Bogleheads' Guide To The 3-Fund Portfolio

This summary is based on the ideas and learnings from "Bogleheads' Guide To The 3-Fund Portfolio", 1st Edition, by Taylor Larimore in 2018. The description of the book mentions: "Investing does not need to be complicated. This all-indexed portfolio contains over 15,000 worldwide securities, in just 3 easily-managed funds, which has outperformed the vast majority of both professional and amateur investors. For a new investor or an experienced investor who wants to simplify and improve their portfolio, this is a short and easy-to-read guide to show how that is possible". The author accurately portrays this and it reliably serves as the ideal philosophy for most investors (although the reasons are not discussed).

As a summary, some short tips include that a 100% stock portfolio can be dangerous; believing a broker is a friend can be dangerous; avoid the lure of individual stocks; past performance does not forecast future performance; investment newsletters are a waste of money and market timing does not work; avoid expensive brokers and their hidden fees; and buying high and selling low is a losing strategy. It is recommended for someone to develop a workable plan, invest early and often, never bear too much or too little risk, diversify, never try to time the market, use index funds when possible, keep costs low, minimize taxes, invest with simplicity, and stay the course.

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.

Investment Industry

Just as the gambling industry wants people to think they can beat the casino, the investment industry wants investors to think they can beat the market. Of course, a few lucky gamblers do beat the casino, although the majority will simply loss their money. It is similar for investors, as some will beat the market, but most will ultimately underperform the market.

Bill Miller was the fund manager of the Legg Mason Value Trust (LMVTX). His fund is the only mutual fund which was able to beat the S&P 500 Index for 15 years in a row. He became a celebrity in the mutual fund world and investors eagerly poured their money into his fund. Unfortunately, like many winning mutual funds, LMVTX plunged to the bottom 1% of its Morningstar category over the next 15 years. When outcomes are based on luck, reversion to the mean brings reality.

John C. Bogle

John C. Bogle (or Jack, as he prefers to be called) is the founder of Vanguard. Vanguard has a mutual structure and is the only investment firm owned by its investors and not by its founder or outside shareholders. This is a tremendous gift to investors at Vanguard, since it means that, unlike other investment firms, Vanguard does not use part of their fees to pay shareholders. The result is that, after expenses, all of the returns go to the investors at Vanguard (usually realized through decreased fees, as profits are aimed to be minimized). Jack Bogle could easily have become a multi-billionaire by taking a share of his company profits; instead, he chose to give the money back to the investors who own the funds at Vanguard.

As of writing, Jack Bogle lived with his wife in an unpretentious home near the Vanguard Campus, drove an ageing Volvo, and still wears the $14 watch given to him by a friend while he was in the hospital waiting for his 1996 heart transplant.

3 Total Market Index Funds

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) and Admiral Shares (VTSAX), introduced in 1992, allow investors to own more than 3,500 company stocks in domestic markets at extremely low cost. Investor Shares have an expense ratio of 0.15%, while Admiral Shares have an expense ratio of 0.04% - putting this in USD means that an investor can invest $10,000 at a cost of only $4 per year. Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) and Admiral Shares (VBTLX), introduced in 1986, allow investors to own more than 8,000 diversified and high-quality bonds in the United States. Investor Shares have an expense ratio of 0.15%, while Admiral Shares have an expense ratio of 0.05%. Vanguard Total International Stock Index Fund Investor Shares (VGTSX) and Admiral Shares (VTIAX), introduced in 1996, allow investors to hold more than 6,000 stock in international markets, including emerging markets. Investor Shares have an expense ratio of 0.18%, while Admiral Shares have an expense ratio of 0.12%. For the first time in history, investors can own more than 17,000 diversified, non-overlapping, and world-wide securities at an amazingly low cost.

Total Market Funds Benefits

The benefits of total market index funds include no advisor risk, no asset bloat, no index front running, no fund manager risk, no individual stock risk, no overlap, no sector risk, no style drift, low tracking error, above-average returns, simplified contributions and withdrawals, consistency, low turnover, low costs, maximum diversification (lower risk), portfolio efficiency (best risk-return ratio), low maintenance, easy to rebalance, tax efficiency, and simplicity.

A title related to financial advice or planning does not imply competence. In most circumstances, the minimum level of education needed to become a broker or financial advisor is lower than that needed to become a hairdresser or electrician - sometimes a high school diploma is not even required to become a broker or financial advisor. Financial advisors are required to take a licensing exam which tests basic product knowledge and awareness of the applicable laws. However, there are no requirements to have any substantive or formal education in financial planning itself.

There can be conflict of interest for advisors and brokers. It is always desirable for the lowest cost to be subtracted from the returns of an investment. However, an advisor wants the largest income for themselves. At the end of the day, whatever the advisor is paid comes out of the returns of the investment. The cumulative impact of advisor and broker fees over an investment lifetime can be staggering. These costs often appear minor and are easily hidden in the fine print of statements. In extreme cases, advisors and brokers may actually earn more than their clients. There is an ethical challenge for advisors and brokers, where many are not diligence enough to put their clients first before their situation.

A good advisor will help determine goals and how much is needed to save to reach those goals, help structure investments for the most appropriate asset allocation, help stay the course during bear markets and recessions, help with insurance needs (including life, disability, and health care), and give advice about taxes, social security, annuities, tax-loss harvesting, rebalancing, order of withdrawals, estate planning, and other financial matters.

When an actively-managed fund is flooded with new money, it is very disruptive and usually results in lower returns. This is due to asset bloat. As investors rush into a popular actively-managed fund, this new cash requires the fund manager to spend more time with additional security analysis. It also increases the duties of the fund manager, as it is imperative to get the new cash invested as quickly as possible. However, the fund manager cannot invest large amounts of cash in a company without impacting the market for the stock of that company. This is because a large purchase of stock will drive up the price of that stock as more shares are bought, especially for companies with smaller market capitalizations and lower liquidity. In addition, mutual fund regulations prohibit a fund from owning more than 10% of the outstanding voting shares of an issuer, which may force the fund manager to consider less-desirable securities. So, the fund manager will find it difficult to invest in a satisfactory manner as their fund grows, because the number of appropriate additional companies shrinks, which makes it difficult to maintain the objectives of the fund (assuming the fund succeeded from these objectives rather than luck). The fund manager also knows that transaction costs (commissions, bid-ask spreads, market impact, and opportunity costs) will increase and this will affect existing shareholders of the fund.

A good example of risk from a fund manager is the Fidelity Magellan Fund (FMAGX) managed by Peter Lynch. Between 1977 and 1990, the fund averaged an annual return of 29%, which made the fund the best performing and largest mutual fund in the world. However, in 1990, Peter Lynch decided to retire. A succession of new fund managers were hired and fired as the fund began to underperform the market. Shareholders, many of whom bought near the top once the fund had become popular, began selling with large losses as the returns of the fund declined. On 2018-01-12, the fund was in the bottom 11% of all of the funds in its Morningstar category based on returns over the last 10 years.

If 1,000 fund managers make a market prediction at the beginning of the year, it is very likely that the calls of at least 1 will be correct consecutively for 9 years. Of course, 1,000 monkeys would be just as likely to produce a seemingly wise result. Of the 355 equity funds in 1970, 233 of those funds have gone out of business and only 24 outpaced the market by more than 1% a year. Having to choose 1 of these 24 funds in 1970 without any prior indicators reveals seemingly terrible odds of less than 7% - odds are probably worse today, as the number of funds has increased with an increase in the competition for outperformance, such that any outperformance is likely to be further diluted over a spread of funds.

Front running an index is when traders know in advance that an index fund must sell or buy a stock when it no longer meets the index specifications - perhaps a small-cap stock has grown too large for its small-cap index or a value stock has become a growth stock. Once the index is updated, traders know that the index fund must sell or buy certain stock. This advance knowledge normally lowers the price of a stock to be sold and raises the price of a stock before it is bought to the detriment of the index fund. A study by Winton Capital Management found that the S&P 500 Index lost 0.2% from 1990 to 2011 due to front running. However, total market index funds do not suffer the impacts of front running, because they hold nearly every publicly-listed stock already and do not target segments of the market.

On the 50th birthday of the S&P 500 Index, only 86 of the original 500 companies still remained, which shows that it is possible to turn a large fortune into a small fortune with individual stocks. Many investors, especially new ones, attempt to beat the market by investing in individual stocks. The temptation is understandable when there is news about the fabulous returns of someone who had the foresight to buy a little-known stock before it became a winner. However, stock pickers love to talk about their winning picks, but they seldom, if ever, talk about their losing picks.

Overlap occurs when different funds share the same securities in a portfolio. So, if an investor owns multiple funds which contain the same securities, the actual result is a less-diversified portfolio. To minimize risk, investors want funds with securities which act differently. If a stock or bond declines in value, it is desirable for other stocks or bonds in the portfolio to gain in value. If 2 funds hold securities which overlap, diversification is reduced and risk increases.

Market sector risk is the risk faced when investing in individual sector funds, such as financials, healthcare, real estate, energy, utilities, commodities, and technology. The risk is that a bet is being placed on a particular sector performing better than other sectors, even though there may be no logical reason to believe that the sector will outperform other sectors.

Style drift is the divergence of a fund from its stated investment style. Most investors want a combination of at least several styles for their diversification benefit - meaning that when a style is doing badly another style may be doing well. Morningstar divides stock funds into 9 style categories, ranging from large-cap value to small-cap growth. It is difficult for the fund manager to maintain the investment style of the fund - small stocks get larger, large stocks get smaller, value stocks become blend stocks, and so on. Morningstar also divides bond funds into 9 style categories ranging from short-term high-quality bonds to long-term low-quality bonds. A similar problem can be experienced - long-term bonds become intermediate-term bonds, intermediate-term bonds become short-term bonds, and short-term bonds reach maturity. This is a prime reason for the high turnover in most bond funds, as they try to target a particular duration.

Tracking error is the difference between the return of a fund and return of its chosen benchmark. A primary goal of index funds is to track their benchmark as closely as possible. Vanguard recently reported that the Total Stock Market Index Fund has lagged its index an average of only 0.14% since inception, Total International Index Fund lagged its index by 0.29% since inception, and Total Bond Market Index Fund lagged its index by 0.29% since inception. Compared to actively-managed funds, these are very low tracking rates and were the result of management, low cost, and minimal trading.

In 2002, S&P Dow Jones Indices introduced its first SPIVA Scorecard, which is the most reliable data comparing actively-managed funds with index funds. In the 2017 year-end SPIVA report, over the 15-year period ending December 2017, 83.7% of large-cap, 95.4% of mid-cap and 93.21% of small-cap fund managers trailed their respective benchmarks. Across each time horizons, the majority of fund managers across each international equity categories underperformed their benchmarks. Funds disappear at a significant rate, where, over the 15-year period, more than 58% of domestic equity funds were either merged or liquidated. Similarly, almost 52% of global or international equity funds and 49% of fixed-income funds were merged or liquidated. This finding highlights the importance of addressing survivorship bias in fund analysis - funds with poor results are the ones normally merged or liquidated, so only the lucky funds remain.

Supposedly, colleges can afford to buy the investment advice of the best and most expensive portfolio managers to handle their endowments. However, according to a press release issued in January 2017, data collected for National Association of College and University Business Officers (NACUBO) shows that the endowments of reporting institutions returned an average of -1.9% net of fees for the 2016 fiscal year and contributed to a decline in long-term 10-year average annual returns to 5.0% - well below the median 7.4% which most institutions report that they need to earn in order to maintain the purchasing power of their endowments after spending, inflation, and costs of investment management. Meanwhile, during this period, the Russell 3,000 Total Market Index returned 7.4%.

Allan Roth, is a CPA, CFP, and fee-only financial advisor. He writes the monthly Investing column for AARP magazine and is the author of various books. Allan Roth did a study to determine the probability that an actively-managed fund portfolio will beat an index fund portfolio, where the index fund expense ratio was 0.23% and actively-managed fund expense ratio was 2.0%. The table prepared by Allan Roth shows that 1 actively-managed fund had a 42% chance of beating an index fund portfolio over a 1-year period, but that the chances become less as more funds are added and as the length of time increases, until there is only a 1% chance with 10 actively-managed funds after 25 years.

Rick Ferri is a CFA, retired financial advisor, and author of highly regarded financial books. Rick Ferri did a study of 5,000 randomly selected portfolios of actively-managed funds and compared them to the funds in the 3-Fund Portfolio. The study concluded that dedicated active-fund investors can look forward to a 99% probability that their portfolio will underperform an all-index fund portfolio over their lifetime.

William Sharpe, Nobel Laureate, wrote "The Arithmetic Of Active Management" for the Financial Analysts Journal in 1991 and came to the following conclusion: "Properly measured, the average actively-managed dollar must underperform the average passively-managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement". This is categorical and cannot be denied, as the fees for the average actively-managed dollar will always exceed the fees for the average passively-managed dollar. Gross of costs, the average actively-managed dollar must have the same performance as the average passively-managed dollar.

Paul Samuelson, Nobel Laureate, wrote "Challenge To Judgement" for the Journal of Portfolio Management in 1974 and came to the following conclusion: "Statistically, a broad-based stock index fund will outperform most actively-managed equity portfolios". This prediction was put forward before the unquestionable recent evidence was available. An investor has to make the choice to either be like the gamblers who try to beat the casino or be the casino by investing in total market index funds - although, it is a relatively easy choice to make once the actual odds are understood.

Turnover is the ratio of how the weights of the securities of a fund are changed or replaced by new securities each year. For example, if a fund invests in 100 different stocks and 50 of them are replaced during 1 year, the turnover ratio would be 50%. Turnover costs (which are hidden from investors) include commissions, bid-ask spreads, market impact, and administrative costs. Turnover costs do not include the additional tax cost to investors when the turnover results in capital gains distributions to the investor. It is even possible for costs from turnover to be larger than the expense ratio of the fund, as the expense ratio only accounts for management fees and operating expenses.

There was a study by the Financial Research Corporation to determine which fund characteristics worked best at predicting performance, including Morningstar star ratings, past performance, turnover, expenses, fund manager tenure, net sales, asset size, alpha (excess return), beta (volatility), standard deviation, and Sharpe ratio. It was concluded that the expense ratio is the only reliable predictor of future favourable fund performance.

Morningstar is a primary source for reliable fund data and did a similar study. They came to the same conclusion that, if there is anything in the whole world of mutual funds which can be taken to the bank, it is that expense ratios help make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. At the end of the day, an investor gets to keep exactly what they do not needlessly pay.

The Lehman Brothers bankruptcy in 2008 is an example of the need for diversification. Lehman Brothers was founded in 1850 and it was the 4th-largest investment bank in the United States in 2000. In the 2008 Bear Market, Lehman Brothers went bankrupt, causing thousands of their employees and individual investors who owned Lehman Brothers shares to lose all or part of their retirement benefits and life savings. Shares of Lehman Brothers were also owned by the Vanguard Total Stock Market Index Fund, but, because this fund was diversified with thousands of other stocks, investors in this fund were marginally affected by the bankruptcy. Diversification, with its lower risk, is the hallmark of a portfolio.

Any portfolio requires regular maintenance, as funds need rebalancing, contributions and withdrawals change, new fund offerings need consideration, funds are merged and liquidated, asset allocation may need adjustments, changes in income, expenses and net worth may require adjustments, changes in tax laws and tax bracket may require adjustments, and beneficiaries change. Fortunately, the 3-Fund Portfolio requires minimum maintenance. This means investors will have less worry and, thus, may spend more time with family and friends or doing whatever they actually enjoy.

Index funds, especially total market index funds, are among the most tax efficient funds when located in taxable accounts. The tax cost ratio measures how much the annualized return of a fund is reduced by the taxes investors have to pay on distributions. For example, if a fund had a 2% tax cost ratio, it means that investors in this fund lost 2% of their assets to taxes. According to Morningstar on 2018-01-12, the average tax cost ratio for equity funds tends to fall between 1.0% and 1.2%. Currently, the Vanguard Total Stock Market Index Fund has a 15-year tax cost ratio of 0.40% - less than half the tax cost ratio of the average equity fund. Investors should never forget that it is the after-tax returns which count.

The tax efficiency of total market index funds derives from several sources. Lower turnover by the fund manager, who does not need to trade securities which trigger taxes which are later passed on to shareholders as distributions. Unlike most equity funds, the Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Index Fund have not distributed a taxable capital gain since 2000. Lower turnover by the individual investor, because there is no need to buy and sell total market index funds and trigger personal taxes. Eligibility for lower tax rate, as the Vanguard Total Stock Market Index Fund and Vanguard Total International Index Fund are eligible for a reduced federal tax rate as qualified dividend income. In 2017, the Vanguard Total Stock Market had 92% of its distributions qualify for the lower qualified dividend income rate, while the Vanguard Total International Stock Index Fund had 71% of its distributions eligible for the lower qualified dividend income rate. It should be noted that bonds are not eligible for the qualified dividend income rate, which is one reason taxable bond funds are usually best placed in tax-advantaged accounts.

According to The Investment Company Institute, in 2016, there were 8,066 mutual funds from which investors were able to choose. A frequent request on the Bogleheads' Forum is for help with simplifying a portfolio. For example, there was recently a request to help track a portfolio which contained a mixture of 90 overlapping securities. The participant did not realize that tracking was not their problem, but their primary problem was their confusing, complex, and high-cost portfolio. Ultimately, this was the result of using several advisors who were friends and relatives.

A portfolio with fewer and larger funds has many advantages. These include lower costs, fewer hidden turnover costs, better tax efficiency, avoidance of low-balance fees, less distortion from contributions and withdrawals, less rebalancing, lesser chance of errors, easier tax preparation, less paperwork, less stress, and more time with family and friends or doing whatever else. Simple to understand and maintain, the 3-Fund Portfolio does not require higher mathematics, spreadsheets, complicated tax returns, being glued to the television (before, during, and after market hours), or reading the Wall Street Journal. There seems to be some perverse human characteristic which likes to make easy things difficult.

Getting Started

Asset allocation (ratio between stocks and bonds) is the most important investment decision, because, with the exception of the actual amount being regularly saved, an asset allocation determines expected return and expected risk. Expected return and expected risk go hand-in-hand, where a higher expected return will have a higher expected risk. The average annual return and worst single-year return of various stock and bond allocations from 1926 to 2015: 0% Stocks, 100% Bonds, average, 5.4%, worst -8.1%; 20% stocks, 80% bonds, average, 6.7%, worst, -10.1%; 40% stocks, 60% bonds, average, 7.8%, worst, -18.4%; 60% stocks, 40% bonds, average, 8.7%, worst, -26.6%; 80% stocks, 20% bonds, average, 9.5%, worst, -34.9%; and 100% stocks, 0% bonds, average, 10.1%, worst, -43.1%. A high percentage of stocks in a portfolio is more volatile and, thus, likely to result in both higher returns and greater losses.

Investment accounts can be complicated, but it mostly boils down to a decision whether to use a Traditional IRA (retirement account, provident fund) or Roth IRA (tax-free savings account). A general rule is that a Traditional IRA should be used if the income tax rate is higher now than it will be in retirement (advantage of deferring tax), while a Roth IRA should be used if the income tax rate is lower now than it will be in retirement (advantage of knowing the tax rate).

Stay The Course

It is vital to stay the course which is chosen, although this will not necessarily be easy. There will be confrontations from many temptations to make changes. When stocks are in a bull market, there will be a great temptation to increase stock allocation. A small deviation from asset allocation is permissible, but should be rebalanced any time stock allocation exceeds around 10% of its desired allocation - during the accumulation phase of investing, this can be done by putting new contributions into the bond allocation or by selling stocks; during the withdrawal phase of investing, withdrawals should be taken from the stock allocation or stocks can be exchanged for bonds in tax-advantaged accounts. When stocks are in bear markets, there will be a strong temptation to sell at least a portion of the stock allocation. However, this is the time when stocks are on sale at lower prices and sticking with the allocation means buying low and selling high when you rebalance - rebalance by adding to the stock allocation until it is again meeting the desired asset allocation.

Jack Bogle wrote: "Stay the course. No matter what happens, stick to your program. I have said, 'stay the course' a thousand times and I meant it every time. It is the most important piece of investment wisdom which I can give to you". It takes knowledge and willpower to stay the course and avoid succumbing to carefully prepared and often misleading marketing by active funds, insurance companies, banks, and advisors seeking to make a profit at the expense of their clients.