Oblivious Investing

While I certainly don’t think that all actively-managed funds are poor investments, I am firmly convinced that most investors would be better off using index funds instead.

Why? Because of costs.

It’s simple math, really.

Let’s imagine that over the next decade, all the publicly owned companies in the world economy earn a grand total of $800 trillion. As a result, the most that all of the shareholders of those companies could earn on their (stock) investments over the decade would be $800 trillion. Simple so far, right?

However, in reality, the total amount earned by the whole group of investors would be significantly less than $800 trillion. Why? Because of investment costs–things like brokerage fees and commissions, mutual fund sales loads, mutual fund operating expenses, and so on.

In fact, the total amount earned by investors will be precisely equal to the total amount earned by all the public companies, minus the grand total of the investment costs incurred. Or, to put it mathematically:

Total Return for Stock Investors = Total Stock Market Return – Total Cost of Investing

The less investors pay (in total) in investment costs, the greater total return we will earn. Or to be blunt: Investors would make more money (in total) if actively-managed funds didn’t exist.

How this affects you

Of course, the real question is whether you will make more money by paying a fund manager to select investments for you as opposed to using an index fund that simply holds every stock in the index. And the answer, of course, is “you might.”

…but it’s unlikely.

Why? For precisely the same reason, actually: investment costs. Let’s say that over the next decade, the stock market earns a 10% rate of return, and investors on average pay investment costs equal to 1.5% of assets. In this scenario, the average dollar invested will earn a return of 8.5% (10% – 1.5%).

The average dollar invested in an index fund, however, would earn very close to what the market itself actually earned: 10%. (In reality, it would be closer to 9.8% after accounting for a typical index fund expense ratio of 0.2% of assets.)

In other words, while some dollars invested in actively-managed funds will beat the market, most of them won’t.

An analogy

Try thinking of it this way: You have a hat in front of you. In it are scraps of paper with the numbers 1-99 written on them. You are given two options:

• Pick a scrap of paper without looking, and you will win an amount of money equal to the number on the paper. Pull a 20, win $20. Pull an 87, win $87. Or…
• Win $72 automatically.

Taking the $72 obviously puts you ahead for 76 out of 99 possible outcomes. Similarly, index funds are shown in study after study to outperform greater than 60% of their actively-managed peers. (The 72% number came from this article.)

What do you think? Want to pick a number?

February 3, 2011 4 comments

• I check the mail everyday.
• I check Google Reader twice per day.
• My email is in a state of “constantly being checked.”
• As a blogger and business owner, there are about 100 other things (revenue, traffic, incoming links, etc.) that I check fairly often.

And from what I gather, I’m fairly normal in this regard. For most people, if something is:

1. Important to us,
2. Easy to check, and
3. Frequently changing/being updated,

…then we tend to check it frequently.

Account balances clearly fit all three requirements. There’s no way to argue that your IRA balance isn’t important. It’s no harder to check your 401(k) balance than it is to check your email. And your brokerage balance changes (sometimes dramatically) everyday.

And That Makes Investing Difficult.

Checking your portfolio everyday can get you into trouble. On a day-to-day basis, the fundamental returns (i.e., the earnings of the companies you own plus the interest on the bonds you own) are invisible. If we assume a fundamental nominal return of 6% per year and we assume 252 trading days per year, that works out to a daily return of just 0.024%. If you ask me, that’s basically invisible.

In an entire month, the fundamental return would be just half of one percent: still pretty close to invisible.

If you check your portfolio everyday or even every month, all you’re seeing is the noise. You can’t possibly notice the slight fundamental return that’s buried within a mountain of P/E-related effects. Yet, dividends and earnings growth are the primary drivers of long-term stock returns. They are what we should be paying the most attention to.

So How Often Should We Check?

Of course, you can’t completely ignore your portfolio. You have to check every once in a while to rebalance and to see if you’re on track to meet your goals.

As for me, I check 2-3 times per year. (One is scheduled; the others are because curiosity gets the better of me on occasion.) For my purposes, that’s plenty.

What about you? How often do you check your portfolio?

February 2, 2011 5 comments

I recently came across an interesting question on the Boglehead forum:

If you could only own one fund, what would you own?

That question got me thinking about one aspect of investing that doesn’t often get discussed: desire for simplicity. While some investors don’t mind managing a portfolio of ten different funds, other investors would never consider anything so complex.

Generally speaking, the more asset classes you include in your portfolio, the better diversification you’ll achieve, but it begins to require more work to manage the portfolio. Also, the additional diversification derived from adding each asset class is less than the diversification gained by adding the prior asset class.

I thought it would be fun (and perhaps helpful to investors reworking their portfolios) to put together a list of portfolios sorted by complexity. The following are my recommended one-fund portfolio, two-fund portfolio, and so on (followed by some additional thoughts). Please feel free to share your own suggestions.

For each fund, the first ticker is the open-end version of the fund, and the second ticker is the ETF version of the fund.

One-Fund Portfolio

• 100% Vanguard Target Retirement Fund of your choice.

Two-Fund Portfolio

• 70% Vanguard Total World Stock Index (VTWSX, VT)
• 30% Vanguard Total Bond Market Index (VBMFX, BND)

Three-Fund Portfolio

• 35% Vanguard Total Stock Market Index (VTSMX, VTI)
• 35% Vanguard Total International Stock Index (VGTSX, VXUS)
• 30% Vanguard Total Bond Market Index (VBMFX, BND)

Four-Fund Portfolio

• 30% Vanguard Total Stock Market Index (VTSMX, VTI)
• 10% Vanguard REIT Index Fund (VGSIX, VNQ)
• 30% Vanguard Total International Stock Index (VGTSX, VXUS)
• 30% Vanguard Total Bond Market Index (VBMFX, BND)

Five-Fund Portfolio

• 30% Vanguard Total Stock Market Index (VTSMX, VTI)
• 10% Vanguard REIT Index Fund (VGSIX, VNQ)
• 30% Vanguard Total International Stock Index (VGTSX, VXUS)
• 15% Vanguard Total Bond Market Index (VBMFX, BND)
• 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Six-Fund Portfolio

• 20% Vanguard 500 Index (VFINX, VOO)
• 10% Vanguard Small-Cap Value Index (VISVX, VBR)
• 10% Vanguard REIT Index (VGSIX, VNQ)
• 30% Vanguard Total International Stock Index (VGTSX, VXUS)
• 15% Vanguard Total Bond Market Index (VBMFX, BND)
• 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Seven-Fund Portfolio

• 20% Vanguard 500 Index (VFINX, VOO)
• 10% Vanguard Small-Cap Value Index (VISVX, VBR)
• 10% Vanguard REIT Index (VGSIX, VNQ)
• 20% Vanguard Total International Stock Index (VGTSX, VXUS)
• 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
• 15% Vanguard Total Bond Market Index (VBMFX, BND)
• 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Eight-Fund Portfolio

• 20% Vanguard 500 Index (VFINX, VOO)
• 10% Vanguard Small-Cap Value Index (VISVX, VBR)
• 10% Vanguard REIT Index (VGSIX, VNQ)
• 10% Vanguard Total International Stock Index (VGTSX, VXUS)
• 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
• 10% Vanguard International Value (VTRIX, n/a)
• 15% Vanguard Total Bond Market Index (VBMFX, BND)
• 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

*Vanguard’s TIPS fund does not have an ETF version. As such, I’ve included iShares Barclays TIPS Bond Fund (TIP) as the comparable ETF.

Regarding Stock/Bond Allocations

In order to make comparisons easy, each of the above portfolios is built using a 70/30 stock/bond allocation. There’s no particular reason that a 70/30 split was chosen over any other stock/bond split.

Any of the above portfolios can be adjusted to fit your ideal stock/bond allocation. Simply increase (or decrease) the allocation to the bond fund(s) and decrease (or increase) the allocation to each stock fund in proportion to its original allocation.

Regarding U.S. vs. International Allocations

Each of the above portfolios is built using roughly a 50/50 split between U.S. and international stocks. Many investors and investment professionals would view this as too heavy an international allocation. You can see my reasoning here and decide for yourself whether to adjust the international allocations downward.

ETFs or Index Funds?

These portfolios could be implemented at Vanguard via traditional open-end index funds or at an online brokerage of your choice using ETFs. If you do opt to use ETFs, you have an additional motivation to keep things simple: Fewer funds means less commissions paid. (Unless you’re using a brokerage firm that offers commission-free trades, that is.)

November 30, 2009 13 comments