Millionaire Teacher
Page 18
It’s as simple as lying in a hammock. But most people get itchy butts. They add fresh money to the index that’s “doing well.” They often ignore the index that may be dropping in value. This damages long-term results.
It gets even worse if investors listen (and act on) financial pornography in the news. That’s what I call financial forecasts. Such forecasts are almost always wrong. But they influence plenty of people.
Here’s an example.
Vanguard’s S&P 500 index averaged a compound annual return of 6.89 percent per year during the 10-year period ending March 31, 2016. That included the massive stock market crash of 2008–2009, when US stocks dropped nearly 40 percent. But the average investor in the S&P 500 did the funky chicken. The typical investor in the S&P 500 averaged a compound annual return of just 4.52 percent during that same time period.1
How Does the Average Index Investor Underperform the Index?
In Figure 7.1, you’ll see a 13-year performance chart of the S&P 500. Note how the index rose, without much interruption, between 2003 and 2007. Each year, as the index rose higher, more investors piled in. They were happy. They were confident.
Figure 7.1 S&P 500, March 31, 2003-March 31, 2016
Source: © The Vanguard Group, Inc., used with permission
By 2008, stocks began to fall, as shown in Figure 7.1. News reports said that stocks would fall further. Buddhas didn’t care. But many would-be meditators ditched their robes and sold. In 2011, after the index had a couple of good years, many investors on the sidelines started to buy once again.
This is like buying more rice when prices are high, and buying less (or none at all) when it’s on sale. By doing so, people pay above average prices over time.
That tumultuous decade saw Vanguard’s S&P 500 gain an average of 6.89 percent per year for the period ending March 31, 2016. But according to Morningstar, the typical investor in that fund averaged a compound return of just 4.52 percent per year. They preferred to buy on highs. They added less (or sold!) on lows.
The free online website Portfoliovisualizer.com shows how much a disciplined investor would have earned. Anyone adding a fixed monthly sum to the S&P 500 index between March 2003 and March 2016 would have averaged a compound annual return of 8.96 percent per year.
By purchasing a fixed amount every month, the investor would have bought more units when the fund prices were lower and fewer units when the fund prices were higher. The fund’s posted return, during this time period, was 6.89 percent per year. But an investor who added regular sums each month would have paid a lower-than-average price for those fund units over time. That’s how the investor would have averaged a compound annual return of 8.96 percent.
Building a portfolio of index funds on your own is simple. But if you can’t sit on a rock (or in a hammock) and ignore the world’s noise, consider hiring an intelligent investment firm. Like Buddhas, such firms would do the rock sitting for you. They would also rebalance your portfolio once a year.
Intelligent Investing for Americans
There’s a growing number of intelligent investment firms now available to Americans. Such companies use low-cost index funds or ETFs. Best of all, they can also prevent investors from sabotaging their accounts. Are their extra fees worth it? Most of the time, yes.
Vanguard
My wife is a financial schizophrenic. We spend more than $5,000 a year on massages. She thinks nothing of it. But she would slap my hand if I picked up an extra basket of organic blueberries. She also draws the line on investment costs. She owns a Vanguard Target Retirement 2020 (VTWNX) fund, shown in Figure 7.2. Its total fees are just 0.14 percent per year.
Figure 7.2 What’s Under the Hood?: Vanguard Target Retirement 2020 Fund
Source: Vanguard Research Center, Vanguard.com
This product doesn’t fall under the media’s robo-advisory label. But it should. It’s a low-cost, hassle-free way to have a complete portfolio of index funds that’s wrapped into a single product. Her fund allocations are shown in Figure 7.2
It’s a balanced fund that contains a US stock index, two US bond indexes, an international stock index, and an international bond index. In other words, she has exposure to the world with just one fund. Vanguard automatically rebalances each fund’s holdings once a year.
Studies show that nobody can predict, with any degree of accuracy, which country’s stock market is going to do well in any given year. That’s why smart investors don’t speculate. Instead, as with investors in Vanguard’s Target Retirement Funds, they own a bit of everything. They also maintain a fairly constant allocation without trying to forecast anything.
Data-crunching firm CXO Advisory proves that trying to forecast the stock market is like panning for gold with chopsticks. Between 2005 and 2012, the firm collected 6,584 forecasts by 68 experts. When predicting the direction of the stock market, the experts were right just 46.9 percent of the time.2 Coin flippers would have beaten them.
Vanguard’s Target Retirement Funds offer the cheapest all-in-one portfolios in the world. If you choose to invest in one, you don’t need anything else. Once a year, Vanguard rebalances the portfolio’s holdings. No, they don’t shuffle the portfolio deck based on which of its index fund holdings are expected to soar in the year ahead. Speculation doesn’t work. So Vanguard doesn’t bother.
Instead, the firm rebalances the holdings once a year to reflect a constant allocation.
Each of Vanguard’s Target Retirement funds has a slightly different name, with a year at the end of it. For example, investors who plan to retire in the year 2025 might choose Vanguard’s Target Retirement 2025 fund. Those who hope to retire in 2035 might choose Vanguard’s Target Retirement 2035 fund.
Every couple of years, each respective fund reduces its exposure to stocks, increasing its exposure to bonds. As people get closer to retirement, most people shouldn’t have a stock-heavy portfolio. Stocks perform better than bonds over the long haul. But they are riskier over the short-term. Many retirees (and those getting close to retirement) prefer a portfolio that’s more stable.
There are two examples in Figure 7.3
Figure 7.3 Vanguard Target Retirement 2010 Fund vs. Vanguard Target Retirement 2045 Fund: 5-year Performance Ending May 23, 2016
Source: © The Vanguard Group, Inc., used with permission
Figure 7.3 tracks the performance of two such funds over the five-year period ending May 23, 2016. They include Vanguard’s Target Retirement 2010 fund and Vanguard’s Target Retirement 2045 fund.
Vanguard’s Target Retirement 2045 fund was the better performer of the two. It gained a total of 42.65 percent over five years. By comparison, Vanguard’s Target Retirement 2010 fund gained 29.55 percent.
But Vanguard’s Target Retirement 2045 fund took on higher risk. It contains mostly stock market index funds, with far lower exposure to bond market indexes. Over time, stocks beat bonds. But bonds are more stable. Young investors, for example, can afford to take higher risk for the possibility of higher future returns. When stock markets fall, they have more time to recover.
Older investors usually prefer stability. After all, many are living on the proceeds of their retirement accounts. For this reason, most retirees would prefer a fund like Vanguard’s Target Retirement 2010 fund. It’s much more stable.
As of this writing, Vanguard offers 11 Target Retirement Funds. I’ve listed them in Table 7.1. You can see their stock/bond allocations and their expense ratios.
Table 7.1 Vanguard’s Target Retirement Funds
Fund Stock Allocation
Bond Allocation
Expense Ratio
Vanguard Target Retirement Income 30%
70%
0.14%
Vanguard Target Retirement 2010 34%
66%
0.14%
Vanguard Target Retirement 2015 50%
50%
0.14%
Vanguard Target Retirement 2020 60%
40%
0.14%
>
Vanguard Target Retirement 2025 65%
35%
0.15%
Vanguard Target Retirement 2030 75%
25%
0.15%
Vanguard Target Retirement 2035 80%
20%
0.15%
Vanguard Target Retirement 2040 90%
10%
0.16%
Vanguard Target Retirement 2045 90%
10%
0.16%
Vanguard Target Retirement 2050 90%
10%
0.16%
Vanguard Target Retirement 2060 90%
10%
0.16%
Source: Vanguard.com
I’m a huge fan of these funds. We own Vanguard’s Target Retirement 2020 fund in my wife’s account.
If a deranged mutual fund salesperson decided to toss me off a bridge, my wife wouldn’t have to worry about her money. She would rather dine on dirt than manage it herself. Fortunately, Vanguard does it for her.
The average DIY investor could build a portfolio of individual index funds or ETFs at a slightly lower cost. But my wife’s portfolio will beat most of them. Vanguard’s Target Retirement funds keep investors calm. That might sound like a strange claim. But let me explain.
Most investors in these funds invest the same amount of money every month (dollar-cost averaging). Many do it through their employers’ 401(k)s. Many never look at their portfolios or follow the markets. Not doing so gives them strong odds of earning good returns.
I looked at Vanguard’s Target Retirement funds with 10-year track records. Morningstar reveals how each fund performed compared to how its average investor did.3
This 10-year period included the stock market crash of 2008–2009. This was when investors freaked. Between 2005 and 2015, Vanguard’s S&P 500 Index averaged 8 percent per year. But the typical investor in the S&P 500 averaged just 6.37 percent per year during the same time period. Once again, fear, greed, and speculation pulled them by the gonads. They ceased to buy when they should have been buying. Sometimes they even sold.
Vanguard’s Target Retirement funds had the opposite effect. Most of its investors kept adding money, every single month. This allowed them to buy more units when prices were low and fewer units when prices rose. As a result, they paid less than the average price.
That’s how Vanguard’s Target Retirement investors outperformed their indexes. At the end of April 2015, I used Morningstar.com to see how they did. Vanguard’s Target Retirement 2035 fund averaged 7.04 percent for the 10 years ending April 30, 2015. But the typical investor in that same fund averaged a return of 8.65 percent per year. Remember, this included the market crash of 2008–2009.
Such was the case with all of Vanguard’s Target Retirement funds. Their investors played cool. They weren’t as worried about picking the wrong funds or rebalancing at the wrong time. As a result, their money outperformed the reported gains of their funds, as shown in Table 7.2
Table 7.2 Vanguard’s Target Retirement Investors Outperformed Their Funds, April 30, 2005 to April 30, 2015
Fund 10-year Annual Fund Return
10-year Annual Investors’ Return
Vanguard Target Retirement 2015 6.18%
6.64%
Vanguard Target Retirement 2025 6.58%
7.70%
Vanguard Target Retirement 2035 7.04%
8.65%
Vanguard Target Retirement 2045 7.39%
9.32%
Source: Morningstar.com; All Vanguard Target Retirement funds with 10-year track records
Vanguard’s Full-Service Financial Advisers
Despite owning Vanguard’s Target Retirement Fund, my wife doesn’t seek advice from Vanguard. She doesn’t have a full-service adviser.
Full-service financial advisers deal with more than just investments. How much should you be saving? What kinds of investment accounts should you open to cover your children’s college costs? How should you deal with estate planning? How could you legally reduce your tax bite? They help with everything.
Done right, it’s a time-consuming process. That’s why most of the better financial advisers won’t take clients with accounts valued below $100,000.
Vanguard is changing that. Vanguard charges just 0.3 percent of a portfolio’s value each year for full-service financial planning. That’s just $300 on a $100,000 portfolio. A minimum of $50,000 is required for investors to qualify for this service. It’s available to all American residents. My apologies to the intrepid expats who live overseas. Vanguard (as with many US-based firms) doesn’t want you in their sandbox.
If you live in the United States, you might be tempted to race to your local Vanguard office. But you won’t find one. To keep costs down, they don’t have brick-and-mortar offices for retail investors. The new wave of low-cost firms is all online. Without multiple buildings to lease or buy, maintain, and power, such firms can save a lot of money. They pass the savings down to you.
I’ve listed a few intelligent investment firms below. Which is the best? That depends on what you’re looking for. Some investors may want to start their journey with a financial advisory firm. But if they develop Buddha-like discipline, they might then choose to branch out on their own. Such investors might prefer Vanguard’s advisory service or a boutique operation like RW Investment Strategies.
Is This the World’s Strangest Financial Adviser?
RW Investment Strategies is run by Robert Wasilewski. If I had to vote for the world’s strangest financial adviser, he would get my pick. Why? His goal is to ultimately fire himself. Most of the time he does.
He doesn’t believe you need to be a Buddha to build and maintain a portfolio of index funds or ETFs. He thinks almost anyone can do it—with the right initial guidance. “I charge 0.4 percent to manage assets less than $1 million,” says Wasilewski, “and 0.3 percent for assets above that. There’s an additional $150 quarterly charge for accounts I manage. I offer three services: hourly consulting at $150 an hour, investment management, and investment management with the goal of the client taking over investment management after three months or six months.”4
Of course, some of his clients want him to manage their money forever. “They’re sometimes too busy to do it themselves,” he says, “or they’re math-o-phobic.”
Investment Coaches Offer Guidance
PlanVision’s Mark Zoril offers something similar. He guides investors to open low-cost brokerage accounts with a firm like Vanguard or Schwab. He then guides the investor in the portfolio’s decision-making. PlanVision charges just $96 a year. As is the case with RW Investment Strategies, I hear great feedback from PlanVision’s clients.5
Investment Firms That Do The Lifting
Other investors might prefer a firm like AssetBuilder. Its co-founder, Scott Burns, is the man who created and popularized the DIY strategy called the Couch Potato portfolio in 1991. Back-tested studies prior to 1991 revealed that a combination of stock and bond indexes, rebalanced once a year, would trounce most investment professionals.
After 1991, the Couch Potato strategy continued to embarrass professional advisers everywhere. Many investors wanted to try it. But they struggled. They feared investing without an adviser. So in 2006, Scott Burns and Kennon Grose created AssetBuilder. They built a series of couch-potato-like portfolios using a different kind of index, offered by the firm Dimensional Fund Advisors (DFA).
DFA’s index funds can only be purchased through a specific type of advisory firm. The firm’s advisers must attend a two-day educational conference, at their own cost, in Austin, Texas, or Santa Monica, California. Yet DFA, unlike most index fund companies, doesn’t try to equal market returns. They aim to beat them by tilting their emphasis toward small-cap (small company stocks) and value companies (stocks that are cheap, relative to their business earnings).
Sonny Wadera, a Canadian financial adviser with Kelson Financial Services Firm explains it well.
“Think of water getting poured into an ice tray,
” he says. “The tray represents the entire market of stocks, but DFA tilts the tray slightly to one side, increasing the weightings of small-cap and value stocks.”6 Historically such stocks have outperformed the market.
Will they keep winning? Nobody knows for sure. But one thing is certain: DFA’s index funds are cheaper than actively managed funds. That’s why, like ordinary index funds, they’ll trounce most actively managed funds over an investment lifetime.
Firms like Betterment, Rebalance IRA, SigFig, and Wealthfront (see Table 7.3) are a lot like AssetBuilder. Investors determine their risk profile with a company representative. Investors send their money. The company then builds and manages a portfolio of index funds or ETFs.
Table 7.3 Intelligent Investment Firms That Build Portfolios of Index Funds
Firm Minimum Account Size Annual Account Charges* Rebalance and Manage Investments Full-Service Financial Planning Included Can Expatriates Open Accounts?
AssetBuilder** $50,000 0.24% to 0.45% Yes No Yes (depending on country of residence)
Betterment None 0.15% to 0.35% Yes No No
PlanVision $0 $96 a year Yes No Yes
Rebalance IRA None 0.50% Minimum $500 per year; $250 start-up fee Yes No No
RW Investment Strategies None 0.30% to 0.40% Yes No Yes
SigFig $2,000 0.25% Yes No No
Vanguard $50,000 0.30% Yes Yes No
Wealthfront $5,000 0.25% Yes No No
*With account charge ranges, larger accounts are charged less, as a percentage of assets.