I received a great question about investing from one of my readers, Jason Phillips. Jason asked whether I agree with Jack Bogle, founder of the mutual fund giant, Vanguard Group, who espouses long term investments in low cost index mutual funds in his book, Common Sense on Mutual Funds. Thank you for the question, and the answer is, yes I do.
Frankly, I’ve never read Mr. Bogle’s books, however I am very familiar with his philosophy. Most of our family’s investments are with Vanguard. The reason for this is that Vanguard has always offered very low cost index mutual funds, and since my approach to investing is based on long term exposure to the investment markets at the lowest possible cost, Vanguard has always been my go-to firm. Here is why.
- Having an appropriate exposure to different investment markets is the foundation of any investment strategy. The amount of money that you have invested in stocks versus bonds is the primary driver of both your investment return as well as the variability of your portfolio’s value. The more you have invested in stocks, the higher the return, but the higher the variability of the value of your investments. The more you have invested in bonds, the lower your returns and the lower the variability of your portfolio’s value. What is appropriate exposure depends on how long you have until you need to spend your money.
- If exposure to the markets is our foundation, then the most direct route to achieving that foundation is to invest in those markets. Index mutual funds provide the performance of the investment market index they are designed to mirror at a low cost. For example, the Vanguard 500 Index Fund tracks the S&P 500 Index with an expense ratio of 0.17%, or less than 17 cents per $100 invested. If the S&P 500 is up by 5.0% in a year, I can reasonably expect my investment in the Vanguard 500 Index Fund to be up by 4.83% (the index performance less the mutual fund expenses). In fact, the Vanguard fund has performed a bit better than index returns less expenses. There are index funds to provide exposure to most major markets, and most mutual fund companies have at least some index funds.
- Active management guarantees a return that is different than the market. Active management is an investment strategy that seeks to out perform a particular market index. To achieve this, the manager either tries to select better performing underlying investments (such as stocks) or reduce exposure to the market at key points with the goal of avoiding losses (market timing), or both. Managers of active investment strategies believe they will perform better than the market over time, and because their strategies are more labor intensive and involve more transactions, the expenses for these strategies are higher. However, because they are investing differently than their market index, there is a chance that the investments will perform worse than that index. Imagine performing worse and paying more. Several studies indicate that active mutual fund managers do not consistently perform better than index funds.
- Investing for the long term is the best way to achieve your investment goals. Over weeks, months or even several years, the direction of investment markets is highly unpredictable. In the short term, the movements of markets reflect headlines, but in the long term the value of investments reflect the actual performance of the economy and the companies the markets represent. Moving in and out of markets risks performing worse than sticking with your strategy over time. The old investment adage, “the market can be wrong longer than you can be solvent” is a reminder of how difficult timing investments can be. If nothing else, the simple cost of frequent trading reduces the potential return.
These four principles are what has driven our family’s investment strategy. If you saw my portfolio, you might be shocked at how simple it is. We hold a small number of mutual funds designed to provide the right market exposure for us. Much of our holdings are in a single fund that we’ve owned literally for decades. The fund is the Vanguard LifeStrategy Growth fund, a fund that invests across an array of global stock market indices. The only reason that we have more than this one fund is that as we neared the end of our working careers we needed to add exposure to bond markets to reduce our overall investment risk. Adding bonds with new deposits instead of trading to a different fund allowed us to avoid realizing capital gains and reduced our tax bill.
The secret to our success in meeting our financial goals was persistence. We saved according to our plan each and every year. We stuck with our investment strategy whether the market was up or down, and we avoided mistakes and expenses through investing for the long term in low cost index mutual funds. It really does work.