Bogleheads® 2022 Conference – Bogleheads University - Principle 9: Invest with Simplicity

00:00:00.000 | (audience applauding)

00:00:03.160 | All right, you guys are in for a treat

00:00:08.220 | because you get Mike Piper back up here.

00:00:10.560 | If we can tear him away from the drinks there in the back,

00:00:13.360 | he's back there serving drinks.

00:00:15.680 | But let's get him back up here.

00:00:16.760 | He's gonna talk about investing in a simple manner.

00:00:20.240 | And the best thing about this with Mike

00:00:22.680 | is that he practiced what he preaches.

00:00:24.880 | And the thing I love about Mike

00:00:27.080 | is I am still learning stuff from Mike.

00:00:28.560 | I sent him an email just last week

00:00:30.000 | to clarify something I did not understand.

00:00:32.080 | He sent me back an email filled with algebra.

00:00:34.720 | He totally understood it.

00:00:38.420 | And so it's great to have Mike as a resource.

00:00:40.880 | Luckily, he's not gonna be talking about algebra,

00:00:42.600 | I hope, in this presentation,

00:00:44.140 | but it should still be well worth your time and attention.

00:00:47.040 | - All right, invest with simplicity.

00:00:56.280 | Back in 2008, or Alan can correct me if I'm wrong,

00:00:59.840 | in 2009 perhaps,

00:01:01.840 | in his book How a Second Grader Beats Wall Street,

00:01:03.800 | he outlined what he called the second grader portfolio.

00:01:06.440 | And this was a portfolio that consists

00:01:07.940 | of a total stock market index fund,

00:01:10.120 | a total international stock index fund,

00:01:12.380 | and a total bond market index fund.

00:01:14.320 | And you keep hearing about this portfolio.

00:01:15.720 | Now we just call it the three fund portfolio,

00:01:18.360 | and it's become largely a default investment recommendation

00:01:21.920 | among the Vogelheads community.

00:01:23.900 | And the reason it's become so popular

00:01:26.200 | is because it's really simple,

00:01:28.240 | and it's extremely well diversified.

00:01:29.820 | Just like Alan and Christine were showing you,

00:01:32.120 | it includes thousands of stocks from around the world

00:01:35.080 | and a diversified collection of bonds

00:01:37.240 | with just three mutual funds.

00:01:38.680 | And in some cases, for some people,

00:01:42.080 | it can make sense to go one step simpler.

00:01:44.760 | You can use a one fund portfolio.

00:01:46.840 | That would include something like a target date fund,

00:01:49.440 | a Vanguard life strategy fund, that's what I use,

00:01:52.320 | or a balanced fund.

00:01:53.720 | A lot of fund companies offer those.

00:01:55.000 | They're very straightforward.

00:01:55.960 | They typically just have a fixed 60% stock,

00:01:58.800 | 40% bond allocation.

00:02:01.000 | But if you're considering using a one fund portfolio,

00:02:03.520 | it's important to keep a lot of different things in mind

00:02:06.160 | before making that decision.

00:02:07.920 | Number one is that it's still important

00:02:09.400 | that the fund has a low expense ratio.

00:02:11.360 | That matters with these funds just as much

00:02:13.120 | as with any other mutual fund.

00:02:14.760 | High expenses are going to eat into your returns.

00:02:17.640 | Number two, it's really important to take some time

00:02:21.740 | to check the actual asset allocation for the fund,

00:02:25.000 | as well as the glide path,

00:02:26.880 | which is how the allocation is supposed to change over time.

00:02:30.080 | Look into that, rather than just relying

00:02:32.280 | on the name of the fund.

00:02:33.820 | For example, if your 401(k) has a 2040 target date fund

00:02:36.840 | and you're planning to retire in 2040,

00:02:39.100 | that fund might not be a good fit for you.

00:02:41.200 | Your personal risk tolerance could be much higher

00:02:43.080 | or much lower than whatever this fund company assumes

00:02:46.440 | is typical for somebody retiring in that year,

00:02:48.520 | because there's more to risk tolerance

00:02:49.960 | than just what year you plan to retire.

00:02:52.040 | So it's important to just look it up

00:02:54.320 | on the fund company website or Morningstar or wherever

00:02:56.960 | and see what the actual asset allocation is

00:02:59.080 | and see if that's a good fit for you,

00:03:00.320 | because maybe, again, using the 2040 example,

00:03:03.160 | maybe the 2030 fund or the 2050 fund

00:03:05.840 | is gonna be a better fit for your personal risk tolerance.

00:03:09.040 | And finally, the last important thing to keep in mind

00:03:10.960 | about all-in-one funds is that they aren't a good fit

00:03:13.920 | for taxable accounts.

00:03:15.520 | We were just talking about using tax-efficient funds

00:03:18.160 | in a taxable account.

00:03:19.640 | All-in-one funds are not tax-efficient.

00:03:21.800 | There's a few reasons for that.

00:03:23.720 | Reason number one is that they use taxable bonds,

00:03:25.960 | whereas for some people,

00:03:27.280 | tax-exempt municipal bonds would be a better fit.

00:03:30.280 | Reason number two is they get in the way of asset location.

00:03:33.320 | Remember, asset location, the whole idea,

00:03:35.360 | is to make sure to only own tax-efficient things

00:03:38.760 | in your taxable accounts.

00:03:40.680 | Well, with an all-in-one fund,

00:03:41.800 | the whole point is to own everything,

00:03:44.440 | so it's going to include some tax-inefficient stuff

00:03:47.120 | in that taxable brokerage account, which isn't ideal.

00:03:50.400 | And number three is that --

00:03:53.200 | the third reason they're tax-inefficient is

00:03:55.160 | that this fund-of-funds structure,

00:03:58.360 | so a target-date fund that owns underlying mutual funds,

00:04:01.880 | it adds another layer of turnover, right?

00:04:04.400 | If you imagine, for example, the Vanguard target-date funds,

00:04:07.600 | they've got four underlying mutual funds,

00:04:09.280 | a U.S. stock fund, international stock fund, U.S. bond fund,

00:04:12.360 | international bond fund.

00:04:13.920 | And each of those four underlying funds has its own

00:04:16.640 | level of turnover, and so that creates some taxes.

00:04:19.480 | But then the target-date fund

00:04:21.160 | that owns those funds has its own turnover because it has

00:04:25.800 | to rebalance among those four underlying mutual funds,

00:04:28.800 | and that creates some additional tax costs for you as well.

00:04:31.560 | And sometimes you'll see a case -- not going to name names,

00:04:34.760 | but a particular fund company this year switched one

00:04:39.680 | of the underlying funds in a significant way.

00:04:42.560 | It created a huge capital gain distribution for shareholders.

00:04:46.040 | It was really expensive.

00:04:47.640 | So these, again, target-date funds, life-strategy funds,

00:04:51.360 | they're neat, they're great in a lot of cases,

00:04:53.120 | but they're not a good fit for a taxable brokerage account.

00:04:57.560 | But why do we talk about investing with simplicity at all?

00:04:59.680 | Like, why did this make it onto the list

00:05:01.000 | of Vogelhead's principles?

00:05:02.880 | Because rebalancing isn't, frankly, all that hard.

00:05:06.840 | If you can use a spreadsheet, you can do it.

00:05:09.120 | You can even do it with pencil and paper and a calculator if,

00:05:12.360 | you know, if you're inclined to do that sort of thing.

00:05:15.400 | But simpler portfolios do save you time.

00:05:19.560 | They take less time to rebalance.

00:05:22.000 | And if you're using an all-in-one fund,

00:05:23.840 | like a target-date fund,

00:05:25.240 | they completely eliminate the job.

00:05:27.480 | So the example I always use is I compare it

00:05:29.280 | to doing the laundry, right?

00:05:30.600 | It's not like that's a really challenging job,

00:05:33.560 | but it would be nice to never have to do it.

00:05:36.800 | That's what a target-date fund does.

00:05:38.800 | It just removes this chore from your life, and that's nice.

00:05:42.360 | But really, that's not the most compelling reason, in my opinion.

00:05:45.280 | That's not the most compelling reason

00:05:46.560 | to use a simpler portfolio.

00:05:49.440 | The better reason for a simpler portfolio is

00:05:52.800 | that it improves investor behavior.

00:05:55.400 | And to talk about that, I want to highlight the study

00:05:57.520 | that has come up, Alan mentioned it also.

00:05:59.600 | It's Morningstar's Mind the Gap study.

00:06:02.000 | And they do this study every couple of years.

00:06:04.480 | And every time, they look at the last 10 years

00:06:07.440 | of mutual fund performance.

00:06:09.280 | And they look at all of the different mutual funds

00:06:11.280 | that Morningstar looks at, so however many thousands

00:06:13.480 | of funds that is.

00:06:15.200 | And for each mutual fund, they look at two things.

00:06:19.160 | First, they look at the regular reported performance figure

00:06:21.560 | for that fund, right?

00:06:22.400 | So that's just the 10-year return figure that you would see

00:06:25.000 | on a fund company website, or in a prospectus,

00:06:27.320 | or in a brochure, or something like that.

00:06:29.080 | And then the second figure

00:06:30.840 | that they calculate is what they call the investor return.

00:06:35.440 | And this is a dollar-weighted figure.

00:06:37.200 | So it accounts for the cash flow that's coming into the fund

00:06:40.840 | or going out of the fund when shareholders buy

00:06:42.560 | and sell shares.

00:06:43.880 | And so the idea with this investor return figure is

00:06:46.920 | to reflect the actual return

00:06:49.920 | that the average investor actually earned in this fund

00:06:52.960 | over the period in question.

00:06:54.920 | So if we consider a hypothetical actively managed fund,

00:06:59.040 | imagine it's brand new at the beginning

00:07:00.560 | of those 10 years, right?

00:07:02.200 | And so because it's brand new, and let's also say it's

00:07:04.640 | from a brand new fund company.

00:07:05.720 | So nobody's heard of it.

00:07:07.000 | It has almost no assets under management.

00:07:09.440 | And imagine that for the first four years

00:07:11.840 | of the 10-year period it has excellent performance,

00:07:15.680 | just incredible returns.

00:07:17.840 | And so during those four years,

00:07:19.480 | people start to hear about it, right?

00:07:20.840 | It gets written up in some articles and so on.

00:07:22.720 | And so a bunch of money comes flooding into this mutual fund.

00:07:26.080 | And then in our example here, let's imagine

00:07:28.080 | that over the last six years of the period,

00:07:30.840 | it has really mediocre performance.

00:07:34.080 | Well, the regular 10-year performance figure,

00:07:36.000 | the 10-year return figure for this fund,

00:07:38.560 | each of those 10 years is going to count the same

00:07:40.840 | as the other 10 years.

00:07:42.360 | So it's going to have a pretty good 10-year return figure

00:07:44.840 | because those first four years were so good.

00:07:47.960 | But the investor return figure is not going to be as good

00:07:51.360 | because those first four years,

00:07:53.920 | nobody owned the fund during those first four years.

00:07:56.320 | So they won't count for very much in the calculation.

00:07:58.960 | In the last six years with the mediocre returns,

00:08:01.720 | that's when most people owned the fund.

00:08:04.400 | So that's what will count for most of the calculation.

00:08:06.960 | So in this example, you'll see a good 10-year return

00:08:11.920 | and a really mediocre 10-year investor return.

00:08:15.400 | There's going to be a big gap between the two.

00:08:17.880 | And that's why they call it the Mind the Gap Study

00:08:19.960 | because we're looking at that difference.

00:08:22.080 | And the point is that that gap is a measure

00:08:25.720 | of how well investors do with the timing of their buying

00:08:29.320 | and selling of the fund.

00:08:30.760 | So in our example here, this hypothetical fund,

00:08:33.600 | this big gap is the result of the fact

00:08:35.760 | that investors did a terrible job

00:08:37.840 | with the timing of their purchases, right?

00:08:39.320 | They bought after the first four good years

00:08:42.840 | and right before the six mediocre years.

00:08:46.000 | So there's a big gap.

00:08:48.120 | Now, where I'm going with all of this,

00:08:49.800 | if we look at the most recent edition of the study,

00:08:52.080 | so it came out this year and it looked

00:08:53.880 | at the 10 years ending December 31st of last year,

00:08:57.800 | these are the gaps for the different categories of funds.

00:09:01.960 | And the two things I want to highlight here are

00:09:04.000 | that the gap was smallest for allocation funds.

00:09:08.000 | That's basically things -- so that's Morningstar's term.

00:09:10.400 | It's basically things that include stocks and bonds

00:09:12.280 | within the same mutual fund.

00:09:14.040 | So balance funds, target date funds, life strategy funds.

00:09:17.720 | And the gap was largest for sector equity funds.

00:09:21.960 | That would be things like a technology stock fund

00:09:24.480 | or a healthcare stock fund.

00:09:27.000 | And because they do this study every couple of years,

00:09:30.120 | of course, the exact figures,

00:09:32.480 | the exact percentages change, right, from one edition

00:09:35.440 | of the study to the other.

00:09:36.920 | But this overall relationship is very consistent.

00:09:40.520 | Every time we see that investors do well with allocation funds.

00:09:44.880 | And to me, that's not the slightest bit surprising.

00:09:47.360 | Because if you think about a target date fund,

00:09:49.080 | imagine you're using that in your 401(k).

00:09:52.200 | All it is is one fund.

00:09:53.480 | You just put money into the same fund.

00:09:55.320 | There's no temptation to move your money around, right?

00:09:58.880 | The whole point is to put it on autopilot.

00:10:01.080 | And so a lot of people do that.

00:10:02.360 | They put it on autopilot.

00:10:03.280 | And that actually works really well.

00:10:05.680 | And then the other thing we see every time

00:10:08.040 | is that investors do really poorly

00:10:10.560 | with sector equity funds.

00:10:12.640 | And again, to me, that's not surprising.

00:10:14.840 | Because when you see portfolios

00:10:16.280 | that include sector equity funds,

00:10:18.440 | they're usually portfolios that have like 30 mutual funds

00:10:21.440 | or something insane.

00:10:22.640 | And so when that's what your portfolio looks like,

00:10:25.720 | there's a huge temptation to move your money

00:10:28.440 | a little bit this way or a little bit that way

00:10:30.000 | or get rid of this fund and add that fund.

00:10:31.840 | And that's not to say that you personally would do that.

00:10:35.160 | But there is very clear,

00:10:38.680 | this data from Morningstar makes it very clear

00:10:41.080 | that investors do that.

00:10:42.760 | And it's generally to their detriment.

00:10:45.320 | And they do it more often

00:10:47.000 | with funds that represent narrow slices of the market

00:10:50.320 | than they do with more broadly diversified funds.

00:10:52.800 | And that's true all the way up

00:10:53.800 | to the most broadly diversified allocation funds

00:10:56.040 | where investors do the best.

00:10:57.440 | So the study also drills down

00:10:59.800 | into narrower categories of funds.

00:11:01.880 | And here we're looking at the gap

00:11:05.280 | for large cap stock funds,

00:11:07.480 | meaning funds that invest in stocks of large companies.

00:11:12.360 | And the gap for large blend funds,

00:11:15.840 | large blend meaning that the fund

00:11:17.400 | is not specifically a growth fund,

00:11:19.840 | nor specifically a value fund.

00:11:21.760 | So it invests in growth stocks and value stocks.

00:11:25.240 | The gap for large blend funds was about,

00:11:27.280 | or exactly three quarters of a percent per year.

00:11:30.000 | The gap for large growth funds was about 1.3% per year.

00:11:35.560 | And the gap for large value funds was about 1.3% also.

00:11:41.360 | It's one of those cases where your intuition could trick you

00:11:43.200 | because you might expect that large blend

00:11:46.560 | is basically a blend of large growth and large value, right?

00:11:50.200 | So you might imagine that the gap for large blend

00:11:54.320 | would be between the gap for large growth

00:11:56.120 | and the gap for large value, and it's not.

00:11:59.040 | It's smaller than either of those other two gaps.

00:12:01.720 | You've got investors doing better

00:12:03.760 | with the more broadly diversified funds

00:12:06.120 | than with the less diversified funds.

00:12:08.400 | So why invest with simplicity?

00:12:12.080 | It does save you time.

00:12:13.320 | And that is, frankly, that's nice, I appreciate it,

00:12:16.720 | but that's not the biggest benefit.

00:12:18.760 | The biggest benefit is just that it makes it easier

00:12:20.440 | to stick with your plan.

00:12:22.160 | And this is a quote from the conclusion

00:12:23.600 | of the most recent version of the study.

00:12:25.440 | The authors wrote, this is their italics, by the way,

00:12:28.280 | they recommended that the reader focus on holding

00:12:30.240 | a small number of widely diversified funds.

00:12:33.600 | They went on to say that as the fund industry has grown,

00:12:36.120 | asset management firms have rolled out

00:12:37.880 | more and more highly specialized funds,

00:12:40.200 | but investors have fared far better by keeping things simple

00:12:43.000 | and sticking with plain vanilla, broadly diversified funds.

00:12:46.200 | And then they went on to write that funds

00:12:47.440 | that offer built-in asset class diversification,

00:12:50.560 | so that's funds that include stocks and bonds

00:12:52.360 | in the same fund, so target date funds,

00:12:54.440 | life strategy funds, balance funds.

00:12:56.560 | They also excelled in the study.

00:12:58.840 | Not only are these funds easy to use,

00:13:00.960 | but they're also easy to live with.

00:13:02.720 | Investors tend to buy and hold them for long periods,

00:13:05.280 | or make investments on a regular schedule,

00:13:07.000 | like in a 401k.

00:13:08.800 | And that enforces investment discipline,

00:13:10.640 | and helps them avoid the temptations and pitfalls

00:13:12.480 | of trading at the wrong time.

00:13:14.680 | So that's it for invest with simplicity.

00:13:16.320 | Got Jim coming up in a minute.

00:13:17.880 | (audience applauding)

00:13:21.040 | (audience applauding)

Bogleheads® 2022 Conference – Bogleheads University - Principle 9: Invest with Simplicity

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