Investing 101

How to Clean Up a Portfolio

I’ve written several times about how much I enjoy the Bogleheads forum. While there’s a wide variety of investing-related discussion there, my favorite posts are the simple nuts and bolts ones in which an investor outlines his/her portfolio and other forum members give feedback.

I think it’s fun to see a jumbled mess of a portfolio get cleaned up into something that’s more diversified, lower-cost, and easier to manage. That’s why, when I’m checking out a portfolio, there are three questions I seek to answer:

Is the overall asset allocation appropriate?
Are there any opportunities to cut costs (including taxes)?
Are there any opportunities to simplify?

When answering these three questions, it’s important to remember is that it’s all one portfolio. By implementing your desired asset allocation at the portfolio level (as opposed to in each individual account), you often create opportunities for cost savings and simplification.

Checking the Asset Allocation

As we’ve discussed before, asset allocation is not a precise sort of thing (nor, for that matter, is the concept of risk tolerance, on which an investor’s allocation should be based). As a result, for a given investor, there are countless possible allocations that could be acceptable.

So, for the most part, this step is just a quick check to make sure that there’s nothing that’s clearly wrong (such as a very large allocation to one individual stock or an extremely stock-heavy allocation when the investor has provided no information that would indicate that he/she has a super-high risk tolerance).

Cutting Costs: Start with the 401(k)

When searching for cost saving opportunities, the first place to look is your 401(k). The reason to start here is that all your other accounts (that is, IRAs and regular brokerage accounts) can be held at your brokerage firm of choice, thereby giving you access to low-cost investments in each asset class in these accounts, whereas you don’t always have great options in a 401(k).

So we start with the lowest-cost fund in the 401(k) and allocate as much as possible to that fund without messing up the desired overall allocation. For example, if:

an investor’s 401(k) makes up 25% of her portfolio,
the lowest-cost fund in the plan is a diversified U.S. stock fund, and
her desired asset allocation necessitates holding 30% of her portfolio in U.S. stocks,

…then we’d allocate the entire 401(k) to that U.S. stock fund, and then use the other accounts to fill in the other necessary portions of the desired allocation.

In contrast, if we change the above example so that the investor’s 401(k) made up 40% of her total portfolio, then we would no longer want to allocate the entire 401(k) to the U.S. stock fund (because she only wants 30% of her portfolio in U.S. stocks). Instead, we’d allocate 3/4 of the 401(k) — or 30% of her total portfolio — to that fund in order to achieve her desired U.S. stock allocation. Then we would look for the next-lowest-cost fund in the plan and proceed from there.

Cost Savings: Tax-Efficiency

After doing everything possible to use low-cost investment choices, the next way to look for savings is to try to make things as tax-efficient as possible. The overall goal is to tax-shelter your least tax-efficient assets (REITs, high-yield bonds, and other taxable bonds) by putting them in your tax-sheltered accounts (IRA, 401(k), etc.) before tax-sheltering your more tax-efficient assets.

For most index fund or ETF portfolios, the most tax-efficient asset class is international stocks, so if you only need to leave one asset class in a taxable account, that’s likely to be your best bet.

Simplifying

With regard to simplification, the first and most obvious step is to minimize the number of accounts involved — combining all your non-401(k) accounts at one brokerage firm. (Personally, I like Vanguard. But they’re not the only good choice.)

The next step is to work to reduce the number of funds involved. In many cases this means using just 1 or 2 funds in each account, with the exception of one account (often the biggest one) in which you would hold each asset class and in which the necessary rebalancing would take place to keep the entire portfolio in line with the desired allocation.

January 30, 2012 11 comments

What Can We Learn from Past Performance?

Housekeeping note: Last Wednesday, I upgraded the hosting service for this site. Unfortunately, I messed up the email server in the process and didn’t notice it until Friday. So if you sent me an email last week and did not get a reply, please accept my apologies and resend the email, as I probably never received it.

When it comes to mutual funds, as we all know, past performance is not indicative of future results.

But past performance can still be useful information. One of my favorite ways to use such data is to get a quick, first-glance look at how similar two funds are.

For example, a reader recently asked about whether Fidelity Total Bond Fund (FTBFX) would be a suitable replacement for Vanguard Total Bond Market Index Fund (VBMFX) — he had wanted to use the Vanguard fund, but the Fidelity fund appeared to be the best bond fund available in his 401(k).

The following chart (produced via Fidelity’s website — see the end of this article for instructions on making similar charts) shows us how an investment of $10,000 in each of the funds would have done over the last 10 years.

Conclusion: They’re certainly not the same thing, but they don’t appear to be wildly different either. It’s at least close enough to merit further research (like comparing the funds’ holdings by looking up each fund on Morningstar and viewing the “portfolio” tab).

Or what if your 401(k) had access to Vanguard’s Large-Cap Index Fund (VLACX), rather than a total stock market fund? The following chart compares the fund’s performance since inception to the performance of Vanguard Total Stock Market Index Fund (VTSMX) over the same period.

Conclusion: “High correlation” would be an understatement. In terms of performance, these two funds are virtually identical — which makes sense, given the degree of overlap between the funds’ holdings.

Or what if you’re feeling tempted to switch from a short-term treasury fund to a long-term treasury fund in order to grab a couple extra percentage points of yield, but you want to get a quick feel for how much additional risk you’d be taking on? The following chart compares the 10-year performance of Vanguard’s Short-Term Treasury Fund (VFISX) to that of Vanguard’s Long-Term Treasury Fund (VUSTX).

Conclusion: These two funds are very meaningfully different. By reaching for that additional yield, you take on a pile of additional risk. (Remember how we discussed that the volatility of a bond fund is proportional to its average duration? This picture shows the difference between a 2-year average duration and a 15-year average duration.)

Important Caveats

Of course, the above past-performance-based comparisons come with some important caveats.

First and most importantly, this is just a first-glance sort of analysis. Before investing in a fund, you’d want to actually take a look at its expenses and its portfolio makeup.

Second, the more actively-managed a fund is, the less reliable this sort of comparison will be. For example, an actively managed stock fund could have performed very similarly to the S&P 500 in the past, but there’s no guarantee that would be the case going forward.

Finally, for index funds, such comparisons become much less meaningful if the fund has switched the index it tracks over the course of the period in question — like Vanguard Total International Stock Index Fund, for example. And the same goes for “funds of funds” that have changed their composition (like the Vanguard LifeStrategy funds and Target Retirement funds).

To make such charts on your own: Visit Fidelity’s website, then click “research,” then “mutual funds.” Then enter the ticker symbol for one of the funds in question. Then, under the resulting chart, enter the ticker symbol for the second fund in the field for “compare funds.”

Credit where credit is due: Boglehead forum member nisiprius has been using such visual comparisons in his posts for years. I’ve often found them to be quite enlightening, so I thought I’d share the idea with you.

January 23, 2012 2 comments

REITs Are Stocks

A reader writes in, asking:

“I noticed that you no longer include REITs in your portfolio. [Mike's note: See here for the post explaining the portfolio change he's discussing.] Do you feel that you’re giving up some degree of diversification? And, for those of us who do include REITs, how would you suggest we count them toward an overall stock/bond allocation?”

I liked this question because it gives us a chance to address a couple common misconceptions about REITs.

What is a REIT?

Real estate investment trusts (REITs) are companies that invest in real estate — sometimes commercial real estate, sometimes residential estate, sometimes both.

REITs are unique because of the way they’re taxed. Specifically, they are not subject to corporate income tax, provided that they satisfy a few requirements. For example, REITs must distribute at least 90% of their taxable income to shareholders every year.

Should REITs Be Counted as Stocks or Bonds?

Despite their unique tax treatment and their high yield, shares of ownership in a REIT are still, by definition, equity investments. In other words, when considering your overall stock/bond allocation, a REIT fund should be counted as a stock fund because it is a stock fund — a sector-specific one, much like a health care fund, for example.

REITs Are Included in Total Market Funds

While my portfolio does not include a REIT-specific fund, it does still include REITs. REITs are included in broad “total stock market” index funds in proportion to their market weight — just like stocks from every other market sector.

REITs are included in many other stock index funds as well. For instance, as of last year, the S&P 500 included 15 different REITs.

REITs as a Diversifier

Because of their high-yield characteristic and because of the fact that REITs are often more closely correlated to real estate prices than to the stock market, REITs are often thought to be a good diversifier for a typical stock portfolio — the idea being to overweight them relative to their market weight in the hope of reducing overall portfolio volatility.

Personally, I’ve found the “REITs as a diversifier” argument (just barely*) convincing enough to include a REIT fund in the index fund portfolio my wife and I were using until recently. That said, having now moved to an all-in-one LifeStrategy fund that does not overweight REITs, I’m not worried that we’re missing out in any way that’s likely to meaningfully impact our long-term success as investors.

*It’s useful to remember that imperfect correlation doesn’t in itself make something a useful diversifier — otherwise you could take a total stock market index fund and overweight any stock in it (on the basis that each individual stock has an imperfect correlation to the rest of the portfolio) and thereby reduce the portfolio’s volatility.

January 9, 2012 7 comments

What are Muni Bonds? And Should I Own Any?

A reader writes in to ask:

“I use Vanguard’s Total Bond Market Index Fund for my bond allocation, but I noticed that it doesn’t include any municipal bonds. Can you walk us through municipal bonds — how they work, who should own them, where you should put them (taxable account? IRA?), and which ones should you own (e.g. a general fund or a state-specific fund)?”

Bonds issued by U.S. states or municipalities are exempt from federal income tax. These bonds are referred to interchangeably as tax-exempt bonds, municipal bonds, muni bonds, or even just “munis.”

Because of their tax-exempt status, the market typically prices muni bonds so that they have lower yields than taxable bonds of a similar credit quality.

Who Should Use Muni Bonds?

Tax-exempt bonds only make sense when investing in taxable accounts. In other words, if all of your investments are in tax-sheltered accounts — 401(k), IRA, etc. — your investments are already protected from taxes, so there’s no reason to accept municipal bonds’ lower yields.

But even for investors who can’t tax-shelter all of their investments, muni bonds still aren’t necessarily the best bet.

Because of stocks’ built-in tax-efficiency (due to the maximum 15% tax rate on dividends and long-term capital gains), it generally makes sense to tax-shelter all of your bonds before tax-sheltering any of your stocks. As a result, municipal bonds typically only make sense if:

Your desired bond allocation is larger than the amount of tax-advantaged space you have, and
You’re in a high enough tax bracket that your after-tax yield on taxable bonds would be less than the yield on muni bonds of similar credit quality.

Example: James has $300,000 in a taxable account and $100,000 in an IRA. His desired allocation is 60% stock, 40% bond (that is, $240,000 stocks, $160,000 bonds for his $400,000 portfolio).

Even after James invests his entire IRA in bonds, he still needs to own $60,000 of bonds in his taxable account in order to satisfy his desired bond allocation. If James’ marginal tax rate is high enough, muni bonds could provide a higher yield than the after-tax yield on similarly-rated taxable bonds.

Of course, as with all broad investing guidelines, there will be exceptions. For example, an investor in a high tax bracket might want to own muni bonds in a taxable account and stocks in her retirement plan at work if the retirement plan has inexpensive stock funds but only super-high-cost bond funds.

Should You Own a State-Specific Muni Bond Fund?

While municipal bonds are exempt from federal income tax, they’re usually subject to state income tax. However, if you buy a bond issued by your own state or by a governmental body within your state, the bond will usually be free from state income tax as well.

State-specific muni funds (e.g., Vanguard California Intermediate-Term Tax-Exempt Fund) exist in order to invest in bonds within a particular state to take advantage of this exemption from state income taxes.

So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The downside is that you’d be sacrificing some degree of diversification.

December 5, 2011 3 comments

Bond Duration: What It Is and Why It Matters

The maturity of a fixed-income investment is simply how long the instrument lasts. For example, a 10-year Treasury bond has a 10-year maturity.

Duration is a slightly more complicated concept, but it’s very useful for understanding how bonds and other fixed-income investments work.

The duration of a bond is the weighted-average period of time before the cash flows involved are received. (Technical note for those curious: The weight for each period is not based on the nominal value of the cash flow received at that time, but rather the present value of the cash flow.)

How About Some Examples?

A CD that has a 5-year maturity has a 5-year duration as well, because the only cash flow involved — the payment received when the CD matures — will be received in five years.

In contrast, a 5-year Treasury bond will have a duration that’s less than its 5-year maturity. If sold for face value, a 5-year Treasury bond with a 1% coupon rate will have a duration of 4.89 years. The reason the duration is less than 5 years is that some of the cash flows (specifically, the interest payments) will be received prior to the bond’s 5-year maturity.

A 5-year corporate bond with a higher yield will have an even shorter duration. For example, if sold for face value, a 5-year bond with a 5% coupon rate would have a duration of 4.49 years. Despite having the same maturity as the lower-yielding Treasury bond, it has a shorter duration. The reason for this is that a larger portion of the bond’s overall value is received prior to maturity (because, due to the higher yield, the interest makes up a greater portion of the total cash flows).

Conclusions: The shorter the maturity of a bond, and the higher its yield, the shorter its duration.

Why Bond Duration Matters

For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in the applicable interest rate, times the duration of the bond.

For example, if a 10-year Treasury bond has a duration of 9 years, and interest rates for 10-year Treasuries increase by 1%, the bond’s price will fall by ~9%. (Conversely, if 10-year Treasury bond interest rates fell by 1%, the bond’s price would increase by approximately 9%.)

The same goes for bond funds: The average duration of the fund tells you how sensitive the fund will be to changes in market interest rates.

For example, Vanguard’s Extended Duration Treasury ETF holds nothing but Treasury bonds, but with an average duration of 27 years, it’s extremely high-risk. When interest rates crashed in 2008, the fund put up a positive 55% return. Then in 2009 when rates came back up, it had a negative annual return of almost 37%.

In contrast, Vanguard’s Short-Term Investment Grade fund (with an average duration of 2.2 years) is much lower-risk, despite the fact that that the credit quality of its bonds is meaningfully lower. In the last 15 years, the fund has only had a negative return once. And that loss was a not-exactly-catastrophic 4.74%.

Conclusion: When considering a bond fund, to get an idea of the risk level involved, you need to check not only the credit quality of underlying bonds, but also their average duration.

November 2, 2011 12 comments

Asset Allocation Comes First. Then Fund Selection

I received this question via email a couple days ago:

“What do you think of Vanguard’s Small-Cap Growth Index Fund? Looking on Vanguard’s site, it looks like it has had very good long-term performance (5 and 10 years), and Morningstar gives it 4 stars.

I know it’s an aggressive fund, but I’m a young investor, so I think that might be OK. What do you think?”

I liked this question because it’s a perfect example of a common investing mistake: Building a portfolio backwards by starting with investment selection.

A better way to build your portfolio is to first decide what asset allocation you want to use, then select which investments you’ll use to meet that allocation. After all, a fund can be a great fund, but have absolutely no place in your portfolio.

For example, I think Vanguard’s Inflation-Protected Securities Fund is excellent. It’s a low-maintenance, low-cost way to invest in TIPS. But I don’t use it because I don’t want an allocation to TIPS in my portfolio (because I’m not very exposed to inflation risk).

Choosing Your Asset Allocation

As we’ve discussed before, when choosing your asset allocation, the most important questions are:

What portion of your portfolio do you want in stocks (as opposed to bonds or cash)?
What portion of your stocks do you want to be invested in the U.S. (as opposed to internationally)?

After you have answers to those questions, you can move on to selecting investments to meet that allocation.

Or, if you want to, you can further customize your allocation in any of several ways–adding an allocation to REITs, tilting your stock holdings toward small-cap and/or value stocks, including an allocation to TIPS, etc. But you don’t have to.

Selecting Investments

After you’ve decided what allocation you want to use, it’s time to go ahead and pick funds to meet that allocation. My approach to investment selection involves just two rules:

In each asset class (U.S. stocks, international stocks, bonds, etc.), select the lowest-cost option available.
Use as few funds as possible.

When selecting investments, it’s important to remember to view your portfolio as a whole rather than viewing each account as a separate portfolio. By doing so, you can simplify your holdings dramatically (because you won’t need to hold multiple funds in each account), and you may be able to reduce your costs as well.

No Need to Complicate Things

There’s little point in researching a fund unless you’ve already decided that the asset class represented by the fund is one that you want to include in your portfolio. And once you have decided which asset classes you want in your portfolio (and how you want to allocate between them), the portfolio almost builds itself–just keep costs low and keep things simple.

May 23, 2011 10 comments

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