The Bogleheads' Guide to Investing

by Mel Lindauer

What most young people don’t understand is that SAVING is more important in the beginning than finding the best performing investment. Having the ability to “Pay yourself first,” manage your debt load, and determine a vision of what you want to accomplish is vital to your success. I read an article last week that stated 40 percent of Americans don’t know where their earnings go. The simplicity of saving, coupled with the power of compound interest, is something to be very happy about.

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

Treasury issues of one year or less are known as Treasury Bills, or T-Bills. Currently, T-Bills are being issued for 13-, 26-, and 52-week periods. Issues of 2, 3, 5, and 10 years are called T-Notes. Issues for periods greater than 10 years are known as T-Bonds. Together, all of these issues are often simply referred to as Treasuries.

Let’s assume someone puts $10,000 in a mutual fund, leaves it there 20 years, and gets an average annual return of 10 percent. If the fund had an expense ratio of 1.5 percent, the fund is worth $49,725 at the end of 20 years. However if the fund had an expense ratio of 0.5 percent, it would be worth $60,858 at the end of 20 years. Just a 1 percent difference in expenses makes an 18 percent difference in returns when compounded over 20 years.

The fastest way to get rich in the stock market is to own the next Microsoft. The fastest way to lose all your money is to own the next Enron. Identifying them in advance is impossible.

If 500 leading U.S. corporations all have their stock prices plummet to zero, the value of your investment portfolio will be the least of your problems. An economic collapse of that magnitude would make the Great Depression look like Lifestyles of the Rich and Famous.

Only consider investing in no-load funds with annual expense ratios of 0.5 percent or less, the cheaper the better.

Your personal financial situation has a direct influence on the type and amount of securities you select, and their allocation within your asset allocation plan. For example, the investor with a pension

The only certainty in investing is that past performance will not repeat.

If you decide to add one or more sector funds, we suggest that your total allocation to sector funds not exceed 10 percent of the equity portion of your portfolio. Jack Bogle had this to say: “You could go your entire life without ever owning a sector fund and probably never miss it.”

Real Estate Investment Trusts (REITs) are a special type of stock. REIT funds often behave differently than other stock funds. This characteristic of noncorrelation can make them a worthwhile addition to larger portfolios. We suggest that REIT funds not exceed 10 percent of your equity allocation.

We believe that investors will benefit from an international stock allocation of 20 percent to 40 percent of their equity allocation.

A single low-cost short- or intermediate-term, good-quality bond fund should be adequate for small investors.

We also suggest a broad-based, diversified bond fund such as Vanguard’s Total Bond Market Index Fund.

our guideline portfolios do not contain high-yield bond funds.

As your portfolio increases in size, it’s time to consider adding a different type of bond—Treasury Inflation-Protected Securities (TIPS). TIPS provide diversification and protection from unexpected inflation. Vanguard offers two TIPS funds—an intermediate-term fund (VIPSX) and a short-term fund (VTAPX). If you decide to include a Vanguard TIPS fund in your portfolio, you can choose between VIPSX ($3,000 minimum) with its higher expected risk and return, and VTAPX ($10,000 minimum) with its lower expected risk and return.

We recommend that mutual fund investors avoid load funds. If financial advice is needed, use a fee-only financial planner—not a mutual fund salesperson who has a conflict of interest.

The expense ratio is the only reliable predictor of future mutual fund performance.

we will avoid all load funds and we will favor low-cost index funds. We will always read the prospectus to determine the published costs of any fund we are considering. We will always know a fund’s turnover so that we have an idea of the fund’s hidden transaction costs—the higher the turnover, the higher the cost is likely to be. We will not use wrap accounts. We will remember that low cost is the best predictor for selecting funds with above-average performance. Above all, we will remember—cost matters.

The lower rates on qualified dividends increase the tax-efficiency of stocks relative to bonds whose yield is taxed at ordinary income tax rates. For this reason, and the fact that stocks benefit from the lower capital gains tax rates, we generally recommend placing stocks in taxable accounts and bonds in tax-advantaged accounts.

If the current market value is more than the manager paid, the unsold security is said to have an unrealized gain.

Short- and Long-Term Capital Gains A short-term capital gain is a profit on the sale of a security or mutual fund share that is held for 12 months or less. A long-term capital gain is a profit on the sale of a security or mutual fund share that is held for more than one year. Tax rates for short-term and long-term capital gains are not the same. It’s very important for tax-savvy investors to understand the difference. Short-term capital gains are taxed as ordinary income at the shareowner’s highest marginal income tax rate, while long-term capital gains enjoy a maximum tax rate of 15 percent—approximately half. One of the easiest and most effective ways to cut mutual fund taxes significantly is to hold mutual funds for more than 12 months. Buy-and-hold is a very effective strategy in taxable accounts.

For maximum tax efficiency in taxable accounts, you should do the following: Favor funds with low dividends. Favor funds with “qualified” dividends. Favor funds with low turnover. Favor tax-efficient index funds and tax-managed funds.

As mentioned earlier, it’s very important when using mutual funds in taxable accounts to use tax-efficient mutual funds or ETFs.

Tax-managed funds reduce or eliminate shareholder taxes by using a variety of tax-reduction techniques:

Keep turnover low. We know that buying and selling funds in a taxable account generates capital gains taxes. Therefore, we will try to buy funds that can be held “forever.” Use only tax-efficient funds in taxable accounts. We will try to use only tax-efficient funds in our taxable account(s). This usually means low-turnover index and/or tax-managed funds. Avoid short-term gains. We know that short-term gains are taxed at about twice the rate of long-term gains. Therefore, we will try to hold profitable shares for more than 12 months before selling. Buy fund shares after the distribution date. Mutual funds pay taxable distributions at least annually. If we buy a fund shortly before a distribution date, we will have to pay taxes on the distribution. If we wait until after the distribution date, the value of our purchase will still be the same (assuming no market change), but we will avoid the tax on the distribution.

Sell fund shares before the distribution date. There may be a small advantage in selling before the distribution date. Sell profitable shares after the new year. If shares are sold in December, the tax will be due with that year’s return. By simply waiting until January to sell, the tax will be reported a year later. There’s usually no sense in paying taxes any earlier than we have to. Harvest tax losses. This is the practice of selling losing securities in taxable accounts for the purpose of obtaining tax losses to reduce current and future income taxes.

If you decide you want to repurchase your losing fund, you must wait 31 days to avoid a disallowance of your tax loss—called a wash sale.

Unlike 401(k) plans, which are designed for profit-making entities, 403(b) plans are designed for nonprofit entities such as schools, universities, churches, and certain charitable organizations. According to the Spectrem Group, which tracks the 403(b) industry, approximately 80 percent of the $578 billion invested in these plans is held inside annuities. Most of the remainder is invested in stand-alone mutual funds. A 403(b) plan is the only salary-deferral plan available for public school employees. 401(k) and 403(b) plans are similar in that they both allow employees to defer tax on a portion of their salary. Both allow matching contributions and generally have the same maximum limits. The major disadvantage of 403(b) plans is their choice of investments. Most offer only high-cost annuities sold by brokerage and insurance firms. It makes no sense (except to the annuity company) to pay the extra cost of the annuity’s tax deferral when the 403(b) or other tax-deferred plan already provides the same tax-deferral advantage. A minority of 403(b) plans offer a variety of options from insurance companies, brokerage companies, and mutual fund companies. This places the 403(b) participant at the mercy of commission-paid salesmen, who often have a serious conflict of interest. Never forget, the more taken from your returns in the form of higher fees and expenses, the less you’ll end up with in your retirement account. If you are a participant in a 403(b) plan, it’s important for ...

By placing your two funds in the proper accounts, you were able to increase the after-tax value of your portfolio by $119,021 ($1,005,451 – $886,430). Proper placement of funds is very important.

Avoid short-term gains by holding for more than 12 months.

Sell losing shares before year-end (tax-loss harvest). Sell profitable shares after the new year (to delay tax payment).

Using past performance to pick tomorrow’s winning mutual funds is such a bad idea that the government requires a statement similar to this: Past performance is no guarantee of future performance.

Consistent with mutual fund studies, winners rarely win again and losers often lose again.

If you think successfully timing the stock market is difficult—and it is the bond market is virtually impossible.

“There are only two kinds of interest-rate forecasters: those who don’t know, and those who don’t know that they don’t know.”

Wall Street can’t stand buy-and-hold strategies because brokers need trading activity to make money.

Warren Buffett wrote in his 1996 annual report to shareholders: “Inactivity strikes us as intelligent behavior.”

“Market timing is a poor substitute for a long-term investment plan.”

“Buy and hold is a very dull strategy. It has only one little advantage—it works, very profitably and very consistently.”

“Simple buy-and-hold index investing is one of the best, most efficient ways to grow your money to the ultimate goal of financial freedom.

many parents decide that these custodial accounts are probably not the best way to save for their children’s college expenses.

So, if you’ve decided to hire an advisor, how should you go about finding one who’s right for you? First, because of the high standards and educational requirements for earning the CFA and CFP designations, we feel that an advisor with one of these designations should certainly be on your short list.

Fee-only advisors normally use the Assets Under Management (AUM) payment arrangement. This involves paying a set percentage of your total assets to the advisor on an annual basis. Depending on the advisor, the costs of AUM can vary widely, from 0.25 percent to more than 2 percent per year. This fee is often negotiable, especially for larger accounts. The AUM does not include trading costs, custodial charges, or any other miscellaneous expenses involved in managing the portfolio.

There are good and bad features with the AUM payment arrangement, depending on the advisor. On the plus side, since your annual fee is paying the advisor, the advisor is free to offer good, no-load mutual funds and other appropriate low-cost investments. On the downside, many good advisors often have higher minimum account requirements that may be out of reach for many investors. And, even if you can meet the advisor’s minimum account requirements, paying up to 2 percent for a bond fund that’s only yielding 4 percent is very costly. In fact, it can consume up to 50 percent of your return. And even with a return of 8 percent per year, a 2 percent fee still represents 25 percent of your total return. It’s important to remember, too, that even in bad years, when your portfolio might suffer a loss, you’ll still be paying the AUM fee. Obviously, then, you want to choose a good financial advisor whose fee is on the low end of the range, since every dollar you pay in fees reduces your total return by an equal amount.

This is called a wealth transfer, since it transfers the money from your pocket into the broker’s pocket.

Two alternative payment options include a one-time fee or an hourly rate arrangement.

And some mutual fund companies, such as Vanguard, also offer one-time financial planning services for a fixed fee. If you have enough assets invested with the fund company, the fee for this planning service might be reduced or even eliminated. This fee-only method of payment is probably the most popular arrangement used by those Bogleheads who do seek professional financial advice.

Rebalancing forces us to sell high and buy low. We’re selling the outperforming asset class or segment and buying the underperforming asset class or segment. That’s exactly what smart investors want to do.

Use tax-loss harvesting in your taxable account as part of your rebalancing strategy. If you have losers to sell, then sell them prior to December 31, so you can get the tax benefits on this year’s tax return.