The 3 Simple Rules of Investing

Why Everything You've Heard about Investing Is Wrong- and What to Do Instead

Michael Edesess (Author) | Kwok Tsui (Author) | Carol Fabbri (Author) | George Peacock (Author)

Publication date: 05/16/2014

The 3 Simple Rules of Investing

Explains why the most common investment advice is misleading, useless, or just plain wrong

* Proves that investing is easy if you follow three simple rules and use a few basic investments

* Explains why the most common investment advice is misleading, useless, or just plain wrong

* Written by a team of veteran financial industry insiders

Personal finances can be a huge source of stress. And confusing and complicated advice from the financial industry, which is supposed to be helping, just makes it worse-and is a reason why many investors are falling further and further behind.

But investing is actually simple, maybe more simple than ever before. As the authors of this clear, practical, and enlightening book-part financial guide, part exposé-prove, there are just three simple rules you need to follow and just a few investment products that are necessary for an ideal portfolio-with perhaps a few optional ones that might help and won't hurt. That's it.

But what about the advice of investment gurus, financial industry pundits, advisors, journalists, and academics? The authors debunk the financial industry's Seven Deadly Temptations-including trying to beat the market, investing via the latest "scientific" financial theories, and succumbing to the lure of expensive and complex-sounding investments.

Whether you are a hesitant first-timer, an experienced veteran, or even a professional institutional investor, this book will help you make wise selections in your 401(k)s and create portfolios for all seasons. And as an added benefit, the authors explain how turning your back on convoluted investment products reduces systemic risk to the overall financial system and deprives Wall Street of some of its undeserved profits, thereby curbing its unhealthy political influence.

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Explains why the most common investment advice is misleading, useless, or just plain wrong

* Proves that investing is easy if you follow three simple rules and use a few basic investments

* Explains why the most common investment advice is misleading, useless, or just plain wrong

* Written by a team of veteran financial industry insiders

Personal finances can be a huge source of stress. And confusing and complicated advice from the financial industry, which is supposed to be helping, just makes it worse-and is a reason why many investors are falling further and further behind.

But investing is actually simple, maybe more simple than ever before. As the authors of this clear, practical, and enlightening book-part financial guide, part exposé-prove, there are just three simple rules you need to follow and just a few investment products that are necessary for an ideal portfolio-with perhaps a few optional ones that might help and won't hurt. That's it.

But what about the advice of investment gurus, financial industry pundits, advisors, journalists, and academics? The authors debunk the financial industry's Seven Deadly Temptations-including trying to beat the market, investing via the latest "scientific" financial theories, and succumbing to the lure of expensive and complex-sounding investments.

Whether you are a hesitant first-timer, an experienced veteran, or even a professional institutional investor, this book will help you make wise selections in your 401(k)s and create portfolios for all seasons. And as an added benefit, the authors explain how turning your back on convoluted investment products reduces systemic risk to the overall financial system and deprives Wall Street of some of its undeserved profits, thereby curbing its unhealthy political influence.

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Meet the Authors

Visit Author Page - Michael Edesess

Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, and sustainable development fields. He is a senior research fellow in the Centre for Systems Informatics Engineering at City University of Hong Kong, principal and chief strategist of DC-based Compendium Finance, research associate of the EDHEC–Risk Institute, and senior fellow and project consultant at two Hong Kong–based think tanks.

He writes regularly for the online journal Advisor Perspectives, coauthored "The 3 Simple Rules of Investing" (Berrett-Koehler 2014) and authored The Big Investment Lie (Berrett-Koehler, 2007). He was a founding partner and chief economist of the Lockwood Financial Group until its 2002 sale to The Bank of New York. Previously a consultant and provider of mathematical computer systems to institutional investors, Dr. Edesess worked with several of the largest banking and consulting firms. He has taught courses in finance, energy and environmental economics, mathematics, and statistics at six universities. He has been interviewed on radio and TV and published in the Wall Street Journal, the Journal of Portfolio Management, and Technology Review, among other publications.

In addition to his work in investments, Dr. Edesess has been active in nonprofit organizations. He chaired the board of International Development Enterprises USA, which focuses on rural smallholders in developing countries, and also chaired the board of Rocky Mountain Institute, a prominent energy efficiency think tank, and the Rocky Mountain Advisory Board of the Environmental Defense Fund. Dr. Edesess holds a bachelor’s degree from MIT and a Ph.D. in pure mathematics from Northwestern University.

Visit Author Page - Kwok Tsui

Kwok L. Tsui is a distinguished statistician whose work focuses on the statistics of quality, informatics, and data mining, and he is an expert on the problem of spurious patterns in big data. He has spent 24 years as a professor and department head at several major universities as well as a practical applied researcher. Prior to his university positions, he was for 4 years a member of Technical Staff at AT&T Bell Laboratories’ Quality Assurance Center. Dr. Tsui is currently head and chair professor in the Department of Systems Engineering and Engineering Management at City University of Hong Kong, before which he was a professor in the School of Industrial and Systems Engineering at the Georgia Institute of Technology.

A recipient of the National Science Foundation Young Investigator Award, he has served in numerous positions in professional statistical societies, including fellow of the American Statistical Association and the American Society for Quality; elected member of the International Statistical Institute; U.S. representative in the ISO Technical Committee on Statistical Methods; department editor of IIE Transactions; chair of the INFORMS Section in Quality, Statistics, and Reliability; and founding chair of the INFORMS Section in Data Mining. In addition to his work on statistical quality and reliability, Dr. Tsui’s current research includes health informatics, data mining, and surveillance in health care and public health, prognostics and health management, calibration and validation of computer models, bioinformatics, process control and monitoring, and robust design and Taguchi methods in industrial engineering. Dr. Tsui holds a Ph.D. from the University of Wisconsin.

Visit Author Page - Carol Fabbri

Carol Fabbri, an experienced financial advisor, certified financial planner, and certified advisor in philanthropy, cofounded Fair Advisors in 2008. As the managing partner of Fair Advisors LLC, an independent financial advisory firm, she works with individuals and nonprofit organizations. Prior to that role, she worked as an advisor at Merrill Lynch and formerly spent a decade as an international business consultant after receiving an MBA at MIT’s Sloan School of Management. She leverages her consulting experience to educate her audiences and simplify the seemingly complex financial environment. She also works with individuals to achieve their goals using financial, estate planning, and philanthropic tools.

Ms. Fabbri’s unique and clear perspective on personal finance issues is often quoted in the national press, including Forbes, Smart Money, and the Wall Street Journal. She is the coauthor of Personal Investing: The Missing Manual (O’Reilly, 2010). To address the broad need for financial literacy courses, she founded Fair Advisors Institute (FAI), a nonprofit dedicated to improving financial literacy through education and research. In 2012, FAI received the “Right on the Money” award for its work providing financial education to foster youth. Her efforts toward educating individuals about personal finance have been recognized locally and nationally. Ms. Fabbri received the TIAW World of Difference Award for her work economically empowering women and has been recognized as a Colorado Top Wealth Advisor. She recently received her black belt in taekwondo and lives in the mountains of Colorado with her husband and son.

Visit Author Page - George Peacock

A 27-year investment industry veteran, GEORGE PEACOCK is a principal at Compendium Financial Investment Advisory, the founder and manager of the Purchasing Power Portfolio, the author of the Yoga of Investing blog, and the managing editor, investments for the online financial site He entered the financial advisory business as an associate at American Express Financial Services (now Ameriprise). He also worked at the Wallace Financial Group, a regional insurance, investment, retirement, and financial planning firm, and Mullin Consulting, advising Fortune 1000 companies on niche compensation benefits for their senior executives. He returned to advising high-net-worth individuals and families when he joined the D.C. office of US Trust, which was later purchased by Bank of America. Mr. Peacock left Bank of America when the firm, like the rest of the investment industry, began relying increasingly on mathematical models whose output depended on a myriad of unknowable assumptions.

At Euclid, he immediately established the Purchasing Power Portfolio, a precursor to the Simplify Wall Street approach described in this book. Mr. Peacock is the president of the Georgetown University Alumni Association and is an ex-officio member of the University’s board of directors. He is also a member of the External Advisory Board of the Georgetown University Alumni and Student Federal Credit Union, the largest student-run credit union in the country, and The Georgetown Chimes, an all-male a capella singing group. A part-time stand-up comic, he lives in Bethesda, Maryland, with his four children, Duncan, June, Hayley, and Mackenzie.

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Table of Contents



The Simplify Wall Street Portfolio

PART I The 3 Simple Rules of Investing


Simplify Your Options


Look Only Forward


Tune Out Noise

PART I I Investing's 7 Deadly Temptations


Beat the Market


Trust It All to Our Expertise


Precisely Calibrate Your Portfolio


Sleep Well at Night with Your Risk Under Control


Use the Strategies That Always Work


Do What Wealthy and Sophisticated Investors Do


Use Modern Scientific Financial Theory


The Invisible Squeeze





About the Authors

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The Simple Rules of Investing


Simplify Your Options

You may not believe this: Whether you’re a small investor with a few thousand dollars to invest, or a wealthy investor with a few million dollars, or a gigantic pension fund with a hundred billion dollars, you need only consider at most about 10 investment products. The rest are of no use and aren’t worth thinking about.

If you were going to buy a computer, how many brands do you need to choose from? About 10? And the same thing for a smartphone—maybe 10 models, at most? This point applies whether you’re a teenager doing homework or a top executive at a Fortune 500 firm.

Shopping for investments is a little different. You’re faced with tens of thousands of investment vehicles to choose from, offered by thousands of investment firms. There are more than 80,000 mutual funds and ETFs (exchange-traded funds) worldwide. There are almost 10,000 hedge funds. The array is mind-boggling. And it keeps expensive financial advisors busy trying to guide confused investors through the mess. They let you know it’s difficult to choose because there are so many choices.

But, actually, there aren’t. If there were 100,000 computers or smartphones to choose from and 99.9% of them cost 5 to 80 times as much as the other 0.1% but weren’t any better, how many would there really be to choose from?

Why aren’t there 100,000 computers or smartphones for the consumer to choose from but there are 100,000 investment vehicles? Because of product and price confusion—a topic we covered in the introduction. Consumers don’t realize that 99.9% of investments cost so much more than the others. Neither do they realize that those few that cost so much less are just as good as or even better than the rest. They have been so confused by the product that they think they’re buying a luxury convertible when they’re only buying a bicycle—and paying 50 times too much for it. They’re so confused that they don’t even know what, exactly, they’re paying.

Hiring a financial advisor to guide you through the mess of investment products is usually no help. Most financial advisors will only reinforce and even add to the confusion because it is what they were taught, it is the industry status quo, and most of them—perhaps too uncritically—believe it. They believe they’re trying to help their clients while also making a living, and they have no incentive to depart from the industry line.


In this book, we’re talking about “passive” or indirect investing—in other words, investing in businesses in which you’re not an owner or employee. We’re not trying to tell you how to actively and directly invest in or run your own business selling, say, hamburgers. (Note, too, that a completely different meaning of “passive” applies to an investment vehicle that invests in all the securities in a market index instead of trying to pick certain ones; an index fund, then, is passive in this way.) If you’ve got savings in a 401(k), an IRA, or taxable individual or joint account, or investments you oversee by being the administrator of a university endowment fund, a pension fund, a foundation fund, or a wealthy family’s office—we’re talking to you. You’ll want to invest these funds very wisely. We’ll name the investment vehicles that you should consider—forget all the others. Of course, you’ll need information about how to use them, but reducing the number of choices will go a long way to reduce the complexity, too, so that the rest will also be easier.

You need only consider a very few types of investments, or what’s known as asset classes: stocks (also called equities), fixed income (bonds and short-term investments like bank accounts, certificates of deposit [CDs], etc.), perhaps real estate, and simple forms of insurance that ensure meeting cash flow needs. Specifically, here’s all you need:

Images Government inflation-protected securities (in the United States, these are Treasury Inflation-Protected Securities, or TIPS)

Images A low-cost total U.S. domestic equity index fund, either a mutual fund or an ETF (this would be part of a world stock fund)

Images A low-cost total international equity index fund, either a mutual fund or an ETF (the other part of the same world stock fund—with one fund, then, you’re investing in both U.S. and international stocks)

Images Single-premium income annuities

Images Low-cost term life insurance

That’s it. If you want to, you could also add these:

Images A low-cost total U.S. domestic bond market index mutual fund or ETF

Images A low-cost total international bond market index mutual fund or ETF

Images A low-cost REIT (real estate investment trust) index mutual fund or ETF (U.S. and global)

Images Individual stocks or bonds you buy yourself through a low-cost broker and keep for many years

Images Small amounts from a very short list of other investments that we’ll discuss later

That’s 10 investment vehicles, max—all you’ll ever need.

In the case of the stock, bond, and REIT index funds, competing versions are offered by a small number of providers for fees of less than a quarter of a percent annually, and often much less. You should confine yourself to only those. Examples appear on the 3 Rules of Investing website, with regularly updated information.

Now we will describe each investment vehicle in more detail.

Government Inflation-Protected Securities (GIPS)

GIPS are the least risky investment on the planet. No other investment you can make or action you can take is closer to 100% certain to preserve the purchasing power of your money for decades to come. That includes stuffing your money under the mattress, buying gold—anything.

The best-known GIPS is the U.S. Treasury inflation-protected securities (TIPS). These can be purchased easily online at the TreasuryDirect website1 of the U.S. Department of the Treasury. Several other national governments also issue inflation-protected securities. The United States is the biggest issuer, however, so to keep things simple we’ll talk mainly about TIPS.

TIPS protect against inflation by increasing the face value by the inflation rate each year. Let’s start with an example. Suppose you buy a TIPS contract for its face value of $1,000, and the interest rate is 1%. Hence, the first year the interest is 1% of $1,000, or $10.

But each year the Treasury increases the TIPS’ face value for inflation. Let’s suppose that in the first year after you bought it, inflation is 2%. That means the face value becomes $1,020, so next year you will get interest of 1% on $1,020, or $10.20. And so on, for the length of the TIPS contract. As this example shows, as the TIPS contract matures, the government continues to pay you interest on the inflated face value. The final payment, then, is likely to be much more than what you paid for the TIPS in the first place, to keep up with inflation.

Another nice thing about TIPS is that they also protect you against deflation. If inflation was actually negative from the time you bought the TIPS until maturity, then you’ll still get your $1,000 back at maturity, not its deflated value.

Is There Really No Risk with TIPS?

Well, no. There’s never no risk. But you can’t get a smaller risk with a long-term investment than with TIPS. There just isn’t one.

There are two risks with TIPS. One is that the government will default on its obligation. That’s a negligible risk, however, if it’s the government of a major developed country. The second risk is a little greater: that the government’s inflation rate may not be your inflation rate.2 The government calculates inflation based on the “average” basket of goods consumed by the average person in the country. But your consumption might be of a different basket of goods. Your goods might increase in price faster than the average—then you could be in trouble. (Of course, their prices could also increase slower than the average, and then you’d be fine.) For example, the price or cost of health care and nursing homes has increased much faster than average prices. And guess what? As you grow older, that’s what you’ll be spending a lot of money on, like it or not. So if the price of health care increases faster than the rate of general inflation, TIPS payments will lag behind.

Be that as it may, the main use of TIPS is to protect against huge fluctuations in general inflation, which really could occur; they occurred in the United States as recently as the 1970s and early 1980s and more recently in some other countries. So if you’re depending on payments from investments over the next 30 to 60 years, it’s a good idea to protect against those fluctuations if you can.

Here’s one more point to keep in mind: TIPS’ longest maturity is 30 years. You can guarantee yourself an income until 30 years out, but what about after that? If you’re retired at age 60, there’s a decent chance you’ll still need to collect an income after age 90. For that you need an annuity—the simplest kind available. It’s on our list of core investment vehicles, and we’ll discuss it soon.

Global Diversification in Global Inflation-Protected Securities (GIPS)

In addition to the United States, a number of other countries issue inflation-protected securities, notably the United Kingdom’s Index-linked Gilts and France’s OATi. To hedge against sovereign risk—that is, the very small risk that a major developed country cannot or will not honor its guarantee—an investor could invest in a diversified portfolio of GIPS maturing on the desired dates. Doing so would take more effort than investing only in the inflation-protected securities of one’s own government; but it would add a small measure of diversification, which will reduce risk.

World Stock Index Funds

The second investment is different. Global stocks—that is, stocks that are listed on stock exchanges in the United States, Europe, Hong Kong, Tokyo, Australia, Brazil, and many other places in the world—are the riskiest major category of investments. When you invest in stocks, there’s no contract to say you’ll ever receive anything back.

Because global stocks are not as certain as GIPS to pay your money back, they have to offer you more. As we noted earlier, at this writing, U.S. TIPS offered a return of only about 1.5% above inflation over the next 30 years.3 Global stocks, however, are likely to provide a higher return, if you wait long enough. As we noted in the introduction, studies suggest that if you hold a diversified stock portfolio for 30 years or more, history suggests you’re likely to get a good return (i.e., about a 5% return, above inflation, on average, give or take perhaps 3%). That likelihood is as high as possible if the portfolio is globally diversified. But it’s not guaranteed, not at all. GIPS, in contrast, are guaranteed by the government that issued them.

Fortunately, it’s easy and very inexpensive to invest in a globally diversified stock portfolio. The simplest way is to buy a world stock index ETF. “Index” in this context simply means a single investment vessel that holds a lot of different shares in various stocks—in fact, hundreds or thousands of them. You’re in effect investing in multiple firms at once, rather than investing in Firm A, Firm B, and so forth. A few world stock index ETFs are similar—from companies like Vanguard, BlackRock iShares, State Street SPDRs, and Schwab. It’s easiest to buy one that simply holds the whole global stock market (e.g., available at the time of this book’s printing, and in the United States, from Vanguard,4 iShares,5 and SPDR6). They can be purchased easily online after opening an online brokerage account with, for example, Schwab, E*TRADE, or TD Ameritrade. These funds have low “expense ratios,” the fees their managements charge per year. For example, two of the lowest-cost world stock ETFs currently have expense ratios of 0.19%7 and 0.24%,8 respectively. Hence, for every $10,000 of the assets you’ve invested, you’ll pay either $19 or $24 in fees that year, depending on which you choose. These two world stock funds are divided in approximately the same way the stocks of the world are divided. One of them reports that it holds 45% in U.S. stocks, 45% in international developed-market stocks, and 10% in stocks of emerging-market countries like Indonesia, Turkey, and China. The other is similar.

World stock funds can be purchased as a single fund or as two funds. You can buy them as one low-cost fund that holds nearly all global stocks or an approximation thereto. This is the way we’ve presented this investment vehicle in our earlier list of the only investments you really need. You may get a better expense ratio, however, by buying two funds, one a U.S. domestic total market fund, the second an international fund comprising the rest of the world stock fund (all countries except the United States). For example, one U.S. domestic total stock market ETF currently has an expense ratio of only 0.05%, one-twentieth of a percent. The same provider’s total international stock index ETF has an expense ratio of 0.16%. If you combine these two funds in the same ratio as in the world stock fund (45% U.S., 55% international), your resulting expense ratio will be only 0.11%, as compared to the 0.19% expense ratio for the lowest-cost world stock ETF. (The low cost of the U.S. total market index fund may be due to the large size of its total assets, about 10 times that of the world stock ETF.) More information is available at the 3 Rules of Investing website.

ETF Versus Mutual Fund

You can buy an index fund as a mutual fund or as an ETF. It’s so messy to explain the differences between how an ETF and a mutual fund are organized that we think we’ll forgo the full explanation and just get to the implications. As we’ve mentioned, both of them are simply ways to buy a basket of stocks or bonds all in one single purchase. With a mutual fund, you can only buy into it once a day. An ETF, on the other hand, trades at any time in the market, just like a stock.

ETFs often have lower expense ratios—the fees you pay every year—than mutual funds. They can also have certain small tax advantages. So if there’s a choice between an index ETF and an index mutual fund, it’s usually better to buy the ETF.

The only time it’s not better to buy the ETF is if you’re going to dribble your purchases out over many small purchases over a period of time. When you buy shares in a mutual fund—as long as it’s a no-load fund, the only kind you should buy—you don’t have to pay for purchasing. When you buy shares of an ETF, however, you may have to pay brokerage fees (again, just as you do whenever you buy and sell a stock). The brokerage fees are generally less per share if you buy in a big lump than if you string out your purchases and buy in many small lumps. In fact, if you buy too many small lumps, you could overwhelm the ETF’s advantages because of all those fees. In that case, you’d be better off going with the mutual fund.9

What About Individual Stocks?

Buying a world stock index fund (or the combination of one domestic index fund and one international index fund) gives you the best-diversified equity portfolio you can get, and at the lowest fee. This is one-stop shopping at its best. Each of the two world stock ETFs we mentioned holds more than 5,000 different stocks and charges less than a quarter of a percent per year. The average mutual fund, by contrast, holds far fewer stocks and charges 1.4%—more than five times as much. The average mutual fund actually charges 28 times as much as the lowest-cost U.S. domestic total stock market index fund.

And that’s only the average fund. About half of them charge more than that. But here’s another point: the actual cost of the average mutual fund is probably much more than 28 times the cost of the lowest-cost total market index fund. The average equity mutual fund buys and sells stocks so much that its turnover (the ratio of stocks bought and sold to those held) can be nearly 100% a year or more. In other words, the basket of stocks in the fund gets totally transformed by the end of the year. The brokerage costs for all that buying and selling, which are taken out of the fund—but aren’t part of the quoted expense ratio—could add as much as another half-percent to the cost. So, diversified low-cost index funds are a good choice.

If you wanted to lower your costs even more, you could create your own basket of stocks by buying each one individually and holding onto them for many years. When you do this, there would be no cost to hold them after you bought them (i.e., no expense ratio), only the initial brokerage cost when you bought them (and, eventually, the brokerage cost to sell when you wanted to cash the stocks in much later).

However, it’s much harder to be well diversified if you buy your own stocks. Diversification among many investments cuts down on the risk of losing a lot of money in one or a few of them. If you take the do-it-yourself approach in building an “index” of stocks, you might wind up not buying enough different stocks to be truly well diversified. You might wind up buying a lot that were in the same industry, for example, or in industries whose securities prices tended to move together, like oil and gasoline.

What About Individual Bonds?

As 1 of the 10 possible investments you could consider, we mentioned bond index funds among the possible “extras” in your portfolio. These could consist of corporate bonds or government bonds or both. We do briefly discuss bonds later in this chapter; and as we’ll see in Rule #2, you don’t really need them for most purposes. Occasionally, they could add a small measure of diversification—and therefore lower risk—and possibly a small expected return, especially for corporate bonds (but with a little added risk—the risk of corporate defaults).

You could buy individual bonds, but you should buy enough different individual bonds to be well diversified, which may be even more difficult to do yourself than it is with stocks. The corporate bonds available for individuals to purchase are concentrated in only a few industries, making diversification challenging. If you buy a bond mutual fund or ETF instead, usually the fund “rolls over” the bonds—that is, it buys some and perhaps sells some—in such a way as to keep their average maturity approximately constant. If it’s an intermediate bond fund, for example, with an average maturity of, say, six years, then when some bonds mature, others will be bought to maintain the average maturity.

If you could buy your own bonds instead, you could arrange them so they produce your desired cash flows. You might organize them so they mature on different dates just as you need the funds, and keep them until they mature. That way, you only need to buy them once. This approach is called “laddering” the bonds.

Insurance Products: Income Annuities and Life Insurance

The last two products on our short list of investment vehicles are single-premium income annuities and low-cost term life insurance. We will be considering only “simple annuities,” which means that you pay a lump sum for them, and they provide you a stream of equal periodic payments, typically monthly, until death. The simple annuities available to you to buy could be inflation-adjusted or not—that is, the equal periodic payments could be in “nominal” dollars, for example $1,000 a month, or in “real,” that is, inflation-adjusted, dollars. We’ll also talk a little about life insurance in this section. We won’t talk about health insurance or any other kind of insurance protection.

Why only these kinds of insurance—simple annuities and term life insurance? Because they’re useful for the planning of lifetime cash flows; in particular, they insure you against early or late death, and the cash flows that each require. In addition, they’re simple enough that they’re not easy targets for product confusion, one of the two main sources of overcharging. Their simplicity also means that it’s more difficult for sellers to create the other source of overcharging, price confusion, because they have to compete with each other to sell the same basic, transparent product.

You should keep an astronomical distance between yourself and annuities with names like “variable annuity” and “equity-linked annuity.” These are among the most egregious examples of products that charge incredibly high fees because people don’t understand them.

Insurance companies truly do provide a service when they offer easy-to-understand simple annuities because they can diversify the longevity risk (the risk of living long and thus drawing a large cash flow) as no individual can. And the insurance companies themselves can benefit from selling that valuable service even with fully transparent pricing, so they have less need, as well as less ability, to create price and product confusion.

A simple annuity can be a single-premium immediate annuity (SPIA) or a deferred-income annuity (DIA). With an SPIA, the purchaser pays a lump sum at, let’s say, age 80. Then the insurer guarantees the purchaser a fixed payment (usually paid monthly and perhaps inflation adjusted) starting immediately, until the purchaser’s death.

Maybe even more useful, DIAs make payments to the annuitant (purchaser) not immediately but at some date later than the date when the annuitant pays the premium. For example, you could pay a lump sum at age 65 and start collecting at age 80. Obviously the premium for this sort of arrangement will be much less than if payments start immediately.

Annuities can help individuals guarantee their lifetime cash flow needs toward the ends of their lives, in a way that no other investment vehicle can do. If they wish to guarantee that they’ll be able to leave a bequest, term life insurance can make that guarantee. If an investor’s cash flow goals are clearly specified, then it’s possible to plan, using a few calculations, the best mix and timing of TIPS, annuities, and life insurance toward the end of the investor’s life, since the only uncertainty is the date of death and not the amount or timing of the payments. The calculations are beyond the scope of this text, but the reader may explore them at the 3 Rules of Investing website.

The Risk Factor

Insurance companies can diversify the risk of any single annuity by selling many annuities. Some of their annuitants will die early and some will die late, so the insurance company’s net total payouts are fairly predictable, if actuarial life expectancies remain roughly the same.

When you purchase an annuity or life insurance, the insurance company is guaranteeing that you’ll receive payments decades in the future. What’s to guarantee that the insurance company will be around that long and that it will have the money to pay you?

This is an important question. After all, in the mid-2000s, the London-based Financial Products division of AIG, a huge insurance company, sold so-called credit default swaps (CDSs) that were supposed to insure against a fall in the market values of certain securities called CDOs (collateralized debt obligations). But the Financial Products division didn’t have anywhere near enough money to pay off the buyers of this insurance. This happened not decades after people had bought CDSs but rather within a year or two after the Financial Products division had promised to pay off if the CDOs fell. Even the whole of AIG didn’t have enough money because the payoffs were so big; and, anyway, AIG itself was not liable for the promises of its Financial Products division. In the end, the purchasers of the insurance got paid off in full because the U.S. government stepped in and made good on the payoffs that had been promised by AIG’s insurance contracts.

But what if the government didn’t step in? In fact, many people believe it was a mistake for the U.S. government to pay off AIG’s promises in full. The next time something like this happens (we hope it won’t, but it very well might), the government is less likely to pay in full. How can we be sure that the insured payments on an annuity and on a life insurance contract, due decades in the future, can be reliably counted on?

Well, we can’t, but the same goes for any promised payments, even those promised by the U.S. government. Every investment has a risk. The question is, how big is that risk?

In the case of annuities and life insurance, the risk can be assessed and minimized. Annuities are offered by large well-known insurance companies like Prudential, Metropolitan Life, Principal, and Mutual of Omaha. That doesn’t guarantee they’ll be able to pay—just look at AIG, an even bigger insurance company, and its CDSs—but it helps. Also, these insurance companies are rated by the same ratings agencies that rated CDOs: Moody’s, S&P, and Fitch, and also by A. M. Best, which rates only insurers. Granted, faith in ratings was severely undermined by their role in the financial crisis, but it helps to check the ratings of your insurers anyway.

Joe Tomlinson, an actuary and financial planner, looked into the question of the safety of annuities in an article in Advisor Perspectives.10 He found that the payment of annuities is backed up by U.S. state Life and Health Guaranty Associations, as well as a nationwide coordinating body for guaranty associations, the National Organization of Life and Health Guaranty Associations (NOLHGA).11 States cap the amount of the guarantee, with $250,000 of the premium being a common cap. Tomlinson concludes, “History shows that annuities have traditionally been an extremely safe investment. Insurance company insolvencies have been few, companies in trouble have often sold business to healthy insurers, and guaranty associations have provided an additional safety net.”

In short, it seems reasonably safe to expect that an annuity will pay in full—about as safe as any investment short of United States Treasury bills—but it’s not absolutely guaranteed. The best thing to do is to divide up the annuity amounts so that each premium is less than the $250,000 (or sometimes $500,000) that your state of residency caps the guarantee.

What about life insurance? Suppose you’re 75 years old and you want to leave $250,000 to a grandchild whenever you die. You can’t be sure you can do it because you might run out of money first, if you live long. You could do it, though, with level term life insurance. With that kind of insurance, you pay the same amount every year, and the contract—you could make it for $250,000—pays off when you die. That way it just becomes another predictable cash outlay. For more information on calculating a mix of TIPS, annuities, and life insurance, see the 3 Rules of Investing website.

Other Possible Investment Vehicles

You don’t really need anything else besides what we’ve discussed so far: GIPS, global stocks, annuities, and term life insurance. (The latter two are, of course, only for individuals, not for institutional investors who are managing funds like pensions and endowments.) GIPS and global stocks cover almost the whole range of risk and return. That means you can select how much risk you want to take by combining those vehicles. Also, by combining GIPS and world stocks, you diversify your portfolio further, in a way, by splitting your risk between the risk of global governments failing and the risk of global corporations failing.

However, if there is little or no cost for adding them, a few other investment vehicles may occasionally increase diversification somewhat and reduce risk a little. You could also increase risk, if desired, possibly adding a little more expected return but also a greater chance of loss. What’s most important is that you shop for investment vehicles that carry a very low fee and then use them judiciously. Let’s explore a few examples.

Possible Higher Returns with Bonds, Real Estate, and Riskier Vehicles

To keep risk reasonably low but try to get a better rate of return, instead of government-issued GIPS, you could buy a diversified set of individual corporate bonds, holding them to maturity. (Unfortunately, as we mentioned earlier, inflation-protected versions of corporate bonds are generally unavailable.) However, in a true global economic disaster, they may be much less safe than government bonds.

History suggests that bond mutual funds or ETFs may not be very useful over investment horizons of 30 years or more,12 but for shorter horizons, low-cost bond funds could play a role. REIT funds (real estate investment trusts) can also help to diversify because they invest in real estate including land, buildings, homes, or farms. In the portion of your portfolio that is not guaranteed by GIPS, you could mix in some low-cost bond index funds and perhaps REITs to moderate the risk and price fluctuations of the more volatile global equity fund. Intermediate-term bond funds, with a shorter time to maturity, will fluctuate in value less than long-term bond funds, but they also will usually offer a higher return than short-term bond funds. To diversify globally, you should complement a domestic bond fund with an international bond fund.

Other ways to increase risk in hopes of getting a higher rate of return include, as we’ve already mentioned, buying a basket of risky stocks, one at a time, and holding them for the long term. There are also very low-cost mutual funds or ETFs that invest in riskier sectors of the stock market, such as emerging markets. You might opt for these if you’ve already controlled for the risk inherent in your other investment components.

“Socially Responsible” Investment

An increasing number of people have become interested in “socially responsible” investment—that is, investing in companies and projects that seek to achieve social and environmental goals.

Socially responsible investing is certainly no worse than other active stock-picking strategies. Strong arguments can be made why it is better than most, yet, conventional investment wisdom has long held that by investing in a socially responsible manner, investors give up something in investment return. This view is wrong, because the strategy of picking stocks by estimating whether they will benefit society in the future is certainly no less likely than any other stock-picking method to produce a good return. Nevertheless, like any active stock-picking strategy, socially responsible investing entails higher costs than passive investing—that is, investing passively in market index funds. Therefore, any would-be socially responsible investor needs to take those costs into consideration. However, at the time of this writing, socially responsible mutual funds are available at expense ratios (annual management expenses) less than 0.30%. Socially responsible funds may also be less diversified across industries than total market index funds.

Alternative Investments

Only very rarely is there an unconventional investment (sometimes called an “alternative” investment) that makes sense and is not too expensive to invest in. Normally they are too difficult to find, their fees are too high, and it takes too much effort to determine (if it’s even possible) whether they’re any good. The cost/benefit analysis of alternative investments is simply unattractive. As we’ve pointed out, no more than one in a thousand such products can provide any benefit.

Some more adventuresome readers, however, may want to play around with other investment vehicles in that part of their portfolio in which they’re willing to take more risk. If you can buy individual stocks, then why not other risky investments, if the cost of buying them is not too great?

An example of just such an investment appeared in a 2007 article about hedge fund manager John Seo. (A “hedge fund” is a basket of a variety of types of investments that is available only to private, usually very wealthy, investors, or to institutional investors like endowment funds and large pension funds, not to smaller investors. But remember that this does not by any means imply that hedge funds are generally better investments; see Deadly Temptation #6 in Part II.) Seo’s hedge fund consisted of “catastrophe bonds.”13 Catastrophe bonds (or CAT bonds) are issued to the public to cover claims that an insurance company may receive for damages from earthquakes, hurricanes, floods, and other large-scale disasters. CAT bonds really are an “uncorrelated” asset class, meaning there’s no reason an earthquake or tornado should hit at the same time as a market meltdown—there’s no correlation between these events. This quality makes CAT bonds a good way to diversify (reduce) risk. On top of this, Seo was not charging the usual sky-high hedge fund fees but way lower fees, just a fourth of a percent. If you can find an investment opportunity like this and then are willing to dedicate the large amount of time it takes to analyze it to make supersure it’s that one-in-a-thousand sensible deal—and its fees don’t obliterate whatever possible advantage you might get out of it—then go ahead and dabble in it. As long as it doesn’t put you at risk of not meeting your most basic goals, an investment like this could be worth your while. (It should be noted that at the time of this writing, CAT bonds are available for purchase only to institutional investors.)

Furthermore, if you’re a very wealthy investor or even the administrator of a large institutional fund like a pension fund or an endowment, you could consider investing directly in, for example, technology start-ups that could help to solve the world’s energy or water or health problems. It’s better to invest directly, by providing finances (capital) straight to the founders of a company, if you can, than through investment vehicles offered by the financial industry, like hedge funds or private equity funds, because you’ll avoid their high fees.

An investor who is sophisticated enough to know that 99.9% of the investments available are not worth thinking about at all can keep her mind open. Occasionally, there’s something worth considering, but frankly, you don’t really need it. GIPS and world stocks will do you fine.


1. You can ignore 99.9% of the investments offered by the financial industry and limit yourself to, at most, 10 specific low-cost investment vehicles.

2. The least risky of these vehicles is government inflation-protected securities, and the most risky is a low-cost world stock index fund or ETF.

3. In addition, if you’re an individual investor, you may consider simple annuities (though not other kinds of annuities) and term life insurance.

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