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The Higher Your Income, The More Obliviously You Should Invest

Mike’s note: While I do not ordinarily publish guest articles, I recently invited Jim Dahle to write something for Oblivious Investor readers, and he was kind enough to oblige, with the following article.

A recent article by Tadas Viskanta, discussing a book entitled Scarcity: Why Having Too Little Means So Muchpromotes the idea that we all have limited psychological “bandwidth.” Much like your computer runs slower when you’re running a dozen programs in the background, so does your mind and life run more poorly when your bandwidth is heavily taxed.

One method of “freeing up bandwidth” is to put your investing plan on autopilot — to invest “obliviously,” as Mike frequently discusses on this blog. Doing so frees you from having to worry about picking stocks, watching active mutual fund managers for the inevitable downturn, evaluating “alternative” investments, and timing the market. As Michael LeBoeuf famously said, “Invest your time actively and your money passively.”

Aside from freeing up bandwidth, a simple investing plan also frees up a great deal of time. My life, for example, became abnormally busy recently. I normally work as an emergency physician full-time and also run an increasingly busy website/blog called The White Coat Investor, where I help doctors and other high income professionals get a “fair shake” on Wall Street. However, in addition to these two jobs, I recently wrote and self-published my first book, The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.

Becoming busier was a very gradual process, but I finally realized I had simply run out of bandwidth. The final straw was when I took my laptop to work one night in the hopes that if the Emergency Room got really slow, perhaps I could deal with some of the 50 or 100 emails I had received that day. As those of you who have had the misfortune to visit an ER are probably well aware, it isn’t exactly a slow-paced job. When your life gets so busy that a job in an ER is the only place left from which you can steal some time in order to balance everything else out, you know you’re in trouble.

When you run out of bandwidth, something has got to give. You don’t want it to be your family or your career. Putting your investment portfolio on autopilot is not only likely to lead to higher long-term returns, but also frees up valuable bandwidth for you to use in the rest of your life, on things that really matter.

High-income professionals like doctors, lawyers, and business owners are even more likely to benefit from an oblivious investing plan than someone in a more typical career field, because their time can be used to generate money at a very high rate. It makes little sense to spend hours trying to eke out a little extra return on the portfolio when those hours could be better spent simply earning more money and increasing the amount contributed to the investment account — especially early in the career when the portfolio is small and the business is growing.

Some choose to hire an investment manager in order to free up this time and bandwidth. That is certainly a reasonable option, if you use a low-cost adviser who uses a smart investing strategy. But choosing a simple, low-cost investing strategy and putting it on autopilot will not only cost you less time and money, but counterintuitively, may also lead to better after-expense portfolio returns in the long run. The higher your income, the more obliviously you should invest. You can spend that time and bandwidth better elsewhere.

In Praise of Balanced Funds

As regular readers have probably noticed, Darrow Kirkpatrick of Can I Retire Yet is one of the writers most frequently included in my weekly roundups. I’ve been enjoying his writing since I first encountered it, so when I met Darrow in person at the Financial Blogger Conference this year, I invited him to author a guest article for this site. I hope you enjoy it.

Balanced funds are mutual funds that combine stocks and bonds into a single investment. Generally they stick to a fixed asset allocation, within certain ranges. Balanced funds have traditionally been favored by conservative investors looking for safety, income, and modest growth. In a word, they’re boring!

For most of my journey to early retirement, I had no interest in balanced funds. I dabbled in individual stocks, then gradually shifted to passive index funds during my heavy accumulation years. Towards the end of that time, as I focused more on safety and retirement income, balanced funds appeared on my radar.

At some point I took a small position in Vanguard Wellesley Income. Then something curious happened. Whenever I had free cash to invest, I’d scrutinize my existing holdings plus my investing “wish list.” After some research, number crunching, and pondering, I’d often just put the money in Wellesley Income! Over time, that one fund has grown to constitute about one-third of my portfolio.

Why did I keep choosing this one balanced fund? Because, regardless of the economic cycle, market cycle, or my own personal life cycle, it was nearly always an appealing investment.

The bond component of a balanced fund tends to dampen out the volatility of the stock market. A balanced fund won’t rise quite as high in the good times, but it will fall far less in the bad times, and you’ll generally make back those dips in reasonable order. So, over time, a balanced fund can limit the stock market’s swings, while delivering much of its returns.

And, while it’s not guaranteed, the stock component of a balanced fund makes the fund more likely to keep up with inflation than a bank CD, a bond, or a bond fund.

Helping You Avoid Mistakes

Another research-documented reason to like balanced funds: They help you to avoid common behavior that leads to investing mistakes.

To appreciate the evidence for this, you first need to understand the concept of investor returns as distinguished from fund returns. We’re all familiar with the annual returns that mutual funds report in their glossy ads. But investor returns are what the average investor actually earns from the fund.

Why would those numbers be different? Consider a fund that has a great quarter and goes up 5% early in the year. That’s approximately a 20% annual return. Investors see that great return and pile in. Then the fund flat lines for the rest of the year. So it winds up the year by earning 5%, while most of its investors earned nothing. That’s investor returns.

In 2011 Morningstar completed a study on the gap in investor returns — how individual investors do compared to their funds’ overall returns. Here’s a snapshot of what they found: In 2010, the average domestic stock fund earned a return of 18.7% compared with only 16.7% for the average fund investor — a 2% difference. For the trailing three years, that gap was 1.28%.

However it was a different story for balanced funds: The gap between investor and fund performance in 2010 was only 0.14%, and just 0.08% for the trailing three years. Results were even better for the trailing 10 years. And results were similar for target-date funds and moderate- and conservative-allocation funds — close kin to balanced funds. As anybody who has crunched retirement numbers knows, a 1-2% difference in annual return over long periods can easily add up to tens of thousands of dollars!

Why do individual investors do better when they are buying and holding balanced funds? It’s probably because balanced funds don’t tend to incite fear or greed — two emotions that can be lethal to investment performance. Balanced funds are easier to live with.

It’s like the difference between a family sedan and a race car. The race car might have awesome performance, in the right hands. But, for those of us who aren’t full-time professional drivers, there are much better vehicles for driving around a city. It’s the same with investing: For most people, a vehicle with predictable behavior, that they can handle, will produce better results. [Mike’s note: That’s my bolding.]

Using a Balanced Fund In Your Portfolio

Should a balanced fund (or a target-date or allocation fund) make up your entire portfolio? That’s a viable option for many. But it may not be possible, given the investment choices in your retirement plan. Or you might want the level of control offered by individual index funds or ETFs. But a balanced fund could still play a useful anchoring role in your portfolio, while serving as a mechanism to diversify or automate part of your rebalancing strategy. That’s how Wellesley Income functions in my portfolio.

Which balanced fund might be best for you? Vanguard Wellington and Wellesley Income have long and enviable track records, and have worked well for me. But note these are actively managed funds. While they have extremely low expenses — 0.25% for Wellesley Income investor shares and 0.18% for Admiral shares, for example — their managers do trade positions in an attempt to enhance performance. Mike makes a good case for the passive index-based Vanguard LifeStrategy Moderate Growth Fund, largely because of the increased international exposure. And if I had it to do over, I’d probably choose one of the LifeStrategy funds too.

In the end, only you can choose what’s right for you. But, whatever you decide, remember this principle: your long-term investing behavior is far more important to success than the exact investments you pick, the exact asset allocation you choose, or the rebalancing strategy you implement. As it turns out, balanced funds just make it easier for you to behave well!

Darrow Kirkpatrick is an author, software engineer, and investor who retired at age 50. He now writes regularly about saving, investing, and retiring at Can I Retire Yet? He is married to a schoolteacher, has a son in college, and is an experienced rock climber and enthusiastic mountain biker.

Vanguard Spotlights Simplicity?

Mike’s note: This is a guest post from Nisiprius — a prolific, anonymous member of the Bogleheads forum from whom I (and many other investors) have learned a great deal. When he’s not sharing his wisdom with us, he is a semiretired software engineer who lives in the New England area.

John C. Bogle once wrote, “the key to whatever success I may have enjoyed… is that the Lord gave me enough common sense to recognize the majesty of simplicity.”

Recent changes in Vanguard’s website look to me as if Vanguard has tightened its focus on indexing and on simplicity for personal investors.

But isn’t “Vanguard advocates indexing” the non-story of all time?

Maybe not. Vanguard has always had a dual personality. It was clearly visible in the “core funds” web page as it appeared for many years:

Vanguard used to include nine funds in their “core” category. Besides Prime Money Market, the other eight were perfectly split between index funds (Total Bond Index, Balanced Index, Total Stock Market Index, and Total International Stock Index) and actively managed funds (Short-Term Investment-Grade Fund, Wellesley Income, Wellington, and Diversified Equity).

Vanguard’s New “Core”

Today, however, Vanguard names only four “core funds”: Prime Money Market, Total Bond, Total Stock, and Total International. They suggest a decision framework that calls for first choosing a stock/bond/cash asset allocation, then implementing it with these funds.

On Vanguard’s personal-investors’ website today, almost all roads lead to Total Bond, Total Stock, and Total International — either directly or via “all-in-one” funds-of-funds which are mostly simple three-fund portfolios of the core funds.

Actively managed funds are out of the spotlight.

Vanguard’s actively managed Wellington Fund used to be as famous as its Five Hundred Index Fund. (The Wellington Fund antedates the founding of Vanguard by quite a bit. Want a thrill? Go to Morningstar’s main page, type VWELX in the “quote” box, click on “more” above the growth chart, and then “maximum” on the expanded chart — and stand back. Seriously, take a look.)

Today, a retail investor who begins at Vanguard’s main page and starts exploring is probably not going to find Wellington unless she is looking for it. You can find it by searching by name or by looking at the “all funds” table, but you are not likely to stumble across it by clicking your way through Vanguard’s fund decision pathways.

A few years ago, Vanguard routinely issued nuanced statements about complementary roles for active and index funds. In 2007, Vanguard’s chief investment officer, Gus Sauter, published a paper entitled “A Framework for Developing the Appropriate Mix of Indexing and Active Management.” Using Modern Portfolio Theory and efficient frontier charts, he said “These analyses demonstrate the asset allocation advantages to an investor of combining index and actively managed funds. They also further the rationale for an overall core-satellite approach, comprising index funds for the core and actively managed funds as satellites.”

But now, Vanguard’s new core funds page does not invite investors to think in terms of “core” and “satellites.” In the Bogleheads forum, the phrase “three-fund portfolio” is used to refer to a portfolio which uses only basic asset classes — usually a domestic stock ‘total market’ index fund, an international stock ‘total market’ index fund and a bond ‘total market’ index fund. The core fund page is now an illustration of how to build exactly this kind of three-fund portfolio.

Vanguard’s All-in-One Funds

If we look elsewhere, we notice that (for example) Vanguard’s Target Retirement 2040 fund is, literally, a three-fund portfolio: Total Stock, Total Bond, and Total International. This is a stunning contrast to the complex compositions of other firms’ target-date funds:

  • T. Rowe Price Retirement 2040 uses 10 funds,
  • ARDVX American Century LIVESTRONG 2040 uses 13,
  • MFS Lifetime 2040 uses 16,
  • American Funds 2040 Target Date uses 17,
  • Schwab Target 2040 uses 19, and
  • Fidelity Freedom 2040 uses no less than 20 funds.

It’s worth noting that, until 2010, Vanguard’s Target Retirement funds were slightly more complex — owning three separate funds (Europe, Pacific, Emerging Markets) in the place of Total International.

The same theme is evident in recent changes to Vanguard’s LifeStrategy funds. These funds-of-funds are all-in-one portfolios for specific life stages or specific degrees of risk tolerance that hold a stable allocation over time. However, they used to include a significant slice of the Vanguard Asset Allocation fund, a “tactical asset allocation” fund that shifted back and forth between stocks and bonds in response to “quantitative models.” Because the LifeStrategy funds owned this Asset Allocation Fund, they also shifted stock exposure up and down. In late 2011 however, Vanguard revamped these funds and they are now, yes, simple three-fund portfolios with fixed allocations.

The retail website does have a path guiding the investor to Vanguard’s Managed Payout funds, which do not fit the pattern. They use a university-endowment-like strategy and employ nontraditional assets, and tactical allocation. Launched in 2008, they hit a perfect storm, and to date have attracted only $0.747 billion in assets. They are certainly not “simple three-fund portfolios.” Nevertheless, each invests over half of its portfolio in, you guessed it, Total Stock, Total Bond, and Total International.

How far does Vanguard’s emphasis on the four “core funds” go?

If I’ve added the right things, the “total assets” numbers for Prime Money Market + Total Bond + Total Bond II + Total Stock + Total International add up to $510 billion. That’s a huge number, but it’s only 30% of Vanguard’s total holdings of $1,700 billion. And by one count Vanguard offers more actively managed funds (67) than index funds (53).

But Vanguard, at least as it presents itself to retail investors on its website, seems to be shining the spotlight on their huge “core” index funds, and on three-fund portfolios made from them. It looks like a rededication to “the majesty of simplicity.”

Components of Investment Risk

The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.

Time as a Component of Risk

When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.

For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.

Why is he thinking about that?

He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.

When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.

Probability of Loss

The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.

Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.

Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.

Magnitude of Loss

The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.

Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.

Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.

When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.

In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.

About the author: Neal Frankle is a Certified Financial Planner in Los Angeles and runs Wealth–a personal finance blog for people interested in making smart decisions about their money.

Roulette ETFs For Today’s Market Conditions

Mike’s note: Since I first found my way to the Bogleheads forum, one of the members I’ve most looked up to is an anonymous writer by the name of nisiprius. He’s always impressed me with his wit and insight, so when he offered a guest post in reply to last week’s “asset allocation comes first” article, I jumped at the chance to publish it. I hope you enjoy it. 😉

Investors are taking a fresh look at roulette ETFs, which invest in bets on roulette wheels at casinos. Roulette gambling has long been used by hedge funds and university endowments, but was formerly out of reach of individual investors due to the time and cost of travel, and the difficulty of diversifying among casinos. But ETFs now provide low-cost access to this asset class.

Bram Stoker, senior analyst at Transylvania Capital Management, says “roulette spins have been shown to have low correlation with stocks, making them a powerful diversifier in a portfolio.”

It is important to understand the differences between roulette ETFs, because they don’t all work in the same way, so look under the hood before deciding which of them you need to add to your portfolio today.

Mike’s note: I’m 95% confident you’ve all figured this out by now, but just in case: This article is a satire, poking fun at (among other things) the product-focused nature of the mainstream financial media.

Index roulette ETFs, such as Roquefort’s ROQ, simply bet on red and black equally. Roquefort uses random numbers generated by a proprietary atomic decay device, and cites academic research that claims this reduces the standard deviation compared to traditional selection methods.

Roquefort also offers two chromic strategy ETFs: REDS, which always bets on red, and BLAK, which always bets on black. Stoker notes that these are riskier: “Be sure you know which color you like before investing.” Roquefort has just introduced OO, which bets on the double zero. The potential for 3500% returns is attractive, but Roquefort notes that due to volatility it may not be suitable for all investors, only for better-than-average investors like you.

Nisiprius Investments Ltd. says that its global roulette fund, WHEE, places bets in Monaco, Macau, Antigua, Baden-Baden, Moscow, and Sun City, South Africa. We talked to fund manager Blaise Pascal, who said “Why are you pestering me with all these silly questions? It’s global, what more do you need to know? Global! Global! Global! Do you hear me, global!”

Strategic Cluster Asset Modeling is a new entrant, providing two actively managed ETFs, CLUS and CLUD. CLUS follows a progressive cluster roulette gambling system, backtested with 40,000 spins. Spokesperson Mary Martingale says it could offer the possibility of a conceivable potential for steady winnings regardless of what the wheel does. CLUS is only for sophisticated investors. The minimum investment is $250,000, and you must include a photograph and three letters of recommendation with your application. CLUD, the 2X leveraged version of CLUS, has a minimum investment of $500,000 and you must send two photographs and six letters of recommendation, and the existing shareholders can blackball you. With $1.35 million assets under management, CLUD is off to a fast start, and both of its shareholders think the world of it.

What is an appropriate roulette allocation? “We are currently recommending allocations of 5-10% to all our clients,” says Stoker. “We think roulette will prove to be a valuable addition to their portfolios. We follow market trends closely, and if roulette doesn’t pan out we’ll have other hot asset classes to recommend, but what with the end of QE2, the sideways trend in the VIX, and uncertainty about the possible end of the world, our analysts think roulette is the place to be today.”

I asked Stoker whether the house percentage could cause the long-term return of roulette funds to show a long-term trend in any particular direction. He replied “Investors who limit their portfolio to assets with positive long-term returns are pathetic losers who are going to miss out. An asset may do nothing but lose money, yet improve the portfolio as a whole. Some guy once won a Nobel prize for showing how bonds help stocks. The correlations for roulette are even lower! You must not consider roulette in isolation, you must consider how it works in the portfolio as a whole.”

Which of these roulette ETFs will you add to your portfolio? Only you can answer that question. But you better add at least one of them. Today!

Questions for New Investors

Mike’s note: I get a lot of questions from new investors. Often, the person is somewhat bewildered about investing in general and is having trouble figuring out where to start.

To that end, I invited my friend Matt–who was in a similar position just a few years ago–to share some of the questions he had when he was new, as well as the answers that he’s settled on as he’s gotten started investing.

Should I pay off debt or invest?

As a general rule of thumb, if the interest rate on your debt is higher than what you expect to earn by investing, pay off that debt as your first investment. Eliminating high-interest debt is a no-risk, high-return investment.

In fact, it might even be reasonable to work on wiping out all debt ASAP. For example, I consider myself to be particularly debt averse: I look at paying off debt as an investment in security. If I lose my income, the less debt I have, the less pressure I’m under. I’m willing to accept somewhat lower returns in exchange for that security.

Should I contribute to my 401(k) while in debt?

Contributing toward your employer-matched retirement plan is a special circumstance when it comes to investing. Think about it this way: If someone approached you on the street and offered to match the dollar amount currently in your wallet if you promise to save it, would you let them do it or would you tell them you can’t because that money is going toward debt?

It’s good to pay yourself first, but it’s even better to let others pay you first.

After you’ve contributed enough to get the maximum employer match, then go ahead and use any surplus to get out of debt. (Paying off debts in order from highest to lowest interest rate.)

Should I buy individual stocks?

Investing in individual stocks is tempting. There’s the possibility of striking it rich–a possibility that just doesn’t exist with broadly diversified index funds.

Still, I’ve chosen to build my portfolio using index funds and ETFs. Two good reasons for choosing index funds and ETFs over individual stocks are:

  • Easy diversification: Just a few funds gives me a diversified portfolio. With individual stocks, diversification requires many more holdings.
  • Less work: There’s no need to watch for news about the companies I own.

But what about stock tips?

If the tip is legit, unless you’re a market insider, chances are pretty good that the info has already been exploited by the time it gets around to you. I advise leaving individual stock ownership to day traders and professionals and sticking to something simpler and easier to understand.

Should I buy bonds?

Given that stocks have historically earned higher returns than bonds, many new investors wonder whether it makes sense to hold any bonds at all. The answer: Yes. Bonds are more secure than stocks, and even a small amount can significantly reduce volatility in a stock-heavy portfolio.

Because I am 35 I hold a fairly aggressive portfolio: 80% stock index funds, 10% bond index funds, and 10% physical precious metals. For my bond position I’ve chosen to use a Treasury bond fund because Treasury bonds are very secure. Using a Total Market bond fund would also be a reasonable choice. Just understand that if you do that, you will be investing in some higher-risk bonds as well.

If you are closer to retirement or more risk averse, it’s probably wise to hold a greater percentage of bonds than the 10% position I presently hold.

Should I buy precious metals?

Precious metals look quite appealing given the returns they’ve earned over the last couple years. But past isn’t always prologue when it comes to investing.

That said, I do actually hold physical silver with a small portion of my portfolio. But it’s not because I’m hoping to get lucky with amazing returns. Rather, I own silver as a sort of insurance policy against a collapse scenario for our debt-based fiat currencies. I prefer physical silver to precious metal ETFs or gold, neither of which would be as useful in such a scenario.

In closing…

If there is something I missed–and I’m sure there is–leave your question in the comments. I’ll answer to the best of my ability.

Matt Jabs set out on a passionate adventure to get out of debt back in January of 2009. He writes about personal finance at and about healthy self-reliance at Subscribe to his blog here.

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