Warren Buffett’s Ground Rules: Do-It-Yourself Investing Guidelines


Okay, so you probably aren’t reading a book titled Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor if you are perfectly happy owning solely index funds forever. While the shared concepts with low-cost, passive investing still apply, here are things to consider if you want to do some of your own picking and choosing between individual stocks and bonds.

Given how much energy an 86-year-old Buffett seems to have, it must have been very interesting to invest with him as a hungry young man. On the other hand, reading through the partnership letters also shows how mature he was in his late 20s and early 30s.

Be honest with yourself. Pick a yardstick ahead of time. You need to pick a proper benchmark against which to measure your performance, not just having positive or negative years. Back in 1966, it was the Dow over the last 3 years. Note that it wasn’t just an index, but also a timeframe of at least 3-5 years.

If you’re going to invest a portion of your portfolio on your own, always keep track of your performance. You need to be honest about your results and whether they beat the rest of your portfolio, or even a simple target-date fund.

Investing modest amounts is an advantage. Use it. Warren Buffett had a lot more flexibility with a smaller asset base. There are many deals out there that on a percentage basis are attractive, but if you have to deploy billions, it won’t even move the needle. For example, there might a 12-month CD that earns you 8% APY, but only on $10,000. If you only have $20,000 to invest, putting a big chunk of your portfolio in a risk-free 8% would be much smarter than stocks over the next year. However, if you have $100 million to invest, such a deal would be a rounding error. Some other transactions like odd-lot tenders are also ideal for smaller investors.

Worry about risk and return, not about the name of the product. It doesn’t matter if it’s a laundromat, rental unit, shares of a public company, or bonds. When Buffett was winding down his partnership, municipal bonds were yielding 6.5% on a tax-free basis. In his mind, it was a better investment to buy the municipal bonds rather than stocks given the near-term prospects. So that’s what he recommended.

Ignore the crowd. Think rationally and independently. If you’re going to “beat the market”, then you have to think differently than the market. You’re looking for some area where the market price is much lower than the intrinsic value. By definition, that means a lot of people will be disagreeing with your opinion.

Develop your best ideas, and then bet big on it. Buffett is not a big fan of owning 100+ stocks in the name of diversification. If you have your 5-10 best ideas, why also invest in the other 90 that are worse? If you’re going to actively manage your portfolio, you must have the conviction to bet big on your opinions.

Self-confidence is required, as you will have periods of bad performance. For me, keeping my conviction during times of underperformance is the primary reason most of my portfolio is indexed. Here a stat from the book credited to Joel Greenblatt: Of the top 25% of managers who had outperformed the market over the decade: 97% spent at least 3 years in the bottom half of performance and 47% spent at least 3 years in the bottom 10%.

If you are hiring an outside manager, look at integrity first. Buffett on the types of managers he seeks for Berkshire:

We look for three things: intelligence, energy, and integrity. If they don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy.

As a side example, here is how Buffett organized his own fee structure for the partnership. If the fund did not accumulate anything past a 6% annual gain every year, he would not take any fees at all. Above the 6% annual rate, he would take 25% of gains as his fee. While some hedge funds also employ a “high water mark” system, they usually still have some form of flat fee that they take, no matter way. If Buffett didn’t reach his 6%, he got nothing. In addition, he had nearly all his own net worth in the partnership as well. He “ate his own cooking”.

Warren Buffett’s Ground Rules: Shared Concepts with Low-Cost Index Funds

groundrules0If you get in a debate about owning index funds, Warren Buffett will likely be invoked as an example of successful stock-picking. A recent book called Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor covers a period when Buffett was arguably at his peak of active stock trading. However, even during this time, Buffett’s rules and wisdom still shared a lot in common with low-cost index investing.

From 1956 to 1970, Buffett managed a relatively modest amount of money through the Buffett Partnership Limited (BPL), mostly from family and close friends. Already a good teacher, he wrote his partners a series of transparent, frank, and educational letters. While he does write a lot about his outperformance goals and successful trades, but here are examples of how you can be both a Buffett fan and an index fund fan.

You are buying fractional ownership of a real business. Too often, stock trading is treating like playing a game with numbers that zip up and down. Even if you just buy index funds, you should always realize that you are still buying a piece of a business and all its future earnings. These businesses employ hard-working people and provide tangible value and useful services to customers.

In the long-term, the market is efficient. Value investing tries to take advantage of times when the quoted prices of shares vary from “intrinsic value”. Market quotes will vary in the short-term, and you can’t predict them. You can only choose whether to buy, sell, or do nothing. However, value investing also relies on the price eventually returning towards intrinsic value in the long run.

If you buy index funds, you do not spend your time and energy determining intrinsic value. However, you also believe that the markets will work themselves out over the long run.

In the short-term, be ready for big drops in prices. Even though index funds give up the search for intrinsic value, all stockholders are subject to the same short-term swings. From a 1965 BPL letter:

If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet Harry Truman – “If you can’t stand the heat, stay out of the kitchen.” It is preferable, of course, to consider the problem before you enter the “kitchen”.

Beating a diversified index of companies is hard. From a 1962 BPL letter. Buffett made these observations more than a decade before a single person owned an index fund… because they didn’t exist yet.

The Dow as an investment competitor is no pushover and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.

You may feel I have established an unduly short yardstick in that it perhaps appears quite simple to do better than an unmanaged index of 30 leading common stocks. Actually, this index has generally proven to be a reasonably tough competitor.

Consider after-tax results. Buffett offers good advice in that you should always keep track of your portfolio on an after-tax basis. If you are creating a lot of short-term capital gains, your outperformance has to be rather significant in order to counteract the additional tax drag. This doesn’t mean that Buffett never traded – he did a lot of transaction in the partnership years – but he also had many years of awesome returns.

Today, some people criticize Berkshire for not distributing a dividend, but in fact Berkshire does a great job deferring taxes so that the growth can keep compounding and keep your after-tax returns higher. If cash is needed, a Berkshire shareholder can always sell some shares.

A market-cap-weighted index fund usually has very low turnover and thus minimized tax drag. An actively-trading mutual fund that has the same pre-tax performance numbers as a passive mutual fund will often have lower after-tax performance.

More assets makes it much more difficult to create outperformance. More assets doesn’t always translate into lower returns, but as Buffett states you must have enough ideas to put that money to good use. From a 1964 letter:

Our idea inventory has always seemed 10% ahead of our bank account. If that should change, you can count on hearing from me.

Buffett stopped accepting new partners when asset levels reached $43 million. He decided to unwind the partnership completely in 1969, for a variety of reasons. He eventually found a better way to align his interests by all becoming shareholders of Berkshire Hathaway (and only taking a small salary as CEO).

A mutual fund with high performance will naturally attract a lot of assets. The good ones will stop accepting funds if the asset levels outrun their supply of great ideas. The bad ones will keep accepting funds because it means higher management fees. However, with Vanguard index funds the problem goes the other way. As the asset levels rise, the costs go down and the performance is unaffected. Here’s an interesting profile of the little-known manager of the Vanguard Total Market Index Fund, which now holds nearly a trillion dollars in assets.

Vanguard Complacency Check

vanguard_logo_snoozeVanguard recently celebrated the 40th anniversary of the Vanguard 500 Index Fund, the first index fund available to individual investors. If you are like me and have a significant portion of your net worth in Vanguard products and services, you should read this Morningstar article No Signs of Complacency at Vanguard which includes excerpts from interviews with Vanguard executives. Here are highly-condensed highlights:

  • Vanguard is huge and getting bigger.
  • Vanguard is still the only place where the firm is owned by the fundholders.
  • Vanguard costs are low, but it will be hard to get much lower.
  • Competitors can sell their products at a loss. Vanguard can’t, so they may not be the cheapest.
  • So far, there are no signs of complacency, wasted money, or ego-driven moves.
  • Vanguard’s next move will be focusing on better service for clients.

My thoughts. Vanguard has focused primarily on asset growth. This was okay, as bigger assets meant lower costs for fundholders. Now that costs really can’t go that much lower, I agree their next move should be to focus on customer service, both in terms of human interactions and online user experience.

Compared to Fidelity and Schwab, it has been in my experience more difficult to get specific, custom requests accomplished with Vanguard. This includes estate paperwork and large transactions. That means it is harder to get someone on the phone, the person on the phone is less responsive and/or knowledgeable, and overall it takes longer for the action to get done (if it is even allowed). These limitations are probably reflective of their focus on cost savings, but hopefully they can find a better balance. (I’d rather they spend money on this, than more advertising.) I do feel that Vanguard has been improving their technology, so I hope they keep that up.

Jack Bogle WSJ Interview Highlights (September 2016)

wsj_bogleWhen Jack Bogle grants an interview, I sit down and take notes in case he drops something significant. Here is a link to his WSJ interview dated 9/2/2016 (paywall, use Google redirection if needed).

  • Bogle estimates 2% annualized returns over the next decade (he does not forecast past that).
  • Stay invested in a diversified portfolio of stocks and bonds at very low cost.
  • Don’t reach for yield. You just have to save more.
  • Don’t go to cash.
  • He’s fine with 5% of your portfolio in gold, if you like that.
  • He’s still sees no need for international stocks.
  • He’s not worried about too much money flowing into index funds.
  • Bogle predicts that in five years, Fidelity will be sold.

The interview is rather vague in a few areas. I am assuming that the 2% annual returns forecast applies to after-inflation returns of a 50% stock and 50% bond portfolio. This is based on Bogle’s October 2015 presentation which predicted 3% after-inflation returns for a 50/50 portfolio. Since then, stock markets are up and bond yields are down, so future expected returns are now even lower.

Another little nugget is a link to a previous WSJ interview from exactly 10 years ago – 9/2/2006. It provides some additional background to the initial creation of the first index fund for individual investors.

Schwab Target Date Index Funds Review


Charles Schwab has announced Schwab Target Index Funds, a new series of “all-in-one” target date mutual funds that are made up entirely of in-house Schwab Index ETFs and a Schwab cash mutual fund. Their existing offering Schwab Target Funds differs in being significantly more expensive and including a mix of passive and actively-managed funds. Each fund will have a target date between 2010 and 2060, spaced in 5-year increments. Let’s take a closer look.

What’s inside? The portfolio for any given target year is composed of 9 different asset classes. Here is a graphical illustration of their “glide path”, or how the asset allocation changes relative to the target retirement date. (Source. Click image to enlarge.)


Here’s a 2016 snapshot of what every fund is holding by target date (Source. Click image to enlarge.):


Overall, the glide path conforms to industry norms, with high equity at younger ages and lower equity as you reach and pass retirement. Here are the ETFs and mutual funds that represent each asset class.

  • US Large Cap Equity – Schwab U.S. Large-Cap ETF (SCHX)
  • US Small Cap Equity – Schwab U.S. Small-Cap ETF (SCHA)
  • International Developed Equity – Schwab International Equity ETF (SCHF)
  • Emerging Markets Equity – Schwab Emerging Markets Equity ETF (SCHE)
  • Real Estate – Schwab U.S. REIT ETF (SCHH)
  • Short-Term Bond – Schwab Short-Term U.S. Treasury ETF (SCHO)
  • Intermediate-Term Bond – Schwab U.S. Aggregate Bond ETF (SCHZ)
  • Inflation-Protected Bond – Schwab U.S. TIPS ETF (SCHP)
  • Cash – Schwab Variable Share Price Money Fund — Ultra Shares (SVUXX)

How much do they cost? What are the investment minimums?

  • Individuals can buy Investor Shares with an expense ratio of 0.13%. The minimum initial investment is $100.
  • Employer-sponsored retirement plans can access the Institutional Shares with an expense ratio of 0.08%. There is no minimum initial investment.

An interesting thing to note is that the mutual funds technically have an extra layer of management fees and “other fees” on top of the expenses from the underlying ETFs and mutual funds. However, Schwab has agreed to cap the expenses at 0.13% for Investor Shares and 0.08% for Institutional Shares. This is supposed to stay in place “for so long as the investment adviser serves as the adviser to the fund”… they might want to re-word that.

In any case, even with the cap, the Investor Shares still cost more than the expenses from the underlying investments. You are basically paying 0.05% to 0.08% for some simple asset allocation. That means you could build your own portfolio using the same Schwab ETFs at a lower cost. You could also get rid of the (unnecessary in my opinion) cash component, which currently only yields 0.43% with another temporary fee waiver as of 8/26/2016. Personally, that’s what I would rather do, but I will admit that some folks will do better with an automated asset allocation.

How does it compare with Vanguard Target Retirement Funds? This is the natural comparison, as Vanguard’s target funds have the most assets and they used to be the cheapest before Schwab came along. Across the series, the expense ratio for their retail fund varies between 0.14% and 0.16%. You can now see why Schwab has priced their funds just below that at the “sale price” of 0.13%. Schwab loves to be cheaper by a basis point or two.

In terms of asset allocation and glide path, here are some side-by-side comparisons:

  • Vanguard has a equity split of 60% domestic and 40% international. Schwab has a equity split of 67% domestic and 33% international (if you consider the 4% US REITs as US stock).
  • Vanguard starts at 90% equity max and reaches 50% equity at retirement age. Schwab starts at 95% equity max and reaches 40% equity at retirement age.
  • Asset classes that Schwab includes specifically, which Vanguard does not: REITs, inflation-protected bonds (TIPS), and cash.
  • Asset classes that Vanguard includes specifically, which Schwab does not: International bonds.

Commentary. Schwab is definitely serious about index funds. They’ve built their own set of low-cost index mutual funds and index ETFs to compete with Vanguard and iShares. They already have an automated portfolio “robo-advisor” called Intelligent Portfolios, which uses these index funds as well as some “smart beta” funds. They’ve added these Target Index funds to grab the 401(k) and individual markets including IRAs. Put another way, they sell flour and butter, and they also sell pre-made pies and cakes.

This is a long-term play for Schwab, as they’ve all but admitted that the index ETFs themselves are currently losing money, while hoping to either make up the difference in other fees, services, or products somewhere down the line (like when interest rates rise again). Schwab will surely grab much more assets from employer retirement plans as a result of this move. In my limited experience with them, I have found Schwab to have solid customer service, at times in fact better than Vanguard. If they can leverage their customer service and human component, I think this is a smart move on their part.

However, if given the choice, I’d recommend my family to buy Vanguard Target Retirement funds first because Vanguard is not a for-profit company and I trust Vanguard more to keep customer interests first over the long run. (I believe that Schwab includes cash where it isn’t necessary in order to increase their future fees from money market funds, which are an important contributor to profits. This isn’t as significant here as in their robo-advisor product, but it will matter more as interest rates rise. More importantly, Vanguard doesn’t play such games.) However, big-picture-wise they are very similar. I’d gladly recommend that they buy a Schwab Target Index fund in their 401(k) or 403(b) plan as they are likely the best options if available. This is a positive development overall for individual investors.

SolarCity Bonds: 6.50% Interest for 18 Month Term

scty0bSome folks don’t like it when I write about investments that aren’t low-cost index funds. The thing is, when I find something intriguing, I like to dig deeper and then keep a record my findings. That way I can look back later and see how things turned out and compare with my opinions at the time. Just because I write about something doesn’t mean I recommend it, you have to read the entire post.

SolarCity is a company that installs and finances solar panels on commercial and residential properties. Back in October 2014, they started to allow individual investors to buy senior, unsecured corporate bonds directly from them online. You could invest as little as $1,000 in these SolarCity SolarBonds and pay no trade commissions or fees. The critical feature is that these “solar bonds” were backed only by the claims-paying abilities of the issuing company. If SolarCity fails, then you could lose your entire principal as well as any interest owed.

In general, the more confident you are that you’ll be paid back, the lower the interest rate the borrower has to pay. Other factors will come into play, such as the overall interest rate environment. With this in mind, check out the history of these bonds:

  • In 2014, SolarCity was issuing 7-year bonds paying a 4% annual interest rate.
  • In mid-2015, SolarCity was issuing 5-year bonds paying a 5% annual interest rate.
  • Currently in August 2016, SolarCity is offering a 18-month bond paying 6.5% annual interest rate. Ends August 30, 2016.


Supposedly, SolarCity is passing on the savings of doing things in-house and not having to pay investment banker fees. I still declined to write about these SolarCity bonds in the past because the yield and term lengths were not good enough to grab my interest. But 6.5% in 18 months? Okay, you’ve at least gotten my attention.

Consider that as of 8/24/16, an 18-month Treasury bill yields approximately 0.70%. The highest 18-month FDIC-insured CD pays roughly 1.35%. Investment-grade (A) corporate bonds are averaging ~1.15% for a 2 year maturity. Even a junk bond ETF like JNK may have a 6.5% yield but an average maturity of over 6 years.

What’s happening? Well, SolarCity is struggling in several areas. It’s been losing money reliably, every year. Here’s the stock price chart:


Perhaps more importantly, it has some big bills that are coming due soon. According to this TheStreet article, SolarCity has $3.25 billion in debt, with $1.23 billion due by the end of 2017. Note that date. At the same time, Tesla has offered to buy SolarCity in an all-stock deal.

Obviously Elon Musk and his SolarCity co-founder cousins want it to happen, as it has been widely-reported that they bought a big chunk of these bonds on their own. See Fortune, WSJ, and MarketWatch.

Why would they buy these bonds? My wild-guess opinion is that it looks like SolarCity is trying to extend its debt long enough so that Tesla can safely buy the company and then refinance things on better terms. I would say that if the deal closes, then these 6.5% bonds will pay off. I believe that Tesla will still be around in 18 months. However, if the deal doesn’t close for some reason, then SolarCity might be in big trouble.

Are these 6.5% bonds worth the risk? Given that Elon Musk and his cousins are a big shareholder in both companies and just bought $100 million of these bonds, that would seem to place your interest in line with theirs at this point. I’d actually rather hold these bonds for 18 months than be a shareholder for 18 months. However, you are still faced with the chance that the deal will hit some unforeseen obstacle, so it all depends on your confidence level. For me, the reward just isn’t high enough to justify the risk of permanent principal loss (I’d rather have a house as collateral), so I am going to pass and wait to see how it turns out.

MogulREIT: CrowdFunded Real Estate for Non-Accredited Investors

rmlogo200While the number of real estate crowdfunding sites keeps growing, most marketplaces still require you to be an accredited investor with high income and/or net worth requirements. However, options for non-accredited investors should improve shortly due to the expanded Regulation A+ per the JOBS Act, which allows the general public to invest in private companies under certain circumstances.

RealtyMogul.com just announced their offering called the MogulREIT I. Instead of being able to buy part of a specific shopping center or providing a loan against a specific apartment complex, these REITs take your money and the sponsors get to pick out a diversified pool of commercial estate. The investor has much less control, but easier diversification. Instead of putting $2,500 into one building, you can spread $2,500 across 20 or 30 properties. Here are more details from their website:

  • Fund intends to be diversified across property types, investment types, and geographies.
  • The Fund expects to pay quarterly distributions starting the second full quarter of operation.
  • The Fund will provide certain redemption opportunities, quarterly.
  • MogulREIT I is audited by Cohn Reznick and administered by Opus Fund Services.
  • $2,500 Minimum Investment.

Here’s what they have to say regarding expenses:

Investors in MogulREIT I will not be charged any sales commissions and the organization and offering expenses are anticipated to be approximately 3% of the target total raise of amount. Traditional non-traded REITs typically charge an average sales commission of 7% and organization and offering expenses of up to 15%**.

There are more details in the full SEC offering circular. Please do your own due diligence.

As I’ve said before, I would tell my family to invest in a low-cost, diversified, publicly-traded REIT fund before investing in any of these non-traded REITs with limited liquidity. For example, buying shares of the Vanguard REIT Index ETF (VNQ) will give you commercial real estate exposure with rock-bottom expenses and daily liquidity. VNQ and its mutual fund equivalents are where the vast majority of my commercial real estate exposure remains.

That said, I find this area of investing to be interesting. I like the idea of focused real estate but don’t enjoy being a landlord. I have invested $2,000 of “experimental money” into the similar Fundrise Income eREIT, as I prefer high-interest loans backed by real estate as collateral. Fundrise also has a Growth REIT which focuses more on real estate equity. The MogulREIT I is supposed to target both income and growth. I currently have no plans to invest in either the Fundrise Growth REIT or the MogulREIT.

Using Your 401(k) and Roth IRA as Emergency Funds

savebuttonbankWe’ve all heard that you should keep an emergency fund in case of unexpected expenses or unemployment. But what if you don’t have the cash? Personal finance author Jonathan Clements presents a mathematical argument for using your 401(k) as an emergency fund in his recent article The Terrible Twenties. Here’s how the math works.

Let’s say you are in the 15% federal income tax bracket and you put $2,000 in your employer’s 401(k) plan. Your out-of-pocket cost would be $1,700, thanks to the initial tax savings. At the same time, your employer matches your contributions at 50 cents on the dollar, with the matching contribution vested immediately. Result: Your $2,000 investment gets you a $1,000 match, bringing your account balance to $3,000.

If you are then laid off and forced to liquidate your retirement account to pay living expenses, you might lose 15% to federal income taxes, plus another 10% to the tax penalty for making a retirement account withdrawal before age 59½. That combined 25% hit would still leave you with $2,250, well above your $1,700 out-of-pocket cost.

To be fair, this isn’t nearly as radical as it seems. Most prioritized lists of “where I should put $XXX?” will put a 401(k) up to the company match as the #1 priority, even above a cash emergency fund.. A company match gives you a way to earn a 50% or 100% instant, risk-free return on your money. This is a rare opportunity that you shouldn’t pass up.

However, not mentioned is that after you exhaust any 401(k) match, you could also consider contributing to a Roth IRA and using that as your emergency fund. The primary reason for this is that Roth IRA contributions can be taken out at any time, without penalty. Unlike Traditional IRAs, withdrawals from Roth IRAs are subject to ordering rules (see Chapter 2 of IRS Pub 590-B), which state that you always withdraw your own contributions first.

In either case, since you can only contribute a certain amount to 401(k) and/or IRAs every year, it would be wise to take advantage of this tax-sheltered space as much as possible. Don’t make a withdrawal if you can avoid it, but if you have limited options, it can make sense to contribute first and hope you can keep the money invested for retirement.

The Vanguard Effect on ETF and Mutual Fund Expenses

vanguard_logoThe following chart taken from this Bloomberg article by Eric Balchunas shows the drastic difference in expense ratios when Vanguard has an offering in an asset class or not.

Like Walmart arriving in a new town, the entry of Vanguard into a particular investment area causes a collective gnashing of teeth as other fund managers are forced to drop their prices to compete. That dynamic is borne out in the table below, which shows the cheapest ETF fees for products that do or do not have a Vanguard-provided equivalent.


This is the “Vanguard Effect”. Here’s my version of explaining how it works:

  • When Vanguard competes in an area, the expense ratios across the board are much, much lower.
  • Note that the cheapest expense ratios you see in those asset classes not necessarily from Vanguard itself. It is often from a competitor like Charles Schwab.
  • When Vanguard doesn’t compete, the expense ratios are much higher.
  • In those no-Vanguard asset classes, the competitor won’t lower prices just because they can. They’ll keep the profit margin as high as they can, as they are bound to serving the business owners as well as ETF share owners. The gap between what they can charge and what they must charge goes to business profits. They aren’t evil, they are just trying to serve their two masters.
  • At Vanguard, the business owner is the ETF share owner. (Vanguard uses the term “client-owned”.) For them, the most efficient way to pass on potential profits is to keep expenses as low as possible.

This is why you see DIY investors always wish Vanguard would offer something like an International Small Value ETF or a US Micro Cap ETF. By simply entering the ring, even the expense ratios of the ETFs we already hold from other providers will go down.

Hours of Work Needed to Buy S&P 500, Gold, and Oil

Here’s an interesting series of charts that measure how many hours of work it has taken to buy various things like the S&P 500 index, an ounce of gold, or a barrel of crude oil. You could see it as an alternative to adjusting historical prices by CPI inflation. Found on Twitter, done by @TheChartmeister.


In July 2016, the average hourly earnings of a production worker according to the Bureau of Labor Statistics was $21.59 an hour. In January 1964, it was $2.50 an hour.

In July 2016, it would take roughly 100 hours of work to buy the S&P 500 index if it was in dollars. Back in 1964, it would have only taken roughly 30 hours of work.

Here are direct links to the tweets.

Reader Question: Good Time To Lower International Stock Exposure?

earth_apolloHere’s a reader question on international equities that reflects some of what I’ve been reading elsewhere and thinking about in my head:

I was doing my mid-year rebalance and noticed that international equity funds did terrible over the past 10 years, I have a fair amount of money in international equities, as do you. I’m considering lowering the % because they generally under perform US funds. Would love your thoughts.

First, let’s look back at some history (i.e. my old posts). Is it really true that US stocks historically perform better than International stocks? Also, the diversification benefit comes from the very fact that these asset classes don’t always move in sync (not perfectly correlated), allowing you to attain a higher risk-adjusted return by holding some of both as opposed to just one or the other.

From 1970-2006, foreign stocks outperformed US stocks, while the point of optimal risk-adjusted returns was a split of 76% US and 24% Foreign Developed (EAFE) (70% is a typo). The chart is taken from a past edition of A Random Walk Down Wall Street by Burton Malkiel.


From 1970-2013, the same chart shows that US stocks now outperformed foreign stocks on average, with the point of optimal risk-adjusted returns at 70% US and 30% Foreign Developed. From Rick Ferri:


From 1970 to 2015, the average annualized return of the S&P 500 has been 10.3%, while MSCI Europe has returned 10.0%. Sometimes US wins. Sometimes International wins. Here’s a chart from Ben Carlson of A Wealth of Common Sense showing the rolling 5 year over- and underperformance of U.S. stocks relative to European markets (MSCI Europe):


This is an example of why “staying the course” sounds easy but it isn’t in real life. On one hand, some of the recent doubt about Europe and Emerging Markets has to be about performance chasing. Look at the recent divergence in two major mutual funds that track Total US (VTSAX) and Total International (VTIAX) indexes, taken from Morningstar. This shows the growth of $10,000 invested 5 years ago:


On the other hand, there are real reasons behind the performance difference. The US economy has been more resilient and the future does look more bright. Europe and Emerging markets have more obvious problems without a visible solution. But that also means that US stocks are more richly valued, and International stocks are “cheaper”. Every model that uses historical data shows that International stocks have a higher future expected return. Here is Research Affiliates as one example:


Summary. The formal advice is that you should have a written “investment policy statement” (IPS) that states why you hold your current asset allocation in the first place. In other words, what where the reasons behind your current allocation? Have they changed? For me, nothing has really changed about why I bought both US and international stocks in the first place. Their long-term historical returns remain similar, and while the US may be slightly ahead at this moment, this could easily change again in the next decade.

It’s not fun to hold these international stocks right now, but I focus on the fact that European and Emerging Markets valuations are relatively cheaper and the dividend payout rates are relatively higher. By owning a globally-diversified passive portfolio, I choose to rely on the markets to work themselves out over time.

Early Retirement Portfolio Income, 2016 Mid-Year Update

dividendmono225I like the idea of living off dividend and interest income. Who doesn’t? The problem is that you can’t just buy stocks with the absolute highest dividend yields and junk bonds with the highest interest rates without giving up something in return. There are many bad investments lurking out there for desperate retirees looking only at income. My goal is to generate portfolio income that will keep up with inflation.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (Taken 7/31/16) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
24% 1.83% 0.44%
US Small Value
WisdomTree SmallCap Dividend ETF (DES)
3% 2.98% 0.09%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
24% 2.71% 0.65%
Emerging Markets Small Value
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
3% 3.14% 0.09%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 3.21% 0.19%
Intermediate-Term High Quality Bonds
Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX)
20% 2.82% 0.56%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
20% 0.82% 0.16%
Totals 100% 2.18%


The total weighted 12-month yield was 2.18%. This means that if I had a $1,000,000 portfolio balance today, it would have generated $21,800 in interest and dividends over the last 12 months. (I will note that the muni bond interest in my portfolio is exempt from federal income taxes.) For comparison, the Vanguard LifeStrategy Moderate Growth Fund (VSMGX) is an all-in-one fund that is also 60% stocks and 40% bonds. That fund has a trailing 12-month yield of 2.04%, taken 7/31/2016.

Both of those yield numbers are significantly lower than the 4% withdrawal rate often quoted for 65-year-old retirees with 30-year spending horizons, and is even lower than the 3% withdrawal rate that I usually use as a rough benchmark. If I use 3%, my theoretical income would cover my current annual expenses. If I used the actual numbers above, I am still slightly short. I will admit that planning on spending only 2% is most likely too conservative. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years.

I still like this income yield calculation as very conservative lower bound that adjusts for stock market valuations (valuations go up probably means dividend yield go down) as well as interest rates (low interest rates now, probably low bond returns in future). As an aspiring early retiree with hopefully 40 or even 50 years ahead of me, I like having safe numbers given the volatility of stock returns and the associated sequence of returns risk.