From Taylor Larimore’s book, “The Bogleheads Guide to Investing”
What is the most important key to wealth?
- “This above all: Saving is the key to wealth. As you will soon learn, the Boglehead approach to investing is easy to understand and easy to do. It’s so simple that you can teach it to your children, and we urge you to do so. For most people the most difficult part of the process is acquiring the habit of saving. Clear that one hurdle, and the rest is easy.” (p. 16)
- “Being a Boglehead requires planning, commitment, patience, and long-term thinking. If there really were easy, quick secrets to getting rich, there would be many more wealthy people than there are today. Promises of fast, easy money are the stuff of flim-flam men on late-night TV infomercials. As financial writer Jason Zweig so aptly put it, “The problem with getting rich quick is you have to do it so often.” If you want to achieve your financial goals in less time, here’s one of the simplest, best pieces of advice that we can give you: When you earn a dollar, try to save a minimum of 20 cents. Some diligent savers actually strive to save 50 cents of every dollar they earn. The more you save, the sooner you achieve your financial goals. There is no substitute for frugality. Deciding how much to save is the most important decision you will ever make because you can’t invest what you don’t save.” (p. 16)
How much should you save?
- “You’ve heard it before and you’ll hear it again. If you wait until you have a few extra dollars to invest, you’ll likely wait forever. The first rule of saving/investing is to take it off the top of your paycheck. How much you save is up to you. We recommend a bare minimum of 10 percent. Very few people save over a third of their income, but the few that do are the ones most likely to retire early. There are no magic formulas for acquiring wealth. The earlier you start and the more you invest, the sooner you reach financial freedom. If you are currently spending all of your income, begin by saving just 1 percent this month and increase it by 1 percent every month for the next year. In a year you will have established the habit of saving 12 percent of your income.” (p. 17)
What’s the most important decision you can make for you portfolio?
- “Your most important portfolio decision can be summed up in just two words: asset allocation.” (p.89)
- “Asset allocation is the process of dividing our investments among different kinds of asset classes (baskets) to minimize our risk, and also to maximize our return for what the academics call an efficient portfolio.” (p. 89)
- “Brinson, Hood, Beebower Study that found that the primary determinant (93.6 percent) of a portfolio’s risk and return is our allocation between stocks, bonds, and cash? Accordingly, we will concentrate our attention on these three primary asset classes and use three guidelines to allocate between stocks, bonds, and cash:” (p. 98)
Here are some guidelines for stocks, bonds, and other assets recommended by age.
“It’s difficult to recommend specific portfolios because each investor is unique. As we learned earlier, we each have different goals, time frames, risk tolerances, and personal financial situations. You may also be restricted to investing in only the funds offered in your retirement plan. We suggest eight simple portfolios depending on your stage in life. Four portfolios use asset classes (not specific funds). These will be useful for non-Vanguard investors. The four remaining portfolios are for investors using Vanguard funds. We assume the investor has emergency cash savings elsewhere equal to 3 to 12 months’ income. High-income taxpayers should consider tax-exempt (municipal) bonds when tax-advantaged accounts are full.” (p. 103)
A Young Investor using Vanguard’s funds
Total Stock market Index Fund- 80%
Total Bond Market Index Fund- 20%
A Middle-Aged Investor Using Vanguard Funds
Total Stock Market Index Fund- 45%
Total International- 10%
REIT- 5%
Total Bond Market Index Fund- 20%
Inflation- Protected Securities- 20%
An Investor in Early Retirement Using Vanguard Funds
Total Stock Market Index Fund- 30%
Total International Index Fund- 10%
Total Bond Market Index Fund- 30%
Inflation-Protected Securities- 30%
An Investor in Late Retirement Using Vanguard Funds
Total Stock Market Index Fund- 20%
Short-Term or Total Bond Market- 40%
Inflation-Protected Securities- 40%
“We assume the investor has emergency cash savings elsewhere equal to 3 to 12 months’ income. High-income taxpayers should consider tax-exempt (municipal) bonds when tax-advantaged accounts are full.” (p. 103)
What about Reits?
- “Real Estate Investment Trusts (REITs) are a special type of stock. REIT funds often behave differently than other stock funds. This characteristic of noncorrelation can make them a worthwhile addition to larger portfolios. We suggest that REIT funds not exceed 10 percent of your equity allocation.” (p. 100)
What about TIPS?
- “TIPS offer investors another U.S. Treasury-issued inflation-protection option. Unlike I Bonds, where the Treasury sets the fixed rate, the guaranteed rate on TIPS is established by the marketplace at the Treasury’s TIPS auctions. Since they are a marketable security, we have more investment options available to us with TIPS than we do with I Bonds: Purchasing TIPS at the Treasury auctions Purchasing TIPS in the secondary market Investing in a TIPS fund, such as Vanguard’s VIPSX or Fidelity’s FINPX If you’re looking for guaranteed inflation protection from TIPS, with no risk of principal, buying your TIPS at the Treasury auction and holding them to maturity would be your best choice, since there’s always the risk of some loss of principal with the other two options. For many investors, however, the flexibility and benefits of a TIPS mutual fund more than offset the risk of possible loss of principal, just as it does with any other bond mutual fund.” (p. 58)
- “TIPS-guaranteed rates are usually higher than I Bond fixed rates. Therefore, if you have room for them in your tax-deferred account, that’s where they should go, because you’d get tax-deferred inflation protection without risking principal. This assumes that you purchase them at auction and hold them to maturity. If you buy or sell TIPS in the secondary market, you may get back more or less than you paid. What if you don’t have enough room for TIPS in your tax-deferred account? If your tax bracket is low, and the difference between the TIPS guaranteed rate and the I Bond fixed rate is large enough, it’s possible that placing the TIPS in your taxable account might provide a slightly higher yield than would a lower-yielding I Bond. When you own TIPS in your taxable account, the major downside is that you have to deal with the issue of paying annual taxes on some income that you won’t receive until maturity. That’s why it’s called phantom income. On the plus side, though, if you live in a state with a high income tax, the interest from TIPS in a taxable account isn’t subject to state and local taxes, whereas it may be subject to your state’s income tax upon withdrawal from a tax-deferred account. Therefore, you’ll have to work that into the equation. Remember, with TIPS, you only receive the fixed-rate portion of the yield on the inflation-adjusted par value on a semiannual basis. The inflation adjustment gets applied to your TIPS principal, but you won’t receive that until the bond matures. Therefore, the higher the rate of inflation, and the higher your tax bracket, the more taxes you’ll be paying on both the income portion that you actually do receive, and on the inflation-adjusted portion that you haven’t received. And, when fixed rates on TIPS are low, it’s even conceivable that you could owe more in taxes than you receive in interest payments in a year when inflation is very high, especially if you’re in a higher tax bracket.” (p. 58)
Why can’t I just rely on Equities, Treasury Bills, and long-term government Bonds to beat inflation?
- “Conventional wisdom states that equities should be the investment of choice for outstripping inflation. However, conventional wisdom doesn’t come with any guarantee, and there have been overlapping periods when both small-company stocks (as defined by the Center for Research in Stock Prices), and large-company stocks (as defined by the S&P 500 Index), have failed to outpace inflation. There have also been long periods when some ultrasafe Treasury investments, such as one-month Treasury Bills and long-term Government Bonds, haven’t posted positive real returns. (Remember, we said earlier that real return is the amount we have left after we subtract inflation from our rate of return.) If we look at the top line on Figure 5.1, we can see what the nominal annualized return (before inflation) of T-Bills has been. That line might give us the impression that T-Bills have been a winning investment over the years. However, when we look at the lower line, we see that the annualized T-Bill’s real return has been negative for many years. During those negative years, T-Bill investors actually lost spending power, and that was before taxes.” (p. 50)
- “So where can an investor turn to for a guaranteed positive real return? The U.S. Treasury currently offers two choices that satisfy this need Bonds and Treasury Inflation-Indexed Securities, commonly referred to as TIPS (Treasury Inflation-Protected Securities). We’ve mentioned both in previous chapters, but let’s now examine how they work in more detail.” (p. 51)
How about using LifeStrategy funds and Life-cyle funds?
- “In an attempt to simplify investing, a recent trend has developed that allows investors to obtain a nicely diversified portfolio by choosing a single mutual fund that meets their desired asset allocation. These offerings invest in other mutual funds, normally from the same company, and usually include stock, bond, and money market mutual funds—thus the name funds of funds. Some of these funds maintain a fairly stable ratio of stocks, bonds, and cash at all times, so it’s up to investors to switch to a more conservative fund as they get older and closer to retirement. The various LifeStrategy funds offered by Vanguard are good examples of these types of funds. Let’s take a look at the composition of a couple of these funds. The Vanguard LifeStrategy Growth Fund has a fairly aggressive target asset allocation of 80 percent stocks and 20 percent bonds. This fund of funds invests in four Vanguard funds: Total Stock Market Index Fund Total Bond Market Fund Total International Stock Index Fund Total International Bond Fund The Vanguard LifeStrategy Conservative Growth Fund has a more conservative target asset allocation of 40 percent stocks and 60 percent bonds. This fund of funds invests in four Vanguard funds: Total Stock Market Index Fund Total Bond Market Fund Total International Stock Index Fund Total International Bond Fund There are two other funds in the Vanguard LifeStrategy series that offer differing asset allocations. They include the LifeStrategy Moderate Growth Fund, which has a target asset allocation of 60 percent stocks and 40 percent bonds, and the LifeStrategy Income Fund, with a very conservative target asset allocation of 80 percent bonds and 20 percent stocks. So there’s a good chance that one of these funds of funds might meet your desired asset allocation.” (p. 42)
- “The more recent products introduced by some fund companies include life-cycle funds of funds that automatically get more conservative as time goes by. As with other funds of funds, the investor simply picks the nicely diversified fund that satisfies their present desired asset allocation. However, unlike other funds of funds that maintain a fairly constant percentage of stocks, bonds, and cash, these life-cycle funds lower the percentage of stocks and increase the percentage of bonds and cash over the years. With the introduction of these life-cycle funds, the mutual fund companies are attempting to simplify things for investors by relieving them of the need to rebalance on a regular basis. And with these funds, there’s no need for an investor to have to change their portfolio as they age and get closer to retirement. The Target Retirement series of funds from Vanguard and the Freedom series of funds from Fidelity are good examples of this type of fund.” (p. 43)
How do you determine your risk tolerance?
- “Knowing your risk tolerance is a very important aspect of investing, and one that the academics have studied extensively. Their experiments prove that most investors are more fearful of a loss than they are happy with a gain. We all know people who are afraid of investing in the stock market because they know they might lose money. Risk-averse savers keep billions of dollars in CDs and bank savings accounts, despite their low yields. At the other extreme, we know of investors like Donald Trump who think nothing of investing hundreds of millions of dollars in speculative investments—and are seemingly unworried even when bankruptcy looms. Most of us have a risk tolerance that lies somewhere between these extremes.”
- “In order to help determine if your portfolio is suitable for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, “Will I sell during the next bear market?” Here are some stats that might help you answer that question. On March 10, 2000, the NASDAQ Composite Index reached an all-time closing high of 5,049. Thirty-two months later, on October 9, 2002, it was down to 1,224—more than a 75 percent loss for investors who sold at that time. At the end of 2006, the NASDAQ Index had struggled back to 2,415, but that was still only half its previous high. Until you have owned stocks in a severe bear market, it’s very difficult to know how far your investments would need to decline before you would decide to sell. Don’t fool yourself. There almost certainly is some point during a market decline when you would consider selling. Imagine that you are in a severe bear market and that you have been watching your hard-earned savings steadily erode for a week, a month, a year, or even longer. You are discouraged. Gloom and doom has set in all around you. You have no idea how much further your investments will decline. Should you sell now, or hope that the market stops its stomach-churning descent? “Experts” on television proclaim that the market is going to go down further. Writers of newspaper and magazine articles confirm that the worst is yet to come. Your friends are selling their stocks, and they advise you to do the same. Your family, happy when you were making money, begins to lose faith in your investing plan. They also urge you to sell before it’s too late. This is what a bad bear market is like. Ask yourself, “What would I do? Would I lose faith and sell, or would I be disciplined enough to stay the course?” In a situation like this, your emotions can be your worst enemy.”
- “One of the chief advantages of an asset allocation plan is that it imposes a discipline that will help you to resist the temptation to sell funds in underperforming asset classes and to resist chasing the current “hot” fund. If, on the one hand, you think you would sell out of fear because the market is down, your portfolio is unsuitable for you. On the other hand, if you can honestly say, “No, I wouldn’t sell because I’ve learned that U.S. bear markets have always come back higher than before,” your portfolio is probably suitable for your risk tolerance. The sleep test is a great way to help determine if your asset allocation is really right for you. When setting up an asset allocation plan, investors should ask themselves: “Can I sleep soundly without worrying about my investments with this particular asset allocation?” The answer should be yes, since no investment is worth worrying about and losing sleep over. It’s important for you to understand that stocks and bonds go up—and they go down, and you need to be comfortable with that fact. These ups and downs are just normal market behavior and should be expected. Experienced investors understand this volatility and accept the inevitable declines. We know that by simply changing our allocation between stocks and bonds, we can lessen the amount of volatility in our portfolio until we reach our comfortable sleep level.” (p. 94)
What if I want to be 100% stocks?
- “If you are new to investing, you should understand that it’s one thing to see your portfolio decline on paper. However, it’s a much different matter to watch your hard-earned savings slowly melt away in a long bear market. If you are an investor who has not yet experienced a bear market, we suggest that you add from 10 percent to 20 percent more bonds than you think you need for safety. This will be your insurance against worry, and might help prevent you from selling at the wrong time.” (p. 97)
- “The Dow stocks plunged 17 percent in 1929, 34 percent in 1930, and another 53 percent in 1931. Few investors can tolerate large year-after-year losses (not knowing when they will end). This is the primary reason why we believe that nearly every portfolio should contain an allocation to bonds.” (p. 96)
What is your personal financial situation?
- “Your personal financial situation has a direct influence on the type and amount of securities you select, and their allocation within your asset allocation plan. For example, the investor with a pension and future social security income obviously does not need to accumulate as large a retirement portfolio as someone without these assets. And someone with significant net worth or a large portfolio does not need to invest in risky investments in search of higher returns. We know a very successful executive who, upon retirement, put all his investments into high-quality, diversified, municipal bonds. The income from the bonds is more than sufficient for his family’s lifestyle. This executive wants to spend his time traveling and on the golf course—not managing a complex portfolio of assorted securities. His simple portfolio may be unusual, but we think it’s probably a very suitable portfolio for him. However, most of us want a return greater than is available from savings, CDs, and bonds. This is why we use stocks to provide the growth and additional income needed to meet our goals.” (p. 97)
Should I carry a mortgage even if I can pay it off?
- “For example, there are times when carrying a mortgage on your home is a better option even when you have the funds to pay it off. Let’s assume you are borrowing at an effective, fixed rate of 5 percent. At the same time, you believe that you can earn an average annual return of 8 percent in a balanced portfolio over the long term. Paying off the mortgage is a can’t-miss 5 percent return. However, investing the money at 8 percent earns an average of 3 percent more per year. With the money invested in liquid assets, you have access to it if needed, and the value of the house will likely appreciate whether it’s mortgage-free or not. Or, perhaps you would rather spend the money than leave a mortgage-free home to your heirs. Is it a risk? Yes, but it’s a calculated risk, and one where the odds are likely to be in your favor. Whether it’s a risk worth taking is for you to decide.” (p. 22)
Why do I need Bonds and which Bond should I pick?
- Selecting the Right Bond Fund Now that we have a basic understanding of bonds and bond funds, how can we apply what we’ve learned to help us select a bond fund that’s appropriate for us? Here are some simple guidelines you might use: Find a bond fund that matches your investment time horizon. For example, if you’ll need the money in two or three years, then you’d want to choose a short-term bond fund. It’s important that you don’t invest in a fund with a duration that’s longer than your time horizon. Don’t time interest rate hikes. Rather, simply invest in a fund that matches your desired characteristics with the intention of holding it for at least the fund’s duration or longer. Match your fund to your risk tolerance. If you’re going to worry about temporary losses in value, select funds with a shorter duration. Why Should I Invest in Bonds? It’s important to understand that bonds and bond funds have a low correlation (they don’t always move in the same direction at the same time) to stocks, so bonds can be a stabilizing force for a portion of your portfolio. For example, in the bear market of 2008, while equity fund losses of 30 percent to 60 percent were common, Vanguard’s Total Bond Market Index Fund gained 5.05 percent.”
- “How Much Should I Invest in Bonds? Determining how much of your portfolio should be invested in bonds and how much should be held in equities (stocks) is an asset allocation decision. You’ll learn how to go about establishing your own personal asset allocation plan in Chapter 8. However, here are a couple of general guidelines that you might find useful: Mr. Bogle suggests that owning your age in bonds is a good starting point. So, a 20-year-old would hold 20 percent of his/her portfolio in bonds. By the time this investor reaches 50, the bond portion of the portfolio would have gradually increased, in 1 percent increments, to now represent 50 percent of his portfolio. Increase your percentage of bond holdings if you are a more conservative investor, and decrease your percentage of bond holdings if you want to be more aggressive with your portfolio.” (p. 34)
How much emergency funds should I have?
“How big of an emergency fund you need depends largely on your net worth and job stability. On the one hand, if you have a very stable job, such as that of a tenured university professor, a cash reserve of as little as three months’ living expenses may be more than ample. On the other hand, if you are self-employed or work in a profession where layoffs are common, you may want to have as much as a year’s worth of living expenses stashed away. For most people, six months’ living expenses is probably adequate.” (p. 11)