Jason Method: If you’re an investor, what does success look like? Does it mean becoming wealthy, or does it mean securing a reasonable retirement, putting children through college, or buying that first home? Whatever your definition, how does an investor become successful?

Hello, I’m Jason Method, and welcome to Vanguard’s Investment Commentary podcast series. In this month’s episode, which we’re taping on May 30, 2017, we’re going to discuss Vanguard’s Principles for Investing Success, which can be found on our website.

With us today is Andy Clarke of the Vanguard Investment Strategy Group and author of Wealth of Experience: Real Investors on What Works and What Doesn’t. Andy is here to explain how everyone from a beginning investor to the most sophisticated advisor can succeed in investing. Hi, Andy, and thanks for joining us.

Andy Clarke: Sure, thanks, Jason.

Jason Method: So tell us, what are the principles, and how long have they been around?

Andy Clarke: Vanguard’s Principles for Investing Success are our philosophy about what it takes to succeed as an investor. And there are four principles. The first is goals, create clear, appropriate investment goals. The second is balance, develop a suitable [asset] allocation using broadly diversified funds. The third is cost, minimize cost. And the fourth is discipline, maintain perspective and long-term discipline.

We first published these principles in 2013, but they’ve been around in some form since Vanguard opened its doors in 1975. And you can actually trace them back even farther to Vanguard Wellington Fund, which was founded in 1929. Vanguard Wellington Fund was the nation’s first balanced fund, and it exemplifies, obviously, balance but also discipline. So it maintains a portfolio of stocks and bonds, and it’s had the discipline to execute this strategy for almost a century of different markets.

Jason Method: Why would these principles be important today?

Andy Clarke: Well, while they’re always important, they’re timeless, I think what changes is how you apply them to the current environment. So today we’re in the middle of a stock bull market and conversations about balance, for example, are about remembering why you have bonds in your portfolio. Stocks are returning double digits; bonds are returning about 2%. Why would you want to hold bonds? Well, we have to remember that bonds are there to play a role in the portfolio. They can cushion the portfolio against the stock market’s occasional and inevitable downturns.

If you go back to 2008, 2009, the financial crisis, the principle is the same, but the conversation is very different. Back then, the conversation was about sticking with an allocation to stocks even though stock prices were tumbling.

Jason Method: These principles sound pretty intuitive, but there is more to them. Let’s discuss each one briefly. What does it mean to have investment goals?

Andy Clarke: Well, a goal is pretty much just what it sounds like. A goal is what you hope to accomplish with your investing, what you hope to accomplish with your investment portfolio. So for individuals, common goals include helping to finance a child’s education or, for all of us, saving for retirement.

Jason Method: Let’s talk about retirement, Andy. That’s a big one, as you mentioned, for really everyone. The first step in there seems to be how to figure out how much you’re going to need, right? And that’s tough, thinking so many years ahead. How do you estimate that?

Andy Clarke: Yeah. You’re right, retirement can be challenging. I mean some goals, like education, are relatively straightforward. You know what tuition is today. It’s easy enough to estimate what it’ll be by the time your child is ready for college, but retirement can be a lot more complex. If we’re 20, 25 years from retirement, we’re not really sure what we’ll need.

So the best approach, and it’s a good approach, is just to start with a ballpark estimate. I’ll give you a simple example of how you might do this on your own, but this is an area where advice can be especially helpful in helping you think through the different steps you’ll need to take to the kind of lifestyle you want in retirement.

So let’s say you estimate you’ll need $65,000 a year in retirement. You check the Social Security website, get a sense that you’ll probably get $25,000 a year from Social Security, maybe you have $10,000 from rental income or a guaranteed income source such as a pension, and you realize that you’ll need to generate another $30,000 from your investment portfolio. How much do you think you’ll need to generate that amount of income each year in retirement? I’d use the 4% rule just to get you in the ballpark. I’d divide 30,000 by 4% and come up with an estimated portfolio target of $750,000.

Jason Method: Okay, and the 4% rule is meaning you intend to take 4% of your portfolio out every year to pay for expenses.

Andy Clarke: Right, that’s right. You take 4% of the initial portfolio’s value out and then adjust that amount for inflation every year. And it’s a simple rule of thumb that historically, at least, has been a reliable means of figuring out how much you can withdraw while limiting the risk of running out of money during retirement.

Jason Method: Aren’t there a lot of other theories about how much you can withdraw in retirement?

Andy Clarke: Yeah. Yeah, this is an active area of financial planning research at Vanguard and throughout the industry. And, you’re right, it can be very complex. And, again, here’s where a skilled, trusted advisor can be very helpful. There are tax implications, different trade-offs that might not be immediately apparent. So the 4% is good for coming up with a ballpark figure, but you can probably refine that estimate and maybe get a more useful picture of the different strategies you could use.

Jason Method: Let’s talk about the next principle, balance. Balance sounds easy, but let’s be honest, many people are afraid of the stock market. We still remember the global financial crisis and how that hurt so many folks. Some people still don’t want to go back in. Tell us about the need for balance and what that means.

Andy Clarke: Yeah, the big picture idea with balance is that you want to combine different assets that behave differently in different market environments. So you mentioned that people are scared of the stock market. That’s sometimes the case. Sometimes they’re not scared enough. And balance is about reminding ourselves that we need to have some balance between growth-oriented assets, stocks, and assets that can provide some cushion against the downturns, bonds.

And you’re inevitably going to be holding something in your portfolio that makes you uncomfortable, but I like a quote from the investment researcher Peter Bernstein, who said that if you’re not holding something that makes you uncomfortable, you’re not really diversified.

Jason Method: If you’re an investor and you’re trying to figure this out, you’re trying to be balanced, it can be daunting to try and pick from so many different options that are out there these days with however many thousand mutual funds and ETFs. Is there a way to sort through all that and achieve the balance that you think you need?

Andy Clarke: I don’t think it needs to be that complex. Here’s a simple solution. One thing you can do is look at the target-date funds that are in so many 401(k) plans, and that’s balance and diversification in practice. So target-date funds, as you know, are targeted to investors with a certain expected retirement date. So you could look at a balanced fund, find the target date that is relevant to you, and then look at what that portfolio’s mix of stocks, bonds, and other assets is. And that gives you a good picture of how you should be thinking about balancing a portfolio.

Jason Method: Is there more to asset allocation than just allocating between stocks and bonds?

Andy Clarke: Well, stocks and bonds is the big one, but I think, you’re right, it is important to emphasize that when we talk about stocks, we’re not talking about just, say, large-cap U.S. stocks—the S&P 500 index fund, for example. We’re talking about diversifying broadly across the stock market—big stocks, small stocks, U.S. stocks, international stocks—and we’re talking about the same broad diversification across the bond market—government bonds, corporate bonds, international bonds.

Jason Method: If an investor has a balanced allocation, say the common one is 60% stocks and 40% bonds, what kind of return can they expect? I mean when you talk about coming up with goals, you have to plug in a number, right, that says, “Hey, I’m going to get this return so I get that end result.” But what’s a reasonable expectation?

Andy Clarke: Well, we can’t know, but my go-to resource for this question is Vanguard’s Economic and Investment Outlook, and you can find that on our website. And in this outlook, we project a range of likely returns or possible returns over the next decade. And you can look at these returns in a bell curve. And in the middle is what we call the central tendency. That’s where we think returns are most likely to fall. They could be much higher; they could be at the tails of the bell curve; they could be much lower.

But when we look at these central tendencies for a balanced fund, what we see over the next ten years is a real return—that’s an inflation-adjusted return—of roughly 3% to 5%, and then a nominal return—that’s without the inflation adjustment—of something like 5% to 7%. So that’s the sort of neighborhood we’re talking about when we’re trying to plug in a number.

Jason Method: Now, we’ve come to the principle of cost, that is, the need to keep costs low. The principles say that costs are forever, like diamonds. What does that mean?

Andy Clarke: Well, not as attractive as diamonds, but I guess equally permanent. Well, investment returns come and go. Investment returns can be very high one year, very low the next, but costs are a constant. They’re an anchor on your portfolio. They’re pulling down the returns of your portfolio whether the financial markets are rallying or collapsing. So what you can do to maximize your share of whatever the market’s return is to minimize the investment management costs you’re paying.

Jason Method: But don’t you get what you pay for sometimes? I mean, should an investor only evaluate products just based on which one is the lowest cost?

Andy Clarke: That’s the perverse thing about investing. In most economic decisions, you’re right, we do get what we pay for. If you go to an expensive five-star restaurant, you’re going to get a better meal than you will at the beach hot dog stand. But in investment management, this balance between cost and value is turned on its head.

Jason Method: Certainly Vanguard research, and other research, has found that lower costs allow you to keep more of any returns you may earn. But is there something worth paying for in investment management?

Andy Clarke: Yeah, well, of course. I mean, if you think about financial advice, where the decisions can be so complex and it’s much more than investment management. It’s financial planning strategies, estate planning, tax planning—those are services that can be well worth paying for.

Jason Method: That brings us to the final principle, which is discipline. You, as an avid tennis player, know something about that.

Andy Clarke: I think I know where you’re going with the tennis question, but that’s really just a specific instance of discipline, so let me talk about the big picture first. Discipline in our principles is about remaining committed to your plan and resisting the impulse to make changes to your plan in the face of these powerful emotions we all feel. And that can be very challenging.

I mean, we all look at the headlines, and we’ll see stories about maybe a particular group of stocks or strategies that are delivering exceptional returns, and we feel the impulse to chase those returns. Or maybe we turn on the TV and we see some smart, persuasive analyst painting a very bleak picture of the future. We get scared and think, it’s time to pull all my money out of the market. Discipline is about trying to resist those impulses.

Now you mentioned tennis, and I think you’re referring to a famous essay by Charley Ellis called “Winning the Loser’s Game.” And Ellis drew this interesting analogy between tennis and investment management.

So this is the 1970s, and he was looking at professional tennis players like Björn Borg, Chris Evert, John McEnroe, with the crazy hair and the shorts up to here. And when he looked at the pros, he saw that they were playing a winner’s game. They won by serving aces, hitting unreturnable shots. But when Ellis looked at the recreational game, he didn’t see people serving aces or cracking these atomic forehands. He saw them dumping the ball in the net or hitting the ball against the fence. In the recreational game, he saw people winning by not losing.

And he saw a parallel between this recreational tennis game and professional investment management. Professional investment management had become so competitive that if you tried to outperform by making aggressive purchases and sales or making aggressive changes to your asset allocation, you were more likely to make a mistake and lose. So his recommendation was: Don’t play that game. Simply minimize your mistakes, passively accept the market’s returns, and you’ll more likely be a winner.

Now Ellis’s essay was about index investing, but I think it has application to this principle of discipline too. And the key point is to minimize mistakes. Once you’ve developed a sensible investment plan, you want to keep your portfolio in play, you want to save aggressively, you want to minimize mistakes such as reacting emotionally to what’s happening in the market, and keep your focus on the long term. And as we demonstrate in the principles, this strategy has proven a key to investment success over decades.

Jason Method: I want to bring up one more thing, and you just mentioned it, and that is that point about saving more. In your book, you cited an academic study of investors that found that some who had been in the lowest 10% of income for their entire careers had sizable retirement savings while some people who had been in the highest income tax brackets had nothing for retirement. Tell us more about what that means.

Andy Clarke: Well, that study was an interesting example of something we’ve probably all heard before, which is it’s not what you earn; it’s what you keep. And these researchers identified a group of people who earned very little but had good, disciplined saving strategies throughout their working years, and they were able to accumulate sizable portfolios and finance ambitious goals such as retirement.

The study also looked at high earners who didn’t have those savings habits. And as much potential as they had to accumulate large portfolios, they didn’t have the sort of critical savings discipline to get there.

Jason Method: That pretty much covers it. Thanks for joining us, Andy.

Andy Clarke: Sure. Thanks, Jason.

Jason Method: Words of wisdom—goals, balance, cost, and discipline—and save more if you can. Thanks for joining us for this Vanguard Investment Commentary podcast. To learn more about Vanguard’s Principles of Investing Success, check out our website.

And be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.


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