Investing 101

This page conveys critical investment knowledge that should form the foundation for every investment decision you make.

Annuities (TSA)
Annuities are almost always extremely complicated and expensive products that enrich sales reps at the expense of investors. On the Bogleheads Forum, people frequently post about regretting the annuities that were sold to them and ask for guidance on how to get out of them. Unfortunately, annuities are prevalent in the education field and unless you consider yourself a financial expert then you should stick with mutual funds.

The Tyranny of Compounding Costs (John Bogle)
Initially, it may seem reasonable that you’re charged a 1.5% fee per year. Let’s do some quick and rough mental math to see if that’s a fair assessment.

Suppose the market gains a fairly typical 6% on the year but inflation is a fairly typical 3%. That leaves you with a “real” profit of just 3%. Paying a 1.5% fee costs you 50% of your “real” profits. This hurts even more over time because the money that went towards fees is no longer invested and generating profit for you.

A core investing principle is to minimize costs, specifically:

  • “Loads” are fees that go to the sales rep who sold you the fund. You’re charged when you buy (front-end load) or sell (back-end load) the mutual fund. High quality mutual funds purchased through fair vendors do not charge loads.
  • “Expense ratio” is a percentage of your total investment that a mutual fund charges you every year to own the fund. For example, a $100 investment in a mutual fund with a 1% expense ratio will cost you a dollar every year. An expense ratio greater than 0.15% should be considered high. My favorite funds’ expense ratios are 0.04% and 0.11%.

How To Measure Fees
The real way to measure fees is to ask yourself, “over time how much of my ‘real’ profit is being consumed by fees?” To do this, download and experiment with the Fund Expense Calculator spreadsheet we created. One example…

Assume the market returns 6% and inflation is 3%. If you pay a sales load of 5.5% and a 1.25% expense ratio then after 30 years the amount you’ve lost to fees is 153% of the profits you actually received. Said another way, fees have taken 60% of the profits you should have received. Said more plainly, the majority of your profit is not going to you.

Total Market Index Funds > Actively Managed Funds
When selecting a mutual fund the primary choice you have to make is whether to buy a total market index fund or an actively managed fund. Total market index funds have rock bottom costs and return whatever the market returns. Actively managed funds have high costs and hope to outperform the market.

Actively managed funds are inferior investments due primarily to the tyranny of compounding costs and the fact that nobody can consistently predict (and therefore outperform) what stocks will return any given day, week, month, or year. This truth was best illustrated in 2005 when John Bogle reviewed the performance of the 355 mutual funds that existed in 1970:

  • 223 funds (62.8%) were closed before 2005.
  • 60 funds (16.9%) lagged the market by 1% or more.
  • 48 funds (13.5%) were within +/- 1% of the market.
  • 15 funds (4.2%) beat the market by 1-2%.
  • 9 funds (2.5%) beat the market by 2% or more.

Fund Selection
The financial industry’s profits depend on convincing you that investing is too complicated for you to understand. Don’t confuse complexity with effectiveness. All you need are 3 total market, low cost, index funds to cover US stocks, international stocks, and US bonds.

Here’s an example of 3 such funds from Vanguard (folks like Fidelity have similar, excellent offerings as well):

Asset Allocation Selection
Asset allocation is just a fancy way of saying that you’ve decided X% of your portfolio will be in bonds, Y% in domestic stock, and Z% in international stock.

Bonds
The most important choice you’ll make is deciding what percentage of your portfolio should be allocated to bonds. Bonds will reduce your expected returns but they’ll buy you stability, peace of mind, and lower the likelihood of behavioral errors like selling during a crash only to reenter the market after the recovery. These mistakes can be far more disastrous than paying high fees.

Our personal approach is to recognize that stocks can lose half their value over night and take many years to recover. After serious introspection, ask yourself how much you can emotionally and financially “afford” to lose in that scenario. If your answer were 37.5% then you’d use the formula (100 – 37.5 * 2) to calculate that 25% of your portfolio should be allocated to bonds.

Stocks
Your last decision is to determine what percentage of your stocks should be split between domestic and international. Honestly, the exact number is far less important than sticking to it.

  • US stocks represent about 55% of the world, international 45%.
  • Vanguard target date funds opt for 60% US and 40% international.
  • Guys like John Bogle have suggested 100% US is fine.

Maintenance
Once you’ve selected your asset allocation, never deviate from it because of changes in the market. Failing to follow this rule is the best way to sabotage your investments.

It is your job to maintain your asset allocation over time. In the beginning this can easily be done by using your new investments to buy whatever you have too little of. When your portfolio begins to dwarf your new investments then maybe once a year or when an extreme event occurs (crash or recovery) you should sell whatever you have too much of and buy whatever you have too little of.

Fund Selection Made Even Simpler!
Instead of owning 3 total market index funds it is possible to buy a single “fund of funds.” A fund of funds contains every total market index fund you’ll need for a fully diversified portfolio. There are two variants, “target date” and “fixed allocation.” This option is worth considering if you value simplicity and want to spend virtually no time managing your portfolio.

Pros

  • Simplicity! What could be easier than owning just one fund?
  • Your asset allocation is automatically maintained, no work for you.
  • Lowers the likelihood of expensive behavioral errors like failing to re-balance during a crash.

Cons

  • Higher fees cut into your profits.
  • Less control over asset allocation.
  • Not well suited for taxable accounts, which isn’t a concern for a 403b or 457b.

Target Date Funds
A target date fund will will automatically maintain your asset allocation and increase your bond holdings as you approach the “target date”. Here are a few examples from Vanguard:

Fixed Allocation Funds
Fixed allocation funds will automatically maintain a constant asset allocation. Here are a few examples from Vanguard: