6John C. Bogle, Common Sense on Mutual Funds (Hoboken, NJ: John Wiley & Sons, 2010), 28.
7Jeremy Siegel, Stocks for the Long Run (New York: McGraw-Hill, 2002), 217–218.
8“Missing the Best and Worst Days,” IFA Advisors, accessed July 7, 2016, www.ifa.com/12steps/step4/missing_the_best_and_worst_days/.
9Ken Fisher, The Only Three Questions That Count (Hoboken, NJ: John Wiley & Sons, 2007), 279.
10“Coca-Cola Report,” The Value Line Investment Survey, November 9, 2001, 1551.
11“Long Term Performance of Major Developed Equity Markets,” Management and Factset Research Systems, accessed April 15, 2011, www.fulcrumasset.com/files/Long%20Term%20Equity% 20Performance.pdf.
12Quote DB, accessed April 15, 2011, www.quotedb.com/quotes/3038.
13“A Long-Term Perspective Chart,” The Value Line Investment Survey, 1920–2005.
14Burton Malkiel, A Random Walk Down Wall Street (New York: WW Norton & Company, 2003), 86.
15Lawrence Cunningham, The Essays of Warren Buffett (Singapore: John Wiley & Sons, 2009), 86–87.
16Forbes, from the archives, “Warren Buffett—1974,” accessed January 5, 2011, www.forbes.com/2008/04/30/warren-buffett-profile-invest-oped-cx_hs_0430buffett.html.
17John C. Bogle, Common Sense on Mutual Funds (Hoboken, New Jersey: John Wiley & Sons, 2010), 32.
RULE 5
Build Mountains of Money with a Responsible Portfolio
“Eat your Brussels sprouts,” I used to hear when I was a kid, “and you’ll grow into a big, strong boy.”
So I ate a bowl of Brussels sprouts for breakfast, a plate of Brussels sprouts for lunch, and a casserole dish of Brussels sprouts for dinner—seven days a week.
If that were true, I’d probably resemble a green, leafy ball with legs by now. Brussels sprouts might be good for you, but you need to eat more than a bunch of tiny cabbages if you want to be healthy.
In the same vein, a total stock market index fund might be good for you as well, but it doesn’t represent a balanced portfolio.
If that were all you bought, your portfolio would gyrate wildly with the stock market. If the market dropped 20 percent, so would your overall portfolio. If the market dropped 50 percent, so would your total investments.
This isn’t good for any investor, especially those approaching retirement and needing more stability. If a 60-year-old plans to use her portfolio as a nest egg, she’s not going to be comfortable seeing all of her hard-earned money plunge into what might look like a bottomless crater during a sharp market decline.
Only an irresponsible portfolio would fall 50 percent if the stock market value were cut in half. That’s because bonds become parachutes when stock markets fall.
What Are Bonds?
Bond is a secret British agent with a license to kill. He sleeps with multiple women, never dies, and every 15 years or so, gets a body transplant to look like a completely different guy.
Financial bonds are just as riveting.
Bonds Get Less Shaken and Stirred
In the long term, bonds don’t make as much money as stocks. But they’re less volatile, so they can save your account from falling to the bottom of a stock market canyon if the market gods want a hearty laugh.
A bond is a loan that you make to a government or a corporation. Your money is safe as long as that entity (the government or the corporation receiving the loan) is able to pay the money back, plus annual interest.
The safest ones you can buy are first-world government bonds from high-income industrial countries. Slightly riskier bonds can be bought from strong blue-chip businesses such as Coca-Cola, Walmart, and Johnson & Johnson. Bonds from smaller, less established companies usually offer the highest rates of interest. But there’s a higher chance that they might forfeit on their loans. The higher the interest paid by a corporate bond, the higher the risk associated with it.
If you’re looking for a safe place for your money, it’s best to keep it in short-term or intermediate-term government bonds or high-quality corporate bonds.
Why short term or intermediate term? If you buy a bond paying 4 percent annually over the next 10 years, there’s always a chance that inflation could make a meal out of it. If that happens, you’re essentially losing money. Sure, the bond is paying you 4 percent annually, but if you’re buying breakfast cereal that increases in price every year by 6 percent, then your 4 percent bond interest is losing to a box of cornflakes.
For this reason, buying bonds with shorter maturities (such as one- to five-year bonds) is wiser than buying longer-term bonds (such as 20- to 30-year bonds). If inflation rears its head, you won’t be saddled with a commitment to a certain interest rate. When a short-term or intermediate-term bond expires, and you get your money back, you can buy another short-term or intermediate-term bond at the higher interest rate.
If this sounds complicated, don’t worry. You can buy a short-term or intermediate-term government bond index, and you never have to worry about an expiration date. It will keep pace with inflation over time, and you can sell it whenever you want. It’s easy.
If You Want to Know How Bonds Work, Here’s the Skinny
You don’t need to know the intricacies of how bonds work. You can just buy a government bond index (which I’ll show you how to do in the next chapter) and that bond index can represent the temperate part of your investment account. But if you want to know how bonds work, here it is in a half-page nutshell.
If you buy a five-year government bond, you know immediately what the interest rate is and that the rate is guaranteed by the government. If you loan a government say, $10,000, they promise to give you that $10,000 back. Along the way, you are guaranteed to earn $500 each year in interest payments, assuming that the interest rate was 5 percent annually.
If you choose to sell that bond before the five years are up, you can do that, but bond prices fluctuate every day. Instead of getting back your $10,000, you might get back $10,500 or $9,500, if you sell before the maturity date.
When inflation/interest rates rise, bond prices fall. If inflation were running at 3 percent annually when you bought a bond that yields 5 percent in interest, and if inflation suddenly jumped to 5 percent, then no new investors would want to buy a bond like yours (paying 5 percent interest with inflation at 5 percent). If they did, they wouldn’t make any money after the increase in the cost of living. But if the price of that bond dropped, the new investor would be lured by the idea of paying $9,500 for the same bond that you paid $10,000. When that bond expired, the new investor would get $10,000 back.
If interest rates dropped, a friend of yours might be dying to buy your $10,000 bond that pays 5 percent in interest annually. But he wouldn’t be alone. Institutional bond traders would rush to buy that bond quickly, resulting in a price increase for it—perhaps from $10,000 to $10,300. Bond-price adjustments are similar to stock-price adjustments. If there’s more demand, the price will rise.
Your friend, however, would earn 5 percent annually on $10,000 (not on the $10,300 he paid for the bond). When the bond expired, he would receive $10,000 back. You’d brag. He’d get upset. And if your friend were anything like my dad, you might find cat food in your shoes.
You can see why there’s a bond “trading market” as people try to take advantage of these price movements. It only follows that there are actively managed mutual funds focused on buying and selling bonds as well.
Bond Index Funds Are the Winner
In case you’re tempted to buy an actively managed bond fund, remember this: bond index funds beat them silly. Costs matter even more in the world of bond funds.
Figure 5.1 reveals that from 2003 to 2008, the average actively managed government bond fund with a sales load (that crafty commission paid to advisers) made 3.7 percent annually and the average actively managed bond fund without a sales load made 4.9 percent annually. As with actively managed stock market mutual funds, those without sales-load fees outperform, on average, those with sales-lo
ad fees.
Figure 5.1 Comparison of Funds
Source: John C. Bogle, Common Sense on Mutual Funds
During the same period, a US government bond index averaged 7.1 percent annually.
The SPIVA Persistence Scorecard measures what percentage of actively managed bond funds beat their bond index counterparts. When measuring three categories of government bond funds (long term, intermediate term, and short term) they found that just 17.67 percent of them beat their index fund counterparts during the 10-year period that ended December 31, 2015.1
Whether you’re buying stock indexes or bond indexes, active management puts a drag on your returns because of the extra fees.
If your account has a bond index, a domestic stock index, and an international stock index, you’ll have a good chance of success.
What Percentage of Your Portfolio Should You Have in Bonds?
The debate over what percentage you should own in stocks and what percentage you should own in bonds is livelier than an Italian family reunion.
A rule of thumb is that you should have a bond allocation that’s roughly equivalent to your age. Some experts suggest that it should be your age minus 10, or if you want a riskier portfolio, your age minus 20; for example, a 50-year-old would have between 30 and 50 percent of his or her investment portfolio in bonds.
Common sense should be used here. A 50-year-old government employee expecting a guaranteed pension when he retires can afford to invest less than 50 percent of his portfolio in bonds. He can take on greater risk (for the promise of higher returns). Stock returns don’t always beat bond returns over the short term, but over long periods, stocks run circles around bonds. That said, bonds could be your secret weapon when stocks hit the skids.
Trounce the Professionals with a Balanced Portfolio
If you’re adding $200 a month to a portfolio, you could add $60 a month to a bond index ($60 is 30 percent of $200) and $140 a month ($140 is 70 percent of $200) to your stock indexes.
In any given year, as you know, the stock market can go crazy, rising or dropping by 30 percent or more. Dispassionate, intelligent investors can rebalance their portfolios if they’re too far from the stock/bond allocation they set for themselves.
For example, if a 30-year-old man has 30 percent in bonds and 70 percent in stocks, he will want to maintain that allocation.
If the stock market falls heavily in a given month, the investor will find that his portfolio (which started out with 70 percent in stocks) now has a lower percentage in stocks than his goal allocation of 70 percent. So what should that investor do when adding fresh money to the account? He should add to his stock indexes.
If the stock market rose considerably during another month, the investor might find that stocks now make up more than 70 percent of his total portfolio. What should he do with fresh money? He should add to his bond index.
Profiting from Panic—Stock Market Crash, 2008–2009
When stock markets fall, most people panic, sending stocks to lower levels. Calm investors, however, can lay seeds for future profits. My personal portfolio was far larger just one year after the financial crisis compared with its level before the crisis scuttled the markets. It helped that I kept a constant allocation of stocks and bonds. As I mentioned in the previous chapter, I started 2008 (before the stock market crash) with a bond allocation at roughly 35 percent of my total portfolio, as shown in Figure 5.2
Figure 5.2 Portfolio at Age 37
Then the stock markets started to fall, giving me a disproportionate percentage in bonds. I invest monthly, so when the markets fell—to keep me close to my desired stock/bond allocation—I bought nothing but stocks and stock indexes. But no matter how much money I was adding to my stock indexes, the markets continued to drop until March 2009.
Figure 5.3 shows how my portfolio looked during the first few months of 2009.
Figure 5.3 Portfolio at Age 38
Despite my monthly stock market purchases, I couldn’t get my stock allocation back to 65 percent of my total. As a result, I had to sell some of my bonds in early 2009 to bring my portfolio back to my desired allocation.
Naturally, I was hoping the markets would stay low. But they didn’t. As the stock markets began to recover that year, I switched tactics again and bought nothing but bonds for more than a year. I was low on bonds because I had sold bonds to buy stocks, and my stocks were rising in value.
This kind of rebalancing is common practice among university endowment funds and pension funds.
Usually investors don’t need to address their stock/bond allocation more than once a year. But when the stock markets go completely nuts—dropping by 20 percent or more—it’s a good idea to take advantage of it if you can.
Having a Foreign Affair
Americans should have a nice chunk of money in a US index; Canadians should have a good-sized chunk in a Canadian index; and so it should follow for Australians, Brits, Singaporeans, or any other nationality with an established stock market. An investor’s portfolio should always have the home country index represented. After all, it makes sense to keep much of your money in the currency with which you pay your bills.
After adding a government bond index to your portfolio, you really could stop right there.
But many investors (me included) like having an international component. The US stock market makes up about 50 percent of the world’s stock market exposure. There are also stock markets in Canada, Australia, England, France, Japan, and China, just to mention a few. Investors can increase their diversification by building a portfolio with global exposure. A total international stock market index would fit the bill.
There are many trains of thought relating to how much of your stock exposure should be international. To keep it simple, you could split your stock market money between your home country index and an international index.
In that case, a 30-year-old American investor (without an upcoming pension) could have a portfolio that looks like the one on Figure 5.4
Figure 5.4 Investment Portfolio Percentages
If you’re making monthly investment purchases, you need to look at your home country stock index and your international stock index and determine which one has done better over the previous month. When you figure it out (hold on for this!) you need to add newly invested money to the index that hasn’t done as well. That should keep your account close to your desired allocation.
What do most people do? You guessed it. Metaphorically speaking, they sign long-term contracts to empty their wallets into the toilet—buying more of the high-performing index and less of the underperforming index. Over an investment lifetime, behavior such as this can cost hundreds of thousands of dollars.
Over my lifetime, the total US stock market index and the total international stock market index have performed similarly. There has been about 1 percent compounding difference between the two since 1970.2 But there are times when one will lag the other. Take advantage of that.
Please note that I’m not talking about chasing individual stocks or individual foreign markets into the gutter. For example, just because the share price of company “Random X” has fallen doesn’t mean that investors should throw good money after bad, thinking that it’s a great deal just because it has dropped in value. Who knows what’s going to happen to “Random X?” It could vaporize like a San Francisco fog.
Likewise, you take a large risk buying an index focusing on a single foreign country, such as Chile, Brazil, or China. Who really knows what’s going to happen to those markets over the next 30 years? They might do really well, but it’s better to diversify and go with the total international stock market index (if you want foreign exposure). Within it, you’ll have exposure to older world economies such as England, France, and Germany, as well as the younger, fast-growing economies of China, India, Brazil, and Thailand. Just remember to rebalance. If the international stock market goes on a tear, don’t chase it with fresh money. If your domestic stock index and the inter
national stock index both shoot skyward, add fresh money to your bond index.
If that sounds too complicated, Scott Burns has popularized an even simpler strategy.
Introducing the Couch Potato Portfolio
A former columnist with The Dallas Morning News, Burns now works with AssetBuilder, a US-based investment company that manages money with indexed strategies. Recognizing that actively managed mutual fund purchases didn’t make sense (thanks to high fees, high-tax consequences, and poor performance), he popularized a simple investment strategy called the Couch Potato Portfolio.
It’s comprised of an equal commitment to a US total stock market index and a total bond market index. In other words, if you were investing $200 a month, you would put $100 a month into the stock market index and $100 a month into the bond market index. You don’t even have to open your investment statements more than once a year.
After one year is up, look at your investment account and figure out whether you now have more money in stocks or bonds. If there’s more money in the bond index, sell some of it to get equal weighting in your portfolio, buying the stock index with the proceeds. If there’s more money in the stock index, sell some of your stock market index and buy the bond index with the proceeds.
Without allowing yourself to fall victim to the market’s crazy “ups and downs,” you would be buying low and selling high once a year.
With a 50 percent bond component, this would be a pretty conservative account. If the stock markets fell by 50 percent in a given year, your account would fall far less than that and you would have a chance to even out your account 12 months later by buying the underpriced stock index with proceeds from the bond index.
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