Where Smart Investors Put Their Money

A major key to success is choosing low-cost and diversified investments.

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The following article comes from the U.S. News ebook, How to Live to 100, which is now available for purchase.

Being a successful investor is not about picking the right stocks, mastering some arcane investment vehicle, or guessing when the market will rise or fall. Success for most individual investors stems from investing at an early age, setting aside new investment funds on a regular basis, and seeking low-cost and diversified investments that aim to equal but not beat market averages.

"The first thing to do about investing is to save some money so you have something to invest," says Princeton University economist Burton Malkiel. His trail-blazing 1973 book, A Random Walk Down Wall Street, documented the tiny odds of picking winning stocks and paved the way for today's reliance on low-cost index funds. "The savings that one does early in life is particularly important" in building wealth, he adds.

Often, when the economy and investment markets are uncertain, "people don't make their contributions or, what's worse, they cash out. It's very important to resist that impulse," Malkiel says. "Dollar-cost averaging," or investing regularly without regard for the markets' ups and downs, helps investors avoid buying high and selling low.

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When deciding where to invest, there are three basic factors to consider, says Christopher Jones, chief investment officer of Financial Engines, an online investment advice company. "The first [question] is what risk do you want to take with your financial investments? If you want higher expected returns, you will have to take on higher risks," he says. "There is no way to avoid that trade-off." Most studies show stocks to be the highest-return investment over the long haul, although they carry more risk. However, Jones says, the odds of stocks going up or down in any given year "gets closer to a coin flip."

"Risk is an area where people make lots of mistakes," Jones adds, especially when they take risks that are inappropriate at their stage in life. Spooked by the market meltdown, some young investors have become too conservative, loading up on bonds, and some older investors have sought riskier investments to make up for market losses.

The start of many people's investing experiences is in 401(k)s and other employer retirement programs. Within 401(k)s, target date mutual funds have become a popular and frequently recommended investment option. These funds reflect Jones' advice by automatically shifting their risk profile between stocks and bonds as their owners age. They are always issued in five-year time frames—2015, 2020, 2025 and so on—and each time period is designed for investors who reach retirement age during that period.

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Jones also recommends paying close attention to expenses associated with various investments. Over time, the difference in annual fund expenses can have a huge impact on the size of your investment nest egg, Jones says. Mutual funds typically charge between one-tenth of one percent to twenty times that, he adds.

Actively managed funds can beat market averages and justify higher expenses, he notes. But it is hard to identify the winners, and the odds are that their managers will not be able to sustain those results. "The reality is that in any given time period, about three-quarters of the active managers out there will be outperformed by a passive index of investments," Jones says.

Passive funds aim to match market averages. Because the composition of index funds, such as those that track the S&P 500, is already defined, they are cheap to manage and have lower fees. In picking a passively managed fund, investors can choose between two types of funds: an index mutual fund and an exchange traded fund, or ETF.

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"Typically, ETFs are baskets of a portfolio that trade on a stock exchange just like a security," says Kevin Simpson, chief investment officer of Capital Wealth Planning in Naples, Fla. The major difference between an ETF and a mutual fund is that ETFs can be bought or sold at any time during the trading day, while mutual funds can only be bought or sold once a day after the close of trading.