Dr Tom Philips says it in fewer than 700 words!
My friend Tom Philips sent me a long email when he saw the post on being a normal person [https://donezra.com/114-being-normal-beats-being-a-theoretical-economic-person/ ]. He particularly liked Dr Meir Statman’s clear identification of our two goals: not to be poor, and to be rich. And he will weave it into a graduate level textbook on portfolio management that he’s in the midst of co-authoring. I’m delighted!
Tom, who teaches in the Department of Finance and Risk Engineering at NYU’s Tandon School of Engineering in New York, NY, also sent me a short note that he wrote for the next generation of his family on investing. I wish I could express myself as succinctly as he does (all you need to know in fewer than 700 words)! He has given me permission to reproduce the note here, and I do so with enthusiasm. By the way, Tom modestly calls his note “Most everything you need to know …” but I’ve taken the liberty of calling it “All you need to know …” And yes, you know and I know that I’m exaggerating – obviously. That’s why a graduate-level textbook is necessary, if you really want to know (almost) everything that’s relevant.
He calls this part “Theory and Beliefs” and has a second part that he calls “Actionable Advice” (for his US-based friends and relatives) which he has also allowed me to reproduce. (OK, it’s a touch over 800 words in total if you count these too, but regardless, it’s remarkable.) For my readers in other countries, of course you will take his recommendations as directional rather than specific, because you will need to find parallel solutions available in your own country (though it turns out that both he and I personally invest with Vanguard), and possibly hedged to your own currency – plus the fact that you may not have the same personal characteristics as Tom’s friends and relatives, to whom this is addressed. The Vanguard characteristics that particularly appeal to Tom are that it “was the pioneer of index fund investing and continues its long tradition of being exceptionally investor friendly – its costs are 80% lower than the industry average, and it has high ethical standards.”
You’ll see that the stuff I’ve written (if you remember it) is extremely consistent with Tom’s note – another reason I like it so much. (Which reminds me – this series of blog posts has become so long that I find it tough to find exactly where I’ve said something in the past. I must find a convenient way to compile an index of it all. For the future …)
Theory and Beliefs
- Investing is putting your savings at risk: no risk (e.g. cash under your mattress), no reward; good risk (e.g. stock and bonds), good rewards; bad risk (e.g. gambling), bad rewards. You’ll earn about 4% each year with moderate risk over the long term if you buy and hold a globally diversified portfolio of stocks and bonds. That’s about 2% better than inflation, which runs about 2% each year.
- If I knew how to earn 15% each year with no risk, I’d tell you; but I don’t, and neither do the charlatans who claim that they do.
- While financial markets offer investors a dizzying array of investments, and while salespeople routinely promise the sun, the moon and the stars, you’ll do just fine by ignoring them and investing in a globally diversified portfolio of stocks and bonds through exceptionally low cost mutual funds known as index funds, which simply buy and hold all the stocks or bonds in the market and don’t trade them.
- But isn’t it better to identify, and invest with, the next Warren Buffett? It absolutely is, if you can identify the next Warren Buffett! But it’s exceptionally hard to prospectively identify great investors, who are a rare breed. What about retaining a consultant who identifies great investors? Great idea if you can reliably identify great identifiers, but they, too, are a rare breed! In short, non-index investing is best left to the few investors who have a proven record of success – index funds work best for everyone else.
- The benefits of global diversification are vastly underestimated. You’ll do yourself a huge disservice by investing only in your home country and in a few stocks, as it’s incredibly hard to tell in advance which countries, regions, sectors and companies will do well and which will do poorly.
- The powers of disciplined saving and compounding are also vastly underestimated: If you save $1 for retirement in each year that you work, over half your retirement savings will come from contributions you made before you turned 40.
- With Social Security as a backup, you need to save approximately 1/6 of your income each year for retirement. Furthermore, you can spend about 3% of your savings each year once you retire.
- P.S. https://opensocialsecurity.com/ is a terrific resource, and it’s free – use it!
- Stocks generally outperform bonds over the long term, but are volatile. Don’t get starry eyed when they rise, don’t despair when they fall.
- You won’t go too far wrong by investing half your savings in stocks and half in bonds, half domestically (i.e. in your home country) and half internationally. If you live in a small country (say Iceland), invest less than half (say 1/4) domestically and the rest internationally.
- Avoid esoteric investments in real estate, private equity, hedge funds etc. Recall point 3 and tune out glamour, noise, and fees, all three of which usually go hand in hand.
- Stocks sometimes get overvalued (e.g. during the Internet bubble in 2000), so it then makes sense to keep less than half your savings (say 1/3) in stocks. At other times (e.g. at the depth of the crisis in early 2009), they get undervalued, so it makes sense to have more than half your savings (say 2/3) in stocks.
- P.S. it’s incredibly hard to tell if stocks are going to rise or fall in the short term, and most periods of overvaluation and undervaluation are obvious only in hindsight.
- Invest at the lowest possible cost – your earnings rightly belong to you, not to someone else. If you are paying more than 0.2% of your assets in fees each year, you are paying much too much. Ditto for sales charges of any kind – they benefit salespeople, not you.
- Finally, never, ever, burn with envy because someone you know claims to have effortlessly made a fortune – virtually all such stories are the product of an active imagination aided by a selective memory.
Actionable Advice (remember: for US investors)
- If you want to invest in one single fund that will work well for the rest of your life regardless of your age, put all your savings into something like Vanguard’s LifeStrategy Moderate Growth Fund, which has 40% in US stocks, 25% in international stocks, 25% in US bonds and 10% in international bonds.
- If you are willing to invest in two funds, put 85% of your savings into Vanguard’s LifeStrategy Growth Fund, and 15% into Vanguard’s Total International Bond Index Fund. This prioritizes domestic stocks over international stocks, but equalizes your exposure to domestic and international bonds.
- If you are willing to invest in 3 funds, put half your savings into the Vanguard Total World Stock Index Fund, one-fourth into the Vanguard Total Bond Market Index Fund and the remaining one-fourth into the Vanguard International Bond Index Fund. To adjust your exposure to stocks, scale these numbers up or down proportionately, e.g. (2/3, 1/6, 1/6) or (1/3, 1/3, 1/3).
Tom adds: “Solution 3 is, in essence, what I do with my own savings. I think the first solution is good, the second is better, and the third is the best, but you’ll be happy with any of them. And if you find investing intimidating, just use the first option: you can’t beat it for simplicity, and you’ll be happy with the results.”
Thanks very much, Tom!
My friend Tom Philips helps you to keep both the principles behind lifetime investing and their implementation simple.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.
I love this! Kudos to Tom Philips for penning and to you for posting!
Thanks, Cindy. Yes, Tom is good, isn’t he!
Thank you for yet another thought-provoking blog. I do like the simplicity of Tom’s advice. It’s very easy to make investing complicated.
I’d be interested in your thoughts about Tom’s high level of bonds in his recommendations. With yields at almost zero, bonds no longer have an income role and yields would have to be negative to see any capital gain. I see that a small allocation of bonds may have a useful diversification role but surely the levels of bond exposure above would significantly reduce Growth Oriented Assets. In a previous blog you talked about keeping 3-5 years of forecast expenditure in Safety oriented assets and keeping the rest in Growth oriented assets (which I think were 100% equities), the 3-5 years giving flexibility in a downturn. Surely this is a better approach than a high level of bonds?
Thank you for the blogs, website and book – invaluable guidance.
Thanks, you’ve identified a fundamental issue! Two responses. One is mine: I didn’t make it clear that keeping 3-5 years of expenditure in safety-oriented assets is intended (a) in decumulation rather than in accumulation and (b) as insurance against having to cash out in a growth market decline, rather than as an investment. The second and more profound answer is from Tom, to whom I referred your comment. He says …
In creating the 50/50 portfolio, I thought about bonds not just as income generators and mean-variance diversifiers, but as senior securities that are unlikely to disappear down a rabbit hole in the event of a disaster. In fact, I thought of my 50/50 portfolio as a minimax solution to the following set of scenarios:
(1) If the global economy fares well, stocks will do well and bonds will do you no harm.
(2) If the global economy fares poorly, stocks will do poorly and bonds will preserve a substantial fraction of your wealth.
(3) If your home country fares well relative to the rest of the world, your domestic portfolio will do well even if your international portfolio doesn’t.
(4) If your home country fares poorly relative to the rest of the world, your international portfolio will do well even if your domestic portfolio doesn’t.
The one scenario that isn’t explicitly modeled but which lurks in the background, is inflation, which can be taken care of by using linkers for the bond component. I wavered a bit on linkers vs. a bond index and then finally decided in favor of a bond index because it offers a substantial pickup in yield and will respond over time to inflationary shocks as coupons are reinvested at higher yields. One can, of course, push up bond yields by moving down in credit quality or by buying preferred stock in place of bonds (Burton Malkiel argues for this), but I’m not a fan as you essentially load up on tail risk.
It is natural to ask if tail risk has bitten anyone in the recent past? Yes it has! Just ask Icelanders, who saw ¾ of their stock market wealth disappear in 3 days in October 2008 and 95% of their stock market wealth disappear in 3 months. And if you turn the clock back to World Wars I and II, as well as to the various revolutions of the 20th century, there are many more such examples.
I crafted my solution to reflect investment theory and these scenarios, and so that it could be implemented (and maintained) by anyone, at any age, with minimal effort. While my solution can clearly be improved on by investors who are willing to put in the work needed to estimate expected returns, think about and monitor risk etc. etc., the vast majority of investors will be better served by my 50/50 portfolio, just as they will be better served by index funds than by actively managed portfolios.
This is a long answer to a short question, but I do hope that it helps your reader, who is essentially betting against tail events when he or she argues for a greater exposure to growth oriented assets. It might not be a bad idea for me to rewrite the note to include these scenarios. [My note: Tom has sent me an updated version that includes this aspect. He really is remarkable!]
Thanks Tom and Don for another informative article. Here’s a recent comment by an Australian FIRE blogger.
“But here is the kicker, you don’t really need to do anymore research if you don’t want to. You can beat over 90% of professional stock pickers by buying Vanguard Australian Shares index/Vanguard International Shares index. Or if you value simplicity even more than I, just buy Vanguard Diversified High Growth index and you are done.”
Putting aside the dubious FIRE philosophy, there is no doubt that a number of these Millennials are savvy and know how to achieve financial independence. It’s very similar to Tom’s recommendations. Yes, the proportions and asset allocations are slightly different, and heavily investing in a small country (eg Australia) is questionable. However, low cost, passive investment in index funds and keeping it simple are powerful messages. Tom’s article is spot on.
Thanks, Martin. Your comments are spot on too!