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The Bogleheads' Guide to Investing

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The Bogleheads’ Guide to Investing

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Do not value money for any more nor any less than its worth; it is a good servant but a bad master. —Alexander Dumas fils, Camille, 1852

Drive-in banks were established so most of the cars today could see their real owners. —E. Joseph Grossman

Income is how much money you earn in a given period of time. If you earn a million in a year and spend it all, you add nothing to your wealth.

It’s not how much you make, it’s how much you keep.

The measure of wealth is net worth: the total dollar amount of the assets you own minus the sum of your debts.

Adding time to investing is like adding fertilizer to a garden: It makes everything grow. —Meg Green Miami, Florida, Certified Financial Planner

The Rule of 72 is very simple: To determine how many years it will take an investment to double in value, simply divide 72 by the annual rate of return. For example, an investment that returns 8 percent doubles every 9 years (72/8 = 9). Similarly, an investment that returns 9 percent doubles every 8 years and one that returns 12 percent doubles every 6 years. On the surface that may not seem like such a big deal, until you realize that every time the money doubles, it becomes 4, then 8, then 16, and then 32 times your original investment.

Bogleheads are investors, not speculators. Investing is about buying assets, holding them for long periods of time, and reaping the harvest years later. Sure, it requires taking risks, but only when the odds are in your favor. Speculating is similar to gambling. Speculators buy an investment with the hope of selling it quickly and turning a fast profit. Like gamblers, some speculators do win, but the odds are stacked against them.

“The problem with getting rich quick is you have to do it so often.”

When you earn a dollar, try to save a minimum of 20 cents.

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.

You have a choice about what to do with every dollar that comes into your life. You can spend it today or save and invest it to make more dollars tomorrow. The key to successful money management lies in striking a healthy balance between the two.

All good wealth builders have just one thing in common: They spend less than they earn. There are two basic ways to find money to invest: You can either earn more money or spend less than you currently earn. We recommend doing both.

If you decide to create added sources of income, do your homework. The secret of any successful business lies in fulfilling unmet needs and wants. Find a need and fill it. Find a problem and solve it. Find a hurt and heal it. People pay money for goods and services that make them feel good and solve their problems. Odds of success are good if you choose an activity that’s in step with your educational background, previous job experiences, aptitudes, and interests.

“When a man with experience meets a man with money, the man with money gets the experience, and the man with experience gets the money.”

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years. —Warren Buffett

When you purchase individual bonds at initial issue, you’re actually lending a specific amount of your money to the bond issuer. In return for lending your money to the issuer, you’re promised a return on your investment that is the bond’s yield to maturity and the return of the face value of the bond at a specified future date, known as the maturity date. These maturity dates can be short-term (1 year or less), intermediate-term (2 to 10 years), and long-term (10 or more years). So, in reality, a bond is nothing more than an IOU or promissory note that pays interest from time to time (usually semiannually) until maturity.

Bond and bond fund values move in the opposite direction of interest rates.

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.

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.

It’s hard to go wrong with any good quality, low-cost short- or intermediate-term bond fund.

I’ve found that when the market’s going down and you buy funds wisely, at some point in the future you will be happy. You won’t get there by reading, “Now is the time to buy.” —Peter Lynch

Mutual funds pool money from lots of investors to buy securities. Those securities can be stocks, bonds, or money market instruments, as well as other types of investments. As an investor in a mutual fund, you actually own a small fractional interest in the underlying pool of securities purchased by the managers of your mutual fund.

Read the fund’s prospectus and understand what you’re investing in!

Exchange-traded funds (ETFs) are basically mutual funds that trade like stocks on an exchange. They are bought and sold continuously throughout the day when the stock market is open. The ETF’s stocklike features appeal to a wide range of investors, including long-term buy-and-hold investors, as well as short-term traders. Perhaps one of the biggest benefits of owning ETFs is the low cost. ETF expenses can be as low, or even lower, than many mutual funds that track the same index.

This makes ETFs attractive to those investors who wish to trade during the day and know the exact price of their trade.

Because ETFs are market traded, they can trade at a slight premium or discount to the value of the underlying securities held in the fund. Generally, the premium or discount is not very large, but you need to be aware of it.

It’s important to note that Vanguard offers their low-cost ETFs commission-free, eliminating the previously mentioned downside associated with having to pay commissions to buy and sell ETFs.

When used properly, low-cost ETFs can certainly play an important role in a long-term investor’s buy-and-hold portfolio. On the other hand, investors are likely to shoot themselves in the foot if they plan to use ETFs as day trading or market timing vehicles.

At the end of that journey, we’ve come to the conclusion that low-cost mutual funds should be the primary investment of choice for most investors.

Control your destiny or somebody else will. —Jack Welch

(Remember, we said earlier that real return is the amount we have left after we subtract inflation from our rate of return.)

You really don’t need to begin saving for retirement before you reach 60. At that point, simply save 250 percent of your income each year and you’ll be able to retire comfortably at 70. —Jonathan Pond

Remember, one of the greatest gifts you can give your children is to be financially independent in your old age, thus ensuring that you won’t become a financial burden to them.

There is a crucially important difference about playing the game of investing compared to virtually any other activity. Most of us have no chance of being as good as the average in any pursuit where others practice and hone skills for many, many hours. But we can be as good as the average investor in the stock market with no practice at all. —Jeremy Siegel, Professor of Finance, Wharton School, University of Pennsylvania, and author of Stocks for the Long Run

That’s the indexer’s edge. More specifically, here are the cost and other advantages of indexing: There are no sales commissions. Operating expenses are low. Many index funds are tax efficient. You don’t have to hire a money manager. Index funds are highly diversified and less risky. It doesn’t much matter who manages the fund. Style drift and tracking errors aren’t a problem. Let’s look at these advantages in more detail.

Only consider investing in no-load funds with annual expense ratios of 0.5 percent or less, the cheaper the better.

The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve?” —Jack Bogle

Your most important portfolio decision can be summed up in just two words: asset allocation.

It was Sancho Panza, Don Quixote’s sidekick, who observed: “It is the part of a wise man to keep himself today for tomorrow and not to venture all his eggs in one basket.” 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.

How do we do this? Well, we begin by asking ourselves two questions: “What investments should we select?” and “What percentage should we allocate to each investment?”

EMT can be described as “an investment theory that states that it is impossible to ‘beat the market’ because existing share prices already incorporate and reflect all relevant information.”

This relationship of risk and return is crucial for us to understand if we are to build efficient portfolios—portfolios that offer the highest return with the least amount of risk.

This is an important lesson for every investor: The greater the risk of loss, the greater the expected return.

Now, let’s start designing our personal asset allocation plan. What are your goals? What is your time frame? What is your risk tolerance? What is your personal financial situation?

The first thing to do when developing an allocation is to come up with a risk profile. —Errold F. Moody

Their experiments prove that most investors are more fearful of a loss than they are happy with a gain.

Don’t fool yourself. There almost certainly is some point during a market decline when you would consider selling.

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?”

Using these three tools and your own experience, you should be able to decide what a suitable stock/bond/cash allocation for your personal long-term asset allocation plan is. This is the most important portfolio decision you will make.

make money, bears make money, but hogs get slaughtered.” If you decide to add one or more sector funds, we suggest that your total allocation to sector funds not exceed 10 percent of the equity portion of your portfolio. Jack Bogle had this to say: “You could go your entire life without ever owning a sector fund and probably never miss it.”

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.

We believe that investors will benefit from an international stock allocation of 20 percent to 40 percent of their equity allocation.

We also suggest a broad-based, diversified bond fund such as Vanguard’s Total Bond Market Index Fund.

The shortest route to top quartile performance is to be in the bottom quartile of expenses. —Jack Bogle

The expense ratio is the only reliable predictor of future mutual fund performance.

In eight out of nine categories, lower-cost funds beat higher-cost funds during 1-year, 3-year, 5-year, and 10-year periods. They also found a similar pattern with bond funds.

Accordingly, we will avoid all load funds and we will favor low-cost index funds. We will always read the prospectus to determine the published costs of any fund we are considering. We will always know a fund’s turnover so that we have an idea of the fund’s hidden transaction costs—the higher the turnover, the higher the cost is likely to be. We will not use wrap accounts. We will remember that low cost is the best predictor for selecting funds with above-average performance. Above all, we will remember—cost matters.

“For all long-term investors, there is only one objective—maximum total return after taxes.”

The lower rates on qualified dividends increase the tax-efficiency of stocks relative to bonds whose yield is taxed at ordinary income tax rates. For this reason, and the fact that stocks benefit from the lower capital gains tax rates, we generally recommend placing stocks in taxable accounts and bonds in tax-advantaged accounts.

One of the easiest and most effective ways to cut mutual fund taxes significantly is to hold mutual funds for more than 12 months. Buy-and-hold is a very effective strategy in taxable accounts.

For maximum tax efficiency in taxable accounts, you should do the following: Favor funds with low dividends. Favor funds with “qualified” dividends. Favor funds with low turnover. Favor tax-efficient index funds and tax-managed funds.

We suggest that the best solution to this problem in taxable accounts is to use low-cost, low-turnover, tax-efficient index funds that do not depend on the skill (or luck) of stock-picking managers. They are tax efficient and low cost, reflect their benchmark index, and can be held indefinitely.

Keep turnover low. We know that buying and selling funds in a taxable account generates capital gains taxes. Therefore, we will try to buy funds that can be held “forever.” Use only tax-efficient funds in taxable accounts. We will try to use only tax-efficient funds in our taxable account(s). This usually means low-turnover index and/or tax-managed funds. Avoid short-term gains. We know that short-term gains are taxed at about twice the rate of long-term gains. Therefore, we will try to hold profitable shares for more than 12 months before selling. Buy fund shares after the distribution date. Mutual funds pay taxable distributions at least annually. If we buy a fund shortly before a distribution date, we will have to pay taxes on the distribution. If we wait until after the distribution date, the value of our purchase will still be the same (assuming no market change), but we will avoid the tax on the distribution. Sell fund shares before the distribution date. There may be a small advantage in selling before the distribution date. Sell profitable shares after the new year. If shares are sold in December, the tax will be due with that year’s return. By simply waiting until January to sell, the tax will be reported a year later. There’s usually no sense in paying taxes any earlier than we have to. Harvest tax losses. This is the practice of selling losing securities in taxable accounts for the purpose of obtaining tax losses to reduce current and future income taxes.

Of all the expenses investors pay, taxes have the potential for taking the biggest bite out of total returns. —The Vanguard Group

The rule is simple: Place your most tax-inefficient funds into your tax-deferred accounts, then put what’s left into your taxable account.

Diversification is a protection against ignorance. —Warren Buffett

In order to diversify your portfolio, you want to try to find investments that don’t always move in the same direction at the same time. When some of your investments zig, you want other parts of your portfolio to zag.

Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it. —Will Rogers

The Motley Fools define market timing as “A strategy based on predicting short-term price changes in securities, which is virtually impossible to do.”

Economists report that a college education adds many thousands of dollars to a man’s lifetime income—which he then spends sending his son to college. —Bill Vaughan

It’s a simple fact of life: More education usually means higher earnings over a lifetime.

Remember, you can always borrow for college, but you can’t borrow for your retirement.

If only God would give me some sign … a clear sign! Like making a large deposit in my name at a Swiss bank. —Woody Allen

Of all the expenses investors pay, taxes have the potential for taking the biggest bite out of total returns. —Michael LeBoeuf

“Asset allocation is critically important; but cost is critically important, too. All other factors pale in significance.”

Foolproof systems don’t take into account the ingenuity of fools. —Gene Brown

We want to make sure that whichever method we choose, it will be one that we’ll stick with through thick and thin during all market conditions.

Rebalancing is simply the act of bringing our portfolio back to our target asset allocation after market forces or life events have changed the percentages of our various asset classes and segments of those classes.

Rebalancing controls risk. It brings our portfolio back to the level of risk that we determined was appropriate for us and that we were comfortable with when we first established our asset allocation plan. As we learned earlier in Chapter 12, one of the primary reasons we hold a diversified portfolio is that asset classes don’t always move in sync, and even when they do, they don’t all have the same expected rate of return or risk level. And, at times, one asset class, or segment of an asset class, might greatly outperform the others, resulting in the outperforming asset class or segment becoming a much larger percentage of our portfolio than desired, while the other portions of our portfolio make up a smaller percentage than called for in our asset allocation plan.

Rebalancing forces us to sell high and buy low. We’re selling the outperforming asset class or segment and buying the underperforming asset class or segment. That’s exactly what smart investors want to do. Although it might be hard for some investors to understand why they shouldn’t simply let their winners run, by doing so, they’d be letting the market dictate the makeup of their portfolio, and thus their risk level.

Rebalancing may also improve your returns, since asset classes have had a tendency to revert to the mean (RTM) over time. By rebalancing, you’re selling a portion of your winning asset classes before they revert to the mean (drop in price) and you’re buying more of your underperforming asset classes when their prices are lower, before they revert to the mean (increase in value). So, you’re selling high and buying low. If you believe in RTM, rebalancing could increase your returns. Jack Bogle believes in RTM, and we do, too.

A fake fortuneteller can be tolerated. But an authentic soothsayer should be shot on sight. —Lazarus Long

Create a simple, diversified asset allocation plan. Invest a part of each paycheck in low-cost, no-load index funds according to your plan. Check your investments periodically, rebalance when necessary, then stay the course.

You aim for the palace and get drowned in the sewer. —Mark Twain

Loss aversion is the flip side of overconfidence. Although overconfidence tends to make us overly bold, loss aversion makes us overly timid about investing.

Begin by writing down your major financial goals on one sheet of paper with dates when you will need the money. Need money for college? How much and when? Need money for a new home? How much and when? Need money for retirement? How much and when? Good planning begins by setting financial goals and target dates.

Pay off your credit card and high-interest debts and stay out of debt. Formulate a simple, sound, asset allocation plan and stick to it. Systematically save and invest a part of each paycheck in accordance with the asset allocation plan. The earlier you start, the richer you become. Invest most or all of your money in index funds. Keep your costs of investing and taxes low. Don’t try to time the market. Tune out the noise, rebalance your portfolio when necessary, and stick with your plan. By doing those things, you will intelligently manage risk.

“Everyone is a fool for at least five minutes a day. Wisdom consists of not exceeding the limit.”

Recency bias. Never assume today’s results predict tomorrow’s. It’s a changing world. Overconfidence. No one can consistently predict short-term movements in the market. This means you and/or the person investing your money. Loss aversion. Be a risk manager instead of a risk avoider. Believing you are avoiding risk can be a costly illusion. Paralysis by analysis. Every day you don’t invest is a day less you’ll have the power of compounding working for you. Put together an intelligent investment plan and get started. If you need help, seek out a good financial planner to assist you. The endowment effect. Just because you own it, or are a part of it, doesn’t automatically mean it’s worth more. Get an objective evaluation. Invest no more than 10 percent of your portfolio in your employer’s stock. Mental accounting. Remember that all money spends the same, regardless of where it comes from. Money already spent is a sunk cost and should play no part in making future decisions. Anchoring. Holding out until you get your price to sell an investment is playing a fool’s game. So is blindly assuming that your financial person is doing a great job without getting an objective reading of what’s really going on. Get a second opinion. Financial negligence. Take the time to learn the basics of sound investing. It’s really pretty simple stuff. Knowing it can make the difference between having a life of poverty or one of prosperity.

I’ve got all the money I’ll ever need, if I die by four o’clock. —Henny Youngman

Current value of your portfolio Your date of death Your portfolio returns every year leading up to your demise Your federal, state, and local tax rates each year until your demise Inflation rates Health care costs Amounts of your pension and any other income Future value of any real estate you may own All unanticipated changes in your pension and health care coverage

As British clergyman and essayist John W. Foster remarked, “The pride of dying rich raises the loudest laugh in hell.” The last suit we wear doesn’t need any pockets.

Insurance is the business of protecting you against everything, except the insurance agent. —Evan Esar

Specifically, you need to consider the following types of insurance: Life insurance for anyone in your family on whom others depend for financial support Health care coverage for everyone in your family Disability insurance on any breadwinner whose future income is vital Property insurance in case of fire, theft, or other disasters Auto insurance Liability protection against expensive lawsuits Long-term care for older family members to prevent nest-egg erosion

Basically, people tend to make three types of insurance mistakes: Insuring the unimportant while ignoring the critical Insuring based on the odds of misfortune Insuring against specific, narrow circumstances

Never fail to buy insurance because the odds of something happening are small.

Only insure against the big catastrophes and disasters that you can’t afford to pay for out of pocket. The cheapest insurance is self-insurance. Carry the largest possible deductibles you can afford. The larger the deductible, the more you are self-insuring and the cheaper the premium will be. Only buy coverage from the best-rated insurance companies. You need insurance companies you can depend on when you need to file a claim.

Most people’s greatest financial asset is their future earning power. Think about this: When you die, your living expenses are over. But let disability strike, and you can face real financial hardships. You still have to eat and pay for living expenses, but can’t work to bring in income. And if that isn’t bad enough, you’re likely to be hit with enormous health care costs too.

Rich people plan for three generations. Poor people plan for Saturday night. —Gloria Steinem

Though no one can go back and make a brand new start, anyone can start from now and make a brand new ending. —Carl Bard

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