My Two Rules of Investing post resulted in several good questions from people, both in comments and in email. I’ve got answers which are worth every penny you’re paying for.

How much should I be investing? Oh, goodness, there’s a question with no good answer. It depends on what your current financial situation is, how old you are, and all kinds of other situations. My general recommended approach is this. First, pay off any and all credit card debt, and do so as fast as you can. Then build up some three to six months’ worth of living expenses in a decent savings account. Then move to investing, and save what you can.

The important thing to realize is that any money you use to buy stocks and bonds should be money you won’t need for years. In the last year or so, the New York Stock Exchange lost half of its value. If you needed to sell stocks today to cover some unexpected costs, you’d be in a world of hurt.

Should I invest in an IRA? Absolutely. Any money you’re planning on using for retirement and not touching until then should go into an Individual Retirement Account.

They come in two flavors: traditional IRAs and Roth IRAs. In traditional IRAs, you don’t pay taxes on the money you put in them today, but you do pay taxes when you withdraw the money. In Roth IRAs, you pay taxes now, and later withdraw the money tax free. In financial jargon, traditional IRAs are tax-deferred investments (because you pay the tax later instead of now), while Roth IRAs are tax-exempt investments (because you don’t pay taxes on the money later). The rule of thumb I always see is that, for most everyone, Roth IRAs are better than traditional ones. You’re putting money in your IRA hoping that it’ll grow. With a traditional IRA, you have to pay taxes on those profits. With a Roth IRA, you don’t.

If I just want to invest some money without having to worry too much about it, what should I do? If you can, get a lifestyle fund. For instance Vanguard has a range of all-in-one funds. You pick a lifestyle fund based on when you’re going to retire. Vanguard then adjusts the stock, bond, and cash blend automatically, so you don’t have to rebalance anything. Even better, they use index funds, so the expense ratio is around 0.18%.

The only problem is that you’ve got to have $3,000 to get into one of those funds, and that can be tricky. In that case, you can either sock money away in a savings account until you reach that point, or start with a fund that will let you invest as little as $50 to $100 a month.

Since the economy’s doing so well, let’s talk investing! Everything I know about investing in stocks and bonds can be boiled down to two rules.

1. Buy index funds.
2. Diversify.

To understand index funds, you have to know what an index is: a collection of companies or bonds that someone tracks to get an idea of how the market is doing. Standard and Poor’s 500 Index is one of the best known by virtue of its age. It takes 500 large companies listed on the New York Stock Exchange and combines their stock price and number of shares to create a single number. But there are lots of other indices, such as the Russell 2000 that tracks small companies, or the Wilshire 5000 that tracks almost all of the NYSE stocks. At its simplest, an index fund buys all of the stocks listed in one of these indices and holds them. It’s a form of investing called passive investing, and is exciting as a bowl of dirt. There’s not any real buy-and-sell action, and you can’t beat the market with an index fund. The best you can do is get a return that matches the index.

Why index funds? Why not individual stocks? What about actively-managed mutual funds, where fund managers are buying and selling stocks to try to beat the market’s average return? I gave up on buying individual stocks early because I suck at picking stocks. I don’t have a lot of time to research companies, and even if I did, I’m going up against all of the mutual fund managers and other investors whose full time job is researching companies. Me buying an individual stock is like me betting on the ponies. I’m putting money into a company hoping the company’s stock value goes up.

That leaves actively-managed funds. As one financial advisor explained to me, if you buy an index fund, you’re spending the most on the stocks that are the most expensive. Wouldn’t you be much better off spending more on cheaper stocks so that, if they go up, you get a much greater return?

The problem is that mutual fund managers don’t actually do that very well. Getting the market’s average doesn’t sound exciting, but how many mutual funds meet even that modest goal? It turns out that most fund managers don’t beat their benchmark index, and they have no real ability to time the market. And even if they do beat their benchmark in one year, there’s little evidence that they can continue to do so over the long run.

It gets worse, though. Every mutual fund charges ongoing fees, expressed as the fund’s expense ratio. Every year, a percentage of the fund’s assets go towards paying the fund managers, paying the research team, paying for marketing, and so on. Those annual fees handicap a fund’s returns right out of the gate. For instance, if a fund has a return of 5% one year and its fees are 2%, the real rate of return is 3%.

In 2007 the simple average of stock funds’ annual fees was 1.46%, though individual fees can go much higher. Index funds, on the other hand, have extremely low fees when done properly. For instance, Vanguard’s 500 Index Fund has an expense ratio of 0.15%. That means your average actively-managed large-company fund has to be 1% better than the market average to beat the Vanguard index fund. And the actively-managed funds can’t even beat the average most of the time!

So why not just buy a single stock index and be done with it? Because you may need that money at a time when the stock market is in the tank. Ideally you’d have some investments that perform well when others are doing poorly. What you’re looking for is a set of investments that are uncorrelated, so that the performance of one is unrelated to the other.

That’s what diversification attempts to do. Instead of holding a handful of stocks, or just some bonds, hold different groups of assets. You should at least own a mix of US stocks (both in large and small companies), bonds, international stocks and bonds, and cash. You sacrifice some potential gain (but not much!) in return for greatly reducing how much your portfolio’s value will fluctuate. And the costs of not diversifying can be dramatic.

What’s tricky is deciding how much to put into what investments — what your asset allocation should be. There are various calculators to help you decide, like the Iowa Public Employees Retirement System’s. But once you’ve set your allocation, don’t fiddle with it. Trying to time the market will cost you a lot of money. Instead, do two things. One, invest systematically. A smaller monthly investment is much better than a yearly lump sum or, heaven help you, trying to time the market. Two, once a year you should rebalance your portfolio. Some of your investments will do well (or at least less poorly) than others, so your percentage of money allocated to different assets will change. Sell off the winners and reinvest in the losers to bring your percentages back in line with your goals. It sounds stupid, but what you’re doing is buying low and selling high.

There are myriad tweaks you can make to those two rules, but they’re where I would start. They won’t guarantee that you’ll always make money, or protect you as the global financial markets merrily burn, but they’re better than just about any other current approach.