Risk and return

 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 really 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, particularly by 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 boglehead principles, refer to Video:Bogleheads® investment philosophy.

Develop a workable plan
Perhaps the most important idea underlying the boglehead approach to investing is that an individual needs to save a significant portion of income every month in order to have the money needed in the future to comfortably retire. There is simply no substitute for spending less than one earns. Individuals also need to avoid excess debt, such as credit cards and home equity loans (or having such debt, paying off the balances). Reducing expenses and unneeded debt can allow an individual to consistently set aside a portion of earnings for decades. If individuals don't save enough, no amount of financial trickery will provide the returns needed for a comfortable retirement.

Invest early and often


Having established a regular savings pattern one can begin the process of accumulating financial wealth. How much saving is enough? Twenty percent of income is a good baseline number. For retirement before age 65, or for leaving significant assets to charity or children, one probably wants to save even more. The importance of establishing a regular savings plan as early in life as possible is that the compounding of investment returns is magnified over longer periods. Figure 1. graphically demonstrates the efficacy of starting the process early.

By far the best way to save money is to arrange to have it automatically deducted from one's paycheck. For people with 401(k) plans, this happens automatically. For investing in an IRA and/or a taxable account, one should set it up with a fund company to have the money automatically deducted from one's 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 as to which accounts one should fund in what order. But always remember, one first needs to save the money.

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. Many investors learned how risky stocks can be in 2008, when they fell 50% off of their previous high. Over time, stocks follow the trend of the economy, which is to grow. But they can have decade-long periods where they do not grow at all. So having the correct allocation to bonds, which can provide ballast for one's portfolio, is also 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. The decision requires an investor to to balance one's ability and need to take risk. The more risk one can handle, the less bonds one needs. If one doesn't have need for a high return (perhaps having already saved enough to retire), one should hold more in bonds. This results in a reduction in the volatility of portfolio returns.

A good guideline is to hold "your age in bonds". When one is younger, one's prime earning years lie ahead, and it will be decades before one needs to access the money. So a big drop in stock prices will not hurt a younger investor, as long as it doesn't cause the investor to flee the market. As one ages, one can afford to take less and less risk. Many people thought they could deal with large amounts of risk, but found after the crash of 2008 that they psychologically could not. Those people should have been holding more bonds. One needs to think very carefully if choosing an asset allocation riskier than "your age in bonds".

Many Bogleheads like to own bond funds instead of individual bonds for the convenience and to diversify the risk of any one bond defaulting. We tend to stick to bond funds with short and intermediate-term duration and high credit ratings. We use our bond holdings for safety, and take our risk in equities. Typical Bogleheads bond allocations are between 50% to 100% nominal bonds (such as Vanguard Total Bond Market) and 0-50% inflation-protected securities (such as Vanguard Inflation Protected Securities), with the median being 20% in a recent poll. The nominal bonds provide protection against a deflationary environment, and the inflation-protected bonds offer protection against the ravages of unexpected inflation. Together, they provide the safety or "ballast" that keeps a portfolio steady.

Diversify
main article:Asset Allocation

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 that investors will receive the average return of all investors. Being average sounds bad, but is actually a great thing. That's because the vast majority of investors perform worse than average, after taking into account the high fees investors 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, which means that over time more than half of those actively managed funds usually underperform index funds.

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 of their tendency to buy after a fund has done well and sell when it is doing poorly. This behavior of buy high, sell low is guaranteed to produce poor results. Instead, Bogleheads put together a good plan and then stick with it, which consistently produces good outcomes.

Use index funds when possible
main article:Indexing

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 also one of the best values, charging fees about one tenth the industry average. By purchasing that one 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 the high returns over time.

Bogleheads also like to use low cost index funds to hold international stocks, so that we 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, but it has historically been even more volatile than domestic stocks. We generally try to hold 20 to 40% of our equity in international.

Keep Costs Low
main article:Expense Ratios



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 being skimmed off in unnecessary fees by the fund company. 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 at all. In that case, Bogleheads will generally invest in some of the largest, most diversified funds with the lowest fees. These are sometimes called "closet index funds", because they tend to perform relatively similarly to index funds (although with higher fees). If one needs to find the "least-bad" funds available in a 401(k), one of the best ways to start is to look for the funds with the lowest expense ratios.

Minimize taxes
main article: Principles of Tax-Efficient Fund Placement

Perhaps the reason that Bogleheads focus so carefully on tax efficiency is that we realize that we have no control over what the equity markets might do in a given year. Rather than obsessing over the unknowable, we like to focus on areas where our decisions can save us significant money, by preserving money for our retirement that would otherwise be paid 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 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 of us who also have taxable accounts, Bogleheads look carefully at the tax efficiency of each of our holdings. We recognize that some kinds of funds, particularly 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 our tax-inefficient funds (particularly bonds) into our 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 the investor is in a higher tax-bracket, holding tax-exempt municipal bond funds should be considered for the taxable account.

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 one's retirement if they are placed in a tax efficient manner.

Invest with simplicity
main article: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.”

Uninformed investors believe that more funds result in better diversification. This is not necessarily true. The fact is that a single total market stock index fund contains thousands of world-wide stocks including all styles and cap-sizes. Total bond market index funds contain thousands of various type bonds with  maturities ranging from less than one year to over thirty years. 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.

A simple portfolio is the ultimate sophistication. It almost always lowers cost (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 the investor to spend more time with family and friends.

A widely held portfolio among Bogleheads forum members is the three fund portfolio allocating investments among a U.S. Total market stock market portfolio; a Total International stock market portfolio, and a U.S Total bond market portfolio. This portfolio is frequently expanded to include a fourth asset class, U.S. inflation-indexed bonds.

Stay the course
main article: Investment Policy Statement

This is perhaps the most challenging part of Bogleheads investing, but is absolutely essential to its success. Bogleheads adopt a reasonable investment plan and then we 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 and hold 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 one's pre-set plan. Even during more 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 do our best not to be distracted, and not to waver. We create an asset allocation with a large ownership of bonds in order to reduce the volatility of our portfolios and help us stay the course. Once one sets up a Bogleheads 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 save a lot, selects an asset allocation containing both stock and bond asset classes, buys low cost, widely diversified funds, allocates funds tax efficiently, and stays the course. One of the wonderful things about Bogleheads 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 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.