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Successful investors need four abilities. First, they must possess an interest in the process. It is no different from carpentry, gardening, or parenting. If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work. Second, investors need more than a bit of math horsepower, far beyond simple arithmetic and alge

[…], or even the ability to manipulate a spreadsheet. Mastering the basics of investment theory requires an understanding of the laws of probability and a working knowledge of statistics. Sadly, as one financial columnist explained to me more than a decade ago, fractions are a stretch for 90 percent of the population

Even if investors possess all three of these abilities, it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it. “Stay the course”

Two of the most virulent behavioral organisms are overconfidence and an overemphasis on recent history.

To recapitulate: a reasonable estimate of the failure rate for the highly rated companies might be in the range of about 2 percent per year, leaving a 5 percent expected corporate bond return. Assuming that the long-term inflation rate is about 3 percent, this leaves an inflation-adjusted return of about 2 percent. In late 2008, for the junk-rated companies, the risk premium (the excess return over a 2 percent Treasury note) might have been as large as 10 percent per year, leaving an expected return of 12 percent on a nominal basis or 9 percent on an inflation-adjusted basis. The higher-than-Treasury returns for high-grade and junk bonds described above are the rewards the investor would have reaped for bearing the risk that the economy and, along with it, the default rate could actually

Always favor expected returns calculated from the Gordon Equation over past returns, no matter how long of a period they cover. This goes double whenever the markets are gripped by the euphoria of a bubble, as occurred in the late 1990s,

Home ownership is not an investment; it is exactly the opposite, a consumption item. After taking into consideration maintenance costs and taxes, you are often better off renting.

Thus, at most you will receive a 3 percent real return (1 percent real price increase plus the 2 percent net “dividend”) on your home; if the current downturn in the housing prices perseveres, it could be much less. A good rule of thumb is to never, ever pay more than 15 years fair rental value for any residence.c This computes out to a 6.7 percent (1/15th) gross rental dividend, or 3.7 percent after taxes, insurance, and maintenance, which is about what you might expect from a mixed portfolio of stocks

Think about it: If Ford had the same expected return as Toyota, who in their right mind would buy Ford? In order to attract buyers for its far riskier stock, Ford must offer investors a higher expected return than Toyota. Although Ford may not survive, if it does, its shares will skyrocket. The company’s stock somewhat resembles a dollar lottery ticket with a 1- in- 10 probability of a $20 payoff. While you might not want to put a large amount of your net worth into a single company, the law of averages dictates that owning a large number of “lottery-ticket” companies should produce enough winners to make up for the majority of eventual deadsters.

Finally, small and value stocks can lag the market for long periods of time—the latter for up to 10 years, and the former for up to 20 years. If small and value stocks always beat the market, there would be no risk, so there would be no risk premium; the reward for owning small and value stocks derives in great part from this risk of relative underperformance.

Let’s summarize what we have concluded so far about expected returns for the major stock and bond classes going forward from early 2009:

When all is said and done, I still know of no better risk analysis tool for retirees under the age of 70 than this simple narrative: At a 2 percent withdrawal rate, your nest egg will survive all but catastrophic institutional and military collapse; at 3 percent, you are probably safe; at 4 percent, you are taking real chances; and at 5 percent and beyond, you should consider annuitizing most, if not all, of your nest egg

Always consider Pascal’s Wager: What happens to my portfolio—and to my future—if my assumptions are wrong?

history of stock and bond returns. These are primarily useful as a measure of risk; they are far less reliable as a predictor of future returns. Never, ever, extrapolate past returns into the future, particularly when those past returns have recently been extraordinarily high or low.

history of stock and bond returns. These are primarily useful as a measure of risk; they are far less reliable as a predictor of future returns. Never, ever, extrapolate past returns into the future, particularly when those past returns have recently been extraordinarily high or low.• The wise investor estimates future returns for stocks with the Gordon Equation by adding the dividend yield to the dividend growth rate. For bonds, the investor estimates future returns by subtracting the expected failure rate from the coupon.

For young savers, investing only in “safe” assets is even more of a disaster, since their retirement nest eggs will not grow adequately in the first place. If we learned anything from the first chapter, it is that investors cannot earn decent returns without taking risks. In the current environment, risks seem very high, and because investors need to be compensated for bearing these risks, returns going forward should of necessity also be high.

Although they should be heavily invested in equities, they are usually too frightened by their first encounter with the bear to buy. Equally, bear markets are wasted on the old, whose lack of human capital and the fact that they are drawing down their portfolios dictate a low equity exposure.

One useful paradigm for assessing an appropriate stock/bond mix involves what I call the “equipoise point.” Here is how it works: During a bull market you will derive pleasure from your stock gains and will regret that you were not more heavily invested; your equipoise point is that allocation at which this pleasure and regret exactly counterbalance each other. Similarly, during substantial market declines, the equipoise point is that allocation where the pain of loss in stocks exactly counterbalances the warm fuzzy feeling provided by your bonds and the capacity they provide to buy more stocks at low prices

One of medicine’s little secrets is that wealthy people, by fragmenting their care through doctor shopping, often get worse treatment than ordinary people, usually by winding up with charlatan “celebrity physicians.” The same is true in finance, where the wealthy have access to managers and investment vehicles not available to plain folks, particularly hedge funds, limited partnerships, and the like.

For some reason, we do not purchase securities in the same way we buy other things. When the price of strawberries rises to $8 per pound in January, we forego them, and when they are virtually being given away at the farmers’ market in June, we load up. Not so with stocks: The higher the price, the more attractive they seem; and the lower they have fallen, the more we are repulsed. Buy low and sell high: these words roll so easily off the tongue. Yet most investors cannot manage it because they lack the emotional stamina to do what needs to be done. Like the out-of-condition athlete, they are in lousy financial shape.

Your primary training tool is the rebalancing process, which forces you to sell high in the good years and to buy low when there is blood in the streets. In the really bad years, such as 2008-2009, this will mean pouring large amounts into falling eq

Financial Planning for a Lifetime: The Basics Each dollar you do not save at 25 will mean two inflation-adjusted dollars that you will need to save if you start at age 35, four if you begin at 45, and eight if you start at 55. In practice, if you lack substantial savings at 45, you are in serious trouble

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