April 6, 2021

Bogleheads® Chapter Series – Getting Started with Investing

Mike Piper discusses investing for those in the Starting Out Life stage.

Hosted by the South Florida Bogleheads chapter. Recorded on April 6, 2021.

The slide presentation can be accessed here

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Bogleheads® Chapter Series - Getting Started with Investing

Mike Piper: Going to be starting at the beginning so nobody gets left behind basically. And one quick note on the material and how you're welcome to use it. I'll be posting the slides, point and pdf format, and you're welcome to email them to anybody, share them on the forum, use individual slides for any purpose you want. Basically use the material in any way that you want to.

So there's three primary things that I want to talk about tonight. The first one is what I call the building blocks, which are basically the primary asset classes. So the primary types of things you would be investing in, and then the primary types of accounts in which you would be likely to own those investments. Next we're going to move on to constructing a portfolio, which is basically the actual nuts and bolts decisions that you have to make in terms of what you're going to include in your portfolio. And then I just want to spend some time on what I call “staying out of trouble”, which is basically avoiding the common mistakes that I see investors make, both beginner investors and more experienced investors.

So starting at the beginning. The building blocks, there's two primary asset classes. The first one is stocks-- and I know a lot of you guys know this, of course, but again we're starting with the basics, we're going to go through it pretty quickly-- so with a stock, it's just a share of ownership in a business. And the way you make money when you own a business is that hopefully the business earns a profit, and when the business does that, in many cases they will distribute that profit to the shareholders. That's called a dividend payment, and so you're just getting money from your shares basically. And the other way you can make money as a stockholder is that often when a business earns a profit instead of distributing it to the shareholders what they will do is reinvest the money into the business itself with the goal of growing the business so that it becomes even more profitable in the future. And when they do that, as long as everything goes well, the business becomes more valuable and because you own a share of the business your stock price will go up as well. So those are the two ways to make money as a stock investor. Through dividend payments and price appreciation. Just a quick note on terminology. Stocks are often referred to as equities. It's just another word for the exact same thing.

The other primary asset class is bonds. And a bond is just a loan that you make to a borrower. So the most common types of bonds are treasury bonds, where you are literally loaning money to the federal government. Then we have municipal bonds, where you're loaning money to a state or local government entity. And then we have corporate bonds, where you're loaning money to a business. And the way you make money as a bond investor is the same way that any lender makes money, which is through interest payments. The borrower is going to pay you interest. And bonds are in the category of investments known as fixed income.

Basically anything that has a yield that is determined by a contract, an agreement, so savings accounts, CDs, and bonds are all fixed income investments, although bonds are the primary fixed income investment for most portfolios. And that's it for asset classes.

Mutual funds aren't technically an asset class but they are still something that you definitely need to know about. The mutual fund is basically just a pool of money that is run by a fund manager. So basically what you're doing when you invest in a mutual fund is you are turning your money over to somebody else. And then that other person, that fund manager, will choose how to invest their money, so they're making the decisions on your behalf, basically.

And a mutual fund owns a collection of other investments. So if it's a stock mutual fund it's going to own a whole bunch of different stocks. It's a bond mutual fund, it's going on a whole bunch of different bonds. Balanced funds own some of both. And then there's sub categories of mutual funds. So there's mutual funds that only invest in a specific industry, or that might only invest in stocks of small companies and so on. 

And mutual funds can be either actively managed or passively managed. With an actively managed mutual fund the fund manager is actively trying to pick only the best investments. So if it's a stock mutual fund, an actively managed stock fund, the manager is going to be picking, trying to pick the stocks that have above average performance, basically.  In contrast, with a passively managed fund, the fund is just trying to track the performance of a given index.

Usually, of course, that raises the question of what is an index. And an index is just a number that reflects the performance of a particular group of investments. So the S&P 500 is a very famous index, you'll hear about it a lot. And what that index represents is just the performance of the stocks of 500 of the biggest companies in the United States. So an S&P 500 fund, it would be a passively managed fund because the fund manager isn't actively trying to pick the best stocks, they're just buying all the stocks that are listed in that index. It's a much more hands-off approach. That's why we call it passively managed.

The common use for passively managed funds is to track the total stock market or total international stock market, or the total bond market. And the two most common types of passively managed funds are index funds and ETFs, and we'll get into the details in a little bit.

So the two big asset classes are stocks and bonds. And the big difference between them is how much risk they involve. With a bond, the borrower is promising to pay you a certain amount of money every year as interest and they're promising to repay the principal at maturity. So they're promising to repay the amount that they borrowed. And the key point here is that a bond is a contract. The borrower is contractually obligated to pay you money according to a specific schedule. 

Whereas with a stock there's no guarantees because, remember with the stock you just own a piece of a business, and there's no guarantee that any business is going to earn a profit. So you're just expecting returns, you're basically hoping for returns. And because stocks have uncertain returns, they also have higher expected returns.

And you can think of that this way. Anytime that you or anybody has money available to invest you always have the option of buying a bond which would give you a predictable rate of return. So why would anyone ever buy stocks with their unpredictable return. The answer is that stocks typically earn greater returns over an extended period. So this slide shows  the period, the last 40 years, from 1981 through 2020.  You could think of this as somebody's whole accumulation stage if they started investing immediately after undergrad and retired typical age. Or maybe this is somebody's accumulation stage and their first several years of retirement.

And what this shows: the blue line is the US stock market; the red line is 10-year treasury bonds; and orange line is short-term treasury bonds. And this shows if you had invested ten thousand dollars at the beginning of this period in each of these three asset classes, this is how much it would be worth at the end of the period.

And as you can see stocks grew by quite a bit more than the bond investments. But stocks really do involve a lot more risk, and that risk, despite what the last 10 years have looked like, it's not a hypothetical or theoretical thing, it's a very real world thing. And if you're a stock investor, you will have to experience this at some point. There will be periods where your stock holdings just perform terribly.

So this slide, for instance, is the years 2000 through 2002. And in case you don't remember that's the dot-com bubble bursting. Internet related stocks have gone up in value quite a bit in the late ‘90s and then people changed their minds about them and they and their stock market overall came crashing down.

And the red line here is the Vanguard Total Bond Market Index Fund, so it represents the US bond market. And the blue line is the Vanguard Total Stock Market Index Fund, so it represents the US stock market. And what you can see is that over these three years bonds did fine. They actually went up in value by 30%, which is a pretty good few years for bonds. And stocks lost almost 40% of their value. 

And it's worth noting that this is three years. So if you're a stock investor during this period you watched your stocks go down for a year, and then another year,and then another year. And a lot of people during at some point later in that window, 2001 to 2002, they basically gave up on stocks. They said, forget it, I've had enough. They pulled their money out of the stock market and moved it into cash, or moved it into bonds.

And that's unfortunate, because when they did that, what ends up happening is that when the stock market recovers, their portfolios didn't recover, because they were left in cash or just bonds. They weren't there, invested in stocks, when the stock market went back up.

And this slide here, it shows the period from October 2007 through February 2009. So this is the global financial crisis. And here again the red line is bonds, and you can see that it helped. They held their value pretty much. And the blue line is the US stock market. You can see that it lost about half of its value.

And that's the nature of being a stock investor. There are periods like this that you just have to be ready and willing to accept them. People often refer to it as the price of admission for stocks. Basically you just have to be willing to wait it out, so that when the market does come back your portfolio will come back. And so that's the way that you can earn the greater returns that stocks typically earn over an extended period.

 And another key point here is that this was the last bear market that we looked at was three years, this one was only a year and a half. You don't know when it's actually going on. You don't know how long it's going to last, and you just have to be willing to wait it out.

So that's it for the primary asset classes and the differences between them. Moving on to the primary types of accounts. We have taxable accounts, traditional IRAs, an IRA generally stands for individual retirement account, sometimes it stands for individual retirement annuity, or individual retirement arrangement ,but the key point is just that these are retirement accounts. Now we have Roth IRAs, 401-ks and 403-bs, and Roth 401-ks and 403-bs.

And a taxable account is basically anything that isn't one of those other special types of accounts. So a regular savings account is a taxable account. Or if you go to a brokerage firm website and open an account and don't tell them that you want it to be one of those special types of accounts, what you'll have is a taxable account. And we call them taxable because the income that you earn in those accounts is generally taxable.

So the interest is taxable-- there are some exceptions, that's kind of beyond the scope of our discussion right now-- but for the most part you have to pay tax on interest that you earn in the account. Dividends are also taxable but at a reduced rate, so you're paying a lower tax rate than you would for most types of income. 

And short-term capital gains are taxable at ordinary income tax rates. A short-term capital gain--a capital gain is when you sell something for more than you paid for it, that's why it's a gain-- and in this case it's a short-term capital gain because it means that you held the asset for one year or less before you sold it. And those are taxed at regular tax rates.

Now we have long-term capital gains, where in this case it means that you've--it's long-term--because you held the asset for longer than one year before selling it. And those are also taxable as income, but they are taxed at a lower rate just like dividends are.

Next we have the traditional IRA, and with those there is a limit to how much you can contribute to that type of account every year. For 2021 that's the lesser of your earned income or six thousand dollars, or seven thousand if you're 50,and with the traditional IRA, in theory at least, the amount that you put into the account is deductible. However, if you have a workplace retirement plan, a 401-k or a 403-b, which we'll talk about in a second, then depending on your income level you might not actually get a deduction for the contributions that you make to the plan.

The other big benefit though of a traditional IRA is that the money gets to grow tax-free while it stays in the account. So you can earn interest and dividends and you can sell things for capital gains and you won't have to pay tax on any of that as long as the money stays in the account.

But then when you take the money out, we call that a distribution, anytime you take money out of a retirement account and distributions from traditional IRAs are taxable as income. So basically you get the deduction when you put the money in, then it gets to grow tax-free while the money stays in the account, but then it's taxable when you take the money out. And if you take distributions before age 59 and a half there can be a 10 penalty. There are various exceptions to that penalty, but the general idea here is that congress created these accounts so that they would be retirement accounts, and they put this rule in place basically to discourage people from taking money out early.

Next we have the Roth IRA. And they share a contribution limit with traditional IRAs. So six thousand dollars for 2021 right. Yeah okay, and with the Roth IRA you do not get a deduction for the amounts that you contribute to the account, but the account does get to grow tax-free just like with the traditional IRA and distributions of earnings, they're completely tax-free if you're at least age 59 and a half, and this is a bit of a simplification, but as long as you've had a Roth IRA for five years. If you take money out early, if you take earnings out early, there would be a penalty.

And one important point about a Roth IRA is that the money that you put into it, the contributions, you can take that money back out tax free and penalty free at any age. So if you're 23 right now and you put 6,000 into a Roth IRA this year and then by next year that 6,000 has grown to 6.500 and it turns out that something comes up and you need to take money out, the 6,000 that you put in. You can take that back out tax free and penalty free even though you're way younger than 59 and a half. It's only if you took out the earnings, if you take out the growth as well, that's where the penalty can come into play.

And the ability to contribute to a Roth IRA  phases out based on your modified adjusted gross income so basically if you earn too much you can't contribute to a Roth IRA. There's a concept called the backdoor Roth IRA which is beyond our discussion here, but if you earn more than the limits shown on this slide, that's something that you should look into because it might be a way that you could effectively contribute to a Roth.

Next we have the 401k plan, which is a lot like a traditional IRA but it's through your employer. So the amount that you contribute to the account  reduces your taxable income. So you get some tax savings this year and the account gets to grow tax free, and then when you take money out it's taxable as a distribution. So again that's a lot like a traditional IRA. Basically all three of those things. One big difference is that there's a much higher contribution limit so it's 19,500 for 2021 or 26,000 if you're age 50 and up. And another critical point about 401-ks is that many employers offer what's called a matching contribution ,which is where as long as you put a certain amount into the account your employer is going to match that contribution. And that's a great deal because they're basically doubling your money for you so it's a 100% risk-free it's 100% return that's risk-free, which is obviously better than you're going to get basically anywhere else. So if your employer offers a match you want to make sure to contribute at least enough to get that match.

And for our purposes 403-b plans, they're basically the same as 401-k plans. Everything we've talked about so far is the same with a 403-b. 403-bs are just through different types of employers, so non-profit employers and some government entities, whereas 401-k plans are usually through businesses. 

And then just like with the IRAs, we have the traditional version and the Roth version, same thing with 401-ks and 403-bs. And one point of note is that your employer doesn't necessarily have to offer a Roth option, even if they offer a regular 401-k or 403-b. And the contribution limit for Roth 401-k and 403-b accounts is shared with regular 401k and 43b accounts. So it's 19,500 for 2021 or 26,000 if you're age 50. And because these are Roth accounts you don't get a deduction for the money that you put into the account but it does get to grow tax-free and as long as you're at least age 59 and a half and as long as your first Roth contribution to the plan was five years ago, then the distributions are tax-free as well, including their earnings.

One point of note about Roth 401-k and 403-b plans, remember just a minute ago we were saying that with a Roth IRA you can take your contributions back out tax-free and penalty free at any time. That doesn't apply to Roth 401-k and 403-b's, it's just Roth IRAs. With the Roth 401-k or 403-b your money is going to be more tied up, and if you take it out before 59 and a half you might have a 10% penalty.

 So that's it for the building blocks.

Audience question: I do have one question and that is could you discuss exactly why a stock and a bond are different under the hood and for your portfolio. When you go into those terrible bear markets that you showed on those graphs, why is the bond, why is holding some bonds, what is it doing to your portfolio?  It looks like the bonds are just cooking along and the stocks are going way down, so my instincts tell me it's just leveling out your portfolio more. But why is that?

Mike Piper: Yeah, that is generally the idea. We'll get to that in a second when we talk about asset allocation. But the reason is that bonds are a contract, right? The borrower is going to keep paying you interest throughout the period, even if the stock market is going down. I mean unless the borrower defaults, which can happen. But as long as you stick to high credit quality bonds then you're going to keep collecting those interest payments year after year after year until the bond matures. So they provide a return that is mostly independent of the stock market.

There are certainly some economic things that can affect both stocks and bonds but it's a contract. The borrower is paying you interest every year so the rate of return doesn't depend on the stock market. So basically would you say that when you have these recessions and the companies are having difficulty so the price of their shares goes down, and even though it's a mutual fund, because it's a mutual fund of stocks, it goes down-- the value of each share goes down so your value goes down--but in a bond, in a bond mutual fund also, the value of the bond may not, doesn't go down necessarily and because it keeps paying interest. It is actually keeping you afloat.

Audience question: The bond’s price, whether it goes up or down, could be affected by whether the company or companies in question, if their credit rating changes that would certainly affect the price of the bond. And it's affected by the interest rate in the market. But if you're holding a bond to maturity you're just collecting those interest payments the whole time regardless of what the stock market is doing. And you're talking about starting out investors in bond mutual funds, not by individual bonds themselves. Is that correct?

Mike Piper: It would it's true with both because a mutual fund is owning individual bonds. That's what they are doing, so in either case you're basically just receiving that interest over time and the prices of bonds can move up and down based on interest rates and changes in credit rating of the borrowers in question. But those fluctuations tend to be quite a bit less dramatic than with stocks and the primary part of the return is through interest, and because that's a contract it's very predictable.

Audience question: Where bond owners are the creditors of the company, if a company goes bankrupt do bondholders get paid?

Mike Piper: They often do. It depends on how the assets of the company--so when a company goes bankrupt it doesn't usually have zero assets, it's got some assets left--and it depends on how the assets of the company compare to the liabilities of the company. But bondholders, as creditors of the company, they are one of the first parties in line to get a share of the assets that the business still has. Whereas stockholders are basically the end of the line if a company's going bankrupt. Stockholders are usually getting nothing, but bondholders might not necessarily get the entire amount that they're promised, but they'll usually be getting something.

Audience question: What is preferred stock?  Is this better than normal stock?

Mike Piper: That's a great question. A preferred stock, it's called preferred precisely because of the topic we were just talking about. In terms of the order of, if a company goes bankrupt a preferred stockholder stands ahead of regular stockholders in line in terms of potentially getting some assets from the company.

A preferred stock has a fixed amount of dividends that it pays, but it's not a contract like with a bond. The company can choose not to pay those dividends in many cases, but the amount of dividends that the preferred stock is supposed to pay, the company has to pay those dividends to the preferred shareholders before paying any dividends to common shareholders. So it's still an equity investment but it's a little bit more like a bond than a regular stock because they generally have a high level of income. And it's a somewhat predictable level of income. But they still can fluctuate in value quite a bit just like regular stocks can, and they don't necessarily pay anything just like regular stocks.

Audience question: So if I have a raw 401-k for longer than five years and then roll it into a Roth IRA, you'll have to meet the five-year rule again? So you have to meet the fighter rule again for withdrawals, the penalty-free withdrawals?

Mike Piper: In that case it depends. It's the Roth IRA five-year rule that we'd be concerned with then. So if that was the first time you opened a Roth IRA, then yes. But if you had the  IRA for 10 years or something and now you're rolling Roth 401-k assets into it then note that then you've met the applicable five-year rule.

Audience question: You spoke about how interest is taxed at a higher rate than dividends. Is it marginally more or are dividends much more favorable? Can you elaborate on that?

Mike Piper: Sure. Depending on your income level dividends sometimes are taxed at a zero percent rate. So dividends can be that, would be quite different to zero percent as opposed to the tax bracket that you're in. However as your income level goes up, your taxable income level, dividends will be taxed at a higher rate. But no matter your income level ,dividends are going to be taxed at a lower rate than regular ordinary interest income. But the difference between the two, it's not a fixed percentage. So sometimes it's a big difference, sometimes it's a smaller difference.

Audience question: If you hold a bond to maturity you're not affected by the price of the bond. How does this work with a bond fund that does not have a maturity date?

Mike Piper: That's getting into something called the duration, is what we're interested in. So the price of a bond is moving up and down based on changes in market interest rates and the duration of the bond fund is going to tell you how sensitive the price of that bond fund will be to changes in interest rates. Basically it's a rough calculation, but for instance, if a bond fund has a six year average duration and interest rates go up by one percent then the price of the bond fund would go down by about six percent. So the average duration times the change in the interest rates. And so the longer the duration of the bond fund the more volatility you're going to experience in its value over time as interest rates move up and down.

So constructing a portfolio. You're going to have to decide whether you want to use individual stocks and bonds or mutual funds. If you are going to use mutual funds you need to decide whether they should be actively managed or passively managed. And you need to figure out what asset allocation you want to use. So the big question there is how much it stocks and how much in bonds. 

So first question, individual stocks and bonds or mutual funds. And the answer. Don't bother picking individual stocks. The reason for this is that the expectations for a company are already priced into the company's stock price. That's a complicated sounding thing. Basically what it means is that a stock's performance is not a function of how profitable the company turns out to be, it's a function of how profitable the company is as compared to what the market expected.

A lot of people think that you just have to pick a profitable company to pick a winning stock, so they look and say, Amazon, Google, those are profitable companies so surely those will be winning stocks going forward. But it's not that simple because to pick above average stocks you don't just have to identify profitable companies, you have to identify companies that turn out to be more profitable than the market expected them to be. 

And that's tricky because the market is on average pretty darn smart. It's made up of a lot of professional investors and that's who you're competing against when you're picking individual stocks because every time you make a transaction, if you're buying there's somebody on the other side of the transaction, there's somebody selling by definition. And if you're selling, there's somebody buying it. And the way it works is that most of the transactions in the market are done by the parties that control the most dollars. So most of the time the people you're competing against here are hedge fund managers, mutual fund managers, pension fund managers and so on. And so you're competing against people who are probably at least as qualified as you are and they probably spend more time doing this than you do. And they probably have access to information that you don't have access to because their company probably has full-time analysts providing them information or they're buying research from other companies that you probably aren't paying for.

So it's it's a competition where the odds are really not in your favor, and when you use individual stocks you're increasing the risk of your portfolio because if you use a mutual fund it's really easy to pick a mutual fund that owns hundreds or thousands of stocks whereas if you pick individual stocks you're probably not going to buy several hundred of them, you're probably only going to buy a handful. And so you're less diversified. And because of who you're competing against you're not increasing your expected returns at all.

So this is using individual stocks as a decision where you're increasing your risk without an increase in expected return which is generally something that we want to avoid. If you're taking on more risk you only want to do that because you're going to be getting higher expected returns. So most people should be using mutual funds rather than individual stocks.

And then that leads us to the question of whether they should be actively managed or passively managed. And remember with an actively managed fund the goal is for the manager to pick investments that are above average right. And so we could ask how often actively managed funds able to actually do that. And as it turns out the answer is not very often. Most actively managed funds perform worse than their passively managed counterparts. 

For instance, Morningstar put out a study that looked at the 20-year period ending in December of last year, and they asked in each of these different categories of mutual funds, what percentage of actively managed funds both (a:) survived through the period so they didn't get shut down by by the fund manager and (b:) they outperformed the average passive fund in that category. And it turns out for US large cap blend funds, so that's actively managed funds that invest in large companies, there's only 12.8 percent succeeded. For large cap value funds it was 16.8 percent ; 11.3 percent for large cap growth funds;  8.7 percent for mid cap funds, 29.6 per cent for small cap funds--so that's better but still way below you know 50%-- much worse odds. You're much less likely to succeed than to fail. And 14.6 percent for foreign large cap funds.

And then on the fixed income side 9.7 percent for intermediate term core bond funds. So basically your odds of success with an actively managed fund, your odds of outperforming the average passively managed fund they're terrible to put it frankly they're really quite bad.

Another way to look at it is you could say, within a given category of mutual fund, so international stock funds for instance, what would be the best way to pick a fund that is likely to be a top performer. And this is what  Morningstar's Russel Kinnel, he's their director of manager research, here's what he had to say. This is from a 2016 article, he said, “The expense ratio is the most proven predictor of future fund returns. We find that it's a dependable predictor when we run the data.” 

That's also what academics, fund companies and of course Jack Bogle will find when they run the data. Again this is from a 2016 article before he passed away. So he was talking about expense ratios here, and the expense ratio is what the fund manager charges to run the fund, and with an actively managed fund the expense ratios are higher because they're paying analysts,they're paying people to do all this research to try to pick the best stocks and best bonds. And with a passively managed fund they're just buying all the investments that are listed on the given index so it's a much more hands-off thing and you can do it with a lot less labor. Basically it's less expensive to do. So passively managed funds have lower expense ratios.

And from the article that the previous quote came from, what Russel Kinnel did is he sorted funds into quintiles by expense ratio, and he asked for each mutual fund what is the likelihood that that fund would survive and be a better than average performer. And basically what you can see here is that the more expensive the fund, the lower the likelihood was. 

A  62% chance of success for the cheapest quintile of funds. Then 48% for the next cheapest quintile, then 39%, and 30%, then 20%. So basically, as the funds get more expensive the less likely they are to be top performers. And the least expensive funds tend to be passively managed funds so they're the most likely top performers.

However you don't have to worry about really small differences in expense ratios if we're talking about 0.05% percent versus 0.07%, that's not the sort of thing that's likely to show up in the performance in any meaningful way. What you really want to be focused on is if you have the choice between 0.05% and 0.5%, so 10 times as much. That's the sort of thing that's going to make a big difference over an extended period of time.

And if you're using passively managed funds you'll have to decide whether you want to use index funds or ETFs and there's one important thing to know about this decision and it is that it doesn't matter. It really doesn't matter. For most people there are hundreds of financial planning decisions that matter more than this one. That's not an exaggeration.

The differences are the advantage of ETFs, they let you use orders other than market orders. And if you're a new investor and you're wondering what is a market order and what is something other than a market order you don't even need to look it up. You don't need to worry about it. You can if you want to but it's not going to be important. Another difference is that ETFs let you place a trade during the day and have it executed right away whereas with an index fund the trade will be executed at the end of the day, which is how mutual funds work, and again that's something that usually doesn't matter. ETfs sometimes have very slightly lower costs and that's an advantage, but again it's pretty slight, and from one fund company to the next it might not even be true. So those are the advantages of ETFs.

The advantage of index funds, basically they let you place round dollar amount orders. In some cases you can't buy fractional shares of an ETF. So let's say you open a  Roth IRA, you put six thousand dollars into it and you want to invest all of that in a certain ETF.  You might only be able to invest five thousand nine hundred and ninety dollars. You might have ten dollars left over sitting in cash because that wasn't quite enough to buy another share. Whereas with an index fund you can buy fractional shares so you can invest the whole six thousand. But that's also a really small difference. So seriously this isn't important. You could flip a coin to make this decision and then never worry about it again for the rest of your life and that would be fine.

So moving on to our third question, which is what asset allocation to use?  The big question here is basically how much of the portfolio should be in stocks, so risky stuff, and how much of it should be in bonds, fixed income, safer investments and this should be based on your risk tolerance.

Your risk tolerance has two components. First there's an economic component which is basically how much risk you can afford to take. And then there's a mental psychological component which is how much risk you can handle psychologically. And on the economic side for most people at the very beginning of their career their economic risk tolerance is low,because you need to get an emergency fund in place. You need a few months of living expenses and something safe before you start investing in something risky because you could get laid off, you can have an unexpected medical expense, an expensive car repair, something like that and you need to know that you have some assets on hand to pay for that sort of thing.

However, once you have an emergency fund in place, if you're early in your career, for the rest of your assets your economic risk tolerance is basically as high as it's ever going to be because if you aren't going to be spending this money until 30 years from now the stock market could go way down next week or next year or next month and that would be fine. It doesn't hurt you at all because all that really matters is what your account balance looks like 30 years from now when you actually are going to be spending the money.

So early in your career once you have an emergency fund, your economic risk tolerance is pretty high. The mental side of things just depends on your personal experiences and it depends on your personality. Some people are just naturally comfortable with more risk and some people aren't, and it's important to just try to know where you stand on that matter personally.

What this slide shows-- this data is from Vanguard--It shows just the average annual return for portfolios of different allocation. As we move down the slide we get to riskier allocations,some more in stocks, and you can see that the average annual return from 1926 to 2019, so a very long period. More stocks means higher returns, on average. But then we look at the next column two, and what that's showing is exactly what it says it's the worst calendar year. So for this given allocation, how much did the portfolio lose in the worst calendar year on record. And you can see that the more money you have in stocks the harder you get hit when the stock market goes down. 

It's pretty straightforward, but the idea here is you want to try to pick an allocation that you can stick with. Something that isn't going to exceed your risk tolerance because when you exceed your risk tolerance it causes stress and anxiety, which is you know detrimental in its own right.

But then it can have very negative financial consequences also because, just like we talked about when we were looking at a couple of bear markets earlier, if the market goes down and you start to panic, you realize you've exceeded your risk tolerance, you're absolutely not comfortable with the losses you're feeling in your portfolio right now. Then you take your money out of the market. Well then when the market goes back up your portfolio does go up along with it. You're sitting there in cash. So you want to pick an allocation that you can stick with even through the down markets.

Now we can next look at what a portfolio might look like in terms of an ideal group of holdings. A common theme on the bogleheads forum is the Three Fund Portfolio and I think it is a great idea. It's basically just a total stock market index fund or a comparable ETF, and a total international stock index fund or a comparable ETF, and then a total bond market index fund or ETF. And with just these three funds you've got everything you need. Your portfolio will be extremely diversified because with those two stock funds you will own literally thousands of companies from around the world, so a massively diversified portfolio of stocks. And your bond portfolio is going to be very diversified well with a total bond market index fund.

So it's everything you need. And as long as you stick with funds from a reputable fund company, so Vanguard, Fidelity, or Schwab for instance, it's going to be low cost as well. And it's simple, which is nice because it makes it easy to understand. Because there's the three funds here. They each represent something very tangible, the US stock market, international stock market and bonds. There's nothing esoteric or weird here. It's just basic things that make sense. You can understand why they're each there.

And it's easier to maintain because with any portfolio what eventually happens is you'll pick a targeted allocation but then some part of your portfolio performs better than the other parts. So if this is the intended allocation then it's going to be this: you'll have a little bit too much of something and a little bit too little of something else. So what you have to do is called rebalancing where you bring the portfolio back to its intended allocation. And if you only have three different funds that's a lot easier to do then if your targeted allocation is ten different funds and it's eleven percent of this and three percent of that seventeen percent of that and so on. Then it takes more math to figure out exactly how many dollars of each of those things you should have. And it takes more transactions to do the necessary buying and selling.

So fewer funds makes that process easier. And if you want to, you can go one step simpler, which is to just use a Two Fund Portfolio where you're just using a total world stock index fund or an ETF. So then what you're doing there is basically it's one fund that owns both the US and international components, and then a bond fund. And that's it, again that's a very diversified portfolio and it's going to be very simple and extremely inexpensive. That would be a great portfolio in my opinion.

And if you want to you can go one step simpler, which is just use a target date fund. Those are the funds with a date in the name. So target retirement 2050 or something like that. And these funds hold an underlying allocation of other funds, and the idea is that over time, as they get closer to the date in the name, they move from an aggressive allocation to a more conservative allocation. 

An important point about these funds though is that there's a lot of variation in the underlying allocation from one fund company to another. So if you're looking for instance, if you looked up the 2035 fund from six different fund companies,and you looked them up on Morningstar and then you clicked over to the portfolio tab so you see the actual asset allocation, they're not going to be the same as each other. There's going to be a fair bit of difference.

So with target date funds what you actually want to do is ignore the date in the name, as crazy as that might sound, just pick based on the allocation. You just want to look at the underlying allocation and pick the one that looks like a fit for your personal risk tolerance. Because you could find that even if you're planning on retiring in 2050 maybe the 2035 fund is a better fit or vice versa. So pick based on the allocation.

And just like with any fund,  pay attention to the expense ratio. Some fund companies have very inexpensive target date funds. Some companies have expensive ones. So if you can get a lower expense ratio your target date fund is likely to be a better performer than if you have a high expense ratio.

That's the second part of our talk. Next we'll move into staying out of trouble. So just some tips for avoiding mistakes.

Audience question: Can you talk about 30-year treasury bond yields and why is that a hot topic nowadays?

Mike Piper: Gosh, I don't honestly know why that's a hot topic nowadays because you know what,I don't pay super close attention to nominal interest rates. I pay much more attention to inflation-adjusted interest rates.Sorry, can't help you. And why are those important? Because it's always real returns that matter, inflation-adjusted returns.

There, you know go back a few decades to when I was a youngin and we had extremely high nominal interest rates but we also had very high inflation, so in real terms bond investors weren't actually doing any better. And if you're looking at after tax numbers, bond investors were not doing very well at all because the whole nominal return gets taxed. And so it's real returns that always matter. And so generally if I'm looking at interest rates I'm going to be looking at TIPs yields rather than nominal treasury yields.

Audience question: Do mutual funds or ETFs report performance net of expenses?

Mike Piper: Yes they should both be  reporting performance net of expenses. So if they do, if two index funds report the same or similar performance and have the same or similar accuracy in tracking  whatever index that they follow but with different expense ratios, why bother picking? Well if two mutual funds, you've got two index funds in the same category, and if you plot them both on a chart and they look like they're basically identical, they probably are, and you probably don't need one as opposed to the other. Either one is probably going to be a perfectly fine choice.

Audience question: Do I need a separate emergency fund if I have an invested taxable account that I can access when I need to?

Mike Piper: Well I mean that taxable account might be your emergency fund. You need to know that you have assets on hand that you can get to in the case of an emergency.  Of course as your portfolio grows, yes absolutely, just the bond part of your portfolio is your emergency fund and that's absolutely fine. 

Audience question: In reference to the Reit fund portfolio you were discussing earlier,  do we need an international bond fund?

Mike Piper: No you don't. With bonds you don't need to diversify at all actually. You could just use treasury bonds, and because one of the primary reasons we diversify with stocks is that any one stock can go to zero because the company can go bankrupt. With bonds there's always the choice of treasury bonds which are backed by the treasury and you don't need diversification at all. If you're using corporate bonds you do want to diversify and that's why if you're using corporate bonds you want to use a total bond market fund. But no, you don't need diversification in bonds at all necessarily, so you don't need an international bond fund.

And especially right now, if you compare Vanguard's total international bond funds to their total US bond fund, the yields on the international fund are lower and the fund has higher risk. So to me it just doesn't seem like a very compelling argument.

Audience question: I have a question Mike. Many investors think that index funds, if they invest in index funds they will be investing and they will receive average returns, that an index fund gives them average, but my understanding is that an index fund just tracks an index. If the index goes up, your fund goes up if the index goes down your fund goes down.

Mike Piper: What the index fund is is not average. It is following the index and keeping you out of trouble because you haven't  tried to beat the index. It's keeping you out of trouble and also what you will never do is do worse than the index.  You are the index. Yeah never do worse than the S&P  500 you will always be at the S&P 500.

The idea that index funds are average is a sales pitch for actively managed funds and it's I mean factually false. The overwhelming majority of actively managed funds do worse than their passively managed counterparts. We just look at those percentages, so the idea that if you're looking at a fund that outperforms 84% of actively managed funds I don't know how you would call that average. I mean the 84th percentile is not average. So no, the idea that index funds will only give you average is I mean factually false. There's no ambiguity about it, they are better than average.

Audience question: And also on a target date fund. For young investors who are looking at their 401-k, for example, and they see maybe 45 or 50 funds, they see a list, a huge list of mutual funds. Yeah, and they don't know what to do, and they just want to move on with their life and just pick something that's good. A  target date fund is great and even if they just pick the target date fund for when they think they're going to retire at 65, let's say, from a good fund company which most 401k plans are. That would be sufficient until they learn more about investing and then maybe they would tweak it. Would you agree with that?

Mike Piper: Yeah. I think target date funds are a great choice for beginners and for people who aren't beginners. I think target date funds are a very sophisticated way to invest. Frankly they are a brilliant conception, that with one fund  you can own this extreme level of diversification and as long as you're using a good fund company. Low costs also, and that's a fantastic product. Yes, I absolutely think for people starting out that's often a great way to go. And it's a perfectly reasonable choice for people who aren't just starting out.

And also since a target date fund then glides down through your life until you retire. It glides down in asset allocation automatically. The fund company does it for you. You don't have to decide well now that I'm 48 years old,Ii think I should be 70% bonds, or should I be 20%. Instead of making those decisions, if you really just want to invest it and not look at and not worry about it, the target date fund will take you into a more conservative asset allocation when you retire.

Yeah, target date funds are low maintenance. They're not entirely hands off because you should still check it every once in a while to make sure it still owns the things that you hope that it owns. but they're very low maintenance. That's great. 

So that I would add they're also rebalancing in between the recalibration that Miriam is referring to, so even before you get to the different asset allocations you're rebalancing which we know is critical. 

Audience question: So Mike, I have a question for you. Going back to the first segment, the catch-up provision. You mentioned where folks can contribute more to their IRAs if they're 50 or over. Is it  that they're 50 by the end of the calendar year or 50 at the time of the contribution. So let's say someone contributes early in the year when they're not yet 50, and then they turn 50 late in the year. What is the rule around that?

Mike Piper: It's the end of the year. so it's 50 by the end of the year. Yes, age at the end of the year, that matters in almost every IRA related case, it's almost always your age at the end of the year. And that's a general tax concept. Marital status also, if you get married in the middle of the year, it's your marital status at the end of the year that determines your filing status. So for most things, there are some exceptions, but for most things they're looking at the end of the year to determine how old you are and whether you're married and so on and so forth.

So staying out of trouble, which is really just some tips for avoiding common mistakes. First I would encourage you to try to keep a long-term focus. A lot of people check their portfolios every day, and you don't have to. And in fact you really probably shouldn't. And you don't even have to check it every month because if you are, again, if you're 30 years from retirement, what your portfolio does tomorrow or next week or next month or even next year it just doesn't matter. What matters is how much money is there on the day that you need to spend the money. And so you can have all sorts of volatility in the meantime and that can be fine. You don't have to worry about what's going on in the market over short periods of time.

Also I would encourage you to watch out for recency bias. And you're thinking recency bias is a cognitive bias that basically we all have as humans, and it's the tendency to assume that whatever has been happening recently is what will continue to happen.And so the way that affects us with investing is that when the market has been going up lately people just assume that that's what's going to continue to happen. And so, like right now, when you've seen a whole bunch of years of good returns in a row you see a lot more people who feel really good about stocks, and they're very high stock allocations because they're just assuming that the market's going to keep going up. And then the opposite thing happens when the market's going down. People just feel bad about stuff because they assume it's going to keep going down. So you see people pulling their money out of stocks.

And both of those things are detrimental. You generally want to pick an allocation that you can stick with, and don't assume that whatever the market is doing right now is what it's going to be doing next week or next month.

My next tip would be to automate your investing to the extent that you can. So with the 401-k you can sign up to have contributions made from every paycheck. And with an IRA you can set it up with a brokerage firm so that a certain amount is taken out of your checking account and put into the account every month. And when you do that you're automating your progress.

Basically, a lot of people what they do is they spend however much they spend and they plan to save and invest whatever's left over. But when you do that a lot of times there isn't very much left over. Sometimes there's nothing left over and so you don't actually make any progress towards your goals over time.

But if you do it in the other order, if you automatically contribute every month, then you'll be forcing yourself to only spend the amount that you should be spending. And you will automatically be making progress towards your goals every month because you are saving every single month. And just like Guru and Mariam were both saying, target date funds automate rebalancing as well. So that's another thing you can automate if you want to. Every day they bring the fund back to the targeted allocation, so that's another way that you can be hands off.

And the more things that you automate with your investing the less often you have to check your portfolio because there's fewer things that need to be done and that's nice because it helps make it easier to not worry about all of that volatility from one day to the next.

My next tip would be to ignore the financial news. The financial media's goal is just to get your attention because that's their business model. They make money based on advertising, so in the online world they just want traffic. They just want you to click on their article. And in the TV world they just want you to watch their TV show so they can sell their ad spots for more. So every day there's a flood of information.

And recently it's been about Tesla and bitcoin and Gamestop. Ten years ago it was about other stuff ten years from now it'll be about other stuff. But the point is that there's always going to be this information just hitting you every day. Millions of articles it feels like, and their goal is just to get you to click on it, so they sensationalize stuff. The headlines are written in a way to make everything sound really exciting or scary or important. 

When it usually actually is not important. It's not important information to your actual financial planning. And if you can tune out all of that noise it frees up time because you're not spending time reading nonsense. But it also frees up mental energy. And with that time and mental energy you can focus on the stuff that really matters. So in investing that would be are you saving enough every month, do you have a reasonable asset allocation, are you using low-cost funds, are you at least making sure to get the matches in your 401k.

And then there's a ton of other financial planning topics that are at least as important that don't have anything to do with investing. Like do you have disability insurance ,and if you have dependents, do you have enough life insurance. And do you have a will that names guardians for your kids. Stuff like that that's really important. And if you can ignore, not be wasting any time and mental energy worrying about what your portfolio did today, and what bitcoin did today. If you can just ignore all that you've got more time and energy to focus on the things that matter.

And my last tip would just be to point out that there's no perfect portfolio. There's no perfect asset allocation, except in hindsight. A lot of times, when people first get started investing or when they first find the bogleheads, they get analysis paralysis. They get totally hung up on trying to figure out exactly the right allocation. Should it be 25% in bonds or 30%? And should it be 30% in international or 40%? And do I need a small cap value fund and do I need a  Reit fund? And do I need this and do I need that, and that prevents you from making any progress because you're trying to get it exactly right.

But you don't have to because there are plenty of good enough allocations. The Three Fund Portfolio that we talked about, that's a great portfolio. The Two Fund Portfolio, that's another really great one. A target date fund, as long as you check the allocation and make sure it's a good fit, that's also a really great portfolio.

And any of those allocations, they're good enough to get the job done as long as you do your part. So as long as you're saving enough every month and as long as you don't do something stupid like take all of your money out of stocks after the market has gone down those allocations they'll be fine. They will be good enough. And there's no best fund except in hindsight either. A lot of people you see spend a lot of time trying to pick exactly the very best actively managed fund, but we don't know which fund will be the best actively managed stock fund over the next 10 years. We only know which one was the best over the last 10 years.

But the good news is that again, there's plenty of good enough funds. If you stick with just the basic total stock market index fund, that's a good enough fund; a total international stock index fund, that's a good enough fund in that category. Just basic index funds or ETFs from a

reputable provider, they're going to have low costs, they're going to be diversified. They're good enough, they'll get the job done. And so that's really all I've got. I hope you got some useful information in terms of the building blocks of a portfolio and the actual decisions in terms of what to include. And then, hopefully, some useful tips for avoiding the common mistakes that we see.


The slides used in this presentation are available at Slides.


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