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I ONCE JOINED a book club led by an amazingly smart guy. We were reading a challenging book by Nassim Nicholas Taleb, the philosopher, investor and probabilities expert. Our discussion leader was a Chartered Financial Analyst who had solved one of the most enduring riddles at Vanguard Group, where I worked at the time.
For many years—decades, really—Vanguard hadn’t offered an international bond fund. Our founder, Jack Bogle, wasn’t a fan of international investing in general. But he was retired by then, and we did offer several international stock funds.
But there was a big problem with international bonds—they were unreliable. We weren’t just being xenophobic. The issue was currency fluctuations. It could wipe out any gain an investor might make internationally when that gain was converted back into U.S. dollars. Exchange rates—luck, really—mattered more to returns than yield, credit quality or anything else we could analyze.
That’s when the leader of our book group made a brilliant suggestion to top management. Why not hedge international bonds against currency fluctuations, so that risk was taken out of the equation? He had cut the Gordian knot. Vanguard opened an international bond fund on that basis in 2013. It was a huge favorite with bond investors seeking diversification, the only free lunch in investing. The fund had $119 billion in assets by late 2021, in part because it’s a mainstay of Vanguard’s target-date funds.
But this isn’t a tale about bonds or international investing. One day at book club, our leader told us a story about his own investing. Because he was super-smart and a CFA, he was frequently tweaking his portfolio for optimal performance. He had the thing tuned up like a Ferrari. His wife, on the other hand, didn’t work in the investment world. She invested her money in index funds and never made a change.
One day, this smart guy was checking their accounts online and noticed something incredible. His wife’s do-nothing strategy had a higher average annual return than his souped-up portfolio. She was beating him at his own business. To say that he was surprised would be an understatement. Stunned is more like it.
What did he do? Simple. He followed the evidence and switched to an index portfolio and stopped fiddling around with his investment mix. He recommended that all of us do the same.
This is unquestionably great advice. But it’s incredibly hard to follow because we’re all so smart and well informed. The flow of information in the investment world is immense. It tends to suggest that you do something right now—this instant—or miss out on the next Tesla or watch huge sums vanish in the next market crash.
Just sitting there doing nothing has proved to be the smartest move 20 years down the line, providing you own at least some stocks. There’s never been a negative 20-year period for U.S. stocks in the last 150 years, Yale economist and Nobel laureate Robert Shiller has found. But it would help us immensely to be like Rip Van Winkle, asleep the whole time. Let me put it this way: I’m trying hard to do nothing, but it’s been a struggle.
I’ll give the last word to Taleb, whose book The Black Swan explains our problem. “I noticed that very intelligent and informed persons were at no advantage to cabdrivers in their predictions, but there was a crucial difference. Cabdrivers did not believe that they understood as much as a learned person—they were not experts and they knew it. Nobody knew anything but elite thinkers thought they knew more than the rest because they were elite thinkers, and if you’re a member of the elite, you automatically know more than the nonelite.”
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
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For index funds to work, we need trading that is more speculative. Don’t convince other people to stop.
Reminds me of one of my favorite sayings, “the enemy of good is better“! But to every rule (indexing wins) is an exception. In another financial forum I follow a member was seeking opinions on moving to index fund(s) in a newly-acquired account from the near-ubiquitous single stock that sat in the account for the past nearly 20 years. That stock happened to be AAPL, so while “yes”, diversification in the form of moving into index funds/ETFs versus AAPL alone is IMO “safer”, I still can’t help but feel that in some ways it’s like selling a golden goose while it’s still growing. Anyone else feel similarly, or am I missing something (other than single stock risk)?
Yes you can hedge against currency changes, however the hedge is not free and takes away from returns. International investing always has a higher cost basis, currency flux, and someone has to fly the analysis team (first class) around the world to investigate companies/investments. Guess who that someone is…. International may still be worthwhile, but a higher returns hill to climb.
When it comes to investing, A lot of knowledge is a dangerous thing.
I know some people who know they should use index funds, but they just can’t stop themselves from “tinkering.” It’s their recreation and they have fun doing it. I don’t think it hurts their standard of living but their heirs might be a little disappointed.
Very good article but ironically what makes it less compelling is that the “brilliant” suggestion from your Vanguard colleague amounts to introducing a feature without a benefit, needless complexity and mediocre returns.
When you compare Vanguard’s LifeStrategy Moderate Growth fund to a “plain vanilla” index fund portfolio using the same 60:40 equity:fixed income ratio what accounts for the former fund’s lackluster returns and much sharper drawdowns are just two things: the pointless “diworsification” into international bonds and equities. Geez, maybe Jack Bogle was onto something? Kidding aside, while the inclusion of international stock remains justifiable, hedged international bonds are useless.
For some reason I can’t post the link to Portfolio Visualizer, but over the past 20 years (since that’s the time frame mentioned in the post) VGMSX has returned 5.93% with a maximum drawdown of 37.84%, while 60:40 VTSMX:VBMFX returned 6.96% with a maximum drawdown of 30.72%.
I don’t find leaving my money untouched in index funds at all difficult. But maybe that is because I find investigating companies and reading most financial news a real drag. I was, briefly, a member of an investment club, back when they were fashionable, and I was glad to quit.
Excellent article but I had to laugh a little because Ferrari engines are notoriously difficult to tune (those that can be), often do not stay tuned, and often appear to be tuned only at low RPM. Run them hard and you’ll quickly find out how finicky and imperfect every tune actually is. The correlation to this guy’s portfolio is too good to not mention this. Give me a Toyota or Mazda “index” tune any day and I will never worry about it.
We read this over and over: it is very hard to beat the average. And I accept that. But instead of buying 100% of the market (which ever that is), could one not eliminate the worst company on the market and then beat the average? Surely one of these experts could eliminate just 1 bad company out of 500. And it that is the case, how bout eliminate the bottom 2 or 5 or 50? Surely this would beat the average in 99 out of 100 years. Any takers?
Trying to pick the worst companies in the market can be just as challenging as trying to pick the best. One strong turn-around and you can be missing out on 10,000% returns.
You introduced a new assumption that the bottom 2 or 5 or 50 remain the same over time. That does not happen, nor does the top 2 or 5 or 50 remain the same.
Try the Dimensional Funds. That is what they try to do.
Too much formal education usually results in too much hubris.
The “elite thinker” remark applies to many things we are currently observing, doesn’t it?