Reading “Bogleheads Guide to Investing” by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf

They are partisan to the Vanguard investment company (the biggest investment company in the world), suggest using its services as the default method of implementing the proposed strategy, and are very revering the founder of the company, John C Bogle. In fact, they are so loyal to Bogle, that they are prominent members of the investment club called “The Bogleheads”, which are generally investing in a manner proposed and advocated by the aforementioned Bogle, naturally, frequently using the products of the Bogle’s company.

So, there IS a clear conflict of interest in the book. Does this make the book worthless? Well, not as much as I would have expected. In fact, most of the strict financial terms are introduced with no relationship to Vanguard whatsoever, the strategy presented has “more or less” solid mathematical foundation, to the degree possible in economics, and in most of the cases where questionable guidelines are proposed, they are supporting their claims with direct references to either Bogle, or some published research in financial economics.

Okay, we have dealt with their financial conflict of interest. They are using Vanguard’s services, and they are interested in the fund having more volume, and henceforth being more stable and capable of providing more leverage. But what is their ideological conflict of interest? What do they want to make you to believe?

The answer to this question is that they consider most of the financial services beyond index mutual fund investment to be akin to a scam or a gamble. I have not yet introduced index mutual funds so far, and it is a complicated term (“index” in this case is an adjective, not a verb) , but I will speak about it later in more detail, and only mention here that an “index” funds (whatever it is) is a fairly recent invention, first introduced in 1975, one year earlier than Vanguard was founded, which naturally makes Bogle and his associates the pioneers of the “indexing” financial product, whereas the industry of financial services has a much longer history. So, they are advocating for a “new” product to replace an “old” product, claiming that the new product is superior to the old products in a way in which a car is superior to a horse carriage. (Even though something introduced in 1975 cannot be called sufficiently old, as for me.)

Now, whether some tool is a necessary and sufficient tool for solving a task depends heavily on the task, and, indeed, the first disclaimer that the authors are making is that the Bogleheads strategy is NOT going to make you rich overnight, and realistically is not going to make you rich ever. Now, they are disparaging their “opponents”, the “big financial industry” by claiming that “becoming rich” is the main advertising claim of theirs. I think that this is an overstatement, as at the moment, in my context, most of the financial industry ads, by far, are not about becoming rich, but rather about preserving current savings from being devalued by inflation. However, I generally agree with the point that “financial industry” is akin to gambling in many respects, and that almost everyone who is proposing you to become rich overnight is a scammer.

This alone already makes me ideologically biased with regards to this question, but hopefully I am disclosing my preferences early enough for you to see the rest of this essay through a suitable lens.

So, while I take their proposed policy with a grain of salt, I do think that the book is a worthy read for a people who generally consider that saving is a more important part of financial industry than for getting rich quickly.

The first thing to consider (and if it is the only thing you remember out of this essay, it would be already enough for me to feel proud) is the following. If you are not investing at all, you are still investing in cash, with a negative interest rate of inflation.

Technically, if you just receive your salary every month and withdraw a bit from your current account for food and clothing, you are already investing, but your money are depreciating each month, with the rate of inflation. So, each step of the scheme above is aimed at making you lose less (or even gain something) on each of the above 6 steps.

The book does not mention it, but, in fact you can invest into anything, which you may consider worthy. For example, having children who are going to feed you when you are old and incapacitated is already an investment, and, in fact, quite a good one, if you manage to maintain a good relationship with your children till old age. Buying gold bullion is also an investment, even though it is probably a very impractical one, as it is often taxed (for example with VAT), and usually with a very high tax.

Since I mentioned taxes already, I need to talk about the first point: getting money into the account. You might think that this is simple: usually your employer just pays the money to you. However, if you are tax-savvy, this might not be so simple. In the USA, there are several “programs” for pension savings, which are either tax-exempt, or tax-deferred. Exemption means that taxes are not paid at all, as long as you keep the money invested until you retire, deferred means that taxes are paid, but when you withdraw the money, not when you receive them, which allows investing the additional tax money for those decades that you keep working. This is, a characteristically American thing, making complex systems for simple matters, but some other countries follow their examples. (I am afraid that trusting certain Eastern countries on this matter is not a smart choice.)

The books is also conspicuously silent on the matter, but there are circumstances when it makes no sense to invest at all. Again, this is quite a dire situation, but it might be that the market is not growing long-term, or falling all of your life, and fund management costs are making your investment incredibly lossy. In this case it makes sense to consume all of your income right away.

Taxes will be mentioned again later, when rebalancing the portfolio will be discussed.

But given that an investment machinery works at all, people usually have the following investment vehicles:

1. Cash
2. Stocks
3. Bonds/TIPS
4. Commodity futures
5. Property

Of those two, Bogleheads do not recommend investing in property or commodities at all, because these two markets are complex and complicated.

Cash is really the worst possible investment, but you can make it just a tiny bit better by getting the bank to pay interest on your savings account.

This leaves us with bonds and stocks.

Stocks are shares in companies, bonds are basically loans to the government, and sometimes to big companies.

For an investor, both of those behave like an asset of a changing value which grows with time on average, but not necessarily instantaneously. Theoretically, a bond has a “maturation date”, when the government takes away that bond and pays the investor back the money, but in reality the money maybe turned into cash by selling the bond on the market.

Both kinds of assets may pay some sums of money during ownership period, for stocks those payments are called “dividends”, and for bonds they are called “coupons”.

In practice, there is very little sense in both of those, because usually cash value can be realised immediately by selling the instrument. In some cases they difference may matter.

In particular, it makes very little sense to pay dividends for a company which grows, because each pound re-invested into the company increases the value of the company and its stocks, and if stock owner wants some cash, it often makes sense to sell the stock. The companies which pay dividends are usually companies which have no space to grow further, that is when re-investing the money is unlikely to bring any profit, stagnant businesses.

Stocks also sometimes let the owner vote at shareholder meetings, but given that most investors are likely to own tiny shares of those stocks, this usually does not matter.

What is good about stocks and bonds is that their price is usually not correlated much. This allows diversifying the portfolio enough so that when stocks fall in price, bonds go up, and the portfolio remains worth about the same value.

Do you remember that there is a theorem which claims that it is possible to replicate the index performace given individual stocks and bonds, and it is even not necessary to buy all possible stocks and bonds. This is true, but it is true on average. This “on average” is not as bad as an “almost fair” game in a casino, where it is possible to win an arbitrary amount of money if you double the bet every time and play long enough, but standard deviation still matters.

That is, in addition to replicating the market on average diversifying the portfolio tries to increase the rate of convergence of the random process of the portfolio to the random process of the index “by variance”.

This property of the portfolio allows us to give a precise mathematical definition of a “risk”. Or, more precisely, “relative risk”, that is the relative risk that a portfolio behaves differently than the index is the standard deviation of difference of the two processes.

Math rulez!

Bonds are generally considered less risky than stocks, and inflation-protected securities (TIPS, effectively bonds) have a risk of zero. Do not forget that this is a relative risk of zero. If the USA has a revolution and the new regime refuses to pay the TIPS returns, the value of money becomes zero. The probability of this event is small, but non-negligible.

Property, gold bullion, commodities, and other exotic volatile investment instruments are generally frowned upon by Bogleheads, but I would not be that dismissive about them, but I would emphasise that using them required several orders of magnitude more knowledge of the market than an ordinary investor possesses.

A portfolio should consist, as Bogleheads suggest, effectively only of different funds of stocks (USA, international, small companies, large companies), and bonds (Federal, Municipal, TIPS).

There are two main reasons for rebalancing.

1. Some of the shares of the portfolio grows too far or falls too much.
2. You are getting older and cannot tolerate as much risk.

2 is usually easy to automate – you just sell a bit of stocks and buy a bit of bonds, but 1 is harder.

There are two main sources of problems with 1:

• Fees
• Taxes

Both of this topics require extensive study, and the book goes into details about them, but to keep the essay short, I will try to summarise the main idea.

Fees should be as low as possible, and this is where different funds compete with each other. However, it is not always possible to keep fees as low as possible, because in addition to the convergence in mean (which is guaranteed to us by the theorem), in variance (which depends on the diversification of the portfolio), there is also convergence in time and trading volume. The last two parameters are really evil. Sometimes to implement the theorem the algorithm would suggest selling a large number of a stock A and buying a large number of a stock B. Mathematically this is sound, but the transaction would incur a brokerage fee which would make it useless.

However, not selling something to avoid the fee is a two-sided sword, because if a stock appreciates, the owner has to pay a sinister thing called “capital gains tax”. After all, technically he became richer, didn’t he? Except this “temporary richness” is not what the balanced portfolio pursues. Sell a stock = pay fee ; hold a stock = pay tax.

This is where it really might be worth finding a professional to do this for you, but the problem is really to find a trader which would be faithfully enforcing the portfolio. You see, most traders are paid as a percentage of trades. No trades = trader is not paid, and he also has wife and kids.

In theory, the two previous sections exhaustively present the ready-to-use strategy. However, this strategy is quite rigid in that it does not take into account various contingencies that may happen in life. For example you might get pregnant, which would greatly decrease your ability to make monthly contributions to the investment account. (Which may or may not be tax-free.)

A worse thing might happen – you might lose the ability to make money due to health issues. The main suggestion of the book is to buy insurance. This is a complicated topic, but it really seems that the seldom-used insurance products, such as incapacitation insurance may make a lot of sense.

This section also has Education in the title, because in some respect paying for a child’s education is similar to insurance – a monthly fee, which in the USA is so large that saving in advance is advised. There are various ways in the USA to pay less tax on education and healthcare insurance.

As I said at the beginning of the essay, this book is not really about getting rich, it is about having some money when you are old.

For specific advice on how to start withdrawing your pension from the savings account, it is worth checking the book itself, but the ubiquitous advice of having a plan, and possibly a few different plans, contingent on how long the investor could possibly continue working, is strongly recommended.

It does not make much sense to die a rich person, but it does make sense to leave some inheritance to your children (which they will have to deal with as with a “windfall”, to which a whole chapter is dedicated in the book) does make sense. There are different way to do it while paying as little tax as feasible.