Another reason to love Vanguard: lower brokerage fees

You may already know that I’m a HUGE Vanguard fan.  Their rock-bottom index fund fees, selection, online account features, and investment philosophy just can’t be beat.  Well, there’s another reason to celebrate them: as of May 4th 2010, Vanguard has significantly reduced its brokerage trading fees.  (See THIS for more details.)

For stocks, commissions are $7 if you have $50,000 – $500,000 in assets (and a ludicrously low $2 per trade if you have more than $500K.)  Even if you have less than $50,000, you still get 25 trades per year at $7, then $20 per trade after that.  For many buy-and-hold investors still a long ways from retirement who hold only a few individual stocks (like me), 25 trades per year could be fine.

AND here’s the kicker: Vanguard’s ETFs can all be traded FREE!  This means you can buy any of their indexes as ETFs instead of funds (garnering yourself even lower annual expense ratios versus buying Vanguard’s funds.)  You can have 25 trades per ETF per year before Vanguard imposes a 60 day waiting period to prevent frequent trading.  This means that you could even dollar-cost-average into these funds twice-monthly.  (That said, if you do frequent dollar-cost-averaging, just using Vanguard’s standard mutual fund services may be better and easier.)

When things you love come together

I love my wife, and I love personal finance.  If my wife suddenly developed an all-consuming passion for, say, investing…, my god.  To me, that’s what Vanguard offering superior online brokerage service is like: when two things that you love come together (Vanguard + inexpensive online brokerage), it’s just beautiful.  It will likely be only a matter of time before I get around to transferring my Scottrade assets over to Vanguard.

What to look for in a broker

If you’re looking for an online broker to open (or transfer) an account to, consider Vanguard.  Compare its features and prices with other online brokers to make the best decision for yourself.  Especially look at trading costs (should be around $10 or less), other fees, usability of the online interface, and online features (I hate paper.)  Also, if the broker offers free dividend reinvestment (Vanguard does, as does ING Direct’s Sharebuilder; Scottrade doesn’t 😦 ), that’s a plus.

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Asset allocation rules of thumb

“Asset allocation”, or the percentage of your assets (usually just financial ones) that you put into different types of things (stocks, bonds, cash, real estate), has been shown to determine a very large portion of a person’s return.  It is also the key determinate in how much volatility your portfolio undergoes.

[UPDATE 12-21-2010: HERE is a very good, quick (5 minute or less), easy-to-use questionnaire from the good people at Vanguard that can be used to estimate your personal asset allocation.  It might be a bit conservative for my taste (too heavily weighted towards bonds instead of stocks), but it’s an excellent starting point to get a ballpark stock-to-bond split.]

While there many ways to arrive at a recommended asset allocation, it often helps to have some simple rules of thumb.  The general idea is that the older you are or the sooner you need the money, the safer your investments should be.  So while a 100% stock retirement portfolio would be great (in my opinion) for a 30 year-old with 30+ years until retirement, it would generally NOT be advisable for a middle-income retiree.

The following rules of thumb that I will discuss assume that the asset allocation is for RETIREMENT, and that the average person won’t be tapping into it until they’re between 60 and 70 years old.

120 minus your age

To simplify between all the different types of assets, people often just make the distinction between stocks and bonds.  For people that own homes and keep some petty cash in their savings or checking accounts, I think just talking about stocks and bonds works well for most people.  One such stock-to-bond ratio rule of thumb is this:  from 120, subtract your age.  The remaining number should be in stocks.  For example, if you’re 60, this rule would tell you to put 60% (= 120 – 60) of your assets into stocks, and the rest (40%) into bonds.

This rule is definitely simple, and reasonably useful.  (It used to be 100 minus your age, but that was when people didn’t live as long.)  My criticisms of it is that may tend to put too much of one’s assets into bonds, especially prior to age 60.  Historically, stocks have out-performed bonds in almost every 30 year period.  Of course, this is no guarantee that they will continue to do so, but it suggests a high probability.

In general, if you have more than 5 – 10 years to go before you need some money, it could be in the stock market.  Thus, I tend to recommend that people who still have 10-20 years to go before retirement put all of their money into stocks.  This assumes that most people will have some fixed income anyway (like social security.)  It also assumes that the person will only be using a small portion of their retirement funds per year (like 4 – 5% of the total account balance.)

Some alternatives

Since I prefer a slightly more aggressive rule of thumb than the above, I came up with the following asset allocation formula: Put 2 times the difference between your age minus 50 into bonds.  I.e.: % in bonds = 2*[Your age – 50]

So, if you’re 50 or under, you put nothing in bonds.  At 60, you’ll have 20% in bonds (= 2*[60 – 50]), and 80% in stocks.  At 70, you’ll have 40% in bonds, 60% in stocks, and so on.  This has the virtue of keeping a 100% stock portfolio until you’re 10 – 20 years out from retirement.  It also ‘catches up’ to the more conservative allocation by increasing the percentage of bonds in your portfolio by 2% per year after age 50.

Another option might be to just use a fixed allocation like 60-40 or 75-25 stocks to bonds.  You might choose to gradually switch from 100% stocks to this fixed allocation over a period of, say, 10 years, like from 50 to 60, or starting 10 – 20 years prior to your target retirement date.

Lastly, you could adjust my 2*[age – 50] formula above to take your target retirement age into account: use % of bonds = 2*[ Age – (Target retirement age – 15) ].  If you’re going to retire at 65, this works out to just 2*[Age – 50] (since 65 – 15 = 50.)  But, if you’re going to retire earlier or later, your recommended asset allocation will adjust accordingly.

Conclusion

Asset allocation is important.  Within each asset class, always diversify as much as you can.  Pick stock and bond index funds with low expense ratios that sample the entire market.  (Large cap and small cap, domestic and international for stocks.)

In general, I like 100% stocks as an allocation for retirement portfolios that still have 10 – 20 years until you start tapping them.  Then, gradually switch to something more conservation using one of the above rules of thumb, or something more exact like a financial advisor or William Bernstein’s “The Intelligent Asset Allocator”.

The financial media makes me laugh out loud

On the heels of my look-back at the stock market decline of 2008 – 2009, the financial troubles of Greece sent shudders through equity markets today.  While I try not to pay too much attention to the emotional swings of “Mr. Market” or his reporters, I read a quote from a trader that I couldn’t help but share:

” ‘We did not know what a stock was worth today, and that is a serious problem,’ said Joe Saluzzi of Themis Trading in New Jersey.”

Understandably, for a guy that trades stocks every day for a living, this is important.  But for this to be featured in the ‘front page’ of Yahoo! Finance suggests that it is of paramount importance for average investors and web surfers to know what their stock prices are at every instant of the day.

Well guess what?  It’s not!

If you’ve read any of my articles on investing, you know that I believe investing in stocks with a short-run focus is dumb.  Stock portfolios should be held for long-term gains and savings goals like college or retirement.  Because of this, it is pointless, time-consuming and emotionally draining to worry about the day-to-day changes in stock prices.  It can be hard to resist the temptation to check daily on your portfolio (I have the same problem), but we must resist the urge!

Super-investor Warren Buffett has been quoted as saying that a person should choose investments such that they don’t care if the stock market closes for 10 years, rendering them unable to trade or check its market price during this time.  As with many of Buffett’s simple statements, there’s a lot of wisdom in this one.

What you should do

Investors should structure their portfolios with the appropriate mix of stocks, bonds, and cash (‘asset allocation‘) and buy highly-diversified, low-fee index funds and plan to hold them up until they need the money (for at least 5 years; the longer the better.)

If you haven’t done this, give your portfolio a checkup and make sure you have an appropriate portfolio given your age and needs.  If you’ve done this, then forget about the market’s daily throes and do something more enjoyable with your free time.  Turn off CNBC and avoid the financial media’s sensationalist ‘news’ that’s designed solely to make you worry over things you shouldn’t and consume more of such stories.  Instead, sleep soundly at night, knowing that you’ve structured your investments such that they require only occasional maintenance and review.

To see if you might benefit from the help of a professional financial advisor, check out my website at greenlakepartners.com.

Hindsight: Looking back on the 2008 – 2009 recession

On October 2nd, 2008, I wrote an article called ‘What do do (and what NOT do to) in today’s turbulent financial markets’.  My main message urged investors to stay calm, and simply assess their financial situation as they would in any other type of market.  Then, I told folks to ‘do nothing’ in terms of changing their current investment plan.  I urged people not to pull their money out of the market, and to continue contributing regularly as they would under any other circumstances.  (I also suggested that now might be a good time to start investing as well.)

Now that the stock market recession appears to have passed (leaving 10% unemployment and several bankruptcies in its wake), let’s take a look at my advice and what the market has done since:

Roughly one and a half years has elapsed since I wrote the article (as of this writing.)  From that time period the total stock market (represented by Vanguard’s VTSMX, the blue line above) is up about 10%, with the S&P 500 (large cap stocks, the red line) up about 7-8%.  If we assume dividends were about 2-3% per year during this time period, the total market return was probably about 15% since then.

During the next 6 months after my article, things continued to get WAY worse, and then improved dramatically from a low in about March of 2009.  Of course, I had no idea which way markets would go in the short-term when I wrote my article (and don’t believe anyone who says they did), but history has demonstrated that after long periods of time, stocks tend to do fantastically well compared to other asset classes.

Academic studies show that investors are terrible at timing the market.  They tend to pull money out when prices dive, and put money in when prices skyrocket (think 1999.)  Obviously, this is contrary to the difficult-to-follow-but-oft-quoted Wall Street adage ‘buy low, sell high’.  Such studies have also shown that the investors who trade the most perform the worst, partly due to excessive trading fees as well as bad timing.

When you combine this information it is clear why a policy of regular stock market investment (‘dollar cost averaging’) into stock market index funds tends to outperform other more active investment strategies.  Perhaps an even greater benefit of this approach is a huge reduction in mental burden on the investor.  Investors who stuck to regular investment plans would have purchased a lot of shares on the cheap during the market decline, profiting immensely during the subsequent rise.

Conclusion

I wrote this look back at the recent recession not to say ‘I was right’.  (For the several months following my advice, stocks plunged!)  For all I knew, the recession could have lasted much longer than it did (or it could have been shorter.)  Stocks could still be below where they were when I wrote the article.

The important takeaway is that sticking to a well-thought-out investment plan makes sense even in times of severe market fluctuations.  A key part of this is making sure you’ve planned out your financial future enough to put things on semi-autopilot.  Start by following these four simple steps to wealth.

(If think you might benefit from professional advice or investment management, send me an email at Ward.Williams@greenlakepartners.com for a free consultation to see if I can assist you.)

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