Bogleheads' Guide To Investing

This summary is based on the ideas and learnings from "The Bogleheads' Guide to Investing", 2nd Edition, by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf in 2014. The description of the book mentions: "Investing can be simple, but it's certainly not simplistic. Over the course of twenty years, the followers of John C. Bogle have evolved from a loose association of investors to a major force with the largest and most active non-commercial financial forum on the internet. You will learn how to craft your own investment strategy using the proven methods which have worked for thousands of investors and how to choose a sound financial lifestyle and diversify your portfolio; start early, invest regularly, and know what you are buying; preserve your buying power while keeping costs and taxes low; and throw out the advice promoted by Wall Street which leads to investment failure. Their trusted advice has been brewed and distilled into an easy-to-use, need-to-know, no frills guide to building up financial well-being". The authors deliver on this with suitable advice.

Summary Disclaimer

It should be emphasized that the summary only includes the content which was found to be relevant. There may have been additional information for many chapters, but it was seen to be unnecessary or incorrect in several cases. In this sense and as a consequence, the information included in the summary may appear different from the information included in the book. Finally, there is every possibility some information was mistakenly missed while reading the book.

Introduction

It is an old statistic which has held very consistent over modern times. Take 100 young Americans starting out at age 25 and, by age 65, 1 will be wealthy and 4 will be financially independent. Unfortunately, the remaining 95 will reach this traditional retirement age unable to self-sustain the lifestyle to which they have become accustomed.

Start Early And Invest Regularly

Income is how much money someone earns in a given period of time. If they earn a $1,000,000 in a year and spend it all, they add nothing to their wealth and they are just living lavishly. Those who focus only on net income as a measure of economic success are ignoring the most important measuring stick of financial independence. It is not about how much someone makes, it is about how much they keep to build up wealth at the end of the day.

The Rule Of 72 is very simple: To determine how many years it will take for an investment to double in value, divide 72 by the annual rate of return. For example, an investment which returns 8% doubles approximately every 9 years, an investment which returns 9% doubles approximately every 8 years, and an investment which returns 12% doubles approximately every 6 years. On the surface, this may not seem like such a big deal, until it is realized that this doubling will compound every time - first becoming 2, then 4, then 8, then 16, and then 32 times the original investment. Assuming a portfolio earns an average annual return of 8% after expenses and taxes, these are the amounts someone has to invest at various ages in order to have $1,000,000 at age 65: $21,320 at age 15, $31,330 at age 20, $46,030 at age 25, $67,630 at age 30, $99,380 at age 35, $146,000 at age 40; $214,500 at age 45, $315,200 at age 50, $463,200 at age 55, and $680,600 at age 60. For illustration, if someone were to start with a single penny and double it every day, on the 30th day it compounds to $5,339,000.

At age 25, Eric Early invests $4,000 per year in a Roth IRA for 10 years and stops investing - his total investment is $40,000. Larry Lately makes yearly deposits of $4,000 in his Roth IRA starting at age 35 for 30 years - his total investment is $120,000. Assuming both portfolios earn an 8% average annual return, at age 65, Eric Early will have a Roth IRA worth $629,700, but Larry Late will have a Roth IRA worth only $489,400. By starting 10 years earlier and making one-third of the investment, Eric Early ends up with 29% more than Larry Late. It should be noted that a Roth IRA is equivalent to a Tax-Free Savings Account (TSFA) or Individual Savings Account (ISA).

In 2000, the National Bureau of Economic Research published a paper titled "Choice, Chance, and Wealth Dispersion At Retirement". The paper reports the results of a study done by economists which compared the lifetime earnings of several thousand American households with their net worth at retirement. The purpose of the study was to determine which factors influence the accumulation of wealth. The investigation found some households with high lifetime earnings and relatively low net worth at retirement and, conversely, it also found households with modest lifetime earnings and relatively high net worth at retirement. The economists concluded that none of the expected factors had a significant impact on wealth at retirement and it was not due to some people enjoying better health, being smarter or luckier in their choice of investments, or receiving large inheritances. The only significant factor was that some people choose to save more than others. Everyone has a choice about what to do with the money which comes into their life. They can spend it today or save and invest it to make more money in the future. The key to successful money management lies in striking a healthy balance between these two choices.

Stocks And Bonds

When someone purchases an individual bond at initial issue, they are essentially lending their money to the issuer of the bond. In return for lending their money to the issuer, they are promised a return on their investment which is the yield to maturity of the bond and makes up the return of the face value of the bond at the maturity date (date on which investors are repaid the principal amount of the bond). These maturity dates can be short-term (1 year or less), intermediate-term (2 years to 10 years), or long-term (10 years or more years). A bond can be issued by a number of entities, including the U.S. Treasury, government agencies, corporations, and municipalities. Bonds from the U.S. Treasury are considered the safest bond investments, since they are backed by the full faith and credit of the U.S. government. The U.S. Treasury issues bonds as Bills, Notes, Bonds, Treasury Inflation-Protected Securities (TIPS), and Savings Bonds (EE Bonds and I Bonds).

In more detail, bonds from the U.S. Treasury with issues of 1 year or less are Treasury Bills or T-Bills with periods for 13 weeks, 26 weeks, and 52 weeks; issues of 2 years, 3 years, 5 years, and 10 years are Treasury Notes or T-Notes; and issues for periods greater than 10 years are Treasury Bonds or T-Bonds. In 1997, the U.S. Treasury introduced Treasury Inflation-Indexed Securities (TIIS) which became widely known in as Treasury Inflation-Protected Securities (TIPS). The U.S. Treasury also currently issues 2 different types of Savings Bonds in the form of I Bonds and EE Bonds. There are also a number of government agencies which issue pools of mortgage-backed securities (MBS), such as the Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Mortgage Corporation (Freddie Mac). Corporate bonds are issued by corporations which need additional funds for various business purposes (expansion, new equipment, new product introduction). The yield of the newly issued corporate bond will be primarily determined by the creditworthiness of the corporation issuing the bonds, current yield of bonds with comparable safety ratings and maturities, demand for the bonds, and call feature of the bonds. Credit ratings are assigned to corporate bond issues by rating agencies, such as Standard & Poor's, Moody's, and Fitch - normally, the higher the credit rating, the lower the yield of the bond.

A fund of bonds does not have a maturity date and may hold some longer-term bonds, intermediate-term bonds, and shorter-term bonds which are nearing maturity. Although, the effective maturity can be seen as the weighted average maturity of all the underlying bonds. Over time, the longer-term bonds become intermediate-term bonds, intermediate-term bonds become short-term bonds, and short-term bonds eventually mature and are replaced with new bonds. The duration of a fund of bonds gives an indication of the expected volatility in price during rising or falling interest rate environments with a higher duration indicating more volatility. When interest rates increase, the value of bonds decreases and, when interest rates fall, the value of bonds increases. Thus, the duration gives an indication of the expected decrease or increase in value given a 1% increase or decrease in interest rates. However, investors should understand that, while interest rate increases cause a decline in the net asset value of the fund, the yield of the fund will increase and, over time, this increased yield will help to mitigate the loss in value caused by the rising interest rates - so, if interest rates rose 1%, the time it would take to make up for the loss in value would be approximately equal to the original duration.

It is important to understand that bonds funds have a low correlation to stocks, so bonds can be a stabilizing force for a portion of a portfolio. For example, in the bear market of 2008, while equity fund losses of 30% to 60% were common, the Vanguard Total Bond Market Index Fund gained 5.05%. A more conservative investor should increase their percentage of bonds, while a more aggressive investor should decrease their percentage of bonds.

The advantages of owning bond funds include: no costs for buying or selling in no-load bond funds; holding a large number of bonds and getting diversification; arranging for interest to be reinvested automatically; and professional research and management by the underlying index. The disadvantages of owning bond funds include: paying costs and expenses; not having assurance of getting the principal amount, since a bond fund does not have a maturity date; and, if used, active management with irrational bets. A low-cost short-term or intermediate-term fund of good-quality bonds should be adequate for most investors.

Mutual Funds And ETFs

Mutual funds pool money from many investors to buy securities. Those securities can be stocks, bonds, or money market instruments, as well as other types of alternative investments. An investor in a mutual fund owns a small fractional interest in the underlying pool of securities purchased by the managers of your mutual fund. The types of mutual fund management styles include active management and indexing. Active managers attempt to select stocks and bonds which they hope will result in their fund outperforming their benchmark or achieving returns similar to the benchmark but with less risk. With indexing, the fund attempts to replicate as close as possible the return of a particular benchmark, such as the S&P 500, Wilshire 5000, or Barclay's Capital Aggregate Bond Index. Because of the higher costs associated with many actively managed funds, active managers have a much higher hurdle to overcome in order to outperform their lower-cost index fund counterparts. Although some active managers do succeed in outperforming an equivalent index, very few managers consistently outperform over long periods of time. The real problem an investor has with active management is trying to identify, in advance, those active managers who will outperform the equivalent index.

Exchange-traded funds (ETFs) are basically mutual funds which trade like stocks on an exchange. They are bought and sold continuously throughout the day when the stock market is open, unlike regular mutual funds which are priced at net asset value only once a day at the close of business by the fund company. Perhaps one of the biggest benefits of owning ETFs is the low cost, as ETF expenses can be as low or even lower than many mutual funds which track the same index. A potential downside is the difference between the market value of an ETF share and net asset value of the underlying securities which make up the ETF. Because ETFs are market traded, they can trade at a slight premium or discount to the value of the underlying securities held in the fund - although, generally, the premium or discount is not very large. When used properly, low-cost ETFs can certainly play an important role in a long-term, buy-and-hold portfolio. On the other hand, investors are likely to incur losses if they plan to use ETFs as day trading or market timing vehicles.

Preserve Buying Power

Due to inflation, it is necessary to consider the real return from an investment. The real return can be negative for both equities and bonds even if the quoted return is positive. A guarantee of a positive total return is referred to as risk-free, as it is usually backed by the full faith and credit of a government (although, once taxes are considered, it is possible a negative total return and it is dependent on the situation). In essence, inflation can be seen to be a negative return which is simply not included in the quoted return, so it is necessary to find the real return by subtracting it afterwards.

How Much Needs To Be Saved

Assuming an inflation of 2%, the estimated real return for various asset classes include: T-Bills with a total return of 2.1% and real return of 0.1%; Intermediate Treasury Notes with a total return of 3.9% and real or 1.9%; Intermediate High-Grade Corporate Bonds with a total return of 4.6% and real return of 2.6%; U.S. Large-Cap with a total return of 7.0% and real return of 5.0%; U.S. Small-Cap with a total return of 7.3% and real return of 5.3%; U.S. Small-Cap Value with a total return of 8.0% and real return of 6.0%; real estate investment trusts with a total return of 7.0% and real return of 5.0%; and International Developed with a total return of 7.4% and real return of 5.4%. If these estimated return figures seem low, especially in light of the exceptionally high returns in the previous bull market, there is most likely an effect of recency bias (projecting recent events into the future). To overcome any recency bias, it is necessary to be aware of and understand reversion to the mean. Although there are no absolute guarantees with revision to the mean, usually asset classes which have outperformed for a period of time are likely to underperform for another period of time until the mean is satisfied over the long term.

Keep It Simple

While most will not publicly admit it, the vast majority of stockbrokers, mutual fund managers, sellers of investment products, and money managers do not earn their keep. In fact, most of them build substantial wealth at the expense of their clients. In a sense, they make millionaires out of investors who could have been multi-millionaires. Assuming someone puts $10,000 in a mutual fund, leaves it for 20 years, and gets an average annual return of 10%. If the fund had an expense ratio of 1.5%, the fund is worth $49,730 at the end of 20 years. However, if the fund had an expense ratio of 0.5%, it would be worth $60,860 at the end of 20 years. Just a 1% difference in expenses makes an 18% difference in returns when compounded over 20 years. In addition to higher fees, every time an active fund sells a profitable stock, it creates a taxable event which is passed on to the investor. This tax subtracts from the return on the investment. On the other hand, broad market indices have very little turnover, since they only replicate all or most of the stock market, and there are very minimal additional taxes as a result.

Jack Bogle said, "If you go back to 1970, there were only 355 equity funds. Only 169 of them survive today, so right away you are dramatically skewing the numbers by not counting the losers. Of those 169 survivors, only 9 beat the S&P 500 through 1999, 3 by 1% to 2% per year, 4 by 2% to 3%, and only 2 by more than that. I would say that 2% is not really statistically significant, but leave that aside for now. Then there are taxes. After tax, maybe only those top 2 truly beat the market. That means it is just a game of chance and a bad one at that". Warren Buffett said, "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results, after fees and expenses, delivered by the great majority of investment professionals". Larry Swedroe said, "Despite the superior returns generated by passively managed funds, financial publications are dominated by forecasts from so-called gurus and the latest hot fund managers. I believe that there is a simple explanation for the misinformation: It is just not in the interests of the Wall Street establishment or the financial press to inform investors of the failure of active managers".

Asset Allocation

The most fundamental decision of investing is the allocation of assets between stocks, bonds, and cash. Markowitz is credited with being the father of modern portfolio theory, where one of his greatest contributions to investors was his recognition that a mixture of volatile non-correlated securities could result in a portfolio with lower volatility and possibly higher return.

Consider an investor choosing between 2 investments with the same expected return. Investment A increases steadily and without a decline, while Investment B fluctuates in value by going up and down as it ends with the same return as investment A. Obviously, most investors would choose investment A for its smoother ride compared to Investment B. This concept is risk aversion, where, given the same outcome, investors will always choose the investment with less risk. Thus, in modern portfolio theory, the only way to entice investors to buy Investment B would be to offer a higher expected return compared to Investment A. The greater the risk of loss, the greater the expected return (or, to put it another way, there is no free lunch).

Published annual returns do not reveal the huge compounding losses that investors actually suffer in a lengthy bear market. The Dow stocks plunged -17% in 1929, -34% in 1930, and another -53% in 1931. Few investors can tolerate large year-after-year losses and not knowing when they will end. This is the primary reason nearly every portfolio should contain an allocation to bonds. The worst annual loss and eventual average return based on stock/bond allocation from 1926 to 2012: 100% stocks, worst: -43.1%, average: 10.0%; 80% stocks/20% bonds, worst: -34.9%, average: 9.4%; 60% stocks/40% bonds, worst: -26.6%, average: 8.7% 40% stocks/60% bonds, worst: -18.4%, average: 7.8%; 20% stocks/80% bonds, worst: -10.1%, average: 6.7%; and 100% bonds, worst: -8.1%, average: 5.5%.

Comparison of domestic versus international index returns from 1998 to 2013: 1998, domestic: 28.6%, international: 20.0%; 1999, domestic: 21.0%, international: 27.0%; 2000, domestic: -9.1%, international: -14.2%; 2001, domestic: -11.9%, international: -21.4%; 2002, domestic: -22.1%, international: -15.9%; 2003, domestic: 28.7%, international: 38.6%; 2004, domestic: 10.9%, international: 20.3%; 2005, domestic: 4.9%, international: 13.5%; 2006, domestic: 15.8%, international: 26.3%; 2007, domestic: 5.5%, international: 11.2%; 2008, domestic: -37.0%, international: -43.4%; 2009, domestic: 26.5%, international: 31.8%; 2010, domestic: 15.0%, international: 7.7%; 2011, domestic: 2.1%, international: -12.1%; 2012, domestic: 16.0%, international: 17.3%; and 2013, domestic: 32.4%, international: 22.8%.

High-yield bonds, also known as junk bonds, appeal to many investors because of their higher yields and sometimes higher returns than investment-grade bonds. However, bonds should be primarily for safety, while high-yield bond funds are more closely correlated to stocks and behave somewhere between traditional high-quality bonds and stocks - in the 2008 bear market, the Vanguard High-Yield Bond Fund fell -21.3%. In addition, taxable high-yield bonds are among the most tax-inefficient of all securities. If an investor wants to increase their return, they should increase their allocation to stocks.

Recommended young asset allocation: 55% domestic large-cap stocks, 25% domestic mid/small-cap stocks, and 20% intermediate-term bonds (using Vanguard, 80% Total Stock Market Index Fund and 20% Total Bond Market Index Fund). Recommended middle-aged asset allocation: 30% domestic large-cap stocks, 15% domestic mid/small-cap stocks, 10% international stock, 5% real estate investment trusts, 20% intermediate-term bonds, and 20% inflation-protected securities (using Vanguard, 45% Total Stock Market Index Fund, 10% Total International Index Fund, 5% Real Estate Investment Trust, 20% Total Bond Market Index Fund, and 20% Inflation-Protected Securities). Recommended early retirement asset allocation: 30% diversified domestic stocks, 10% diversified international stocks, 30% intermediate-term bonds, and 30% inflation-protected securities (using Vanguard, 30% Total Stock Market Index Fund, 10% Total International Index Fund, 30% Total Bond Market Index Fund, and 30% Inflation-Protected Securities). Recommended late retirement asset allocation: 20% diversified domestic stocks, 40% short-term or intermediate-term bonds, and 40% inflation-protected securities (using Vanguard, 20% Total Stock Market Index Fund, 40% Short-Term or Total Bond Market, and 40% Inflation-Protected Securities).

Costs Matter, Keep Them Low

The Financial Research Corporation conducts research for industry insiders. One of their most important studies was to determine which of 11 common predictors of future mutual fund performance really worked. The predictors studied were Morningstar ratings, past performance, expense ratio, turnover, manager tenure, net sales, asset size, alpha, beta, standard deviation, and the Sharpe ratio. Their study concluded that the expense ratio is the only reliable predictor of future mutual fund performance. This is somewhat related to the fact that indexing tends to have the lowest expense ratios, while also having to outperform active management after fees.

In another study, Standard & Poor's examined all diversified U.S. stock funds in 9 different Morningstar categories of style box. The study, reported in the 2003-09 issue of Kiplinger magazine, divided the funds in each style box into funds with above-average costs and funds with below-average costs. In 8 out of 9 categories, lower-cost funds beat higher-cost funds during 1-year, 3-year, 5-year, and 10-year periods. They also found a similar pattern with bond funds.

Taxes, Mutual Fund Taxation

A mutual fund manager incurs a realized capital gain or capital loss nearly every time a security is sold. At the end of the fiscal year, the manager will add up all the profits and all the losses from the sale of securities in the fund portfolio. If the result is a net profit, the capital gains will be passed on to the fund shareholders. If the result is a net loss, the fund manager will carry forward the excess losses to offset gains in future years.

The tax efficiency of securities generally progresses from most efficient to least efficient through low-yielding case, money market, tax-managed stock funds, total market stock index funds, mid-cap and small-cap index funds, active stock funds, balanced funds, real estate investment trusts funds, domestic bond funds, international bonds, and then high-yield bond funds. Generally, the most tax inefficient funds would be placed in tax-deferred accounts with the most tax efficient funds placed in taxable accounts (if they cannot also be placed in tax-deferred accounts).

Diversification

When investments (like stocks and bonds) do not always move together, they are said to have a low correlation coefficient. The correlation for any 2 investments can range from 1.0 (perfect correlation) to -1.0 (negative correlation). Basically, if 2 investments normally move together at the same rate, they are said to be highly correlated and, when 2 investments move in opposite directions, they are said to be negatively correlated. When 2 investments each randomly go their separate ways, independent of the movement of the other one, there is said to be no correlation between them with a correlation of 0. In actual practice, most investment choices available to you will have a correlation somewhere between 1.0 (perfect correlation) and 0 (non-correlated). It is very difficult to find negatively correlated asset classes which have similar positive expected returns.

Performance Chasing And Market Timing

According to an Investment Company Institute study, about 75% of all mutual fund investors mistakenly use short-term past performance as their primary reason for buying a specific fund. The financial media consistently churns out favourable stories about recent winning funds and imply that fund managers have some sort of special insight that makes them so successful. Since investors are continually bombarded with these stories about top-performing funds in nearly every financial publication they read, they feel that is the criteria they should use in selecting their mutual funds. However, this is simply the hot fund-of-the-month club with performance figures usually for cherry-picked funds over carefully selected favourable periods of time. Index funds, by their very nature, are seldom top performers over short periods of time. More importantly, index funds are almost never bottom performers. This is because they will only ever provide the average return. A wise investor realizes that it is more important to meet financial goals than to take chances in the hope of becoming richer - it takes a knowledgeable and self-confident investor to select a fund that is not among the current hot performers.

The definitive study of market timing investment newsletters, from Graham and Harvey tracked and analysed more than 15,000 market-timing predictions by 237 newsletter writers from June 1980 through December 1992. Their conclusion were that there is no evidence that newsletters can time the market - consistent with mutual fund studies, winners rarely win again and losers often lose again. One of the interesting sidelights to this study was that by the end of the 12.5-year period, 94% of the newsletters in the study had gone out of business. Hulbert also did a study of newsletter portfolios and, after constructing a hypothetical portfolio made up of each top-performing newsletter-recommended portfolio from 1981 through 2003, these former winners produced an average annualized loss of -32.2% over the 12 months following their top showing. Compare this dismal second-year performance to the Wilshire 5000 total stock market index, which, during the same second-year period, had an annualized gain of 13.1%. Specifically, to understand the danger of using newsletter recommendations, consider the Granville Market Letter which produced a phenomenal 245% return in 1991. This was followed by a loss of -84% in 1992, such that the actual 2-year return was a loss of 61%.

Similarly, of the 33 newsletters offering bond forecasts during the 5-year period ending 2006-12-31, only 2 newsletter editors outperformed the Shearson All-Maturities Treasury Index during the same period. Twice a year the Wall Street Journal polls about 50 of the top economists in the United States for their interest rate forecasts. Arbor Research did a study to see how these predictions actually turned out. From 1982, the beginning of the Wall Street Forecasting Survey, through 2006, the expert economists have been right in forecasting the direction of interest rates only about 33% of the time. Galbraith once said, "There are only two kinds of interest-rate forecasters: those who do not know and those who do not know that they do not know".

Invest For College

According to the Bureau of Labour Statistics, U.S. Census Bureau figures show that a college graduate with a Bachelor's Degree can expect to earn nearly $1,000,000 more than a high school graduate over their 40-year working lifetime. And those with a Master's Degree can expect to make more than twice as much as a high school graduate over their working lifetime. Some high school (no diploma), $1,000,000; high school diploma or equivalent, $1,200,000; some college (no degree), $1,500,000; associate degree, $1,600,000; Bachelor's Degree, $2,100,000; Master's Degree, $2,500,000; Doctoral Degree, $3,400,000; professional degree, $4,400,000.

Manage A Windfall

A commonly heard statistic is that more than 75% of windfalls are squandered. Whether this is true, most financial practitioners agree that well over 50% are lost in a relatively short period of time. NBC News reported that more than 70% of lottery winners exhaust their fortunes within 3 years. For this reason, the first thing a beneficiary should do is deposit the money in a safe account for at least 6 months and leave it alone, get a realistic estimate of what the windfall can buy, make a wish list, and get professional help. The emotions which accompany a windfall are temporary and usually go away within 6 months and the most important secret to preserving a windfall is to not touch it until the emotions subside. Resist all temptations to do any of the following: invest in speculative investments or products pitched by brokers, insurance salespeople, and other financial types; lend or give money to friends or relatives who want a personal bank; buy a luxury home to tell the world; buy an expensive and flashy car to impress friends; take a first-class round-the-world luxury cruise; go on a shopping spree to buy expensive clothing and jewellery; make a large donation to a favourite charity or cause; buy a boat, aeroplane, or other expensive toy; or quit a job. Although it might be possible to buy and do all of these things, this is not the time to do it. It is the time to pause, chill out, and do some serious reflecting, information gathering, and planning. For the time being, just go on with the same life prior to the windfall.

It is generally agreed by financial planners that one can spend $5,000 per year for every $100,000 of capital invested in a well-diversified balanced portfolio. To make inflation-adjusted withdrawals, it is recommended that an investor begins by withdrawing only 4% of their portfolio. However, a windfall left to compound can have an enormous and positive impact. Unfortunately, most people do not choose to do this. An after-tax windfall of $600,000, invested at an annual return of 8%, grows to $1,200,000 in 9 years and $2,400,000 in 18 years.

Needing An Advisor

If someone needs an advisor, they should seek out a professional with CFA and CFP designations, because of the high standards and educational requirements for earning these qualifications. In addition, this professional will be obligated to avoid and disclose any conflicts of interest. It is also better to seek out a fee-only advisor, rather than an advisor who earns based on commission. Fee-only advisors normally use the assets under management payment arrangement, which involves paying a set percentage of the total assets to the advisor on an annual basis, but other alternative payment options include a one-time fee or an hourly rate arrangement.

Track Progress And Rebalance

Rebalancing controls risk. It brings a portfolio back to the level of risk that the investor determined was appropriate for them and that they were comfortable with when they first established their asset allocation plan. One of the primary reasons for holding a diversified portfolio is that asset classes do not always move in sync and even when they do, they do not all have the same expected rate of return or risk level. At times, one asset class or segment of an asset class, might greatly outperform the others, resulting in the outperforming asset class or segment of an asset class becoming a much larger percentage of the portfolio than desired, while the other portions of the portfolio make up a smaller percentage than called for in the original asset allocation plan. Rebalancing forces an investor to sell high and buy low. They are selling the outperforming asset class or segment and buying the underperforming asset class or segment.

There are a number of rebalancing methods, such as never rebalancing, monthly rebalancing, quarterly rebalancing, rebalance if more than 5% from target at month-end, and rebalance if more than 5% from target at quarter-end. Often, investors who do not rebalance are simply letting their winners run in the belief that doing so would produce much higher returns. Contrary, research has shown that the increased returns were actually found to be small or even non-existent when compared with the additional risk (as measured by the volatility) taken on by those investors who did not rebalance. In addition, the study showed that portfolios which were never rebalanced had the lowest Sharpe ratios of all the rebalancing methods studied. Since the Sharpe ratio measures the additional return an investor receives for taking on more risk, this lower ratio indicates that investors who did not rebalance were not being as well compensated for the additional risk they were taking.

Rebalancing may also improve returns, since asset classes have had a tendency to revert to the mean over time. By rebalancing, an investor is selling a portion of their winning asset classes before they revert down to the mean and they are buying more of their underperforming asset classes before they revert up to the mean. So, they are selling high and buying low. Even if revision to the mean will not occur in the future but rather the market behaves as a random walk with each market move being independent of previous moves, remember that an investor will still benefit from rebalancing because they are controlling the level of risk in their portfolio. Experienced investors have learned that risk control helps to keep their emotions in check and this in turn keeps their portfolio in line with their long-term plan.

The most common method of rebalancing is based on time. The typical time frame is either quarterly, semi-annually, or annually. However, Morningstar found that investors who rebalanced their investments at 18-month intervals reaped many of the same benefits as those who rebalanced more often but with fewer costs. Another advantage of the Morningstar method in a taxable account is that an investor is assured of having long-term capital gains, since they are automatically holding the fund for longer than 12 months. A second method of rebalancing involves the creation of expansion bands. A window is created, such as plus-or-minus 5% from the desired allocation, and rebalancing occurs whenever an asset class exceeds those bands.

Tune Out The Noise

The number of media outlets dedicated to investing and money management has mushroomed. There are 24-hour radio and television networks, newspapers, books, magazines, newsletters, and internet websites churning out an endless stream of material - some of it useful, but much of it dangerous to easily influenced investors. No matter the medium, all of the media has the primary goal of attracting and holding an audience. The media make money either by charging the audience and/or by selling advertising. Most sales and advertising pitches from brokerage houses, actively managed funds, and money managers are variations of the single message: "Invest with us because we know how to beat the market". Far more often than not, this promise is fictitious at best and financially disastrous at worst. The only ways to outperform the stock market are by either choosing superior investments and/or through superior market timing. The research conclusively shows that the ability to do either with any degree of consistency is so rare that it might as well be chalked up to chance.

To quote Eugene Fama, one of the giants of modern portfolio theory, "I would compare stock pickers to astrologers, but I do not want to badmouth astrologers". Likewise, when it comes to investment newsletters, the only way to make money with a newsletter is by selling one. At the end of the day, there are three kinds of investment experts: those who do not know what the market will do and know they do not know, those who do not know what the market will do but believe they know, and those who do not know what the market will do and get paid to pretend they know. When it comes to predicting what the stock market will do in the short run, everyone is equally blind.

Mastering Investments By Mastering Emotions

It is wants, desires, and feelings which cause people to make thousands of choices every day which ultimately determine who they become. Someone will become the sum of their choices and most choices are made emotionally. However, when it is time to make investing decisions, emotions need to be left out of the decisions. This is one area of life where acting on emotional impulses will likely lead down a path of financial wreck and ruin. Playing hunches, blindly following the crowd or an investment guru, trying too hard, acting on a hot tip, relying on supreme self-confidence, going for it to make a quick killing, playing it ultra-safe, and a multitude of other emotionally-based investment decisions will almost always leave someone poorer. The paradox of money is that, while most people are very emotional about acquiring it, behaving emotionally about money is a recipe for losing it.

Thanks to greed, investors excitedly chase performance and buy when the market is up. Thanks to fear, investors panic and sell when the market is down and lock in their losses. When it is blindly assumed that the happenings of today will be the results of tomorrow, the focus is only being applied to the short-term with recency bias. If the market is down, most people assume it is going down further and sell. If the market is up, most people assume it is going to continue going up and buy. The result is that most people sell at bargain-basement prices, buy at high prices, and lose money in the process. The stock market is a very expensive place to learn that nobody is endowed with the gift of investment prophecy. If someone wants excitement, they should get excited about their career, family, community, place of worship, favourite causes, sports teams, hobbies, or anything else they want to feel passionate about.

Recency bias - never assume the results of today predict the results of tomorrow. Overconfidence - no one can consistently predict short-term movements in the market. Loss aversion - be a risk manager instead of a risk avoider. Paralysis by analysis - every day which someone is not invested is a day less they will have the power of compounding working for them. Endowment effect - just because someone owns it or is a part of it does not automatically mean it is worth more. Mental accounting - remember that all money spends the same, regardless of where it comes from, such that money already spent is a sunk cost and should play no part in making future decisions. Anchoring - holding out until the price gets to a desired target to sell an investment is playing a game for fools. Financial negligence - take the time to learn the basics of sound investing, as it is really pretty simple stuff. Knowing it can make the difference between having a mediocre life of poverty or one of prosperity.

Protect Assets By Being Insured

Specifically, consider life insurance for anyone on whom others depend for financial support; health care coverage for everyone in a family; disability insurance on any breadwinner whose future income is vital; property insurance in case of fire, theft, or other disasters; auto insurance; liability protection against expensive lawsuits; and long-term care for older family members to prevent nest-egg erosion. When it comes to buying insurance, almost everyone tends to over-insure in some areas and under-insure in others. Basically, people tend to make the mistakes of insuring the unimportant while ignoring the critical, insuring based on the odds of misfortune, and insuring against specific, narrow circumstances. The common insurance mistakes can be avoided by only insuring against the big catastrophes and disasters which cannot be afforded to be paid for out of pocket (cheapest insurance is self-insurance), carrying the largest possible deductibles which can be afforded (larger the deductible, the more self-insuring is applied and cheaper the premium will be), and only buying coverage from the best-rated insurance companies which can be depended on when needing to file a claim.

If someone has no dependents or are financially independent, they do not need life insurance. Everyone should save and invest their money and not buy life insurance until the situation requires it. If life insurance is needed, buy term insurance. Term insurance is basic pay-as-you-go and no-frills insurance and it is the cheapest way to go and serves the purpose. Term insurance is purchased at a fixed rate for specified periods of time such as 5, 10, 15, or 20 years. The longer the period, the higher the rates will be. Buy the longest period which can be afforded and is needed. Make sure the policy is guaranteed renewable, meaning that future coverage can be purchased regardless of health. Also, when asking an insurance salesperson about purchasing term insurance, get ready for lengthy sales pitch about how term insurance is insufficient, penny-wise, and pound-foolish. They will likely try to sell more expensive policies that build cash value, such as whole life, universal life, and variable universal life. They may say that it is a good investment in addition to life insurance. Although cash-value policies are investment vehicles, the costs associated with them are typically too high to make them good investment options. It is vital to avoid mixing investing with insurance - insurance is for protection and investing is for wealth building.

The greatest financial asset of most people is their future earning power. When someone dies, their living expenses are over, but, if they become disabled, there is a reality of facing financial hardships. Most people need long-term disability coverage to insure their future earning power. Sadly, while 70% of Americans carry life insurance, only 40% of Americans carry disability insurance. The maximum amount someone can purchase is usually 60% of their income. Some other features a good disability policy will have is that it covers inability to work in a specific occupation, requires a waiting period of no more than 90 days before coverage begins, carries a cost-of-living adjustment, provides the longest benefit for as long as possible or at least until age 65, and benefits are provided for partial disability. There is a 20% chance that a 35-year-old will become disabled before age 65 and a 1-in-7 chance that they will be disabled for at least 5 years. The odds of becoming disabled are far greater than the odds of dying prematurely. When considering just the income lost, a year of total disability can erase 10 years of saving for someone who saves 10% of their income.

5 out of 1,000 people will experience a house fire - average cost: $3,400. 70 out of 1,000 people will have an auto accident - average cost: $3,400. 600 out of 1,000 people will require a nursing home stay - average cost: $50,000 per year with an average stay of 3 to 5 years. If shopping for long-term care, a good policy will contain daily benefit equalling the current daily cost of a nursing home, inflation protection of 5% per year, benefit payment period should be at least 3 to 5 years, elimination period should be affordable, coverage cannot be cancelled for any reason other than for failure to pay premiums, cover both skilled and non-skilled care, cover home health and assisted living care without requiring a prior hospital stay, no exclusions for particular illnesses (such as Alzheimer's disease and dementia), benefit triggers specify when coverage begins, waiver of premium when coverage begins, annual premium cannot be raised unless it is raised for every policyholder, and policy is tax qualified.

Passing It On When Passing On

The last suit someone wears does not need any pockets. Everyone should have a will. Taxes take a lot of it. Laws will change over the next 40 years. If possible, try to give to family and causes while still alive to see the fruits of those gifts.

Anyone Can Do It

Choose and live a sound financial lifestyle. Pay off credit card debt, establish an emergency fund, get spending under control, and, most importantly, learn how to live within means, since that is really the key to financial freedom. Start to save early and invest regularly. The earlier someone starts, the longer they will enjoy the powerful benefits of compounding. Know more about the various investment choices available, such as stocks, bonds, and mutual funds. For most investors, mutual funds offer great diversity in a single investment. Do not invest in things without understanding them. Figure out approximately how much might be needed for retirement, so progress can be tracked along the way. Indexing via low-cost mutual funds is a strategy which will, over time, most likely outperform the vast majority of strategies. An asset allocation plan is based on personal circumstances, goals, time horizon, and need and willingness to take risks. Risk and higher expected returns go hand-in-hand. There is no free lunch. Make an investment plan as simple as possible. Costs matter. No one can control market returns, but everyone can control the cost of their investments. Commissions, fees, and mutual fund expense ratios can rob investors of much of their investment returns. Keep costs as low as possible. Taxes can be the biggest expense. Invest in the most tax-efficient way possible. Put tax-inefficient funds in tax-deferred accounts and select tax-efficient investments for taxable account. Remember the importance of diversification. An investor should want some investments which zig while others zag. Rebalancing is important. Rebalancing controls risk and may reward an investor with higher returns. Stick with the chosen rebalancing strategy. Market timing and performance chasing are poor investment strategies. They can cause investors to underperform the market and jeopardize financial goals. Know how to handle a windfall. Answer the question of whether or not a financial advisor is needed. Understand the importance of protecting the future buying power of assets by investing in such things as inflation-protected securities. Remember, inflation is a silent thief that robs future buying power. Tune out the noise and do not get distracted by daily news events. Avoid hot investment trends and following the herd as it stampedes toward the edge of the cliff. Believing that it is different this time can cause severe financial damage to a portfolio. Protect assets with the proper types and amounts of insurance. Insurance is for protection, it is not an investment. Emotions need to be mastered if someone wants to be a successful investor. Letting emotions dictate investment decisions can be hazardous to wealth. Most people need to make their money last at least as long as they do. Overly optimistic withdrawal rates may cause someone to run out of money before they run out of breath. Proper estate planning ensures that assets pass to heirs in a reasonable time and with minimum taxes.