Jon Cleborne: “Good evening, and welcome to tonight’s live webcast on the Keys to Investing Success. I’m Jon Cleborne.
Today’s investing environment can make investing seem more challenging than ever. You’ve got market swings, elections, Brexit, fed policy, low interest rates. It can be so hard to figure out what to do. So our goal tonight is to give you some sound investing guidance so you have the best chance of achieving your financial goals.
Joining us tonight are Matt Piro of Vanguard’s Portfolio Review Department, Bryan Lewis of Vanguard’s Personal Advisor Services, and Frank Chism of Vanguard’s Investment Strategy Group. They’ll discuss Vanguard’s guiding principles and how you can apply them to your investing decisions.
So welcome, gentlemen.
Speakers: Thanks for having us.
Jon Cleborne: Tonight, we’ll spend most of our broadcast answering your questions. There’s two items I’d like to point out before we get started. First, there’s a widget at the bottom of your screen for accessing technical help. It’s the little blue widget on the left. And if you’d like to read a bit more about tonight’s topics, you can click the green resource list widget on the far right-hand side of the player. The red widget is for submitting questions to our panelists that are here with me tonight. Sound good?
Jon Cleborne: Alright. Well, before we get into our first discussion, I’d like to just take a second and ask the audience a question. So on your screen now you’ll see our first poll question which is, how confident are you in your ability to manage your investments? Very confident, somewhat confident, or not so confident at all.
So if you take a minute and just respond now, we’ll share your answers in just a couple minutes.
So with that we’ll go ahead and get rolling here. So I think you can’t have this conversation right now without asking a question; it was probably the most frequently asked question amongst all that were submitted prior to the webcast, which is how do I make sense of this election that’s coming up, and how should that impact my portfolio? So maybe, Frank, I’d ask you, what are your thoughts on the topic? How do we make sense of the election and how to think about investing with it?
Frank Chism: Sure, Jon, a great question, and we get it a lot. So, you know what, we would encourage folks to remember and keep in mind is that the election’s a few weeks out. We do see an often increased stock market volatility in and around an election, usually just before it. But then that volatility often dies down after the fact. And what we encourage people to do is keep in mind, you know, you have long-term goals, you have goals you set out, an investment plan you have in place. And we would encourage you just to keep with that.
You know, it’s very difficult to know what the outcome of the election’s going to be a) in a couple weeks; b) it’s very difficult to know the impact of any particular candidate. And we know whatever impact it is, it’s going to take quite a while for that to work itself out. Things aren’t going to change immediately the day after the election.
So, again, and this is probably something you’re going to hear often from me tonight, is stay with your plan, stay invested, keep doing what you’re doing, and probably this is going to come and go relatively quickly.
Bryan Lewis: And to piggyback off that, there’s a lot of uncertainty that comes along with an election, but there’s always going to be something within the market, right, whether it’s oil concerns early on in the year with China; in the summer it was Brexit. But there’s always going to be something that is within the markets that’s going to drive some level of uncertainty when it comes to investing. And the best thing you could do is try to control what you really can control, which is having a balanced and diversified portfolio, focusing on lowering your cost with your investments, and sticking to that strategy over time.
Jon Cleborne: Yes, I think that’s good counsel. So we got our poll results back in and I think the results seem to reflect some of the anxiety that’s out there. So if we look at the results here, I got 27% of folks said they were very confident in their ability to manage their investments. But about two-thirds came back as somewhat confident, and just a few that are feeling not confident at all. So there’s some anxiety out there.
So maybe to build off of that for a second, why don’t we talk about the keys to success of building a long-term portfolio and how should we think about the foundational elements of that? So, Frank, I’d kick that to you, and, Bryan, feel free to jump in here.
Bryan Lewis: Absolutely.
Frank Chism: Yes. So when we start with—Before you invest anything, and it’s the same way we like to think about, if you’re going to build a house you need a plan. Anything you do, you have to set out, “What are my goals?” So our key philosophy is start with your goals, and then you want to have a balanced even approach to that, you want to pay attention to cost, and then you want to be disciplined. So just to give you a brief example and, then, Bryan can talk a little more specifically about how you go about doing these things.
But the goals are very simple. What are you saving for, what are you investing for? Is this for retirement, are you trying to fund your kid’s education? You know, what are your goals as you see them, what’s the time horizon for those goals? Those should be definitive goals that you have written down, that you understand, and you have to have steps in place to reach those. You should take a balanced approach, and you have to have a balanced portfolio. You have to have things that are going to move different directions at different times in the market. So if you have volatility in stocks, that’s why we always suggest you’re going to have some bonds as well. So you have to have a balanced approach.
Cost is very important, and that’s something I know is going to come up quite a bit this evening. But the only thing you can really control about your investments is how much are you paying for them? You can’t control the market or the outcome of the market, so cost is important.
And then, finally, discipline. And I think Bryan and his colleagues, this is where they really help with that, is if two-thirds of our folks are saying they’re somewhat sure of what they’re doing, it helps to have your plan and stick to it. And it helps to have someone who can help you say, “Hey, this was our plan, and things look rocky out there right now, but we said this is what we’re going to do, and we’re going to stick to it regardless of what we see in the near term.
Matt Piro: Yes, Frank, but I might just jump in on the cost side of things because we do have some data here on the expenses. And I think sometimes clients forget how much cost can really erode their returns. So what we’re showing you here is how costs can really erode your returns over time. In particular, high costs which compound over time to really eat into the return that you ultimately would achieve if you had a lower cost option.
So this chart here is showing you how that compounding effect really shows itself over time. And if you look out over say 25 years, that compounding of those high expenses has eroded roughly a third of your return with this expense ratio of 1.2%.
And if you compare that with a lower cost option, one of .18%, you’ll see the erosion of returns is much lower from costs. So while the costs still compound over time, you’ll see they compound at a much lower rate because of that lower expense ratio. So you’re losing much less of your return to costs which will help you meet your goals and keep the returns that are ultimately being delivered through the products you’re invested in.
So that’s why it’s critically important for us to focus on cost and help investors really understand the impact cost has on the returns they ultimately, you know, they reap the benefits of.
Bryan Lewis: And to take a look at that even further, talking with my clients that I help manage their portfolios, you really have to—obviously, we all want to make money but what is the money for, what’s its purpose, right. Is it for retirement, is it paying off a house, is it building a legacy for your family? And once you’re able to clearly define those goals, to Frank’s point, you’re able to focus more on building that portfolio, and we do follow a top-down approach.
And, essentially, what that means is you first want to determine your stock-bond ratio, your asset allocation. Certainly, you do want to have some cash for your day-to-day living expenses as well as for emergencies, but focusing on the stock and bonds to build that portfolio to really lead to getting you to the long end of the objective, which is meeting your goal.
And once you’re able to determine the asset allocation, which is again which I’ll help my clients work through, based on their situation, you can start going into, alright, how much U.S. exposure should I have? How much international exposure should I have? And then you can start to drill down on large-, mid-, small-company exposure, value versus growth.
And the last piece to this that we select in the planning process is actually the securities or the mutual funds that you ultimately go with. And that’s where, to our point, you really want to focus on using low-cost investments to achieve that.
And the last piece that Frank brought up was the discipline, right. You need to stay committed, start as early as you can, and really save as often as you can to set yourself up for success in the long run.
Jon Cleborne: So one of the things that I think we’re—I’d like to throw out to the audience here is another poll question—because I think it will help us to focus our comments as we continue forward.
So one question that we’d have for the audience is how often do you review your investment portfolios performance? Are you looking at it semiannually, annually, more frequently, or never? So if you take just a minute and respond to that, we’ll come back to that in a second here.
But you just talked a little bit about cost and the impact of cost. So one of the questions that were submitted in advance was from Shawna in Salt Lake City. And she said, “I’m trying to move my investments out of another investment firm and invest in index funds. And I’ve come to the realization that 30% of my gains are eaten up by fund expenses. How do I evaluate index funds and how do I make sure that I’m well diversified when I’m investing in one?
Frank Chism: I’d be happy to talk to that, Jon. First of all, what do we mean by diversified? So I think that’s something, that’s a word we use all the time, people think about that, you hear diversity quite a bit. When we talk about diversification in investments, we’re talking about covering as much of the available universe that you can get your arms around.
So in terms of index investing, what we at Vanguard always believe is that you should have, you should cover as much of the investable market as possible. So, for example, if you are going to invest in the United States in the stock market, we would want you to use something arguably that’s trying to get access to all of that market. There’s about 3,500 stocks roughly in the U.S. We would want you to use something that’s going to get most of those, so you’re going to cover all the sectors in the United States, you’re going to cover; you know, Bryan talked earlier about growth, he talked about value, he talked about large companies, middle-size companies, small companies. We would want you to be covering all of that in one investment, if possible.
So what does that mean, Shawna, for you to look out for is, if you look at an index fund, and it’s a U.S. index fund, and it only has a couple hundred names in it, that’s probably not as diversified as you would want to be. You want to look for something that’s really got a large number of securities, that’s covering as much of the available market as possible.
Jon Cleborne: Alright. So I think our poll response has come in here, and so let me take a peek here. So we asked how often do you review your investment portfolio’s performance, and it looks like about 20% were semiannually, about 15% annually, 65% are looking at it more frequently, and just 2% are never looking at it. So we’ve got folks that are checking on this pretty frequently in the audience, and so I’d say a pretty reasonably confident and reasonably engaged group of clients watching tonight.
So let’s talk a little bit about the investing principles, Frank, that you had talked a little bit about earlier, and, Bryan, you mentioned as well, particularly as we think about sort of pre- and post-retirement. So can you talk a little bit about how those principles apply when you’re thinking pre- versus post-retirement, and what type of an impact that would have on your performance?
Frank Chism: Sure. So, I mean, I can start and Bryan—You know, the way to think about it. So before retirement, you kind of draw a line and you say “I’m in front of retirement what do I need to do,” and then after retirement. And most people, the biggest single goal they’re probably going to have in their lifetime is retirement. And then Bryan mentioned a few others and I did too earlier, where before retirement you’re going to have competing goals. You’re going to have goals to send kids to college, maybe purchase a home, etc., so you’re going to have to juggle and balance and prioritize those goals as you get there.
And, again, our process helps you with that because we’re very clear and upfront about the importance of setting those goals, maintaining a balanced portfolio, and staying with your discipline through that.
And then once you get to retirement, then your goals really change, and it’s important that you recognize before you get to that line that my goals are going to be changing soon, my time horizon is not what it was. My risk tolerance is probably, maybe it’s not quite what it was. And then you have to shift your goals and shift your plan; you’re probably still going to be in a pretty well-balanced portfolio, obviously. But you change your plan and now you’re thinking about retirement, you’re thinking about leaving money to your heirs, if there’s any left, of course, to do that. The people are living much, much longer now. So assuming you have something left, that’s the idea.
But my point is, through both pieces of that cost, discipline are always going to be very important, but really setting those goals and understanding how to prioritize them and update them as you need to is going to be very, very important.
Bryan Lewis: And to take that a step further as well, when you start looking at how do you improve your return, a lot of people; we’ve talked a lot about cost that chips away at the return, but also taxes. And one of the things that as an advisor we focus on is looking at how do we improve your after-tax return? How do you keep as much of that market return as possible?
And there’s this idea called asset location, similar to real estate, right, location, location, location. But when you start looking at, alright, if you have clients that have multiple registrations, right, so you have retirement accounts such as IRAs, 401k(s); other investors also have taxable accounts such as an individually registered account, or a joint account. You can be strategic with, alright, you have a desire to asset allocation, let’s figure out where you can actually place those investments.
So this notion of asset location is trying to figure out where to own the most tax-efficient investments, and that is in your nonretirement account. And, generally, what we mean by that is you want to own stock index funds in a nonretirement account. And then inside a tax-deferred account, similar to an IRA or 403(b) or 401(k), you want to own thetax-inefficient investments. And what I mean by that is actively managed funds, bonds, taxable bonds, these are great places to move into a tax-deferred account to shelter that income.
And if you look at building a portfolio, that would be strategic in this manner and, again, this is what will help my clients focus on. You’re able to capture and keep more of that return because you’re paying less in tax over time.
Jon Cleborne: So maybe to take just a step back, there’s a question that’s come in, it’s live from Chris, who’s asked, “Can you give some specifics around what a balanced portfolio really might look like?” So maybe, Bryan, I’d turn to you on that one.
Bryan Lewis: Yes, so there’s no set allocation for any investor. This is what I’ll help clients, based on their goals and objectives, will determine what’s an appropriate mix between stocks and bonds to match their risk tolerance and their time horizon.
So if you’re a younger investor saving for retirement, you can typically afford more risk, so you’ll likely have more equity exposure, stock exposure within the portfolio. Or for somebody who’s retired and they can’t afford as much risk, you’re likely going to have more bonds within the portfolio to add a layer of stability to that.
So there isn’t a one-size-fits-all. It’s very dependent on each investor. Vanguard has great tools on our website that you can go to and use but the asset allocation is the biggest decision that Vanguard believes you’re going to make because that’s going to dictate a lot of the risk and return that you’re going to experience over time. So we do spend a lot of time with our clients upfront making sure we get that right, and then you can focus more on down the road which investments and which mutual funds you select to make up that mix of stocks and bonds.
Jon Cleborne: So maybe to build off of that for just a second, so Robert in Sugarland, Texas, had asked, “We recently, in many of our advice services, and some of our balanced products, raised the allocation to international stocks. So if you think about stocks and bonds being one really major component of asset allocation, another becomes what’s your allocation U.S. versus non-U.S.?
So, Frank, maybe I’d kick that to you. What drove the change there?
Frank Chism: Sure. So the change that Robert’s referring to, we made that change in the beginning of 2015. And so we’re talking about a balanced portfolio in terms of stocks and bonds, and that’s kind of our high-level asset allocation. And that’s going to drive most of your returns.
When you look into the stock portion of that, then you have to decide how much do I want to have in the U.S., “How much do I want to have internationally? Do I want to include emerging markets? What’s that makeup of my stock portion of my portfolio going to look like?”
And, you know, I’ve said earlier, and it’s going to sure come up again, we’re generally market cap–weighted investors. And what that means when we say market capped–weighted investors is we feel like in any market you’re going to own, you should own the market, each piece of the market at the size of the market that it makes up.
So if you look at all of the stocks in the whole world, and you look at how much is in the U.S., it’s about half. So about 50% of all the stocks in the world are companies domiciled in the United States. And then about 50% are outside the U.S. So we’re not there yet in terms of our advice methodology; there’s a lot of reasons for that. The biggest one is a very well-known behavioral bias, which is most people tend to have more of their stock portfolio in their home country; it’s called home country bias.
So if you look out at the U.S. mutual fund market, you would see that about 70% of the equity mutual funds are in the U.S., are owned U.S. stocks, and about 30% are outside. Now we moved a little bit ahead of that, we’re about halfway between that and what the global market cap would be.
So the reason we do it and the reason it’s important is really for diversification, to get back to Robert’s question, so why did we do it? It’s purely about diversification. Even though the U.S. is one of the biggest countries in the world, our stock market is half of the global stock market. You still have some individual country risk; if most of your stocks are in one country, there could be an event singular to the United States that doesn’t affect the international markets quite the same way.
So it’s not a movement to time the market. We’re not trying to take advantage of, it’s not a performance-enhancing technique. It’s really just a matter of we want to broadly diversify, and we want to move probably more as we go further, towards the market cap weighting of the world. But, really, in one answer it’s diversification. It’s to spread the risk of the portfolio out as much as we can.
Jon Cleborne: Okay. So we got a question on, actually, it was a follow-up, Bryan, I think to some of the things that you were talking about earlier. So we alluded to actively managed funds, and, Matt, maybe you can touch on this too. So Merzy asked, “What makes an actively managed fund less tax-efficient?”
Matt Piro: Yes, I think the thing that sometimes happens with actively managed funds is there’s a little higher degree of turnover. What turnover is is how much the portfolio changes. So with an actively managed fund, you’re working with a professional investment manager who’s making active decisions on which securities to buy and sell.
And oftentimes, not always, but oftentimes there’s a higher degree of change there as these professional managers are adapting to the market environment, maybe their views on individual securities have changed, and they might just turn the portfolio over a little bit more.
But, again, it’s not across the board, but generally speaking, that is one of the reasons why you sometimes do see a little bit less tax efficiency from active funds, whereby index funds, they don’t do that, right. They buy a set set of securities that are represented by a benchmark or an index, and you really hold those securities and the weight in which they are represented within that benchmark or the index, and just hold it, right. So it’s much more buy and hold like from an investment strategy perspective, which definitely differs from active funds.
And I think that’s really one of the big reasons why you have that. I don’t know, Bryan, if you have anything to add.
Bryan Lewis: Yes. And I think it’s important to clarify, there’s two types of capital gains that you can have. You can experience it at the fund level, right; that’s out of your control as an investor. At year-end if there’s a lot of trading, to your point, within the fund, they’re going to pass that along to you. And that’s going to be taxable in that year.
And the other capital gain is as an investor, you can then sell that investment and pay short-term and/or long-term capital gains. So when you get into this, my point earlier was an index fund, although it’s possible, it doesn’t happen often that there’s a capital gain distribution in an index fund. So we’d rather have that type of structure and then, if they do pay a capital gain with an actively managed fund, it’s in a tax-sheltered account where you’re not paying tax on that.
Jon Cleborne: So we’ve talked a little bit about diversification throughout the course of the conversation. I think there was a really interesting question that came in; I think a lot of us have felt this way. So Richard, from Windsor, Massachusetts, said, “Diversification, it feels like it’s a seesaw. One side goes up, the other side goes down. Has anyone really run the numbers and compared a diversified portfolio versus an all-stock portfolio?”
So, Frank, I think you guys have actually run the numbers on this, so.
Frank Chism: We have run the numbers, yes, and I’ll pull a chart up in just a second. But, Richard, it’s an excellent point. I mean, when you originally hear about diversification and you hear, well, if one thing goes up, I want to have something else in my portfolio that goes down. Or if this goes down, I want this to go up. And if that happens in exactly the same proportion, then to Richard’s point, you probably don’t get anywhere, right.
But the real thing of it is that over the fullness of time, an all-stock portfolio will do better. There’s something we talk about in the markets is that there’s what we call an equity risk premium. And all that really means is people have to get paid more to hold equities because stocks have more volatility. Bonds are by nature not as volatile as stocks are. So if I’m going to issue stock as a company, and you three guys are going to buy that stock, you want to be compensated better than if you’re going to buy a bond from me because the bond’s just going to pay you occasionally; the risk is much lower.
So to answer your question, if you hold it forever, equities tend to do better, stocks tend to do better. The question is the volatility is really very, very high. So most investors and, again, this is kind of a behavioral aspect of it, most investors aren’t able to stomach that kind of volatility, particularly as you get closer to needing to use the money.
And then the bonds, if you hold bonds forever, bonds over the last 15–20 years have done really remarkably well, but longer-term they should not do as well. But if we could go to our diversification chart, we can show you quickly.
So what we’ve done with this chart is we’re just trying to show, say you started with roughly $100 at the beginning of 2007, and we go into the crisis of 2008. The dark blue line is 100% stocks, and you can see that line goes down the furthest, clearly; it went down about 40% that year. A 50/50 stock/bond portfolio went down significantly, but not nearly as bad. And a 30% stock, 70% bond portfolio went down quite a bit as well, but did the best of those three.
Now over the fullness of time, as you come out of that, as you can see from our chart, 100% stock portfolio is going to recover more quickly because, as the market recovers, it has more risk to it and it’s going to do what you see here, is it’s actually going to catch up and go past the balanced portfolio.
But the reason we talk constantly about balance and the question earlier came up, it’s a good one, what do we mean by that, is what is your ride from A to B? And that’s really the key to being in a balanced portfolio, is what does that ride feel like? And do I want my ride, do I want to go up 20% one year and down 30% the next year, and then up 10% the next year, or do I want to kind of be somewhere in the middle? And as the chart shows, that’s really what a balanced portfolio does for you.
So to answer your question, if you could stomach 100% stocks and you have 25, 30, 40 years, fine. Most people, their time horizon may not be long, and it’s a wild, wild ride. And depending on when you decide to get off the ride, if you have a 40% decline the year before you went off, that’s the risk you run.
Bryan Lewis: And it also assumes that in that chart that you’re rebalancing, right, on the way down. A lot of investing, it’s emotional, right. It’s easy to, and this is what clients will come to me for, is when the stocks are down or if bonds are down, it’s easy to want to get out of that and go into something that’s doing well for that year. But it’s very, very important, critical to your success when it comes to investing over time to stick with your plan, rebalance accordingly. And as an advisor, what we would look for is actually not to sell something that’s underperforming, it’s actually probably buy more of that and really follow the old sell high, buy low concept.
So that’s really what I’ll help my clients work through and it will allow the portfolio to rebound more quickly if you’re being disciplined in a down market.
Matt Piro: Yes, I think that’s one of those things that’s so powerful about that chart is if you think about if you were able to be disciplined, you can see, I mean, yes, there was a pretty significant drawdown, but then there was a huge bull run. And, you know, for the vast majority of folks, if they were able to stay fully invested, they made it all back up plus a good bit more. But if you happen to get a little bit spooked along the way and you bailed out too early, a lot of investors didn’t ride that back up, and that’s one of the unfortunate things. It’s why discipline becomes so important.
Jon Cleborne: You know, maybe if we could touch base on, Stephanie from Hopewell has got a question here around, getting back to our question around a diversified portfolio. “Can investing in one stock fund and one bond fund suffice, or do I need a whole bunch of different funds in my portfolio to have a really good diversified portfolio?”
Matt Piro: I think it depends. It really depends on the stock fund that you’ve selected. I think if it’s 50, 100, 200 stocks, it’s probably not diversified enough. It’s very easy to pick a stock fund and it only be say a large-company or a large-cap fund, or just a sole growth fund. And then you’re missing all other elements to the U.S. stock market.
Similar on the bond side, it could just be a short-term bond fund that’s all Treasuries. We prefer to see a little bit more balance. And often when you pick a single stock fund and a single bond fund, although it could be diversified, likely, it’s not going to completely cover the entire market, both on the domestic side and the foreign side.
Now with that said, you could easily, theoretically, pick a single fund, such as a target retirement fund, that is literally giving you thousands of stocks and thousands of bonds, and that could be the diversification that you do need.
Jon Cleborne: Well, so let’s talk about that for a second. So the concept of a target retirement fund is it’s basically a number of different funds underlying that in one single fund, and you get pretty broad diversification. So Vanguard’s got a number of them that are options that are available for folks.
Ed, in Pensacola, asks, “Are target date funds still a good option in today’s environment?” And most of those funds, particularly ones for folks that are closer to retirement, tend to have a pretty hefty allocation to bonds. And his question is, “All the talk about bonds crashing has me anxious.” So maybe I’d ask for you guys’ perspective on that one.
Bryan Lewis: Yes, I can take that. So, yes, I still, we really believe that they are applicable and great investments, whether it’s a bear market or a bull market. And the reason is that they’re diversified. Particularly those who have retirement accounts, they’re great for an IRA, 401(k) to use. Where you may run into a concern, which I was mentioning earlier, from a tax efficiency standpoint, target retirement funds may not be ideal for a nonretirement account just because of the bonds they’re generating are going to be taxed as ordinary income. But there’s no question that they are diversified and you have thousands of stocks and thousands of bonds.
So if the market is going down, one of the benefits of using the target retirement fund is that the portfolio managers are in there and they’re going to be targeting bonds and stocks and then, as you get closer to that date that you select, it’s going to gradually get more conservative.
And to the point of bonds, you know, it’s a valid concern is interest rates are low. And this is what I get a lot of questions about, is why would I want to go into a bond fund that’s giving 1.5% when I can go to stocks that have a significant upside potential to them?
And there’s really two reasons you want to look at bonds. One could be for income, they do generate income for investors, especially those that are in retirement. But I would argue that it’s more for adding that layer of stability from the stock market, as the chart we were just looking at, is it does provide some downside protection from the stock market.
And, you know, looking at it, I think of it, the way I describe it to clients is, “Think of it as driving a car, right. The further away from retirement, your foot’s on the gas, right. As you get closer and closer to retirement, you might need to put your foot on the brake, tap that to slow the car down a little bit.” And that’s what you should do when you get closer to retirement is start to get a little bit more conservative.
Matt Piro: And, Bryan, that point about interest rates and where yields are today being so low, certainly is a point of questioning we receive a lot from clients. And I do think it’s important, though, that is a predictor of kind of your expected return; it’s a big component of that within fixed income. And I do think it’s fair to say that Vanguard does have a more guarded outlook in terms of our outlook for future returns from fixed income.
Over the last, say, decade or so, depending on which bond market you’re looking at, you receive probably 4.5, 5% in returns. And, of course, that’s not guaranteed to happen again in the future, and, in fact, our median expectation would be lower than that. But it doesn’t mean, to your point, that it doesn’t have a clear purpose though in a portfolio. By having a reasonable expectation as an investor in terms of what to expect from a return perspective, is important. And I do think that’s perhaps why we’re getting these questions about where rates are is partly because of return expectations, which I do think, again, I think it’s only fair for us to acknowledge they are lower because of the lower starting point from an interest rate perspective today.
Frank Chism: That’s right, and let’s keep things in perspective too. When you talk about things like crash, and there’s folks on television, who talk about bonds are going to get crushed and you’re going to get your face ripped off in bonds. Bonds don’t behave, like the diversification chart we showed is that’s equities went down 40%. Bonds didn’t go down 40%. Bonds went—A bad year in the bond market is you go down single digits, maybe double digits at the like really outlier.
So I think the concern is warranted. Certainly, it’s something to be there. But from our point of view, and my group is part of the folks who help oversee the target date funds, the ballast piece and the bounce you get from bonds off of equities is going to be there.
And the other thing, too, is rates are low. The ten years had under 2% and 1.8. They can always go longer. It’s hard to say that, but they can, they’re lower in other parts of the world. In some places we have negative rates. So if everybody had moved out of bonds when we thought the real bad stuff was coming in bonds, that would have been four or five years ago.
So part of it, too, is that’s a timing decision to some degree that we’re just not comfortable trying to go in and make, particularly in something like a target retirement fund.
Bryan Lewis: And I’ll talk to investors about this where they’re waiting for interest rates to go up. And we’ve been waiting for how many years for this to happen, and look where we are.
Bryan Lewis: And look how much potential upside you missed had you been on the sidelines. So it’s difficult. Again, I have to keep mentioning it’s an emotional decision that you make, but you need to have a strategy. And if you could stay disciplined and stick with that strategy over time, that’s going to lead to or increase your chances to being successful over time.
Jon Cleborne: So maybe if we can shift gears a little bit here. I want to build on the talk about fixed income for just a second and bonds. So, Matt, you and I both work in the group that oversees Vanguard’s new product development process, and we talked a little bit about some principles that guide our overarching investing philosophy. I wonder if maybe you could talk a little bit about when we think about launching new funds, for example, we launched a bond fund earlier this year, how do we think about incorporating those principles into the new product development process?
Matt Piro: It’s absolutely core to what we do. I mean as we’re evaluating new products that we’re going to bring out to offer to our clients, the conversation always begins with what we call the investment case, right. And what we mean by that is really understanding the purpose of the fund, the role we expect it to play in a client’s portfolio, whether the strategy that will be employed is enduring and is something that’ll stand the test of time. We are not proponents of bringing out kind of flavor of the day type products. We want these to be enduring strategies and products that our clients can use for the long term, which, of course, is one of our key principles.
You know, Jon, you mentioned a new fund earlier this year, and I think the one you’re probably referencing is the Vanguard Core Bond Fund. And I think this is a great example of our principles in action in terms of structuring that fund. This is a fund that is designed to invest pretty much an investment-grade U.S. bond funds, get back to the role of bonds in a portfolio. Our research is very clear that it is investment-grade bonds that provide that ballast against the equity risk in your portfolio.
So we very carefully evaluated how to structure this product and wanted to ensure that we invest in investment-grade bonds so that investors can use that fund, which is an actively managed fund. For those people who are tuning in tonight who know our Total Bond Market Index Fund, think of it as an active version of that, so there is some active risk. But the role within the portfolio is very much the same. And we did that purposefully. And I think that’s really a great demonstration of our investment principles coming into play as we design a new fund that we brought out earlier this year.
Jon Cleborne: So one of the questions that we got a lot as we were looking through the questions that were submitted in advance was around gold. And, hey, why doesn’t Vanguard have a gold fund? And so maybe I’d be interested in your thoughts on just gold as an investment and then also, you know, why not have a gold fund?
Matt Piro: Right. I mean gold always attracts a lot of attention. It can be quite speculative. You can see the price of gold move up and down quite viciously, and I think it’s times where it’s moving up quite, that’s when you see a lot more interest. But there are some investors out there who think gold has a role in a portfolio, whether it’s something to do with inflation or safety. And that’s fine for those investors to have that perspective. It’s not necessarily our perspective.
Tying back to the speculative point, we do worry about that with gold. And then just fundamentally speaking, as you try to think about how gold is valued, there’s no earnings, there’s no cash, there’s no income like a bond. So coming to a valuation of gold is very challenging. So there’s a lot of reasons we think it’s complicated and most investors are probably best served with not kind of investing there, though, again, some may think it’s appropriate.
The other thing we see is some people look to have exposure indirectly to gold through gold equities. And there are some funds out there that give you exposure there. I think an important point to start is as we think about a diversified stock fund, you have exposure to gold equities already. And in a market cap–weighted portfolio, gold equities are a part of that. So any decision to allocate more to gold equities strategies is an active decision to overweight that.
And that can be tough because it’s a very volatile market. We talk about discipline, that stomach, during tough times. Well, a sector like that is as volatile as they come. And I think it’s very challenging for investors to really invest for the long term in that part of the market. So for those reasons, we’re cautious on the use of gold and we generally steer away from it, but, of course, recognizing others might have a different point of view, but that’s certainly our perspective on that.
Jon Cleborne: So, again, maybe to shift gears for a second here, Joel in Woodbury asked, “Some of the research seems to indicate that Vanguard’s individual portfolios they tend to be concentrated in sort of large-capitalization stocks. So big companies basically. And that there’s a shortage of the smaller-growth companies that might be out there in portfolios. Can you comment on that a little bit, Bryan?
Bryan Lewis: Yes, and I think it’s important to define market cap for some viewers.
Jon Cleborne: Yes.
Bryan Lewis: It’s in a simple example, you take a company, a stock, and you take outstanding shares of that and you multiply it times its share price and that will dictate whether it’s a large company, a mid, or a small company. And if you take a step back and you look at the market, generally speaking, you’re going to see that there are more large companies than there are mid and small companies. So we do want to replicate that.
Particularly when you look at value versus growth, it’s roughly half and half. We want to replicate that as well. And if you deviate from that, that’s when you start to take on potentially some additional risk. And by risk, it generally means volatility within the portfolio and not everybody can tolerate that. So we want to try to mimic the market and build a portfolio around that that’s going to give you the market return. And, really, the way I describe it is get you from point A to point B with the least amount of risk.
Frank Chism: The other way to think about market capitalization too that I think is helpful is to think, you know, it’s really the reflection of all of the investors’ opinion about those stocks in that market. So there’s a reason Apple is as big of a stock that it is. It’s because it’s an enormous company and lots of people bought it. And the price of that, so in Bryan’s equation, you have the number of stocks outstanding and then you have the price. And the price is being set by the aggregate of all investors. And the size, ultimately, is being set by just the extension by all the investors.
So at any given point in time, the market cap–weighted index is a reflection of everybody’s opinion of those stocks. And as smaller and mid-size stocks do better and people purchase more shares and their share price increases, and then they issue more shares because they want to expand, they want to become bigger, that gets to be a bigger part of the index. And it really sort of intuitively makes sense that that’s the reflection of all the investors.
When you do it in a different capacity, when you say, “I’m just going to go through and equal-weight everything or I’m going to use some other mechanism,” and you move away from that, then to Bryan’s point, you’re taking a lot of risk because you’re putting as much weight in a small company that maybe not everybody has that much confidence in and you’re taking away money from a bigger company that’s been around longer and it’s stayed and it’s growing, etc.
Jon Cleborne: So we’ve talked about this. A couple of times we’ve used these terms like value and growth. Can you guys just define that a little bit?
Speaker: Yes, yes.
Jon Cleborne: And, Frank, I just look to you.
Frank Chism: Sure.
Jon Cleborne: Help folks understand when we say value companies versus growth companies, what are we talking about?
Frank Chism: Yes, so what we’re talking about is how do you characterize a company? And there’s a couple different ways to think about it. For me, I think about it in terms of the maturity of the company. So a growth company is generally going to be a company that is trying to get bigger. They’re trying to expand. Starbucks is a good example. Not today, but a handful of years ago. They were expanding, they were growing, they were adding shops everywhere. Now there’s one practically everywhere so I cease to call them so much of a growth name, but the idea is they’re growing.
So when they earn more money, they put that back in the business. They try to grow more. They’re not paying dividends necessarily. And most investors in growth names, the return you’re going to get is in the stock price appreciation because you’re not going to get a dividend. You’re going to benefit with the company gets bigger and bigger.
So if you looked at a growth index, you would see Apple, Google, Facebook, Amazon. These are big companies that are really working to get bigger and bigger and bigger. If you look on the value side, these are companies that are a little more mature. Their market share is probably a little closer to where it’s ultimately going to be. They tend to pay dividends. They tend to have a little slower revenue growth, and there you’re going to see companies Johnson & Johnson, GE, Microsoft, companies been around a long time been doing business.
And what investors try to do is if you think that we’re in a growth environment and everything’s going to expand and companies that are growing are going to do better, then people tend to favor growth. And if you think times are going to maybe get tough, then people tend to favor value and more defensive companies and companies have been around, their revenue is a little more stable. And I think to Bryan’s point what we really try to do is we want you to have all of those things because it’s very difficult to know when is growth going to do well, when is value going to do well? And, really, from our point of view, you should really cover both of those. But, in essence, that’s the sort of, you know, if you could keep those kind of names in mind, that’s a good way to think about growth value.
Jon Cleborne: So when we’re thinking about sort of specific stocks and specific types of stocks, we’ve talked a little bit about active management earlier in the program and the ability of a manager to choose the stocks that are going to outperform. So, Matt, again, this is part of what our team does on a regular basis. So can you talk a little bit about the pluses and minuses of investing in actively managed stocks or stock funds or actively managed mutual funds more generally?
Matt Piro: Yes, absolutely. I mean I think to start, though, I’ll go back to the importance of asset allocation. I think that’s always important to keep in mind that our research would tell you that it is roughly 90% of the pattern of performance that your portfolio ultimately delivers is based on that decision. So this decision of active versus index is much further down the decision tree, if you will.
But a couple things that I think about here is, one, I do start with costs. Index funds typically do have a lower expense ratio. They are a lower-cost vehicle. On average across the industry, active funds do tend to be a little bit more expensive.
Now that’s not true across the board. For example, at Vanguard we have very low-cost active funds. But you do pay a little bit more for access to active management. And why is that? Well, that’s because of the resources behind that, the team of investment managers and analysts who are trying to pick those stocks that will ultimately outperform.
And that’s really what most investors are looking to achieve when they select an active fund. So this is really what you’re going after in most cases is some degree of outperformance, outperformancing in some market or a part of the market. And that’s really, ultimately, what you’re going for.
So if you’re going to invest in an active fund, there’s another thing you have to keep in mind and that’s the concept of patience because it is an unreasonable expectation for active managers to outperform year in and year out. There’s just too much evidence that it’s very challenging. So, inevitably, you are going to experience periods of underperformance.
So even the most successful funds that we have evaluated, and, Frank, your team in the Investment Strategy Group did some great research on this where we looked at funds over a 15-year period and we isolated funds that we deemed to be successful. And when we looked at the performance over that 15-year period, we actually saw most of those funds experience periods of underperformance in 4, 5, 6 calendar years of that 15-year period.
And these are funds that deliver that outperformance, which is what investors were looking for over that long-term period of time. But you need to be willing to stay the course and remain convicted in that particular active strategy. So that’s an important thing to keep in mind. So I think about costs and I think about patience as two of the important components of kind of really understanding if you are comfortable with that tradeoff as you make that decision as an investor.
Frank Chism: And it’s interesting you said, Matt, we also did some work around making the decision in picking active managers. And what we found is you do have these periods of significant underperformance or you have 2, 3, 4 years in a row. And it’s not like picking a restaurant.
And so my wife and I whenever we’re anywhere, it’s like, “Where do you want to eat?” You go on Yelp, you go somewhere, and you have 200 people say, “This restaurant’s great.” And it’s probably pretty good. That’s probably a pretty good indicator of where to go eat. Or colleges, right? I have an 18-year old. I looked at colleges last year. And Princeton’s not going to be number 2 for five years and then go to number 200. It’s probably still going to be up there.
And the thing with active management is it’s cyclical, right, and managers tend to outperform. The way they pick stocks tends to come in and out of favor and you really have to think about it differently. You can’t just say, “Hey, this guy is doing great for the last 2 or 3 years. I think we’ll go with that.” Or, “This person’s done really poorly for 2 or 3 years, we should get out.” If anything, it may very well be you should take the opposite approach. Not necessarily, but it’s more to it than just I’m going to get an active manager and they’re going to outperform forever. So, yes, excellent the way you laid that out.
Jon Cleborne: So when you think about adding an actively managed fund to a portfolio, how should you think about that? How much actively managed—How much of an allocation do you want to have the actively managed funds versus passive funds or index funds? How do you guys generally counsel folks on that front?
Bryan Lewis: This is what I will talk to clients about, right. Is it more important to never underperform the market or is it a goal of yours to try to outperform? And you go through all the risks of that with clients.
And I think it really depends on the different types of accounts that you have whether you have these taxable accounts, as I was alluding to earlier, or IRAs, 401(k)s. Vanguard, we’re very good and I think we’re known for indexing, but we’re very good at actively managing portfolios as well. And I think patience is the key. You don’t want to abandon a fund when it’s down because then you start chasing returns and over time that’s going to be detrimental potentially to the portfolio and meeting your objectives with the portfolio. So talking through the risks.
And I think it really depends on the types of accounts that you have. Typically we don’t want to have actively managed funds in a taxable account, to our point earlier about the capital gain distributions. But if you have a preference for that, ideally we’d rather see that in a tax-deferred account first.
Jon Cleborne: So you’ll hear an industry buzzword out there from time to time; you’ll hear smart beta. And a lot of times people will think about that as an index fund that isn’t market cap–weighted, as we had talked about earlier.
So, Frank, maybe I’d ask you. Over the long run, which is better, to have a cap-weighted index fund or an index fund that’s weighted by something else?
Frank Chism: So, no. Interesting question and there is a lot of research about this. It depends a lot on who you talk to and what the answer may be around that. Generally, and just to kind of go back and flush out the definition, and when we say, “indexing,” we generally mean market cap–weighted indexing. S&P 500 is a very good example of that. And then to do something different folks can get an equal-weighted S&P 500. So, again, instead of having 3% in Apple and on down the road, you would have the same amount in every single stock. So which one’s going to be better in the long term?
First of all, it’s very difficult to know what’s going to happen over the long term. But generally what people do when they’re weighting an index differently where they’re creating a way to invest differently than market cap–weighting, what they’re trying to do is take advantage of some of these things. And we talked about it a little bit earlier where if you do it differently, you’re going to get more smaller companies. You’re going to get more midsize companies. You’re going to get a little more value than you’re going to get growth.
So the question then becomes are those things going to outperform over 10, 15, 20, 25 years? Maybe they would. I mean I do think that one of the enduring things we’ve seen is small companies often tend to do better. Value tends to do better, although it hasn’t done better for the last 6, 7, 8 years. And it’s very cyclical and it really depends.
But the thing you have to keep in mind too is, and these guys both talked about that, maintaining a market cap–weighted index Matt talked about there’s no turnover practically. There’s very little turnover. You’re not trading, you’re not generating tax issues and tax costs. And it’s also very inexpensive to do because as the market moves itself, it keeps itself in balance.
When you talk about doing it a different way, you’re talking about really being active. And we tend to think of anything that’s not market cap–weighted indexing, even if you’re calling it indexing, we would still say that’s active. And when you do that, then you’re going to introduce trading costs, you’re going to introduce a lot of moving around. You have to pay somebody to come up with this methodology that they’re going to use and to implement it and to redo it.
So my point is if maybe other parts, you know, if you’re going to get more smaller companies, if you’re going to get a little more exposure to value over 10, 15, 20 years, it’s not obvious to me and to the folks in my group that that won’t get eaten up by the additional trading costs which are going to drive up your taxes and the additional expenses you’re going to pay to have somebody do that. So it may ultimately wash itself out when you go to implement it.
It sounds good academically, but sometimes when you really think about “How am I going to implement this?,” a lot of those benefits may very well go away.
Jon Cleborne: Yes, absolutely. Amazingly enough, we are getting close to the end of our time together here. So maybe I’d ask just two follow-up questions. So I think one of the things that I constantly wrestle with with investing is it is complex. There are a lot of different layers to it. Some folks really love to go after it and find it to be a bit of a hobby. Some folks are really confident and others maybe a little less so.
So, Bryan, can you talk a little bit about sort of how Vanguard helps people if they’re struggling with this, talk a little bit about the advisor services?
Bryan Lewis: Yes. So I work within Vanguard’s Personal Advisor Services, which is our advisory group. And we can partner with clients on an ongoing basis. And I typically would say clients that may lack the time to manage their portfolio, maybe the willingness or the ability to do it are the clients we typically work with on an ongoing basis. But we also, I find that clients that, and I think the poll question was great because it was talking about how often people are looking about this. But a lot of people don’t think about their spouses so generally we find is that there’s one primary spouse that does a lot of the management of the portfolio. What’s your plan B? What happens if something happens to that spouse?
And that’s something that we’ll partner with our clients on an ongoing basis. We do look at their accounts every quarter. It’s generally every 90 days from the date that they enroll. And I want to be clear it’s not that we’re in there, we’re changing the portfolio. It’s that we’re remaining disciplined with the strategy that we’ve agreed. And whether you’re an accumulator, so somebody who’s really far away from retirement, someone who’s within a few years or a pre-retiree from retirement, or even in retirement, we can work with you through that, you know, the different stages of investing.
And I know we’ve been talking a lot about the portfolio piece of this, but as CFPs or certified financial planners, there’s other things that come along with holistic planning that we will partner with. You think of estate planning—when should I take Social Security, do I need long-term care—these are all things that we will talk through individually with our clients to see if it’s applicable. And I think it’s peace of mind.
Jon Cleborne: That’s great. That’s great. So maybe I’d ask, we’ve just got a minute or two left, for sort of closing thoughts. As we think about sort of everything that folks are facing today, sort of parting words of wisdom if you will.
Matt Piro: Yes, we’ve covered a lot of ground tonight. I just reflect and think about the key things we’ve discussed, which really comes back to what we believe in and our principles. We’ve touched on the importance of cost. So I’d encourage viewers to keep that in mind and sometimes ask the tough question to the person you might be working with about costs.
It’s about goals, as we’ve discussed, and really understanding your why. Like why are you investing? Is it for education? Is it for retirement? What else is it? And really just understanding that this can be tough. It can test you emotionally, right? You touched on this a little bit, Bryan. So that discipline and then having a support system around you, people like you, Bryan, that can be really powerful and really help you to ultimately achieve your goal. So those are a few things I think we touched on quite well tonight.
Bryan Lewis: And to piggyback off that as well is do your best. It’s difficult to tune out much of the noise that we hear in the market. If you’re feeling uneasy about this, I think especially if you’re feeling uneasy about the election, it’s always great when you have events like this to reevaluate your portfolio to make sure it’s balanced and it’s matching what your risk tolerance is.
And if you’re feeling uneasy, like I said, there’s great tools on our website. Give Vanguard a call. We can talk through this. What I don’t like to see is a lot of investors are saying, “Here’s what I did. What are your thoughts?” I’d rather you come to us and say, “Here’s what I’m thinking. What are your thoughts?” So be disciplined. And I think if you are able to do that, you’re going to be successful.
Frank Chism: And, finally, along the same lines, our survey came back that a handful of people never look at their investments and then you have a few people look at them pretty frequently. I would say you want to be between that somewhere.
There’s a lot that happens on a day-to-day basis. There’s tons of news. But when we look back at any given year, probably only three or four things that were really newsworthy that really moved the market. And what’s more important is to keep sight of the long-term goals, keep your balance, stay disciplined. And to Bryan’s point, you said it very well, don’t get swayed by that.
And when people ask me, “Hey, X, Y, or Z happened in the market. This is going on,” first thing I always ask people is, “What’s changed about your situation? Have your goals changed? Has your retirement date changed? And if not, stay the course. Keep doing what you’re doing. Keep investing and all the rest of it’s going to take care.”
Jon Cleborne: Alright, well I think those are great parting thoughts, Guys. So thank you.
I just offer to the audience a couple of quick points. So, one, we got a little bit of feedback that the charts were helpful for folks and so the charts that we displayed earlier in the webcast. Those will be available through the replays that are going to come out in just a couple of weeks. So if you’d like to see those again, you’ll be able to see them.
Additionally, there were some questions about the portfolio advisory service that Bryan had talked a little bit about. So there’s additional details on that in the widget that is at the bottom of your screen, the green resource widget.
So in just a couple weeks we’ll send you an email with a link to view the highlights of today’s webcast along with transcripts. And we’d ask if we could have just a few more seconds of your time. If you’d select the red survey widget, it’s the second from the right at the bottom of your screen, and respond to a quick survey. Your feedback really helps to shape these events and ensures that the topics that we cover are meaningful.
So please be sure to join me on November 9 for our emerging markets webcast. And you can register using the link in that green resource widget at the bottom of the player.
So from all of us here at Vanguard tonight, thanks so much for joining us this evening and have a great evening.
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