EPTA lot of the Boglehead investing philosophy is intuitive and common sense. Plenty of people are already investing this way without having put a name to it. All of this information is taken and regurgitated, without much shame, from various books and online sources, especially the Boglehead’s Guide to Investing and the Boglehead wiki.
The Basics of Creating Wealth
In the immortal words of Nate Dogg, hold up. First off, what is wealth? Wealth is your net worth. It is NOT your net income. A partner in a big law firm could be raking in $1 million a year. If he spends $1 million a year, then his net worth is theoretically zero. A teacher who makes $40k a year but puts away 20% of every paycheck (we will get to where to put it later), he will be accumulating true wealth. It’s not how much you make, it’s how much you keep and where you put the money you keep. To calculate your net worth, add up the dollar value of everything you own. This includes your bank accounts, stocks, bonds, mutual funds, retirement plans, valuables, cars, home, etc. Then add up how much you owe, including mortgage and credit/car/educational/business/etc loans. Subtract what you owe from what you own. If you were to retire today, that is the number you’re working with to keep you from dying poor.
Now that we got that out of the way…
- Eliminate credit card and other high-interest debt. You will never get a guaranteed return on your investment that will exceed credit card interest rates. Paying your debt off is risk-free and tax-free. Just having any significant credit card debt in the first place is an indication that you are living with a paycheck-to-paycheck mentality. You cannot accumulate wealth if you live this way. But you can start to pay it off NOW.
- Live wisely. There is a certain competitive fire in most of us to have the biggest house we can buy or the nicest car we can afford. After all, we worked hard for the money. Why can’t we enjoy using all of it? This mentality is something you have to fight. Save in any way you can. Getting a big house you cannot really afford will cripple you financially. Buying new cars can be a huge money sink. Everyone knows that a new car depreciates faster than a porn star. Consider getting a 2-3 year-old car and keeping it for a long time. If you absolute must get a new car, at least try to make it practical and gas-efficient. Always consider cheaper alternatives to what you’re buying.
- Establish an emergency fund. This should be in a liquid, readily available money source, such as a bank savings account or money market account. It is to respond to accidents, disasters, and other unforeseen events. Conventional wisdom is that 3-6 months worth of your income is adequate to put aside.
- Save early and often. Pay yourself first. Start now. Before paying your bills or taxes, take out at least 20% of your income to invest in your future financial independence. Why do you need to start now? “The magic is in the compounding.” Time is on your side when you are young. A dollar you invest today will be worth much more than that by the time you retire. To illustrate: Suppose you invest a one-time sum of money at an 8% annual rate of return. How much money would you need to invest at various ages to have $1 million by age 65? If you start at age 25, you need to invest around $46000. If you start at age 55, you’ll need to invest around $460000, or ten times more. And we’re talking about a one-time investment. If you invest consistently, the results will be compounded even further.
- Allocate assets according to your age and risk aversion. A basic portfolio will contain stocks and bonds. Stocks offer a higher return but with significantly higher volatility. This is something anyone should know after the past couple of years. Poker players will understand the concept well. Bonds offer a lower return but more stability. To achieve good returns while minimizing risks, you diversify your portfolio in include both classes of assets. The simple Boglehead formula to calculate how much of your investments to put in each: You should own your age in bonds. If you are 25 years old, you should put around 25% of your investment in bonds, and 75% in stocks. The idea is that when you are young, time is in your favor and you have a long time to realize the higher rate of return on stocks. You also have the advantage of human capital. Your income-earning years are in front of you. When you are 55 and close to retiring, you will want more security and thus around 55% bonds. This is just a general starting point. If you are young but have never lived through a prolonged bear market, you may want to allocate a higher percentage to bonds.
- Use low-cost index funds for the stock portion of your portfolio. Index funds follow entire markets, like the S&P 500 or the Wilshire 5000. They instantly diversify your portfolio and massively reduce the risk from owning stocks in only a few companies. They also outperform 60 to 80% of actively managed mutual funds (where an expert picks a lot of stocks for you to own). Actively managed funds have fund managers that will deduct 1-2% of your balance to pay themselves and for expenses. Passively managed funds have expense ratios between 0.2 to 0.5%. Remember the power of compounding. That difference can become quite sizable after applying decades of exponential math. And once again, the majority of fund managers do not beat the market. Passively-managed index funds incur no sales commissions, have very minimal operating expenses, and are easy to track. Vanguard (company founded by John Bogle, hero of the Bogleheads) and several other companies offers very low-cost index funds.
I’m pretty much going to just copy a few quotes from the Boglehead’s Guide to illustrate what some big names in finance think about index funds:
Frank Armstrong, author of The Informed Investor: “Do the right thing: In every asset class where they are available, index!—Four of five funds will fail to meet or beat an appropriate index.”
William Bernstein, Ph.D., M.D., author of The Four Pillars of Investing,frequent guest columnist for Morningstar and often quoted inThe Wall Street Journal: “An index fund dooms you to mediocrity? Absolutely not: It virtually guarantees you superior performance.
Warren Buffett, chairman of Berkshire Hathaway and investor of legendary repute: “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.”
Jonathan Clements, author and writer of the popular Wall Street Journal column “Getting Going”: “I am a huge, huge, huge fan of index funds. They are the investor’s best friend and Wall Street’s worst nightmare.”
Arthur Levitt, former chairman of the Securities Exchange Commission and author of Take on the Street: “The fund industry’s dirty little secret: Most actively managed funds never do as well as their benchmark.”
Paul Samuelson, first American to win the Nobel Prize in Economic Science: “The most efficient way to diversify a stock portfolio is with a low fee index fund. Statistically, a broadly based stock index fund will outperform most actively managed equity portfolios.”
Charles Schwab, founder and chairman of the board of The Charles Schwab Corporation: “Only about one out of every four equity funds outperforms the stock market. That’s why I’m a firm believer in the power of indexing.” - Keeping it simple is perfectly fine. Some specifics. Most Bogleheads prefer the Vanguard Total US stock market index fund to form the core of their portfolio. A good number like to diversify their stocks between domestic and international markets. A common allocation for stocks is 70% domestic and 30% international, using the Total Market index and the Total International index. This simple formula will be all most people need. More experienced Bogleheads like to separate out the markets for more control over certain classes of stocks. You might want to consider that when your portfolio grows large enough to meet the fund minimums for those classes. For bonds, there is a Total Bond Market index fund also. Bogleheads generally use this or short-term, high quality bonds. Bottom line: With just two stock funds and one bond fund in your portfolio, you will outperform the majority of investors.
- Be tax-efficient. Take full advantage of tax-advantaged accounts like IRAs and 401(k)s. These allow your money to grow without giving up a portion every year to taxes. Max these out whenever possible, especially if your employer provides some sort of match for the 401(k). That’s free money! If your income is too high to put all of your portfolio in these accounts, then you want to put the tax-inefficient parts of your portfolio in the tax-advantaged accounts. For the average investor, bonds are inefficient because they produce interest every year that is taxed. Index funds are tax-efficient because they produce low dividends and capital gains. So if you have to split up the portfolio, put as much of the bond portion into the IRAs and 401(k)s.
- Stay the course. Investing is all about the long term. What happens tomorrow, next month, or even over the next few years is inconsequential compared to the total time during which you will be investing. In the long run, stocks and bonds make money, and at a very decent rate. Saying this and actually living through it is obviously very different, but young investors should be jumping at the opportunity to invest even more during a bear market because of dollar-cost averaging.
To quote the Boglehead wiki: “Bogleheads do our best not to be distracted, and not to waiver. We create an asset allocation with a large ownership of bonds in order to reduce the volatility of our portfolios and help us stay the course. Once you set up a Bogleheads portfolio, the only real course correction needed is to rebalance once per year (on your birthday, if you want), to bring your stock/bond allocations back to your pre-set levels. (You generally want to increase your bond holdings slightly every year, such as by setting your percentage of bonds to your age.) 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.”
That’s the Boglehead philosophy in a nutshell. Who’s with me?
