Low-Maintenance Investing with Index Funds and ETFs

A reader writes in, asking:

“What happens when an investor in a fund sells their shares? Who buys the shares? And what happens if more people want to sell than buy? Is it possible to have something like a ‘run on the bank’ in which the fund crashes because many investors pull their money out at the same time?”

What happens when you sell a fund depends on whether it’s:

• an ETF (or closed end fund) or
• a traditional (“open-end”) mutual fund.

When you sell an ETF or closed-end fund, the transaction is between you and a third-party buyer. And the price of the fund will be determined by what the buyer is willing to pay for it. (The share price of the fund, however, is typically very close to the value of the underlying investments because institutional investors perform arbitrage trading in order to capitalize on — and eliminate — any such discrepancies.)

When you place a sell order for an open-end fund (e.g., Vanguard’s ordinary mutual funds), the transaction is between you and the fund company. The fund simply pays you cash equal to the NAV of the share you sold.

Background: At the end of trading each day, the total value of the assets the fund holds is divided by the number of shares outstanding. The result is the Net Asset Value (NAV), which is the price at which buy and sell orders of the fund will be executed that day.

In other words, as a fund shareholder, the value of your fund shares will be determined primarily (or exclusively) by the value of the underlying assets held by the fund. And, for the most part, the value of the underlying investments won’t be strongly affected by the actions of other investors in the fund, because most funds own only a small percentage of the total market value of each of their holdings.

For example, Vanguard’s Total Stock Market Index Fund — an absolutely massive fund — owned $5.63 billion of Exxon stock as of the end of 2011, according to Morningstar. Given Exxon’s total market capitalization of $401 billion, that’s just 1.4% of the company. Obviously the actions of the other 98.6% of the stock’s shareholders will be the dominant factor in the stock’s performance. And the same sort of analysis applies for most holdings in mutual funds.

Conclusion: When you own a mutual fund, the bulk of the risk you take on is the result of factors outside of the fund itself, not the result of actions by other shareholders in the fund.

A reader writes in asking:

“I’m 26, and I recently enrolled in my company’s 401k. I know to contribute at least enough to get the maximum match. But how much should I contribute to be on track to retire comfortably? I’ve read numbers anywhere from 10% on up.”

This is one of the most frustrating questions I ever receive. It’s frequently asked, and it’s super important, but I don’t have a very good answer.

The reason the question is so difficult to answer is that it spans such a lengthy period of time. It’s like the already-difficult-to-answer “how much money do I need to retire?” question, but with an additional 3-4 decades of uncertainty tacked on at the beginning of the analysis.

Safe Savings Rates

The best research I’ve seen on the topic is Wade Pfau’s study of “safe savings rates.” Pfau analyzed U.S. historical data (starting in 1926) to determine what percentage of salary an investor had to save per year in order to meet a certain income goal in even the worst-case historical scenario.

For example, Pfau found that for an investor who:

• Uses a fixed 60% stock, 40% bond allocation,
• Has 40 years to save,
• Expects retirement to last 30 years, and
• Wants to replace 70% of his/her pre-retirement income,

…a 12.27% savings rate would have gotten the job done in each historical scenario. (Table 1 of the article I linked to above shows the “safe savings rate” for various sets of inputs.)

Applying This Concept to Real Life

Unfortunately, applying this “safe savings rate” concept to your real-life finances is a bit tricky.

One complicating factor is the fact that safe savings rates are simultaneously:

• Probably higher than necessary (because in all historical U.S. outcomes except one, they resulted in excess savings), and
• Potentially not high enough (because the historical worst-case scenario is not in fact the worst-case scenario).

This is not a fault of Pfau’s work in any way. It’s simply the nature of using historical data to answer questions about the future. But how does one deal with such uncertainty? Should you adjust your savings rate upward (relative to the historical safe savings rate) just to be on the safe(r) side? Or should you plan for a more historically-normal scenario and adjust your savings rate downward?

In addition, we must remember that Pfau’s calculations involved a number of simplifying assumptions.

For example, he assumed that the investor’s inflation-adjusted income is constant throughout his/her working years. In real life, there are raises, promotions, layoffs, career changes, etc. For most people, the constant-real-income assumption is a conservative one — most people’s inflation-adjusted income increases over time. But it’s certainly possible that a particular investor could have the opposite experience. So, how should you adjust the “safe savings rate” to apply it to your own life? Again, there’s no easy answer.

And the calculations ignore taxes completely too. In real life, taxes will play a role in determining:

• The net rate of return that your investments earn (if you’re investing in a taxable account), and
• The amount that you’ll have to withdraw from the portfolio per year in order to have a given level of after-tax income.

Of course, it’s difficult to predict with any meaningful degree of certainty how your personal tax rate will change over the next 6-7 decades.

Pfau’s research is helpful in that it gives us something to work with. But once we account for all the different types of uncertainty involved (e.g., investment returns, tax rates, changes in your income over the course of your career, changes in Social Security, the age at which you’ll retire, and the age at which you’ll die) it’s simply not possible to get any more than a very rough idea of how much a young person should be saving for retirement each year.

While I admit it sounds like a total cop-out, I think the most honest answer I can give to somebody early in her career is, “save what you can (hopefully 10% or more), and make sure to reassess the situation every few years.”