The Little Book of Common Sense Investing

While an index-driven strategy may not be the best investment strategy ever devised, the number of investment strategies that are worse is infinite.

But I also fear, again deep down, that very few investors will follow that approach—the essence of simplicity—for their entire investment portfolio. You must now be as exhausted as I am by the unremitting pounding of my theme that simplicity is the answer and that complexity simply doesn’t work. But we investors seem all-too-willing to ignore the verities described in this book. Instead of index funds, we opt for costly active funds and trade them to excess. Why? We are sold funds more often than we buy them. We have far too much self-confidence. We crave excitement. We succumb to the distraction that is the stock market. We fail to understand the arithmetic of investing, and the arithmetic of mutual funds.

I cannot tell you whether betting on a particular manager who pursues an active investment strategy will win or lose in the future. But I can guarantee that it hasn’t worked very well in the past. To be sure, there are lots of smart, engaging, purposeful money managers and financial advisers. And all of the activity that seems endemic to the investment business can be exciting and enticing. But after all is said and done, there are no surefire solutions for investment success—wealth without risk, if you will. It’s just not a realistic expectation. Nonetheless, building an investment portfolio can be exciting, and trying out modern remedies for age-old problems lets you exercise your animal spirits. If you crave excitement, I would encourage you to do exactly that. Life is short. If you want to enjoy the fun, enjoy! But not with one penny more than 5 percent of your investment assets.

That can be your Funny Money account. But at least 95 percent of your investments should be in your Serious Money account. That core of your program should consist of at least 50 percent in index funds, up to 100 percent. What about your Funny Money account? Enjoy the fun of gambling and the thrill of the chase, but not with your rent money and certainly not with college education funds for your children, nor with your retirement nest egg. Test, if you will, two or three aggressive investment strategies. You’re likely to learn some valuable lessons, and it probably won’t hurt you too much in the short term. Here are seven Funny Money approaches, and my advice about using them:

1. Individual stocks? Yes. Pick a few. Listen to the promoters. Listen to your broker or adviser. Listen to your neighbors. Heck, even listen to your brother-in-law.

2. Actively managed mutual funds? Yes. But only if they are run by managers who own their own firms, who follow distinctive philosophies, and who invest for the long term, without benchmark hugging. (Don’t be disappointed if the managed fund loses to the index fund in at least one year of every three!)

3. “Closet index” funds whose returns are tied closely to the returns of the stock market and that carry excessive costs? No.

4. Exchange traded funds? Those that track defined industry sectors that exclude the field in which the family breadwinner earns his or her living? Maybe. Those that hold the classic index portfolio? Ye s . But in the Serious Money account. Whatever the case, don’t speculate in ETFs. Invest in them.

5. Commodity funds? No. Of course, there will be commodity bubbles that will attract you only after they have inflated to absurd proportions. But unlike stocks and bonds, commodities have no fundamentals to support them (neither earnings and dividends nor interest payments).

6. Hedge funds? No. Too much hype. Too much diffusion of performance among winners and losers. Too many different strategies. Too many successful managers who won’t accept your money. Too much cost and too little tax efficiency. The management fees are so high that they often destroy even the small chance you have of winning. (The hedge fund, it is said, is not an investment strategy but a compensation strategy.)

7. Hedge funds-of-funds? No. Really, no. If a regular hedge fund is too expensive, just imagine a fund of hedge funds that lays on another whole layer of expenses.

In your Serious Money Account, 50 percent to 95 percent in classic index funds. In your Funny Money Account, not one penny more than 5 percent.

If you decide to have a Funny Money Account, be sure to measure your returns after one year, after five years, and after ten years. Then compare those returns with the returns you’ve earned in your Serious Money Account. I’m betting that your Serious Money will win in a landslide. If it does, you can then decide whether all that fun was adequate compensation for the potential wealth you’ve relinquished.

Fun, finally, may be a fair enough purpose for your Funny Money account. But how, you ask, should you invest your Serious Money Account—that 50 percent to 95 percent of your assets which you now depend on, or will one day depend on, for retirement? Use an index fund strategy. Even better, use it for 100 percent of your assets.

The fact that few of you are likely to go that far doesn’t mean it isn’t the best strategy. Here, listen to Warren Buffett: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” (Don’t forget that indexing is also, for most investors, the best way to own bonds.)

While I favor the pristine and classic all-U.S.-stock-market and all-bond-market approach, there are perfectly reasonable alternative strategies for supplementing the index funds in your Serious Money portfolio. Kept within limits, here are some acceptable variations:²⁴

• An international flavor: While international businesses comprise more than 30 percent of the revenues and profits of U.S. corporations, many investors seek a larger global participation. Although foreign stocks account for about one-half of the world’s market capitalization, I recommend that they account for no more than about 20 percent of your own equity portfolio. By far the soundest way to acquire that participation is to hold (no surprise here!) a low-cost total international index fund that tracks the returns of all non-U. S. corporations. A modest holding in a low-cost emerging market index fund is also a reasonable approach, but be sure you understand the risks.

• Slice-and-dice: Impressed both by the long-term performance (and recent performance) of value stocks and small-cap stocks, some investors hold the all-market (or S&P 500) index fund as the core, and add a value index fund and a small-cap index fund as satellites. I’m skeptical that any kind of superior performance will endure forever. (Nothing does!) But if you disagree, it would not be unreasonable to hold, say, 85 percent in the core, another 10 percent in value, and another 5 percent in small-cap. But doing so increases the risk that your return will fall short of the market’s return, so don’t push too far.

• Bond strategy: The all-U.S.-bond-market portfolio remains the bond investment of choice. It holds investment-grade corporate bonds, mortgage-backed securities, and U.S. Treasurys, and has an intermediate-term maturity in the range of 5 to 10 years. Yet we all differ in our liquidity preferences, income requirements, and tolerance for volatility. Combining a mix of index funds linked to short-term, intermediate-term, and long-term bonds in varying amounts is a sound way of honoring these preferences. I don’t recommend money market funds in this mix (they are for savings, not for investment), but rather favor short-term bond funds for investors who lean toward greater short-term stability of principal and in return are willing to accept less durability of income over the long term.

• Inflation protection: Inflation-linked bonds provide excellent protection against the long-term erosion of the purchasing power of the dollar, particularly in tax-deferred accounts. The U.S. Treasury offers these bonds in various maturities, which pays a basic interest rate (currently about 2.4 percent on the 10-year Treasury note) and is adjusted for inflation (currently expected to be about 2.3 percent). This all-in yield totals 4.7 percent, the same as the regular 10-year Treasury. The difference is that if inflation rises (or for that matter, falls), the total return that you earn will reflect the change. Since the value of Treasury note at maturity is deemed risk-free, there is no need for the diversification of an index fund. If you prefer a bond fund owning inflation-linked bonds, choose only the lowest-cost funds (in effect, an index strategy).

• Asset allocation: How much in stocks? How much in bonds? Asset allocation is almost universally considered the most important determinant of your long-term investment return. Most of us will want more stocks when we’re young, have relatively small assets at stake, many years to recoup losses, and do not depend on investment income. When we’re older, we’re likely to prefer more bonds. If we’ve planned intelligently and invested wisely, our asset accumulations have grown to substantial size; we have far less time on our side; and when we have retired we will rely on our portfolios to produce a steady and continuing stream of income. My favorite rule of thumb is (roughly) to hold a bond position equal to your age—20 percent when you are 20, 70 percent when you’re 70, and so on—or maybe even your age minus 10 percent. There are no hard-and-fast rules here. (Most experts think my guidelines are too conservative. But I am conservative.)

• Balanced index funds: Since the formation of the first balanced index fund in 1990 (60 percent total U.S. stock market, 40 percent total U.S. bond market), many variations on that theme have been created. First came Life Strategy Funds, each with a fixed allocation ranging from roughly 20 percent to 80 percent in stocks (often with a moderate international allocation), and the remainder in U.S. bonds. More recently, Target Funds have come to the fore. Here, investors can begin with an allocation appropriate to their age, which inches gradually toward a more conservative allocation as they approach the retirement age they have targeted. Such gradual rebalancing makes considerable sense. Essentially, your allocation strategy is on automatic pilot for your lifetime. The most effective way to implement this strategy is through target funds investing in stock and bond index funds. Such a strategy is likely to be carefree (even boring), just as it is likely to be enormously productive. The low-cost index fund is especially important today in your asset allocation strategy. With the equity premium—the spread between the prospective stock return (about 7 percent per year) and prospective return on the U.S. 10-year Treasury Bond (now less than 5 percent)—at only about 2 percent, you can eat your cake and have it too. For index funds can deliver virtually that entire premium to investors. In contrast, even costs as low as 2 percent per year for an actively managed equity fund would erase the entire premium. Under these circumstances, for example, a fund investor with 75 percent stocks in an active equity fund and 25 percent in bonds would earn a net annual return of 5 percent per year. But an investor in a passive equity fund, pursuing a far more conservative 50/50 strategy, would earn 6 percent. Twenty percent more return with 33 percent less risk would seem to be an offer that’s too good to refuse.

For all the inevitable uncertainty amidst the eternally dense fog surrounding the world of investing, there remains much that we do know.

As you seek investment success, realize that it’s never given to us to know what the returns stocks and bonds will deliver in the years ahead, nor the future returns that might be achieved by alternatives to the index portfolio. But take heart. For all the inevitable uncertainty amidst the eternally dense fog surrounding the world of investing, there remains much that we do know. Just consider these commonsense realities:

• We know that we must start to invest at the earliest possible moment, and continue to put money away regularly from then on.

• We know that investing entails risk. But we also know that not investing dooms us to financial failure.

• We know the sources of returns in the stock and bond markets, and that’s the beginning of wisdom.

• We know that the risk of selecting specific securities, as well as the risk of selecting both managers and investment styles, can be eliminated by the total diversification offered by the classic index fund. Only market risk remains.

• We know that costs matter, overpoweringly in the long run, and we know that we must minimize them. (We also know that taxes matter, and that they, too, must be minimized.)

• We know that neither beating the market nor successfully timing the market can be generalized without self-contradiction. What may work for the few cannot work for the many.

• We know that alternative asset classes such as hedge funds aren’t really alternative, but simply pools of capital that invest—or overinvest or disinvest—in the very stocks and bonds that comprise the portfolio of the typical investor.

• Finally, we know what we don’t know. We can never be certain how our world will look tomorrow, and we know far less about how it will look a decade hence. But with intelligent asset allocation and sensible investment selections, you will be prepared for the inevitable bumps along the road and should glide right through them.

Our task remains: earning our fair share of whatever returns that our business enterprises are generous enough to provide in the years to come. That, to me, is the definition of investment success. The classic index fund is the only investment that guarantees the achievement of that goal. Don’t count yourself among the losers who will fail to outpace the stock market. You will be a winner if you follow the simple commonsense guidelines in this Little Book.

Don’t Take My Word for It

The ideas in this closing chapter seem like common sense to me, and perhaps they seem like common sense to you as well. But if you have any doubt, listen to their echo in these words by Clifford S. Asness, managing principal of AQR Capital Management. “We basically know how to invest. A good analogy is to dieting and diet books. We all know how to lose weight and get in better shape: Eat less and exercise more . . . that is simple—but it is not easy. Investing is no different. . . . Some simple, but not easy, advice for good investing and financial planning in general includes: diversify widely . . . keep costs low . . . rebalance in a disciplined fashion . . . spend less . . . save more . . . make less heroic assumptions about future returns . . . when something sounds like a free lunch, assume it is not free unless very convincing arguments are made—and then check again . . . stop watching the stock markets . . . work less on investing, not more. . . . In true Hippocratic fashion: Do No Harm! You do not need a magic bullet. Little can change the fact that current expected returns on a broad set of asset classes are low versus history. Stick to the basics with discipline.”

The wisdom of Cliff Asness is in fact age-old. Consider these thoughts from Benjamin Franklin, the master of common sense and simplicity. “If you would be wealthy, think of Saving as well as Getting. . . . Remember that time is money. . . . Beware of little Expenses; a small Leak will sink a great Ship. . . . There are no Gains, without Pains. . . . He that would catch Fish, must venture his Bait. . . . Great Estates may venture more, but little Boats should keep near shore. . . . Tis easy to see, hard to foresee. . . . Industry, Perseverance, and Frugality make Fortune yield.”

The simple ideas in this chapter really work. A few years ago, I received this letter from a Vanguard shareholder holding our 500 Index Fund and Total Stock Market Index Fund, several of our managed equity funds and taxable and tax-exempt bond funds, and a diversified list of individual stocks.

“Most of my shares were purchased when you were chairman. I am 85 years old and have never earned more than $25,000 a year. I started investing in 1974 with $500. I have only bought—never sold. I remember when things were not going well, your advice was ‘stay the course.’ ” He enclosed a list of his investments at the start of 2004: Total value, $1,391,407.

As a dyed-in-the-wool indexer, of course, I believe the classic index fund must be the core of that winning strategy. But even I would never have had the temerity to say what Dr. Paul Samuelson of M.I.T. said in a speech to the Boston Society of Security Analysts in the autumn of 2005: “The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel and the alphabet.” Those two essentials of our existence that we take for granted every day have stood the test of time. So will the classic index fund.

While an index-driven strategy may not be the best investment strategy ever devised, the number of investment strategies that are worse is infinite.

In your Serious Money Account, 50 percent to 95 percent in classic index funds. In your Funny Money Account, not one penny more than 5 percent.

Reasonable alternative strategies for supplementing the index funds in your Serious Money portfolio.

For all the inevitable uncertainty amidst the eternally dense fog surrounding the world of investing, there remains much that we do know.