Article: The Evolution of an Investor

This article is over three years old, but its story is quite interesting and its message profound so I thought I'd link to it now.  It's the story of Blaine Lourd, who got rich as a stock broker, but later changed his tune when he realized he was nothing more than a salesman pushing companies for no particular reason other than making money for himself.  He wasn't serving the best interest of his clients.  Eventually, he decided to take action and now only recommends Dimensional Fund Advisors' index funds to his clients.

It's a fairly lengthy piece, but definitely worth the read.  Check out The Evoluation of an Investor by Michael Lewis, the financial journalist who has written for Vanity Fair and The New York Times Magazine as well as published several best-selling books, on

Bond Bubble? My Thoughts

Somebody posed a question regarding the bond market in the comments section of another post, so I thought I'd also clarify my thoughts on that matter in this post as well. There has been a lot of talk about a bond bubble and investors are wary and seeking alternative investments. Is that a wise course of action?

First, I think having the proper perspective on this issue is in order. Even in a doomsday scenario for bonds, the losses would pale into comparison to the potential losses and risk involved with investing in stocks. To further illustrate this point, check out the Growth of $10,000 chart of Vanguard Total Bond Market (VBMFX) courtesy of Morningstar since 1986.  The blue line is VBMFX, while the orange is the average intermediate term bond fund, and the green line is the BarCap US Aggregate Bond Index.

Growth of $10,000 since 1986
Source: Morningstar, Inc.
As you can see, it's been pretty smooth sailing and the volatility of such high-quality bonds is not that grave.  The most severe pullback was the big "bubble" of 1994, which produced a maximum loss of about 4%.   Google Finance reports VBMFX's worst three-month return as -3.00%.  While we certainly could have a historic pullback, previous measures of risk and volatility are indeed helpful.  (Note that the average intermediate-term bond fund pulled back nearly 9% in late 2008 after the MBS mess.  Yet another illustration as to why high-quality index funds are the way to go.  Clearly, too many bond managers took unnecessary risk in the effort to reach for yield).

Compare this total bond fund (blue line) to VFINX (Vanguard S&P 500; orange line) for even more perspective.

Growth of $10,000 since 1986
Source: Morningstar, Inc.
The decreases that were more apparent on the first graph have all but vanished when you compare it to the volatility of equities.  The bumps are nothing but small pebbles on the bond side.  So, while there is definitely risk involved in the bond market (I'm not saying it always goes up), it's important to have the understanding that the risk is still paltry compared to stocks even in this time of low interest rates.

Having said all that, I don't think investors' concerns about the bond market are without merit.  We live in unusual times and find ourselves in unusual circumstances - on the surface, the cautionary tales about bonds at this point in time do seem to have some valid points as we have somewhat "the perfect storm" of conditions that would signal a bond bear market.  

When interest rates rise (and they will undoubtedly rise unless we fall into a similar situation to Japan in the 1990s with low interest rates for a long period), your bond funds will take a hit in the short-term.  The longer duration of the fund, the bigger the hit.   However, as long as you hold your bond fund longer than the average duration, you should still end up ahead of the game and not have to really worry that you'll end up with a loss in the position over the long-term.  In this article from Vanguard, it is suggested that rising interest rates actually benefit investors over the long-term as long as you reinvest your interest income (Bonds and rates: The reality behind the headlines, February 2010).  They provide the following data:

Bond Fund Total Returns (annualized)
           Change in yield                            Year 1                 Year 3              Year 5                Year 7                  Year 10
Rising Interest Rates
Constant Interest Rates
Falling Interest Rates

Source: Vanguard

You can read their assumptions in the attached article.  Essentially, though, they conclude that while falling interest rates lead to better performance in the short-term, consistently rising rates are actually better for long-term performance (7+ years) assuming investors stay the course and reinvest interest income.

They conclude: "[I]f you're holding bond funds as part of your long-term asset allocation, a rise in rates probably shouldn't prompt you to make any changes. Indeed, you can benefit by sticking with the bond allocation that's right for you."

Here are two more Vanguard articles with similar messages and talking about the current bond environment: Should you beware of a bond bubble? (August 2010) and Risk of loss: Should investors shift from bonds because of the prospect of rising rates? (July 2010).  They have much the same message - don't fret about a bond bubble due to rising interest rates since over the long-term the small decrease will be more than compensated for.  They believe that individual investors are best served by maintaining their asset allocation and holding for the long-term, since reinvesting interest income will put you ahead. This is undoubtedly true. If you're a long-term investor, shouldn't you only be concerned with the long-term performance?  

I'll provide a contrarian viewpoint courtesy of the Finance Buff's blog entry You Should Still Beware of A Bond Bubble (August 2010).  He posits that if interest rates go up as expected, bond values will go down. It doesn't matter that the losses are small compared to the potential losses in equities - it's still a loss.  Shouldn't investors actively avoid such obvious potential losses?  And while it's true that reinvesting interest income in your bond funds over the long-term will benefit you in a rising interest rate environment, the Finance Buff argues that the returns would have been even better if you sidestepped the short-term rise in interest rates and invested in bonds at a slightly later time.

I think both perspectives have a valid point.  Interest rates are going to go up; it's just a matter of when. When that occurs, your bond fund's NAV will take a hit. The longer-term duration funds will take a larger hit than the shorter-term ones. Over the long-term, this temporary hit will be compensated by reinvesting interest income at higher rates and you'll end up ahead if you stay the course.

Bonds are held as part of an individual's portfolio to moderate volatility and increase diversification.  Thus, you shouldn't completely abandon your bond holdings nor switch to equities with that allocation under any circumstance. Nevertheless, if you are uncomfortable with potential for short-term losses in the bond portion of your portfolio, I think there are a couple viable alternatives. 

First, you may elect to shorten the duration of your bond holdings.  Instead of selecting a Total Bond Market Index fund (VBMFX has an average duration of 4.7 yrs), choose a short-term index like VBISX (2.6 yrs). This will cut the potential for short-term losses in about half.  (Obviously this comes at the expense of expected returns. There is no free lunch.)

For more information on how bond prices interact with interest rates, see this bogleheads article: Bonds: Advanced Topics - Duration

"For example, a bond with a duration value of 5 years would be expected to lose 5% of its market value if interest rates rose by 1% (100 basis points)."  Thus, while the total bond fund might lose 5% of its value, the short-term index would lose only 2.5%.  These figures are not exact and for illustrative purposes as there are other factors that can affect such an outcome.

Secondly, you may choose to use CDs as an alternative to your bond position. This is what the Finance Buff suggests.  You could also use a combination of short-term bonds and CDs.  I think that's a reasonable course of action.   Or even all three positions if it's a significant sum of money - keep a total bond, short term, and CDs.  Spread your money across the strategies.

In the end, while the above two options will probably reduce the chance for a significant short-term pullback and you'll be less affected by the potential "bubble," you will not be able to time it perfectly as to when to get back in the bond market. Thus, you'll miss some opportunity and whether you come out ahead (when compared to simply sticking with your previous asset allocation to total bond) will largely be determined by luck.

Thus, if you're simply interested in your long-term performance, it probably makes the most sense to stick to your asset allocation plan. If you're concerned about short-term volatility in the bond market and have discipline to jump back in, it's reasonable to shift to shorter durations and/or CDs and then re-assess this position as time goes on. Will you come out ahead of the other strategy? Maybe.  Will your short-term volatility be decreased? Yes.

TD Ameritrade Joins the Commission-Free ETF Train

TD Ameritrade has followed the leads of Charles Schwab, Fidelity, and Vanguard to offer commission-free ETFs to its customers.  The firm will now offer over 100 ETFs commission free if held for at least 30 days.  These include the following: 47 iShare funds, 32 Vanguard funds, 12 State Street Global Advisors funds, 3 PowerShares funds, 2 Van Eck funds, 2 iPath funds, 1 WisdomTree fund, 1 Barclays Bank PLC fund, and 1 Deutsche Bank AG fund.  If held for less than 30 days (which should not happen for long-term investors anyways), TD Ameritrade will charge $19.99.  Competitive pressures are really getting to these firms!  This marks the only of the aforementioned four that is offering investors more than just funds from one particular family.  (You should have ample selection from the other three to create a low-cost diversified portfolio, so I wouldn't fret.)  Although WellsTrade has done this for the past few years - offering 100 commission-free online trades (any stock or ETF) as long as it's linked to a PMA package (requires a $25,000 minimum).  Lots of great choices of brokerage firms now for the low-cost ETF investor.

Vanguard Reduces Minimum Required for Admiral Shares

In yet another aggressive move, Vanguard has announced that they're reducing the minimum amount required to qualify for Admiral shares.  Admiral shares are a separate share class included for more than 50 funds that hold the same investments as the investor shares, but charge significantly lower expenses - typically about the same as the ETF class (in some cases even lower though).  The minimums are now as follows:

$10,000 for most broad-market index funds;
$50,000 for actively managed funds

Previously, to qualify for this share class required a $100,000 investment, so this is quite a substantial change.  This move makes sense in light of the fact that Vanguard ETFs now trade commission free through VBS, so those with smaller investments could previously get a lower expense by converting to the ETF class without any tax ramifications (due to Vanguard's unique fund/ETF structure).  Now, that conversion may not be necessary since one can acquire Admiral shares for basically the same cost as the ETF.  You can easily change the share class of your funds online by clicking on "Convert an Account" on the righthand side.  The cost basis information from your investor shares are transferred automatically, so you don't have to worry about tax ramifications.
Vanguard's mutual funds may be more appealing than ETFs to those who want to set up an automatic investing plan, don't want to place limit orders during the work day, and want to purchase at the NAV.  ETFs may appeal more to those who want the flexibility of intra-day trading and large lump-sum investors.

This is great news!  The brokerage firms have really been pushing each other to improve their offerings with aggressive cost-cutting measures in the last couple years.  In the end, it's the individual investor who wins.

Vanguard Adjusts International Equity in Target Retirement and Other Balanced Funds

Vanguard has announced that they're increasing international equity exposure of Target Retirement, LifeStrategy Funds, and the STAR Fund from about 20% of equities to approximately 30% of equities.    This is addition to the move of holding Vanguard Total International Stock Index Fund (VGTSX) instead of Vanguard European Stock Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund in the funds in an effort to simplify the holdings.  Lastly, this is all in conjunction with the changes to the International Stock fund's change from tracking the MSCI® EAFE + Emerging Markets Index to now tracking the MSCI All Country World ex USA Investable Market Index.  The new index covers 98% of the world's non-US markets and includes small-capitalization companies as well as Canada and Israel unlike before.  Not only that but Vanguard plans to introduce 5 share classes of the fund, including an ETF (with a 0.20% ER).  Previously, one had to invest in FTSE All-World ex-US to get access to the ETF VEU (0.25% ER).

Personally, I like the changes.  I always thought 20% international exposure was a bit low, especially considering Vanguard's own recommendation of 20-40%.  Here is Vanguard's rational courtesy of John Ameriks, a Vanguard principal and head of Vanguard Investment Counseling & Research:
First, a detailed quantitative analysis suggested that U.S. investors obtain maximum diversification benefits when non-U.S. stocks make up 20% to 40% of their equity portfolios. Related to that is the growth of non-U.S. stocks as a percentage of the global equity market and the declining costs of implementing and managing non-U.S. equity positions.

In addition, it is our view that we will be able to make this change with minimal transaction costs to investors at this time. Fundamentally, we believe that a modestly higher allocation to international equities has the potential to improve diversification and reduce volatility in these portfolios over the long term. Since 2006, Vanguard has advocated that U.S. investors hold 20% to 40% of their equity portfolios in non-U.S. stocks. We continue to hold that view, and this change places these funds firmly in the middle of that range.
While some may argue this is performance chasing (international markets have performed much better than US markets in the past decade), I would argue that their previous allocation was out of tune with their own research and the steadily increasing market capitalization of foreign markets (now 56% of the world market; if you want to track that, simply invest in VT).  In my mind, 30% is more reasonable to offer the potential of greater returns and increased diversification (nothing is guaranteed, of course).  I personally hold about 40% of my equities in international funds.  It's also a nice addition that this index will now include small-caps (much like the difference between the S&P 500 and the Wilshire 5000).  It is now not imperative to have a separate small-cap foreign holding unless you purposefully want to overweight.

Previously, while the single Target Retirement fund offered a great simple solution for investors who want to set it and forget it, it notably lacked foreign small-caps and it's exposure to international markets was a bit low. Now it seems to be a more viable all-in-one solution.  That comes with a couple of caveats.  Firstly, the stock/bond allocation hasn't changed so one should look at those when determining which fund best suits his or her objectives rather than looking at the end date.  Others do not find the shift from stocks to bonds to be appropriate, and rather shift from equities to bonds earlier in their lives.  Finally, I personally like some exposure to REITs and that still is not included in the fund.  However, you could do much worse than the Target Retirement Funds.  They are simple all-in-solutions that are inexpensive and highly diversified.  I am glad Vanguard made the changes to not only increase the foreign allocation, but also including small-caps, Canada, and Israel by following a different index for the international fund.  

Good job Vanguard!

Book Review: A Random Walk Down Wall Street

I recently re-read the classic investing text A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (W. W. Norton & Company, 464 pp) by Princeton Professor Burton Malkiel.  In my opinion (and many others), this is the single best investing book ever written.  Malkiel covers a wide array of topics including stock valuation theories, bubbles, technical and fundamental analysis (even explicitly covering individual technical strategies and debunking the conclusions of repeated outperformance), modern portfolio theory, behavioral finance (a particularly interesting topic in my mind), efficient-market theory, and then a guide to come up with a portfolio that will challenge those on Wall Street.  Before creating a portfolio for the first time, get this book.

There are certainly easier texts to read for beginners.  Thus, if you're just starting and want a more simplified approach than a 450+ page text, you might look elsewhere.  However, Malkiel writes in a very accessible manner such that even neophytes can understand more complex theories.  I'd say that the average investor would be able to follow A Random Walk Down Wall Street more easily than The Intelligent Investor, for instance.  There's a reason that the book has been repeatedly updated over the course of 35 years and has sold over a million copies.  What I especially enjoy about this book is not only the broadness of topics covered, but also how Malkiel methodically analyzes various strategies and supports his conclusions with ironclad findings.  He doesn't dismiss other points of views simply by saying "trust me," but rather provides ample evidence to backup his viewpoint.  Malkiel worked in the financial industry for several years and has been in academia for quite some time, churning out economic studies.

The first portion of the text covers stocks and their value.  Malkiel divides each section clearly to explain various topics in a concise manner.  This also provides a simplified manner in which to jump around a bit, if so desired.  One doesn't need to read the text from page 1 to page 464 in order to gain great insight.  Rather, it's certainly doable to skip to the section that most interests you.
Near the beginning, Malkiel posits the two main theories and approaches to asset evalution: the firm-foundation theory and the castle-in-the-air theory.  Down to their most basic premise, the former simply argues that each investment derives its value from the analysis of present company metrics and market conditions as well as future prospects.  That is, the stock's trading price is tied to the firm's earnings and growth patterns; when the price becomes at odds with those fundamentals, the market corrects itself.  One would consider Benjamin Graham, Warren Buffett, and David Dodd to subscribe to this perspective.

On the other hand, the castle-in-the-air theory posits that stock prices are determined simply by what other people are willing to pay for it.  That is, how will the crowd react to various reports and news of the firm.   Will the crowd view the stock in an optimistic and favorable light?  That will cause the price to increase, and the castle-in-the-air specialist seeks to make the move prior to most others.  John Keynes is the most famous economist to hold this view.

Malkiel then goes on to describe "the madness of crowds," illustrated perfectly with the tulip bulb craze in Holland in the late 16th century when prices spiraled out of control.  The book then gives a brief history of stock evaluations from the 60s to the 90s, giving a great historical look at investing and the market.  To conclude part one, the author discusses bubbles, specifically highlighting surfing on the internet.

Part two is the big debunking of Wall Street (my words) section.  Essentially, Malkiel describes how various contenders such as fundamentalists and technical analysts play the game and why such strategies fall short.  In part three, he describes the modern portfolio theory in a clear manner that defines risk and how diversification works in practice.  He then covers behavioral finance, giving space to overconfidence, herding, and loss aversion among other topics.  Finally, Malkiel head-on addresses various beliefs as to why the efficient-market theory doesn't hold true.

Finally, at part four, Malkiel gives real-world advice for individual investors and how to make one's portfolio better.  This is really the meat and potatoes of the text and if you simply want guidance to your individual portfolio and asset allocation, I'd skip to this section.  Malkiel recognizes that many investors cannot accept the indexing model, and thus offers four rules on picking individual stocks, while emphasizing the odds are stacked against outperformance when choosing individual companies to invest in.

In the end, Malkiel shuns Wall Street's antics and its rampant marketing that the pros always win.  He credits the majority of the outperformance of the select few fund managers to dumb luck saying that very few individuals actually possess the capabilities and foresight to continually pick winners.  After eliminating the selection bias of surviving funds, you'll see how poorly Wall Street truly performs and that the fees they charge you are excessive.  Malkiel professes to a low-cost diversified set of index funds that gradually grow more conservative as you near retirement.  As he concludes, "The indexing strategy is the one I most highly recommend [...] Investing is a bit like lovemaking.  Ultimately, it is really an art requiring a certain talent and the presence of a mysterious force called luck.  Indeed, luck may be 99 percent responsible for the success of the every few people who have beaten the averages [...] If you know you will either win or at least not lose too much, and if you index at least the core of your portfolio, you will be able to play the game with more satisfaction."

Rating: 5 out of 5

The Importance of Asset Location

There are certain factors in investing in which we have little to no control.  With this fact in mind, we have to give ourselves the best chance for success by strategically pinpointing the factors that we can control, and effectively utilize them to our advantage.  The first and most important of these is asset allocation, which has been discussed on this blog and articles on the web, newspapers, and magazines ad nauseum.  That is, stocks vs. bonds, value vs. growth, US vs. foreign, etc.  Certainly, the propensity for articles to address these issues is with merit as asset allocation has, according to published studies,  been responsible for nearly 90% of a portfolio's performance over the long-term (signifying the insignificance of market timing among other decisions).   

The second key factor within our control that indexers love to stress is the ability to control fees - both fees with your financial advisor and fees within a fund as measured by its net expense ratio.  Studies have shown that minimizing fees maximizes returns; even seemingly small differences (such as 0.4%) add up over the course of several years and you should do everything in your power to get the lowest cost investment to fulfill your asset allocation.   The third significant decision within our control is the actual security selection.  Although for indexers this point is not terribly interesting as we simply choose a fund that offers one of the lowest fees and fulfills the particular asset class we desire.  

That brings me the fourth and final aspect of investments in which he have control over - minimizing taxes in our investments.  We can do this by having a logical asset location - that is, which investments we choose to hold in taxable accounts and which we hold in tax-advantaged (401k, Roth IRA, etc.) accounts.  While we certainly can't control what the government will do in the future to tax rates (and it would be a futile affair to attempt to predict such decisions), we can exploit how Uncle Sam deals with long-term capital gains and things of that nature to minimize the amount the US government takes from our investment gains.  Small differences in taxes can compound in huge figures over the long-term and investors would be wise to consider the tax efficiency and placement of their investments to reduce their tax burden.  Avoiding (or at least minimizing) certain taxes is one of the most important strategies to maximize long-term growth of one's investments, but is a topic that is, unfortunately, frequently glossed over in articles and discussions on portfolio management.  As will be evidenced in this post with evaluations of after-tax final portfolio values based on asset location, the difference can be stark.  This is a topic that shouldn't be brushed aside.

A Basic Primer on the Rationale

Your tax burden varies largely based on the type of investment as well as the investment style and turnover of the particular fund in question.  In essence, the taxes you're responsible for depends on the taxable distributions and the rate on those.  This can vary based on if dividends are qualified, how often a fund distributes capital gains, and other factors.  The basic premise behind tax-efficient investing is to place your efficient investments in taxable accounts (and thus you won't lose as much to taxes) and your inefficient investments in tax-advantaged accounts (since you have no tax liability until distributions, or not at all if we're talking about Roth accounts).

As a general rule, bond funds are tax-inefficient because the gains they generate are all taxed as ordinary income and are subject to your marginal income tax bracket.  (Although municipal bonds have no such restriction, but typically offer lower yields to compensate).  REITs, likewise, are required by law to distribute at least 90% of their income as dividends, which is overwhelming at the non-qualified divided rate.  Thus, although REITs are traded as stocks, they too are extremely tax-inefficient.  

While stock funds are generally efficient, if they are actively managed and have a high turnover rate, it may be possible that they generate a lot of short-term capital gains.  Likewise, a fund that pays high dividends (like many value funds do) may not be as efficient.  Foreign funds typically are quite tax efficient since they are eligible for the foreign tax credit.

Hypothetical Scenarios

While the general feeling for indexers is "stocks in taxable, bonds in tax-advantaged" that is not always the case as Rande Spiegelman for the Schwab Center for Investment Research explains in his report "Location, Location, Location: Dividing Your Portfolio between Taxable and Tax-Advantaged Accounts."  He summarizes his findings in table form as follows:
Spiegelman poses two hypothetical scenarios for two different investors.  You can read his assumption on page 2 of the report, but the first case involves "Tishana" who is in the 40% combined marginal bracket and has a portfolio value starting at $200,000 (50% in taxable, 50% in tax-advantaged).  In the first portfolio (Portfolio A), Tishana places her highly efficient stocks in her taxable accounts and her bonds in tax-advantaged accounts.    In the second portfolio (Portfolio B), Tishana places her bonds in taxable and highly efficient stocks in tax-advantaged.

Total Portfolio A
Total Portfolio B
Advantage (Disadvantage) of Portfolio A

As you can see in the above, Tishana would have more than $210,000 more in her final portfolio value after 40 years of investing if she practice tax-efficient placement of her investments.  $210,000!  That's certainly not an insignificant amount of money; it's more than her beginning portfolio value and more than 10% of her final portfolio value.  Would you want to pay $200,000 more in taxes over 40 years simply because you don't want to practice tax-efficient investing?  Of course not.

Next in the article, Spiegelman proposes a situation in which Tishana instead invests in actively managed stock funds in taxable and bonds in tax-advantaged.  In that case, while Portfolio A outpaced Portfolio B in the 5, 15, and 30 year timelines, Portfolio B actually had the higher value after 40 years to the tune of $105,000.  By the way, Portfolio A when utilizing actively managed funds ended at $1,524,169, a full $317,499 less than if Tishana had used tax-efficient index funds.  And that's when assuming the actively managed fund performed identically to that of the index fund, something most actively managed funds fail to do.  Even giving the active managers' the benefit of the doubt on that, the fund has to not only outperform the benchmark to break even because of higher fees, but also because of higher taxes.  Yet another reason to go the passive approach!  Again, such a decision could save you huge amounts over the long-term.

The article then discusses Sam who has a lower 30% combined marginal bracket.  In Sam's case, the difference isn't as severe since he loses less to taxes in general so doesn't need to concern himself as much.  Still, the advantage for Portfolio A when using over 40 years is $96,621, which is a quite considerable sum.  In the case wherein Sam uses actively managed funds, Portfolio B outpaces Portfolio A after 30 years. Thus, if you absolutely insist on using actively managed funds (which I do not recommend), then you should consider the turnover and management strategy of the fund to determine the best placement, argues Spiegelman.

Likewise, Vanguard has a nice report worth considering titled "Asset Location for Taxable Investors" written by Colleen M. Jaconetti in 2007.  Jaconetti concludes the following:
If an investor’s primary goal is to maximize after-tax return, then, in general, an optimal portfolio, from an asset location perspective, would hold broad-market index equity funds/ETFs or tax-managed equity funds in taxable accounts and taxable bond funds in tax deferred accounts. This assumes the investor is willing to forgo owning active equity funds (or other tax-inefficient investments), unless space in his or her tax-deferred registrations allows for it.
Jaconetti also proposes hypothetical scenarios similar to the Schwab study above to illustrate this point in real dollars.   Such scenarios are helpful to the average investor to actually associate such decisions with real-dollar amounts as opposed to simply learning about these theoretical rules of thumb.  All the same assumptions are made for the first three scenarios as stated on page 2 of the report.

In the first scenario, highly efficient index equity funds are used in taxable account and taxable bond funds are in tax-deferred.   The post-liquidation value after 10 years is $1,694,671.  In the second scenario, taxable bond funds are used in taxable accounts and index equity funds are used in tax-deferred accounts.  In this case, the portfolio grows to $1,531,413.  As you can see, this is considerably less than the first scenario.  In the third scenario, the investor utilized municipal bond funds in taxable accounts (which are tax-free) and index equity funds in tax-deferred.  Such an example grows to $1,583,088.  While this is better than the second option, it still lags the first scenario considerably.

In scenario four, there are a few different assumptions as stated on page 4.  In this case, the investor utilizes active equity funds in taxable and taxable bonds in tax-deferred accounts.  Such an account has a post-liquidation value of $1,623,108 after 10 years.  It is better than Scenarios 2 and 3 suggesting that even if you have actively managed funds, you should still place them in taxable.  This conclusion seemingly contradicts that from Schwab, but if you look at the actual Schwab report, he came to the same conclusion for the 15-year timeframe (closest to the 10-year that Vanguard considered).  It wasn't until 30 or even 40 years where the opposite conclusion was delivered.  While scenario 4 beat scenarios 2 and 3, it still lags the first one.  Yet another piece of evidence to support the idea of investing in index funds.

In the end, after ten years, Scenario 1 in which the investor utilizes tax-efficient index funds in taxable accounts and taxable bonds in tax-deferred performed the best after taking taxes into consideration.  Scenario 2 lagged by more than $163,000, while Scenario 3 trailed by $111,583, and 4 was $71,563 behind, suggesting that such a location decision is less important for those implementing actively managed funds.  As stated at the onset, scenario 1 optimizes returns.

Other Research Reports

Dammon, Poterba, Spatt, and Zhang from CMU, MIT, CMU, and UT-Dallas reached the same conclusion as the Vanguard report utilizing arbitrage arguments in their 2004 TIAA-CREF Paul A. Samuelson Award-winning paper, which they discuss in a research dialogue.  They conclude:
Using arbitrage arguments, we showed that holding equities in taxable accounts
and bonds in tax-deferred accounts is the optimal asset location strategy even if capital gains are realized and taxed on an annual basis, as long as the tax rate on capital gains is less than that on interest income. This implies that even actively-managed mutual funds that generate large capital gains (losses) each year should be held in taxable accounts and bonds in tax-deferred accounts. The asset location decision is a matter of indifference only if capital gains are fully taxed each year (i.e., no deferral) and dividends, capital gains, and interest are all taxed at the same rate.
It appears that that Schwab came to a different conclusion as to where to place actively managed funds (and that's the only significant difference) than Vanguard and the above academics due to different assumptions that you cannot predict.  (Although Schwab came to the same conclusion over shorter-time frames.  Just not the 40-year hypothetical growth scenario).  This is yet another reason to hold index funds - you know what you are getting and can manage it in a way to confidently minimize taxes.  This much is sure, though - placing tax-efficient stock funds in taxable and bonds in tax-advantaged accounts is indisputable and can save you a boatload of cash.  These investors also single out REITs as stock investments that make the most sense in tax-advantaged accounts.  Of course, tax-exempt bonds should also be held in taxable accounts.

William Reichenstein, the Pat and Thomas R. Powers Chair in Investment Management at the
Hankamer School of Business at Baylor University, brings up yet another point in his paper "Asset Allocation and Asset Location Decisions Revisited."   He concludes that not only is their an optimal asset locations as discussed above, but that the profession in general has been "miscalculating an individual's asset allocation, and the measurement error can be substantial.  Asset allocation should reflect after-tax funds because goods and services are purchased with after-tax money."  This is quite an interesting point that will be revisited in the future post, but I think it's important to note that if your tax-advantaged accounts are largely bonds and your taxable accounts are filled with stocks, then your intended asset allocation may actually be out of whack with the after-tax value of such investments and a tax-adjustment may be prudent.  

To conduct such adjustment, simply multiple the pretax values in tax-deferred accounts (401k, Traditional IRA, etc. not Roth accounts) by 1 minus the expected tax rate during retirement.  Taxable accounts are also subject to capital gains taxes so an adjustment there may also be wise (such as adjusting for the 15% long-term capital gains tax for your stock gains).   There is still some debate in investment circles about this approach, though, and many state that investments don't care where they are housed and thus calculating asset allocation percentages by adjusting for taxes is unnecessary.  

To get back to the main point of the post, Reichenstein holds somewhat of a morphed view of the Schwab report and TIAA-CREF award-winning paper above.  While he agrees that bonds should be tax-advantaged and stocks should be in taxable accounts, he also posits that such a decision is much more important for a passive investor than to an active investor.  He also concludes that if one absolutely insists on holding bonds in taxable accounts, then one should adjust his or her asset allocation to have a relatively large bond holding.  That is, such decisions should not be made in a vacuum and instead the optimal asset allocation and asset location decisions should be made jointly.

In yet another paper published in February 2006, "Trends and Issues: Tax-Efficient Saving and Investing," Reichenstein highlights a few key points.  The first being that individuals should maximize their contributions to tax-deferred and after-tax accounts as much as possible as they all "allow for tax-exempt growth on their after-tax values."  He again brings up the point of miscalculating one's asset allocation by not adjusting for after-tax values and thus individuals "overstate the allocation to the dominant asset class held in tax-deferred accounts."  This is the paper you should consult if you want a clear explanation as to how to calculate your "true asset allocation" as I briefly described above.

For a more simplified description of the above including various investment choices, one can consult the Bogleheads wiki article on this topic.  The wiki summarizes the strategy as follows:
  1. Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes.
  2. If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.). 
  3. If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund. 
There is also a helpful graphical representation of how efficient various asset classes are as reproduced below.
That is certainly a helpful graphic to refer to when making asset location decisions.


While devising an investment plan, establishing a reasonable asset allocation based on your risk tolerance, objectives, and timeline is probably the single most investment decision you can make.  Security selection to minimize fees and optimize returns while fulfilling a particular asset class also is vital in your investment well-being.  In addition to those two factors, however, the decision to implement a tax-efficient investment plan to minimize taxes has proven to provide a significantly larger nest egg.  The effect of taxes on one's portfolio should not be understated and one must consider the tax-efficiency of their investments when considering asset location.  This is certainly an area that is often neglected but shouldn't be as the ramifications are profound.  Studies utilizing historical data on the distributions and capital gains of investments as well as the current tax laws in place lead to an overwhelming benefit to the investor to place taxable bonds in tax-advantaged accounts and highly efficient stock funds in taxable accounts.  Notable exceptions to the stocks in taxable accounts include REITs and actively managed funds with high turnover.

The location of your investments is vital to minimize taxes and maximize your after-tax portfolio return.  I can assure you that you won't be sorry for considering tax-efficiency in your investment plan.  It could mean literally hundreds of thousands of dollars more in your name when all is said and done.


Dammon RM, Poterba J, Spatt CS, Zhang HH. "Maximizing Long-Term Wealth Accumulation: It's Not Just About 'What' Investments To Make, But Also 'Where' To Make Them," TIAA-CREF Institute. 2005.

Jaconetti, Colleen.  "Asset Location for Taxable Investors," Vanguard Investment Counseling & Research.  September 12, 2007.

"Principles of Tax-Efficient Fund Placement," Bogleheads Wiki. 2010.

Reichenstein, William.  "Asset Allocation and Asset Location Decisions Revisited," The Journal of Wealth Management.  Summer 2001.

Reichenstein, William.  "Tax Efficient Saving and Investing," TIAA-CREF Institute Trends and Issues.  February 2006.

Spiegelman, Rande.  "Location, Location, Location: Dividing Your Portfolio between Taxable and Tax-Advantaged Accounts," Schwab Center for Investment Research.  June 2004.

Schwab Reduces Expense Ratio on its ETFs; Bond ETFs in the works

Schwab has reduced the expense ratio on its commission-free ETF offerings (currently only eight).  Certainly the amounts we're talking about are not huge; it looks like Schwab is attempting to beat Vanguard by at least 0.01% on all its funds (which amounts to $1/yr for a $10,000 investment). The only fairly significant change is its emerging market ETF, which has been reduced to 0.25% from 0.35%.  The rest have decreased by 0.02%.

Following is an updated comparison of ETF offerings from Schwab, Vanguard, iShares/Fidelity, and SPRDs, courtesy of Schwab.  Obviously, they highlight their own offerings!  Recall that the Schwab, Vanguard, and Fidelity customers can trade these ETFs without paying transaction charges.  Schwab currently has 8 such offerings, Vanguard has 43, and Fidelity/iShares has 25:

Domestic Equity ETFs





















International Equity ETFs














Source: Charles Schwab & Co

In the end, all three brokerage firms have ample low-cost offerings and the differences are negligible.  I wouldn't move my money to Schwab simply because they currently have slightly lower expenses (which are subject to change and aren't significant to begin with, except for perhaps the SCHE / EEM difference).  But it's certainly good news that the firms are continually trying to get our business by providing more low-cost offerings.  The more competition, the better.

The bigger news to me that dropped back in April is that three Schwab bond ETFs are in the worksSchwab's largest obstacle in my mind for getting individual investors to have the entirety of their portfolio with them was the lack of diversified and inexpensive bond funds.  Supposedly, they'll be offering a TIPS ETF, a short-term US Treasury fund, and an intermediate-term US Treasury fund.  While those three pale in comparison to what Vanguard offers, most people could make a decent portfolio with them.  You certainly could do much worse.

Jason Zweig: Using Sector Funds to Reduce Human Capital Risk

I was surfing the web and came across Jason Zweig's personal website, which has a wealth of interesting articles and insights.   Zweig, a finance columnist for The Wall Street Journal, former senior writer for Money magazine, and the editor who added extensive commentary following each chapter in the 2003 revised version of Benjamin Graham's The Intelligent Investor, is definitely one of the "good guys" in the finance and personal investing world.  He subscribes to the low-cost indexing approach that is far too uncommon among financial commentators these days.

In any event, I came across his article "Get Smart About Sectors," published in December 2002 in Money.  At first glance, this seems like a very un-Zweig-like article.  Sector investing?  Doesn't that increase risk and reduce diversification?  Well, yeah, if you're simply investing in a sector because you think it's "hot" and your motivation is simply to optimize returns.  Rather, Zweig's article proposes another motivating factor behind sector investing - to serve as a hedge against human capital.  That is, your job.  Particularly if you work in a high-risk industry, you may want to think about balancing that risk with your financial capital in a sector that correlates the least with your human capital.  This is the basic tenet behind diversification; and Zweig argues that this strategy will help reduce risk and increase diversification.
I have heard of this strategy in passing, but hadn't come across a detailed article such as Zweig's until now (despite the fact that it was published in 2002!).  This premise certainly makes sense.  Just ask those at Enron who loaded up on company stock (as a sidenote, I recommend keeping your company's stock holding as less than 5% of your net worth if at all possible).  On page 2, you can consult a chart of the various sectors and which sector correlates the least with it.   For example, if you work in mining, you might consider having a position in a utilities sector fund since it has the lowest correlation at -17.  Zweig does not encourage moving into and out of sectors in an attempt to time the market's movements.  Rather, he encourages a buy-and-hold long-term approach just as he does with typical index funds. 

Zweig comments that the average sector fund charges 1.74%.  That "average" is an absurd fee and can be easily avoided.  Perhaps they didn't exist at the time of the article, but you can gain access to any of these sectors through Select Sector SPDRs.  They have an expense ratio of about 0.22% - a far cry from the 1.74% average.  Another alternative if you don't want to go to the ETF route, is to use the Fidelity Select Funds, which are actively managed and charge about 1.0%, but only have a $2,500 minimum.  (You must hold these for 30-days or will be charged a redemption fee.)  Vanguard also has several sector specific funds and ETFs that are in the 0.25%-0.38% range, but some require a minimum investment of $25,000 and charge a redemption fee of 1% if held for less than one year.  But, again, you're planning to hold it more than one year anyways, right?  Consult each individual prospectus or fund page for details.  Some are actively managed, while others are simply indexes.   For example, here is one of the Energy funds.

Just remember, it is not advisable to attempt to use sector investing as a means to outperform the market and move into and out of hot sectors every two months.  (Although I did explore a sector rotation investing strategy in a post here.  The conclusion basically was that any outperformance one experiences due to sector rotation can be attributed to higher risk and volatility.  While during certain periods this strategy did outperform, there were other periods of significant underperformance.  Volatility overall was much greater than simply holding the total market.)   

In the end, the idea that sector funds can be used as a hedge against potential job loss and serve to further diversify your portfolio is an interesting one.  I don't think this strategy is imperative for everybody to use by any means, but if you're in a particularly high-risk industry or have concerns about job security or pay raises, this strategy might be one to consider.

Update: There is a timely article that's worth a read about the importance of human capital and its relevance to risk-taking in one's investments in today's Wall Street Journal.  The article, "How to Think Smarter About Risk," is written by Mosche Milevsky, an Associate Professor of Fianance at York University in Canada.  While he doesn't talk about sector investing, he introduces the concept of "personal beta," advising individuals to consider how a drop in the stock market would affect their paycheck and how such risks should be considered when devising a portfolio.  If you're an investment banker your earnings are more tied to the stock market and you may want to take fewer risks with the rest of your portfolio.  On the other hand, if you're a nurse or tenured professor such market movements have little relevance and you may want to be more aggressive and in stocks with your financial capital.  Interesting read!
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