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WE LIVE IN A WORLD rife with intolerance—and that intolerance, alas, has infected the once-civilized world of index-fund investors.
Back in the 1990s, we indexers were such a small minority that simply owning index funds was a common bond. But now that more than half the fund market is given over to index funds, internecine skirmishes regularly erupt, with folks debating what’s the right way to index and belittling those who take a different approach.
Want to know what’s the “right” way to index? Arguably, you should own the ultimate in diversification, which is the global market portfolio—every stock and bond, U.S. and foreign, weighted according to its market value. This is the mix that reflects the collective judgment of all investors everywhere and should offer the highest risk-adjusted expected return.
In theory, depending on your goals and risk tolerance, you could change this portfolio’s risk and expected return either by adding risk-free investments—think Treasury bills—or by borrowing at the risk-free rate to leverage the portfolio. Do you invest this way? As far as I know, almost nobody does. But arguably, if you don’t, you have no standing to claim that your approach to indexing is the right one.
Why don’t folks own the global market portfolio with varying degrees of leverage? For starters, there’s no agreement on what the global market portfolio looks like. Should you include commodities, collectibles and real estate? Should your real estate exposure consist solely of commercial properties, or should you also add residential real estate? And what about private companies?
Trickier still is the question of leverage. The fact is, most of us can’t borrow cheaply enough to make leverage a winning proposition and, indeed, short-term borrowing rates today would likely match or exceed the yield on the global market portfolio’s bond allocation, plus there’s always the risk of a margin call.
Even if you throw out the use of leverage and ignore commodities, collectibles and other alternative investments, today’s global market portfolio might include 36% U.S. stocks, 24% foreign shares, 21% U.S. bonds and 19% international bonds. It would be easy enough to replicate that mix by combining 60% in Vanguard Total World Stock ETF (symbol: VT) with 40% in Vanguard Total World Bond ETF (BNDW).
To be sure, if you’re a purist, even this mix comes up short—because the foreign bond exposure is currency hedged. But forget such quibbles. Let’s face it: How many U.S. investors own a portfolio that looks anything like this investment mix, especially the 19% allocation to foreign bonds?
The bottom line: Almost nobody indexes in the theoretically correct way. Instead, we make all kinds of judgment calls as we wrestle with eight key questions:
Have you answered the above eight questions? Next come questions where your answers could get you labeled not just as a fool, but as a heretic. We’re talking about questions like: Is it okay to own a few individual stocks? What about actively managed stock funds? I own neither. But I know plenty of indexers who do, in part because they need an outlet for their speculative urges. Is that so terrible, assuming it’s a small part of someone’s portfolio?
The bottom line: Every indexer makes judgment calls. Yes, there may be choices that are more sensible than others. But there’s no one index-fund portfolio strategy that’s right for everyone. Instead, the right portfolio is the one that works for you. Those who denounce the approach of others aren’t smarter or more faithful to the indexing creed. Instead, their only distinction is their greater intolerance.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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A target date fund, usually offered in your employer’s retirement plan, coupled with a small cap blend or value fund should ensure a good retirement for most investors like you and me. Rebalance once a year.
The time saved not worrying about all the choices created by the financial services industry can be spent investing in what matters: the people in your life!
Big takeaway is there is no perfect way to invest. Lots of good ones though. I have 2 index funds and ETFs that cover a wide gamut: large, small, mid and value companies, and some foreign. I also own Amazon, Berkshire B, Google (GOOG & GOOGL), Netflix, Republic Services and Visa. The stocks were bought in 2011, 2012 and 2016 when I was still working. They have all appreciated so much I don’t want to sell and pay the taxes. The lowest gain is 252% and the highest is 821%, which is Google. I am not an active investor and do not consider myself a great investor. I simply bought these stocks and held them. They did the rest. I sold my short and ultra short treasury index funds at Vanguard when interest rates rose and they started going down, so now are getting almost 5% in VG’s federal MM fund. It may turn out that my kids inherit these huge gains so they don’t have to pay the capital gains taxes.
Nice article, Jonathan! I totally agree “there’s no one index-fund portfolio strategy that’s right for everyone. Instead, the right portfolio is the one that works for you.”
I think the key is for us to follow sound personal finance principles, such as save & invest and live within our means, and let the 8th wonder (i.e., compounding) do the heavy lifting to accmulate wealth for us.
If we are seeking simplicity as most of us espouse, I would suggest using VGWAX, the Global Wellington fund at Vanguard with an expense ratio of .37% for your entire long-term portfolio. Then your children and spouses would have a simple portfolio that needs no rebalancing. Do your research. Jim
Excellent article, Jonathan. I’m a “half-dexer” — about half my total portfolio is indexed (mostly in the S&P 500), with the other half a combo of managed funds and individual stocks (mostly Berkshire Hathaway). My non-index half is not invested with the thought that I can beat the market, however — it’s because I like the different approaches at what I believe the real goal is, which is to beat inflation, and grow wealth in real terms. Since we’re all in that boat, I agree – let people row however they want.
Me too, John. I have roughly half my money in S&P index and the other half in Berkshire. Berkshire is a long-term holding, dating back to mid 90’s. Because of recent growth, Berkshire is more than 50%. As you note, I am not trying to beat the index, but feel Berkshire represents the best basket of companies America has to offer. It is exceptionally well managed. Also, Berkshire has very low agency cost and I get the same fair deal as their management.
Terrific article. Thanks, Jonathan.
Now, in my retirement years, I yearn to simplify our investments. A 3 fund portfolio or similar has great appeal. But when you’ve held various investments for decades, the problem is whether to bite the bullet on the capital gains in order to achieve that simplicity. So far at least, I’ve been reluctant to take that bite.
If Congress were to eventually eliminate the stepped up basis at death, that might be the nudge I need.
Hi Andrew…that may be something only you can decide, but Please, don’t give Congress any ideas.😉
Hi, Marjorie, and hope all is well. That idea has been around a long time but so far hasn’t gone anywhere. I’ll likely have to do my simplifying without the nudge!
I know President Biden would like to end the step up basis for gains in excess of 1 million,calling it a loophole—why is it when they want to eliminate any policy that benefits the taxpayer in any way, they call it a loophole. Same way with File and Suspend. For many years it was a viable option, then all of a sudden, it’s a loophole.
Andrew…didnt mean to go off on a tangent and hope your tax planning works in your favor. So many factors to consider.
I always enjoy your comments. They have a courteous and gentle quality.
Oddly my portfolio is much like the one you mentioned. 37% US equities, 22% International equities, 21% US bonds, 13% International bonds and 5% Alternatives.
You raised some excellent questions that any investor would benefit from considering. I am amused, or more accurately, annoyed by the tendency for some to not merely disagree or dissent, but also ridicule those with whom they disagree.
I have no original ideas, but I have formed some from your and many others’ writings. Given that we all have different, even if similar, long term goals, and levels of tolerance for risk or volatility, there are numerous useful strategies to choose from. I doubt that there is a single “best” strategy. Choosing a plan based on your goals and risk tolerance, and then “staying the course” (Jack Bogle) and “don’t do anything stupid” (Charlie Munger) will provide a good long term result for anyone.
I admit my bias. I am mostly an index investor, but I take flyers on some less-comprehensive (but still respected) funds, too. I avoid international investing. I will only invest in foreign markets indirectly, through US-listed public companies that have global (or at least some foreign) operations. Why? Primarily because I trust the regulatory structure that deals with securities in the US, and I simply don’t trust the structures that are supposed to bring integrity to securities elsewhere (or I don’t know enough about them.) But I act the way I do also because I suffer that confirmation bias (reinforced throughout my life) that non-US markets have more and bigger negative surprises, and because IMHO, every non-US market is still influenced greatly by what happens here anyway. What I get indirectly is enough for me.
I tilt toward value stocks and smaller companies for over 10 years as Jonathan has. Now at 78 and retired I would like to switch out.
How do you do it without losses?
Even though small and value have lagged over the past 10 years, I’d be surprised if you have losses on those positions. As for me, the poor performance of the past decade makes me more enthusiastic, not less.
Thanks Jonathan. I will stay the course and report back when I am 90.
I’m planning on it!
During accumulation our strategy was to have one life strategy fund and mirror that fund as best as possible in accounts that did not have the fund. In retirement, as we consolidate accounts, we’ve found it’s actually simpler for us to have a three fund portfolio.
When you are retired and you are accessing your portfolio for living expenses the simplest is some combination of a short term bond, and any combination of broad stock index fund(s), a world; or broad US, and or international funds(s) depending on your biases. The ratio of these funds will depend upon your risk tolerance. When you need income sell off that which has gained since you last harvested your gains to rebalance. This portfolio is better than a target fund as when you sell the shares of a target fund you are selling both stock and bond positions at the same time.
I’ve thrown in the towel…target date index funds.
Excellent article Jonathan. I’ve struggled with the 8 questions most of my investing life. In some ways it was easier when I was busy working and involved in kids activities. I had less time to think about my investments, and dutifully plowed money in each paycheck. That worked well in the 80s, 90s, and 2000s. In retirement I have much more time to check the market and think about tweaking, but I’m trying hard to stick with an investment plan.
So many questions, so many variables, so many choices and decisions to make. Is it any wonder many 401k plans offer so many investment options under the guise of fiduciary duty?
In that process employees are confused and I doubt a financial literacy course can sort it out. I don’t even know what an index fund investor is anymore.
HumbleDollar readers are typically at the top of the info chain, what can we expect of the average worker with a 401k trying to create a retirement nest egg?
Is there any hope of a simple approach for those who should set it and forget it?
Even the ease of index funds is not so easy it appears.
It is MUCH easier and better today than it was in the 80s and 90s.
There were no index choices in my 401k back then. Only mediocre managed funds with sky-high expense ratios.
I had no clue, because expenses were a secret – not published anywhere and even if there were any employees who knew to ask about expenses, they’d be quickly dismissed by the fund administrator.
Companies refused to answer questions about any of the funds or provide any help, beyond processing your enrollment – and said so in big block type on every 401k collateral piece. They made it clear: employees were 100% on their own. They just told us to hire a financial advisor. So basically you had a bunch of high priced funds with zero guidance to understand them.
The plans today are 100% better – more info available, lower cost choices; target date styles that keep things simple, so many easier routes.
When I was helping my daughter set up her retirement portfolio we just picked the Vanguard target fund that matched her retirement year. Unlike her father she does not have any interest in investing. Research has shown that the majority of time the less you fiddle with your investments the better the results, so she’ll probably have better results than me.
Firm believer in the THREE FUND BOGLEHEAD PORTFOLIO. What can be any simpler. Simplicity rules in long term investing. Of course you can own Munis and CDS for income. The accumulation phase is a no brainer. Gladly more investors are getting the message as passive investing has overtaken the active fools.
Not sure why the negative votes for Ken’s reply. I do not adhere to the 3 fund Boglehead portfolio, but that is certainly a reasonable investing strategy.
Your investing knowledge will be deeper from being more curious and less judgmental about why others invest their money differently than how you do.
That idea is a big part of the value of HumbleDollar. I read every investing strategy in the articles and comments with interest to stimulate my thinking. I think a periodic read of Jonathan’s Guide is useful, too.
Yes. True about most things.