The ideas behind Boglehead’s investment philosophy(1) came from John Bogle, the founder of Vanguard. The principles are underpinned by research on Modern Portfolio Theory(2) and the resulting Capital Asset Pricing Model(3). Broadly,this research shows that when choosing between 2 investment portfolios with similar returns, an investor will always prefer the portfolio with the least risk. If the investor wants more return, he or she will have to take more risk.
Bogleheads investment philosophy follows 10 simple principles :
- Develop a workable plan
- Invest early and often
- Never bear too much or too little risk
- Diversify
- Never try to time the market
- Use index funds when possible
- Keep costs low
- Minimize taxes
- Invest with simplicity
- Stay the course
Today I’ll explain the first 5 principles to you. In the next blog post I’ll cover the last 5 principles.
Develop a workable plan
To get started, your finances need to be healthy. To achieve this, you must first create a budget. You can save (a lot) by spending less than you earn and living below your means.
One of the most important steps towards financial independence is to make a financial plan. This will give you insight into your financial goals and how you can achieve them.
My blog post How much should I invest for financial independence gives you an idea of what assets you need to build to become financially independent.
Invest early and often
Starting investing at an early age is key. But don’t panic if you started investing a little later. Building wealth is still better than not building wealth.
Why start early with investing? The answer is simple: compound interest.
Albert Einstein called compound interest the eighth wonder of the world. Here, you realize return on previously accumulated return (for example, reinvested dividends). Time plays in your favor, the impact becomes greater in the long(er) term. This creates a snowball effect, like a snowball rolling down a mountain and getting bigger.
Let me outline this with an example.
Emma starts investing 10 years earlier, but builds up twice as much capital as Mark! It is therefore important to start investing early.
Never bear too much or too little risk
Your risk profile is an important part of your financial plan. How much risk am I willing to take? Do I sleep well at night knowing that I could lose half of my invested assets?
The degree to which an investor is able and willing to take risk depends on a few factors : investment horizon, stability of income, need for liquidity and possible alternatives if the investment plan should fail.
If you still have a long investment horizon ahead, for example more than 10 years, you can take more risk. After a bear market, when the (stock) market has seen massive declines, there is still plenty of time to recover.
The stability of your income is also important. You can take more risk if you have a stable income in the long term.
You can look at the need for liquidity together with your emergency fund. If you don’t need a lot of extra liquid assets (usually cash) in the short term to deal with an emergency, you can take more risk. If you have a small(er) emergency fund, you should consider taking a little less risk.
The final factor that can affect your risk appetite are the alternatives if the investment plan were to fail. You can, for example, continue to work longer, take a part-time job, or reduce your budget. The more alternative options, the more risk you can take.
You can reduce risk by using asset allocation.
By determining your asset allocation, you’re going to create an appropriate mix of riskier assets and lower-risk assets. Riskier assets are, for example, stocks or real estate. Lower-risk assets are, for example, cash, short-term bonds or medium-term bonds.
To estimate the possible loss in a stock market crash, we can look at figures from the past : the Bogleheads calculated the cumulative return after inflation in the 2000-2002 bear market(4).
A portfolio of 80% stocks and 20% bonds lost about 35% in these 2 years and a portfolio of 50% stocks and 50% bonds only lost about 14%. We also learn from the past that risky assets can yield more in the long term than lower-risk assets.
Which breakdown do you make between risky and lower-risk assets? This is a personal choice. Some offensive investors opt for 100% risky investments, as these can generate higher returns over time, where more defensive investors build in more security based on a portion of lower-risk assets.
Some rules of thumb to determine the asset allocation, but this is just a possible guide :
Option 1 : Your age in risk free assets. For example, if you are 40 years old, the allocation is 60% risky / 40% lower-risk.
Option 2 : Risky assets = 110 minus your age. For a 40-year-old, this means 70% risky / 30% lower-risk.
Option 3 : Risky assets = 120 minus your age. For a 40-year-old, this means 80% risky / 20% lower-risk.
Diversify
Investors following the Bogleheads philosophy like to select broadly diversified index funds/ETFs. The main reason for this is spreading the risks. Suppose you invest in the stock market and buy shares of 1 company. If this company goes bankrupt, you lose the entire value of your investment. But if you invest in 1000 different companies on the stock market, for example using an ETF, when one company goes bankrupt you don’t lose the entire value of your investment. Therefore, it is best to invest on a global scale, regardless of countries and/or sectors. With a (market cap) total world index fund/ETF, you have an average return of the total world market, regardless of which part of the world or which sector performs best.
Never try to time the market
Timing the market means to predict the future by buying stocks and selling them in the short term for a profit. I have to disappoint you: it is almost impossible to time the market. You need to know the right moment to buy and the right moment to sell.
Emotions also play a role. Typical investors buy when a fund has done well (“greed”) and sell when the fund has done badly (“fear”). This produces worse results than holding the fund (“buy & hold”).
Time in the market beats timing the market
It is better to buy regularly, at random times (“time in the market”) rather than trying to determine the right time to buy or sell (“timing the market”).
In the next blog post I’ll explain the last 5 principles of the Boglehead’s investment philosophy.
This info is for informational, educational and entertainment purposes only, and does not constitute financial, accounting, or legal advice. Please do your own research (disclaimer).
Sources :
(1) Bogleheads® investment philosophy – Bogleheads. (n.d.). Bogleheads. Consulted on 2021, August 7, https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investment_philosophy
(2) Wikipedia. (2021, July 7). Modern portfolio theory. Wikipedia. https://en.wikipedia.org/wiki/Modern_portfolio_theory
(3) CAPM – Capital Asset Pricing Model – Bogleheads. (n.d.). Bogleheads. Consulted on 2021, August 7, https://www.bogleheads.org/wiki/CAPM_-_Capital_Asset_Pricing_Model
(4) Bogleheads. (2019, November 29). Asset allocation – Bogleheads. www.bogleheads.org. https://www.bogleheads.org/wiki/Asset_allocation