Bogleheads® investment philosophy

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The Bogleheads® follow a small number of simple investment principles that have been shown over time to produce risk-adjusted returns far greater than those achieved by the average investor. Many of these ideas are distilled from Nobel prize-winning financial economics research on topics like Modern Portfolio Theory and the Capital Asset Pricing Model. But they are very easy to understand and to implement, and they work. In fact, the basis of all of these principles is the idea that successful investing is not a complicated process, and can be accomplished by anyone with a small amount of effort.

These ideas come from the investing philosophy of Vanguard-founder Jack Bogle. They have been further distilled and explained in thousands of posts on the Bogleheads forums, starting with original contributors Taylor Larimore and Mel Lindauer. More advanced concepts were first widely introduced to the Bogleheads community by investing author Larry Swedroe, a tradition that has been carried on by Rick Ferri among many others.

This wiki article provides many details about how to apply these principles, given constraints, such as the specific tax-advantaged accounts an investor has available. For a video presentation of Bogleheads principles, refer to Video:Bogleheads® investment philosophy.

Develop a workable plan

Live below your means. Perhaps the most important idea underlying the Bogleheads approach to investing is recognizing you need to save a significant portion of income every month to have enough money for a comfortable retirement. There is no substitute for spending less than you earn. The Bogleheads approach to developing a workable financial plan is to have a sensible household budget - one that provides for needed expenditures, discretionary pleasures, savings for big ticket items, and savings for long term retirement planning. Avoid excess debt, such as credit cards and home equity loans. If you have such debt, pay off those balances first. Reduce expenses and unneeded debt so you can consistently set aside a portion of earnings for decades. If you don't save enough, no amount of financial trickery will provide the returns needed for a comfortable retirement.

Invest early and often

Fig.1. Returns compounded at 8% per annum


Once you establish a regular savings pattern, you can begin the process of accumulating financial wealth. How much saving is enough? Twenty percent of income is a good baseline number. If you plan to retire before age 65 or plan to leave significant assets to charity or children, you probably need to save even more. The reason starting a regular savings plan early in life is important is that compounding of investment returns can be magnified over a longer period. Figure 1. demonstrates the benefit of starting early.


The best way to save money is to arrange automatic deductions from your paycheck. Many 401(k)s already provide this convenience. When you invest in an IRA or taxable account, select a fund company able to automatically deduct money from your bank account the day after pay day. This concept, described as "paying yourself first," goes a long way towards establishing and reinforcing reasonable spending habits.


There are specific guidelines for which accounts you should fund and in what order. But always remember, you first need to save the money. Saving regularly is more important than investment selection when starting this lifelong process.


Never bear too much or too little risk

Owning stocks is necessary to get the return needed for a comfortable retirement. Stocks provide us with a share of the profits generated by the economy. But in exchange for that high return, stocks are extremely volatile, risky. Many investors learned how risky stocks can be in 2008 when they fell 50% from their previous highs. Over time, stock prices follow the trend of the economy, which is to grow. But, prices can stagnate or decline for decade-long periods. This is why having an allocation to bonds is a necessary element of asset allocation.

Bonds are a promise to pay back a loan of money on a pre-set schedule. Bonds do not produce the same high returns that stocks do, but they are much less volatile. The way to get reasonable growth without stomach-churning drops is to hold a mix of stocks and bonds.

How much bonds? That's the basic question of asset allocation. Before you decide, you first need to balance your ability, willingness, and need to take risk. The more risk you can handle, the less bonds you need. If you do not have need for a high return (perhaps you already saved enough to retire), you should hold more in bonds. The benefit is a reduction in the volatility of portfolio returns. A good guideline is to hold "your age in bonds." When you are young, your prime earning years lie ahead, and it will be decades before you need to access the money. So, big drops in stock prices will not hurt as long as you do not flee the market. As you age, you can afford to take less and less risk.

It is easy to underestimate risk. Many people found out the hard way after the crash of 2008. Those people learned too late they should have been holding more bonds, so you should think carefully before choosing an asset allocation riskier than "your age in bonds." If you have not been through a major market downturn before, it is hard to explain how your logical considerations of risk can quickly become emotional ones.

Bogleheads like to own bond funds instead of individual bonds for convenience and diversification. The high number of bonds in these funds let you ignore the risk of any one bond defaulting. Interest rate risk can be managed if you select funds with short and intermediate-term duration, while default risk can be managed by selecting funds with high credit ratings. The central idea here is that your bond holdings are for safety. Bogleheads tend to take risks on the equity side, not the bond side.

Bogleheads typically divide bond allocations between just two categories: nominal bonds such as the Vanguard Total Bond Market fund, and U.S. Treasury Inflation Protected Securities (TIPS) such as the Vanguard Inflation Protected Securities fund. The use of a TIPS fund provides additional diversification as well as inflation protection.[footnotes 1]

I-Bonds are also an attractive alternative to TIPS. They are sold directly to investors by the U.S. Treasury.

Diversify

Rather than trying to pick the specific securities or sectors of the market (US stocks, international stocks, and US bonds) that will outperform in the future, Bogleheads buy funds that are widely diversified, or even approximate the whole market. This guarantees they will receive the average return of all investors. Being average sounds bad, but it is actually a great thing. That's because most investors perform worse than average after taking into account the high fees they can pay for actively managed funds. If there were no fees, then every year, half of all actively managed funds would outperform the index (because the index is the average). It might seem like an investor would just want to invest in those outperforming funds. But there is no persistence to the results. Funds that outperform one year tend to underperform in the next. And in the real world, investors pay high fees on managed funds. That means more than half of those actively managed funds usually underperform index funds over the long haul.

Never try to time the market

There is a large amount of research showing that typical mutual fund investors actually perform far worse than the mutual funds they invest in because they tend to buy after a fund has done well and tend to sell what they own when it has done poorly. This behavior of buy high, sell low is guaranteed to produce poor results. Instead, Bogleheads create a good plan and then stick with it, which consistently produces good outcomes over the long term.

Use index funds when possible

The best and lowest cost way to buy the whole stock market is with index funds (either through traditional mutual funds or ETFs). The first such retail fund was pioneered by Jack Bogle in 1976, and was called "Bogle's folly" by some members of the financial industry. Today, Vanguard Total Stock Market is the largest mutual fund in the world, and is also one of the best values. Fund expenses weigh in at about one-tenth the industry average. By purchasing this single fund, an investor owns a piece of essentially every public company in the US. This diversification lowers risk, because the failure of any one company does not have a big effect. The investor is still exposed to the high volatility of the overall stock market, but in exchange the investor gets to participate in whatever returns the market is generous enough to give over time.

Bogleheads also like to use low cost index funds to hold international stocks, so they can take advantage of economic growth in other countries. Vanguard Total International Stock Market is one such fund that owns a portion of most international public companies in both the developed and developing worlds. International equity may or may not provide higher growth than US equity over time, and it has historically been even more volatile than domestic stocks. The amount held varies, but is normally between 20 to 40% of the equity allocation.

Keep Costs Low

Figure 2. Reducing Expenses by 1% Per Year [footnotes 2]

The difference between an expense ratio of 0.15% and 1.5% might not seem like much, but the effect of the compounding over an investing lifetime is enormous. After 30 years, a fund with a 1.5% expense ratio will provide an investor with several hundred thousand dollars less for retirement than a 0.15% index fund with the same growth. And remember that most managed funds actually underperform index funds. Costs matter, and investors need returns compounding for their own benefit, not the benefit of fund companies who skim unnecessary fees off the top. Figure 2. is an example showing that 1% of additional costs will reduce available retirement funds by 10 years.

Unfortunately, some 401(k) plans do not offer any index funds. In this unfortunate situation, Bogleheads generally look for the largest, most diversified funds with the lowest fees. These "closet index funds" tend to perform relatively like index funds (although with higher fees). If you need to find the "least-bad" funds available in your 401(k), start by looking for the funds with the lowest expense ratios.

Minimize taxes

Perhaps the reason that Bogleheads focus carefully on tax efficiency is that no one controls how equity markets might perform in a given year. Rather than obsessing over the unknowable, you should focus on areas where your decisions can save money: by preserving money for retirement what would otherwise go to Uncle Sam. The most important rule for tax efficiency is to take full advantage of tax-advantaged accounts such as 401(k)s and IRAs. These allow your money to grow, using the magic of compound interest, without a portion being removed every year to pay taxes. Many investors have large enough tax-advantaged accounts to hold all of their retirement savings, and so never need to worry about tax efficient placement. But for those who also have taxable accounts, look carefully at the tax efficiency of each holding. Some fund types, like total market equity index funds, are extremely tax-efficient, because they produce very low dividends and capital gains. By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate. So Bogleheads put tax-inefficient funds ( bonds) into tax-advantaged accounts. Other tax-inefficient funds that should usually go in tax-advantaged accounts are REITs, small value funds, and actively managed funds that frequently churn their holdings. If there's not enough room for bonds in tax-advantaged accounts, and you are in a higher tax bracket, holding tax-exempt municipal bond funds in a taxable account may be a good choice. Bogleheads who hold taxable accounts also often make use of tax loss harvesting, which is a technique to turn market downturns into immediate tax savings. The key thing to remember about tax efficiency is that tax-efficient asset placement matters. The same funds can produce hundreds of thousands of dollars more for your retirement if you place them in a tax efficient manner.

Invest with simplicity

Simplicity: A three fund portfolio

John Bogle, in his speech, “ Investing With Simplicity, ” said: “Simplicity is the master key to financial success. When there are multiple solutions to a problem, choose the simplest one.” [1]

It is not necessary to own many funds to achieve effective diversification. A single total stock market index fund contains thousands of stocks, including all styles and cap-sizes. A total bond market index fund contains thousands of bonds of various types and maturities. In his Little Book of Common Sense Investing, Mr. Bogle recommends a simple portfolio of only two funds for many investors: Vanguard Total Stock Market Index Fund and Total Bond Market Index Fund. [2]

A simple portfolio has many advantages. It almost always lowers costs (including taxes), makes analysis easier, simplifies rebalancing, simplifies tax-preparation, reduces paper-work and record-keeping, and enables caregivers and heirs to easily take-over the portfolio when necessary. Best of all, a simple portfolio allows you to spend more time with family and friends, and less time managing your finances.

A portfolio held by many Bogleheads forum members is the three fund portfolio, which allocates investments among a U.S. Total stock market index fund, a Total International stock market index fund, and a U.S Total bond market index fund. Many Bogleheads extend the bond portion of this portfolio to include a fourth asset class, U.S. inflation-indexed bonds.

As Bogleheads author William Bernstein says in reference to the three fund portfolio: "Does this portfolio seem overly simplistic, even amateurish? Get over it. Over the next few decades, the overwhelming majority of all professional investors will not be able to beat it." [3]

If your entire portfolio is in a tax-advantaged account, you can simplify even further by owning a single Target Retirement or LifeStrategy fund. Each of these "all-in-one" funds combines the funds in the three fund portfolio into a single fund with a specified stock/bond ratio, so you can select a fund with the appropriate amount of risk. The Target Retirement funds have the additional benefit of a low, $1,000 minimum investment, making it even easier for you beginners to get started with a simple, low-cost, highly diversified mutual fund. Some Bogleheads use more than three or four funds in their portfolios, but as with all investment decisions, you should be aware of the risks and costs before doing so.

Stay the course

This is perhaps the most challenging part of Boglehead investing, but is essential to its success. Bogleheads adopt a reasonable investment plan and then stay the course. When index funds were dramatically outperforming all the alternatives in the 1990's, this advice was easy to follow. But with the crash of 2008, many investors panicked, or at least wavered in their commitment to buy, hold, and rebalance investing. Bogleheads realize that in exchange for the high returns that stocks produce over time, the equity markets are enormously volatile. After big drops, it can be very difficult to continue to follow your pre-set plan. Even during normal markets there are always distractions, such as attractive new asset classes that have recently outperformed, or fancy alternative investment vehicles, such as hedge funds. Bogleheads strive not to be distracted, and strive not to waver. Create an asset allocation that includes bonds to reduce the volatility caused by the stock part of your portfolio, then rebalance when needed. This balanced approach will help you to stay the course. Once you set up a Boglehead portfolio, the only real course correction needed is to rebalance once per year to bring the stock/bond allocations back to pre-set levels. (Investors generally want to increase bond holdings slightly every year, such as by setting the percentage of bonds "to your age in bonds".) Although making only that one change every year takes discipline, it is also an enormous relief to be able to tune out the endless chatter of when and what to buy and sell.

Conclusion

In summary, a Bogleheads investor tends to (1) save a lot, (2) select an asset allocation containing both stock and bond asset classes, (3) buy low cost, widely diversified funds, (4) allocate funds tax-efficiently, and (5) stay the course. One of the wonderful things about Boglehead investing is that it generally only requires a part of a day to set up, and then about an hour a year of effort to rebalance. Beyond that, there is no need to watch the markets or follow financial news. Even better, it works. Although Bogleheads investing may seem strangely simple, it is based on decades of comprehensive research showing that buying and holding the whole market consistently outperforms many of the alternatives. In addition to learning the details of Bogleheads investing from this wiki, we urge you to visit the Bogleheads forum. One may or may not enjoy some of the endless debates about vagaries such as dollar cost averaging or non-deductible IRAs. But nearly everyone appreciates the shared commitment to implementing financial plans that enable us to accomplish our life goals.

See also

Notes

  1. Bogleheads' Guide To Investing, John Wiley & Sons, Inc., 2007, page 103.
  2. Results are simulated. The saving phase simulates a participant with a salary of $45,000 at age 25, linearly increasing to $85,000 by age 65, making yearly contributions of 6% of salary at age 25, increasing by 0.5% per year to a maximum of 10% and with a 50% company matching contribution up to the first 6% of salary. In retirement, $63,750 (75% of final salary) is deducted at the beginning of each year. The blue-shaded area shows ending savings with an after cost investment return of 9% assumed at age 25, linearly decreasing to 6% at age 80 and remaining constant thereafter. Inflation is assumed to be a constant 3%. The tan-shaded area assumes 1% greater return each year due to reducing the costs of investment by 1%. All amounts are in present-day dollars. Source: AllianceBernstein, as presented to the DOL/SEC Hearing On Target Date Funds And Similar Investment Options.

References

  1. John Bogle, Investing With Simplicity
  2. John Bogle, Little Book of Common Sense Investing
  3. Bernstein (2010), The Investor's Manifesto. John Wiley & Sons, Inc., p. 89. ISBN 978-0470505144

External links