment simply owns all thestocks that make up the index rather than attempting to pick the beststocks. Its goal is to match the performance of the index, not beat it.Index investments, with their firm ambition to match, not beat, themarket, are, ironically, better performers than most actively managedmutual funds, and thus better choices for most investors.

But, gee, aren't you supposed to aim high? How can an investmentthat aims for mediocrity be such a good idea?

Why It's Not Easy Being a Mutual Fund Manager

You might think that just throwing darts at the newspaper stocklistings would produce market-matching or market-beating results forat least half of those who try just by sheer luck. Actually, on manyoccasions, monkeys randomly selecting stocks have fared better thanprofessional money managers. (We're not making this stuff up --check this out.)

Odd as it seems, less than 10% of U.S. stock mutual funds that havebeen in business for at least 10 years have actually beaten the S&P500 over the last three-year, five-year, and 10-year periods, accordingto Morningstar.com.

The problem is, trying to outguess the market, either by trying todetermine which way the entire stock market is heading or by pickingthe companies expected to go up the most, costs serious money.You've got to hire somebody (usually a team of people) to do all thatguessing and stock picking for you. And then, on top of that, you'vegot to hire another bunch of people to advertise the myth that the
http://www.mgmt.purdue.edu/faculty/Rau/Funny/DartThrowing.htmlhttp://www.morningstar.com/Cover/Funds.htmlhttp://www.mgmt.purdue.edu/faculty/Rau/Funny/DartThrowing.htmlhttp://www.morningstar.com/Cover/Funds.html


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particular guessers you've hired have particularly good crystal balls sothat people will give your guessers lots of money to invest. With allthese people, the costs can add up pretty quickly. But those costsseverely handicap the poor money managers, making beating themarket -- or even matching it -- a very difficult task.

So what does this mean for you? By far, the majority of investors whohave attempted to beat the market using mutual funds with moneymanagers at the helm have failed to attain the average returns of themarket. The amount of money this has cost them is staggering. Don'tget on that boat.

From 1984 to 1999, the stock market as measured by the S&P 500index provided an annualized return of 17.7%, compared with just15.0% for the average diversified mutual fund. That's a 2.7%underperformance for the average mutual fund. That might not soundlike much, but year after year, it adds up. Had you invested $10,000in 1984 in an average mutual fund, by the end of 1999 your accountwould have stood at a respectable $93,000. But had you matched themarktwith an index fund, your balance would have been a shade over$135,000. That's a difference of $42,000! And that gap continues towiden. After 25 years, the market-matching account would be morethan twice the size of the average mutual fund-matching account.

Why Do Managed Mutual Funds Do So Poorly? Let Us Count theWays

ExpensesFirst, there is the expense ratio of the average fund. That's theaverage amount that a fund charges its shareholders every year tocover salaries, glossy brochures, and TV ads. During the study periodwe mentioned above, the average expense ratio for a managed mutualfund was about 1.2%. (Over the last couple of years, expense ratioshave been rising, and the average currently stands at 1.5%.) Bycomparison, the Vanguard S&P 500 Index Fund expense ratio is0.18%, and the expense ratio for Spiders is 0.12%. This means that

for a $10,000 investment, you'd fork over $150 per year to theaverage mutual fund (one that doesn't perform as well as an indexfund), versus just $18 for the year to the index fund or $12 forSpiders. High expense charges are the biggest handicap for fundmanagers. Just to cover that expense fee, they have to beat themarket by 1.5%. But that's not the only problem these poor fundmanagers have to face.


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TurnoverMany funds buy and sell their holdings at a rapid pace. No matter whoyou are, buying and selling stocks is not free. There are always tradingcosts involved. Currently this turnover of stocks occurs at an averagerate of 85% per year. That's right, the average fund buys and sells

almost as many stocks as it owns (typically, many billions of dollarsworth of trading). The transaction costs involved in buying and sellingso many shares every year result in an additional 0.7% of your moneydisappearing into some broker's pocket every year. Index funds havemuch less turnover each year than most managed mutual funds.

Cash ReservesFund managers typically hold about 8% of their portfolios in cashreserves. They feel that they need some cash on hand to cover apotential imbalance between cash flowing into the fund and cashdemands when investors sell, and they think they need these reservesto buy into the market when it is underpriced. This practice, known as"market timing," is expensive. Remember how the market outperformsCDs, Treasury bills, and bonds? Those safe, low-return investmentsare where the funds park their cash waiting for the "right" time to buy,but few of them manage to get the cash into the market at theoptimum time. This holding of cash reserves by mutual funds results inanother 0.6% of annual underperformance.

Add it all up and you see that after the 1.5% loss to expenses, 0.7%loss to turnover, and 0.6% lost to cash inefficiency kick in, even fund

managers who are skilled (or lucky) enough to have picked stocks thatmatched the market's performance are 2.8% behind.

TaxesAnd then there are taxes. All that buying and selling generates"taxable events." Any stock sold at a profit results in capital gains,which are taxed. This doesn't come out of the fund's stated returnslike the factors discussed above, but it does come out of your pocket(unless you are investing in a tax-advantaged account like an IRA or401(k) plan.) Mutual funds range from pretty good to abysmal when itcomes to tax efficiency, but index funds are very tax efficient. Theymight do a bit of balancing on a daily basis, selling or buying to keeptheir holdings in the right proportion to each other, but major sellingonly takes place when the index is changed. For example, whenCompany XYZ is added to the S&P 500, all S&P 500 index funds willbuy proportionate shares of Company XYZ and sell the stock itreplaced. This doesn't happen too often, though.


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Did you get all that? We sure hope so. But if not, remember this much-- index funds can capture most of the gains the stock marketgenerates because that's what they are designed to do. They havevirtually no cash reserves, very low turnover, and low expenses, plusthey don't have hotshot managers guessing what the next hot stocks

will be.

Matching the returns of the stock market, rather than the returns ofaverage mutual funds, means a lot over time. Consider this example,from a recent speech by outgoing SEC Commissioner and friend of theindividual investor, Arthur Levitt:

"A $1,000 mutual fund investment made in 1950 with returnsmirroring the S&P 500 would be worth over half a million dollars today.But, before you start shopping for the yacht, there's still a bit of mathto do. After you figure in the compounding costs of mutual funds,conservatively a little under 2%, that figure is reduced to just$230,000. If the fund is not meant to be tax efficient, that numberdrops to -- if you can believe it -- just $65,000. Without payingattention to costs, an investor stands a better chance of earning amillion dollars as a contestant on Survivor."

The Pros and Cons of Index Funds

Pros:

They outperform the vast majority of managed mutual funds. They typically have no loads or sales commissions. So you can

add small amounts to your holdings regularly without payingsales fees.

The have low annual expenses.

You can authorize a regular automatic withdrawal from yourbank account and the money will go straight into your fund. Youdon't even have to lick a stamp.

Cons:

Not all index funds are available from every broker or fundcompany. (You may need to buy into an index fund directly fromits company, such as Vanguard.)

Some index funds charge high maintenance fees and/orcommissions (loads). Just avoid those funds. There are plenty ofpretty much identical funds with very low fees.
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Index funds are not actively managed. They simply own thestocks that make up a certain index.

The performance of an index investment is not dependent on a

money manager selecting the "right stocks." Its value rises andfalls with the index on which it is based.

Total market index funds outperform the vast majority ofmanaged mutual funds.

Index funds typically have no loads or sales commissions. Soyou can add small amounts to your holdings regularly.

Index shares are purchased from a broker for the broker'sstandard commission.

Mutual fund managers face an uphill battle trying to outperformthe market average. They charge you a lot in fees and sales

loads, they keep a sizable portion of their money in cash, andthey buy and sell very frequently -- thereby generatingcommission charges and taxable gains.

Index funds and index shares can essentially match theperformance of the stock market at a very low cost to you.

For anyone who isn't yet ready to select their own individualstocks in which to invest or anyone who has no interest inpicking individual stocks, index investments represent the best,no-brainer place for long-term investment money.

Index investing is a monument to the wisdom of fullyparticipating in the stock market, as opposed to trying to beat

the market.

Lesson Resources

Index Funds.com More on Mutual Fund Fees From Morningstar

The Truth About Mutual Funds

Homework

Assignment 1:Compare historical performance among several index funds. You willfind a fairly comprehensive list in our Index Center. Check out howthey have performed for the last few years, then pick a few that lookinteresting and call the company to get their average annual return forthe past five and 10 years compared to the average annual return oftheir underlying index. This can be a real eye-opener.
http://www.indexfunds.com/http://quicktake.morningstar.com/DataDefs/FundNutsAndBolts.htmhttp://www.fool.com/school/mutualfunds/mutualfunds.htmhttp://www.fool.com/school/mutualfunds/tables/indextypetable.htmhttp://www.indexfunds.com/http://quicktake.morningstar.com/DataDefs/FundNutsAndBolts.htmhttp://www.fool.com/school/mutualfunds/mutualfunds.htmhttp://www.fool.com/school/mutualfunds/tables/indextypetable.htm


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Here are recent average annual returns for the S&P 500 index to getyou started. The fund companies should have comparable indexreturns for each fund, back to the fund's start.

Last 1 Year Return (2000) -10.02%

Last 3 Years Returns (1998-2000) 11.91%






Assignment 2:Pick a broker or a fund company and investigate the index fundsavailable through that broker or company and what it would cost you(if anything) to buy an index fund through the brokerage. Ask about allcosts associated with the fund, including expenses, loads, andcommissions. If there are loads, be sure to ask if they apply to futuredeposits as well as the initial deposit.


Assignment 1:

We thought we'd have a beginning investor go through the homeworkassignments. The "answers" below should be considered as examples.There are no absolute solutions to this homework.

I clicked over to the Fool's Index Center as the starting point for asource of information on index funds. I narrowed down the list tofunds with an expense ratio of 0.2% or less. That gave me thefollowing funds:

Ssga S&P 500 Index

Fidelity Spartan US Equity Index USAA S&P 500 Index Vanguard S&P 500

Fidelity Spartan Market Index Schwab S&P 500 Select CA Inv. S&P 500 Index

Dreyfus Basic S&P 500 Index Vanguard Total Stock Mkt.
http://www.fool.com/school/mutualfunds/tables/indextypetable.htmhttp://www.fool.com/school/mutualfunds/tables/indextypetable.htm


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Since I don't have a lot of money sitting around, I narrowed the listeven further to those requiring an initial investment of $3,000 or less,leaving me the following funds to choose from. (Note: Initialinvestment requirements are lower for IRA accounts.)

Wilshire 5000 Total Market Index Vanguard Total Stock Mkt

USAA S&P 500 Index

Since USAA S&P 500 is restricted to military personnel, I eliminated it,leaving me with two funds.

It turns out that Vanguard has a very nice website that contained all ofthe information I needed. So rather than calling them on the phone, Ivisited www.vanguard.com and found the following information:

AVERAGE ANNUAL RETURNSVanguard S&P 500

5 Year 18.31%

10 Year 17.35%

S&P 500

5 Year 18.33%

10 Year 17.46%

Vanguard Total Stock Market

3 Year 10.92%

5 Year 16.68%

Wilshire 5000 Total Market Index

3 Year 10.77%

5 Year 16.68%

(Note: The Vanguard Total Stock Market fund has not been around for10 years. I therefore chose three and five years as my comparisonpoints.)

Both funds compare well with the average annual returns of theirunderlying indexes. Anyway, these are only two of a very largenumber of funds to choose from.

Assignment 2:Again, I found myself in need of a good starting point. Looking close tohome, I used the Fool's Discount Broker Comparison Table to choose abroker. I am sure there are many other sources with more
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comprehensive lists, but as a beginner, I honestly didn't want to havetoo many choices.

Out of the list, I randomly chose Ameritrade. I then visited theirwebsite to look for costs associated with buying an index fund. The

commission to buy a no load mutual fund through Ameritrade is$18. (Note: You can also buy most no load mutual funds directly fromthe mutual fund company for no commission.)
http://www.ameritrade.com/http://www.ameritrade.com/tell_me_more/http://www.ameritrade.com/http://www.ameritrade.com/tell_me_more/


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LESSON 4

LESSON 4: BEYOND THE S&P 500: SELECTING YOUR INDEX INVESTMENTIntroduction

Index funds have gathered a lot of attention over the last couple ofyears for good reason. The S&P 500 has outperformed more than 90%of all domestic equity mutual funds over the past three, five, and tenyears. Mutual fund managers have been gnashing their teeth over

their inability to beat the average return of this index, against whichtheir performance is usually judged.

The best-known index investment is the very first one, started by JohnBogle at Vanguard all those years ago -- the Vanguard S&P 500 IndexFund that we discussed in the last lesson. But index investing is by nomeans confined to the S&P 500. If you name a measurement of themarket or some segment of the market, then somebody has probablyslapped an index fund or an index share on top of it: the Russell 2000(an index of 2,000 small-company stocks), the Wilshire 5000 (prettymuch the entire stock market -- there are about 9,000 publicly traded

companies, but the "Wilshire 8,723" just doesn't sound right), and theDow Jones Industrial Average (the 30 stocks that make up the Dow),just to name a few of the big ones.

There is a case to be made for buying more than one index. Theadvantage of adding a small-cap index or an international index is thathistorically, small-caps have tended to flourish when the bigcompanies were slow. International markets also don't always move inlockstep with the U.S. market, so owning different indexes canpossibly smooth out your returns from year to year. That's the theory

anyway. There is no evidence that after a few decades you would endup with more money in your account if you decide to diversify beyondthe S&P 500, but if you want some possible protection from marketvolatility, adding some smaller, specialized indexes is not a bad idea.For beginners though, we suggest sticking with one of the broad-basedindexes while you study your other choices.


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Which Index Investment Is Right for You?

Even if you limit your choices to broad-based indexes, you still have a

number of products to choose from.

Our Index Center will give you an overview of some of the morepopular indexes. The American Stock Exchange Index Share websitelists many more, each with its own index share. Take a quick look ateach page. Whew!

Index investing used to be pretty simple, but this proliferation ofproducts threatens to turn a simple investing decision into a mass ofconfusion. While we wouldn't want to discourage anyone who has apassionate desire to own the Russell 3000, we think that dithering

over the choice of indexes is a serious waste of time. The S&P 500 hasbeen the best performer over time and we suggest that it is a goodchoice for almost anyone. Another good choice would be the "TotalMartket" index (often based on the Wilshire 5000 index). Both indexestrack the U.S. market and will let you participate in the economicgrowth of our country.

Still, there remains the question of whether an index fund or an indexshare is best for you. Spiders (the S&P 500 index share, remember)have lower expenses than the Vanguard 500 fund, but Spiders are

traded like stock and incur a commission each time they are bought orsold. For large purchases, the lower annual fee will wipe out the effectof the commission in a year or two, but if you plan to make frequentsmall deposits, those commissions could be a deal killer.

As a general rule of thumb, the larger each purchase is, the more cost-effective index shares are versus an index fund, but for any givenlarge purchase, the differences are not great. If your style of investingtends toward making frequent small investments, you will definitelywant to go with a fund to avoid monthly commissions. Funds don'tcharge you to buy more shares, but if you tend to make large deposits

(more than $2,000), the lower expense ratio that index shares offerwill offset your commissions fairly quickly.

Index Funds or Index Shares?

Index Funds
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Pros:

Usually no commissions -- funds are great when adding smallamounts frequently.

Automatic investing -- you can authorize an automaticwithdrawal from your bank account and the money will gostraight into your fund. You don't even have to lick a stamp.

Cons:

Not all funds are available from every broker or fund company.

Some may charge high maintenance fees and/or commissions(loads).

Index Shares (or Exchange Traded Funds)

Pros:

Can be purchased like stock from any broker (setting up abrokerage account instead of a mutual fund company accountgives you more flexibility later if you want to move into stocks).

Lower management fees.

Cons:

You pay a commission each time you buy -- if you are investingsmall amounts frequently, this would be a deal killer.

Where to Find Index InvestmentsHere's just a smattering of some of the many index funds available,with some info on them, as of mid 2000:

TickerSymbol

Name of FundInitialDeposit

AnnualFees

Phone #

PEOPX

Dreyfus S&P 500

Index $2,500 0.50% 800-373-9387

SWPIX Schwab S&P 500 Inv. $2,500 0.35% 800-435-4000

VFINX Vanguard 500 Index $3,000 0.18% 800-662-7447

SWTIXSchwab Total StockMarket Index Inv.

$2,500 0.40% 800-435-4000


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VTSMXVanguard Total Stock

Market Index$3,000 0.20% 800-662-7447

WFIVXWilshire 5000 IndexPortfolio

$1,000 0.55-0.70% 888-200-6796

A Sampling of Index SharesThese can be purchased from any broker simply by specifying theticker symbol.

Name Ticker Index Tracked

Spiders SPY S&P 500

Diamonds DIA Dow Jones Industrials

Cubes QQQ Nasdaq 100

iShares S&P 500 IVV S&P 500

iShares U.S. Total Market IYY Dow Jones Total Market Index

(These ETFs all trade on the American Stock Exchange.)

A Final Word: Watch Those Fees!

Watch carefully what some companies are selling as "index funds." Thereal point of investing in index funds is not to try to pick the "hot"

index (or the "cold" index before it gets hot). Putting your money intoan index fund -- any index fund -- can deliver great results to thelong-term shareholder, because index funds keep costs so low -- or atleast they shouldkeep costs low. The Vanguard 500 Index Fund hasannual costs (the expense ratio) of roughly 0.18%. Most index shareshave similar expense ratios. That means that when you put yourmoney into the Vanguard 500 Index or an index share, about 99.82%of that money keeps working for you.

Full-price brokerage Morgan Stanley Dean Witter, on the other hand,

runs an S&P 500 index fund (buying the exact same stocks asVanguard's fund) with annual costs of 1.5% -- nearly eight times asmuch! When Morgan Stanley sells you an index fund, it essentiallysays, "You should be happy with only 98.5% of your money still inyour pocket every year. We deserve the other 1.5% for doing such agreat job." Just say "no thanks" to that.


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And it can get even worse. Many banks offer index funds with highexpense ratios andsales loads! The Wells Fargo S&P 500 Fund, forinstance, has a 0.71% annual expense ratio anda 5.75% upfront sales

load. They expect you to pay someone to sell you a fund with anexpense ratio four times that of their competition that is guaranteednot to perform as well. When you buy an index fund with a 5.75%load, that's 5.75% of your money gone right there! And then WellsFargo has the audacity to take 0.71% every year thereafter!

We have just three words to say about funds with loads (sales fees):Don't buy them. We know of no case where the rationale for paying aload held up outside of the salesman's spiel, which, if honest, wouldsimply be, "Pay this load 'cause my income depends on it." Don't do it!Stick with index shares or companies like Vanguard or the many other

low, low, low cost providers of the world.


Index investments are proliferating like mutual funds did in the'90s, but for a beginning investor, the choice is simple --matching the S&P 500 is a no-brainer.

An index fundis best for those who make small frequentinvestments.

Index shares are more cost-effective for those who invest more

than $2,000 at one time. (But use a discount broker -- you stilldon't want to pay a big commission.) Investigate fees associated with any index fund carefully.

Don't buy funds with loads or annual expenses over 0.2%.

Lesson Resources

The Motley Fool Index Center EFTs or Index Funds, Which One Is Best for You? American Stock Exchange's Index Shares

Morningstar's EFT Center

Homework Assignment

Congratulations! Believe it or not, you're halfway done. Easyhomework this time. At least we hope it will be easy. Decide whichindex investment best suits your situation. If you feel a fund is thebest choice for you, use the information you gained in the last two
http://www.fool.com/school/indices/introduction.htmhttp://www.kiplinger.com/columns/value/archive/2000/si0523.htmhttp://www.amex.com/indexshares/index_shares_over.stmhttp://www.morningstar.com/Cover/ETF.htmlhttp://www.fool.com/school/indices/introduction.htmhttp://www.kiplinger.com/columns/value/archive/2000/si0523.htmhttp://www.amex.com/indexshares/index_shares_over.stmhttp://www.morningstar.com/Cover/ETF.html


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homework assignments to select the fund you prefer.

Sample Homework Answer

Vanguard's Wilshire 5000 looks good to me. It has the lowestminimum deposit and I can make additional monthly deposits at nocost. The annual expenses are higher than some of the other choices Ichecked though, so I'm going to plan to switch to either the Vanguard500 Index Fund or Spiders in a year or so.

LESSON 5

LESSON 5: WHICH TYPE OF ACCOUNT IS RIGHT FOR YOU?Introduction

Now that you know whatto invest in as a beginner (and possiblyforever) you need to get your money into an account so that youcan buy into the index of your choice (S&P 500, Total Market, etc.).But what kind of account -- and where? The next two lessons coverexactly that. In this lesson we discuss the various types of accountsavailable to you, and in the next lesson we'll go through the stepsinvolved in actually setting up an account with a brokerage or

mutual fund company.

Once upon a time, our grandparents drove their Chevy Impalas tothe bank to do business and manually recorded their bankingtransactions in their savings vehicle of choice -- a passbook savingsaccount. We might romanticize the car, but there's nothingromantic about the passbook. Nowadays, with money marketaccounts, bank CDs, 11 types of IRA accounts, option accounts,margin accounts, the advent of the computer, the Internet,discount brokers, and the transformation of financial service

institutions into one-stop shops, we have a virtual buffet ofavailable choices.

What's an investor to do? Get educated, of course. In manyrespects, a brokerage account is just a more versatile bankaccount, and it's no more difficult to open. But before you open anaccount, you need to know what kind of account you want. There


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are lots of choices -- enough to drive you bonkers if you don'tapproach the subject with some basic facts. Understanding thetypes of accounts available will help you decide which will work best

for yourinvesting goals.

CDs and Money Market Accounts

Let's start by assuming that you know about savings accounts andyou want to do better. One step up from savings accounts aremoney market accounts and CDs (certificates of deposit). Both payhigher interest rates than traditional savings accounts and areoffered by banks, brokerages, and mutual fund companies. Both arepretty safe. You won't get rich investing in either, but you won't get

poor, either.

CDsWith a certificate of deposit (CD), you fork over your money for aspecified period of time (three months, six months, one year, twoyears, etc.). In exchange, you get a certificate specifying theinterest to be paid, the length of the contract, and the amountdeposited. At regular intervals, you'll receive interest on your CD.When you redeem the CD, you receive your original principal, plusaccrued interest. Most bank CDs are insured by the FDIC. So far, sogood.

If you park your funds in CDs, remember that you're committed forthe term of the CD. Withdrawing early will get you a ticket on yourwindshield in the form of the dreaded "substantial penalty for earlywithdrawal." Don't let the language scare you off -- if you run intoan emergency and need your cash, or if you decide to move it intothe fast lane and go for a higher return, you can retrieve yourmoney. Find out exactly how substantial the penalty is in yourspecific case. It may be only a few months' worth of (fairly paltry)interest.

Money MarketA money market account is a mutual fund that invests in securitiessuch as U.S. Treasury bills, short-term corporate debt, and CDs.Because money market accounts stick to short-term, low-risksecurities, they are relatively safe and easily accessible. Yields arenot fixed like they are with CDs. Instead, they vary according to


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short-term interest rates. At the time of this writing, they werehovering in the 4-5% range.

Until you've decided which long-term investing methodology is foryou, money market accounts are safe, efficient havens for yourcash. You get a reasonable rate, often comparable to a CD, withoutthe potential penalties. Brokerage accounts often "sweep" any cashin your account into a money market account every night so that itearns interest. Even if you aren't ready to make your first investingdecision, you can open a brokerage account and earn interest in amoney market account until you're ready to invest. Nothing beatsearning while you're learning.

In addition, many money market accounts offer check-writingcapabilities, making them ideal holding places for money earmarkedfor short-term goals and emergency funds.

Beyond Banks

Once you know what type of account you want to open, the nextquestion is... where? Your choices are banks, mutual fundcompanies, and brokerages, but all three are expanding theirservices, and the lines between them are blurring as eachorganization tries to be all things to all people. Any of the threetypes of institutions may offer money market accounts, CDs, credit

cards, and checking accounts. Some banks and brokers will alsooffer financial planning services and mutual funds. Some mutualfund companies offer brokerage accounts. As far as we know, banksstill have a monopoly on drive-through tellers.

Retirement Accounts: IRAs

An Individual Retirement Account, or IRA, is a personal retirementsavings plan for U.S. taxpayers who receive taxable compensation(meaning income from work, not investment income) during the

year and meet certain income and age requirements. Mostinvestment accounts -- including bank accounts, mutual fundaccounts, and brokerage accounts -- can be designated as IRAaccounts. Other than the tax consequences, an IRA accountfunctions exactly like a regular account, although certain risky kindsof investments may be prohibited. It can be opened through abank, mutual fund, or brokerage house, and you decide which
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investments to buy. You can invest in CDs, money marketaccounts, bonds, mutual funds, index shares, and individual stocks.

Quick Overview of IRAsThe Roth IRA is fully available to individuals making up to $95,000and couples making up to $150,000. (If you make a bit more thanthat, you can sometimes make a partial contribution -- see "IRAContributions.") Annual contributions to Roths are limited to$4,000, and the contributions are not tax-deductible like those totraditional IRAs can be. That's OK though, because when you retire(and under other limited circumstances), the withdrawals are notsubject to federal income tax at all. In other words, you can'tdeduct what you put in, but everything that comes out is tax-free

(as long as you follow a few rules). Roth IRAs are the Holy Grail ofretirement investing. For those who qualify, a Roth IRA should bethe first investment account you open.

Traditional IRAs allow your money to compound tax-free,but withdrawals are taxed as regular income. Contributions to atraditional IRA may or may not be tax-deductible, depending onyour income and eligibility to participate in a tax-qualifiedretirement plan through your employer. As with a Roth,contributions to traditional IRAs are limited to $4,000 per year. (Bythe way, you will often see that described as a $8,000 limit for

married couples, but IRAs are never joint accounts. Individualscontribute to their own personal account, married or not.)

The traditional IRA has two advantages. Folks with low incomes orthose who are not covered by an employer retirement plan candeduct their contributions from their income, reducing their currenttaxes, and the income limits are somewhat higher. In our opinion,the only people who should opt for the traditional IRA are thosewho don't qualify for a Roth. If you are eligible to deduct your IRAcontribution, you may be tempted to choose a traditional IRA for

the immediate tax savings, and that's a legitimate choice, but youwill pay far more in taxes during retirement. Looking back, we'repretty sure you will wish you had paid the higher taxes upfront andgone for the Roth.

Self-employed people can choose from a variety of investmentaccounts with higher limits than IRAs. These include SEP-IRAs and
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Keogh plans. If you are self-employed, you're probably alreadyfamiliar with such plans, but if not, you owe it to yourself to getfamiliar with them as soon as possible. They offer higher limits than

other IRAs and -- the best part -- you can have a SEP-IRA or Keoghplan in addition to a Roth IRA.

Retirement Accounts: 401(k)s

Another popular retirement account is the 401(k), offered throughyour employer. With a 401(k), the employer permits eligibleemployees to elect to contribute a percentage of their pay (pre-tax)to a retirement account established on their behalf. You don't paytaxes on the money that goes into a 401(k), although you will pay

regular income taxes on withdrawals made during retirement.Besides getting to invest with untaxed dollars, all the earnings onthose contributions compound untaxed until the money iswithdrawn from the account. This tax deferral adds an enormouskicker to the compounding effect of those deposits during theemployee's career.

In most 401(k) plans, you're offered several investment choices,most or all of which are mutual funds. You'll frequently find anindex fund among your choices -- if not, contact the 401(k)administrator at your company and ask that one be added. We've

heard of many Fools who have been successful in getting an indexfund option added to their choices.

There's a good chance that if you participate in a 401(k), youremployer will give you money for doing so. Many employers matcha portion of the money deferred by their employees. Find out ifyour employer provides matching contributions. If it does, youabsolutelyshould commit yourself to deferring every dollar you canup to the amount that your employer is willing to match. It's freemoney and it grows tax-deferred -- grab it.

To make the most of the tax advantages offered through variousretirement plans, we suggest investing in the order listed below.Max out each option that is available to you before moving on tothe next. Note that these are general guidelines, and since eachperson's situation can be slightly different, the following might notbe the absolute best route for you.
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1. Company-sponsored 401(k) with matching funds2. Roth IRA3. Company-sponsored 401(k) with no matching funds or

retirement plans for the self-employed4. Traditional IRA (if you don't qualify for a Roth)5. Regular brokerage account


Short-term savings should be in a risk-free account such as aCD or money market account.

Mid-term money can be in either a risk-free account or instocks.

The differences between brokerages, banks, and mutual fundcompanies have blurred -- most will offer many types ofaccounts.

Almost any type of account can be designated as an IRAaccount.

Roth IRAs are the best thing for investors since discountbrokerages. Take full advantage of one if you qualify.

If you employer offers a 401(k) plan with an employer match,participate fully up to the amount the employer will match.That's free money!

Lesson Resources

Short-Term Savings Center Retirement Plan Primer

All About IRAs All About 401(k)s

BankRate.com

About Interest Rates BanxQuote

The Motley Fool Investment Tax Guide (featuring a large

section on retirement accounts)

Homework

Assignment 1:Scavenger hunt! For your short-term savings and emergency fund,you need a risk-free account. Comb the Web (or your local
http://www.fool.com/savings/savings.htmhttp://www.fool.com/Retirement/RetirementPlanPrimer.htmhttp://www.fool.com/money/allaboutiras/allaboutiras.htmhttp://www.fool.com/money/401k/401k.htmhttp://www.bankrate.com/http://banking.about.com/cs/interestrates/http://www.banx.com/http://www.foolmart.com/shopping/Product_View.asp?PRODUCT_ID=MF030_02http://www.fool.com/savings/savings.htmhttp://www.fool.com/Retirement/RetirementPlanPrimer.htmhttp://www.fool.com/money/allaboutiras/allaboutiras.htmhttp://www.fool.com/money/401k/401k.htmhttp://www.bankrate.com/http://banking.about.com/cs/interestrates/http://www.banx.com/http://www.foolmart.com/shopping/Product_View.asp?PRODUCT_ID=MF030_02


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newspaper or yellow pages, if you prefer) for the best rates on CDsand money market accounts. It's easy to do online, since several

sites have been set up to compare rates. BankRate.com andbanx.com are two good ones, but feel free to use any Internetsearch engine. Find three institutions that offer high rates for eachtype of account. Either online or via some phone calls, confirm theCD rates and terms, including the exact penalty for earlywithdrawal. For both types of accounts, confirm the minimumdeposit required.

Assignment 2:

Which type of financial institution is right for your mid- and long-

range savings? In the following list, answer the questions on theleft. If your answer is "Yes," check the right side of the page for thefinancial institution that is best suited to your needs. If the answeris "No," proceed to the next question.

BRO = Brokerage Company, B = Bank, MFC = Mutual Fund Company

1.

I would like to open an IRA.BRO, MFC, B

2.

I have some mid-range goals and would like to put thatmoney in a CD account.

BRO, MFC, B

3.

I want unlimited check-writing, cash machine access,and a location convenient to my home.

B, someMFCs

4.

I need only limited check-writing capability and wantmy money to return the highest interest rate available.

BRO, MFC

5

.I want to buy and sell stocks.

BRO

6.

I want to buy mutual/index funds from a specific familyof funds.

MFC, BRO

7

.

I want to buy mutual/index funds from a variety of

companies.

BRO

8.

I want to invest small sums each month directly into amutual/index fund for low or no fees

MFC

9.

I want to eat creamy dessert treats and not gainweight.

TCBY
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Assignment 3:

Now apply what you've learned to your specific situation. Go backto the investing goals that you wrote down in Lessons 1 and 2. Add

a column titled "Account." Write down which type of account youthink would work best for each goal: money market, CD, brokerage,or mutual fund company.


Been prowling the Web? What an amazing amount of stuff out there-- sometimes beautifully organized and at your fingertips, andsometimes just downright frustratingly difficult to find. I hope yourexperience was good. Here's mine.

Assignment 1:I have a son starting college in two years, so his first year's tuitionneeds to be in a safe, preferably high-interest account. I care moreabout a good rate than about having this money in a local bank, soat banx.com I selected U.S. Composite for the location box. I thenselected an 18-month CD. Well, well, a local (sort of) bank, E*TradeBank in Arlington, Virginia, had the best rates (annual percentageyield: 6.0%) and a minimum of $1,000 -- I can live with that. Iclicked their logo and went to their site, looking for early withdrawalpenalties or some other downside. I didn't see a category called

"Penalties" or "Downsides," so I tried customer service -- but stillno good. I sent them an email. I didn't like it that they were notupfront about the penalties, so I went back to banx.com and wentthrough the same procedure with NetBank, which offered 5.9%,also with a $1,000 minimum. I found the early withdrawal penaltiesin three clicks (under "Truth in Savings").

NetBank looked good, but just to be fair I also checked out my localcredit union. They have something called a Share Certificate thatalso looked pretty good. The minimum is $500 and the penalty for

early withdrawal is only a month's interest. I was surprised. MaybeI'll just stick with them.

Assignment 2:

1. No (been there, done that).2. Yep, I have kids heading to college soon and I really do need
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to get some of their money out of the market.3. No. All of my banking needs are taken care of by my credit

union, so checking and ATMs are not an issue.4. No, check-writing is of little importance to me. All my bills are

paid by CheckFree.5. Stocks -- yep, I want to trade, but that's already covered.6. Mutual funds -- nope.7. Mutual funds -- no.8. No, I am content to put my small sums in a money market

account until I have enough to buy some stock.9. Well, yes!

OK, what have I got here? This being the real world and me beingan instructor for the seminar, it's safe to say that I already have

one or two brokerage accounts. What I really need is a good placefor Kenny's college money. That's mid- to short-term money. Thatmeans I need to look for good rates on CDs, since I can staggertheir maturity to coincide with the tuition bills.

Assignment 3:Here are my goals from Lesson 1, with appropriate accounts added:

Goal Cost When needed Account

Trip to Europe $10K 3-5 yrs Brokerage

College for Kenny $5K/yr x 4 4 yrs CD

College for Tory $5K/yr x 4 4 yrs CD

Retirement $1MM portfolio 15 yrs BrokerageNew roof $3K 1 yr Money Market

SUV, used $18K 2 yrs Money Market

I hate to admit it, but I've been letting my short-term savings languish in a

savings account at the credit union. This is my wake-up call to convert that to amoney market account!


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LESSON 6

LESSON 6: HOW TO OPEN AN INVESTMENT ACCOUNTIntroduction to Brokerages

Welcome back! You've learned about the importance of saving andinvesting, the best investing choices for beginners, and what kinds ofaccounts you need to get started. Now all that's left is to put yourmoney where your mouse is and set up an account. You can start theprocess right here online. Since opening a brokerage or mutual fundaccount may be a first-time experience for you, we'll go through theprocess very carefully, starting with: How do you go about actuallyopening an account? And with whom?

What Is a Broker?Simply put, a broker is a middleman. Since you probably aren'tinclined or able to run down to the New York Stock Exchange eachtime you want to make a trade, your broker does it for you -- for afee. How much of a fee? Well...

Full-Service Brokers


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In the bad old days, the men were men, the fees were hefty, and theinformation flow was choked off before the individual investor ever gotnear it. In exchange for making trades for you -- and for throwing in

some "expert advice" -- brokers would charge hundreds of dollarseven for relatively small trades. These brokers still exist, and areknown as "full-service" brokers. Some of them do a bang-up job foryou, and earn the hefty fees they charge. Many, though, don't serveyou as well as an index fund would. In general, we don't think much ofmost full-service brokers, simply because we feel that you are the bestcaptain of your investing ship. And, as the historical returns of"managed funds" have shown, the returns that you get from using"expert advice" don't come anywhere near justifying the expenses yourun up for it.

Discount BrokersWith the advent of the Internet, more and more people have turned todiscount brokers. (Discount brokerages actually originated offlineseveral decades ago, pioneered by Schwab.) How much of a discountdo you get? Well, that varies according to the firm, but you can buy orsell stock for $10 or less per trade these days. You don't get much (ifanything) in the way of advice. (Which is good -- the only thing worsethan no advice is badadvice!) What you get instead is the ability tomake trades easily and cheaply -- and various online tools for stockresearch if you want them.

On our website, we have a discount brokerage comparison table thatallows you to see some sponsoring brokers' services and fees side byside. Another good resource for comparing brokers is Gomez.com.Keep in mind as you compare brokerages that while all the apparentdifferences and details can seem overwhelming, there really isn't thatmuch of a difference between most brokerages. Just about any brokerwill place and execute your orders and send you monthly statements.It's hard to go wrong in choosing one. Still, don't pick entirely blindly.Do a little research until you find an appealing brokerage that offers allyou need.

Comparing Brokerages

There are, broadly speaking, two factors to consider when choosing adiscount broker: fees and services

Fees
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