Bogleheads® investment philosophy

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 The Bogleheads follow a few simple investment principles that have historically produced risk-adjusted returns that are better than the returns of average investors. These principles are the results of Nobel prize-winning research on Modern Portfolio Theory and the Capital Asset Pricing Model. They are however easy to understand and implement, and they work. Using these principles can make it simple to invest successfully. Anyone can do it with a small amount of effort.

The main ideas come from the investing philosophy of Vanguard's founder, John Bogle. They have been distilled and explained in a comprehensive set of articles on this Wiki. You can find additional information in the thousands of posts on the Bogleheads forum, starting with those of original contributors Taylor Larimore and Mel Lindauer. Investing authors Larry Swedroe, Rick Ferri, and others have introduced more advanced concepts.

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.

Live below your means
You should try to spend less than you earn. In other words, you should have money left over at the end of the month. This is called "living below your means" and to do it you need to consider how you spend your money. If you do this correctly, you will still have the things you really need to be happy.

Establishing a household budget is an important step in living below your means as it provides visibility on income and expenses.

But living below your means means more than just balancing your budget. It is important to know the difference between what you need and what you want.

Develop a workable plan

 * Watch the video: Start with a sound financial lifestyle.
 * Watch the video: Develop a workable Plan

The Bogleheads approach to developing a workable financial plan is to first establish a sound financial lifestyle.

The first step to a workable financial plan is establishing a sound financial lifestyle, starting with a sensible household budget. A budget makes sure that you can cover necessary expenditures such as housing, food and clothing, discretionary items such as eating out and holidays, saving for large items like home purchase and higher education for your children, and saving for retirement.
 * Avoid bad debt. Typically, this would be any debt with a high interest rate, for example credit card debt. If you have any, pay it off first.
 * Understand that you may need to save a significant portion of your income every month to give you enough money for a comfortable retirement. There is no substitute for spending less than you earn. Live below your means. If you do not save enough, your assets will not provide the returns you need for a comfortable retirement.

After establishing your sound financial lifestyle, you it is useful to write a simple plan for yourself. Of course you cannot know the future, but writing a plan will help you shape your ideas. The plan does not need to be perfect, just reasonable. Include assumptions in your plan, but be ready to change them when you get better ideas or better information. Your goal is to make this plan a reality. Writing it down will help you gain the discipline to do that.

Never bear too much or too little risk

 *  Watch the video

Your risk tolerance is your ability to stick to an investment plan through difficult financial and market conditions. To know if an asset allocation matches your risk tolerance, ask yourself if you held it, would you sell during the next bear market? This is very hard to answer honestly before you have experienced one.

To give you enough money for retirement, you want assets with a decent expected return. This means you need to own stocks. Stocks return a share of the profits generated by publicly owned companies. But although they offer a chance of good returns, stocks are volatile and risky. In 2008, some markets fell 50% from their previous highs. Over time, stock prices roughly follow the trend of the economy, which is to grow. But prices can stagnate or decline for decade-long periods. This is why your asset allocation needs to include bonds as well as stocks.

Bonds are a promise to pay back a loan of money on a set schedule. Bonds do not have the expected returns of stocks, but they are much less volatile. A mix of stocks and bonds will produce reasonable growth while limiting the size of the inevitable drops.

How much in bonds? This is 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. When you are young, your prime earning years lie ahead, and it will be decades before you need to access the money. So, higher stock allocations may be suitable, because big drops in stock prices will not hurt as long as you do not sell during the drop.

John Bogle wrote: "[A]s we age, we usually have (1) more wealth to protect, (2) less time to recoup severe losses, (3) greater need for income, and (4) perhaps an increased nervousness as markets jump around. All four of these factors suggest more bonds as we age."

Although your exact asset allocation should depend on your goals for the money, there are a few general guidelines that you can follow. These are based on practice rather than on theory, and are only a starting point for decision making, not the end.

Although your exact asset allocation should depend on your goals for the money, there are a few general guidelines that you can follow. These are based on practice rather than on theory, and are only a starting point for decision making, not the end.

For example, Benjamin Graham wrote: "We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums."

Alternatively, John Bogle recommends "roughly your age in bonds". For instance, if you are 45, 45% of your portfolio should be in high-quality bonds. He describes the idea as just "a crude starting point" which "[c]learly ... must be adjusted to reflect an investor's objectives, risk tolerance, and overall financial position". He also suggests that you should treat any national or state retirement income you might receive as if it is a bond, setting its assumed value appropriately.

This "age in bonds" and its variants, age minus ten years or age minus twenty years, are only approximate starting points. You will probably want to adjust them to fit your circumstances. For example, if you have a guaranteed state or other pension, this changes both your need and your willingness to take risk. Some investors do not add pensions and Social Security to their asset allocation of bond holdings.

It is easy to underestimate risk and to overestimate your tolerance for risk. In 2008, many people learned too late that they should have been holding more bonds. Think carefully before choosing an asset allocation with high stock market allocations. If you have not been through a major market downturn before, your abstract logical thoughts about risk can quickly become emotional ones. The developing field of neuroeconomics explains how mental traits and emotional effects that work well in other areas undermine our ability to deal rationally with markets and investing.

You should generally own bond funds instead of individual bonds, for convenience and diversification. Using individual corporate or municipal bonds require a very large holding in order to achieve the broad diversification and increased safety of a bond fund. The high number of different bonds in bond funds lets you ignore the risk of any one bond defaulting. You can manage Interest rate risk by choosing funds with short and intermediate-term duration, and  default risk by choosing funds with high credit ratings. The idea here is for your bond holdings to reduce violent up and down swings in overall portfolio value. You want your risks on the equity side, not the bond side.

Aim to select an asset allocation that lets you sleep at night, and avoid the destructive urge to sell out in a panic the next time the market plummets, then having to worry over when is the time to get back in. This leads to selling low and buying high, the exact opposite of prudent investing.

You may be able to divide your 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]. Inflation protected bonds provide both additional diversification and inflation protection.

I-Bonds are also an attractive alternative to TIPS. You can buy them directly from the U.S. Treasury; you can buy them using your IRS tax refund; they do not need to be held in a tax-protected account; and they accrue interest tax-deferred for up to 30 years. There are annual limits on how much you can buy in I-bonds.

Invest early and often

 *  Watch the video



Once you have a regular savings pattern, you can begin accumulating financial wealth. How much saving is enough? For retirement, 20% of income may be a good starting point, but this will vary widely from person to person. If you want to be retire before age 65, or plan to leave significant assets to charity or to children, you probably need to save even more. Starting a regular savings plan early in life is important because investment returns compound 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 offer this. When you invest in an IRA or taxable account, choose a provider that will automatically deduct money from your bank account the day after pay day. This is described as "paying yourself first," and it goes a long way towards establishing and reinforcing reasonable spending habits.

There are guidelines for which accounts you should fund and in what order. But always remember, you first need to save the money. When you start, saving regularly is more important than your choice of investments.

Diversify

 *  Watch the video

Rather than trying to pick the specific stocks or sectors of the market that may outperform in the future, buy funds that are widely diversified, or even approximate the whole market. This guarantees you will receive the average return of all investors.

Being average sounds bad, but it is actually good. Most investors perform worse than average after taking into account the high fees they pay for actively managed funds. Studies of manager performance in the US indicate that on average, managers may possess stock selection skill, but their management costs more than outweigh their extra performance. And while there is evidence of persistent poor performance, there is no evidence of persistent good performance. Funds that perform well in one year tend to perform poorly in the next. And investors pay high fees for actively managed funds. As a result, over the long term, more than half of actively managed funds usually perform worse than index funds.

Invest with simplicity

 *  Watch the video

John Bogle wrote: "Simplicity is the master key to financial success. When there are multiple solutions to a problem, choose the simplest one."

You do not need to hold many funds for effective diversification. A single total stock market index fund contains thousands of stocks. And a total bond market index fund contains thousands of bonds of various types and maturities. You can easily build a highly effective portfolio with just two or three funds. In his Little Book of Common Sense Investing, John 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 has many advantages. It almost always lowers costs (including taxes), makes analysis easier, simplifies rebalancing, simplifies any tax-preparation, reduces paperwork and record-keeping, and enables others such as 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.

Many forum members hold the three fund portfolio. This 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. Some extend the bond part of this portfolio to include a fourth asset class, U.S. inflation-indexed bonds. (The Vanguard Target Retirement and LifeStrategy funds add international bonds as a fourth asset class.)

Bogleheads author William Bernstein wrote, in reference to the three fund portfolio:

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 four underlying index funds into a single fund with a given 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 to start out with a simple, low-cost, yet highly diversified mutual fund.

Some forum members 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 you do this.

Use index funds when possible

 * Watch the video

The best and lowest cost way to buy the whole stock market is with index funds, either through traditional mutual funds or exchange-traded funds (ETFs). John Bogle pioneered the first retail index fund in 1976; some members of the financial industry called it "Bogle's folly".

Today, Vanguard's Total Stock Market Fund is the largest mutual fund in the world, and it is also one of the best values. Its fund expenses are about one-tenth of the industry average. By purchasing this single fund, you own a piece of essentially every public company in the US. This diversification lowers risk, because any one company failing does not have a big effect. You are still exposed to the high volatility of the overall stock market, but in exchange you participate in whatever returns the market gives over time.

Forum members also like to use low cost index funds to hold international stocks, so that they can take advantage of economic growth in other countries. Vanguard's Total International Stock Market Fund is one example; it 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 members hold varies, but is normally between 20 to 40% of their equity allocation.

Minimize costs

 *  Watch the video



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 you with several hundred thousand dollars less for retirement than a 0.15% index fund with the same growth. Remember that most managed funds perform worse than index funds. Costs matter, and you need returns compounding for your own benefit, not the benefit of fund companies. 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. If yours does not, look for the largest, most diversified funds with the lowest fees. These will often tend to perform relatively like index funds, although with higher fees. If you need to find the "least bad" funds in your own employer pension, look for those with the lowest annual costs.

Minimize taxes

 *  Watch the video

Nobody controls how equity markets might perform in a given year. Rather than worrying about this, focus on areas where your decisions can save money. In particular, do what you can to preserve money for retirement that would otherwise be lost to tax.

Determining your asset allocation (% stocks / % bonds), which sets your portfolio's level of acceptable risk, is the single most influential decision you can make on your portfolio's performance. Consider taxes only after you have designed your portfolio.

The first step 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 lost to tax every year. 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 if you also have taxable accounts (that is, accounts in which you pay taxes the year they are due), 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.

As a result, Bogleheads put tax-inefficient funds (bonds) into tax-advantaged accounts. Other tax-inefficient funds that should usually go into tax-advantaged accounts are REITs, small value funds, and actively managed funds that frequently churn their holdings. If you do not have enough room for bonds in your 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 use tax loss harvesting. This 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.

Never try to time the market

 *  Watch the video

US research shows that typical US mutual fund investors actually perform far worse than the mutual funds they invest in because they buy after a fund has done well and then sell when it has done poorly. Studies on timing using returns data show no evidence of positive timing. Most investors earn less than the market due to two common timing mistakes: buying yesterday's top performers; and letting their emotions lead them to try to predict stock markets.

Instead, Bogleheads create a good plan and then stick with it. This consistently produces good outcomes over the long term.

Stay the course

 *  Watch the video

This can be the most challenging part of successful investing, but it is essential. When index funds were dramatically outperforming all the alternatives in the 1990s, this advice was easy to follow. But in 2008, many investors panicked, or at least wavered in their commitment to buy, hold, and rebalance investing. Realise that in exchange for the high returns that stocks produce over time, equity markets are enormously volatile. After big drops, it can be very difficult to continue to follow your plan. Even during normal markets there are always distractions, such as attractive new asset classes that have recently outperformed.

Try not to be distracted, and try 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 will help you to stay the course. Once you have set up your portfolio, the only change needed is to occasionally rebalance to bring your stock/bond allocations back to their assigned levels. 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
A Bogleheads investor will
 * save a lot,
 * select an asset allocation containing both stock and bond asset classes,
 * buy low cost, widely diversified funds,
 * allocate funds tax-efficiently,
 * and stick closely to a plan.

This generally takes only 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 this 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, visit the Bogleheads forum. You 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 a shared commitment to financial plans that enable us to reach our life goals.