New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

2019 Edition: Social Security Made Simple | Adding a Fund to Improve Diversification

Quick announcement: the 2019 edition of Social Security Made Simple is now available on Amazon. To be clear, there haven’t been any major changes to Social Security since the Bipartisan Budget Act of 2015, so as with last year’s edition, the updates are relatively minor.

For anybody who has not read the book, the outline is as follows:

Part One: Social Security Basics
1. Qualifying for Retirement Benefits
2. How Retirement Benefits Are Calculated
3. Spousal Benefits
4. Widow(er) Benefits
Part Two: Rules for Less Common Situations
5. Social Security for Divorced Spouses
6. Child Benefits
7. Social Security with a Pension
8. The Earnings Test
Part Three: Social Security Planning (When to Claim Benefits)
9. The Claiming Decision for Single People
10. When to Claim for Married Couples
11. The Restricted Application Strategy
12. Age Differences Between Spouses
13. Accounting for Investment Returns
Part Four: Other Related Planning Topics
14. Social Security and Asset Allocation
15. Checking Your Earnings Record
16. How Is Social Security Taxed?
17. Do-Over Options
Conclusion: Six Social Security Rules of Thumb
Appendix A: Widow(er) Benefit Math Details
Appendix B: The File and Suspend Strategy
Appendix C: Restricted Applications with Widow(er) Benefits

You can find the print edition here and the Kindle edition here.


A reader writes in, asking:

“I started a Roth IRA last year, and I currently own the Vanguard Target Retirement 2060 fund. I am planning to add a second fund this year to improve diversification. What would your suggestion be?”

Short answer: I probably wouldn’t add a second fund.

When the entire portfolio is allocated to an all-in-one fund (such as a target date fund or a Vanguard LifeStrategy fund), you don’t have to do any rebalancing, because the fund does it for you automatically. Once you add a second fund to the mix, you will have to rebalance. And once you’ve decided that you don’t mind rebalancing periodically, you might as well just go with a DIY allocation of individual index funds/ETFs anyway, so that you can get the lower expense ratios relative to an all-in-one fund.

Second, adding a new fund would probably not improve diversification in the sense of spreading your money out over a greater number of underlying securities. With a Vanguard Target Retirement fund, you already own four different “total market” funds (U.S. stocks, international stocks, U.S. bonds, and international bonds). For example, adding an allocation to the Vanguard Value Index Fund or the Vanguard Small-Cap Index Fund wouldn’t add any more stocks to the portfolio, because the stocks owned by those funds are already owned by the Vanguard Total Stock Market Index Fund (and therefore owned by your Target Retirement fund).

That said, some people have allocation preferences that are different from “total market” weightings (e.g., they prefer to overweight small-cap stocks relative to their market weighting). And some people have different allocation preferences among the four “total market” components (e.g., they prefer a larger or smaller allocation to international stocks or bonds than what you’d have in your Target Retirement fund).

But target retirement funds are explicitly designed with the goal of being suitable for the “typical” investor. If you can’t articulate something that would make your needs/preferences different from most other people — if you can’t already articulate a particular reason for you to stray from a simple total market allocation such as the one in your Target Retirement fund — then there’s generally no need to do so.

Why Stock Prices Are Still Volatile in an Efficient Market

A reader writes in, asking:

“Last month Facebook’s price fell because the new European privacy law hurt their advertising revenue. I always see the ‘experts’ saying that we shouldn’t invest in individual stocks because an ‘efficient market’ makes it impossible to pick winners and losers. But the idea that every stock is perfectly priced all the time seems wrong on its face. I can tell you right now that if the U.S. passes a similar privacy law, Facebook’s share price will fall again.”

The idea of an efficient stock market isn’t that the stock market can predict the future. Nobody knows what is ultimately going to happen (either with Facebook or with any other company/industry/country).

That is, the market price for a stock doesn’t mean that this is where the price will stay; it’s simply the consensus best estimate, given the information that is currently available.

By way of analogy, imagine that I’m hosting a raffle, in which the winner gets $100. I’m going to sell exactly 100 tickets to the raffle. How much is each ticket worth?

Each ticket is worth $1, because each ticket has a 1% chance of winning $100. (That is, $100 prize x 1% probability of being the winning ticket = $1 value.)

Of course, the reality is that, of the 100 tickets, 99 of them will turn out to be completely worthless, and one lucky ticket will turn out to be worth $100. But we don’t know in advance which ticket will be the lucky one, so until the raffle actually happens, each ticket is worth $1. (In probability/finance jargon, we say that each ticket has an “expected value” of $1.)

The point of the efficient market concept isn’t that an efficient market would successfully predict which raffle ticket will be the winning ticket. Rather, the point is that an efficient market would successfully price each ticket at $1 prior to the raffle.

With regard to Facebook, there’s a possibility that new regulation will come along that impedes the company’s profitability, in which case the stock will be worth significantly less than it’s worth right now. Or, maybe no such event will occur, and the company’s stock price will rise back to what it was before all the hullaballoo.

But because we don’t yet know what’s going to happen, an “in the middle” price is the current consensus price, even though everybody knows it will ultimately turn out to be wrong (i.e., even though everybody knows the value of the company will ultimately turn out to be more or less than the current market value — just like everybody knows that none of the raffle tickets will ultimately be worth $1).

Investing in Your Earning Potential

A reader writes in, asking:

“Does it ever make sense to slow down the rate at which I’m saving for retirement, or even put it on hold completely, in order to direct money toward expenditures that could increase my income? I suspect that putting money toward additional education in my field would have a good payoff. But I also know that saving and investing is particularly powerful when I’m young. How would one actually go about doing such an analysis?”

To the first question: yes.

Investing in your own earnings potential is often a very good idea (e.g., by getting a particular certification, license, or degree in your line of work, or by putting money into a business that you’re starting), even if it means putting off saving for retirement for a brief period. This is especially true for people early in their career, because the increased earnings will be in effect for many years.

I did this myself, a little over 10 years ago. There was a period of almost two years (around age 23-24) when my wife and I saved nothing for retirement, because we were putting money into my publishing business. The business was growing, and it seemed likely that additional funding would pay off — and it has. The resulting increase in our income has significantly exceeded the return that we would have achieved via additional 401(k) savings. (Plus, now I get to do work that I find much more enjoyable than what I was doing before.)

How to Calculate a Projected Return

If you want to actually make a comparison of rates of return, you first need to come up with a year-by-year estimate of the cost and the payoff from the investment you’re considering. In some cases you may be able to find good statistics on the topic (e.g., how much more, on average, do people in your field with a particular certification earn than people without that certification?).

Then you can use the IRR function in Excel to calculate the rate of return from the projected cash flows. The tutorial in the previous link explains how to use it, but it’s pretty straightforward. You type the projected cash flows in a column of cells, with the cash outflows (i.e., the money you expect to spend) as negative values and the cash inflows as positive values.  Then, in another cell, you use the “IRR” function, selecting the range of cells that includes your projected cash flows (e.g., “=IRR(A1:A17)”).

Then you can compare the calculated return from your projection to the return you would expect from additional investment in your portfolio. (Important note: in each case, you want to adjust the cash flows to account for taxes. For example if you expect an additional $10,000 per year of income, and you have a 25% combined state/local marginal tax rate, you’d enter $7,500 as the expected cash inflow in each cell.)

It varies quite a bit from one case to another, but it’s not at all rare for the rate of return from career-related expenditures to greatly exceed the rate of return you could expect from regular stock/bond investing.

How Risky Is It?

It is important, however, to recognize that comparing a projected rate of return from career-related spending to the rate of return you would expect from additional retirement savings isn’t an apples-to-apples comparison, as the risk level may be quite different.

For instance, if you’re a 23-year-old accountant, getting your CPA certification is very likely to substantially improve your earnings over the course of your career. Frankly, this is probably less risky than putting money into a stock index fund.

Conversely, investing a lot of money into an entrepreneurial endeavor can be super high-risk. You’re essentially buying a single stock (i.e., an undiversified investment), and it’s a riskier stock than your typical publicly traded company. (See, for instance, this cautionary tale I recently encountered of a man whose failed restaurant endeavor cost him his house.)

But, in summary, yes, investments in your own earnings potential are worth considering, even if they would require you to put saving for retirement on pause for a brief period. And this is especially true if:

  1. You are early in your career, and
  2. The hoped-for increase in earnings is very likely to actually occur (i.e., it is not especially speculative).

Worrying about Market Declines and High Valuations

A reader writes in, asking:

“The stock market’s tumble over the last week combined with the fact that stock valuations are still so high makes me wonder about the appropriate way to respond. Time to take some money off the table? I suspect I know what you’ll say, but I’m interested to hear anyway.”

The total U.S. stock market (as measured by the Vanguard Total Stock Market Index Fund, VTSMX) fell by less than 10% last week. If that made you super nervous, that’s a good indication that your stock allocation is too high. A 10% decline should not be a big deal — especially when it comes after a 9-year bull market during which the value of U.S. stocks rose by roughly 400%.

If a decline of less than 10% makes you nervous at all, imagine how you’ll feel about a 30%, 40%, or 50% decline. The goal of asset allocation is to craft a portfolio with which you’d be able “sit tight” (or possibly even rebalance into stocks) during a full-blown bear market.

Making Use of Market Valuations

It’s true that the stock market is still highly valued relative to historical norms. (This should not be a surprise, given the huge returns over the last 9 years.)

But how useful is that information for the purpose of predicting returns going forward?

The following chart shows the correlation between the S&P 500’s valuation (as measured by PE10) and its inflation-adjusted returns for periods of various lengths from 1926-2017. As you would expect, the correlation is always negative, which means that the higher the market’s valuation at any time, the lower we should expect returns to be going forward.

Valuations and Returns

But the correlation between PE10 and ensuing short-term returns has been pretty weak. For instance, the correlation coefficient between PE10 and 1-year returns is just -0.22. The correlation is quite a bit stronger if we look at 10-year real returns (-0.63 correlation) or 20-year real returns (-0.75 correlation).

In other words, valuation levels are not very good at predicting short-term market returns. They are much better at predicting longer-term returns.

But even if we have good reason to suspect poor returns over the next, say, 10 years, a 10-year period of poor returns could come in a lot of forms. The market could be roughly stagnant, with inflation taking a toll. Alternatively, we might see another 7 years of gangbuster returns, followed by a super bad bear market for 3 years. Or we might see a 2-year bear market, followed by 4 years of good returns, then another 4-year bear market. And so on. (Or, the next 10 years could be a period for which valuation isn’t even predictive in the first place! A negative 63% correlation is still far from perfect.)

Point being, we never know what’s about to happen in the near term. So valuations aren’t very useful for trying to “dodge” a bear market, so to speak.

But because they do have decent predictive power over the long-term, valuations are useful for questions such as, “how much should I be saving per year?” And, “how much can I afford to spend per year in retirement?”

And with today’s high valuations, we should expect pretty modest returns — suggesting that high savings rates (for those in their accumulation years) and low spending rates (for those in their retirement years) are probably prudent. This was true a year ago, and it’s still true today.

Financial Planning Priorities

A reader writes in, asking:

“I am getting my financial house in order for the first time. I have no debt and a good income, but have not paid much attention to investing until now. A friend directed me to your blog and to the bogleheads website, but I am finding it all to be overwhelming. Do you have any suggestions for which topics to read about/focus on first?”

The Bogleheads forum is filled with investing enthusiasts. As such, there are several advanced topics that get a lot of discussion there, which most people can safely ignore. For example:

  • Should you use international bonds?
  • Should you use “smart beta” funds?
  • Should you tilt toward small/value/momentum/profitability?
  • Should you include corporate bonds in the portfolio? A TIPS fund?
  • Should the bonds be short-term, intermediate-term, or long-term?
  • How often should you rebalance to your target allocation?

When getting started, most people should ignore all of the above topics and simply start with a “three fund portfolio,” or possibly even a low-cost “all-in-one fund” (e.g., a Vanguard Target Retirement fund).

In fact, most people should never spend any time thinking about the above topics, because:

  1. There’s a limited amount of time that they’re willing to devote to financial planning, and
  2. There are other financial planning topics that are much more important.

For example, all of the following financial planning to-do items are more important than the asset allocation questions listed above.*

  • Basic insurance planning (i.e., making sure you have appropriate health insurance, life insurance if anybody is dependent on you for income, disability insurance unless you’re retired, etc.)
  • Budgeting (i.e., selecting a spending/saving rate that’s appropriate relative to your income/assets)
  • Basic portfolio allocation (i.e., stock/bond allocation, as well as making sure there isn’t too much in one single stock)
  • Basic estate planning
  • Basic tax planning
  • Social Security planning (if near retirement)
  • Minimizing portfolio costs (i.e., making sure to use funds with low expense ratios)

It’s only after taking care of all of these items that it would make any sense to think about things like whether or not your portfolio should include “smart beta” mutual funds. And even for people who have taken care of these other financial planning to-do items, there’s still no need to spend time thinking about all of those advanced asset allocation questions. In nearly all cases, it’s perfectly fine to stick with that simple “three fund portfolio” — or even the single all-in-one fund in some cases.

*I’ve attempted to order this list roughly from highest to lowest priority. The exact order of priority will vary from one person to another though. For example, if you’re unmarried and have no kids, estate planning would be a lower priority than it would be for somebody with children. And estate planning would be an especially high priority for a married couple who each have children from a prior marriage.

What Does an Investment Portfolio Need?

I recently encountered a conversation about the characteristics of a good portfolio. The person speaking (whom I didn’t know) had a long list, but it got me thinking about what I would include on such a list.

I came up with only three things. (That is, only three characteristics that make a portfolio strictly better than a portfolio that does not have those characteristics.)

  1. Diversification,
  2. Low costs (including tax costs, if applicable), and
  3. An appropriate overall level of risk.

With regard to diversification, the most critical thing is diversification among individual holdings (unless we’re talking about FDIC-insured CDs or Treasury bonds, for which diversification isn’t needed). Point being: Don’t set yourself up for financial catastrophe if a single company goes out of business. Also helpful, but less important, is diversification among asset classes — have some stocks and some fixed-income.

With regard to costs, the lower you can get the better. But it’s important to think in dollars rather than proportions. For instance, the difference between an expense ratio of 0.8% and an expense ratio of 0.2% is much greater than the difference between 0.2% and 0.05%, even though in each case the less expensive option is 1/4 as costly as the more expensive option. On a number of occasions I’ve heard from people considering changing fund companies in order to shave just a few hundredths of a percent off their average expense ratio. It would be rare for such a change to be worth the hassle for anything other than a very large portfolio.

When it comes to choosing an appropriate level of risk, it’s important to know that this is a very rough thing. Your risk tolerance isn’t something that can be measured precisely. In addition, your risk tolerance will change over time. (And the riskiness of different combinations of investments changes over time too!) Finding something that feels “approximately right” for you is as good as you’re ever going to get here.

The reason I’m such a big fan of index funds (and/or ETFs) is that, in most cases, it’s easier to achieve each of the three goals above by using index funds. Index funds are typically very well diversified, with very low costs. And it’s easy to achieve any particular level of risk with index funds. But the above goals certainly can be achieved with actively managed funds. Vanguard, for instance, has a long list of actively managed funds with super low costs.

For many investors — myself included — “simplicity” would also be on the list of characteristics that improve a portfolio. And simplicity is also aided by the use of index funds or ETFs. But I’ve left it off the list because some people truly do not care about it. They’re perfectly happy to manage portfolios with 10 different funds across several different accounts. And there’s nothing wrong with that.

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2019 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security