First of all, I am not a professional stock picker. I am an independent investor who never studied business and never knew what he was doing in the stock market – except saying to myself, “I’m not paying some broker to do this for me and charge me on the front end, the back end, and every in and out in between.

Back to my story.

I used to think there were two options for my IRA: mutual funds and individual stocks. Bonds were out of the question. One of my friends told me, “Just say no to bonds.” And I figured bonds were for people 65 and over who had “retired” from trying to make enough money to retire.

I tried mutual funds for several years, and from 1994 – 2000 I did well. Looking back, it was a no lose environment. You could throw darts at the charts and hit winners. Janus, T. Rowe Price, Mutual Series – it didn’t matter!

But along the way, addiction set in. Those 20 – 30% profits were not enough. I got caught up in the exuberance of technology. I craved the highflying funds that were amped up on tech stocks. Well, around 2001, things went south and I lost big time.

Along the way, I had ventured into individual stocks. I reasoned,  “Stocks can go up 5% in one day. That’s more than a lot of mutual funds accomplish in a year. This is a no brainer.” I paid for the price for that, too. Clearly I did not have the genetic makeup to do well in the stock market.

Eventually, I came out of denial. It was time for recovery. No, I didn’t go to Betty Ford. I went to the sidelines. I dried out. Went into cash and some of the most boring big companies I could find. I thought dividends were better than nothing, so I tried parking in places like Procter & Gamble, AT&T, Boeing – you know the names. That was a step in my recovery. Then I had a financial awakening.

Around 2007 I learned about ETFs. “Wait. These are just index funds with a fancy name. I don’t have any trouble falling asleep. No Ambien in my medicine cabinet. Why would I go the route of index funds and commit my IRA to years of sloth and boredom?”

Then I learned about asset allocation, spreading my money around to various asset classes and periodically rebalancing. I found out about the law of compound returns and that it works if you stop trying to beat the market — lower fees and fewer mistakes! Is this really how it’s done?

I learned more about the ups and downs of ETFs – how owning a basket of stocks made sense. After all, market movements make money for managers, not individual stocks. That was an awakening for me. And I learned how markets moved in opposite directions. So if US stocks were on the outs, other indexes would probably be moving up.

So I tried this new approach, cautiously at first.  Just a few ETFs. Although I had never fretted over my IRA at 3 am, I noticed that I was not so preoccupied with my IRA. “Mad Money” was less interesting than the Lakers’ game. The Wall Street Journal was still interesting, but I was not reading the financial pages first. I wasn’t checking my portfolio two or three times a day.

Okay. My name is Miller and I’m a stockaholic.

I still own a few large stocks. I admit it –– I am not fully recovered. I still have a stash of McDonalds, Apple and a couple of other anonymous stocks.

But on the bright side, I am 90% in ETFs. I have US stocks: small, medium and large. Bonds: short, intermediate and long. Europe (bad for the moment), Asia, Canada. TIPS (which performed remarkably well last year) emerging markets, REITS, global real estate, gold and energy. I am diversified big time, with allocations appropriate for my risk tolerance, age and when I will retire.

I feel very comfortable with this arrangement. I don’t worry about the market. When I do check my portfolio, the “reds” are offset by “greens.” When one market is having a bad day, invariably the bonds or other markets pick up the slack. I’ve given up stocks for ETFs and gotten back my sanity.

Own stock markets, not stocks. Diversification means that you own enough stocks in a “market” so that no one stock can have any kind of major impact on your portfolio. Many brokers buy their clients 30 large companies and declare, “You’re diversified!” You know, all the usual big names. So how did that work out in 2008 when the largest U.S. companies, like General Motors, General Electric, Citibank and Bank of America, dominated a portfolio? Not so well. Do you subscribe to Netflix? Reed Hastings, its CEO, was often hailed as the next Steve Jobs until last July when Netflix began falling from $300 per share down to $75 this week¬—a loss of 75 percent. Big or small, individual companies blow up. And it happens suddenly. Want to minimize the risks that come from bad things happening to “good” companies? That means owning thousands of stocks.

Look inside most mutual funds and you’ll see 100 stocks, but for all the wrong reasons. To be a successful mutual fund manager, you must concentrate your bets on your favorite stocks. It’s the only way they have a shot at outperforming the market. But mutual funds with big Netflix positions are underperforming this year. So the typical mutual fund manager figures out over time that he can lose his job trying to be a hero and turns into a “closet indexer,” exchanging job security for any chance of beating his market (and justifying his fees).

That’s why we only recommend ETFs. They get you stock diversification and save you 80 percent in fees. Want to invest in small U.S. companies? Why pick a few good companies or hire a mutual fund manager? Just own one ETF and you’ll own literally hundreds of stocks. Netflix? Let it crash! You’ll never notice.

Spread it around. And consider this: There are other stock markets outside of the United States. Germans don’t obsess about our Dow. Half of all companies are outside of the United States. And world markets tend to move quite independently. Therein lies the second secret of diversification: What causes some to go up often causes others go down.

Yale professors studied money managers over 10 years to uncover the source of their portfolio performance. They found that 90 percent of the returns came from which markets they invested in. Less than 10 percent came from the individual stocks they bought and the timing of buying and selling investments. For example, if they owned small-cap stocks and that group of stocks did well that year, the performance of that market was the source of their success—not the specific small-cap stocks they had chosen.

Markets are the ingredients of successful diversification—and the more you have, the better. Diversifying into markets is kind of like creating a prized recipe. Garlic, lemon, oregano, and thyme are not too appetizing on their own. But when skillfully combined with a host of other ingredients, the results can be spectacular.

You want to own a host of diverse markets, and not just “safe” ones. Horseradish might be dangerous if consumed by itself, but as part of an overall recipe, it delivers positive results. The same goes for adding risky markets. Adding one or two to the mix can have a leavening effect that may actually reduce risk and volatility, while adding to overall performance.

U.S. stocks and stocks in Europe, Japan, and Australia tend to move independently from each other. So allocating money to all of these markets creates instant diversification. Emerging markets like China, Russia, India, Brazil also move to the beat of a different drummer. Bonds and real estate are even further afield from stocks, so adding these markets provides excellent diversification. Every year, some market wins and others lose, and no expert can predict the future. So the answer is simple: Own them all!

With the proper mix of markets—U.S. stocks of large and small companies, foreign developed countries, emerging markets, U.S. government bonds, real estate, and commodities (using ETFs for each of these markets)—you can consider yourself fully diversified. Now that’s a good salad!

Camped out in lower Manhattan for over a month, the protestors have spawned copycat events across the nation and abroad. While some identify with the frustration of youth trying to break into a job market that supplies a meager one job for every five seekers and a youth unemployment rate of 18 percent, others take issue with the movement’s anti-capitalist hysteria that seeks to penalize hard-working and productive Americans.

So what’s the fuss?

Behind all the brouhaha, however, there are some very real frustrations that all Americans, left and right, can identify with. How is it that politicians and bankers were in cahoots creating loose-money legislation and convoluted debt-backed securities that in turn were sold to the unsuspecting? How is it that trillions of dollars of government debt in the form of TARP, QE1, QE2, and beyond have been placed upon the shoulders of future generations to somehow resolve? How is it that some of the very bankers who were complicit in this disaster that destroyed the financial lives of millions of hard working citizens in turn made off like bandits? How is it that the Feds have embraced an inflationary exit strategy that threatens every hard-earned dollar you have saved and invested?

While protestors and non-protestors alike seek to place the blame for this travesty at the right doorsteps, these protests expose some deep assumptions about what is owed to us as citizens. These assumptions, once exposed, reveal some important lessons on investing as well.

Many of the protestors believe that they have a right to a well-paying job. And why should they not expect this basic opportunity? It has been the inalienable right of every American generation to date, spare the Great Depression, and therefore is deeply embedded in the warp and woof of the American mind. This assumption, however, is proving to be ill founded. While much of the third world can only dream of the minimum wage opportunities America affords, we have come to expect a middle-class life as a fait accompli for most, or at least the college educated.

The new reality is that the middle class is shrinking before our eyes as jobs flee to other nations whose middle classes are emerging. And gone the way of the shrinking middle class is the shrinking American Dream. Once assumed to be on tap for all hard-working citizens, this fount of prosperity and success seems to be running dry for many.

Who’s occupying your portfolio?

The new realities are just now beginning to sink in for many investors. You deserve nothing. Times have changed. You can’t just waltz your way into the American middle class anymore. You can’t rely on being a benefactor of past generations. The middle class is shrinking, and many who fail to work harder and invest smarter will be moved out while others in the world economy are invited in.

Additionally, you cannot look to Wall Street or the U.S. government to look after your retirement. It appears that Social Security will eventually fail. When it comes to The Street, we now know that many money managers will work to their own benefit, and if you happen to benefit along the way, you lucked out. If not, it’s your tough luck.

The critical question for today’s investor is, “Who is occupying my portfolio?” Is it an investment advisor? A fund manager? A small selection of equities and thus a small sample of fallible corporate directors and executives? When you look into the virtual room of your own portfolio, do you find yourself both present and vigilant? Sadly, many will find themselves strangely absent. Often it is because they are fearful of getting it wrong. Whether you are a do-it-yourself investor or an investor who delegates his funds to a professional, your presence in knowing what is in your portfolio, both in terms of fees and investment vehicles, and why is critical.

Additionally, at times such as these, the beauty of index investing is revealed. You can remove the advisor risk. You remove the money manager risk. You remove the individual corporate corruption risk.

You enjoy spreading your bets broadly across hundreds if not thousands of companies and are left to focus on what matters most in portfolio management—asset allocation. Now it is up to you to get globally allocated, remain disciplined with rebalancing, and behave like an adult managing something of great importance.

In the end, some may choose to set up camp in a tent, point a finger, and occupy Wall Street. I suggest you occupy your portfolio instead.

Unemployment. The U.S. government uses dishonest statistical skullduggery to calculate the “official unemployment rate.” Lying with statistics is easy. It is not how you count, it’s how you define what to count, and over the years both political parties have used this trickery.

When the government reports unemployment, it understandably excludes people that are under 16, institutionalized (in jail, hospital), are in the military, or retired. What many do not know, however, is that the government also excludes discouraged workers—people who want to work but have not been able to find a job and have given up looking after four weeks or longer. In this economic climate, there are many citizens who want to work but have taken an understandable hiatus from pounding their head against the wall of employment rejection. But by excluding all unemployed people who have not applied for a job in four short weeks, the unemployment rate is dramatically skewed downward.

A simpler way of looking at the unemployment story is through the often-overlooked employment-to-population ratio, or how many able-bodied adult Americans actually work compared to those that don’t. You may be shocked to learn that this number stands at just over 58 percent. There are many stay-at-home parents and others who are not interested in employment who should not be considered as unemployed, but to think that more than 4 out of 10 able-bodied Americans simply don’t have work is eye opening.

Inflation. What about inflation? Could it be that the governmentskews inflation number downward, too? The Consumer Price Index (CPI) is calculated monthly based on a basket of 84,000 goods. This sounds straight forward enough, but there is a twist. New methodology was introduced in the calculation of the CPI in which goods and services in the defined basket could be substituted. Some argued that if beef, for instance, goes up in price, consumers may switch to something cheaper like chicken. Therefore, items that are actually moving dramatically higher in price are switched out for “similar” items that are not inflating at the same dramatic rate.

Although there is a debate among economists on this new methodology, the renowned economist John Williams described this change as manipulative and suggested a return to the more honest and accurate fixed-basket methodology.

Why might the government prefer reporting a lower inflation rate? Could the fact that the government must make inflation adjustments to pension benefits, government entitlements such as Social Security, and even the returns on Treasury Inflation Protected Securities (TIPS) based on the CPI number? A higher number means much higher government expenditures.

Because the CPI is artificially skewed downward, it makes sense for investors to respond by adding to their TIPS allocation and other commodities such as gold and energy that help protect a portfolio from the actual rate of inflation.

Mutual fund returns. It is not just the government that may be trying to play you by the numbers. Take a closer look at your investment adviser and the mutual funds he may have sold you. When you receive your annual performance report from your adviser, note that most do not report the 1 to 1.5 percent fee taken from your portfolio annually.

Unfortunately, the story gets worse. Although mutual funds report performance after mutual fund fees, such reports do not take into consideration taxes—a kind of invisible fee. Although churning is against SEC rulings, according to Vanguard founder John Bogle, the average turnover for actively managed funds increased from 65 percent in 1975 to 90 percent in 2000. This buying and selling may help the fund report a higher return, but for the unassuming investor, the result is much lower performance.

Many of these churned stocks will create tax liabilities, some at short-term interest rates, reducing the performance of the fund significantly. When you add the invisible fee of taxes to adviser fees, it’s no wonder index funds and ETFs with low fee structures and tax efficiency are rapidly becoming the preferred investment choice for so many.

When it comes to investing, it pays to know the real numbers both in your portfolio and the economy. By having honest reporting, you can make informed decisions that protect and guide your retirement future.

In the last 80 years, stocks have returned about 10 percent, while bonds have returned about 5 percent. An average balanced portfolio should therefore return around 7.5 percent over a long time period. If you grow your money at 7.5 percent each year, you’ll double your money every 9 to 10 years. Let us call these “returns before advice and taxes.” This is the baseline.

Paying for investment help can be very expensive. If you pay mutual fund and advisory fees of 2.5 percent, you have a silent “business partner” who is taking a third of your 7.5 percent investment profits for advice. Over a 20-year period, unless these advisers are making up the difference, which is statistically close to impossible, you lose big money—slowly, quietly, and imperceptibly. Your account will grow in good years, but it won’t grow enough. Over time, you’ll notice that everything is becoming more expensive and your portfolio is “small” when years ago it seemed much larger.

If investment advice doesn’t do you in, taxes will. Mutual funds and advisers never report investment returns “after tax” because this would dramatically reduce returns. Most mutual funds are trading machines, generating huge amounts of short-term capital gains. But taxes are never factored into the advertising. Let’s say that federal and state taxes are 40 percent on short-term gains and 20 percent on long-term gains. You invest in two funds. Let’s call them the “Furious Trading Fund” and the “Buy and Forget Fund.” If Furious is up 15 percent, you’ll net 10 percent after tax. But Buy and Forget only needs to be up 12.5 percent, to net you same 10 percent after tax. Furious has to do 20 percent better than Buy and Forget just to get you to the same place!

Smart investors don’t pay much in taxes on their investments because they don’t trade in and out their positions. They spread their money around the world in different types of stocks and bonds in percentages based upon their objectives (called “asset allocation”) using exchange-traded funds (ETFs). They own a core portfolio with most of their net worth consisting of 10 to 15 ETFs to get nearly complete diversity in stocks, real estate, commodities, and bonds. Each ETF represents an entire stock or bond market that is an essential ingredient to a portfolio. They hold these same ETFs forever.

But this is far from “buy and hold.” Over time, the relative proportions of each ETF within the portfolio will need to change. If bonds are up this year and stocks are down, it is critical to trim bond ETFs and add to stock ETFs. People age and should start shifting more of the portfolio into bonds: same ETFs, different weightings.

Here’s where taxes are minimized. After owning a passively managed ETF portfolio for one year, all gains that come from selling the ETFs are taxed at long-term rates. And ETFs have a special tax structure that rarely generates taxable income except for dividends. By trimming and adding, you only incur a small amount of long-term tax, but the gains continue accruing tax-free. The smart investor tinkers around a few times a year, but never “gets in and gets out.”

If you keep Uncle Sam and Wall Street at bay, you can keep most of your returns. If you let them into your portfolio, you may well find yourself half as rich as you could have been.

And now just this week, FocusShares entered the game by launching 15 of the lowest cost ETFs ever offered in the public markets. (They also trade for free at Scottrade.) You can own the S&P 500 for 0.05 percent annually and no trading costs? What has Wall Street come to? Real value?

This revolution is good news for the everyday retirement investor. Gone are the days of having to sort through mutual fund brochures and Morningstar ratings. Now the big challenge is to analyze the free-trade allure to discover the best ETF building blocks worthy of their retirement dollars.

How should an investor decide which ETF to use? Should free trades trump expense ratios in making such selections? Here are a few things to consider when sorting through your ETF options:

Let purpose trump cost. The purpose an ETF serves in your asset allocation is more important than splitting hairs on cost. For instance, many of our MarketRiders portfolios concentrate on small-cap value stocks in a portfolio, even though these ETFs tend to have higher expense ratios. It is better to embrace the slight fee increase to achieve your desired asset allocation targets than to skip on the proper allocations in search of lower fees.

Understand the key areas of cost. Another important step in analyzing the value of commission-free ETFs is to understand the three main sources of ETF costs.

• Trading commissions. Most of the leading discount brokers charge around $8 to $10 a trade. If you have a globally diversified retirement account consisting of 14 ETFs and rebalance that account four times a year, you are making 56 trades. At $10 per trade, you are adding an annual $560 fee drag on your portfolio’s growth. For larger portfolios, these trading fees become less meaningful, but with smaller portfolios these fees can become significant. For example $560 in trading fees on a $500K portfolio represents less than .11 percent annually. On a portfolio of $50K, this annual burden dramatically increases to 1.12 percent.

• Fund expenses. While ETFs are run by sophisticated computers and have attractively low fund expense ratios, not all ETFs are created equal. When you look at the common indexes for U.S. large-cap stocks as supplied by the leading ETF providers, the fees vary slightly. Vanguard’s S&P 500 ETF (symbol VOO) costs 0.06 percent, while Schwab’s U.S. Large-Cap ETF (SCHX) costs 0.08 percent, State Street Bank’s SPDR S&P 500 (SPY) costs 0.09 percent, iShares S&P 500 Index (IVV) costs 0.09 percent, and now FocusShares Morningstar Large Cap ETF (FLG) costs 0.05 percent. A $100,000 investment in SPY versus FLG will differ a mere $40 annually because of their expense ratios. This is probably not a big reason to choose one ETF over another. The fund expense-ratio story can change, however, when you move into more specialized indexes. Take the emerging market index, for instance. While Vanguard offers MSCI Emerging Markets ETF (VWO) at 0.22 percent, Schwab offers its Emerging Markets Equity ETF (SCHE) at 0.25 percent, State Street offers SPDR S&P Emerging Markets (GMM) at 0.59 percent, and iShares offers MSCI Emerging Markets Index (EEM) at a whopping 0.69 percent. It is not surprising VWO just trumped the long standing emerging market leader, EEM, in assets under management, with an expense ratio differential of 0.46 percent and a great history of tracking the same index with excellence.

• Bid/ask spreads. While trading costs and expense ratios are easy for investors to understand, they often overlook a third cost: the bid/ask spread. The “ask” is the market price at which an ETF can be purchased and the “bid” is the market price at which an ETF can be sold. The bid/ask discussion can quickly become highly technical, but what investors need to know is that ETFs with lower volumes tend to have larger spreads, which essentially becomes another type of transaction cost. An ETF can trade for free, but because the ETF has poor volume, or weak market maker competition, the bid/ask spread can cost as much as the trading expense on larger transactions.

So what is the answer? Is it better to construct your retirement portfolio with commission-free ETFs offered at your broker, or to choose ETFs with the lowest expense ratios, or look at volumes and bid/ask spreads? Even with the three variables above, the answer becomes a very personal one that requires a bit of thought. How often will you trade? How much money is in your portfolio? Who’s your broker?

There is one conspiracy however, worthy of your attention: Those on Wall Street don’t want you to know that their industry is a sham. For Wall Street, the hypnotic malaise they cast over the unknowing investor is nothing less than an $11 trillion dollar shell game. Their gambit makes the baccarat table at the Bellagio look like the neighborhood lemonade stand.

And like any good shell game, they keep the pea moving so you never really understand what just happened. Hideous mutual funds vanish into thin air leaving only winners so that fund companies can claim their funds are leaping tall indexes in a single bound. High fees slip out the back-end of your account while you lie in bed asleep at night, thinking they got your back. And how about that reporting? It’s so convoluted you would have to be a Nobel Laureate in economics to even know what you made—or lost—after fees and taxes in any given year. Did you know that it practically took an act of Congress to force 401(k) providers to tell employees in plain language how much they are paying in fees?

Speaking of Nobel Laureates, fortunately there are a few that have been paying attention: Harry M. Markowitz, Merton H. Miller, William F. Sharpe, and Nobel candidate Eugene Fama, not to mention other notable luminaries such Princeton professor and author Burton Malkiel, John Bogle the founder of Vanguard, and William Bernstein, the acerbic author and truth teller. If you haven’t yet familiarized yourselves with their findings, the time has come to do so. They’ve blown Wall Street’s cover in reams of research. Never mind that they conclusively demonstrate that low-cost indexing beats active management by a long shot, or that the buy, hold, and rebalance style of investing trumps the vein-popping practices of Jim Cramer and crew.

Worse yet, the good guys’ PR campaign is weak. While they stutter in the corner, Wall Street is rolling out eloquent waves of hypnotic media, which roll over us as in a tsunami of minute-long TV ads, billboard artistry, and heart-grabbing radio spots. Each makes you want to pull out your hanky, pick up the phone, and call your mom to say you love her.

Who cares about facts when Smith Barney speaks? Why not talk to Chuck? He sure seems like a nice guy. His name is Chuck. Have you ever met a mean Chuck? Or what about the TD Ameritrade guy, Sam Waterston. He played stalwart Jack McCoy on the NBC series “Law & Order.” He sure cracked the code there, so he’ll be the guy I can trust for my retirement, right?

Yes, Charles Schwab, TD Ameritrade, and others are excellent brokers. For a fair, low price you can have excellent trade execution and fulfillment, as well as receive tremendous customer service and online reporting. But watch your pocket if you go to these firms for investment advice. Chances are they will roll out the four-color glossy print, full-court press, and slip you right into some mutual funds from their supermarket that drip, drip, drip away your hard earned savings in high fees and underperformance.

Conspiracy theories are for the birds. Ours, however, isn’t one of them.  Facts are for the discerning. When it comes to Wall Street, the facts have been revealed by the best economic minds in the world. Are you listening?

First, understand that 2010 was an excellent year in the stock market. Everyone should have made money. But did you make enough money to compensate for the risks you took? The only way to do this is to create a valid benchmark for your entire portfolio.

The common wisdom is to use the Standard & Poor’s 500 stock index as a gauge. But if you have a well-diversified retirement portfolio and own small-, mid-, and large-cap U.S. stocks, international stocks, real estate, bonds, and even commodities, the S&P alone is insufficient; it is only one of several indices of your portfolio. Judging a diversified portfolio’s returns just by the S&P is like grading a salad just by the lettuce. A salad is made up of many ingredients-and so is a portfolio. You have to measure the interplay of all components to find out if your portfolio achieved “market” returns.

To measure your portfolio’s results with a true apples-to-apples comparison, you have to compare it with a portfolio that includes all of the indices in your portfolio. For example, if you had 50 percent of your money in S&P 500 large-cap mutual funds and 50 percent in bond funds, you would average the 2010 returns of the S&P 500 and bonds, and compare that with your returns. If you did better than the average of these two indices, then you did well.

Our 2010 Report Card presents returns for five of our MarketRiders portfolios using ultra-low fee exchange traded funds (ETFs) from Vanguard, iShares, and State Street.  These all-ETF portfolios include different allocations to all industry-accepted asset classes as “baseline” portfolios as a way to benchmark 2010. They don’t have the fees that you’ll find in mutual fund portfolios, so we’re left with “pure” returns.

For example, in 2010 a 90 percent bond portfolio should have gained almost 4 percent with extremely low risk. In the worst month, this portfolio lost only about 1 percent. Alternatively, a diversified 10 percent bond portfolio should have experienced a robust 16 percent rise by the end of the year. However, to get to that point, investors endured a loss of more than 6 percent in the worst month-a one-year swing of 22 percent!

To see how your retirement portfolio performed in 2010, use the instructions on our Report Card and compare it to the returns of one of our five passive low-fee portfolios. If you are paying fees for managers to actively pick stocks and manage your portfolios, you now can see if you are getting your money’s worth. If you have a typical portfolio with these allocations that didn’t achieve these results, you are underperforming and might want to make some changes.

The tax basics. First, some tax basics for all types of funds. When you make a profit, you have to pay the government in the form of the capital gains tax. Capital gains rates differ depending on whether the asset is held less or more than a year, creating short- or long-terms gains. These tax rates vary depending on an investor’s income level, but generally, federal tax rates under the Bush-era tax plan can be as high as 15 percent for long-term and 35 percent for short-term capital gains. State taxes also apply.

Most ETFs also generate dividends, which are taxed. By meeting a specific set of holding criteria, long-term ETF investors will predominantly enjoy qualified dividend tax rates up to 15 percent with the exception of funds that track real estate investment trusts (REITs), which are unfortunately taxed as ordinary income. While both ETFs and mutual funds can generate capital gains, the tax implications of each are significantly different.

How mutual fund taxes work. Imagine that everyone in your neighborhood filed a joint tax return. What if your neighbor, Joe, happened to sell his business and you were required to pay a portion of his tax? Not acceptable, you would say.

Unfortunately, that is how mutual fund investing works. If one investor in the fund sells his position, the fund manager must sell underlying stock to give that investor his money back. That underlying stock may have a very low tax basis because it was added to the fund years before you ever invested. As a participant in the fund, you get hit with a portion of the tax consequence of the other person’s sale.

This mutual fund tax bomb grows daily and will eventually explode when rebalancing and redemptions force these low cost-basis shares to be traded. There have been instances where a mutual fund manager has held an underlying equity for years, accruing significant capital gains, only to eventually sell and foist a portion of the tax burden onto the new shareholder who just entered the fund.

That’s why looking at a mutual fund’s published performance is an inadequate measure for an investment decision. And unfortunately, there’s little visibility of the size of the boat anchor the fund is dragging in the form of excess taxes.

How ETF taxes work. ETFs are like mutual funds in that investors buy a broad range of underlying equities in one purchase, but they differ in that they are traded like a stock throughout the trading day. Capital gains taxes must be paid on ETF profits as well, but with a significant twist.

Although quite technical, simply put, ETF shares are created through an intermediary, a type of middleman that stands between the individual investor and the ETF provider. The ETF provider engages in “in-kind” transactions, trading baskets of securities for very large blocks of shares with the middleman.

As individual investors buy and sell shares of an ETF, a super-computer enabled arbitrage happens between the ETF provider and the middleman in the blink of an eye. Your shares are combined with the shares of other buyers and sellers that are traded for the underlying equities with the fund itself. In this way, individual investors never directly buy underlying taxable shares. This method allows the ETF provider to manage the tax bill for investors. In fact, this methodology is so effective that it is rare for an ETF to generate any taxable income at all.

Additionally, the cost basis of the underlying equities within the ETF is constantly being reset upward and at arms length from the individual investor. The result is wonderful. The ETF behaves like an individual equity in terms of taxes, but enjoys the diversification of a mutual fund–the best of both worlds.

For these reasons, ETFs are growing. In 2008, Morningstar conducted a survey on capital gains distributions for ETFs across 27 broad-based indexes over 5-, 10- and 15-year time horizons. The study showed only two ETFs made capital gain distributions over the past five years while just one ETF made distributions over the past 10 years.

As an example of their lower capital gains structure, iShares compared its ETFs with actively managed mutual funds in multiple categories over 10 years (2000 through 2009). The iShares Russell 1000 Growth Index Fund (IWF) had a capital gains rate of zero percent compared with 2 percent for the average, actively managed U.S. large-cap, open-end growth fund over that period. The iShares Russell 1000 Value Index Fund (IWD) also had a capital gains rate of zero percent compared with 2.9 percent for the average, actively-managed, open-end U.S. large-value fund over the decade.

Dumping your old mutual funds in favor of the more sophisticated and tax-efficient architecture of ETFs is like tossing out the old Motorola flip phone in favor of a new, 4G smartphone. The technology is simply better. Along with low fees and reliable performance, tax efficiency is another reason to get on the ETF bandwagon. You will be glad you made the change.

Gallup researchers have helped clear up this conundrum through a series of worldwide polls. The results have once again stirred interest in this ancient debate, answering with the discovery that annual earnings over $75,000 fail to add to an individual’s happiness. Thinking less about money and financial security-as opposed to net worth-also played heavily into an individual’s happiness.

Daniel Gilbert from the University of Liege took the Gallop finding further through his research into what is now known as the “experience-stretching hypothesis.” His studies demonstrate that when individuals experience greater luxuries, their ability to appreciate the simpler pleasures in life decreased incrementally. These findings put an ironic twist on the American dream of wealth and the good life. As Gilbert points out, just when someone has finally gathered the discretionary income to enjoy the finer things, he subconsciously trains himself to lose appreciation for the more common, daily pleasures.

Jonah Lehrer of Wired commented on these findings as well, stating, “Strangely, the more we indulge our desires, we strangely end up simply needing more. Discovering satisfaction-the ability to appreciate all we already have, is revolutionary.

Before you jump on the “money can’t buy me love” bandwagon, however, it is important to note that the findings revealed that money can, in fact, be useful in promoting well-being in several surprising ways. Here are four ways money can, in fact, buy you happiness:

Invest in index funds using asset allocation: Beware of the torrent of wealth managers pitching their Yoda-like prognostications, technical analysis wizardry, or insider stock tips. The Wall Street machine seeks to appeal to your greed glands and lure you into its complicated web of high fees and high stress. These active investment strategies fall short both financially and psychologically. Low-cost indexing, asset allocation, and regular portfolio rebalancing will empower you to reject the greed mantra and free your mind for the more important activities.

Give to charity: Charitable giving was shown to improve a person’s sense of happiness. When people freed up money to support a cause they believed in, their happiness rating increased. When you determine your asset allocation, you may want to practice the historic discipline of carving out some pre-determined portion of your earnings for charitable causes. Adding this giving principle to your portfolio’s allocation will provide an excellent return to your sense of well-being.

Invest in personal growth: When money was spent on personal or professional growth, an individual’s overall sense of well-being increased. Graduate studies, counseling, and other forms of development seem to pay great dividends in personal satisfaction.

Allocate to memory capital: Money may not be able to buy you love, but according to research, it can buy you great life memories. Researches call “memory capital” money spent creating outstanding experiences that will be savored over a lifetime. Such memories are revisited by individuals throughout the seasons of their lives, delivering an excellent psychological annuity.

In the end, research affirms what many intrinsically know. Materialism has its limitations, and money should be used both for retirement planning as well as for living. While global diversification through index funds and ETFs will aid retirement goals, allocating to charity, personal growth, and memory creation are also essential parts of a well-diversified life.