Investing FAQ for the Bogleheads® forum

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Investing FAQ for the Bogleheads® forum provides short answers, and links to longer answers, for questions which often come up in the Bogleheads forum, in order to avoid repetitive discussions and to provide a quick reference for common answers. If you would like to ask one of these questions but have follow-up questions or an unusual situation which may not be covered by the FAQ, feel free to ask it.

If you would like to propose an addition to this FAQ, it should be a question which is asked frequently, and which can be answered reasonably well in one or two paragraphs. A longer answer is also useful; make it a separate Wiki page and link from the FAQ.

Contents

Getting started

Why is Vanguard special?

Unlike other investment fund companies, Vanguard is owned by, and thus run entirely for the benefit of, its investors. Partly as a result, Vanguard has very low costs (see Vanguard FAQ).

From Vanguard's Why invest with us webpage:

Your interests are the only interests we serve Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. Helping our investors achieve their goals is literally our sole reason for existence. With no other parties to answer to and therefore no conflicting loyalties, we make every decision—like keeping investing costs as low as possible—with only your needs in mind.

The low costs are important because of the power of compounding. Paying 0.2% costs (typical for a Vanguard investor) for 30 years means that you lose 6% of your investment to costs. Paying 1.2% costs (common for many investors) means that you lose 30% to costs.

How can I best get investing advice from the Bogleheads?

Follow the suggestions in the Asking Portfolio Questions sticky post.

I just received a windfall; what should I do?

Put the money in a money market fund or other cash investment (such as an FDIC or NCUA-insured savings account), and don't do anything else substantial with it for several months while you learn about what to do. You may, of course, need to use some of the windfall money to pay any taxes due on the windfall, and you might also want to pay down high-interest debt such as credit cards.

A windfall, by definition, changes your financial situation substantially. In addition, it usually comes with an emotional event such as a divorce, death, or buy-out, and that event may also change your financial situation. Therefore, it is best to let the money sit in something which cannot lose value, such as a money-market fund, while you take time to learn what you can do with it and deal with your emotions. This protects you against making an inappropriate investment which will be expensive to sell, or making an investment which is too risky and then shows its risk, or spending more of the windfall than you can afford.

This will be a good time to seek professional advice, particularly if you have never managed a substantial amount before. If you move the money to Vanguard (even to a money-market fund), you may qualify for a free or low-cost plan from Vanguard Financial Planning Services. You may also want to meet with an independent fee-only planner; as with Vanguard, such a planner does not receive a commission from directing you to specific funds. Again, don't try to make a quick decision.

Should I invest a lump sum all at once or gradually?

I have a loan; should I pay it down or invest the money?

Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a low-risk, long-term bond investment, and you can pay the loan down without any liquidity problems.

Paying down the loan earns you a guaranteed return equal to the after-tax interest rate; it is a long-term return because you won't actually be able to use the benefit until the loan is paid off (when you no longer make payments, or have a smaller final payoff amount). Investing in a risky asset may earn you more, but only by taking more risk, just as investing in stocks rather than bonds may earn you more. In both cases, you have a risk-return tradeoff. Therefore, a bond investment gives a fair comparison.

Common requests for information

Why did my fund price suddenly drop in value?

If your fund suddenly dropped in value, check the fund's website to see if a distribution has been declared. A fund's price reflects the amount invested in the fund. Returning some of that investment back to the investors reduces the amount remaining in the fund - which is reflected by a drop in the share price.

If your fund is paying out a dividend and/or capital gains distribution, the Net asset value (NAV) of the fund will drop by the per share amount of the distributions on the payment date (sometimes quarterly, often annually). The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.

Why did my fund price drop so much more than the market?

The most common reason investors ask this question is that the fund paid out a distribution of dividends or capital gains; you received in cash, or had reinvested in the fund, an amount equal to the drop, so you did not lose anything as a result of the distribution. There are also other possible reasons.

  • If you are holding an actively managed fund, the manager's style (size and value/growth) and /or security selection weightings can be quite different from market weighting. Thus the return can vary from that of the market.
  • If you are holding an international stock fund, you should be aware that Vanguard employs a practice known as "fair value pricing" to determine a fund's closing NAV. Foreign bourses close early in relation to the US market, and there are times in which a great deal of market moving information comes to the market during the time lag. One feature of the mutual fund timing scandals of the early 2000's were certain investors who attempted to arbitrage the expected change from the "stale" foreign closing NAV prices of an international mutual fund into its expected closing US NAV. Fair value pricing is employed in instances where news indicates a substantive change in market value from the closing home market price. The adjusted price is used to more accurately reflect the "true" market price for US investors, thus foiling would-be market timing arbitrageurs.
  • If your fund is paying out a dividend and/or capital gains distribution, the NAV of the fund will drop by the per share amount of the distributions on the payment date (sometimes quarterly, often annually). The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.

The stock market had a significant drop, what should I do?

First, do not act emotionally. Think things through before making any changes.

Second, if you decide to make a radical change, don't do it until next week. Chances are you will change your mind again by then.

See: Tips on answering the question - What Should I Do?, forum discussion

Does it matter that different share classes have different prices?

No. Share class net asset value (NAV) is entirely arbitrary. If you invest $5,000 and the NAV is $10, you'll get 500 shares. If the NAV is $20, you'll get 250 shares. Either way, you bought five thousand dollars' worth.

How do I use specific identification of shares when selling?

If you sell a Vanguard mutual fund, then send Vanguard a secure Email with a text such as, "I am about to place an order to sell 234.456 shares of the XYZ Fund. Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email." You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you. (You still need to follow this procedure for selling shares purchased before 2012; for shares purchased in 2012 or later, Vanguard keeps track of shares for you.)

If you have "non-covered" shares of stocks or ETFs in your Vanguard brokerage account (purchased before 2011 for stocks, before 2012 for ETFs), you can enter the lot information yourself and then use specific identification when you sell online.

Asset allocation

Asset allocation is a complicated process; which parts are most important?

The most important decision to make in your asset allocation is the percentage you hold in stock. This is the primary factor in determining the risk of your portfolio; in a severe bear market as in 1973-1974 or 2007-2009, your loss would probably be about half the percentage you have in stock.

Therefore, you want to get the correct stock allocation before worrying about finer details, and you should be willing to pay some extra cost to get the correct allocation. For example, it is worth paying an extra tax cost if you must hold bonds in your taxable account, or using a higher expense bond fund in your 401(k).

Most of my investments are taxable; how should this affect my allocation?

You should still try to get the correct bond allocation, even if you must hold bonds in a taxable account, because this controls the risk of your portfolio. Compare after-tax yields to see whether municipal bonds or taxable bonds make sense.

For other parts of your allocation, you should try to find tax-efficient alternatives. If you don't have room in your tax-deferred accounts, you should probably avoid active funds and REITs, and possibly avoid value stocks. Index ETFs, index funds with ETF classes, and tax-mangaged stock funds, are usually tax-efficient. Even in an index fund, value stocks have an extra tax cost because of their higher dividend yield; you have to decide whether the extra tax cost is worthwhile. (REITs, even with the index fund, should still be avoided in taxable because they have a high yield in non-qualified dividends.)

Taxable accounts

Should an active fund be held in a taxable account?

No. An actively managed fund tends to distribute capital gains, for which you have to pay tax if the fund is held in a taxable account. The extra tax cost of most active funds is over 1%, and you want to avoid a fund with an extra 1% tax cost for the same reason you want to avoid a fund with an extra 1% in expenses. In addition, even if the fund has a low tax cost now, it might change managers and the new manager could sell most of the old manager's picks for a gain, or you could decide that you no longer like the new manager and have to sell the fund yourself for a gain.

If you already have an active fund with very low turnover (around 10% or less) and low costs, and you would have a large capital gain if you sell it, then it may be worth keeping the fund rather than paying the tax cost to sell it.

Should a balanced fund be held in a taxable account?

No. In a taxable account, it is better to hold bonds and stocks separately, even if you cannot move the bonds into a tax-deferred account.

If you have a balanced fund, you can only sell bonds and stocks simultaneously. If you want to sell only bonds, in order to hold fewer bonds or a different type of bonds, you will have to sell the stock as well and pay a capital-gains tax.

I have the wrong fund in my taxable account, but it will cost me to switch; should I do it?

Usually, it is worth switching even if you pay a capital-gains tax to switch; if you have significant short-term gains, wait for them to become either losses or long-term gains for the tax savings. Meanwhile, consider turning off reinvestment of dividends and capital gains to avoid buying even more shares of the wrong fund.

If the annual difference in taxes and costs is more than 10% of the tax you would pay, you should almost always switch. If the difference is less, multiply the amount saved per year by the number of years you expect to hold the fund, and if that is equal to, or even close to, the tax cost, then you should come out ahead by switching. Here is a spreadsheet which you can use to make the comparison.

Should I reinvest dividends in my taxable account?

Usually, you should not reinvest dividends in the same fund automatically, but direct them to a money-market fund. Directing the dividends to a money-market fund gives you tax-free money for rebalancing; if you reinvest the dividends in a fund which is over its target weight at the time, you may need to sell the same shares to rebalance and pay a tax bill. Automatic reinvestment of dividends in any fund will make accounting more complicated (more tax lots and possible wash sales), particularly if you use Specific identification of shares to minimize taxes.

You might want to reinvest in a fund which charges a purchase fee if you are still in the accumulation phase so that you can rebalance with new money; you do not pay the purchase fee on reinvested dividends.

Asset location

Which funds should I place in my taxable account?

As a basic rule, broad based market-weighted equity index funds are tax-efficient, so they are appropriate for a taxable account. Good choices include the Vanguard Total Stock Market Index Fund and the Vanguard FTSE All-World ex-US Index Fund (or their ETF versions). Similarly, tax-managed stock funds are excellent choices for a taxable account if they fit your allocation.

While municipal bond funds are exempt from Federal taxes, there is an implicit tax cost to holding them, as their yields are lower than the yields on corporate bonds of comparable risk. Therefore, you should try to hold bonds in your tax-deferred account if you can fill your taxable account with tax-efficient stock funds. If you run out of tax-deferred room, you may need to hold bonds in your taxable account.

The following chart provides a handy graphic illustration of a tax-efficient asset location hierarchy:

Approximate Tax Efficiency Ranking for Major Asset Classes
Most Tax Efficient

Place Anywhere
Tax Efficient Fund Placement - Arrow.png
Least Tax Efficient
Place in Tax-Free
or Tax-Deferred

Assets

Efficient

  • Low-yield money market, cash, short-term bond funds
  • Tax-managed stock funds
  • Large-cap and total-market stock index funds
  • Balanced index funds
  • Small-cap or mid-cap index funds
  • Value index funds

Moderately inefficient

  • Moderate-yield money market, bond funds
  • Total-market bond funds
  • Active stock funds

Very inefficient

  • Real estate or REIT funds
  • High-turnover active funds
  • High-yield corporate bonds

I have a Roth and a 401(k); what should I place where?

First select the best (usually lowest-cost) funds in your 401(k) plan, Complete your asset allocation plan by selecting appropriate funds and placing them in your Roth.

If all else is equal (for example, both funds are with Vanguard), it is slightly better to have higher-returning funds in the Roth IRA, because it is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.

I have a bad 401(k); should I invest in it or in a taxable account?

See linked article for guidance on how to make the most of a 401(k) plan with high-expense and/or mediocre fund choices, including a formula on when you might be better off investing in a taxable account over a 401(k) plan without an employer match, as well as suggestions on how to improve your company's plan.

Should I invest in a Roth or traditional IRA or 401(k)?

Your first choice is to always contribute to your 401(k) up to the company match. Whether you should invest in a Roth or Traditional IRA, or Roth or traditional 401(k), primarily depends on whether you expect to be in a higher or equal income tax bracket at retirement (pick the Roth) or a lower income tax bracket at retirement (pick the Traditional IRA if you are eligible for a deduction). After maximizing your IRAs, and if your 401(k) plan is satisfactory, contribute the maximum 401(k) deferral amount ($17,500 in 2014[1]) into the 401(k).

If you can max out your 401(k) or IRA, and expect to be in about the same tax bracket at retirement, the Roth is better because it allows you to effectively tax-defer more money. For example, if you are in a 25% tax bracket, you can invest $5,500 in a Roth IRA, or $5,500 in a traditional IRA (of which the IRS owns 25%, so it is only worth $3,875 to you) and have $1,325 in tax savings which you must invest in a taxable account.

Choosing specific funds

This section discusses only the comparisons between similar funds. It is not intended to give asset allocation recommendations, which are strongly dependent on your individual situation and too complex to give a general answer.

Which international index fund should I use?

Vanguard's main choices for broad international equity exposure are the Vanguard Total International Stock Index Fund and the Vanguard FTSE All-World ex-US Index Fund. The primary difference is that Total International includes small-cap stocks as well, so it is a more complete index; if you use the FTSE fund and also want to add small-caps, you will need to add the Vanguard FTSE All-World Ex-US Small-Cap Index Fund. Both funds cover almost all of the world except for the US, both have ETF classes, and both are suitable for a taxable account because they are eligible for the foreign tax credit.

Detailed comparisons are available in FAQ on Vanguard international funds.

How do I compare bond funds?

Once an investor has decided on the duration and credit quality of their low-cost bond fund options (See John Bogle), a decision must be made about tax expense. For taxable account bond holdings the after-tax return of the fund portfolio can be a determining factor in fund selection. In general bonds face the following taxes:

  • Corporate bonds are subject to federal and state tax;
  • Treasury bonds are subject to federal tax but are exempt from state tax;
  • Municipal bonds are generally exempt from federal tax, but are subject to state tax (unless the bond is issued in one's state of residence, in which case it is generally tax-free income). Some types of municipal bonds are subject to the alternative minimum tax.

The Bond Fund Yield Calculator courtesy of The Finance Buff can be used to compare the after tax yields of a bond fund.

Income Tax Rates are available from the following sources:


The fund provider can give you the percentage of a tax-exempt money-market or bond fund's assets held in securities subject to the alternative minimum tax, and the percentage of a taxable money-market or bond fund's assets which are held in Treasury bonds exempt from state tax; note that some states have a minimum percentage of Treasuries for deductibility. Information from Vanguard can be obtained at the Vanguard web site:

Vanguard Bond Fund Link

Should I use bonds or bond funds?

For most investors, buying a bond fund is better than buying individual bonds unless you are buying Treasury bonds and you have a need to control your own allocation to bonds of different maturities. You do pay a small management fee to hold a bond fund; for most of Vanguard's bond funds, the expense is about 0.2% for Investor shares and 0.1% for Admiral shares. In return, you get diversification and more liquidity.

Should I use Total Stock Market or tax-managed funds for US stocks?

Vanguard Total Stock Market Index Fund, being very tax-efficient, is the natural choice for broad US equity exposure, and the US stock index funds with ETFs are also tax-efficient. Tax-Managed Capital Appreciation and Tax-Managed Small-Cap may save a bit in taxes over non-tax-managed large-to-mid-cap and small-cap funds if you must hold such funds separately. There is relatively little benefit to holding a combination of Vanguard Tax-Managed Small-Cap Fund and Vanguard Tax-Managed Capital Appreciation to approximate the total stock market; any tax savings will likely be canceled by the lower expenses of Total Stock Market.

Should I use target retirement funds?

The Vanguard Target Retirement Funds are excellent choices if your portfolio is entirely tax-deferred and entirely in target retirement funds; in particular, they are an ideal way to get started investing for retirement because they cover many types of investments with a single fund. You can also use non-Vanguard target retirement funds in the same way; if your 401(k) is not with Vanguard but has a target retirement fund which holds reasonable funds and does not add any extra costs, you can use it in your 401(k) and a Vanguard fund in your IRA.

You should not use target retirement funds if they are not all, or almost all, of your portfolio. The target retirement funds are designed to adjust your portfolio automatically to a reasonable allocation given your time to retirement. If you have other funds, your whole portfolio will not keep the correct allocation unless you adjust your non-target-retirement portfolio on your own, and once you have done that, you no longer gain anything from the simplicity of the target retirement funds.

If you have both tax-deferred and taxable accounts, there is a tax cost for using target retirement funds, or any balanced funds. You want to hold tax-efficient assets such as stock index funds in your taxable account, and tax-inefficient assets such as bonds in your tax-deferred account; using a target retirement fund in both accounts will lead to a higher tax bill than necessary.

If you have only a taxable account and will always be in a reasonably low tax bracket (so that corporate bonds are not too costly for your bond holdings), the simplicity of the target retirement funds may be worth the slight additional tax cost.

Exchange-Traded Funds (ETFs)

What is an ETF?

An ETF is a fund which is not bought or sold from the mutual fund company, but bought or sold from another shareholder on the stock exchange. The ETF provider also allows investors to convert a specified large block of shares of the ETF into shares of the securities the ETF holds, or vice versa. Therefore, the price of an ETF tends to stay close to the price of the underlying securities; if an institution can convert 100,000 shares of an ETF into $5,000,000 worth of stock, then it will want to buy the ETF if the price drops significantly below $50 so that it can profit from the conversion.

Vanguard's ETFs are a share class of the index funds (See Vanguard ETF/fund ratios for details). Therefore whether you buy the index fund directly from Vanguard or the corresponding ETF on the stock exchange, you have the same holdings. If you hold the index fund and would prefer to hold the ETF, you can convert the fund shares to ETF shares; this does not require selling or buying shares, and thus you do not pay tax on any gains.

Should I use mutual funds or ETFs?

Use whichever is more convenient and lower in cost for your own situation. The choice has no effect on your investment philosophy, as mutual funds and ETFs are two different ways of holding the same type of investments.

ETFs often have a lower expense ratio than mutual funds, but you must have a brokerage account to hold ETFs, and the brokerage has its own costs, both for the account and the commissions and bid-ask spreads you pay when trading. Most Vanguard ETFs have the same expense ratio as Admiral shares, so the cost savings goes away if you qualify. ETFs avoid the purchase and redemption fees charged by some funds, and are thus particularly attractive alternatives to mutual funds which charge those fees.

If you have a 401(k), you will be restricted to the mutual funds available there, and cannot buy ETFs unless your 401(k) has a brokerage option. If you have a non-Vanguard brokerage account, you probably want to hold Vanguard funds as ETFs rather than mutual funds (or else buy the mutual funds directly from Vanguard), as most brokerages charge a larger fee for buying Vanguard mutual funds than the commission for buying ETFs.

Do ETFs have a tax advantage?

Most stock ETFs have a potential tax advantage over similar mutual funds. However, Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF.

When a mutual fund or ETF sells a stock, it has a taxable capital gain (or loss) equal to the difference between what it received and what it paid. If an institutional investor converts shares of an ETF to stock, the ETF provider can give away the shares of stock with the lowest purchase price; these are the shares which would have the highest gain if sold. Thus ETFs can often reduce the capital gains they must distribute. The ETF conversion process does not reduce dividends; therefore, taxable bond and REIT ETFs, asset classes with total returns comprised primarily of non-qualified dividend income, still have a high tax cost.

Some ETFs have distributed capital gains in their early years, but few have distributed gains later. For example, only three Vanguard stock ETFs have ever distributed a capital gain, and only one of those three (REIT Index) distributed a gain after its second year. Refer to Vanguard Funds: Distributions for detailed tax data on individual funds.

How should I place orders to buy and sell ETFs?

The least risky way to buy or sell an ETF is to place a limit order matching the best available offer. For example, if your broker's data shows that someone is offering to sell shares at $20.02, you can place a limit order to buy at $20.02. You will buy at that price unless the offer to sell was taken or withdrawn before your placed your order to buy; if it was withdrawn, you do not automatically buy at the next-best offer (which could be at a much higher price), as you would if you placed a market order.

References

  1. 401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals, from the IRS