 that we can share going forward with beginners as well. So we're gonna be starting at the beginning so nobody gets left behind basically. And one quick note on the material and how you're welcome to use it. I'll be posting the slides in our point MPDI format and you're welcome to email them to anybody, share them on the forum, use individual slides for any purpose you want. Basically use the material in any way that you want to. So there's three primary things that I wanna talk about tonight. The first one is what I call the building blocks, which is basically the primary asset classes. So the primary types of things you would be investing in. And then the primary types of accounts in which you would be likely to own those investments. Next we're gonna move on to constructing a portfolio, which is basically the actual nuts and bolts decisions that you have to make in terms of what you're going to include in your portfolio. And then I just wanna spend some time on what I call staying out of trouble, which is basically avoiding the common mistakes that I see investors to make both beginner investors and more experienced investors. So starting with the beginning, the building blocks. There's two primary asset classes. The first one is stocks. And I know a lot of you guys know this of course, but again, we're starting with the basics and we're gonna go through it pretty quickly. So with a stock, it's just a share of ownership in a business. And the way you make money when you own a business is that hopefully the business earns a profit. And when the business does that, in many cases, they will distribute that profit to the shareholders. That's called a dividend payment. And so you're just getting money from your shares basically. And the other way you can make money as a stockholder is that often when a business earns a profit instead of distributing it to the shareholders, what they will do is reinvest the money into the business itself with the goal of growing the business so that it becomes even more profitable in the future. And when they do that, as long as everything goes well, the business becomes more valuable and because you own a share of the business, your stock price will go up as well. So those are the two ways to make money as a stock investor through dividend payments and price appreciation. Just a quick note on terminology, stocks are often referred to as equities. It's just another word for the exact same thing. And the other primary asset class is bonds. And a bond is just a loan that you make to a borrower. So the most common types of bonds are treasury bonds where you are literally loaning money to the federal government. Then we have municipal bonds where you're loaning money to a state or local government entity. And then we have corporate bonds where you're loaning money to a business. And the way you make money as a bond investor is the same way that any lender makes money, which is through interest payments. The borrower is going to pay you interest. And bonds are in the category of investments known as fixed income. Basically anything that has a yield that is determined by a contract and agreement. So savings accounts, CDs, and bonds are all fixed income investments, although bonds are the primary fixed income investment for most portfolios. And that's it for asset classes. Mutual funds aren't technically an asset class, but they are still something that you definitely need to know about. The mutual fund is basically just a pool of money that is run by a fund manager. So basically what you're doing when you invest in a mutual fund is you are turning your money over to somebody else. And then that other person, that fund manager, they will choose how to invest their money. So they're making the decisions on your behalf basically. And a mutual fund owns a collection of other investments. So if it's a stock mutual fund, it's going to own a whole bunch of different stocks. If it's a bond mutual fund, it's going to own a whole bunch of different bonds. Balanced funds own some of both. And then there's subcategories of mutual funds. So there's mutual funds that only invest in a specific industry or that might only invest in stocks of small companies and so on. And mutual funds can be either actively managed or passively managed. With an actively managed mutual fund, the fund manager is actively trying to pick only the best investments. So if it's a stock mutual fund and actively managed stock fund, the manager is going to be picking or trying to pick the stocks that have above average performance basically. In contrast with a passively managed fund, the fund is just trying to track the performance of a given index usually. Of course that raises the question of what is an index? And an index is just a number that reflects the performance of a particular group of investments. So the S&P 500 is a very famous index. You'll hear about it a lot. And what that index represents is just the performance of the stocks of 500 of the biggest companies in the United States. So an S&P 500 fund, it would be a passively managed fund because the fund manager isn't actively trying to pick the best stocks. They're just buying all the stocks that are listed in that index. It's a much more hands-off approach. And that's why we call it passively managed. The common use for passively managed funds is to track the total stock market or total international stock market or the total stock market. And the two most common types of passively managed funds are index funds and ETFs and we'll get into the details in a little bit. So the two big asset classes are stocks and bonds and the big difference between them is how much risk they involve. With a bond, the borrower is promising to pay you a certain amount of money every year as interest and they're promising to repay the principal at maturity so they're promising to repay the amount that they borrowed. And the key point here is that a bond is a contract. The borrower is contractually obligated to pay you money according to a specific schedule. Whereas with a stock, there's no guarantees because remember with a stock you just own a piece of a business and there's no guarantee that any business is going to earn a profit. So just expecting returns or basically hoping for returns. And because stocks have uncertain returns, they also have higher expected returns. And you can think of that this way. Basically anytime that you or anybody has money available to invest, you always have an option of buying a bond which would give you a predictable rate of return. So why would anyone ever buy a stocks with their unpredictable return? The answer is that stocks typically earn greater returns over an extended period. So this slide shows is the period the last 40 years basically from 1981 through 2020. You could think of this as somebody's whole accumulation stage if they started investing immediately after undergrad and retired at a typical age or maybe this is somebody's accumulation stage and their first several years of retirement. And what this shows, the blue line is the US stock market. The red line is 10 year of treasury bonds and orange line is short-term treasury bonds. And this shows if you had invested $10,000 at the beginning of this period in each of these three asset classes, this is how much it would be worth at the end of the period. And as you can see, stocks grew by quite a bit more than the bond investments. But stocks really do involve a lot more risk. And that risk, despite what the last 10 years have looked like it's not a hypothetical or theoretical thing. It's a very real world thing. And if you're a stock investor you will have to experience this at some point. There will be periods where your stock holdings just perform terribly. So this slide, for instance, is the year 2000 through 2002. And in case you don't remember that's the dot com bubble first thing. Internet related stocks have gone up in value quite a bit in the late 90s and then people changed their minds about them and they and their stock market overall came crashing down. And the red line here is the Vanguard total bond market index fund. So it represents the US bond market. And the blue line is the Vanguard total stock market index fund. So it represents the US stock market. And what you can see is that over these three years bonds did fine. They actually went up in value by 30%, which is pretty good a few years for bonds. And stocks lost almost 40% of their value. And it's worth noting that this is three years. So if you're a stock investor during this period you watched your stocks go down for a year. And then another year and then another year. And a lot of people during at some point later in that window 2001 to 2002 they basically gave up on stocks. They said, forget it, I've had enough. They pulled their money out of the stock market and moved it into cash or moved it into bonds. And that's unfortunate because when they did that what ends up happening is that when the stock market recovers their portfolios didn't recover because they were left in cash or just bonds. They weren't there invested in stocks when the stock market went back up. And this slide here it shows the period from October, 2007 through February, 2009. So this is the global financial crisis. And here again, the red line is bonds. And you can see that they held their value pretty much. And the blue line is the US stock market. And you can see that it lost about half of its value. And that's the nature of being a stock investor. There are periods like this that you just have to be ready and willing to accept them. People are often referred to it as the price of admission for stocks. Basically you just have to be willing to wait it out so that when the market does come back your portfolio will come back. And so that's the way that you can earn the greater returns that stocks typically earn over an extended period. And another key point here is that this was the last bear market that we looked at was three years. This one was only a year and a half. You don't know when it's actually going on. You don't know how long it's going to last. And you just have to be willing to wait it out basically. So that's it for the primary asset classes and the differences between them. Moving on to the primary types of accounts. We have taxable accounts, traditional IRAs. An IRA generally stands for individual retirement account. Sometimes it stands for individual retirement annuity or individual retirement arrangement. But the key point is just that these are retirement accounts. Then we have Roth IRAs, 401Ks and 403Bs and Roth 401Ks and 403Bs. And a taxable account is basically anything that isn't one of those other special types of accounts. So a regular savings account is a taxable account. Or if you go to a brokerage firm website and open an account and don't tell them that you want it to be one of those special types of accounts, what you'll have is a taxable account. And we call them taxable because the income they earn in those accounts is generally taxable. So the interest is taxable. There are some exceptions that's kind of beyond the scope of our discussion right now. But for the most part, you have to pay tax on interest that you earn in the account. Dividends are also taxable, but at a reduced rate. So you're paying a lower tax rate than you would for most types of income. And short-term capital gains are taxable at ordinary income tax rates. A short-term capital gain. A capital gain is when you sell something for more than you paid for it. That's why it's a gain. And in this case, it's a short-term capital gain because it means that you held the asset for one year or less before you sold it. And those are taxed at regular tax rates. Now we have long-term capital gains where in this case, it means that it's long-term because you held the asset for longer than one year before selling it. And those are also taxable as income, but they are taxed at a lower rate just like dividends are. So next we have the traditional IRA. And with those, there is a limit to how much you can contribute to that type of account every year. For 2021, that's the lesser of your earned income or $6,000 or 7,000 a grade to 50,000. And with the traditional IRA, in theory, at least the amount that you put into the account is deductible. However, if you have a workplace retirement plan, so 401K or 403B, which we'll talk about in a second, then depending on your income level, you might not actually get a deduction for the contributions that you make to the plan. The other big benefit, though, of a traditional IRA is that the money gets to grow tax-free while it stays in the account. So you can earn interest and dividends and you can sell things for capital gains and you won't have to pay tax on any of that as long as the money stays in the account. But then when you take the money out, we call that a distribution. Anytime you take money out of a retirement account and distributions from traditional IRAs are taxable as income. So basically you get the deduction when you put the money in, then it gets to grow tax-free while the money stays in the account. But then it's taxable when you take the money out. And if you take distributions before age 59 and a half, there can be a 10% penalty. There are various exceptions to that penalty. But the general idea here is that Congress created these accounts so that they would be retirement accounts. And they put this rule in place, basically, to discourage people from taking money out early. Next we have the Roth IRA. And they share a contribution limit with traditional IRAs. So $6,000 for 2021. So I need a right click on it, hold on. Yeah, use two fingers to click. Okay. And with the Roth IRA, you do not get a deduction for the amounts that you contribute to the account. But the account does get to grow tax-free, just like with the traditional IRA. And distributions of earnings, they're completely tax-free. If you're at least age 59 and a half, and this is a bit of a simplification, but as long as you've had a Roth IRA for five years, if you take money out early, if you take earnings out early, there can be an end to it. And one important point about a Roth IRA is that the money that you put into it, the contributions, you can take that money back out, tax-free and penalty-free at any age. So if you're 23 right now and you put $6,000 into a Roth IRA this year, and then by next year, that's 6,000 has grown to 6,500. And it turns out that something comes up and you need to take money out. The 6,000 that you put in, you can take that back out tax-free and penalty-free, even though you're way younger than 59 and a half. It's only if you took out the earnings, if you took out the growth as well, that's where the penalty can come into play. And the ability to contribute to a Roth IRA, it phases out based on your modified adjusted growth income. So basically if you earn too much, you can't contribute to a Roth IRA. There's a concept called the backdoor Roth IRA, which is beyond our discussion here. But basically if you earn more than the limits shown on the slide, that's something that you should look into because it might be a way that you can effectively contribute to a Roth. Next we have the 401k plan, which is a lot like a traditional IRA, but it's through your employer. So basically the amount that you do to the account, it reduces your taxable income. So you get some tax savings this year and the account gets to grow tax-free. And then when you take money out, it's taxable as a distribution. So again, that's a lot like a traditional IRA, basically all three of those things. One big difference is that there's a much higher contribution limit. So it's 19,500 for 2021 or 26,000 if you're age 15 up. And another critical point about 401ks is that many employers offer what's called a matching contribution, which is where, as long as you put a certain amount it'll take me two minutes to fix it. Okay, hold on. So as long as you put a certain amount into the account, your employer is going to match that contribution. And that's a great deal because they're basically doubling your money for you. So it's a 100% risk-free, it's a 100% return that's risk-free, which is obviously better than you're going to get basically anywhere else. So if your employer offers a match, you wanna make sure to contribute at least enough to get that match. And for our purposes, 403B plans, they're basically the same as 401k plans. Everything we've talked about so far is the same with a 403B. 403Bs are just through different types of employers, so nonprofit employers and some government entities, whereas 401k plans are usually through businesses basically. And then just like with the IRAs, we have the traditional version and the Roth version, same thing with 401ks and 403Bs. And one point of note is that your employer doesn't necessarily have to offer a Roth option even if they offer a regular 401k or 403B. And the contribution limit for Roth 401k and 403B accounts is shared with regular 401k and 403B accounts. So it's 19,500 for 2021 or 26,000 at your age 15 up. And because these are Roth accounts, you don't get a deduction for the money that you put into the account, but it does get to grow tax-free. And as long as you're at least age 59 and a half, and as long as your first Roth contribution to the plan was five years ago, then the distributions are tax-free as well, including the earnings. One point of note about Roth 401k and 403B plans, remember just a minute ago, we were saying that with a Roth IRA, you can take your contributions back out tax-free and penalty-free at any time. That doesn't apply to Roth 401k and 403Bs. It's just Roth IRAs with a Roth 401k or 403B. Your money is going to be more tied up. And if you take it out before 59 and a half, you might have a 10% penalty. So that's it for the building blocks. We can pause here for questions if you want to or I can move on to constructing a portfolio and the nuts and bolts decisions that we have to make. Miriam, do we have any questions that we want to tackle right now? Oh, you're muted right now. I'd like to open it up to the green. I decided to open it up to participants for questions. If you have one for Mike, you can put it into the chat or raise your hand and we will unmute you and you can ask it out loud. Mike, I do have one question and that is, could you discuss exactly why a stock and a bond are different under the hood for your portfolio when you go into those terrible bear markets that you showed on those graphs? Why is the bond, why is holding some bonds? What is it doing to your portfolio? It looks like the bonds are just cooking along and the stocks are going way down. So my instincts tell me it's just leveling out your portfolio more, but why is that? Yeah, that is generally the ideal. We'll get to that in a second when we talk about asset allocation. But the reason is that bonds are a contract, right? The borrower is going to keep paying you interest throughout the period, even if the stock market is going down, I mean, unless the borrower defaults which can happen, but as long as you stick to high credit quality bonds, then you're going to keep collecting those interest payments year after year after year until the bond matures. So they provide a return that is mostly independent of the stock market. There are certainly some economic things that can affect both stocks and bonds, but it's a contract and the borrower is paying you interest every year. So the rate of return doesn't depend on the stock market, basically. So basically would you say that when you have these recessions and the companies are having difficulty, so the price of their shares goes down and even though it's a mutual fund because it's a mutual fund of stocks, it goes down, the value of each share goes down, so your value goes down, but in a bond, in a bond mutual fund also, the value of the bond may not even go, may not, doesn't go down necessarily, right? And because it keeps paying interest, it is actually keeping you afloat. Right, yeah, the bonds price, whether it goes up or down, it could be affected by whether the company or companies in question, if their credit rating changes, that would affect the price of the bond certainly and it's affected by interest rates in the market, but if you're holding a bond to maturity, you're just collecting those interest payments the whole time regardless of what the stock market is doing. And you're talking about for starting out investors owning bond mutual funds, not individual bonds themselves, is that correct? It's true with both because a mutual fund is owning individual bonds, that's what they are doing. So in either case, you're basically just receiving that interest over time and the prices of bonds can move up and down based on interest rates and changes in credit rating of the borrowers in question, but those fluctuations tend to be quite a bit less dramatic than with stocks and the primary part of the return is through interest and because that's a contract, it's very predictable. So we did receive a couple of questions. So one where bond owners are the creditors of the company, if a company goes bankrupt, do bond holders get paid? They often do. It depends on how the assets of the company. So when a company goes bankrupt, it doesn't usually have zero assets, it's got some assets left. And it depends on how the assets of the company compare to the liabilities of the company, but bond holders as creditors of the company, they are one of the first parties in line to get a share of the assets that the business still has. Whereas stockholders are basically the end of the line, if a company is going bankrupt, stockholders are usually getting nothing, but bond holders, they might not necessarily get the entire amount that they're promised, but they'll usually be getting something. Another question, what is preferred stock? Is this better than normal stock? That's a great question. Preferred stock, it's called preferred precisely because of the topic we were just talking about in terms of the order of if a company goes bankrupt, a preferred stockholder stands ahead of regular stockholders in line in terms of potentially getting some assets from the company. A preferred stock pay, it has a fixed amount of dividends that it pays, but it's not a contract like with a bond, the company can choose not to pay those dividends in many cases, but the amount of dividends that the preferred stock is supposed to pay, the company has to pay those dividends to the preferred shareholders before paying any dividends to common shareholders. So it's still an equity investment, but it's a little bit more like a bond than a regular stock is because they generally have a high level of income and it's a somewhat predictable level of income, but they still can fluctuate in value quite a bit just like regular stocks can and they don't necessarily pay anything just like regular stocks. So if I have a Roth 401k for longer than five years and then roll it into a Roth IRA, do I have to meet the five year rule again? Do you have to meet the five year rule again? For withdrawals, the penalty free withdrawals. In that case, it depends, it's the Roth IRA five year rule that we'd be concerned with then. So if that was the first time you opened a Roth IRA, then yes, but if you had already had a Roth IRA for 10 years or something and now you're rolling Roth 401k assets into it, then you've met the applicable five year rule. And move on or? Yeah, that's all the questions that I've seen. If anybody else has any questions posted in the chat. The only other question, Mike, is about ETFs. And is there a preference ETFs or mutual funds? Yeah, we're gonna talk about that in just a second. Oh, okay, okay. I had a quick question before you move on. Like you spoke about how interest is taxed at a higher rate than dividends. Is it marginally more or is it, are dividends much more favorable? Can you elaborate on that? Sure, depending on your income level, dividends sometimes are taxed at a 0% rate. So dividends can be, that would be, you know, quite different to 0% as opposed to the tax bracket that you're in. However, as your income level goes up your taxable income level, dividends will be taxed at a higher rate. But no matter your income level, dividends are going to be taxed at a lower rate than regular ordinary interest income. But the difference between the two, it's not a fixed percentage. So sometimes it's a big difference, sometimes it's a smaller difference. Thanks. And we did receive one more question. If you hold a bond to maturity, you're not affected by the price of the bond. How does this work with a bond fund that does not have a maturity date? Ooh, that's getting into something called the duration is what we're interested in. So the price of a bond is moving up and down based on changes in market interest rates. And the duration of the bond fund is going to tell you how sensitive the price of that bond fund will be to changes in interest rates. Basically, it's a rough calculation, but for instance, if a bond fund has a sixth year average duration and interest rates go up by 1%, then the price of the bond fund would go down by about 6%. So the average duration times the change in interest rates. And so the longer the duration of the bond fund, the more volatility you're going to experience in its value over time as interest rates move up and down. Can we go ahead? Yeah. All right. So constructing a portfolio, you're going to have to decide whether you want to use individual stocks and bonds or mutual funds. If you are going to use mutual funds, you need to decide whether they should be actively managed or passively managed. And you need to figure out what asset allocation you want to use. So the big question there is how much it's stocks and how much in bonds. So first question, individual stocks and bonds or mutual funds? And the answer, don't bother picking individual stocks. The reason for this is that the expectations for a company, they are already priced into the company's stock price. That's a complicated sounding thing. Basically what it means is that a stock's performance is not a function of how profitable the company turns out to be. It's a function of how profitable the company is as compared to what the market expected. A lot of people think that you just have to pick a profitable company to pick a winning stock. So they look and say, Amazon, Google, those are profitable companies. So surely those will be winning stocks going forward, but it's not that simple because to pick above average stocks, you don't just have to identify profitable companies. You have to identify companies that turn out to be more profitable than the market expected them to be. And that's tricky because the market is on average, pretty darn smart. It's made up of a lot of professional investors. And that's who you're competing against when you're picking individual stocks. Because every time you make a transaction, if you're buying, there's somebody on the other side of the transaction, there's somebody selling by definition. And if you're selling, there's somebody buying. And the way it works is that most of the transactions in the market are done by the parties that control the most dollars. So most of the time, the people you're competing against here are hedge fund managers, mutual fund managers, pension fund managers, and so on. And so you're competing against people who are probably at least as qualified as you are. And they probably spend more time doing this than you do. And they probably have access to information that you don't have access to because their company probably has full-time analysts providing them information or they're buying research from other companies that you probably aren't paying for. So it's a competition where the odds are really not in your favor. And when you use individual stocks, you're increasing the risk of your portfolio because if you use a mutual fund, it's really easy to pick a mutual fund that owns hundreds or thousands of stocks. Whereas if you pick individual stocks, you're probably not going to buy several hundred of them. You're probably only going to buy a handful. And so you're less diversified. And because of who you're competing against, you're not increasing your expected returns at all. So this is using individual stocks as a decision where you're increasing your risk without an increase in expected return, which is generally something that we want to avoid. If you're taking on more risk, you only want to do that because you're going to be getting higher expected returns. So most people should be using mutual funds rather than individual stocks. And then that leads us to the question of whether they should be actively managed or passively managed. And remember with an actively managed fund, the goal is for the manager to pick investments that are above average, right? And so we could ask how often are active managed funds able to actually do that? And as it turns out, the answer is not very often. Most actively managed funds perform worse than their passively managed counterparts. For instance, Morningstar put out a study that looked at the 20-year period ending in December of last year. And they asked, in each of these different categories of mutual funds, what percentage of actively managed funds, both A, survived through the period so they didn't get shut down by the fund manager and B, they outperformed the average passive fund in that category. And it turns out for US large cap blend funds, so that's actively managed funds that invest in large companies. There's only 12.8% succeeded for large cap value funds, so it was 16.8%, 11.3% for large cap growth funds, 8.7% for mid cap funds, 29.6% for small cap funds. So that's better, but still way below 50%. Much worse odds of, you're much less likely to succeed than to fail. And 14.6% for four in large cap blend funds. And then on the fixed income side, 9.7% for intermediate term core bond funds. So basically your odds of success with an actively managed fund, your odds of outperforming the average passively managed fund, they're terrible to put it frankly. They're really quite bad. Another way to look at it is you could say, within a given category of mutual fund, so international stock funds for instance, what would be the best way to pick a fund that is likely to be a top performer? And this is what Morningstar's Russell Kinnell, he's their director of manager research, here's what he had to say. This is from a 2016 article. He said, the expense ratio is the most proven predictor of future fund returns. We find that it's a dependable predictor when we run the data. That's also what academics fund companies, and of course Jack Bo will find when they run the data. Again, this is from a 2016 article before he passed away. So he's talking about expense ratios here. And the expense ratio is what the fund manager charges to run the fund. And with an actively managed fund, the expense ratios are higher because they're paying analysts basically, they're paying people to do all this research to try to pick the best stocks and best bonds. And with a passively managed fund, they're just buying all the investments that are listed on the given index. So it's a much more hands-off thing and you can do it with a lot less labor basically. It's less expensive to do. So passively managed funds have lower expense ratios. And from the article that the previous quote came from, what Russell Kennel did is he sorted funds into quintiles by expense ratio. And he asked for each mutual fund, what is the likelihood that that fund would survive and be a better than average performer? And basically what you can see here is that the more expensive the fund, the lower the likelihood. It was a 62% chance of success for the cheapest quintile of funds, then 48% for the next cheapest quintile and 39 and 30, then 20. So basically as the funds get more expensive, the less likely they are to be top performers. And the least expensive funds tend to be passively managed funds. So they're the most likely top performers. However, you don't have to worry about really small differences in expense ratios. If we're talking about 0.05% versus 0.07%, that's not the sort of thing that's likely to show up in the performance in any meaningful way. What you really wanna be focused on is if you have the choice between 0.05% and 0.5%, so 10 times as much, that's the sort of thing that's gonna make a big difference over an extended period of time. And if you're using passively managed funds, you'll have to decide whether you wanna use index funds or ETFs. And there's one important thing to know about this decision. And it is that it doesn't matter. It really doesn't matter. For most people, there are hundreds of financial planning decisions that matter more than this one. That's not an exaggeration. The differences or the advantage of ETFs, they let you use orders other than market orders. And if you're a new investor and you're wondering what is a market order and what is something other than a market order, you don't even need to look it up. You don't need to worry about it. You can if you want to, but it's not going to be important. Another difference is that ETFs let you place a trade during the day and have it executed right away, whereas with an index fund, the trade will be executed at the end of the day, which is that's gonna mutual funds work. And again, that's something that usually doesn't matter. ETFs sometimes have very slightly lower costs and that's an advantage, but again, it's pretty slight. And from one fund to the next, it might not even be true. So those are the advantages of ETFs. The advantage of index funds, basically they let you place round dollar amount orders. In some cases, you can't buy fractional shares of an ETF. So let's say you open Roth IRA, you put $6,000 into it and you want to invest all of that in a certain ETF. You might only be able to invest $5,990. You might have $10 left over sitting in cash because that wasn't quite enough to buy another share, whereas with an index fund, you can buy fractional shares. So you can invest the whole 6,000, but that's also a really small difference. So seriously, this isn't important. You could flip a coin to make this decision and then never worry about it again for the rest of your life and that would be fine. Moving on to our third question, which is what asset allocation to use? The big question here is basically how much of the portfolio should be in stocks, so risky stuff and how much of it should be in bonds, fixed income, safer investments. And this should be based on your risk tolerance. Your risk tolerance has two components. First, there's an economic component, which is basically how much risk you can afford to take. And then there's a mental psychological component, which is how much risk you can handle psychologically, basically, and on the economic side, for most people at the very beginning of their career, their economic risk tolerance is low because you need to get an emergency fund in place. Basically, you need a few months of living expenses and something safe before you start investing in something risky because you could get laid off, you can have an unexpected medical expense, an expensive car repair or something like that, and you need to know that you have some assets on hand to pay for that sort of thing. However, once you have an emergency fund in place, if you're early in your career for the rest of your assets, your economic risk tolerance is basically as high as it's ever going to be because if you aren't going to be spending this money until 30 years from now, the stock market could go away down next week or next year or next month, then that would be fine. It doesn't hurt you at all because all that really matters is what your account balance looks like 30 years from now when you actually are going to be spending the money. So early in your career, once you have an emergency fund, your economic risk tolerance is pretty high. The mental side of things just depends on your personal experiences and it depends on your personality. Some people are just naturally comfortable with more risk and some people aren't. And it's important to just try to know where you stand on that matter personally. What this slide shows, this data is from Vanguard. It basically shows just the average annual return for portfolios of different allocations. As we move down the slide, we get to riskier allocations, some more in stocks. And you can see that the average annual return over from 1926 to 2019, so a very long period, more stocks means higher returns on average. But then we look at the next column too and what that's showing is exactly what it says. It's the worst calendar year. So for this given allocation, how much did the portfolio lose in the worst calendar year on record? And you can see that the more money you have in stocks, the harder you get hit when the stock market goes down. It's pretty straightforward. But the idea here is you wanna try to pick an allocation that you can stick with, something that isn't going to exceed your risk tolerance. Because when you exceed your risk tolerance, it causes stress and anxiety, which is detrimental on its own, right? But then it can have very negative financial consequences also because just like we talked about when we were looking at a couple of bear markets earlier, if the market goes down and you start to panic, you realize you've exceeded your risk tolerance, you're absolutely not comfortable with the losses you're feeling in your portfolio right now. Then you take your money out of the market. Well, then when the market goes back up, your portfolio doesn't go up along with it. You're sitting there in cash. So you wanna pick an allocation that you can stick with even through the down markets. Now, we can next look at what a portfolio might look like in terms of an ideal group of holdings. A common theme on the Boglehead's form is the three fund portfolio. And I think it is a great idea. It's basically just a total stock market index fund or a comparable ETF and a total international stock index fund or a comparable ETF and then a total bond market index fund or ETF. And with just these three funds, you've got everything you need. Your portfolio will be extremely diversified because with those two stock funds, you will own literally thousands of companies from around the world. So massively diversified portfolio of stocks and your bond portfolio is going to be very diversified well with a total bond market index fund. So it's everything you need. And as long as you stick with funds from a reputable fund company, so Vanguard, Fidelity or Schwab for instance, it's going to be low cost as well. And it's simple, which is nice because it makes it easy to understand because there's, if the three funds here, they each represent something very tangible, the US stock market, international stock market and bonds. There's nothing isoteric or weird here. It's just basic things that make sense. You can understand why they're each there. And it's easier to maintain because with any portfolio, what eventually happens, right, you'll pick a targeted allocation, but then some part of your portfolio performs better than the other parts. So if this is the intended allocation, then it's going to be this. You'll have a little bit too much of something and a little bit too little of something else. So what you have to do is call rebalancing where you bring the portfolio back to its intended allocation. And if you only have three different holds, that's a lot easier to do. If your targeted allocation is 10 different funds and it's 11% of this and 3% of that, 17% of that and so on. Then it takes more math to figure out exactly how many dollars of each of those things you should have. And it takes more transactions to do the necessary buying and selling. So fewer funds makes that process easier. And if you want to, you can go one step simpler, which is to just use a two-fund portfolio where you're just using a total world stock index fund or an ETF. So then what you're doing there is basically, that's one fund that owns both the U.S. and international components. And then a bond fund. And that's it. And again, that's a very diversified portfolio and it's going to be very simple and extremely expensive. That would be a great portfolio in my opinion. And if you want to, you can go one step simpler, which is just use a target date fund. Those are the funds with a date in the name. So target retirement 2050 or something like that. And those funds hold an underlying allocation of other funds. And the idea is that over time, as they get closer to the date in the name, they move from an aggressive allocation to a more conservative allocation. An important point about these funds though, is that there's a lot of variation in the underlying allocation from one fund company to another. So if you were looking, for instance, if you looked up the 2035 fund from six different fund companies and you looked them up on Morningstar and then you clicked over to the portfolio tab so you see the actual asset allocation, they're not going to be the same as each other. There's going to be a fair bit of difference. So with target date funds, what you actually want to do is ignore the date in the name as crazy as that might sound. Just pick based on the allocation. You just want to look at the underlying allocation and pick the one that looks like a fit for your personal risk tolerance. Because you could find that even if you're planning on retiring in 2050, maybe the 2035 fund is a better fit or vice versa. So pick based on the allocation. And just like with any funds, pay attention to the expense ratio. Some fund companies have very inexpensive target date funds. Some companies have expensive ones. So if you can get a lower expense ratio, your target date fund is likely to be a better performer than if you have a high expense ratio. And that's the second part of our talk. Next we'll move into staying out of trouble. So just some tips for avoiding mistakes. We can stop here for questions if we want to. Sure, we have a few questions here. The first question we received, can you talk about 30 year treasury bond yields? And why is that a hot topic nowadays? Gosh, I don't honestly know why that's a hot topic nowadays. Because you know what? I don't pay super close attention to nominal interest rates. I pay much more attention to inflation adjusted interest rates. Sorry, can't help you. And why are those important? Why are those important? Because it's always real returns that matter. Inflation adjusted returns. They're, you know, go back a few decades to when I was a youngin' and we had extremely high nominal interest rates but we also had very high inflation. So in real terms, bond investors weren't actually doing any better. And if you're looking at after tax numbers, bond investors were not doing very well at all because the whole nominal return gets taxed. And so it's real returns that always matter. And so generally if I'm looking at interest rates, I'm going to be looking at tip shields rather than nominal treasury yields. All right. Next question. Do mutual funds or ETS report performance net of expenses? Yes. They should both be reporting performance net of expenses. So if they do, if two index funds report the same or similar performance and have the same or similar accuracy in tracking whatever index that they follow but with different expense ratios, why bother? Why bother picking, well, if two mutual funds, you've got two index funds in the same category and if you plot them both on a chart and they look like they're basically identical, they probably are. And you probably don't need to one as opposed to the other. Either one's probably going to be a perfectly fine choice. Okay. Let's see. Do I need a separate emergency fund if I have an invested taxable account that I can access when I need to? Well, I mean, that taxable account might be your emergency fund. You need to know that you have assets on hand that you can get to in the case of an emergency. Of course, as your portfolio grows, yes, absolutely just the bond part of your portfolio is your emergency fund and that's absolutely fine. All right, in reference to the three fund portfolio you were discussing earlier, do we need an international bond fund? No. You don't. With bonds, you don't need to diversify at all actually. You could just use treasury bonds and because one of the primary reasons we diversify with stocks is that any one stock can go to zero because the company can go bankrupt. With bonds, there's always the choice of treasury bonds which are backed by the treasury and you don't need diversification at all. If you're using corporate bonds, you do wanna diversify and that's why if you're using corporate bonds, you wanna use a total bond market fund. But no, you don't need diversification in bonds at all necessarily so you don't need an international bond fund and especially right now, if you compare Vanguard's total international bond fund, their total US bond fund, the yields on the international fund are lower and the fund has higher risk. So to me, it just doesn't seem like a very compelling argument. I have a question, Mike. Many investors think that index funds, if they invest in index funds, they will be investing and they will receive average returns that an index fund gives them average. But do I understand index fund just tracks an index? If the index goes up, your fund goes up. If the index goes down, your fund goes down. What the index fund is, is not average, it is following the index and keeping you out of trouble because you have not tried to beat the index, it's keeping you out of trouble. And also what you will never do is do worse than the index. You are the index. Never do worse than the S&P 500, you will always be at the S&P 500. Yeah, the idea that index funds are average is a sales pitch for actively managed funds. And it's, I mean, factually false. The overwhelming majority of actively managed funds do worse than their passively managed counterparts. We just look at those percentages. So the idea that, if you're looking at a fund that outperforms 84% of actively managed funds, I don't know how you would call that average. I mean, the 84th percentile is not average. So no, the idea that index funds will only give you average is, I mean, factually false. There's no ambiguity about it. They are better than average. And also on a target date fund, for young investors who are looking at their 401k, for example, and they see maybe 45 or 50 funds, they see a huge list of mutual funds. And they don't know what to do. And they just wanna move on with their life and just pick something that's good. A target date fund is great. And even if they just pick the target date fund for when they think they're gonna retire at 65, let's say, from a good fund company, which most 401k plans are, that would be sufficient until they learn more about investing and then maybe they would tweak it. Would you agree with that? Yeah, I think target date funds are a great choice for beginners and for people who aren't beginners. And I think target date funds are a very sophisticated way to invest, frankly. They are a brilliant conception that with one fund, you can own this extreme level of diversification. And as long as you're using a good fund company, low costs also. And that's a fantastic product. Yes, I think absolutely for people starting out, that's often a great way to go. And it's a perfectly reasonable choice for people who aren't just starting out. And also, since a target date fund, then glides down through your life until you retire, it glides down and asks at allocation automatically. The fund company does it for you. You don't have to decide, well, now that I'm 40 years old, I think I should be 70% bonds or should I be 20? Instead of making those decisions, if you really just want to invest it and not worry about it, the target date fund will take you into a more conservative asset allocation when you retire. Yeah, target date funds are low maintenance. They're not entirely hands off because you should still check it every once in a while to make sure it still owns the things that you hope that it owns. But they're very low maintenance. That's great. For that, I would add they're also rebalancing in between the recalibration that Miriam's referring to. So even before you get to the different asset allocations, you're rebalancing, which we know is critical. So Mike, I have a question for you for the going back to the first segment, the catch-up provision you mentioned where folks can contribute more to their IRAs if they're 50 or over. Is it that they're 50 by the end of the calendar year or 50 at the time of the contribution? So let's say someone contributes early in the year when they're not yet 50 and then they turn 50 late in the year. What is the rule around that? That's the end of the year. So as long as they're 50 by the end of the year. That's it. Yeah, it's the age at the end of the year that matters. In almost every IRA related case, it's almost always your age at the end of the year. And that's a general tax concept, marital status also. If you get married in the middle of the year, it's your marital status at the end of the year that determines your filing status. So for most things, there are some exceptions, but for most things, they're looking at the end of the year to determine how old you are and whether you're married and so on and so forth. Great. Shall we move on? So, okay. Sure. All right, so staying out of trouble, which is really just some tips for avoiding common mistakes. First, I would encourage you to try to keep a long-term focus. A lot of people check their portfolios every day and you don't have to. And in fact, you really probably shouldn't and you don't even have to check it every month because if you are, again, if you're 30 years from retirement, what your portfolio does tomorrow or next week or next month or even next year, it just doesn't matter. What matters is how much money is there on the day that you need to spend the money. And so you can have all sorts of volatility in the meantime and that can be fine. You don't have to worry about what's going on in the market over short periods of time. Also, I would encourage you to watch out for recency bias and your thinking. Recency bias is a cognitive bias that basically we all have as humans and it's the tendency to assume that whatever has been happening recently is what will continue to happen. And so the way that affects us with investing is that when the market has been going up lately, people just assume that that's what's going to continue to happen. And so like right now, when you've seen a whole bunch of years of good returns in a row, you see a lot more people who feel really good about stocks and they're very high stock allocations because they're just assuming that the market's going to keep going up. And then the opposite thing happens when the market's going down. People just, they feel bad about stocks because they assume it's going to keep going down. So you see people pulling their money out of stocks and both of those things are detrimental. You generally want to stick, pick an allocation that you can stick with and don't assume that whatever the market is doing right now is what it's going to be doing next week or next month. My next tip would be to automate your investing to the extent that you can. So with the 401k, you can sign up to have contributions made from every paycheck basically. And with an IRA, you can set it up with a brokerage firm so that a certain amount is taken out of your checking account and put into the account every month. And when you do that, you're automating your progress basically. A lot of people, what they do is they spend however much they spend and they plan to save and invest whatever's left over. But when you do that, a lot of times there isn't very much left over. Sometimes there's nothing left over. And so you don't actually make any progress towards your goals over time. But if you do it in the other order, if you automatically contribute every month, then you'll be forcing yourself to only spend the amount that you should be spending. And you will automatically be making progress towards your goals every month because you are saving every single month. And just like Yuri and Mary and we're both saying, target date funds automate rebalancing as well. So that's another thing you can automate if you want to. Every day, they bring the fund back to the targeted allocation. So that's another way that you can be hands off. And the more things that you automate with your investing, the less often you have to check your portfolio because there's fewer things that need to be done. And that's nice because it helps make it easier to not worry about all of that volatility from one day to the next. My next tip would be to ignore the financial news. The financial media's goal is just to get your attention because that's their business model. They make money based on advertising. So in the online world, they just want traffic. They just want you to click on their article. And in the TV world, they just want you to watch their TV show so that they can sell their ad spots for more. So every day, there's a flood of information. And recently it's been about Tesla and Bitcoin and GameStop. 10 years ago, it was about other stuff. 10 years from now, it'll be about other stuff. But the point is that there's always going to be this information just hitting you every day, millions of articles it feels like. And their goal is just to get you to click on it. So they sensationalize stuff. The headlines are written in a way to make everything sound really exciting or scary or important when it usually actually is not important. It's not important information to your actual financial planning. And if you can tune out all of that noise, it frees up time, right? Because you're not spending time reading nonsense, but it also frees up mental energy. And with that time and mental energy, you can focus on the stuff that really matters. So an investing that would be, are you saving enough every month? Do you have a reasonable asset allocation? Are you using low cost funds? Are you at least making sure to get the match in your 401K? And then there's a ton of other financial planning topics that are at least as important that don't have anything to do with investing. Like, do you have disability insurance? And if you have dependence, do you have enough life insurance? And do you have a will that names guardians for your kids? Stuff like that that's really important. And if you can ignore, not be wasting any time and mental energy, worrying about what your portfolio did today and what Bitcoin did today, if you can just ignore all that, you've got more time and energy to focus on the things that matter. And my last tip would just be to point out that there's no perfect portfolio. There's no perfect asset allocation except in hindsight. A lot of times when people first get started investing, or when they first find the Vogelheads, they get analysis paralysis. They get totally hung up on trying to figure out exactly the right allocation. Should it be 25% in bonds or 30%? And should it be 30% in international or 40%? And do I need a small cap value fund? And do I need a REIT fund? And do I need this? Do I need that? And that prevents you from making any progress because you're trying to get it exactly right. But you don't have to because there are plenty of good enough allocations. The three fund portfolio that we talked about, that's a great portfolio. The two fund portfolio, that's another really great one. A target date fund, as long as you check the allocation and make sure it's a good fit. That's also a really great portfolio. And any of those allocations, they're good enough to get the job done as long as you do your part. So as long as you're saving enough every month, and as long as you don't do something stupid, like take all of your money out of stocks after the market has gone down, those allocations they'll be fine. They will be good enough. And there's no best fund, except in hindsight either. A lot of people you see spend a lot of time trying to pick exactly the very best actively managed fund. But we don't know which fund will be the best actively managed stock fund over the next 10 years. We only know which one was the best over the last 10 years. But the good news is that again, there's plenty of good enough funds. If you stick with just the basic total stock market index fund, that's a good enough fund. The total international stock index fund, that's a good enough fund in that category. Just basic index funds or ETFs from a reputable provider, they're gonna have low costs, they're gonna be diversified. They're good enough, they'll get the job done. And so that's really all I've got. I hope we got some useful take place in terms of the building blocks of a portfolio and the actual decisions in terms of what to include. And then hopefully some useful tips for avoiding the common mistakes that we see.