Saturday, October 11, 2014

Slow and steady also wins the investing race

kw: book reviews, nonfiction, investing

Sometimes all it takes is one good, good man. In the realm of investing, Jack Bogle is that man, and the Bogleheads are his disciples. Three of them, including the one Jack calls "Prince of the Bogleheads", have written the first book you need to read to learn about investing: The Bogleheads' Guide to Investing, by Mel Lindauer ("Prince"), Taylor Larimore, and Michael LeBoeuf. I read the second edition, just out (the first edition was in 2006).

In 2007 I wrote about what I call the "P07 Prosperity Index" or PPI (see it here). It is simply the Dow Jones Industrial Average (DJIA) divided by the Consumer Price Index (CPI) and the US Population. Neither DJIA nor CPI is perfect, but these are the best we have readily available. If you look at the general trend of the DJIA after the crash of 1929, you see a general, jittery rise, with big hiccups. But the PPI shows a different story. Here is my original chart showing 1928-2001:

After the 1929 crash, which lasted until 1933, we see 5 eras:

  • 1935-1954 - A generally flat, if wavy, trend.
  • 1954-1966 - The post-war boom got under way after all the men on the GI bill got out of college and established careers.
  • 1966-1982 - The "flat market": the DJI stayed near 1,000 but inflation and a growing population meant the true value of stock investments fell to 1/3 of their original value.
  • 1982-1998 - The boom of the "Reagan Years" followed by the Dot-Com Boom, AKA the Dot-Com Bubble.
  • After 1998 - Another flat market, with a modest rise in real terms (not shown here) after the crash of 2008-9 (remember, you must divide out both inflation and population growth).

The scary thing about the years since about 2000 is that there is no safe haven. Passbook savings at a 5% annual rate could be had during my formative years, and until I was 50 years old. Now, the best-performing CDs earn about 1%. So to stay ahead of inflation, one must invest. The trouble is, even though about half of American families now own investments such as mutual funds or stock accounts, few have the slightest investment intelligence. What to do?

Bogleheads to the rescue! Jack Bogle has a short list of mottoes. The two most basic are "Keep it Simple" and "Keep Costs Low". The first 16 chapters of the book cover all the basics of investing, beginning, with getting your own house in order. That means living within your income. Otherwise, you have nothing to invest. Close the book and take care of that first.

Consumer Debt is the biggest drag on a family's finances. Do you have a running balance on your credit card(s)? The highest-paying investment you can make is to pay consumer debt down until you pay it off. You are paying 15%-20% annually. For every $1,000 of your balance, you are paying $150-$200 per year. If you have the average (Average!!) of $8,200 credit card balance, you are paying between $100 and $135 every month in interest. What could you do with another $100 or so of income?

That's right. Invest it. If we could still get 5% passbook savings, and put the $100 monthly into that, it adds up over time. In a year, you'd have just over $1,200. That $1,200 would earn another $60 every year you leave it in savings. The next year's $1,200 would do so also. In 20 years you'd have saved $24,000, but your passbook balance would be nearly $40,000. Keep on for another 20 years: savings total $48,000, but your balance is now $145,000. Compound interest has added nearly $100,000 to your investment. Do you want to retire a millionaire? Starting at age 25, save $690 monthly for 40 years in an investment that earns 5%.

Getting 5% can be hard, but it is sure easier than getting the 10% or 20% that the radio personalities talk about (but you never meet anyone who actually earns that much!). The Bogleheads can show you how to earn 5%-7% with comparative safety. Nothing is totally safe. Even passbook savings during my youth might have been lost if a bank failed. FDIC insurance started in 1934, but the insured limit was pretty low until 1980, when it rose from $20,000 to $100,000 (it is now $250,000).

A tale of two families: My wife and I had some good friends in the early 1980s, and we had very similar incomes. Let's call them Bill and Jane Spender. My wife and I had two cars, and each had cost about $1,000. We had a house with a $30,000 mortgage. The Spenders also had two cars that hadn't cost much, and bought a house, winding up with a $45,000 mortgage. Then they traded in one of their cars and bought a minivan. Its payment was more than half as much as their mortgage. So right away, their debt service costs were 2.25 times as much as ours. Not long after buying the van and making a couple of payments, Jane complained to my wife that they were barely making ends meet. She replied, "It was your choice. Your old car still worked." As you might imagine, the relationship was rather strained for a while after that. We moved away a couple of years later, and after another 10 years, went to visit them. They were living in a trailer in the woods. They still had the van, but fortunately it was now paid off. They were actually beginning to save a little money. The difference? We learned to live within our income a decade and a half before they did.

That's a lot, just on the message of the first couple of chapters. But if you attain the discipline to live on less than you earn, and save regularly, you have what it takes to invest the slow, steady way they Bogleheads recommend.

Keeping it simple: Diversify the easy way with a small number of mutual funds. Specifically no-load funds such as the majority of funds at Vanguard and Fidelity, and others found, for example, at T. Rowe Price. A mutual fund is already diversified, so get a stock index fund, a bond index fund or total bond market fund, and perhaps a little of a global or international value index fund. Just to track the DJI you have to buy 30 stocks. And what does it cost per trade at E*Trade?

Keeping costs low: This means investing in instruments that have very small management fees. Way too many folks go to a "financial adviser" and agree to have their money managed for a yearly fee of "only" 1.5% (more or less) of their account value. By the way, try asking the adviser if he or she will waive the management fee in any year that the balance has gone down. Not bloody likely! If the person agrees, you may have found an honest adviser!!! Anyway, this adviser is probably also a broker, and will invest in either stocks and bonds directly (if you've agreed to that) or in mutual funds. Either way, there is nearly always a commission paid, to the broker/adviser. Brokers never deal in no-load funds. For stocks and bonds the commission ranges from 5% for small purchases down to about 0.5% for larger ones. For most mutual funds, it is about 4%. If you are lucky, the adviser will leave things mostly alone and only make changes about once or twice a year. Every such change has its cost. The upshot? Your adviser is making from 3%-6% of your money. You might make some, and you might lose some. Your adviser can't lose!

The problem is, over any span of a few years, the performance of most advisers and other kinds of fund managers is below that of a stock index such as the DJI or S&P 500. For the past 20-30 years, the indexes yield in the 6% range, plus or minus a point depending on which 10-year span you choose. If your adviser can gain only 6%, and is taking 3% or more, that is not good for you. If you could gain the same 6% and your expenses were less than 1%, that's a huge difference in the long term.

Consider the example above. Instead of 5%, you earn only 3%; or, rather, your account earns 6% but the adviser takes half of it each year. In 20 years you have some $32,000 and in 40 about $90,500. Between what you paid the adviser, and the 3% that didn't compound, you've lost $8,000 over the first 20 years and nearly $55,000 over 40 years.

By the way, if you want to pay this adviser 3% to take care of your money for 40 years, and still retire a millionaire, what monthly amount must you save? $1,105/month, or about 1.6 times as much, just to account for the advisory fees and commissions and lost compounding. So you may not think 3% is too much, until you realize it eventually adds up to $415/month.

Here we find a little selling in the book, but I think it justified. The authors are not employees or affiliates of The Vanguard Group, which Jack Bogle started in 1976 with the first index fund. It became the first among many index funds, and has very low management cost. Its expense ratio is below half a percent. The "Admiral" version, for larger investors, has expenses below 0.2%. While the authors present examples using general indices, they also show how certain specific Vanguard funds would fit in, and they recommend them. So do I; I have had Vanguard as my major investment company for 25 years.

In the second part of the book we find strategies to get investments on track and keep them there. The discussion of portfolio rebalancing in Ch 17, "Track Your Progress and Rebalance When Necessary", made so much sense I finally decided I'd better make rebalancing a habit. I made a simple model of two Vanguard index funds since their inception late in 2001. One tracks the S&P 500 and the other tracks the "Total Bond Market". The S&P has, like the DJI, gyrated all over the place. The Bond index is much more stable, though it has had periods of loss. Over the past 13 years the stock fund's average rate of return has been about 6%, and the bond fund's return has been 4%. That includes the market crash 6 years ago, when stocks fell by 40% and even bonds fell a little.

As you might expect, a 50:50 mix of bonds and stocks fell right in the middle, about 5%. It still gyrated a lot, but much less than stocks alone. But with rebalancing, things were a little different. The gyrations were a little less while the return rose. Specifically, using a starting investment of $10,000 (what fund prospectuses always use) and rebalancing every January except the first one in 2002, with or without rebalancing there was an early dip to about $8,650 in Fall of 2002. The crash of 2008-9 dropped the "no rebalance" portfolio from $13,513 to $10,085 and the rebalanced portfolio from $13,719 to $10,265. $10,000 in the S&P by itself would be well below this, at $7,341. The power of rebalancing occurred during the early long (4y) rise followed by a long fall that took 16 months. Rebalancing in January of 2008 and 2009 shifted money from bonds to stocks even as stocks grew cheaper while bonds continued rising. During the prior 4 rebalancings, money from rising stocks had been shifted to bonds. This captured a portion of the stocks' profits. By the rebalancing of January 2010, stocks were again outpacing bonds, and the shift back toward bonds resumed. As of August 2014, the now badly unbalanced portfolio (56% stocks and 44% bonds) totaled $19,195 while the yearly rebalanced one was $20,880. The difference is $1,685. In the past 2 months both portfolios have lost about $400. The effective yearly earnings come to 5.2% for the unbalanced portfolio, and 5.7% for the rebalanced one. I think it is worth my while to make simple rebalancing adjustments once yearly for the sake of $1,700 per $10,000 invested.

That is just one useful thing I learned from the book. I also find that their recommended asset allocation for someone like me in early retirement, with perhaps 20 years to live, is half stocks and half bonds, like the portfolio I modeled, with a dollop (10% of the total) of international stocks included. My own investments are a bit bond-heavy, so I might benefit from adjusting that also.

Being financially conservative, I've been right in line with many of their recommendations, but I believe many worried investors will find a great many helpful principles within these pages. Now if only I'd had the insight to start putting away $690/month at the age of 25!

1 comment:

Anonymous said...

Excellent website. Plenty of useful information here.
I'm sending it to a few buddies ans also sharing
in delicious. And naturally, thanks to your sweat!