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.

But what is the purpose of investing? It sounds like a stupid question, but ask 10 investors, and you’ll get a surprising variety of answers. Is there an answer that allows us to conduct ourselves in a rational way that is not influenced by fear and greed?

Try this out. A recent biography on the world’s most famous investor is titled “The Snowball—Warren Buffett and the Business of Life.” The term “snowball” is a metaphor for a core investment concept: the law of compound returns. Understanding it is critical to your success as an investor and should be at the center of all your investment decisions.

Think of the law of compound returns as a force of nature that describes how wealth grows. A small snowball rolling down a hill will gather weight, which increases its speed, which keeps increasing its size. Wet snow and a long hill are the conditions that turn a snowball into a very large boulder. Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.

Trading, taxes, and fees. Management fees and taxes dry out your snow. A small difference can mean the difference between having a boulder when you retire, or a snowball. Have you checked the taxes you’re paying on your mutual funds? It’s probably taking 1 to 2 percent off your returns because managers change all the stocks out an average of once every 18 months. Mutual fund charges, broker, or advisors fees on portfolios average 2 percent. But index funds and ETFs run about 0.25 percent. You might not think that’s a big difference.

But here’s how it is. Take a $100,000 portfolio. Using the market’s long-term average growth of 10.4 percent a year, compounding your gains over 20 years, and deducting the 3 percent in fees and taxes, you’d have $287,928 after taxes. But if your fees and taxes were 0.25 percent instead of 3 percent, you would have $607,465. That’s over a 100 percent difference! That’s double your money. All based upon a tiny difference in fees and taxes of 2.75 percent.

How quickly will your money double? Einstein’s “Rule of 72″ says if you take your yearly percent return and divide into 72, you get the number of years it takes to double your money. Let’s start with $100,000. If you have a 9 percent return (divided into 72), your money will double in eight years ($200,000). In another eight years, you would have $400,000, and so on. But if you get a 6 percent return (divided into 72), your money will double every 12 years ($200,000). Within 24 years, someone getting 9 percent will have twice as much as someone getting 6 percent.

Here’s an answer to the initial question. Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming. Then you must help the law of compound returns work its magic. It is not to compete against the stock pickers and market timers on Wall Street—or even hire one to manage your money.

No one can give you a longer hill—your age and personal working situation define your time horizon. But you can keep your snow wet. Taxes, trying to time the market, paying large investment fees, and making investment mistakes interrupt the law of compound returns and lower your returns. They dry out your snow.

So when the market has ups and downs, remember that if positioned correctly, your portfolio will grow over time—capitalism demands a return. Your job is not to react to your fear and your greed, but rather to stay out of the way, remove the obstacles to the law of compound returns, and let this force work its magic on your money.

Today, the United States is facing its own Wimpy-esque moment in the form of the debt ceiling. The free burgers have flowed for sometime now, but the patrons have grown wise to the scam. The pitch of pushing off today’s payment until some future Tuesday has become a bit haggard and worn thin for many in America. Simply look to Greece, Portugal, Spain, and others to see what it is like to have one’s hamburgers taken away—and the forced diet does not look pretty.

Strangely, as the U.S. citizenry passionately criticizes their government for running up the budget deficit, a greater irony is afoot: When it comes to debt management, Americans are sadly worse than their government.

While government debt sits at 94 percent of national revenue, U.S. household debt sits at a whopping 107 percent of personal income. The household balance sheets of Americans are in worse condition than anytime since the Great Depression. The ratio of household debt-to-GDP is greater than anytime since 1929. And while we all are trying to comprehend a poorer nation, many American’s have not yet comprehended their own personal poverty.

A burger today? From the early 1940s through the late 1960s, an ethos of saving before spending ruled the roost. If you sought to buy a house, 20 percent was required for a down payment. Similarly, substantial savings were required to buy a car, and home furnishings, clothing, and more were paid for primarily with cash. By the 1970s, however, rampant inflation helped form a debt culture that found footing and gained steam.

If you saved, inflation threatened to erode the value of your savings, while the price of your desired purchases continued to rise. What was the point of saving when individuals could buy with little to nothing down, deduct interest from their federal tax obligations, and have those things they longed for?

Over the coming decades, American household debt ballooned, eventually doubling from $7 trillion to $14 trillion between 2001 and 2007. Debt fears, however, were assuaged by the rapidly growing value of real estate as homeowners used equity lines to buy more property, cars, and pay for vacations and toys. Burgers were flowing for all.

Then in 2008, the sudden and violent decline in house prices revealed just how bad the debt binge had been. Tuesday had finally arrived and like Wimpy, our wallets were a bit too thin to meet our obligations.

Feeding the furnace or building an engine. Criticizing government fiscal irresponsibility should in turn lead us to honest self examination. At the heart of this audit should be the confrontation of personal debt and the embracing of basic investing disciplines.

Each person must make a decision to feed the debt furnace or build a retirement engine.

Like Wimpy, we all experience the gnawing hunger to consume more than we need. Each time we reach out, through credit, for a burger today, we take our future dollars and throw them into the blazing furnace of consumption. The heat of the moment is delightful, but the end result is the poverty unfolding before our nation.

When we behave like wise and disciplined investors, we resist our pulsing appetites, take our hard earned dollars, and direct a predetermined portion to smart, long-term investments. In doing so, such investors build an engine through the miraculous power of compounding interest. Unlike Wimpy and other debtors, this interest works in your favor. Ben Franklin understood that for such savers, “Money can beget money, and its offspring can beget more.” Einstein called compounding the “eighth wonder of the world.”

Those who reject debt and invest wisely create a powerful engine, so that Tuesday’s obligations can be fully met on time, leaving a few burgers to spare.

Simply put, the law of compound returns says money left alone creates more money. Einstein said, “Compound interest is the eighth wonder of the world.” Ben Franklin echoed that thought, saying, “Money can beget money, and its offspring can beget more.” Warren Buffett’s partner Charlie Munger expressed a similar sentiment about money: “Never interrupt it unnecessarily.”

Think of the law of compound returns as a small snowball rolling down a hill gathering weight, which increases its speed, which keeps increasing its size. Wet snow and a long hill are the conditions that turn a snowball into a very large boulder. Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.

Your job as an investor is to find a level of risk that you can live with and then structure an efficient portfolio accordingly. Then you must let the law of compound returns work its magic.

No one can give you a longer hill, but your investment choices will determine if your snow is wet. Taxes, investment fees, and underperformance interrupt the law of compound returns and lower your returns. They dry out your snow.

Using exchange-traded funds can lower fees by 80 percent, which helps you keep more of your returns. But remember: Trading ETFs frequently can increase taxes and take a bite out of the snowball as it rolls down the hill. The less trading you do the longer you can defer taxes, which leaves more money to snowball year after year. After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate. And because most ETFs track indexes, you will never lose your money betting on investment themes that don’t pan out.

The “law of 72″ helps us understand compounding. Divide your yearly return by 72. The result is the number of years it will take for your money to double. Money doubles every 12 years with a 6 percent return and every eight years with 9 percent. That means if you are 40 years old, a $100,000 investment with a 6 percent return will double twice to $400,000 by the time you are 64 years old. At 9 percent, it will double three times to $800,000! If you achieve a consistent higher rate of return for many years, your wealth can snowball into a fortune. But you have to live some with volatility.

Inflation is the dark side of the law of compound returns and determines how your savings deteriorate over time. Assuming real inflation is 4 percent per year, with the law of 72 that means every 18 years prices double, and your money will buy half of what it did before. As an investor you fight the reality that 20 years after you retire your money will lose 50 percent of its buying power.

The law of compound returns is a slow, powerful, and largely invisible force that you can’t ignore. Because of how it operates with inflation, your money will be worth half of what it is today in 18 to 24 years. But if you can reduce your fees, taxes, and increase your returns by just 2 to 3 percent per year, you’ll double your savings in 24 years.

Think of the Law of Compound Returns as a force of nature that describes how wealth grows.  A small snowball rolling down a hill will gather weight, which increases its speed, which keeps increasing its size.   Wet snow and a long hill are the conditions that turn a snowball into a very large boulder.  Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.

If you achieve a higher rate of return for many years, your wealth can snowball into a fortune. For example, from 1925 – 2003 a portfolio of bonds smoothly appreciated an average of 5.4% per year (dry snow) snowballing to 61 times its original size, while a portfolio of US stocks appreciated 10.4% (wet snow), snowballing to over 2200 times its original size.    But higher returns require that you stomach large portfolio fluctuations.  During this period US stock investors endured depressions, wars and periods of stagnation, as the bond holders calmly clipped coupons and watched their capital depreciate.

Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming.   Then you must help the Law of Compound Returns work its magic.

At MarketRiders, we can’t give you a longer hill, but we can help keep your snow wet.    Taxes, investment fees, and underperformance interrupt the Law of Compound Returns and lower your returns.  They dry out your snow.

First, using low fee ETFs and investing with our software lowers your fees and increases your returns without assuming any more risk.  Second, deferring taxes lets more money continue to snowball year after year.  Trading in and out of ETFs can increase taxes and takes a bite out of the snowball as it rolls down the hill.  That is why we recommend ETFs that are well-constructed indexes that you’ll never have to sell.  After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate.  And finally, since ETFs mimic an index they will have good and bad years.   But, unlike an investment manager, an ETF will never lose your money betting on an investment theme that didn’t pan out.

Take a minute to play with this calculator to see how much your money will snowball given different rates of return and time horizons.

So when it comes to investing in any type of fund, be it index mutual funds, exchange traded funds (ETFs) or mutual funds, investors need to be their own advocate.  Do your homework to understand your true costs as no two funds are exactly alike.  ’Americans save trillions of dollars for college education and retirement by investing it with funds managed by industry and giants like the Vanguard Group and Fidelity Investments.’

If you are new to the game, beginners should brush up on Investing 101 basics. There are a lot of choices. Make the smartest choice for YOU.  Just remember, time is your friend.  Money spent on fees today, compounded over time, is money that could be sitting in your retirement account. Do your homework, you will thank yourself later!

Wall Street interrupts the Law of Compound Returns.  Wall Street would have you believe that you need to interrupt this force of nature with heavy-handed human intervention and hefty costs that drain away your investment. Working counter to the Law of Compound Returns, Wall Street dooms you to failure. But it will succeed in taking your money-if you let it.

So what is one to do?  Investing in low cost index funds, ultimately exchange traded funds,  and taking on a more passive investment style will allow your money to grow efficiently-without the oversized management fees and tax implications that are Wall Street’s bread and butter (and caviar and steak).  Diverting the 1-2% you have paid in fees over the years into your own pocket will over time be a substantial gain for you.

An example of compounding:
Let’s say you are 40 years old and invest $100,000. You earn a 9% return the first year, so now you have $109,000. You reinvest your $9,000 and it continues to earn 9%, so you have $118,810 by the end of the second year. If your investment keeps growing at 9% (and you don’t withdraw any of the gains), your money starts growing at an astounding rate.*  The same holds true for the 1-2% you would keep by managing our own money.  The percent itself may seem small but over time is significant in savings.

So for all you beginners to ‘do-it-yourself investing’, look to building a portfolio of low cost index funds or ETFs.  With a good asset allocation and attention to rebalancing your portfolio as needed, you will benefit with more retirement dollars to spend in the future than if you hired an advisor to manage your money for you.

* Of course 9% is just an example, but it is consistent with the average annual compounding rate of the U.S. stock market over the past (80) years.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.