Millionaire Teacher (14 page)

At the end of the calendar year, the investor simply rebalances the portfolio back to the original allocation. If the U.S. stock market index did better than the Canadian index, then the investor would sell some of the U.S. index to even things out with the Canadian index.

If the bond index beat both stock indexes, then some of the bond index would be sold to buy some of the Canadian and U.S. stock market indexes. Of course, if you're making monthly contributions to the account, you could rebalance monthly by simply buying the laggard—to keep your allocation evenly split three ways.

(
MoneySense
tracks a portfolio following this strategy online at the following link: <
www.moneysense.ca/2006/04/05/classic-couch-potato-portfolio-historical-performance-tables/
>).

You can see, in
Table 5.3
, how $100 invested in 1975 would have grown if it was rebalanced annually with equal allocations to the Canadian stock index, the U.S. stock index, and the Canadian bond index. Note that from 1975 to the end of 2010, a combination of bond indexes and stock market indexes wasn't just “for wimps.” The rebalancing combination of indexes with bonds actually beat the returns of the Canadian stock market index. You really can employ the safety of bonds and enjoy some decent returns in the process.

Table 5.3
Invested in the Canadian Couch Potato Portfolio vs. Canadian Stock Index (1975–2010)

Source:
Moneysense.ca (1976–2009 data)
Globeinvestor.com
(2009–2010 data)
10

Creating a disciplined plan to rebalance a portfolio removes the guesswork from investing, and it forces investors to ignore their hearts. As I mentioned before, we don't tend to be rational. Most people like buying shares that have risen in value and they like selling shares that have fallen in value. Smart investors don't behave so irrationally.

Contrary to what many people think, beating a 100 percent stock market index is possible over time using bond indexes as your little helpers. You will end up with less volatility and the possibility of better returns.

Notes

1.
David Swensen,
Pioneering Portfolio Management
(New York: Free Press, 2009), 170.

2.
Paul Farrell,
The Lazy Person's Guide to Investing
(New York: Warner Business Books, 2004), 12.

3.
Scott Burns, “Couch Potato Didn't Do the Market Mash,” February 2, 2003,
Dallas News
online, accessed November 1, 2010,
http://www.dallasnews.com/s/dws/bus/scottburns/couchpotato/columns/stories/020203dnbizburnscol.d6d1e.html
.

4.
Morningstar data for VTSMX (Vanguard total stock market index) and VGTSX (Vanguard total international stock market index) 2003–2008.

5.
Scott Burns, “Sloth Triumphs Again,”
UExpress.com
, February 15, 2009, accessed November 1, 2010,
http://www.uexpress.com/scottburns/index.html?uc_full_date=20090215
.

6.
Ibid.

7.
“Monthly Self Managed Couch Potato Returns,” AssetBuilder, accessed January 16, 2011,
http://assetbuilder.com/couch_potato/couch_potato_results.aspx
.

8.
Daniel Solin,
The Smartest Investment Book You'll Ever Read
(New York: Penguin, 2006), 63–64.

9.
Ibid., 63.

10.
“Couch Potato Performance,”
MoneySense
online, accessed November 1, 2010,
http://www.moneysense.ca/2006/04/05/classic-couch-potato-portfolio-historical-performance-tables/
.

RULE 6

Sample a “Round-the-World” Ticket to Indexing

Contrary to what some investment books have inadvertently led you to conclude, index funds have boarded ships and airplanes to find happy homes outside of the United States. In this section, I'll give you examples of how to build an indexed account whether you live in the U.S., Canada, Singapore, or Australia. Feel free to check out the section relating to your geographic area, or read with interest how our international brothers and sisters can create indexed accounts. Even if you live in a country not mentioned here, as long as you have the ability to open a brokerage account in your home country, you can build a portfolio of indexes.

The people I'm profiling below are real. These are their real names—and their real stories.

Indexing in the United States—An American Father of Triplets

When Kris Olson's wife, Erica, had triplets in 2006, she single-handedly gave birth to a quarter of a soccer team. Suddenly, there were three more mouths to feed, a minivan to buy, and three college educations to save for.

I'm not suggesting that anyone would hold a charitable benefit with accompanying violin music for a well-paid specialist in pediatrics and internal medicine. But if you're American, and suddenly more aware of your own financial obligations, Kris' story of opening an indexed investing account could provide some direction.

The 40-year-old doctor realized that investing money was similar, in many ways, to the global health work he does in the poverty-stricken, tsunami-affected regions of Sumatra, Indonesia, where he occasionally flies to train midwives. This latest passion comes on the tail of his volunteer work along the Thai-Burmese border, as well as in Darfur, Cambodia, Kenya, and Ethiopia.

Realizing that donations to developing countries are best done in person, he and his wife Erica (a registered nurse) often brought their own medical supplies to the countries they visited. Simply sending supplies was an invitation for third-world middlemen to plunder the goods before they arrived.

In 2004, Kris recognized that something similar was happening to his investments at home, which had been laboring in actively managed mutual funds for years.

“My financial adviser was a really nice guy, but I realize that he skimmed money off me like guys at a third-world country border. I was flushing money down the toilet in tiny sums that were adding up,” he said.

On a trip to Indonesia, Kris made a stopover in Singapore, where he purchased cardiopulmonary resuscitation (CPR) training material to take to midwives in Aceh. I met him for lunch at a Japanese restaurant, and over sushi, he asked me what indexes he should buy for his investment account.

The largest index provider in the U.S. is Vanguard, a nonprofit investment company based in Pennsylvania. If you go to their website, the array of indexes can be confusing at first. But I suggested that Kris—who was 35 years old at the time—should keep things simple: buy the broadest stock index he could for his U.S. exposure, the broadest international index he could for his “world” exposure, and a total bond market index fund that approximated his age. Here's the allocation I recommended:

• 35% Vanguard U.S. Bond Index (Symbol VBMFX)
  
• 35% Vanguard Total U.S. Stock Market Index (Symbol VTSMX)
  
• 30% Vanguard Total International Stock Market Index (Symbol VGTSX)
  

I gave my advice on this basis: Vanguard doesn't charge commissions to buy or sell; he would be diversified across the entire U.S. stock market and the international stock markets; and he would have a bond allocation that would allow him to rebalance his account annually.

“Kris,” I said, “don't listen to Wall Street, don't read financial newspapers, and don't watch stock market-based news. If you rebalance a portfolio like this just once a year, you'll beat 90 percent of investment professionals over time.”

When Kris got back home to the U.S., he put his old mutual fund investment statements on the dining room table, logged on to the Vanguard site, and telephoned the company from the website's contact information.

A Vanguard employee walked Kris through the account opening process as they negotiated the website together. She simply asked for his existing mutual fund account numbers—for both his IRA account (a tax-sheltered individual retirement account) and for his non-IRA mutual funds.

Over the telephone, the Vanguard representative then transferred his assets from his previous fund company to Vanguard where he diversified his money into the three index funds. Then, after taking his regular bank account information, she set up automatic deposits into Kris's index funds according to the allocation he wanted.

At the end of each calendar year, Kris took a look at his investments. “It didn't take much,” he said. “I just rebalanced the portfolio back to the original allocation at the end of each year, (as seen in
Figure 6.1
) selling off a bit of the ‘winners' to bolster the ‘losers.' It was the only time I ever looked at my investment statements—just when it was time to consider rebalancing.” I was able to confirm Kris's investment returns (in U.S. dollars) using the fund-tracking function at
Morningstar.com
.

Figure 6.1
Kris Olson's Account Allocation

January 2007

Kris noticed that the portfolio he established one year earlier had gained 15.4 percent during the course of the year, with most of the gains coming from his international and U.S. stock market indexes. He called Vanguard on the phone, logged on to his account online, and the Vanguard representative guided him through the process of selling off some of his stock indexes to buy his bond index, bringing him back to his desired allocation. Kris was ready to tune Wall Street out for another year with his portfolio aligned the way it was when he started.

January 2008

Worldwide, stock markets continued to rise from 2007 to 2008. At this point, Kris's profits had really increased, gaining 25.86 percent from the initial 2006 value and nine percent for the 2007 calendar year. Fighting the urge to buy more of what was propelling his portfolio (his stock indexes), Kris sold off portions of his international and U.S. stock indexes to buy more of his bond index with the proceeds. It didn't require any judgment on his part—he just adjusted his account back to its original allocation.

January 2009

When Kris looked at his statements at the beginning of 2009, he noticed his total portfolio had dropped in value as the biggest stock market decline since 1929–1933 was starting to take its toll. It fell 24.5 percent but Kris just rebalanced his portfolio again, selling off some of his bond index to buy falling U.S. and international stock indexes, bringing it back to the original allocation.

January 2010

Kris knew the stock markets took a real beating during the previous year—everyone was talking about it. But because he sold off some bonds the previous year to buy stocks, he benefited from the low stock market levels. By January 2010, his account had increased 23 percent for the year thanks to the rebounding stock markets. Once again, Kris took 10 minutes in January to rebalance his account, selling some stock indexes to buy more of his bond index. When Kris was finished, he was back to his original allocation.

January 2011

By January 2011, Kris' account had gained another 11.6 percent over the previous 12 months. From January 1, 2006, until January 1, 2011, his account's profits had increased by 30.7 percent, despite going through the worst stock market decline (2008–2009) in many years.
1
Rebalancing once again, he sold off some of his stock indexes to buy some more of his bond index. Considering that Kris is now 40 years old, he should be increasing his bond allocation slowly to match his age.

A medical doctor knocks out the investment professionals

It's fine for Kris's portfolio to have gained 30.7 percent from January 2006 to January 2011, but how would it have done if it was professionally managed by a fund manager with his or her pulse on the markets?

You'd assume that a doctor spending just 10 minutes a year on his finances would get scalped if he ever challenged the investment professionals. But here's the rub. If a mutual fund could be managed for free—with no salaries paid to any affiliated employees—then Kris's odds of beating the professionals with a fully indexed account would be slightly less than 50–50. (After all, he's paying rock-bottom fees to own the world's stock and bond markets, and only about 50 percent of actively managed stock market money will beat the market [before fees].) However, by factoring in the real fees of active management along with taxes, the good doctor operates in a climate where the odds are significantly in his favor—if he indexes his money.

Because Kris's account is balanced between stocks and bonds, we can check his performance, in
Figure 6.2
compared with three of the best known balanced mutual funds in the U.S.: Fidelity Balanced Fund <
http://fundresearch.fidelity.com/mutual-funds/summary/316345206
>, T. Rowe Price Balanced Fund <
http://corporate.troweprice.com/ccw/home.do
>, and American Funds Balanced Fund <
www.americanfunds.com
>.

Figure 6.2
Indexed Portfolio Beats Balanced Funds (2006–2011)

Source:
Morningstar.com
2

Each of these funds had teams of researchers coming to work each day to juggle their fund holdings, trying to make the best possible returns. But that all costs money, as you know. As a result, Kris beat each of them handily over the past five years by 11.3 percent, 6.68 percent, and 17.57 percent, respectively.

Will he beat all of them every year? Certainly not. But over time, he's likely to pull further and further ahead. Are there balanced funds in the U.S. that beat Kris's returns over the past five years? Sure there are. But we have no way of knowing which funds will beat Kris over the next five years, so Kris's smartest choice is to keep his balanced portfolio of indexes.

Where Vanguard makes things even easier

If the idea of spending 10 minutes a year rebalancing your portfolio is too much, Americans can opt for something even easier. Vanguard offers products called Target Retirement Funds, which offer a blended combination of stock and bond indexes. They're supposed to shift slightly more money into bonds as you get closer to retirement without the investor having to raise a finger to rebalance.

The funds are named based on your projected retirement date, but ignore the named date on the fund. For example, Kris would likely choose the Target Retirement 2015 Fund <
https://personal.vanguard.com
> because 40 percent of it is allocated toward bonds and Kris is now 40 years old. He isn't really planning to retire in 2015, but he would choose this fund because it has a bond allocation that matches his age.

Between January 2006 and January 2011, Vanguard's Target Retirement 2015 Fund gained 24.14 percent, a return that also beat each of the big three balanced funds found in
Figure 6.2
: Fidelity Balanced Fund, T. Rowe Price Balanced Fund, and American Funds Balanced Fund.

What's more, if held in a taxable account, the Target Retirement Funds are much more efficient than most (if not all) actively balanced funds. In
Table 6.1
, you can see the respective “turnover” rates for each of the balanced funds we compared with Kris's account. And remember, the lower the turnover, the higher the tax efficiency.

Table 6.1
Turnover Rate of Respective Funds

Source:
Morningstar.com
3