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Read an Excerpt from The Smartest Investment Book You'll Ever Read

Inflation: The Natural Predator of Your Nest Egg

Retirees understandably worry about the stock market's gyrations. Who wouldn't, especially given the current unprecedented fiancial meltdown? But they don't spend nearly as much time fretting about inflation.

In recent years, inflation doesn't seem to have been much of an issue. For more than a decade, the nation's annual inflation rate has rarely inched above 3 percent. As 2009 began, economists were far more worried about deflation.

Yet even a seemingly innocuous inflation rate can flatten the cushion of a retiree's otherwise solid budget. When inflation is running at 3 percent, the value of $100 will plummet to $76 in just ten years. If you wait two decades, the value of that $100 is worth no more than $56.

It's easy to illustrate how destructive inflation can be if you look at hypothetical portfolios of retirees from twenty or thirty years ago. Today's retirees can easily live that long or longer.

I used the inflation calculator from the federal Bureau of Labor Statistics to see how much money a retiree would need today to match the buying power of an American who retired with a $500,000 nest egg twenty years ago. Thanks to inflation, today's retiree would require $924,695. (You can play with your own numbers at www.bls .gov/data/inflation_calculator.htm.)

The current crop of retirees will likely feel the pinch of inflation more acutely because it is likely they will have to spend more on medical costs, which have been rising faster than inflation.

Unfortunately, the only inflation indexing that most retirees can count on today is their Social Security checks, which provide an annual cost of living allowance.

Countless research has illustrated that conservative portfolios run the risk of running on fumes. One landmark study examined what would happen if an investor withdrew 6 percent a year from an all- bond portfolio. The study concluded that the investor had only a 27 percent chance of having anything left after thirty years.

As you contemplate how you're going to structure your portfolio in retirement, you'll want to plan to deal with inflation.

The solution— as hard as this might be to swallow in today's volatile markets— involves adding stocks to your portfolio. I'll discuss exactly how you should do that in Part Two.

What's the Point?
If you don't fortify your portfolio against inflation, you're likely to outlive your money.

Chapter 7

The Investing Secret Your Broker Won't Tell You

Index funds have a large following among institutional investors such as pension funds and insurance companies. Ironically, one of the most vocal advocates of index funds for individual investors is Warren Buffett, self-made billionaire and chairman of Berkshire Hathaway Inc. [who] made his fortune through individual stock selection.

— Richard A. Ferri, CFA, author of All About Asset Allocation

Indexing can make you feel like an investing genius.

Here are the major benefits of indexing:

• Market returns (which are superior returns)
• Low cost
• Broad diversification
• Tax efficiency
• Minimal cash holdings

Let's take a look at these more closely.

Market Returns

Index funds make a simple promise: Everybody who indexes will earn market returns minus low transaction costs.

Here's an example: If the S&P 500 index (the popular benchmark for blue chip stocks) generated a yearly return of 9 percent, you could count on the Vanguard 500 Index Fund, the Fidelity Spartan 500 Index Fund, or some other large- cap index fund to produce a return that's almost identical.

The goal of an index fund manager is to be a clone of a corresponding index.

When an index stumbles, so will its index fund. When the index is doing well, so will the index fund. Over time, stocks and bonds of every size and category have grown, which means index funds have too.

It is perfectly understandable if you're not impressed by "average" market returns. After all, it's far easier to tout the stellar returns of carefully selected actively managed funds. Unfortunately, these returns are almost always ephemeral. An actively managed fund can enjoy a streak of phenomenal luck— but nearly all actively managed funds eventually stumble. Their long-term (and even shorter- term) performance returns lag behind comparable index funds.

Why do proponents of actively managed funds struggle so much against those average returns?

These stock jockeys eventually smack into a brick wall called the "efficient market." Think about it this way: Wall Street is transparent— any news about any stock quickly makes the rounds, and the stock is adjusted accordingly. Consequently, it's almost impossible for professionals to outsmart all the other investors trying to beat the markets.

The difficulty of surpassing index returns on a sustained basis is even harder than it appears, thanks to something called "survivor bias." Every year, a huge number of actively managed funds go out of business. During one recent five-year period, according to Standard & Poor's, more than one in four stock funds vanished. The funds that disappear are typically the ones with terrible performance statistics. Fund companies will often get rid of the embarrassing funds by merging them into more successful ones.

With the dead bodies hidden away, the remaining actively managed funds look better than they deserve.

Low Cost and Lovin' It

Index funds are the cheapest game in town. The Vanguard 500 Index Fund, which is the nation's most popular index fund, charges shareholders just 0.15 percent to manage their assets. That means if you had $10,000 invested in the fund, your tab for the year would be a paltry $15. There are even cheaper class shares for larger investors. For a new shareholder who invests at least $100,000 in the Vanguard 500 Index, the cost would drop to 0.07 percent, or only $70 a year.

The typical mutual fund can easily charge ten times more than a comparable index fund. People don't appreciate that price gap, because the difference doesn't seem wide. A fund that charges 1.7 percent doesn't seem like a porker compared to one that charges 0.07 percent. In reality, the gulf is huge.

Let's suppose you invested $50,000 in a stock index fund that charges 0.20 percent in expenses, and your neighbor invested the same amount in an actively managed stock fund that charges 2 percent. Let's assume you both earned an annual 8 percent return before expenses.

A decade later, your index fund would be worth $105,964. The fund of the poor guy next door would be worth $89,542. Your neighbor's cost for holding this fund would have been $16,422.

Broad Diversification

Index funds hold more securities than actively managed funds. By diversifying the number of holdings, index funds reduce the risk of having a concentrated position in a smaller number of stocks.