This post contains my notes for the Bogleheads’ Guide to Investing. I find the ideas in the book mostly match what I am following and there are also a few new things that I learn.

The basic thrust of The Bogleheads’ Guide to Investing is “Choose a sound financial lifestyle. Start early and invest regularly. Know what you’re buying. Preserve your buying power. Keep costs and taxes low. Diversify your stock portfolio [and diversify your stock risk with a bond portfolio].”

Take the below steps before starting investment

  • Graduate from the paycheck mentality to the net worth mentality: It’s not how much you make, it’s how much you keep.
  • Pay off credit card and high-interest debts.
  • Establish an emergency fund: for most people, six months’ living expenses is probably adequate.

Start early and invest regularly

  • Rule of 72: To determine how many years it will take an investment to double in value, simply divide 72 by the annual rate of return. For example, an investment that returns 8 percent doubles every 9 years (72/8 = 9).
  • Buying on margin is not a prudent risk. Speculators buy an investment with the hope of selling it quickly and turning a fast profit. Speculating is similar to gambling. Investment requires planning, commitment, patience, and long-term thinking.
  • Finding the money to invest
    • Save at least 10% from the paycheck
    • Create a tax-free fortune, e.g. contributing to a Roth IRA
    • Commit future pay increases to investing
    • Shop for used items, e.g. depreciation in the first few years of a car’s life is the greatest cost of owning one.
    • Move where the cost of living is cheaper
    • Create a side income
    • Not all debt is bad debt. The key is to keep interest rates low, preferably tax deductible, and borrow funds only when the expected payoff is higher than the cost of borrowing.

Know what you are buying

Bonds

Bonds is essentially lending money to the bond issuer, who promises a return that is the bond’s yield to maturity and the return of the face value of the bond at maturity date.

  • Treasury issues: safest bond, backed by the US government, includes Bills, Notes, Bonds, Treasury Inflation-Protected Securities (TIPS), and two types of U.S. Savings Bonds (EE Bonds and I Bonds). Treasury interest income is exempt from state and local taxes.
    • T-Bills, T-Notes, and T-Bonds
      • Treasury issues of one year or less are known as Treasury Bills, or T-Bills.
      • Issues of 2, 3, 5, and 10 years are called T-Notes.
      • Issues for periods greater than 10 years are known as T-Bonds.
      • Together, all of these issues are often simply referred to as Treasuries.
    • TIPS:
      • offer protection against the ravages of inflation.
      • the guaranteed rate is established by the marketplace at the Treasury’s TIPS auctions
      • guaranteed rates are usually higher than I Bond fixed rates
      • Tax-deferred
    • US Savings Bonds:
      • have a minimum one-year holding period
      • tax-deferred for up to 30 years.
      • EE Bonds come with a minimum guaranteed yield of 3.526 percent if held for 20 years, since they are guaranteed to at least double in that time period.
      • Tax free for all qualifying educational expenses.
    • I Bonds (the ‘I’ stands for inflation) (compare with TIPS for inflation protection)
      • US saving bonds, issued by the US Treasury with a fixed rate.
      • Yield is divided into two components:
        • The first component of the yield is the fixed or real rate that’s in effect when you purchase the I Bond. This real rate is the amount you’ll receive over and above inflation, and it remains the same for the life of the bond (up to 30 years).
        • The second component of the yield is a variable inflation-adjustment rate that’s recalculated and announced twice annually, in May and November. This variable rate is based on the rate of inflation over the six-month measuring period just prior to the adjustment dates, as measured by the CPI-U.
      • IRS taxes both parts of the return.
      • Tax-deferred for up to 30 years.
  • Government Agency Securities: pools of mortgage-backed securities (MBS) issued by a number of government agencies that investors can purchase, either directly or via bond mutual funds
  • Corporate Bonds
  • Municipal Bonds:
    • State and local governments sell bonds to pay for various government and/or government-approved projects.
    • Normally free from federal taxation, and free from taxes in the state of issue. Use “Taxable-equivalent Yield Calculator” to compare with non-tax free investment.
    • Some municipal bond issues are subject to the IRS Alternate Minimum Tax (AMT).

If you are to sell the bond in the secondary market prior to maturity, keep in mind that bond and bond fund values move in the opposite direction of interest rates. When interest rates increase, the value of bonds and bond funds decreases. However, the yield of the bond fund will increase, and, over time, that increased yield will help to mitigate the loss in value caused by those very same rising interest rates.

Guidelines to select a bond fund:

  • Find a bond fund that matches your investment time horizon.
  • Don’t time interest rate hikes.
  • Match your fund to your risk tolerance.

Guidelines to determine how much to invest in bonds:

  • Mr. Bogle suggests that owning your age in bonds is a good starting point. So, a 20-year-old would hold 20 percent of his/her portfolio in bonds.
  • Increase your percentage of bond holdings if you are a more conservative investor.

Mutual Funds

Mutual funds pool money from lots of investors to buy securities, including stocks, bonds, money market instruments, and other types of investments.

Mutual fund management styles:

  • Indexing: attempts to replicate as close as possible the return of a particular benchmark, such as the S&P 500, the Wilshire 5000, or the Barclay’s Capital Aggregate Bond Index. The index fund managers generally do not buy stocks and bonds that are not in their benchmark, and they hold individual stocks and bonds in proportion to the weight of the stock or bond in the benchmark.
  • Active management: attempt to select stocks and bonds that they hope will result in their fund outperforming their benchmark, or achieving returns similar to the benchmark but with less risk. Usually has higher costs.

Advantages of Mutual Funds:

  • Diversification
  • Professional management
  • Low minimums
  • No loads or commissions
  • Liquidity
  • Automatic reinvestment

Funds of funds

A single mutual fund that meets their desired asset allocation and these offerings invest in other mutual funds, normally from the same company, and usually include stock, bond, and money market mutual funds

Annuities

An investment with an insurance wrapper. Usually not worth buying.

  • Fixed Annuities: an insurance product that pays you a specific rate of return for a specified period of time (usually one to five years). Often, the fixed annuity offers a short-term high initial rate and accompanied by “gotcha” lower subsequent rates and high surrender fees (penalties) that can last for up to 10 years. Offers tax deferral. Backed by the insurance company.
  • Variable Annuities: an insurance contract that allows you to invest in a limited number of sub-accounts (clones of mutual funds). Most have surrender fees, often lasting for many years. Expenses tend to be high. Offers tax deferral. No need to buy inside an already tax-deferred retirement plan. Not tied to the performance of the insurance company.
  • Immediate Annuities: In exchange for a sum of money from you, the insurance company will promise to pay you a specific amount of money, on a regular basis, for the remainder of your lifetime. Backed by the insurance company.

Exchange-traded funds / ETFs

Basically mutual funds that trade like stocks on an exchange. Low cost. Need to buy with a broker that may charge a commission.

How much to save?

There are a lot of different financial calculators available online that estimate how much to save to reach the retirement goal. Example: bankrate retirement calculator.

Keep It Simple: Make Index Funds the Core, or All, of Your Portfolio

Empirically, passive investing has at least 70 percent chance of outperforming any given financial pro over an extended period of time. And over some 20-year periods, passive investing outperforms as many as 90 percent of actively managed funds.

Index investing requires practically no time or effort and outperforms about 80 percent of all investors. An index fund attempts to match the return of the segment of the market it seeks to replicate, minus a very small management fee. For example, Vanguard’s Index 500 seeks to replicate the return of the S&P 500; the Total Stock Market Index seeks to replicate the return of a broad U.S. stock market index; and the Total International Index seeks to replicate the return of a broad cross-section of international stocks. In addition to stock index funds, there are bond index funds that seek to replicate the performance of various bond indexes. There are also index funds of funds that hold various combinations of stock and bond index funds.

Advantages of index fund:

  • No sales commissions
  • Low operating expenses: usually the expense ratios are under 0.5%
  • Tax efficient: Every time an active fund sells a profitable stock, it creates a taxable event that’s passed on to the investor. Index funds however have very little turnover.
  • No need to hire a money manager: because it’s so simple
  • Higher diversification and less risk
  • Little consequences as to who manages the fund
  • Style drift and tracking errors not a problem

Only consider investing in no-load funds with annual expense ratios of 0.5 percent or less, the cheaper the better.

There are two basic types of index funds: index mutual funds and exchange-traded funds (ETF). We believe that the vast majority of investors will be better off buying index mutual funds rather than ETFs.

Asset Allocation

Efficient Market Theory (EMT): an investment theory that states that it is impossible to ‘beat the market’ because existing share prices already incorporate and reflect all relevant information.

Modern Portfolio Theory (MPT): a mixture of volatile noncorrelated securities could result in a portfolio with lower volatility and possibly higher return.

the Brinson, Hood, Beebower Study: the portfolio manager’s attempts to actively manage their fund cost the average fund a 1.10 percent reduction in return compared to just buying and holding an index composed of the S&P 500 Index, Shearson Lehman Government Corporate Bond Index, and 30-day Treasury Bills (cash).

2003 Vanguard Group study: 77 percent of the variability of a fund’s return was determined by the strategic asset allocation policy. Market timing and stock selection played relatively minor roles.

Risk tolerance

If you think you would sell out of fear because the market is down, your portfolio is unsuitable for you. On the other hand, if you can honestly say, “No, I wouldn’t sell because I’ve learned that U.S. bear markets have always come back higher than before,” your portfolio is probably suitable for your risk tolerance.

The sleep test is a great way to help determine if your asset allocation is really right for you. When setting up an asset allocation plan, investors should ask themselves: “Can I sleep soundly without worrying about my investments with this particular asset allocation?” The answer should be yes

Subdividing your stock allocation

Specialty stock funds include gold, technology, health, energy, utilities, and many more. Specialty funds are often volatile because they concentrate on relatively few stocks in specific industries that often go in and out of favor. We suggest that your total allocation to sector funds not exceed 10 percent of the equity portion of your portfolio.

Real Estate Investment Trusts (REITs) are a special type of stock. REIT funds often behave differently than other stock funds. This characteristic of noncorrelation can make them a worthwhile addition to larger portfolios. We suggest that REIT funds not exceed 10 percent of your equity allocation.

International stocks

U.S. stocks represent about half the value of world stocks, with foreign stocks representing the other half. Foreign stocks offer diversification and possibly higher returns, but they also carry more risk in the form of political instability, weak regulation, higher transaction costs, and different accounting practices. A foreign stock investment is really two investments — one in stocks and one in currencies. Both elements provide additional diversification to a domestic portfolio.

We believe that investors will benefit from an international stock allocation of 20 percent to 40 percent of their equity allocation.

Subdividing your bond allocation

A single low-cost short- or intermediate-term, good-quality (broad-based and diversified) bond fund should be adequate for small investors. The bond fund should have a duration equal to or less than the expected time frame needed to meet your goal.

We do not include high return bonds, also known as junk bonds, for several reasons:

  • Bonds are primarily for safety. Stocks are primarily for higher return (and risk). Junk bonds muddy the important distinction, thereby making risk control more difficult.
  • Taxable high-yield bonds are among the most tax-inefficient of all securities.
  • It’s more efficient (higher return per unit of risk) to invest in stocks, rather than high-yield bonds.
  • High-yield bond funds are more closely correlated to stocks. Thus, they offer less diversification benefit than do traditional bond funds.

TIPS provide diversification and protection from unexpected inflation. If you decide to include a Vanguard TIPS fund in your portfolio, you can choose between VIPSX with its higher expected risk and return, and VTAPX with its lower expected risk and return.

  • A Young Investor’s Asset Allocation
    • Domestic large-cap stocks 55%
    • Domestic mid/small-cap stocks 25%
    • Intermediate-term bonds 20%
  • A Young Investor Using Vanguard Funds
    • Total Stock Market Index Fund 80%
    • Total Bond Market Index Fund 20%
  • A Middle-Aged Investor’s Asset Allocation
    • Large-cap domestic stock fund 30%
    • Small/mid-cap funds 15%
    • International funds 10%
    • REITs 5%
    • Intermediate-term bond fund 20%
    • Inflation-Protected Securities 20%
  • A Middle-Aged Investor Using Vanguard Funds
    • Total Stock Market Index Fund 45%
    • Total International 10%
    • REIT 5%
    • Total Bond Market Index Fund 20%
    • Inflation-Protected Securities 20%
  • An Investor in Early Retirement
    • Diversified domestic stocks 30%
    • Diversified international stocks 10%
    • Intermediate-term bonds 30%
    • Inflation-Protected Securities 30%
  • An Investor in Early Retirement Using Vanguard Funds
    • Total Stock Market Index Fund 30%
    • Total International Index Fund 10%
    • Total Bond Market Index Fund 30%
    • Inflation-Protected Securities 30%
  • An Investor in Late Retirement
    • Diversified domestic stocks 20%
    • Short- or intermediate-term bonds 40%
    • Inflation-Protected Securities 40%
  • An Investor in Late Retirement Using Vanguard Funds
    • Total Stock Market Index Fund 20%
    • Short-Term or Total Bond Market 40%
    • Inflation-Protected Securities 40%

Costs Matters: Keep them low

Load funds

  • Front-end sales commission (load): paid a when they purchase their fund shares. The load reduces the amount of money actually invested.
  • Deferred sales charges: often called back-end loads. The most common type of back-end load is a contingent deferred sales load, or CDSL. The total amount of the load paid by the investor will depend on how long the investor holds their shares. CDSL charges typically decrease to zero if the investor holds his or her shares long enough. A fund or class with a contingent deferred sales load will typically also have an annual 12b-1 fee.

Avoid load funds.

No-Load Mutual Funds costs

  • Purchase fees
  • Exchange fees
  • Account fees
  • Redemption fees
  • Management fees
  • 12b-1 fees: paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses
  • Other fees: custodial expenses, legal expenses, accounting expenses, transfer agent expenses, and other administrative expenses.

Fees not covered by the prospectus

  • Hidden transaction costs: caused by fund turnover, include brokerage commissions, bid-offer spreads, and market impact costs.
  • Brokerage commissions
  • Soft-dollar arrangements: a commission for providing added benefits to the fund manager.
  • Spread costs: the difference between the market maker (dealers and specialists) bid and ask prices
  • Market impact costs: Extra cost to attract enough sellers or buyers when buying or selling securities in large blocks
  • Turnover: refers to the amount of buying and selling activity that’s done by the fund manager in a given year. Studies have found that funds with a low turnover (lower costs) have a higher average return than similar funds with high turnover (higher costs). Prefer funds with low turnover.
  • Wrap fees: imposed by brokerage firms, sold to investors who want a private money manager of their own. Avoid the wrap.

Taxes

  • Stock dividends: possibly a major source of fund returns. “Qualified” ones are taxed at lower rates than ordinary income tax rates. Recommend placing stocks in taxable accounts.
  • Bond dividends: taxed at the marginal (highest) income tax rate. Recommend placing bonds in tax-deferred accounts.
  • Capital gains: occurs when a stock or bond is sold for a profit.
    • Realized Capital Gains and Losses
      • If the sum of all profits and losses is a net profit, the capital gains will be reported on IRS Form 1099-DIV.
      • If the result is a net loss, the fund manager will carry forward the excess losses to offset gains in future years.
    • Funds may have unrealized gains or losses.
    • A short-term capital gain is a profit on the sale of a security or mutual fund share that is held for 12 months or less. Taxed as ordinary income at the shareowner’s highest marginal income tax rate.
    • A long-term capital gain is a profit on the sale of a security or mutual fund share that is held for more than one year. Has a maximum tax rate of 15 percent.

Tax efficiency recommendations:

  • Favor funds with low dividends.
  • Favor funds with “qualified” dividends.
  • Favor funds with low turnover.
  • Favor tax-efficient index funds and tax-managed funds.

Relative Tax Efficiency Ranking for Major Asset Classes (the first one is the most tax efficient):

  • Tax-exempt (muni) bonds
  • EE and I bonds
  • Tax-managed stock funds
  • Most stock index funds
  • Large-growth stocks
  • International stocks
  • Large-value stocks
  • Small-cap stocks
  • Small-value stocks
  • Stock-trading accounts
  • Balanced funds
  • REIT funds
  • Inflation-protected securities (TIPS)
  • Taxable domestic bonds
  • International bonds
  • High-yield bond funds

Tax-managed funds reduce or eliminate shareholder taxes by using a variety of tax-reduction techniques:

  • Low turnover.
  • Use HIFO (highest-in, first-out) accounting. This keeps capital gains, which are passed through to shareholders, to a minimum.
  • Tax-loss harvesting. This is a strategy in which the manager sells losing stocks to accumulate tax losses, which can later be used to offset capital gains from winning stocks.
  • Selecting low-dividend paying stocks.
  • Holding securities for long-term gains.
  • Use redemption fees. Tax-managed funds frequently require redemption fees in order to discourage shareholders from selling profitable shares, resulting in capital gains and unnecessary trading costs.

Strategies to tax-manage your own portfolio:

  • Keep turnover low
  • Use only tax-efficient funds in taxable accounts.
  • Avoid short-term gains.
  • Buy fund shares after the distribution date. Mutual funds pay taxable distributions at least annually. If we wait until after the distribution date, the value of our purchase will still be the same (assuming no market change), but we will avoid the tax on the distribution.
  • Sell fund shares before the distribution date.
  • Sell profitable shares after the new year. There’s usually no sense in paying taxes any earlier than we have to.
  • Harvest tax losses. This is the practice of selling losing securities in taxable accounts for the purpose of obtaining tax losses to reduce current and future income taxes. If you decide you want to repurchase your losing fund, you must wait 31 days to avoid a disallowance of your tax loss—called a wash sale.

Bonds in taxable account

  • Municipal bond funds: invests at least 80 percent of its assets in federal tax-exempt bonds. You need to calculate the comparable yield of an equivalent taxable bond fund and compare.
  • US savings bonds (I and EE Bonds): tax-deferred for up to 30 years, and are free from state and local taxes.

401(k) Plans

  • Employer contributions to deferred compensation plans are not reported on the employee’s W-2 forms and are not reported as income on the employee’s income tax return. However, they are included as wages subject to Social Security, Medicare, and federal unemployment taxes.
  • One of the big problems with many 401(k) plans is their high cost. Many employees (and their employers) don’t know the true costs associated with their plan. Most costs never show up on the plan participant’s statements.
  • 401(k) Summary Plan Description (SPD) will tell you what the plan provides and how it operates.
  • Every 401(k) plan files an annual report on a series Form 5500. This contains information regarding the plan’s assets, liabilities, income, and expenses. But it will not show the expenses deducted from investment results, or fees and expenses paid by your individual account. Fees paid by your employer will also not be shown.
  • Suggestions:
    • Invest in your 401(k) up to the company match.
    • If eligible, invest in an IRA up to the maximum.
    • Contribute to the 401(k) up to the maximum.
    • Additional funds should go into tax-efficient mutual funds.

403(b) Plans

  • Designed for nonprofit entities such as schools, universities, churches, and certain charitable organizations.
  • Similar to 401(k), tax-deferral and allow matching contributions with maximum limits.
  • Choice of investments is the biggest disadvantage. Most offer only high-cost annuities sold by brokerage and insurance firms.
  • It is possible that your plan has an escape hatch allowing you to move your money to an outside low-cost 403(b) plan provider such as Fidelity, T. Rowe Price, or Vanguard.

Traditional Individual Retirement Account (IRA)

  • A personal savings plan that gives tax advantages while saving for retirement. Contributions to a traditional IRA may be tax deductible, though it does not get taxed until it’s distributed. The earnings are not taxed until they are distributed.
  • All IRA withdrawals (except for Roths) are taxable at the investor’s marginal income tax rates. There is a 10 percent tax penalty for withdrawing money if the distribution takes place before the retirement, except for certain cases.
  • Factors favoring a traditional IRA
    • You expect your income in retirement to be less than it is now.
    • You expect your future tax rate to be lower.
    • You need the tax deduction now.
    • Traditional IRAs may provide better protection from creditors.

Nondeductible Traditional IRAs

  • Two disadvantages (except for Roth IRA):
    • turn capital gains into higher-taxed ordinary income
    • require the filing of IRS Form 8606 to track your contributions and tax basis.

back-door Roth

  • Investors can contribute to a traditional IRA or a nondeductible IRA, and then immediately convert that to a Roth IRA

Roth IRAs

  • Another type of personal saving plans.
  • Contributions to a Roth IRA are not tax deductible. Withdrawals are not taxed.
  • Factors favoring a Roth IRA
    • You expect your future tax rate to be higher.
    • Roth IRA savings are worth more. The reason is that the Roth IRA contains after-tax dollars, which are more valuable than the pretax dollars in a regular IRA.
    • You want access to your funds. Roth IRAs incur no penalty on early withdrawal of contributions
    • Withdrawals are not reportable income; therefore, they do not affect Social Security payments or increase adjusted gross income.
    • No required minimum distribution (RMD) at age 70½. This allows continued growth for the benefit of heirs.
    • Eligible contributions can be made at any age, unlike traditional IRAs where contributions must stop at age 70½.
    • Heirs pay no income tax on proceeds, as they do with traditional IRAs.

Rebalance

Rebalancing is the act of bringing the portfolio back to the target asset allocation after market forces or life events have changed the percentages of the asset classes and segments.

Rebalancing forces us to sell high and buy low. Rebalancing may also improve the returns, since asset classes have had a tendency to revert to the mean (RTM) over time.

When to rebalance:

  • Time based, quarterly, semiannually, annually, 18 months.
  • Percentage changes. Requires more frequent monitoring. Can create short-term capital gains.

How to rebalance:

  • For those who need current income, withdraw funds from the asset class that’s had the hot hand (selling high).
  • Direct new money into funds that are below the target asset allocation.
  • Rather than have the distributions reinvested in a fund that may already be overweighted, have the distributions in your taxable account directed to your money market account, and then redirected to the fund that needs it for rebalancing.

Other things to consider when rebalancing:

  • Rebalance your tax-deferred account first, whenever possible, since there are no tax consequences.
  • Consider getting rid of any fund(s) that no longer fit into your overall plan.
  • If you’re in the withdrawal phase, use both voluntary and/or required distributions from your tax-deferred account to help rebalance your portfolio.
  • Use tax-loss harvesting in your taxable account as part of your rebalancing strategy. If you have losers to sell, then sell them prior to December 31, so you can get the tax benefits on this year’s tax return.
  • If you have winners to sell in your taxable account, you might want to wait until after January 1 to sell in order to push the tax bill into the following year.
  • The more frequently you rebalance your portfolio by selling profitable funds in your taxable account, the sooner you’ll pay taxes on any profits.
  • Consider owning a fund of funds that meets your desired asset allocation requirements, such as one of the LifeStrategy or Target Retirement series from Vanguard that automatically handles the rebalancing chore.

Insurance

Common insurance mistakes:

  • Insuring the unimportant while ignoring the critical
  • Insuring Based on the Odds of Misfortune
  • Insuring against specific, narrow Occurrences. E.g. plane crash insurance, health care policy against a specific desease.

Key rules for being properly insured

  • Only insure against the big catastrophes and disasters that you can’t afford to pay for out of pocket. The cheapest insurance is self-insurance.
  • Carry the largest possible deductibles you can afford. The larger the deductible, the more you are self-insuring and the cheaper the premium will be.
  • Only buy coverage from the best-rated insurance companies. You need insurance companies you can depend on when you need to file a claim.

Recommended insurances:

  • Life insurance: for everyone, buy term insurance, which is basic pay-as-you-go, no-frills insurance.
  • Healthcare coverage: for everyone
  • Disability insurance: breadwinners
  • Property insurance in case of fire, theft, or other disasters
    • Think of replacement cost
    • Make a list of all personal possessions or make a video
  • Auto insurance
  • Liability protection against expensive lawsuits
  • Long-term care: older family members