plaintalk€¦ · Dreaming of retiring early? ... Learn easy steps you can take on your own using...

G E T A F I N A N C I A L S T A R T

Investment Basics

financial skills for life™plaintalk®

Dreaming of retiring early? Saving for college? Trying to invest tax-

efficiently? Learn easy steps you can take on your own using clear,

candid PlainTalk investment guides. And when you’re ready for the

next steps, Vanguard can provide the expert consultation and advice

you need. For more information, visit www.vanguard.com/visit/plaintalk

or call 1-800-818-0084.

Contents

T H E V A N G U A R D G R O U P®

1 What Is Investing? Why Invest Regularly?Saving, Speculating, and InvestingThe Three Major Asset Classes

6 The Financial Markets Keep the Economy in PerspectiveSecurities MarketsMarket IndexesMarket Cycles

15 The Importance of Diversification What’s the Best Asset Allocation? A Lesson in DiversificationRebalancing Your Portfolio

17 Stock Investments What Is a Stock?The Risks of Investing in StocksInternational Stocks

22 Bond Investments What Is a Bond?Types of BondsInterest Rates and Bond PricesManaging Your TaxesThe Risks of Investing in Bonds

31 Cash Investments Types of Cash InvestmentsThe Risks of Investing in Money Markets

33 Mutual Fund Basics What Is a Mutual Fund?How Mutual Fund Investors Make MoneyAdvantages of Mutual FundsDisadvantages of Mutual FundsMutual Fund CostsTaxes and Mutual FundsActive Management and IndexingDollar-Cost Averaging

44 How to Select a Mutual Fund Step 1: Think About Your GoalsStep 2: Look at the Company Behind the FundStep 3: Double-Check Your CostsStep 4: Consider the Fund’s VolatilityStep 5: Examine Investment ReturnsStep 6: Build a Diversified PortfolioStep 7: Check Out a Fund’s PoliciesThe Six Rules of Successful Investing

T H E V A N G U A R D G R O U P

Foreword

You don’t have to be a genius to be good at investing.

You don’t even have to spend a lot of time on it. Lots of

people have built significant wealth over their lifetimes by

doing just a few things right.

Of course, you can always consult a financial planning

expert to help you get on the right track. And there will be

times in your life when that’s the right step—such as when

you are ready to retire or need to make a big financial

decision. When those times come, Vanguard can help.

But whether you seek help or go it alone, it pays to learn

the basics of investing. Knowledgeable investors are savvier

shoppers for investments and investment services. They

more fully understand the information they receive. And

perhaps most important, they’re better able to stick with

their investment plans through the inevitable ups and downs

of the markets—a key to building wealth.

This booklet is designed to make the basic concepts of

investing easy to understand—and perhaps pique your

interest in learning more. We hope you’ll keep it on your

reference shelf as you pursue your investment program.

1I N V E S T M E N T B A S I C S

Do you remember when you first

had money of your very own? That

satisfying jingle in your piggy bank?

That crisp new dollar bill? If you’re

like many Vanguard investors, you

grew up learning the importance and

discipline of saving. But what you

probably didn’t learn from your parents

or teachers is how to invest—how to

take some reasonable risks with your

money in hopes of earning the higher

returns necessary to more easily

achieve your financial goals.

For many of us, the concept of investing

can be intimidating. But the truth is

that with just a little effort, virtually

anyone can learn how it’s done. For

the sake of your lifelong financial

well-being, it’s important to make

that effort. And it’s a great idea to

get your family members—spouse,

parents, and children—involved if

you can. It’s never too early or too

late to develop the skills you need

to lead a financially savvy life.

Keep in mind that all investments

involve risk. The key to success is

learning how to invest prudently.

What Is Investing?

invest

2 T H E V A N G U A R D G R O U P

Why Invest Regularly?

What are your financial goals? Buy

a home? Pay for your children’s

education? Launch a family business?

Retire comfortably? Saving steadily

for your goals is a good habit to

develop. But investing your savings

on a regular basis is even better.

Investing consistently puts more

horsepower into your savings and

can put you on track to reach your

financial goals.

That’s because when you seek the

higher returns possible through

investing, you enjoy the effects of

compounding in a bigger way.

Compounding occurs as you continually

reinvest your returns, and those returns

earn their own returns, and so on. The

longer you invest, the more startling the

effects of compounding can become, as

shown in Figure 1 below.

Invest for the long term, and put

the power of compounding to work

for you.

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

5 10 15 20 25 30 35 40

Number of Years

25 30 35 40

People who keep their money investedthe longest enjoy the greatest effects of compounding.

In this hypothetical example, each personinvested $2,000 at the start of each year forten years and then contributed nothing more.The example assumes investment returns of8% a year before taxes; it does not representthe return on any particular investment.

Figure 1. The Longer You Invest, the Bigger the Boost


Saving, Speculating, and Investing

Most people understand that investing

involves taking some risks with their

money. But how much risk is

reasonable? To gain some insight,

consider the differences between

saving, speculating, and investing.

Saving

Saving money in a money market

fund or a bank account has its place in

everyone’s life. It’s important to keep

some ready cash available in case of an

emergency—and for those financial

goals that are coming up in the next

couple of years.

These types of accounts provide a

high degree of safety and stability.

But ironically, counting on savings

accounts—which typically offer modest

returns—to help you pay for long-term

goals is risky indeed. That’s because

your money may not grow fast enough

to keep up with inflation. Look at

how inflation erodes the assets in the

retirement account shown in Figure 2.

$600,000

$500,000

$400,000

$300,000

$200,000

$100,000

5 10 15 20 25 30 35 40

Number of Years

Nominal Dollars Real Dollars

When you calculate how much yourinvestments might grow over time, thetotal can be amazing—and deceiving. At first glance, you may think you’ll havemore than enough money to meet yourneeds. But when you see how inflationdecreases your purchasing power, youmay be in for a shock.

This illustration shows how investing$2,000 each year for 40 years would add up to $518,113 (nominal dollars),assuming an 8% annual investmentreturn. Good news! But now for the bad news: The prices of goods andservices will increase over the years as well (4% a year in this illustration).That means your $518,113 would buygoods and services worth just $112,234(real dollars) in today’s marketplace—probably a lot less than you thought.

This hypothetical illustration does notrepresent the return on any particularinvestment.

Figure 2. How Inflation Erodes Savings

$518,113

$112,234


Speculating

Speculating amounts to gambling, pure

and simple. It occurs when people take

risks beyond what they can afford in

hopes of making a killing—and it

comes in many forms. Speculators may

jump on a hot tip by buying a stock

without fully understanding it. They

might trade frequently or try to time

the market. They might concentrate

their money in just a few stocks or

specialized mutual funds, hoping

they’ve picked the next big winner.

All of these activities are types of

speculation, and they have little to

do with investing.

Investing

Investing is a thoughtful, prudent

approach to money management.

Successful investors take the risks

necessary to try to achieve higher long-

term returns, but they are disciplined in

their method. They set clear financial

goals, know how many years they have

to achieve their goals, think carefully

about their own ability to withstand

market volatility, and select investments

that match their needs. Just as

important, they invest additional money

on a regular basis, and they hold their

investments for years—even decades.

Investors understand that Rome wasn’t

built in a day.

To guide them, successful investors

develop a plan geared to their particular

goals, tolerance for risk, and personal

financial situation. Their plan helps

them decide what kinds of investments

to include in their accounts. With a

plan in place, they’re able to put their

investment program on “autopilot,”

which means they are less likely to

get derailed by emotions. Savvy

investors know that jumping in and

out of the market is among the most

counterproductive things they can do.

The Three Major Asset Classes

Investors typically build a portfolio

using a mix of stocks, bonds, and

cash investments. Here are the

characteristics of the three major

asset classes and the role each might

play in your portfolio:

• Stocks represent shares of

ownership in a particular company

and historically have provided the

highest long-term total returns. Over

the long run, stocks have typically

gained an average of about 10% a

year, helping them to stay well ahead

of inflation, which has averaged more

than 3% a year. But to enjoy these

long-term returns, investors have

had to brace themselves for sharp

declines from time to time, because

stocks have been more volatile than

bonds or cash investments.

• Bonds are, in essence, loans to a

government or company. They have

provided lower long-term returns—

an average of about 6% a year—than

stocks, but their returns usually have

been less volatile. Investors typically

invest in bonds for two reasons: for

interest income and to help smooth

the ups and downs of stock investing.

• Cash investments include bank

certificates of deposit, U.S. Treasury

bills, money market funds, and other

accounts that hold ready money.*

They have provided lower returns

than stocks and bonds—an average of

about 4% a year—but with little or no

fluctuation in price. All, or nearly all,

of the return from cash investments

consists of interest. Investors typically

use cash investments to stash money

that they want to have on hand for

emergencies or that they’ll need to

cover a big expense in the next year

or two.

As always in investing, remember that

past performance is no guarantee of

future results.


*Treasury bills are guaranteed as to the timely payment of principal and interest. An investment in a money marketfund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to losemoney by investing in such a fund. Bank deposit accounts and CDs are guaranteed (within limits) as to principal andinterest by an agency of the federal government.


The Financial MarketsWhen you become an investor, you

enter a dynamic environment where

many forces are at work. Market

cycles play out against a backdrop of

economic, social, and political events,

and many commentators can’t resist

trying to assign causes to every hiccup

in the markets.

But expert analyses frequently differ

widely, and for good reason. It’s often

impossible to explain market activities

until long after the dust has settled.

And since plunges and rallies may

be fueled by emotional responses to

events, short-term market moves can

defy reasonable explanations altogether.

Fortunately, day-to-day overreactions

tend to work themselves out over time

as prices adjust to fundamental business

and economic realities.

So what does this all mean to you?

Keep the Economy in Perspective

The direction of the economy is

certainly important. It affects the

financial markets as well as how safe

your job is, how your income may

grow, what things will cost you, and

how much interest you’ll pay to

borrow money.

perspective


The federal government tries to

influence the economy through its

fiscal and economic policy. The Federal

Reserve System, in particular, tries to

keep the economy growing and keep

inflation in check by regulating the

money supply and influencing short-

term interest rates. Consumers—and

their spending habits—also have a big

influence on the economy. Statistics

known as economic indicators track

such things as gross domestic product,

consumer spending, manufacturing

activity, inflation, productivity, and

unemployment, and help provide

clues as to the overall direction of

the economy.

However, as an investor, you probably

need to consider only one economic

question: Do you think that the

economy will grow over time, as it

has in the past? If so, then you need

not give lots of thought to the short-

term moves in the economy.

A lot of the daily news and

commentary you hear about the

economy and the markets often

amounts to little more than “noise”—

and if you obsess about it, you could

make the mistake of abandoning your

investment plan. Build a diversified

investment portfolio that will allow

you to weather the ups and downs,

and don’t let short-term economic

trends—positive or negative—throw

you off track.

Vanguard shareholders can stay

abreast of economic news with

Vanguard’s Economic Week in Review.

Register for your free e-mail copy at

www.vanguard.com/visit/econ.

quick t ip"


Securities Markets

If you watch television news, you’re

probably familiar with chaotic scenes

of traders on the floor of the New

York Stock Exchange (NYSE). While

that venerable institution is an icon of

the investing community, it is only one

of the ways securities are bought and

sold in the United States and around

the world.

Stock Trading

The NYSE—America’s best-known

exchange—was founded in the late

1700s to facilitate the buying and

selling of stocks. The NYSE still

operates in the traditional way:

Brokers shout out bids on the stock

exchange floor until they reach

agreement on a price.

While the NYSE facilitates its trading-

floor activities through computerized

trading systems, the Nasdaq Stock

Market conducts business solely

through a computer network. It has

no physical trading floor. The NYSE

and the Nasdaq have certain size,

asset, and earnings requirements for

companies who want to trade their

stock on those exchanges.

Other stock exchanges in the United

States include the American Stock

Exchange (AMEX), which lists

primarily small- and mid-cap stocks,

as well as exchange-traded shares of

mutual funds. There are also regional

exchanges in such cities as Philadelphia,

Boston, Chicago, and Los Angeles that

trade stocks of interest in their own

areas, as well as stocks that are listed

on other exchanges.


Bond Trading

Most bonds are traded “over the

counter” by dealers who buy and

sell over the phone or by computer.

Most bond buyers make their

purchases through bond brokers,

who generally maintain inventories

of various types of government and

corporate bonds that they use to fill

customer orders. But U.S. Treasury

bonds can also be purchased directly

from the Federal Reserve through

its TreasuryDirect program.

Market Indexes

Want to know how the stock market

is doing? Or determine how your

investments are performing against

the market as a whole—or a specific

market segment? There are a number

of indexes you can use.

The Dow

The oldest barometer of the stock

market is the Dow Jones Industrial

Average (DJIA), sometimes referred to

simply as “the Dow.” The DJIA tracks

the stocks of 30 major companies from

a variety of industries.

The companies included in the DJIA

have gradually changed over the years,

but to be included in the index, a

company has to be extremely strong

and considered a “market bellwether”—

a company whose stock is a good

indicator of overall investor sentiment.


Other Major Indexes

Even though they are large companies,

the 30 in the DJIA account for only

about 25% of the total value of all

stocks listed on the NYSE. So, many

investors watch broader market indexes

to gain a better feel for the overall

direction of the stock market or for

other market segments, such as bonds

or small- or mid-capitalization stocks.

Here are some of the more commonly

watched market indexes:

• Dow Jones Wilshire 5000 Composite

Index. The broadest measure of the

U.S. stock market, this index tracks

the stocks of virtually every publicly

traded company.

• Standard & Poor’s 500 Index. The S&P

500 is a market-cap-weighted index

of 500 leading companies chosen

by Standard & Poor’s to represent

the broad U.S. economy. Because

the companies included in this

index tend to be among the nation’s

largest, the S&P 500 is generally

considered to be a good benchmark

for large-cap stocks.

• Nasdaq Composite Index. This index

tracks the stocks traded through the

Nasdaq system. The index tends to

be more volatile than the S&P 500,

in part because a larger proportion of

the Nasdaq consists of big technology

companies, which tend to be sensitive

to economic cycles.

• Lehman Brothers Aggregate Bond Index.

This index tracks the overall

investment-grade taxable U.S. bond

market, including bonds issued by the

U.S. government and its agencies and

by leading corporations.

• Morgan Stanley Capital International

Europe, Australasia, Far East Index.

The MSCI EAFE Index tracks

more than 1,000 stocks from

more than 20 developed markets

in Europe and the Pacific Rim, and

is one of the primary benchmarks

for international stocks.


Market Cycles

Just as the economy as a whole

goes through cycles of strength and

weakness, so do the financial markets.

But though the economic and market

cycles are related, they often don’t

coincide. One reason: Investor

sentiment is generally focused on the

future of the economy, not the present

state of affairs. And to keep things

interesting, there’s a lot of interim

volatility that’s not directly attributable

to the economy—or anything else.

In any case, market ups and downs

can be extreme and unpredictable. To

be successful as an investor, you have

to learn to prepare for the unexpected

and not let your emotions derail your

long-term investment plans. Take

solace in history. Over the long haul,

the U.S. stock market has risen more

than it has declined, reflecting the

fact that the economy and business

activity have expanded and overcome

periodic downturns.

Bull Markets

Wall Street has long used the term

“bull market” to describe a prolonged

period of generally rising prices. While

bull markets can certainly be sustained

over long periods, the gains achieved

during these periods can occur in

spurts, catching investors by surprise.

In fact, by the time many investors

realize that a bull market is under way,

they’ve already missed out on a big

portion of the returns.

That’s why people who take a buy-and-

hold approach to investing usually do

better in the long run than their friends

who jump in and out of the market.

Figure 3. Recent Bear Markets: Stocks

Start of Bear Market Length (in months) Percentage Price Decline

August 1956 15 –21.6%

December 1961 6 –28.0

February 1966 8 –22.2

November 1968 18 –36.1

January 1973 21 –48.2

September 1976 17 –19.4

January 1981 19 –25.8

August 1987 3 –33.5

July 1990 3 –19.9

March 2000 31 –47.4

Source: Standard & Poor’s Corporation.


Bear Markets

If you’re going to be a long-term

investor, there’s no way around it:

You’ll come face-to-face with the bear

at least once, if not several, times. In

Wall Street parlance, bear markets are

the flip side of bull markets. There is

no one agreed-upon definition, but a

bear market for stocks is generally

defined as a decline of 20% or more

in broad market indexes over at

least a two-month period. And bear

markets can last far longer than that,

as you can see in Figure 3.

The worst bear market in history

lasted from September 1929 through

July 1932, when stock prices fell a

sickening 86%.

Bear markets also strike bonds.

When interest rates rise, bond prices

fall. Many factors affect interest rates:

Federal Reserve policy, the inflation

rate, economic growth, and investors’

expectations. As you can see in Figure 4,

bear markets in bonds can be every bit

as severe as those in stocks.


Bear Market Catalysts

Why do bear markets occur? One

reason is human psychology: During

bull markets, optimism about the

economy and market returns can

overrule caution. Businesses may

expand until there is overcapacity,

developers may build more offices

or homes than can be occupied, and

investors may bid up the prices of

securities. When reality doesn’t turn

out to be as good as the optimistic

outlook, prices can fall hard.

Political events or conflicts also can

touch off bear markets—or exacerbate

market trends that are already in place.

For example, in 2001, the terrorist

attacks on the World Trade Center

and the Pentagon sent an already weak

market on a further downward spiral.

Political and social factors aside, there’s

generally a link between economic

trends and market trends. Such factors

as increasing inflation, rising interest

rates, declining or stagnant corporate

profits, and high unemployment are

negative signals to investors.

Figure 4. Recent Bear Markets: Bonds

Source: Vanguard Fixed Income Group.

Length Percentage Price DeclineStart of Bear Market (in months) (10-year constant maturity)

March 1967 38 –23.0%

March 1971 54 –18.2

December 1976 39 –32.7

June 1980 15 –27.9

May 1983 13 –17.1

January 1987 9 –15.5

October 1993 13 –17.9

December 1998 13 –14.6


Investing During Different Market Cycles

One of the most common mistakes

investors make during bull markets

is to move more money into their

“winning” investments in hopes of

hitting it big. One of the most

common mistakes investors make

during bear markets is to lose patience

and sell the investments whose prices

are dropping.

So how should you react to market

cycles? If your reasons for investing

haven’t changed and you have a

balanced portfolio of stocks, bonds,

and cash investments, doing nothing

is usually best—in both bull and

bear markets.

Don’t make investment decisions based

on short-term market movements.

Stick to your long-term investment

plan. You may occasionally need to

rebalance your portfolio to maintain

your target asset mix, but you shouldn’t

abandon your plan.

Although this buy-and-hold philosophy

sounds simplistic, emotions can make it

difficult to follow. Here are a few tips

for getting through both the good times

and the bad:

• Maintain your balance. Hold a mix of

stocks, bonds, and cash investments

that’s tailored to your objectives,

time horizon, risk tolerance, and

personal financial situation.

• Continue investing regularly. Set up

an automatic investment plan or

make regular contributions to your

employer-sponsored retirement plan.

• Make changes gradually (if necessary).

If market conditions are making

it hard for you to sleep at night,

perhaps your risk tolerance isn’t as

great as you thought it was. To limit

the chance that your emotions may

be overriding a sound investment

plan, make any changes to your

portfolio gradually. And remember

that selling shares could result in

capital gains taxes.

• Tune out noise. Investors are

bombarded by unprecedented

amounts of financial news and

information every day. This

information can sometimes create a

senseless urgency to act. Successful

investors are able to tune out the

noise and keep their focus on their

long-term goals.


Deciding how to allocate your

assets among stock, bond, and cash

investments is the most important

investment decision you can make.

It largely determines how well your

portfolio will perform in the long run.

What’s the Best AssetAllocation?

No single asset allocation works for

everyone or every situation. To help

you decide what allocation is best for

you, consider these factors for each of

your goals:

• Time horizon. The more time you

have until you’ll need your money,

the greater your ability to weather

short-term declines in the prices of

your holdings. So if your time horizon

is at least ten years, emphasizing

stocks in your investment program

may help you achieve your financial

goals more readily.

• Risk tolerance. If you spend a lot of

time worrying whenever the stock

market takes a dive, you may have

too high a percentage of stocks in

your portfolio. While you probably

need to hold some stock investments

to help you achieve your long-term

goals, balance them with enough

bond and cash investments so that

you can sleep at night even when

markets are volatile. Develop an

investment plan you can stick with

through thick and thin, because

consistency is key.

• Personal financial situation. How secure

is your job? How much do you owe?

How much have you saved? If you

haven’t set aside enough money for

emergencies, short-term financial

problems could force you to tap your

long-term stock and bond investments

at an inopportune time, such as in the

midst of a market downturn. So if

your immediate situation looks iffy,

make sure you have enough short-

term bond and cash investments in

your portfolio to see you through.

The Importance of Diversification

When you’re ready to determine

your personal asset allocation, go to

www.vanguard.com/visit/createyourplan

and follow the easy steps.

"web link


A Lesson in Diversification

Shortsightedness can tempt some

investors to put too many eggs in one

basket. For example, after the enormous

gains in the stock market during the

1990s, some people began to think that

there was no point in investing in bonds

or cash investments, so they poured all

their money into stocks. Many came to

regret that move when the stock market

started tumbling in 2000.

As stock prices continued to fall

through 2001 and 2002, some investors

grew frightened or disillusioned and

sold their beaten-down stocks in favor

of bonds and cash investments. These

investors were caught in the trap of

buying high and selling low because

they weren’t prepared for substantial

fluctuations in stock prices. And

chances are that they were on the

sidelines when the stock market

began to rally again in early 2003.

By holding some bond and cash

investments all along the way, these

investors might have found it easier

to ride out the stock market’s

downturn. Keep in mind, however,

that diversification does not ensure

a profit or protect against a loss in

a declining market.

Rebalancing Your Portfolio

Once you establish your asset allocation,

you’ll want to review your portfolio

once or twice a year to make sure it

stays on track. If you find that your

asset allocation has drifted away from

your original target by more than

5%, you may want to rebalance your

portfolio to bring it back in line. You

can do this in one of three ways:

• Add new money to the asset

class that’s underrepresented in

your portfolio.

• Direct dividends and capital gains

distributions from the asset class

that exceeds its target to the one

that’s underrepresented.

• Shift money from one asset class

to another (although this may have

tax implications).

Rebalancing your portfolio can help

you become a disciplined investor

and keep your emotions out of your

investing decisions.


Of the three major asset types, stocks

have delivered the highest returns over

the long run. That’s why many long-

term investors make stocks the biggest

portion of their portfolios. But while

stocks as a whole have well outpaced

inflation over very long periods, their

tendency to suffer very steep declines

from time to time has often kept

investors off balance. Stocks are

volatile by nature, in part because they

closely reflect the constantly changing

prospects of the corporations that

issue them. But they are also affected

by investor psychology that can

fluctuate between extreme optimism

and deep pessimism.

What Is a Stock?

When you invest in a stock, you

become a part-owner in a corporation.

This ownership gives you the right to

share in that company’s future financial

performance—whether good or bad.

When the company is doing well, it

may decide to pay out some of its

profits by distributing dividends to

shareholders. Or it might reinvest

those profits back in the company in

hopes of increasing future sales, which,

in turn, may increase the value of your

shares. But what if the company runs

into trouble? Dividend payments could

shrink or disappear, and the value of

your stock investment could drop or

even be wiped out.

The combination of dividends paid

and changes in the stock price is what’s

called the stock’s total return. Dividend

income and capital gains are subject to

state and federal income taxes if the

stock is held in a taxable account.

When a stock is sold from this type of

account, any profit is taxed as a short-

or long-term capital gain, depending

on how long the investment was held.

Stock Investments


The Risks of Investing in Stocks

Before investing in a stock or stock

mutual fund, an investor should

understand the risks involved.

• Market risk. When you invest in

stocks, one of the most significant

risks you face is the volatility of

the overall market. Over the years,

stock prices have skyrocketed—and

plummeted—over relatively short

periods, but over the long run, the

upside has won out because corporate

profits and the economy have grown

over time. You can reduce market risk

by holding stock investments for a

long time—at least ten years.

• Specific risk. Concentrating your

portfolio in too few stocks or in just

one or two industry groups increases

your risk of losing money because

of troubles at one company or in a

single industry group. Stock market

leadership can switch suddenly among

sectors from, say, technology to energy

to retailing companies. And even great

companies with superb track records

can stumble or be affected by an

unpredictable development. You can

reduce specific risk by investing in

a mutual fund that holds the stocks

of many companies across a wide

variety of industries.

• Manager risk. Investment managers

can make good decisions that result

in market-beating returns—or they

can make bad decisions. You can

virtually eliminate manager risk by

investing in an index fund that seeks

to track the performance of all or part

of the U.S. stock market. In choosing

an actively managed fund, take a look

at the investment advisor’s years of

experience and track record. Has the

fund performed well compared with

its peer group and its benchmark

index? While there’s no guarantee that

future performance will be as good—

or as bad—you can at least get a sense

of whether the fund has been

consistently competitive.

• Investment style risk. Various types of

stocks—such as growth and value

stocks or large-company and small-

company stocks—can experience

cycles during which they do either

better or worse than the overall stock

market. Those periods have, in the

past, lasted for as long as several

years. You can reduce this risk by

making sure your investments

cover small, medium, and large

companies, as well as growth

and value companies.


International Stocks

Of course, the United States is not the

only country with a stock market. By

investing internationally, many investors

find they can lessen the fluctuations

in returns for their overall portfolios—

and sometimes improve investment

returns, according to Vanguard research.

That’s because U.S. stocks and

international stocks often experience

ups and downs at different times—

although there are times when they

move in sync, particularly during sharp

declines and rallies.

In return for the diversification that

international investments can add

to their portfolios, investors must

be willing to take on all the risks

of domestic stock investing, plus

some others.

• Currency risk. Investments denominated

in foreign currencies decline in value

for U.S. investors when the U.S. dollar

rises in value against those currencies.

Conversely, foreign investments rise in

value when the U.S. dollar weakens.

There have been prolonged periods

when the dollar weakened against

foreign currencies and others when

it strengthened.

diversify


• Country risk. Events in a specific

country—such as political upheaval,

financial troubles, or a natural

disaster—can drive down the stock

prices of companies in that country.

You can reduce (but not eliminate)

this risk by choosing an international

fund that invests in many countries

and has a strong focus on developed

nations.

• Liquidity risk. Sometimes foreign

stocks can be difficult to buy or sell,

in part because trading volume on

foreign stock exchanges tends to be

much lower than on U.S. exchanges.

Liquidity risk means the fund

manager may have trouble buying

or selling stocks without causing their

prices to fall or rise substantially. You

can reduce this risk by focusing on

funds that invest in many countries

and in those with well-established

financial markets.

International and Global Funds

An easy way to invest internationally

is to choose an international stock

mutual fund (which invests solely in

the securities of foreign countries)

or a global fund (which holds both

U.S. and overseas securities). Most

people who already hold domestic

stock investments in their portfolios

prefer an international stock fund to

avoid duplication of U.S. holdings.

Developed and Emerging Markets Funds

Some international funds select stocks

from many countries, while others

focus on a particular region or country.

Still others select investments from

countries that have similar economic

conditions—either developed markets

or emerging markets. A developed

country is a fully modern industrial

nation with a well-established stock

market—such as most Western

European nations, Canada, Japan,

and Australia. Emerging markets are

nations that are evolving from an

agricultural to an industrial economy or

from a government-controlled economy

to a free market—such as Argentina,

Indonesia, Hungary, and Turkey.

Not surprisingly, the risks are generally

higher in the emerging markets, where

governments and financial markets

may be less certain. On the other

hand, emerging markets offer the

potential for faster economic growth.


Vanguard suggests that your

international stock investments

amount to no more than 20% of

your stock portfolio.

quick t ip"


If stocks have historically posted

higher long-term returns, why invest

in bonds?

First, there’s no guarantee that stocks

will outpace bonds in the future. But

there are other reasons to hold bonds.

Bonds generally provide higher levels

of current income than most stocks,

which is important to some investors,

particularly retirees. Many other

investors include bonds in their

portfolios to help give them the

courage to stick with stocks through

the tough times. That’s because bonds

help to offset some of the volatility

of stocks since bond and stock prices

often move in opposite directions.

Even when they don’t, bonds tend

to be less volatile—and the regular

interest payments that bonds generate

can be very reassuring when stock

prices are dropping.

What Is a Bond?

A bond is simply a loan from the

bond’s purchaser (an investor) to

the bond’s issuer (a corporation,

government, government agency, or

some other institution). Typically, the

issuer promises to make regular interest

payments and to repay the face amount

(the principal) of the bond when it

comes due (reaches maturity).

The market value of a bond fluctuates

continually because of movements in

interest rates. Bond prices also can

move up or down because of changes

in the financial health of the bond’s

issuer. Because bonds typically offer

periodic payments of a fixed amount

of interest, they are sometimes called

“fixed income” investments.

If you invest in a bond fund, your total

return includes your interest income

(yield) and any changes in your fund’s

share price (capital return). Over the

long run, most of your return will

come from the interest income. While

changes to the share price of a bond

fund can be significant in the short

run, these changes tend to balance

each other out over time.

Bond Investments


Types of Bonds

Bonds are issued by a variety of

institutions, giving investors a range

of choices. Here are brief overviews

of some of the most common types

of bonds.

U.S. Treasury Securities*

U.S. Treasury bonds, notes, and bills

are considered the safest of all debt

securities because they are backed

by the full faith and credit of the

U.S. government. This means that the

government will use its full taxing and

borrowing authority, as well as revenue

from nontax sources, to pay the bonds’

interest and repay their principal.

Treasury bills are debt securities that

will mature in 1 year or less after being

issued, while Treasury notes mature in

more than 1 year and up to 10 years.

Treasury bonds mature in more than

10 years and up to 30 years.

Because Treasury securities are

U.S. government obligations, their

interest payments are not subject

to state or local income tax.

U.S. Government Agency Securities*

Some agencies that are owned, backed,

or sponsored by the U.S. government

also issue securities. The most common

of these are mortgage pass-through

securities such as those issued by the

Government National Mortgage

Association (GNMA, or “Ginnie

Mae”). Mortgage pass-through

securities are actually backed by large

pools of home mortgage loans. When

homeowners make their monthly

mortgage payments, money goes to

mortgage-servicing companies and

eventually to the owners of the

mortgage-backed securities.

Ginnie Mae securities are backed

by the full faith and credit of the

U.S. government, but the securities

of most agencies are not. Nonetheless,

bond professionals regard agency

securities as having very high credit

quality, meaning investors are very

likely to receive interest and principal

payments in full and on time.

*U.S. government backing of Treasury or agency securities applies only to the underlying securities and does notprevent fluctuations in the market prices of the securities.


Municipal Bonds

Municipal bonds, or tax-exempt

bonds, are issued by state and local

governments. Most municipal bonds

pay interest that is exempt from

federal income tax* and from state

income tax in the issuer’s state. Unlike

U.S. government bonds, which are all

regarded as being very safe, municipal

bonds offer different levels of safety,

depending on the financial strength

of the issuer. Some are regarded as

very safe, others less so.

Before investing in municipal bonds,

you should calculate your taxable-

equivalent yield to find out whether

taxable or tax-exempt bonds would

provide a higher after-tax yield

for your particular situation. Use

the formula on page 25 to help you

make a comparison.

Corporate Bonds

Like the U.S. Treasury, corporations

issue securities in a wide variety of

maturities, from a few months to

30 years or more. Unlike Treasury

bonds, corporate bonds vary greatly

in quality: Some are regarded as very

likely to pay all interest and principal

when due, but others are regarded as

less secure. Bonds that are considered

to be low quality (sometimes called

high-yield bonds, or junk bonds) pay

higher interest rates than bonds that

are considered more secure, because

high-yield bond issuers are more

likely to default, thus exposing their

buyers to greater risk.

*Although the income from a municipal bond fund is exempt from federal income tax, capital gains realized eitherthrough a fund’s trading or from your redemption of shares are taxable. For some investors, a portion of the fund’sincome may be subject to the alternative minimum tax as well as to state and local taxes.

Determine whether a tax-exempt fund

is a good choice for you with our Taxable-

Equivalent Yield Calculator. Go to

www.vanguard.com/visit/yieldcalculator.

"web link


*This hypothetical illustration does not represent the return on any particular investment.

%Your Taxable-Equivalent Yield

To find out if you would benefit from

investing in a tax-exempt bond mutual

fund, you should compare your taxable-

equivalent yield with the yield available

on a taxable bond fund with similar

characteristics.

Suppose a California investor were

considering two long-term bond

funds—a corporate bond fund yielding

6% and a California municipal bond

fund yielding 4.5%. Here’s how the

investor could figure out which fund

would pay more after taxes:

1. Convert her combined state and

federal tax rate (30%) to decimal

form: 30 x 0.01 = 0.30

2. Subtract the decimal figure from 1:

1 – 0.30 = 0.70

3. Divide the tax-exempt yield of 4.5%

by 0.70: 4.5 ÷ 0.70 = 6.4

4. Compare the 6.4% taxable-equivalent

yield of the municipal bond fund

with the 6% yield from the taxable

corporate bond fund. In this case, the

municipal bond fund yielding 4.5% is

the better after-tax investment.*

Remember, municipal bond funds

aren’t always the right choice. Some

investors, especially those in lower tax

brackets, may find that a taxable fund

would provide a higher after-tax yield.


Interest Rates and Bond Prices

One of the most important things to

know about investing in bonds is that

bond prices and interest rates move in

opposite directions. When interest

rates are rising, bond prices are falling.

And when rates are falling, bond prices

are rising.

Why do bond prices and interest rates

move in opposite directions? Let’s say

a person invests $1,000 in a 20-year

Treasury bond that has a 5.5% yield

(interest payments totaling $55 a year).

If interest rates rose to 6.5%, people

could buy new $1,000 bonds that pay

$65 a year, so no one would pay $1,000

for the older bond. In fact, its price

would drop to $889 in order for a buyer

to receive the same percentage yield as

the 6.5% bond. On the other hand, if

interest rates fell and new Treasury

bonds were offered with a 4.5% yield,

the price of the original 5.5% bond

would rise to $1,131.*

Share prices of bond mutual funds are

affected in the same way. In general,

the longer a fund’s average maturity

(the average amount of time until

each bond in the fund is repaid), the

more a bond fund’s share price (or

net asset value) is affected by changes

in interest rates.

*This hypothetical illustration does not represent the returns on any particular investments.


Credit Ratings

Independent bond-rating agencies evaluate the financial health of bond issuers and rate the creditquality of their bonds. Here’s how Moody’s Investors Service and Standard & Poor’s Corporation ratebond credit quality.

Investment-grade bonds (considered suitable for investors seeking to maintain a relatively high levelof credit quality in their bond portfolios)

Speculative, or “junk,” bonds (considered suitable for investors willing to accept additional riskand volatility)

Moody’s S&P

Aaa AAA Judged to be the best quality, carrying the smallest credit risk. U.S. government and U.S. agency bonds carry these ratings.

Aa AA Regarded as high quality. Together with Aaa and AAA bonds, they are known as “high grade” bonds.

A A Possess many favorable investment attributes and are consideredto be high medium-grade bonds.

Baa BBB Considered medium-grade—neither highly protected nor poorly secured.

Moody’s S&P

Ba BB Judged to have speculative elements; their future cannot be consideredwell assured.

B B Generally lack characteristics of a desirable investment.

Caa CCC Considered poor quality, with danger of default.

Ca CC Regarded as very speculative in quality.

C C Considered to have poor prospects of repayment, though the issuer maystill be paying interest.

D D In default.

Note: Moody’s applies numerical modifiers (1, 2, and 3) in some of its rating classifications. Themodifier 1 indicates that the bond ranks in the higher end of its category, 2 indicates a midrangeranking, and 3 indicates a lower-range ranking.

The Standard & Poor’s ratings from AA to CCC may be modified by a plus sign (+) or a minus sign (–) toindicate a higher or lower ranking within the rating category.


Managing Your Taxes

As an investor in bonds, you’ll want

to give some thought to taxes. That’s

because the bulk of a bond’s total

return comes from interest, and

interest is typically taxed as ordinary

income by the federal government

and by states that impose an income

tax. While bond prices do fluctuate,

capital gains (and losses)—which are

often taxed at lower rates—historically

account for a very small part of bonds’

long-term total return.

Investors can avoid paying taxes on

bond interest income by holding

their bonds in tax-deferred or tax-

free retirement accounts. Or they

can invest in tax-exempt bonds (also

called municipal bonds), which are

issued by state and local governments

and agencies, in nonretirement

accounts. Because interest paid by

tax-exempt bonds is not taxed by the

federal government or by the state

that issued the bonds, their pre-tax

yields are typically lower than those

of taxable bonds. (Capital gains,

however, would be taxed by both

the federal and state governments.)

Note: Because municipal bonds are

already exempt from income taxes,

they should never be held in a tax-

deferred or tax-free account such as

a traditional IRA or a Roth IRA.


The Risks of Investing in Bonds

Before investing in a bond or bond

mutual fund, an investor should

understand the risks involved.

• Interest rate risk. The prices of bonds

fall when interest rates rise, and they

rise when rates fall. The longer a

bond’s maturity, the greater the risk

of significant price fluctuations

caused by changes in interest rates.

You can reduce—but not eliminate—

interest rate risk by investing in

shorter-term bonds.

• Income risk. Income from bond funds

may fall because of declining interest

rates. Income risk is higher for short-

term bond funds than for long-term

funds because short-term bonds

mature sooner and that principal must

be invested at the new interest rate.

• Call risk. Some bonds can be called

(redeemed by the issuer before they

mature) whenever the issuer decides

it’s advantageous to do so. When

a bond is called, investors must

reinvest their money, often at a lower

yield. A similar risk—prepayment

risk—affects mortgage-backed

securities such as Ginnie Maes. When

interest rates fall, many homeowners

pay off their mortgage loans, so the

securities backing those loans must

also be paid off.

• Credit risk. Bonds can fall in price

if an issuer defaults or if a bond’s

credit rating is lowered. Sometimes

an event such as a merger, buyout,

or takeover can lead to a lower credit

rating. That’s because some corporate

restructurings are financed by the

issuing of a large amount of new

debt—a burden that could hurt the

company’s ability to pay off existing

bonds. Because a mutual fund invests

in many bonds, the credit risk from

a single default or rating change

is reduced.

• Inflation risk. The rising cost of

living may erode the purchasing

power of your investment over

time. For example, if inflation ran

at 3% for five years, the value of a

$100 interest payment would fall

to $86 in actual purchasing power.

• Manager risk. Many bond funds

are actively managed, meaning that

the investment advisor researches

various bonds and chooses which

ones to buy and sell. Manager risk

is the danger that the fund’s advisor

will make poor choices that lead to

losses or subpar returns for investors.


Vanguard® Total Bond Market Index

Fund offers bond investors maximum

diversification and low costs. The

fund seeks to track the performance

of the entire U.S. investment-grade

taxable bond market by investing

in a broad selection of short-,

intermediate-, and long-term bonds.

Call us at 1-800-818-0084 for a no-

obligation information kit.

quick t ip"


Thinking of buying a new car during

the next year? Planning on making a

down payment on a house soon? Or

are you setting aside money for some

unforeseen emergency?

Cash investments—very short-term

debt securities that pay a modest

return but maintain the value of the

investor’s principal—are appropriate

for any of those financial goals.

Types of Cash Investments

For individual investors, the most

common types of cash investments

are money market funds, bank savings

accounts, short-term CDs, and

U.S. Treasury bills. Of those, only

money market funds and savings

accounts offer real liquidity—the

ability to easily withdraw cash

immediately and without penalty.

Like bond funds, money market

funds invest in forms of debt, and the

value of such investments change as

interest rates rise or fall. However,

because these securities mature in less

than 90 days, the price changes are

very small. As a result, the managers

of money market funds have been able,

with very few exceptions, to maintain

a $1 share price.

While cash investments have been the

least volatile of the three major asset

classes, they also have provided the

lowest returns. That’s why some

investors, if they can afford to take

more risk, seek higher yields by

investing some of their emergency

money in short-term bond funds

(holding bonds that mature in 1 to

2 years)—even though their share

prices fluctuate modestly.

Is it time for you to set up your

emergency fund? You can open

a Vanguard money market

account online in just minutes at

www.vanguard.com/visit/openacct.

Or call 1-800-818-0084 to request

a prospectus and application.

"web link

Cash Investments


The Risks of Investing in Money Markets

Money market funds provide stability of

principal because they seek to keep their

share price steady at $1. But that doesn’t

mean they are risk-free. Here are some

risks to consider when thinking about

money market funds.

• Income risk. When interest rates

decline, a money market fund’s

yield will too. And that means an

investor’s income will fall. Because

money market funds typically react

to increases or decreases in market

interest rates more quickly than

bond funds, income risk is higher

for money market funds than for

bond funds. Of course, the reverse

is also true: When interest rates rise,

the yields of money market funds

tend to quickly rise in response.

• Inflation risk. Because money market

funds seek to maintain a stable share

price, they offer no opportunity for

capital gains. The rate of inflation

could be higher than the yield on a

money market fund for short or even

long periods, so the purchasing power

of your investment could decline.

• Credit risk. Money market investors

can lose money if the issuer of a

security defaults or its credit rating

is lowered. However, because a

money market fund invests in many

securities, the credit risk from a single

default or rating change is minimal.

• Manager risk. Money market funds

are actively managed, meaning that

the investment advisor researches

various securities and chooses which

ones to buy and sell. The manager

also can influence a fund’s results

by adjusting the average maturity

of the securities it holds to try to

take advantage of changes in market

interest rates. Manager risk is the

danger that the fund’s advisor will

make poor choices that lead to losses

or subpar returns for investors.


Investors who have the time, money,

and inclination can build a portfolio

one security at a time. But it’s not

easy. Identifying, researching, and

monitoring investments—and

keeping careful records—requires

a big commitment of time and effort.

Besides, to have a stock portfolio that’s

well diversified, some experts say you’d

need to invest in at least 100 stocks,

carefully chosen to include all major

industries and both large and small

companies. That’s why most people

prefer the convenience and instant

diversification that mutual funds

bring to their investment programs.

What Is a Mutual Fund?

The idea behind a mutual fund

is simple: Many people pool their

money in a fund, which then invests

in various securities. Each investor

shares proportionately in the fund’s

investment returns—the income

(dividends or interest) paid on the

securities and any capital gains or

losses caused by the sale of securities

held by the fund.

Every mutual fund has a manager

(also called an investment advisor) who

directs the fund’s investments according

to the fund’s objective, such as long-

term growth, high current income, or

stability of principal. Depending on

its objective, a fund may invest in

stocks, bonds, cash investments, or a

combination of these three types of

financial assets.

Mutual Fund Basics


How Mutual Fund Investors Make Money

You can make money in three ways

from stock and bond funds.

• Income returns from the fund. A fund

passes on to its investors the net

income from interest or dividends

the fund earns.

• Capital returns from the fund. When

a fund’s profits from selling securities

are greater than its losses from selling

securities, then it distributes those net

capital gains to investors.

• Capital returns from your selling of fund

shares. A fund’s share price—or net

asset value (NAV)—fluctuates along

with changes in the values of its

holdings. So you can make money by

selling fund shares for a higher price

than you paid for them.

Money market funds provide only

interest income. Because they seek

to maintain a stable net asset value

of $1 a share, they should not have

capital gains or losses.

Advantages of Mutual Funds

Mutual funds have become popular

among American investors because

they offer four real advantages.

• Diversification. A single mutual fund

can hold securities from hundreds or

even thousands of different issuers, far

more than most people could afford

on their own. This diversification

reduces the risk of a serious loss due

to problems in a particular company

or industry.

• Professional management. Few

individual investors have the time or

expertise to manage their personal

investments every day, efficiently

reinvest interest or dividend income,

and investigate the thousands of

securities available in the financial

markets. Most investors prefer to

rely on a mutual fund’s investment

advisor, who has access to extensive

research, market information, and

skilled securities traders—and who

decides which securities to buy and

sell for the fund.


• Liquidity. Shares in a mutual fund

can be bought and sold any business

day, so investors have easy access to

their money. While many individual

securities can also be bought and

sold readily, others are not widely

traded. In those situations, it could

take several days or even longer to

build or sell a position.

• Convenience. Mutual funds offer

services that make investing easier.

Fund shares can be bought or sold

by mail, telephone, or the Internet, so

you can easily move your money from

one fund to another as your financial

needs change. You can even schedule

automatic investments into a fund

from your bank account—or arrange

automatic transfers from a fund to

your bank account to meet expenses.

And most major fund companies

offer extensive recordkeeping services

to help you track your transactions,

complete your tax returns, and follow

your funds’ performance.


Disadvantages of Mutual Funds

As with any investment, mutual

funds come with some caveats, and

you should understand those before

you invest.

• No guarantees. Mutual funds are

regulated by the U.S. Securities

and Exchange Commission,

which requires funds to disclose

the information an investor needs

to make sound decisions. But unlike

bank deposits, mutual fund shares

are not insured or guaranteed by

the Federal Deposit Insurance

Corporation (FDIC) or any other

agency of the U.S. government.

The value of a mutual fund will

fluctuate (except for a money market

fund) so it’s possible for investors to

lose money if they sell shares for less

than they paid for them.

• Diversification “penalty.” While

diversification eliminates the risk of

catastrophic loss that would occur if

you own a single security whose value

plummets, it also limits the potential

for making a killing in the market if

that security’s value shoots up. And

importantly, diversification does not

protect you from a loss caused by an

overall decline in financial markets.


Mutual Fund Costs

Mutual funds can be a lower-cost way

to invest when compared with buying

individual securities through a broker.

However, a combination of sales

commissions and high operating

expenses at some fund companies can

reduce your investment returns. That’s

why it’s important to compare the costs

of mutual funds.

Here are the primary costs associated

with a mutual fund.

Sales charges. If you invest in a fund

with a sales charge, you might have

to pay a fee up front—called a front-

end load—as a percentage of your

investment, or you might have to pay a

fee when you sell fund shares, known as

a back-end load. A fund levying a level

load charges no front- or back-end

loads, but instead imposes an annual

fee in addition to operating expenses.

No-load funds have no sales charges.

Expense ratio. Every fund has an expense

ratio. This is money deducted from

fund assets to pay for annual operating

expenses, including investment advisory

fees, legal and accounting services,

postage, printing, telephone service,

and other administrative costs. In 2004,

the mutual fund industry average

expense ratio was 1.35%, according

to Lipper Inc.

The lower the expense ratio, the more

of its returns a fund can pass on to

its shareholders.

12b-1 fees. Some funds charge a 12b-1

fee to pay the fund’s marketing and

distribution costs. This fee, which is

incorporated into the expense ratio, can

include a sales charge to compensate

sales people.

Trading costs. Still another expense is

the cost of trading securities, including

charges such as brokerage commissions.

These costs are not included in the

fund’s expense ratio, but they reduce the

returns investors receive. Funds with

high turnover rates—an indication of

frequent trading activity—may have

high trading costs that reduce your total

return over time. Frequent trading also

may generate taxable capital gains.

Compare the costs of Vanguard

funds with those of other fund

families by using our “Compare Fund

Costs” tool at www.vanguard.com/

visit/costcompare.

"web link


Taxes and Mutual Funds

The profits on a mutual fund

investment are typically subject to

federal (and often state and local)

income tax unless you’re investing

through a tax-deferred or tax-free

retirement or education account.

In a regular taxable account, the

dividend income and capital gains

distributions you receive are taxed

each year, regardless of whether you

receive the distributions in cash or

reinvest them in additional shares.

Dividend (or interest) income from

bonds and cash investments is taxed

at ordinary income tax rates, while

qualified dividend income from

stocks is taxed at a lesser rate. Capital

gains distributions are taxed as either

short-term gains or long-term gains,

depending on how long the fund

held the securities. A fund that buys

and sells securities frequently may

add to your tax bill with hefty capital

gains distributions.

You also pay taxes on any capital gains

you incur if you redeem fund shares at a

profit. The rate is lower for long-term

capital gains, which are gains on shares

held for more than one year.

Active Management and Indexing

You can build a portfolio using

either actively managed funds or

index funds—or both—but you

should understand the two types

of management before you

begin investing.

The manager of an actively managed

fund seeks to produce investment

returns that are better than the fund’s

designated market benchmark (or

index) by buying and selling individual

stocks or bonds. Each manager follows

a stated strategy for trying to “beat

the market.”

Index funds try to track market

indexes—not beat them—by

buying and holding all (or a large

representative sample) of the

securities in their target indexes.


How Actively Managed Funds Work

Whatever a fund’s primary objective,

there are several techniques active

fund managers can use to try to beat

their market benchmark.

One way to try to improve on stock

market returns is to be a smart

stock picker. Typically this is done

by taking either a “top-down” or a

“bottom-up” approach.

Top-down managers start by looking at

economic trends to help them predict

which industries will prosper in the

future. Once they’ve zeroed in on some

industries, they look within them to

find the most promising companies.

By contrast, bottom-up managers

look for outstanding companies in

any industry, assuming that a great

company will do well even if it’s in

an industry that’s not thriving at

the moment.

Bond managers can try to beat the

market through astute analysis of bonds’

creditworthiness or by anticipating

changes in interest rates and adjusting

the average maturity of their bond

holdings accordingly. While bond prices

move in the opposite direction of

interest rates, the prices of shorter-term

bonds usually change less than those of

longer-term bonds. So a fund manager

who expects interest rates to rise may

buy shorter-term bonds—within the

fund’s stated range. And a manager

who expects interest rates to drop may

buy longer-term bonds.


How Index Funds Work

Index funds use one of two tech-

niques—replication or sampling—to

track the performance of their target

indexes.

Many stock index funds—but not

bond index funds—use the replication

method, meaning that they hold

every security in their target index

in the same proportion as the index.

If a company’s stock made up 1% of

the value of the S&P 500 Index, then

an S&P 500 index fund would invest

1% of its assets in that stock.

Index funds that use the sampling

method select from the target index

a representative sample of securities

that will resemble the target index

in terms of key risk factors and

other characteristics. For instance,

if a particular industry makes up

10% of a target index, a stock fund

might invest 10% of its assets in that

industry—even though it may not

hold every one of the underlying

stocks. Stock index funds use sampling

when the target index is so large that

it’s too expensive and inefficient to

buy all of the stocks in the index. Bond

index funds typically use sampling as

well since many bonds tracked in a

broad index are not traded often

enough to be obtained at a fair price.

Broadly diversified index funds

can be ideal core holdings for an

investment portfolio, and, with

dozens of index mutual funds,

Vanguard is a market leader in

index investing for individual

investors. Find out about Vanguard’s

broad range of low-cost index funds

at www.vanguard.com/visit/

indexfunds.

"web link


The Case for Indexing

Indexing is based on a simple fact:

Before expenses are counted, investors

as a group earn the market return,

whatever that happens to be for any

given period. If one investor—through

luck or skill—gets a higher-than-

average return, another is left with a

below-average return.

Index investors aspire to be “average.”

They know that while some actively

managed funds have done better than

average, most have done worse.

Now the paradox: If index funds serve

up average returns, why have they been

able to beat most actively managed

funds that invest in similar securities

over the long run? The answer is low

costs. By eliminating research and

keeping trading—and so brokerage

commissions—low, index funds don’t

have to take as large a bite out of fund

returns to cover their costs. So their

average return before expenses becomes

an above-average return after expenses,

as shown in Figure 5.

Index funds can also help investors

keep their taxes down. Since most

index funds buy and hold the securities

that make up the index, these funds

typically don’t generate as many taxable

capital gains as actively managed funds.

For this reason, some investors hold

index funds in their taxable accounts

and any actively managed funds in their

tax-deferred or tax-exempt accounts.

Note: While indexes that track large-

capitalization stocks tend to have

relatively low turnover of their holdings,

not all indexes are as tax-efficient. For

instance, small-company indexes change

as companies grow and become

medium-size or even large companies.

And as companies come and go from

the indexes, funds that track them must

buy and sell to follow suit. However, a

small-cap index fund will still typically

have lower turnover than an actively

managed small-cap fund.

Figure 5. The Indexing AdvantageTen years ended December 31, 2004

Average Annual CumulativeReturn Return

Average GeneralEquity Fund 11.1% 185.7%

Low-CostIndex Fund* 11.7 204.1

*The returns of the Dow Jones Wilshire 5000Index have been reduced by 0.20% per yearto reflect the expense ratio of a low-costindex mutual fund.

This hypothetical illustration does notrepresent the returns on any particularinvestment.

Source: Lipper Inc.


Dollar-Cost Averaging

One of the great conveniences of

investing in mutual funds is that

most fund companies make it easy

to put your investment program on

autopilot—that is, to invest on a regular

basis. Investing regularly is a great habit

to develop, not just for helping to build

wealth, but also for managing the ups

and downs of the market.

Investing a fixed amount in a

particular fund at regular intervals,

whether the market is up or down, is a

strategy called dollar-cost averaging.

Because the amount you invest is

constant, you buy more shares when

the price is low and fewer when the

price is high. As a result, the average

cost of your shares is lower than the

average market price per share during

the time you are investing.

You’re already benefiting from dollar-

cost averaging if you’re participating

in an employer-sponsored retirement

plan that withholds money from

your paychecks. This is a convenient,

systematic way to build an investment

portfolio, and because the amounts you

invest remain constant, you can easily

budget for them.

Figure 6. How Dollar-Cost Averaging Works

Monthly Investment Share Price Shares Acquired

$400 $10 40

400 8 50

400 5 80

400 8 50

400 10 40

2,000 (total) 260 (total)

Average share price: $8.20 ($10 + $8 + $5 + $8 + $10 = $41; $41 ÷ 5 months = $8.20).

Your average share cost: $7.69 ($2,000 ÷ 260 shares).

Dollar-cost averaging cannot eliminate

the risks of investing in financial

markets. It does not ensure a profit or

protect you against a loss in declining

markets, nor will it prevent a loss if

you stop dollar-cost averaging when

the value of your account is less than

your cost. You should also consider

your willingness and ability to invest

continually—even through periods

of market decline—because the

advantages of dollar-cost averaging

depend on your making regular

purchases through thick and thin.

No investment method can guarantee

a profit if you sell at the bottom of the

market. But if you’re a patient investor

who contributes a fixed amount of

money in regular installments, you can

greatly reduce a loss that would result

if the market dropped sharply right

after you’d made a large investment.


Setting up an automatic investment

plan is easy with the Vanguard

Automatic Investment Plan. Go

to www.vanguard.com/visit/

autoinvest or call 1-800-818-0084

for details.

quick t ip"


With thousands of mutual funds to

choose from, how do you decide

which ones are right for you?

One of the most common and serious

mistakes that investors make is to look

solely at investment performance. Past

performance—and especially short-term

past performance—is a lousy predictor

of future returns. Markets tend to run

in cycles, so a fund that’s been hot often

turns cold, as you can see from Figure 7.

But if you shouldn’t rely on past

performance in choosing a mutual

fund, how should you decide which

funds to own? We suggest following

these seven steps.

How to Select a Mutual Fund

Decide how you want to allocate your

assets among stock, bond, and cash

investments before you select specific

funds by following the steps in

“How to Create Your Investment

Plan” at www.vanguard.com/visit/

createyourplan.

"web link

Figure 7. Hot Funds Can Turn ColdThe top-ten general U.S. stock funds in 1995 did not do so well in later years. Their rankings in other years are shown below.

1995 1996 1999 2004

Number of Funds Considered 1,247 1,509 3,050 6,493

Fund (investment focus)

Fund A (multi-cap growth stocks) 1 1,296 250 5,359

Fund B (small-cap core stocks) 2 1,504 132 406

Fund C (small-cap growth stocks) 3 106 190 3,107

Fund D (mid-cap growth stocks) 4 1,482 38 5,900

Fund E (multi-cap core stocks) 5 1,382 223 6,411

Fund F (small-cap growth stocks) 6 1,023 62 4,585

Fund G (small-cap growth stocks) 7 1,234 460 1,356

Fund H (small-cap growth stocks) 8 1,302 43 878

Fund I (small-cap growth stocks) 9 1,481 1,776 6,393

Fund J (small-cap growth stocks) 10 957 185 5,213

Ranking of funds at year-end is based on their total returns for that year.

Source: Lipper Inc.


Step 1: Think About Your Goals

Instead of starting your evaluation of

a fund with its performance, start by

thinking about your own investment

goals, as shown in Figure 8. For current

income or short-term goals, a bond or

money market fund is probably right for

you. But for your longer-term goals, you

might want to consider a stock fund or

a balanced fund that invests in both

stocks and bonds.

Trade-Offs to Expect

If you seek growth of capital, you’ll need a

fund that invests most—if not all—of

its assets in stocks. Stock prices fluctuate

every business day, so the share price of

any fund that invests in stocks will also

fluctuate in value every day. Stock price

swings can be considerable.

If you seek a stream of income, you’ll need

a fund that invests in debt securities

such as bonds. Bond prices fluctuate,

and so do share prices of bond funds—

although usually not to the same degree

as stock funds.

Figure 8. Start With Your Goals

You want a fund If you want to . . . that seeks to provide . . . The fund might invest in . . .

Invest for a goal that’s ten years Growth of capital. Stocks.or more away.

Receive monthly income. Income. Bonds.

Invest for a goal that’s ten years Growth of capital and some income. Stocks that have above-averageor more away—but you also dividends, or a combination of stockswant some current income and and bonds.are willing to sacrifice somegrowth potential.

Keep your principal safe while Preservation of capital Money market securities or earning some dividend income. plus some income. short-term bonds.


If you want both growth and income, you’ll

want either a fund that emphasizes the

stocks of companies that provide

dividend distributions, or a balanced

fund, which invests in a combination of

stocks and bonds. Remember that, in

general, the more current income you

want, the less growth you can expect

over the long term.

If you want to preserve your principal,

you’ll want a money market fund,

which is designed to maintain a stable

share price while providing current

income. In return for this stability, you’ll

have to accept less income than if you

invested in a bond fund. To seek a bit

more income without sacrificing too

much stability of principal, you could

choose a short-term bond fund. This

type of fund experiences modest price

fluctuations but typically offers higher

yields than money market funds.

growth


Step 2: Look at the CompanyBehind the Fund

Before you turn your hard-earned

money over to an investment company,

make sure you’re comfortable with the

way they do business. You’re entering

into a partnership with that company,

and you want to be sure it works out

well for you.

Some of the issues to consider may

seem obvious, but it’s surprising how

often investors fail to consider them.

• Is the company forthright? If the

companies you look into don’t frankly

discuss the potential drawbacks of an

investment, you may be getting into

something that’s a bad deal for you.

Don’t let them sell you a fund just

because they’re peddling that fund

this week; make sure it’s one that fits

your goals.

• Does the company follow a disciplined

approach to investing? Some companies

don’t ensure that their fund managers

stick to the investment strategy

outlined in the prospectus. For

example, a large-cap stock fund might

begin investing in small companies if

the fund manager believes small

companies will do better than large

ones in the near future. Or a stock

fund manager might decide stocks

are overpriced, so he’ll start buying

bonds. Ultimately, you could end up

with holdings that differ significantly

from what you originally had and not

even know it. And that means that

you could be straying unintentionally

from your target asset allocation and

taking on more (or less) risk than you

bargained for.


• Does the company promote the

performance of funds that have

done well recently? Because past

performance is a very poor predictor

of future returns, companies that

trumpet how well a fund has done

recently are often trying to “cash in”

on a fund’s recent hot performance.

And as you saw earlier in this

chapter, that hot performance could

turn very cold in the near future. You

shouldn’t chase performance, and

your investment company shouldn’t

encourage it.

• How much does the company charge

for its services? No two ways

about it: Costs are a drag on

your investment returns, and the

higher the expenses, the greater

the drag. You can’t entirely avoid

expenses, but you can avoid some

costs—such as sales commissions

—by investing in no-load mutual

funds. Look for a mutual fund

company that has a history of

maintaining low costs.

• Does the company put experienced

managers at the helm? How many

years of experience does the manager

have, and what is his or her track

record? Some fund companies

allow relatively new managers to

gain experience at their smaller

funds. Make sure you know what

level of expertise you’re getting.


Step 3: Double-Check Your Costs

Because costs can significantly affect

your long-term investment returns,

take time to understand all the

costs you will be paying. All funds

have expenses, but some funds cost

significantly more to own than others.

The fees and expenses you pay reduce

your investment returns directly (they’re

deducted before you get your return), as

shown in Figure 9. That’s why it pays to

shop around.

Make sure you take into account all

the types of expenses associated with

owning a fund. These include sales

charges, operating expenses, 12b-1

fees, and trading costs.

$100,000

$80,000

$60,000

$40,000

$20,000

Figure 9. How Costs Affect Returns

Fund A0.30%Expense Ratio

Fund B1.20%Expense Ratio

Investment expenses can have a majorimpact on investment returns. Forexample, over 20 years in a tax-deferredaccount, an investment of $20,000 inFund A, which has an annual expenseratio of 0.30%, grew to $88,175.Meanwhile, a $20,000 investment inFund B, which has an annual expenseratio of 1.20%, grew to only $74,551. Thedifference between the two amounts ismore than two-thirds of the value of theoriginal $20,000 investment.

This hypothetical example assumes an 8% annual return and includes thereinvestment of interest, dividends, and capital gains distributions; it does not represent the performance of any particular investment.

$88,175

$74,551


1 2 3 4 5 6 7 8 9 10

Year

Fund A Fund B

50%

40%

30%

20%

10%

0%

–10%

–20%

–30%

Two hypothetical mutual funds hadidentical average annual total returns of 8% over a ten-year period, but theirreturns were quite different each year.Fund A had some years that were muchbetter than the best years for Fund B. But Fund A also lost money in otheryears. If you lose confidence in a fundbecause of such uneven performance,you may not be willing to keep up yourlong-term investment plan.

This hypothetical illustration should not beconsidered indicative of the return on anyparticular investment.

Figure 10. Same Results, Different Route

Step 4: Consider the Fund’s Volatility

The share prices of stock and bond

funds continually fluctuate, but some

fluctuate more than others. Some

investors don’t mind this volatility—

they have plenty of time to wait until

they’ll need their money, they’re used

to the ups and downs of investing, and

they have enough money set aside for

emergencies so they won’t have to sell

their investments when prices are

down. But most investors would prefer

to avoid unnecessary volatility.

Although looking at investment

performance won’t tell you how

the fund will do in the future, it

can give you a sense of how volatile

an investment has been in the past.

In fact, two funds can deliver the

same long-term performance with

very different levels of short-term

volatility, as shown in Figure 10.


A simple way to assess a fund’s

volatility is to look at its track record—

quarter by quarter or year by year.

Most investments are at least a little

like a roller-coaster ride, but the ups

and downs of investing can be more

hair-raising than any trip to an

amusement park. So compare the

fund’s best years with its worst, and ask

yourself if you’d have been able to hang

on through the entire ride. Then, to

make a more sophisticated evaluation

of the fund’s volatility, look for the

following measures in the prospectus.

• Beta is a statistical measure of

how volatile a stock or bond fund’s

returns have been compared with an

appropriate market benchmark (for

instance, the S&P 500 Index for a

large-company stock fund). By

definition, the beta of every index is

1.00, no matter how volatile the index

is. This is important to keep in mind

because a volatile fund can have a low

beta if its benchmark is very volatile.

The returns of a fund that has a beta

higher than 1.00 have fluctuated, up

and down, more than those of the

benchmark. A beta lower than 1.00

means the fund has been less volatile

than the benchmark. A fund’s beta can

change over time.

• R-squared measures how much a stock

or bond fund’s past returns can be

explained by the returns from its

benchmark index. If a fund’s total

returns were precisely synchronized

with the index’s return, its R-squared

would be 1.00 (100%). If a fund’s

returns bore no relationship to the

index’s returns, its R-squared would

be 0. The higher the R-squared,

the more the fund’s return can be

explained by the index’s—and so

the market’s or market segment’s

—performance. The lower the

R-squared, the more the return

can be explained by the fund

manager’s decisions.

• Duration is an estimate of how much

a bond fund’s share price will rise or

fall in response to changes in interest

rates. To calculate the change in a

fund’s share price, take the fund’s

average duration (measured in years)

and multiply it by the percentage-

point change in interest rates. If

rates fall 0.5 percentage points and

a fund’s duration is ten years, then

the share price will rise about 5%.

The longer the duration, the greater

the share price fluctuation.


Step 5: Examine Investment Returns

The next step is to evaluate some

funds in the category you choose.

The information you’ll need is found

in a fund’s prospectus and most recent

annual or semiannual report. Start with

each fund’s investment returns—both

total return over many years (five to

ten is best) and returns year by year

or quarter by quarter.

What Is Total Return?

Total return is the percentage increase

or decrease, before taxes, in the value

of an investment over a specific period

of time, including any distributions

from the investment and any change

in its market value. Total return figures

do account for operating expenses but

typically do not factor in the costs of

front-end loads or sales charges, so be

sure to take those costs into account

when you make your comparison.

Use a mutual fund’s total return to

help judge the fund’s performance

against other funds with similar goals

and investment styles.

For a mutual fund, total return includes

two components: income and capital.

Income. A fund may produce income

from investments in interest-bearing

securities (such as bonds or cash

investments) or from dividends paid

on stocks the fund owns. This income

is distributed to shareholders, who

can generally choose to either receive

the distributions in cash or have

them reinvested in additional shares

of the fund.


Capital. A fund’s share price rises

when the securities it owns rise in

value. As long as the fund holds these

securities, the price changes result in

unrealized (“paper”) capital gains.

(Similarly, if the securities a fund

owns decline in value, the fund’s

share price will fall, thus leading to

an unrealized capital loss.) When a

fund sells securities that have risen in

value, the gains are “realized” and are

distributed to shareholders. As with

income distributions, shareholders

can typically choose to receive capital

gains in cash or have them reinvested

in additional fund shares.

When total returns are calculated, it

is assumed that income and capital

gains distributions are reinvested.

Total returns are commonly quoted

for time periods of one, five, and ten

years (or, for newer funds, since the

fund’s inception).

What counts in investing is what

you get to keep, so find out whether

your funds are being managed

tax-efficiently. Because taxes are

often the largest cost associated

with owning fund shares, be sure

to check after-tax returns for any

funds you hold in taxable accounts.

(After-tax returns are generally

listed in a fund’s prospectus.)

quick t ip"


Put Fund Returns in Context

How do you assess a fund’s total

return? Look at it in context.

Say you were invested in a stock fund

that returned 15% in one year. That

might make you pretty happy. But

what if funds with similar objectives

returned 20% over the same period?

Suddenly 15% wouldn’t look so good.

So to find out how competitive a

fund’s performance has been, you

need to compare it with its peer-

group average over the same period.

You should also compare the fund’s

performance with its benchmark

index.* Some of the most common

indexes are listed in Figure 11. Both

peer-group and index data are readily

available in financial publications such

as The Wall Street Journal. Two of the

best-known providers of such fund

information are Morningstar, Inc.,

and Lipper Inc.

Note: Don’t be fooled by fund

companies that advertise cumulative

returns, which show how much an

investment has grown or shrunk over

several years. A large cumulative return,

when translated into average annual

returns, may not be large at all. Let’s say

a stock fund had a cumulative return of

101% over 12 years. That’s an average

annual return of 6%, which may or

may not compare well with the fund’s

competitors or its benchmark index.

Figure 11. Indexes for Selected Market Segments

Market Index

All U.S. stocks Dow Jones Wilshire 5000 Composite Index

Large-cap U.S. stocks Standard & Poor’s 500 Index

Small- and mid-cap U.S. stocks Dow Jones Wilshire 4500 Completion Index

International stocks, excluding emerging markets Morgan Stanley Capital International Europe, Australasia, Far East Index

Investment-grade U.S. bonds Lehman Brothers Aggregate Bond Index

Short-term investment-grade U.S. bonds Lehman Brothers 1–5 Year Government/Credit Bond Index

Intermediate-term investment-grade U.S. bonds Lehman Brothers 5–10 Year Government/Credit Bond Index

Long-term investment-grade U.S. bonds Lehman Brothers Long Government/Credit Bond Index

High-yield U.S. corporate bonds Lehman Brothers High Yield Bond Index

Tax-exempt bonds Lehman Brothers Municipal Bond Index

*The performance of an index is not an exact representation of any particular investment as you cannot invest directly inan index. Benchmark comparative indexes represent unmanaged or average returns on various financial assets, whichcan be compared with funds’ total returns for the purpose of measuring relative performance.


Step 6: Build a Diversified Portfolio

As you build your portfolio, select

funds that complement one another in

their investment styles. Let’s say you

own a large-cap stock fund in your

portfolio. To be properly diversified,

you should add funds that invest in

small and medium-size companies too.

The goal is to diversify your portfolio

so that you don’t have periods when

all your investments are badly lagging

the market. This way, you’ll be less

likely to change your investment plan

in pursuit of hot funds.

An investment style box is a tool that

helps you see at a glance the kind of

holdings that a fund emphasizes. A

fund’s position in a style box indicates

its investment emphasis in each of two

criteria, which vary depending on the

type of fund.

Get details on Vanguard’s

diverse lineup of low-cost and

tax-efficient funds when you visit

www.vanguard.com/visit/fundpt.

"web link


Make Use of Style Boxes

Style boxes for stock funds typically

classify them according to two criteria,


The vertical axis shows the size of the

companies that the fund emphasizes.

The size of a company is typically

measured by the market value (market

capitalization, or “market cap”) of the

stocks it owns. For example, a fund

may be labeled “large-cap” because

the majority of its assets are invested

in the stocks of large companies—even

though it may also hold the stocks of

mid- and small-cap companies.

The horizontal axis shows the

investment style used by the fund.

• Growth-oriented stock funds

emphasize companies that, due to

market expectations of strong future

profits and revenue growth, sell at

above-average prices in relation to

such measures as earnings, book

value, and revenue.

• Value-oriented stock funds

emphasize companies from which

the market does not expect strong

growth. These companies generally

have below-average prices relative to

their revenue, profits, and assets.

• Blend funds are those that invest in

both growth stocks and value stocks.

Figure 12. Sample Stock Fund Style Box

Value Blend Growth

Style

Mar

ket C

ap

Large

Medium

Small

In this example, the fund would be considered a large-capitalization value fund.


Style boxes for bond funds typically

classify them according to two criteria,


The vertical axis shows the average

credit quality of the bonds held in the

fund. For taxable bond funds, credit

quality is divided into Treasury/Agency

(U.S. government and agency bonds,

the highest quality), Investment-Grade

Corporate (the next-highest quality),

and Below Investment-Grade. For tax-

exempt bond funds, credit quality is

listed as high, medium, and low.

The horizontal axis shows a fund’s

average maturity—the average of the

length of time until all the bonds held

in the fund are scheduled to be repaid.

The longer the average maturity, the

steeper a fund’s share-price swings

tend to be in reaction to changes in

market interest rates.

• Short-term bonds mature in 2 years

or less.

• Intermediate-term bonds mature in

3 to 10 years.

• Long-term bonds mature in more

than 10 years.

In this example, the fund would beconsidered a long-term investment-grade corporate fund.

Figure 13. Sample Taxable Bond Fund Style Box

Short Medium Long

Average Maturity

Aver

age

Cred

it Q

ualit

y

Treasury/Agency

Investment-GradeCorporate

BelowInvestment-Grade


Take Advantage of Balanced Funds

An easy way to achieve diversification

in your portfolio with just one fund is

by investing in a balanced fund. Also

known as “hybrid” funds, these funds

invest in both stocks and bonds, in

various proportions. Some are even

geared toward certain stages of an

investor’s life. For example, a balanced

fund geared toward an investor in

retirement might have an asset mix of

20% stocks and 80% bonds. You can

simplify your portfolio considerably by

choosing a balanced fund with a stock-

to-bond ratio that’s appropriate for

your situation.

Step 7: Check Out a Fund’s Policies

Make sure the funds you select pursue

policies that protect your interests and

make investing convenient.

• Are your interests protected?

Excessive trading by just a few of

a fund’s shareholders can disrupt

operations and boost expenses that

all shareholders have to absorb. So if

you are a long-term investor, look for

policies that protect your interests. For

example, some fund companies limit

the number of redemptions investors

can make within a given period.

Some funds further hold down trading

costs by charging a redemption fee on

shares sold before they’ve been held

for a specified period of time. This

type of fee—which can range from

0.25% to 2%—is not a sales charge

because it is paid directly to the fund,

not the fund company, to discourage

short-term trading.

• What recordkeeping services are

provided? Fund companies typically

offer account statements and other

basic conveniences that can make

recordkeeping easier for shareholders.


But before you invest in a taxable

account, make sure the fund will

keep track of the cost basis of your

shares. If the company doesn’t

track this information, you’ll have a

recordkeeping chore on your hands

when you decide to redeem your

shares. When it comes time to do

that year’s tax return, you’ll have to

go back and check every statement

to figure out what you paid each

time you reinvested dividends and

capital gains or made new

investments.

• What other conveniences are offered?

A fund’s prospectus will describe

only the services directly linked to

an account in that fund, so ask the

company about other services it

offers that you might need to

properly manage your investments.

Some of those include:

• Specialized services to help you

invest for retirement, including

assistance with IRAs.

• A comprehensive website

that allows you to manage

your accounts, learn more about

investments, and get advice online.

• Special services for those who

invest substantial assets with

the company.

• Brokerage services, including

convenient access to mutual

funds from other companies.

• Personal advisory services,

including financial planning, asset

management, and trust services.

You can open a Vanguard fund account

online in just minutes. Simply go to

www.vanguard.com/visit/openacct.

Or call 1-800-818-0084 to request

a prospectus and application form.

"web link


The Six Rules of Successful Investing

To succeed as an investor isn’t

hard—but it does take planning

and discipline. What if you’re not

disciplined by nature? That’s okay.

Many successful investors know

they can’t rely on discipline, so they

put together an investment plan

and set it in motion. Through

automatic investments to your

employer-sponsored plan, an IRA,

and other accounts, you can start

to accumulate assets.

Here are six simple guidelines that can

help you become a successful investor.

1. Live beneath your means. It sounds

simple, but in today’s material

world it can be hard to do. The

fact is, unless you spend less than

you earn, you will have nothing to

invest. Decide how much you will

set aside before you decide how

much you’re going to spend, and

you’ll have taken the first step

toward successful investing.

2. Diversify, diversify, diversify. You can’t

predict which way the markets will

move next—or which investments

will go up or down—but you can

spread the risk around by investing

in a mix of stocks, bonds, and cash

investments—and diversifying your

investments within each of those

asset classes. That way, when some

investments are not growing or

are even falling in value, other

investments can carry the day,

helping to even out the ups and

downs of your total portfolio.

The best way for many people

to ensure diversification in their

portfolios is to invest in mutual

funds that hold a broad range

of securities. Investing in index

funds that mirror the entire stock

and bond markets can make your

job easy.


3. Keep costs down. If you’re a careful

shopper, you know that you

generally get what you pay for.

But when you’re buying mutual

funds, that adage doesn’t hold

water. Instead of ensuring quality,

high costs actually reduce how much

of a fund’s returns you get to keep.

Think about it. The investment

manager of any mutual fund first

has to deliver enough returns to

compensate for a fund’s expense

ratio (the percentage of assets used

to pay a fund’s operating costs)

before chalking up the first dollar

of return for the fund’s shareholders.

The higher a fund’s costs, the higher

the hurdle.

Some fund costs—such as the expense

ratio (including 12b-1 fees that pay

for marketing and distribution costs

to new shareholders at the expense

of existing ones)—are reflected in the

advertised performance of a fund. But

you have to take other costs—such as

any front- or back-end loads—into

account yourself. And those costs can

be hefty. You can’t control which way

the market will go next, but you can

certainly control what you pay to own

a fund. Choose low-cost, no-load

mutual funds.

4. Pay attention to taxes. After

investment costs and inflation,

taxes take the biggest bite out of

your return. To reduce taxes, start

by making maximum use of all

the tax-advantaged investing

opportunities you can, such as

employer-sponsored retirement

plans, traditional IRAs and Roth

IRAs, and college savings plans.

Next, for your taxable accounts,

consider investing in:

• Municipal bonds or municipal

bond funds, which are exempt

from federal (and often state and

local) income tax.

• Tax-managed mutual funds, which

use special strategies in seeking to

reduce taxes on investment returns.

• Index funds, which tend to have

lower turnover and so are less likely

than actively managed funds to

pass along taxable gains.

Finally, make sure you have the right

types of investments in the right

accounts. In general, hold the least

tax-efficient funds (such as taxable

bond funds) in your tax-advantaged

accounts, and the most tax-efficient

funds (such as stock index funds) in

your taxable accounts.

Whatever your financial goals, PlainTalk investment guides can help you

achieve them. If you enjoy the convenience and interactivity of online

planning, visit PlainTalk on the Web at www.vanguard.com/visit/plaintalk.

It’s packed with useful investment information and planning tools.

PlainTalk programs are also available by mail. Order online, or call

1-800-818-0084 business days from 8 a.m. to 10 p.m. or Saturdays

from 9 a.m. to 4 p.m., Eastern time.

1-800-818- 0084

vanguard.com


5. Buy and hold for the long run. No

one can accurately predict the ups

and downs of the market often

enough to make market-timing a

consistently winning strategy. But

even if you were smart enough to

beat the odds, frequent buying and

selling could increase your taxes

and trading costs enough to wipe

out any gains. Besides, market

rallies often occur suddenly and over

very short periods of time. If you

happened to be out of the market

during those few days, you could

miss most or all of the gains for that

year. Don’t waste your time trying

to predict the market. Be a buy-and-

hold investor.

6. Know yourself. Some people can

shrug off big market swings; others

cannot. If you can’t sleep at night

because the value of your investments

is bouncing around, you need to build

a portfolio with a more conservative

mix of assets and, if you can, increase

your savings rate to increase the

chances of achieving your goals.

You may not reach your goals quite

as fast, but you’ll likely be more

rested along the way.

www.

Are you ready to select a

Vanguard fund? Use our “Narrow

Your Fund Choices” tool to find a

fund that’s right for you. Go to

www.vanguard.com/visit/narrow.

"web link

Facts on Funds, Financial skills for life, PlainTalk, The Vanguard Group,Vanguard, The Vanguard Difference,Vanguard IRA, and the ship logo aretrademarks of The Vanguard Group, Inc. All other marks are the exclusiveproperty of their respective owners.

World Wide Webwww.vanguard.com

Toll-Free Information1-800-818-0084

Post Office Box 2600Valley Forge, PA 19482-2600

For more information about Vanguard funds, visit www.vanguard.com, or call 800-662-7447, to obtain aprospectus. Investment objectives, risks, charges, expenses, and other important information about a fundare contained in the prospectus; read and consider it carefully before investing.

© 2005 The Vanguard Group, Inc.All rights reserved.Vanguard MarketingCorporation, Distributor.

PTLA 022005

plaintalk€¦ · Dreaming of retiring early? ... Learn easy steps you can take on your own using...

Documents

Transcript of plaintalk€¦ · Dreaming of retiring early? ... Learn easy steps you can take on your own using...