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Bogleheads University 101 2023 - Investment Selection with Rick Ferri


Whisper Transcript | Transcript Only Page

00:00:00.000 | I was so internalizing the message to just get on with things and get out of the way
00:00:11.440 | that I forgot to introduce myself.
00:00:14.380 | I'm Christine Benz, and I am Director of Personal Finance and Retirement Planning at Morningstar.
00:00:20.920 | I'm also the President of the Board of the John C. Bogle Center for Financial Literacy.
00:00:26.320 | I'm thrilled to introduce Rick Ferry, who has been my partner in planning this conference
00:00:31.520 | for the past couple of years.
00:00:33.600 | Rick is a prolific author.
00:00:35.360 | He has how many books, Rick?
00:00:38.000 | Six?
00:00:39.000 | Six books, with a focus on asset allocation and low-cost investing.
00:00:44.200 | He hosts the Bogleheads on Investing podcast, and he has an investment advisory practice
00:00:52.000 | that is hourly, which is a little bit different and difficult to find.
00:00:57.160 | He was my predecessor as President of the Board on the John C. Bogle Center for Financial
00:01:02.360 | Literacy and has donated a ton of his time to Bogleheads over the years.
00:01:06.520 | Rick is going to talk to us about investment selection.
00:01:25.560 | Thank you again for coming to the conference, and I hope you enjoy it.
00:01:29.800 | I know you're going to get an awful lot of information over the next three days.
00:01:34.040 | This conference used to only be two days; now it's three days.
00:01:37.700 | My talk today is on investment selection, which is how do you actually go about investing
00:01:45.000 | in the things that Alan talked about?
00:01:47.680 | I'm going to give you just a quick review of investments that are out there.
00:01:56.960 | I call these things the income-producing investments, which is trying to loan Alan $1,000 and hope
00:02:02.440 | you get it back.
00:02:05.080 | Income-producing investments, that's all they do is produce income, would be treasury bonds,
00:02:09.960 | corporate bonds, certificates of deposit, municipal bonds, and so forth.
00:02:13.820 | These are loaning people money, and they pay you back with interest and eventually get
00:02:19.800 | your money back.
00:02:21.000 | That's the idea.
00:02:22.000 | Those are the income-producing investments.
00:02:24.360 | First I'm going to go over, again, the list of different investments that are out there
00:02:27.400 | in the public markets, meaning you can go buy this stuff in the public markets.
00:02:34.880 | Not loaning it to Alan, that would be a private investment, but in the public markets, these
00:02:39.640 | are the things that you can buy.
00:02:42.720 | The next type of investment pays both dividends and it has growth.
00:02:47.960 | It could go up in value, and that is U.S. stocks, international stocks.
00:02:53.760 | You own part of these companies.
00:02:56.160 | Extra limited partnerships are like stock, a little bit complicated on the tax side,
00:03:01.360 | but the idea is you are a partner in a company, and it's a publicly traded company, so the
00:03:06.080 | stock is, if you will, publicly traded on the exchange.
00:03:10.580 | Then there's real estate that you can buy on public exchanges, and they're called REITs,
00:03:16.160 | Real Estate Investment Trusts, where you can get paid rents, and those rents flow through
00:03:21.040 | to you, treated a little bit differently for taxes, but again, all of this stuff you can
00:03:26.160 | buy in the public markets, on the stock market, or the over-the-counter type markets.
00:03:33.440 | And then there's these things that just change price, the more speculative things.
00:03:37.280 | They don't pay any dividends, they don't pay any interest.
00:03:40.200 | You are buying something with the hope that it goes up in value, and then you turn around
00:03:44.520 | and sell it at a higher price.
00:03:46.700 | So anything you buy, somebody else is selling, and anything you are selling, somebody else
00:03:53.280 | is buying, and as Alan said, it's a zero-sum game.
00:03:58.680 | There's no real growth in that, and that would be commodities, precious metals, collectibles,
00:04:03.360 | maybe a little bit different with collectibles.
00:04:04.760 | That, by the way, you can't get on the public market, there are very few available out there.
00:04:09.920 | And currencies, including the cyber currencies, like the Bitcoins and things like that.
00:04:14.600 | The idea is you buy them at one price, they go up in value, you sell them at another price,
00:04:19.960 | you make money, and you're buying and selling based on price only, no cash flow is coming
00:04:27.540 | off of those things.
00:04:29.080 | So publicly available investments.
00:04:31.880 | Now, my talk today is about how you buy.
00:04:36.840 | Those are the what's, that's what you can buy, and now this is how you can buy them.
00:04:43.560 | So this is a pretty structured market out there, pretty structured.
00:04:47.720 | The first way you can buy them is direct.
00:04:52.000 | So you go to the stock exchange, and you buy individual securities, you buy physical metals.
00:04:57.540 | So you're buying Apple stock on the stock exchange, you're buying Google stock on the
00:05:04.120 | stock exchange.
00:05:05.120 | You open up a brokerage account, and you buy stock.
00:05:08.300 | You could open up a brokerage account and buy treasury bonds, you can buy individual
00:05:12.200 | corporate bonds, you can buy mortgages.
00:05:14.860 | All of these individual securities trade, and if you have a brokerage account someplace,
00:05:19.720 | you can buy them in your brokerage account.
00:05:24.240 | You can buy Bitcoin, you can buy gold through an exchange-traded fund.
00:05:28.960 | You can buy real estate through real estate investment trusts.
00:05:33.080 | So they're mostly exchange-traded, they're fully liquid.
00:05:36.160 | If you bought them now, you could sell them 10 minutes from now, if you wish.
00:05:39.960 | You would pay a small commission or so, or a spread between the bid and the ask price
00:05:44.800 | when you sold them, because there's a market maker in the middle, so that's the cost of
00:05:51.600 | trading.
00:05:52.600 | So you could buy individual direct, or you could buy them in a partnership.
00:05:58.600 | Okay, now what is a partnership?
00:06:01.360 | This is where you get together with 500 or less individuals, other investors, and you
00:06:06.760 | buy a piece of a partnership.
00:06:09.640 | Usually what trades inside of a partnership are things like real estate, private real
00:06:13.760 | estate, not real estate that's traded on the market, venture capital, hedge funds, and
00:06:19.480 | so forth.
00:06:20.480 | It's generally, these partnerships are securities that you can purchase, but they're not very
00:06:27.480 | liquid.
00:06:28.480 | There's usually a general partner who gets paid a fairly high fee.
00:06:32.920 | You'll get your money back eventually, hopefully, and there is a market for these things, but
00:06:39.280 | it's not liquid like the stock market or the bond market.
00:06:43.860 | So partnerships are another way you can pool your money, or really the first way, you pool
00:06:47.820 | your money with 500 or so other people, and you go out and you buy these different things
00:06:53.800 | in the partnership, and now you own a piece of it.
00:06:57.640 | You don't have any say in how the partnership actually works, but you get the cash flow
00:07:00.960 | from it, if there is cash flow.
00:07:02.640 | You get the appreciation if there's appreciation because there's somebody that's managing that
00:07:07.120 | partnership for you.
00:07:09.040 | That's called a limited partnership.
00:07:11.240 | Okay, one more.
00:07:14.000 | Let's go.
00:07:15.600 | Okay, now the next thing is a little bit simpler, and that's called a traditional mutual fund.
00:07:20.880 | These were first created back in 1924, so they've been around now for 100 years, and
00:07:27.040 | here's where a company said, "You know, we can go out and we can buy stocks, and we can
00:07:31.120 | pool them together in one account, and we can invite people to buy into that account,
00:07:36.200 | to buy shares of that account."
00:07:38.120 | Pretty much an unlimited number of people.
00:07:41.080 | So you get a company like a Fidelity, Massachusetts Investment Trust, or any number of mutual
00:07:47.000 | fund companies who create a pool of capital, and they sell shares of that pool to you,
00:07:57.400 | and it's liquid on a daily basis.
00:07:59.160 | You can buy these shares at the end of the day.
00:08:01.560 | You could sell them at the end of the next day, and you will own a large number of stocks,
00:08:08.840 | or if it's a bond mutual fund, you'll own the bonds in there.
00:08:12.160 | There's all 4,000 different types of mutual funds.
00:08:16.280 | Some of them are actively managed, like Alan was saying.
00:08:18.960 | Some of them are index funds, and mutual funds are the most common investment in 401(k) plans,
00:08:26.200 | 403(b) plans, 457 plans, things that you have at work.
00:08:31.440 | They're mutual fund investments, traditional mutual funds, and they have liquidity at the
00:08:36.400 | end of the day at what's called net asset value.
00:08:38.640 | Now, there's a manager of that fund, and they charge a management fee.
00:08:42.120 | Some of them are high management fees, and some of them are very low, like the index
00:08:45.880 | fund management fees, and that's how the people who are managing that pot of money get paid.
00:08:50.600 | So this is a mutual fund.
00:08:52.600 | Sometimes there's a commission to buy them.
00:08:55.400 | If it's in your 401(k) or 403(b) or 457 plan, there's not going to be a commission, but
00:09:01.360 | mutual funds are what you'll find in those plans.
00:09:04.840 | All right, the last thing is relatively new.
00:09:08.400 | It's only been around for about, call it 25 years now, I think it is.
00:09:13.400 | It's called an exchange-traded fund, an exchange-traded fund.
00:09:17.760 | This, first and foremost, is a mutual fund.
00:09:21.160 | It's a pot of money that is being managed in stocks or bonds, but the big difference
00:09:26.720 | between an exchange-traded fund and a traditional mutual fund is the exchange-traded fund is
00:09:33.660 | trading shares on the exchange, on an exchange.
00:09:37.760 | During the day when the market is open is when you buy exchange-traded funds and sell
00:09:42.720 | exchange-traded funds, whereas traditional mutual funds, you're buying and selling at
00:09:48.300 | a price that is determined after the market closes, so that's the big difference.
00:09:54.240 | Exchange-traded funds trade on an exchange during the day.
00:09:57.240 | They're kept very tight as far as the value of what the fund is trading at is very tight
00:10:05.520 | to what the market is trading at and the underlying securities they're trading at through this
00:10:10.000 | arbitrage mechanism that actually goes on in the ETF industry.
00:10:14.200 | I don't want to get into the mechanics of it, but just feel pretty safe if you're buying
00:10:17.960 | and selling exchange-traded funds in the middle of the trading day, not at the beginning or
00:10:22.680 | the end, but in the middle of the trading day, that you're going to get fairly good
00:10:25.900 | pricing when you're buying and selling your exchange-traded funds.
00:10:29.940 | This is very popular in taxable accounts, because a lot of people like to get on their
00:10:35.880 | Vanguard account or Schwab account or Fidelity account.
00:10:38.160 | They like to buy something like a bond fund or a stock fund, and they like to know exactly
00:10:42.480 | how much they paid for it right then and there, and you would do that with an exchange-traded
00:10:47.560 | fund.
00:10:48.560 | If you bought a mutual fund in your Schwab account or you bought a mutual fund in your
00:10:51.640 | Vanguard account, you wouldn't know what you paid for it until the end of the day, because
00:10:58.320 | that's when it's priced.
00:11:00.280 | If you're doing rebalancing, which Alan talked about, when the market goes down, you want
00:11:03.700 | to sell bonds and buy more stocks, and when the market goes up, you want to sell some
00:11:08.280 | stock and buy more bonds, and you want to be super quick about how you do that, then
00:11:14.240 | you could do it with exchange-traded funds.
00:11:15.920 | You just get right on your Vanguard account, you get right on your Schwab account or your
00:11:19.000 | Fidelity account.
00:11:20.320 | You could sell a few shares of the stock fund to buy a few shares of the bond fund to rebalance
00:11:25.120 | your portfolio, and you're done.
00:11:28.140 | Most of the brokerage firms don't charge anything for a commission to buy and sell ETFs, but
00:11:32.600 | there is a very small spread between what you would pay for the fund, the shares, and
00:11:38.180 | what you would sell them for, maybe a penny a share.
00:11:44.360 | Those are the mechanisms of getting into the markets, the public markets, the stock market,
00:11:50.600 | bond market, partnership market.
00:11:53.440 | These are the ways that people do it.
00:11:57.120 | Okay.
00:11:58.120 | Now, Alan hit on this a little bit.
00:12:00.400 | I'm going to go into it a little bit more on an advanced slide.
00:12:09.280 | What is the difference between an actively managed fund and an index fund?
00:12:12.520 | Alan hit on this a little bit.
00:12:13.640 | I'm going to dive into it a little bit more.
00:12:16.040 | Why are bogleheads so kind of gung-ho on using index funds rather than active funds?
00:12:23.480 | I'm going to go to the right side first.
00:12:27.280 | Actively managed fund, let's say a stock fund, actively managed is all about beating the
00:12:33.200 | market.
00:12:34.200 | I want to outperform the whole stock.
00:12:36.480 | I want to beat the market, beat the benchmark, and I'm going to put my money in a mutual
00:12:41.840 | fund or an ETF, or I'm going to go out and buy individual stocks that I think are going
00:12:46.600 | to beat the stock market.
00:12:48.000 | They're going to outperform, okay?
00:12:51.640 | Usually if it's a mutual fund or an ETF, the fees internal in that are going to be anywhere
00:12:56.240 | between a half a percent to one percent, so they're going to be fairly high.
00:12:59.600 | You've got to pay a manager, pay a company for their expertise to go out and investigate
00:13:06.240 | all these different companies and decide which companies are going to go up, which companies
00:13:09.840 | are going to go down, how to put together the portfolio and put it into this fund.
00:13:13.520 | I mean, you have to pay for all of that research and management of that actively managed fund
00:13:18.520 | with the hope of outperforming the stock market.
00:13:22.400 | Alternatively, you buy the whole market.
00:13:25.840 | You say, "I don't know how to pick managers who are going to outperform.
00:13:31.360 | I'm not sure the managers know how to pick stocks that are going to outperform," which
00:13:34.880 | I'll show you in a minute, "so I'm just going to buy an index fund, an index fund that covers
00:13:39.360 | the entire U.S. stock market or maybe a portion of the market, like the largest 500 stocks,"
00:13:44.920 | and they call that the S&P 500 because there's about 3,600 stocks on the stock market, so
00:13:50.080 | the largest ones are in the S&P 500.
00:13:54.440 | That's an index fund.
00:13:55.440 | You can buy them for bonds, stocks, commodities, I mean, you name it, but what you're doing
00:14:00.240 | is you're just buying that basically the entire market, and the fee, the money management
00:14:04.680 | fee for the fund manager in the index fund is very, very low.
00:14:09.800 | As Alan was saying, it's 0.03 percent.
00:14:13.160 | They're as low as 0.015, and Fidelity actually has some index funds that have a 0 percent
00:14:18.960 | management fee, so they're really inexpensive.
00:14:21.680 | You get broad diversification, and what's the best part about buying index funds, which
00:14:26.680 | is what the Bogleheads like besides low fee, is that they actually outperform the market.
00:14:33.840 | Here's a little bit of how the S&P 500 index fund is created.
00:14:42.320 | You have all these stocks that trade on the stock exchange, Google, Home Depot, Apple,
00:14:47.360 | you name it out there, NVIDIA, blah, blah, blah, on and on and on, there's 3,600 stocks.
00:14:53.600 | They all trade on a stock market, and that's called the secondary market.
00:14:58.160 | When these things come public, when a company who has never traded stock before comes public
00:15:01.920 | ever, that's called the primary market.
00:15:05.580 | What you see, the Dow Jones Industrial Average, the S&P 500, the NASDAQ, the market is up
00:15:12.040 | today, the market is down.
00:15:13.240 | What we're looking at is what's called the secondary market.
00:15:17.000 | That's the stock that's already public.
00:15:18.920 | It's already out there, and it's trading between buyers and sellers.
00:15:23.340 | That's what's going on on the stock market.
00:15:25.600 | Well, what companies like Standard & Poor's have done is they've kind of ranked these
00:15:30.360 | companies by the largest companies, which may be Apple, to the smallest companies, which
00:15:35.680 | I can't even tell you, Bob's Bicycle Shop or something might be the smallest company,
00:15:40.280 | but they rank them from the largest to the smallest, and what they do is they say, "Let's
00:15:43.840 | take the top 500, generally, I mean, there's a little bit of nuances to this, but take
00:15:48.880 | the top 500 stocks, and let's call that the S&P 500."
00:15:52.600 | Those are the 500 biggest companies, basically, in the United States.
00:15:57.000 | They say, "How did those companies do, relative to their size?"
00:16:01.000 | The big companies are going to count more in the S&P 500 than the number 500 company.
00:16:08.560 | The Apple computer will count more in the S&P 500 than whatever the 500th company is.
00:16:16.440 | Then they take all that, and they rank it, and then every, basically, 15 seconds, they
00:16:21.840 | calculate what the value of the S&P 500 is, and that is an index.
00:16:30.120 | They call it the S&P 500, and when those stocks pay dividend, it gets calculated into the
00:16:33.680 | total return of the index, and this is where you get your indexes.
00:16:37.720 | Standard & Poor's S&P is an index provider.
00:16:41.920 | They provide the index that the index funds are going to track, and so you can have an
00:16:49.640 | index that tracks 500 stocks.
00:16:51.440 | You can have an index that tracks 3,600 stocks, and tomorrow, we're going to be talking with
00:16:56.400 | Jerry O'Reilly, who is the manager of the Total U.S. Stock Market Index Fund, largest
00:17:01.860 | mutual fund in the country, in the world, actually, and it tracks about 3,600 stocks.
00:17:08.600 | Anyway, so here, then, is Vanguard.
00:17:11.960 | Vanguard comes along, and they say, "I want to use your index, S&P, to create a mutual
00:17:17.160 | fund."
00:17:18.360 | So they license the index from S&P, and they get all the data from S&P, and they create
00:17:24.520 | that mutual fund and that ETF.
00:17:29.240 | That is the Vanguard 500 Index Fund, or the Vanguard 500 ETF, so that's how it all works.
00:17:34.640 | The stocks come out first, they trade on this market second, the index providers pick them
00:17:39.400 | up in an index next, and then the fund provider or the fund sponsor, we call them Vanguard
00:17:44.560 | or State Street or Fidelity or Schwab or whomever is doing the index fund, licenses the index,
00:17:52.680 | they create the mutual fund, and they offer those shares to sale to you.
00:17:58.160 | Now, getting back to the performance of index funds versus the active managers.
00:18:04.840 | So who wins?
00:18:05.840 | Are the active managers able to pick stocks?
00:18:08.480 | This is just U.S. large cap stock mutual funds, U.S. small cap stock mutual funds, international
00:18:15.040 | stock mutual funds, real estate mutual funds, government bond mutual funds, corporate bond
00:18:19.680 | mutual funds, and municipal bond.
00:18:21.360 | This is just a sampling of the different categories of mutual funds that are out there.
00:18:28.100 | Over to the right are the percentage of times the index beat the mutual fund.
00:18:37.160 | So the indexes have beaten the mutual fund, and U.S. large cap, over a five-year period
00:18:43.040 | of time, 87% of the time, the index has beaten 87% of the mutual funds out there.
00:18:51.160 | Over a 20-year period of time, 94%.
00:18:54.080 | So if you're going to hold something for a long term, would you rather try to pick that
00:18:57.920 | 6% of the large cap stock active managers and hope that your fund manager is going to
00:19:05.120 | be in that 6% or do you just buy an index fund and you're going to be in the top 10%?
00:19:11.800 | And it's not just large cap, it's small cap, and international, and real estate.
00:19:17.240 | Now we don't have data on 20 years for government bonds, corporate bonds, and municipal bonds,
00:19:21.720 | but if you look, it's the same thing over and over and over again.
00:19:25.200 | Over time, the indexes outperform the active managers.
00:19:29.720 | So if you can buy the index rather than use the active managers, there's a high probability
00:19:36.000 | your portfolio will do better than going out trying to pick managers or pick funds that
00:19:41.940 | are going to outperform.
00:19:44.120 | So that's why we, the Bogle heads, say this makes a lot of sense to us.
00:19:47.880 | Jack Bogle created the first U.S. stock market index fund, that S&P 500 index fund I showed
00:19:52.720 | you earlier.
00:19:53.720 | It has been out since 1976 and it is way up there in the top percentage of large cap funds,
00:20:03.000 | has outperformed almost everything, and you don't have to do anything.
00:20:06.760 | Just buy the index fund.
00:20:09.200 | Now this, by the way, was produced by an independent source, Dow Jones S&P, who provides indexes,
00:20:18.280 | have been gathering this data for years, and so have other companies like Morningstar.
00:20:23.920 | And Morningstar's data shows the same thing.
00:20:26.960 | The same thing.
00:20:27.960 | If you're just buying index funds in all your asset class categories, then you're probably
00:20:33.400 | going to outperform trying to beat the market.
00:20:36.200 | Now I did a study, it's been a while now, but, oh, by the way, one of the reasons why
00:20:41.760 | is because, again, what Alan referred to, the active funds have to charge more money.
00:20:45.480 | They have a lot of people they have to employ to go out and figure out which stocks are
00:20:48.600 | going to go up and which stocks are not, so they end up paying on average about .7 percent
00:20:53.040 | per year is what it costs to have an active fund because there's a lot of people that
00:20:57.240 | need to be paid, whereas an index fund, it's a lot cheaper.
00:21:00.800 | That difference in cost is the major reason, the biggest reason why the index funds over
00:21:06.280 | time outperform the active managers.
00:21:11.080 | Okay.
00:21:13.560 | Last slide.
00:21:15.080 | This is just a study that I did with Alex Benke back 10 years ago now, actually.
00:21:21.320 | I'd like to see it redone because I think the data's even going to be better.
00:21:25.440 | All I did here was say, if all we did was go out and buy three different index funds,
00:21:34.760 | a U.S. stock market index fund that covers the whole entire U.S. stock market, an international
00:21:41.240 | index fund that covers the whole international stock market, and a bond fund that covers
00:21:45.760 | the investment-grade bond market, which is a total bond market index fund, and I just
00:21:51.520 | held those three funds, and that's all that I did, or I went out and I tried to pick a
00:21:58.800 | U.S. stock fund that was going to beat the market, I tried to pick an international fund
00:22:02.320 | that was going to beat the market, and I tried to pick a bond fund that was going to outperform
00:22:05.760 | the market.
00:22:06.760 | Again, this data's from 2012, and it's gotten better.
00:22:10.360 | What is the probability that my portfolio of index funds would outperform that portfolio
00:22:17.480 | of my active funds that I was trying to pick?
00:22:22.880 | And what we found, at least during that period of time through 2012, I think this is, I want
00:22:27.560 | to say a five-year period of time, oh, I'm sorry, it was a ten-year period of time from
00:22:35.640 | 2003 to 2012, that 88 percent of the time, the all-index fund portfolio outperformed
00:22:44.400 | any other strategy that you could have had to try to go out and beat the market, so trying
00:22:48.640 | to pick the active funds.
00:22:50.520 | And as you go out further and further, as you go out 15 years and 20 years, that line
00:22:55.520 | moves all over, these are all the losing portfolios, and these are the winning portfolios.
00:23:00.400 | So even the winning portfolios didn't win by much.
00:23:02.480 | There was a few that really did.
00:23:04.360 | So this is what people are shooting for.
00:23:06.200 | This is what they see.
00:23:07.200 | This is what they're trying to, oh, look at that, these funds beat the market by 2 percent
00:23:11.240 | per year.
00:23:12.240 | Okay, there's a possibility you might pick a fund that beats the market by 2 percent
00:23:17.560 | per year, but there's a low probability that you will, and you have to understand the difference
00:23:23.120 | between possibility and probability.
00:23:26.400 | And in here, with the Bogleheads, we're all talking about the probability.
00:23:30.160 | What's the probability you're going to get to your financial independence?
00:23:33.760 | What's the probability you're going to get to retirement?
00:23:36.060 | If you're using index funds, you have a much higher probability of making more in the markets
00:23:42.300 | than you will if you're using a combination of active funds.
00:23:46.500 | So that's the talk today that I have on investment products and why indexing works and why we,
00:23:54.420 | the Bogleheads, believe in this as part of our philosophy.
00:23:58.540 | So we have, Bogleheads, we have an investment philosophy, and there are 10 points to it,
00:24:02.580 | but here are just four of them that fit into what we just talked about today.
00:24:06.540 | Invest with simplicity.
00:24:08.300 | Don't make it complicated.
00:24:09.660 | Make it easy.
00:24:11.180 | When I leave here, I go next door to the 501 people, and I try to convince them of that
00:24:16.660 | when I debate Paul Merriman on small-cap value investing and factor investing.
00:24:22.280 | Keep it simple.
00:24:24.220 | Secondly, minimize cost and taxes, as Alan talked about.
00:24:29.260 | Keep that down, and you'll do better.
00:24:32.100 | Thirdly, use index funds when possible, and last, stay the course.
00:24:36.580 | Thank you.
00:24:41.140 | (audience applauds)