Tag Archives: Index Funds

Defining Your Investment Style

There are many different approaches an investor can take in managing their money.  Some approaches are hands-off and require little effort to maintain the desired asset allocation.  Other approaches are more time intensive and might require daily or weekly management.  There are other approaches that fall somewhere in-between.

No matter how you decide to invest, you need to have an investment philosophy.  It should be part of your financial plan.  Without having direction, there is just too much noise to misdirect you on a daily basis.  Every hot investment tip will sound like a good idea.  That will lead an investor to try to chase performance.

It is up to you to decide how you want to invest your money.  Some approaches are considered more favorable than others because they are tax efficient, cost very little, and allow investors to capture average market returns.  There are approaches that rely on investment professionals to try to beat the market.  Some investors feel confident that they can manage their own selection of individual securities and want to pick their own stocks.  There are also Robo-Advisors that investors can use to manage their investments.

When it comes to trying to invest to build wealth, there are countless avenues for investors to explore.  There is passive investing, active investing, crowdfunding, and countless other forms of ventures to invest in.  The purpose of this post is to cover some of the most common forms of investing where the transactions can occur with the click of a mouse.

Index Funds

Index funds are what their name implies.  An index fund is a mutual fund that is composed of stocks that track a specific index.  For example, if you buy a share of an S&P 500 index fund, you are buying an investment that is made up of the largest publicly traded U.S. corporations.

There is little actual management and turnover with index funds.  That is what makes them cheap and tax-efficient.  A management team is not required.  There is very little trading and turnover within most index funds.

There are index funds that track large-cap stocks, small-cap stocks, international stocks, and bonds.  There are index funds that hold every publicly traded stock in the world.  There are also index funds that track individual sectors or sub-asset classes such as consumer stables, natural resources, technology stocks, and other sectors.

An investor can keep it simple and buy three index funds like the total U.S. stock fund, total international stock fund, and total bond market fund that would allow them to own every publicly traded stock in the world.  An investor can slice and dice and break it down into many different funds and build a custom portfolio with different tilts.  There truly are limitless possibilities.

Managed Funds

Managed funds are like index funds.  They invest in a basket of different stocks or bonds.  The major difference is that they do not track an index.  They have a fund manager or team of managers who try to beat a benchmark.  For example, a managed large-cap growth stock fund would try to beat the S&P 500 index.

Compared to index funds, managed funds have higher fees.  The average expense ratio for a managed large-cap stock fund is 0.99%.  The expense ratio for the Vanguard S&P 500 is 0.04%.  That is almost one whole basis point.

The goal of the fund manager is to outperform its benchmark.  Based on the difference in fees, the fund manager must outperform the S&P 500 by almost 1% per year to just break even.  That is very difficult to do.  It is getting even harder as the result of the shrinking alpha.

For the fund manager to try to beat their respective benchmark, they need to make trades.  They are paid to buy stocks within the fund that they think will outperform.  They also must identify the stocks that they think will underperform and sell them.

All of that buying and selling is called turnover.  Some managed funds have a turnover ratio of 90% or more of their portfolio annually.  If a managed fund is held in a taxable account, all those trades trigger capital gains that are passed on to the investor.

Most managed funds do not beat their benchmark.  In 2016, only 34% of large-cap mutual funds beat the S&P 500.  It gets worse with time.  Only 10% of large-cap mutual funds beat the S&P 500 over the last 15 years.

What happens to the underperformers?  Usually, a new manager is brought in to right the ship.  If its performance does not improve, it normally merges with another fund.

Individual Stocks

Investing in individual stocks can be rewarding.  If you select the right stock, you will outperform the major indexes.  Just look at Google, Amazon, or even Apple.

The problem with investing in individual stocks is that it is hard.  Most active mutual fund managers who have unlimited resources cannot consistently do it.  It is not likely that an individual investor will outperform the S&P 500 for a decade or longer.

Can an investor get lucky when they buy a few stocks?  Sure, they can.  That, however, is speculation.  Investing is not gambling.

When an investor buys an individual stock, it is a vote of confidence in a company.  It is a vote that they know the stock is undervalued compared to its market price.  They are making a statement that says they know more about the fundamental business operations of the company and they are positive that it is sure to appreciate.

They do not know any of those details.  The individual investor receives their information from the financial media or a stock screener.  They are the last to know anything about the value of a stock.  The professionals, analysists, and insiders know before the media.  They provide the information to the media.  The media informs the individual investor.

Robo Advisors

Robo-Advisors are the new frontier for individual investors.  Robo-Advisors are financial management platforms that allow investors to manage their investments based on algorithm-based variables.  An investor plugs in their goals, risk profile, and other survey data and Robo-Adviser does the rest.

The technology used by Robo-Advisors is not new.  The investment industry has been using it to rebalance accounts since the early 2000’s.  It is new, however, for individual investors to have access to this type of asset management technology.

Even though it has been around for some time, it is fascinating technology.  Since it is automated and based off an algorithm, there is not much room for human error.  Not only can it be used for investment selection, but it can also be used for more sophisticated processes like tax-loss harvesting.

There are some nice benefits to using a Robo-Advisor.  They are a much more affordable option than having to hire a human Financial Advisor.  The annual fee to use a Robo-Advisor is between 0.2% to 0.5%.  That is much more affordable than must shell out up to 2% for a human financial advisor.  The minimum amount that is required to invest with a Robo-Advisor is much lower than the standard six-figure minimum that many traditional human financial advisors require.

Conclusion

The above investment styles are just a few of the more popular methods for individual investors.  Over the years, my portfolio has become primarily made up of a few index funds.  I have invested in a few managed funds but sold off all except one.  As far as individual stocks, I have only bought and sold five individual stocks since I started investing.  I have not owned any individual stocks since 2004.  Many investors in the financial independence community use individual stocks as part of their dividend strategy.  As for the Rob-Advisors, I have invested using that technology, but do see its value for tax-loss-harvesting in a retirement account.

What is your approach to investing?

Do you follow any of the methods that I covered or a blend of a few different approaches?

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Bonds to Reduce Volatility

During the first ten years of my investing career, my asset allocation was solely invested in stocks.  From 1997 until 2007, my portfolio returned 8.5%.  I wrote about that period in my first post of this series 100 Percent Invested in Stocks.  In this post, I will write about how adding bonds to my portfolio reduced volatility during the decade that followed.

By the year 2007, my portfolio had five years of positive returns.  At that time, I was reading a good amount of Jack Bogle’s writings on asset allocation.  He suggested holding (100 – your age) in stocks.

After investing for 10 years, it made sense for me to reduce the volatility of my portfolio.  However, I still was focused on aggressive growth because I had the goal of retiring early.  I felt an asset allocation equal to my age in bonds was too conservative.

Another factor that I had to consider was that I was newly married.  Prior to getting married, my wife and I decided to manage all our finances together.  We sat down and evaluated how we wanted to invest our money after we were married.

At that point, I was 30 years old and my wife was 37.  We decided on adding 25% of our portfolio to bonds.  It was close to equaling (110 – our average age) in stocks.

This is how our new asset allocation looked:

S&P 500 Fund – 43%

Extended Market Index Fund – 13%

Total International Stock Market Index Fund – 19%

Total Bond Market Index Fund – 25%

My second decade as an investor was equally as volatile as my first decade. In 2007, our portfolio was off to a solid start by returning over 10%.  Then 2008 came.  That was the beginning of the great recession that resulted from the subprime mortgage bubble burst.  In 2008, our portfolio had a loss of more than -30%.  If I had my original asset allocation of 100% invested in stocks, we would have lost more than -40%.

Just as during the dot.com bubble and the three years of negative returns that followed, we just kept investing and moving forward.  We stuck to our normal schedule of dollar cost averaging.  We also stuck to our plan of semi-annual re-balancing.

Fortunately, the market bottomed out in March of 2009 and one of the greatest bull markets began.  By the middle of 2010, we had recovered all of our losses. From 2009 to 2016, our portfolio averaged over 10.5% annually.

That 10.5% return did not occur without volatility.  During this period, there were peaks and valleys along the way.  There were budget crises, polarizing politics, debt-ceiling debacles, federal government shutdowns, and threats of austerity.

Over the course of those ten years, our portfolio had an average return of 5.24%.  If we were invested in 100% stocks the average return would have only been 5.58%.  By adding 25% in bonds, there was almost zero impact on growth.  The bonds did help to reduce volatility.

If you are not comfortable with having 100% of your portfolio invested in stocks, consider adding some bonds to your allocation.  Bonds are susceptible to interest rate increases, currently have low yields, and do not hold up as well as stocks during periods of inflation. Bonds do, however, reduce volatility when the stock market is in decline.  That is the main reason why they have an important role in our asset allocation.

Please keep an eye out for Part-3 in my series on asset allocation.  In Part-3, I will write about the balanced-growth asset allocation that we will hold until we reach early retirement (FIRE).

Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.

100 Percent Invested in Stocks

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Do you think you have the risk tolerance to invest 100% of your portfolio in equities?  I had an asset allocation of 100% invested in equities for over 10 years.  At this stage in my life, However, I no longer have the need or desire to have that asset allocation.  That was how my portfolio was invested when I reached my first milestone of Saving $100,000 by age 30.

This is the first of a 4-post series about my asset allocation.  This series on asset allocation is about my asset allocation at different points in my investing career.  The series is based on where I started, what happened, where I am at now and where I will be heading based on age and risk tolerance.

My investing career began in 1997.  This was a time Alan Greenspan referred to as a period of irrational exuberance.  The stock market was soaring.  The S&P 500 had an average return of over 15% per year from 1989 to 1999.  If a person invested $100 in the Vanguard 500 Index Fund (VFINX) in 1989, it would have grown to $692 by 1999.

In 1997, I purchased my first mutual fund.  My first fund was the Vanguard 500 index fund (VFINX).  This was the only investment that I owned from 1997 until 2000.  I would purchase at least $500 worth of this funds shares per month.  Over that 3-year period, the Vanguard 500 averaged a return of nearly 20% per year.

In 2000, as the result of my savings and market returns, my portfolio was large enough to add more funds.  To improve my diversification, I wanted to add small caps and international stocks to my asset allocation.  I added the Vanguard Extended Market Index Fund (VEXMX).  By adding the Vanguard Extended Market Index fund to my portfolio, I could replicate the total stock market because I already owned the Vanguard 500 Index Fund.  The third fund that was added was the Vanguard Total International Stock Market Index Fund (VGTSX) for international exposure.

My asset allocation was:

Vanguard 500 Index Fund – 60%

Vanguard Extended Market Index Fund – 15%

Vanguard Total International Index Fund – 25%

As far as equities are concerned, my new portfolio was diversified.  It contained every major publicly traded U.S. and international stock.  In my mind, I was ready for the new century and another decade of 20% annual returns.

It did not take long for the economy to change for the worse.  In March of 2000, the dot.com bubble burst.  On September 11, 2001, New York City and Washington D.C. were attacked by terrorists.  By 2003, the U.S. was fighting two wars in Afghanistan and Iraq.  Those unfortunate events drove the U.S. economy into an extended recession.

As the result of those events, the stock market posted losses for three consecutive years.  The average annual return on my portfolio was a loss of -16%.  In other words, if you invested $100 in January or 2000, it was worth $61 by January of 2003.

How did I handle the prolonged recession and market contraction of the early 2000s?  I stayed the course.  I dollar cost averaged the same amount of money into my investments every month.  My goal was to reach financial independence, so I rode out those volatile markets and took advantage of buying equities at a reduced price.  I would, however, feel unnerved when I paid attention to the media.  Fortunately, I was too busy working and going to college to become obsessed with the media.  I honestly do not remember ever feeling overly fearful during this period.

My patience did ultimately pay off.  By sticking with my allocation, I was rewarded handsomely between 2003 and 2007.  Over the course of those next five years, my portfolio had an average return of more than 16% per year.

During my first 10 years as an investor, my portfolio returned slightly more than 8.5% per year.  This asset allocation, however, was extremely volatile.  The best year returned 34% and the worst year had a loss of -20%.

An asset allocation of 100% invested in stocks is not suited for every investor.  It worked for me because I was young and able to dollar cost average when the market was both up and down.  This type of volatility does cause many investors to sell low and buy high.  That is a losing game if you want to reach financial independence.  If you cannot honestly handle a -40% drop in the value your portfolio, then a portfolio made up of 100% stocks might be too aggressive for you.

There is a simple solution if the volatility of a portfolio invested in 100% stocks causes you to feel insecure.  Add a percentage of bonds to your portfolio that matches your risk tolerance.  In my next post, I will write about how adding bonds to my asset allocation reduced the market volatility of the next decade.

Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.

Meeting the Bogleheads

In February, I attended my first Bogleheads chapter meeting.  It was a long drive.  I drove over 100 miles to the Philadelphia meeting in King of Prussia, Pa.  I have been a follower of the Bogleheads.org forum for many years and have spent countless hours reading the Bogleheads.org forum.

The Bogleheads take their name from John C. Bogle who founded Vanguard in 1975.  He created the Vanguard 500 Index Fund (VFINX).  The Vanguard 500 Index fund (VFINX) was the first index fund available to individual investors that tracks the S&P 500.  John C Bogle has also made a career of being a champion for small investors.  His approach to investing is to build a portfolio of low-cost index funds that are tax efficient and to stay the course during all market conditions.

The Bogleheads are a group of people who follow the investment teachings of John C. Bogle.  They have a forum Bogleheads.org.  They also have written The Bogleheads Guide to Investing and the Bogleheads Guide to Retirement Planning.  The Bogleheads are an altruistic group.  They help others learn about investing at no cost and have donated the proceeds from their books to charity.  A person can post a question about investing, education, careers, consumer goods, as well as other topics related to personal finance on the forum.  Most questions receive many answers from highly knowledgeable and experienced investors.

The Bogleheads’ Guide to Investing

The Bogleheads’ Guide To Retirement Planning

The Bogleheads’ Guide to the THREE-FUND PORTFOLIO

I did not know what to expect since it was my first meeting.  Everyone was friendly and welcoming.  They were happy to see everyone who was in attendance.  Even though I did not know anyone, it was like a meeting with old friends.

There were about 30 people who attended the meeting.  They said that it was one of the larger chapter meetings.  Some people were longtime members.  Others were first-timers, such as myself.  There were people in attendance from Philadelphia, Maryland, New Jersey, Washington D.C., and the Poconos.

It was nice to put a face to some of the avatars that are regular contributors to the forum.  It was a pleasure to meet “Lady Geek”.  If you follow the forum, you know her as the moderator who regularly monitors the posts.  She makes sure that the rules are followed.  If someone strays from following the rules, the post will be removed or the thread will be locked.  The Bogleheads forum is as close as it comes to being a perfect online community.  That is due to the hard work that the moderators put into keeping it positive and educational.  No politics, religion, trolling, or solicitation is allowed.

The topics that were discussed over the course of two hours were:

  • Retiree Portfolio Model, a highly informative lecture on Roth conversions (think MBA level).
  • Social Security tax impact calculator, how a Roth Conversion can impact your Social Security taxes (think Ph.D. Level).
  • Asset allocation, Lady Geek gave a great lecture on asset allocation based on risk tolerance (think undergrad level for newcomers).

It was truly an intense 2-hour lecture.  It was almost information overload.  I left the meeting feeling stimulated and exhausted.  I cannot wait to attend the next meeting in May to listen to the lectures on tax loss harvesting.

The Bogleheads have chapter meetings in most major U.S. cities.  They are free to attend.  I highly recommend attending if you are into reaching FI and FIRE.  If you are interested, there is a local chapter section on the forum to find a meeting near you.  Also, if you are interested in the calculator and more detailed notes from the February 2017 meeting, they can be found under the Philadelphia chapter meeting section on the Forum.