Bogleheads® investment philosophy

🇺🇸  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 John 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

 * 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.

Develop a sensible household budget - one that provides for needed expenditures, discretionary pleasures and savings for big ticket items like home purchase and higher education for dependents, as well as savings for long term retirement planning.
 * Avoid bad debt; if you have such debt, pay off those balances first.
 * 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. Live below your means. If you don't save enough, no amount of financial trickery will provide the returns needed for a comfortable retirement.

Next, after establishing your sound financial lifestyle and you start investing for the future, many believe it is valuable to put a simple plan in writing. Relax! Of course you can’t know the future! But it will serve you to imagine one scenario. The enemy of a good plan is the search for a perfect plan. Make assumptions, and then change them when you get better ideas or better information. Our goal is to enable these possibilities. Putting your plan in writing will help give you the discipline to “stay the course”.

Invest early and often

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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
To know whether an asset allocation is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?, which is very hard to accurately assess before you have already gone through a bear market.


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Owning stocks is necessary to get the expected return needed to accumulate funds for retirement. Stocks provide us with a share of the profits generated by publicly owned companies in the economy. But in exchange for the hope of high return, stocks are extremely volatile and risky. Many investors learned how risky stocks can be in 2008 when they 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 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 expected 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 in 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. 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 since big drops in stock prices will not hurt as long as you do not flee the market. John Bogle advises that "as 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, some rules of thumb exist to guide your decision. A rule of thumb is just: (1) a method of procedure based on experience and common sense ; (2) a general principle regarded as roughly correct but not intended to be scientifically accurate". Any rule of thumb is only a starting point for decision making, not the end.

Consider Benjamin Graham's timeless advice:

John Bogle recommends "roughly your age in bonds"; for instance, if you are 45, 45% of your portfolio should be in high-quality bonds. Mr. Bogle 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". Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.

"Age in bonds" and its variants, (age - 10) or (age - 20), are only crude starting points to be adjusted for the investor's circumstances; a key circumstance being the presence or absence of a pension, which would change ones willingness or need to take risk. Some Bogleheads 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. 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 with high stock market allocations. 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. There is an entire field of neuroeconomics now developing explaining how mental traits and emotional effects that work well in other areas undermine our ability to deal rationally with markets and investing.

Bogleheads like to 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 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, to reduce violent up and down swings in overall portfolio value. Bogleheads tend to take risks on the equity side, not the bond side.

The goal is 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 agonize over when its a "good time' to get back in. This leads to selling low and buying high, the exact opposite of prudent investing.

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.

I-Bonds are also an attractive alternative to TIPS. They are sold directly to investors by the U.S. Treasury; can be bought using your IRS tax refund; don't need to be held in a tax-protected account; and accrue interest tax-deferred for up to 30 years. There are annual limits on how much you can buy in I-bonds.

Diversify

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Rather than trying to pick the specific stocks or sectors of the market that may 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. Studies of manager performance indicate that, before costs, managers, on average, possess stock selection skill, but actual performance is insufficient to overcome the costs of management. In addition, while there is evidence of persistence of poor performance, there is no evidence of persistence of outperformance. 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

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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. Studies on timing using returns data show no evidence of positive timing. The vast majority of investors earn less than the market due to two common timing mistakes: buying yesterday's top performers, and letting your emotions cause you to attempt to predict the direction of the stock market. 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

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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 Fund 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 Fund 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

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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

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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

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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.

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. The Vanguard Target Retirement and LifeStrategy funds add international bonds as a fourth asset class.

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."

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 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

 *  Watch the video

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.