Friday, June 20, 2014

Book Review #3:The Bogleheads' guide to investing: Authors: Taylor Larimore, Mel Lindauer, Michael Leboeuf

This is a review of the book 'Boogleheads' guide to Investing'

  Bogleheads are a group of enthusiasts of Vanguard Mutual Fund and its founder Mr.John Bogle.

Bogleheads' guide to investment is a book for those who are new to investing. Covering over 23 Chapters (written in small fonts !) this book acts as a full spectrum Investment Guide who has money to invest but don't know how or where (to invest).

When I first looked at this book as a part of my project on reviewing 50 Books on Finance, I decided against reviewing this. Yet another 'Dummies Guide' I thought. Even the reviews on the initial pages of the book confirmed my suspicion. 'Explains investing in mildly amusing tone', raved one reviewer. 'Explains the basics of investing, for both beginners and experts alike', said another.

A 'Dummies Guide' on investing which is 'Mildly Funny'? Not worth reviewing.

Fortunately I decided to borrow it, more so because I did not get any better books. I am lucky I borrowed it. This book as abundance of information and tonnes of wisdom. Even experts can learn new stuff from this book. Or they may come up with a different perspective on what they already know.

Both are good.

This book is divided into two parts. Part 1 spans from Chapter 1 to Chapter 16 and discusses 'Essentials of Investing'. Part 2 spanning Chapter 17 through Chapter 23 discusses 'Follow through strategies to keep you on target'. 

Like the other 'How to' books on making money and generating wealth, this book too starts with talking about your mind. If you want to become seriously rich, there are three behavioral traits that you must inculcate. They are:
  1. Graduate from paycheck mentality to net worth mentality
  2. Pay off credit card and high interest debts
  3. Establish an emergency fund.
The point about 'Net Worth' mentality require some elaboration. As you might have read in my review of the book 'Rich Dad Poor Dad', the rich work on the asset side of your financials while the middle class work on the Income side. The reason they (middle class) do that is because they are not financially literate. Working on building the asst side of your personal balance sheet is what is called 'Net Worth' mentality. Conversely, working on the Income side of your personal financial statement is called 'Paycheck' mentality.

One caveat against point 2. While no debt is better that most of the debts, if you get a loan at low interest, fixed rate terms you should go for it. Of course provided that you have your principal already invested in a high interest investment opportunity. 

So, ok, you have moved to the 'Net worth' mentality, now what? You know the difference between Assets and Liabilities, so how do you build your net worth. That is achieved by starting early and investing regularly. This chapter talks about the benefits of compounding and compound interest. If you invest 6000 rupees per month at 10%, you will have a Crore of rupees at the end of 30 years.

Over the next two chapters the Bogleheads go on to cover various investment options available to an average investor. The coverage spans Stocks, Bonds, Treasury issues, Government agency securities like GNMA,  Fanne Mae, Freddie Mac etc, Corporate Bonds, Municipal Bonds (Munis) etc. Chapter 3 focuses primarily on debt instruments. There is on section on the difference between Maturity and Duration (Read it, it is very important if you are a bond investor). Chapter 3 concludes by discussing three aspects relating to Bonds, vis, why should I invest in Bonds, How much should I invest (Thumb rule: A percentage equal to your age should be invested in debt and 100 minus your age should be in equity. For example, if you are 55 years old, 55% of your networth should be in Debt and 45% should be in equity. Of course this depends on your risk profile) and finally is is better to own an individual bond or a bond fund.

Chapter 4 continues the discussion into the realm of mutual funds. The book discusses 10 advantages of mutual funds, the difference between active management and indexing (latter is cheaper), and Fund of Funds. The third one is important. A fund of fund (FoF for short) is a fund that invests in other mutual funds. This way one FoF will give you the necessary allocation between Equity and Debt as you may wish. Life-cycle funds are a specific category of FoFs which become more conservative as years go by. This automatically does the Investment rebalancing as time progresses.

From mutual funds, the discussion moves on to Annuities - Fixed, Variable and Immediate, and finishes by a discussion on Exchange Traded Funds (ETFs). While discussing the various disadvantages of Annuities (ET Wealth had one full issue dedicated to this topic), authors point out that Annuities are 'normally sold not bought'. My advice, stay away from annuities (In India they are known as 'Pension Plans'). They are a very bad way to invest for future.

Discussion on Exchange Traded Funds (ETFs) clarified a long standing doubt in my mind about the difference between ETFs and FoFs. While NAV of FoFs are calculated on an end-of-the-day basis, the NAVs of the ETFs are calculated on a real time basis. One advantage of ETFs is that the fund expenses are relatively low compared to stand alone mutual funds.

Chapter 3 and 4 together gives a good summary of the investment options available to an investor.

Focus of Chapter 5 is on the 'Silent Thief', aka inflation. While compounding works in favour of an investor, inflation compounding works against her. The book discusses two investment options to protect against inflation. One is the Inflation Indexed Bonds (IIBs or I Bonds) and Treasury Inflation Protected Securities (TIPS). There is a lot of math in this chapter, the focus being on analysis of various Inflation, Tax Rate and Fixed Rate scenarios. 

There were two aspects in this chapter that were interesting to me. One was that the chapter destroyed the claims of many investment analysts that equities are best protection against inflation. The book points out different time periods when equities performed worse than inflation. The second aspect was that RBI has recently introduced IIBs in India. I need to look them up. Look to be an interesting investment option !.

Chapter 6 discusses the various aspects one should consider while deciding on how much amount one must save to plan for a smooth retirement without impacting ones quality of life. Various factors should be considered including current age, retirement age, expected no of years since retirement, expected rate of return, expected inflation rate, estate planning, inheritance and if one has other sources of income. Authors advice all to think thoroughly through all the details and plan for your savings.

I think this chapter is a misnomer. While the title is 'How much to save', the focus is on 'How much one will need' without any mention of how one will get there. There is some math given in the book that may be useful for people planning their investments.

Chapter 7 focuses on the best investment vehicle. The authors advise is to Keep it simple. There is no doubt in author's mind that Index Funds are the way to go. They convincingly prove (and if you need further proof, there are testimonials from some of the leading investment experts out there who also recommend index funds) that over the long term, index funds outperform more than 90 percent of the funds out there. The higher return of index funds come from the fact that their costs are very low.

So, why should you invest in index funds? Various reasons. Index funds have no sales commissions, low operating expenses (which means that more of your money stays invested), tax efficiency, no need to pay for expert advice, higher diversification and hence lower risk, there is no style drift and finally there is no tracking errors.

I have one question related to index funds. How come some funds perform better than others?

Chapter 8 on Asset Allocation is, in my opinion, is one of the most important chapters in this book. The authors site some very important theoretical concepts to bolster their case for asset allocation including Efficient Market Theory, Random Walk Theory and Modern Portfolio Theory. There are four question that one has to consider while deciding on asset allocation.
  1. Investment Goal
  2. Time Frame
  3. Risk Tolerance
  4. Current financial situation
Ideally one should allocate assets between different investment classes discussed earlier in Chapters 4 and 5. One should have investments in Stocks, Bonds, International Markets (and may be in Real Estate). It is surprising that Gold (a favorite asset class for Indians) do not even fare in this book !

The authors round off the chapter with a few sample portfolio for different age groups.

Chapter 9 is on costs. While reading this point, I was a bit surprised that I have not seen this point mentioned in any of the investment books that I have read previously. Costs are important. Your real returns will be equal to your actual returns less inflation less costs. As per this article while the long term return on US Stock Market is about 10.4 percent, the long  term costs are about 3.3 percent. This demonstrates the importance of keeping your costs down.

Is there any way to keep the costs down? Yes, we discussed this already. Invest in Index Funds. A part in Stock Index Funds, part in bond index funds and the rest in international index funds.

And remember, these costs do not even include taxes. Taxes further lower your return.

Next two chapters, Chapter 10 and Chapter 11 are on taxes. Authors give different examples of how taxes can significantly impact our returns from our investments. To effectively manage taxes, authors give the following suggestions.
  1. Invest in long-term tax deferred investment opportunities. That way, taxes are deferred to your post retirement years where you will fall into a lower tax bracket
  2. Buy low-cost, low turnover funds: Most of the taxes paid by the mutual funds are while buying and selling securities. A low turnover fund will ensure that the transaction taxes will be kept minimum. Why low cost? What is the relevance to taxes? Well, every time a Mutual Fund charges expenses on you, a part of it goes as taxes. So if the costs are low, the taxes are kept low. That is where Index Funds and ETFs come in. 
  3. Learn and understand the tax implications of your transactions. That will significantly alter the returns on your investments. 
Chapter 12 talks about diversifying your portfolio to lower the portfolio risk. While diversification will lower your risk, the authors also mention that diversification could increase your return. Details of how diversification could increase your return is not further considered in this Chapter. Diversification means buying different asset classes. The key is that for effective diversification, the return on these asset classes should have low or negative correlation. If the returns of two asset classes move totally against each other, when return on one is positive the return on other is equally negative, the returns on these asset classes are negatively correlated. (Time Spend on playing Computer games and Marks obtained in exam perfectly negatively correlated, for example. Let me sneak that one in least my son happens to read this review).

Another simple measure to evaluate the Correlation between two Investment classes is R-squared. Higher the R-squared between two investment classes, lower the Diversification effect of owing those investments.

Chapter 13 discusses whether one should chase performance or if one should time the market. Author's advise? Don't. Through convincing examples, authors point out the futility of both performance chasing and market timing. When it comes to market, or mutual funds for that matter, past performance is never an indicator of future performance. One cannot forecast even the direction of the market, let alone the future value of the market.

Authors advise the investors to cut out the external noise (Financial Channels, Pink Papers etc) and follow a well planned and consistent strategy through market ups and downs. No doubts for guessing that this strategy should consist of a liberal dose of Index Mutual Funds. Also bond funds and International Markets.

Chapter 14 discusses Savvy ways to invest for college while Chapter 15 talks about how to handle a windfall. Authors suggest the following four step process in case you are a recipient of a windfall.
  1. Deposit the money in a safe account for six months and leave it alone
  2. Create a realistic estimate of what the windfall can buy
  3. Make a wish list
  4. Get professional help.
My suggestion if you receive a windfall? Pay off your high cost debt including credit card debt.

You will notice that I did not speak anything about Chapter 14. That is because the chapter focuses on US. Being from India I did not understand most of it. But if you are a parent in US with kids to be sent to college in the near future, I recommend you to read this chapter. 

Chapter 16 recommends that as an investor, one should take the services of a Financial Advisor. It is very easy to become a Financial Advisor. What an investor should be looking for is a CFA (Chartered Financial Analyst) or a CFP (Certified Financial Planner). Find an advisor whose interests are aligned with yours. Authors strongly advice us to avoid financial advisors who are also Sales agents of financial products. 

And pay them.

Chapter 16 ends the Part 1 of this book

Chapter 17 starts the Part 2 of the book ('Follow through strategies to keep you on target') by discussing about Portfolio Rebalancing. They advice that at the beginning of your investments you should have a clear asset allocation plan. On a regular interval, you must review the performance of the portfolio and rebalance where required. The authors caution against the tendency to let the winners run pointing out that market has a tendency to 'Revert to mean (RTM)'. The significance of RTM is that over a period of time both winners and losers will revert to mean. This means that a misaligned portfolio when returns to mean will wipe out all the accumulated profits. 

In a counter-intuitive way, portfolio rebalancing can increase your portfolio returns by helping you to use MTM to your advantage. For instance, in the medium term, the chances are that today's winners will lose and today's losers will gain as they revert to the mean. Portfolio rebalancing will help us to keep our profit and invest it in potential gainers of tomorrow. 

There is a lot of noise out there in the form of Visual media, written media, advertisements trying to sway the investor in one direction or other. The noise out there that impacts an investor is the focus of Chapter 18. A savvy investor should learn to ignore and tune out the constant stream of information normally pointing out the next path-breaking opportunity. She should use the three guiding principles of Sticking to index funds, investing regularly and sticking to the investment strategy to win the investment game in the long-term.

Where are the emotions? I was wondering as I read all these chapters. Never have I espied an investment book that do not point out the behavioral impact on investment and returns. Greed and Fear have to be a staple component of the investment book. Without them the book is incomplete.

That is why was elated (relieved) when I read the title of Chapter 19. 'Mastering your investments means mastering your emotions', proclaimed the title. This is a very good chapter. My friends Greed and Fear were there of course. Also were other behavioral traps like Recency Bias (Giving more importance to recent events and ignoring earlier events), Overconfidence (I am unique, just like everyone else), Loss aversion (sticking with a loss making investment), Analysis paralysis (being paralyzed by information and noise and failing to take action), Endowment effect (one is more confident on things which are more familiar, like an employee investing his savings in the shares of the company that he works for), Mental accounting (giving different mental value to money based on the source. Money that you earned is worth more than the money that you received as a refund from IRS), Anchoring (not selling a losing investment till it touches your target price) and finally the worst of them all, Procrastination.

How do you overcome emotions? By following the three step mantra mentioned earlier. Invest in Index funds, Invest regularly and rebalance your portfolio on a regular basis.

How do you ensure that your investments lasts the entire duration of your retirement and then some? That is the focus of Chapter 20. Retired people face the spending dilemma of Overspending or Underspending. Best way to handle this dilemma is by taking the following steps. One, keep your fixed expenses as low as possible. Ensure that there are no loans remaining to be repaid and keep credit card debts as low as possible. Two, identify a viable way to earn some income. Internet has made it possible for one to sit at home and sell their knowledge and services. See if that is feasible for you. Three is to delay retirement as late as possible. Every year you delay the retirement is another year of income. Four, invest into an annuity (though this is a very bad way of ensuring income during retirement).

In my opinion, the most important investment planning as you approach retirement years is to transfer the equity portion of your investments into lower risk debt options. Coupon payments will ensure you regular income while your capital remains protected from the vagaries of stock market. Another option, a bit more riskier will be to purchase a dividend option of a conservative mutual fund. While not immune from Stock Market flucuations, some of these funds have a history of declaring regular dividends.

Chapter 21 touches another key subject, vis. Insurance. It is important to ensure that one has the following insurance.
  1. Life Insurance
  2. Medical / Health Insurance
  3. Disability Insurance
  4. Property Insurance against fire and flood
  5. Liability Insurance against expensive law suits
  6. Long-term care for older family members to prevent nest-egg erosion.
Three key insurance mistakes that people make are.
  1. Insuring the unimportant while ignoring the critical. Purchasing extended warranty on your car, TV etc without a liability cover to handle expensive law suits.
  2. Insuring based on the odds of misfortune. Not buying a flood insurance because you are living in a dry area.
  3. Insuring against specific, narrow circumstances.Buying a travel insurance prior to an air travel for example. 
There is one key aspect of buying a life insurance that this book covers and which I can't stress enough. It is the importance of Term Insurance. In Term Insurance, you are buying Insurance and nothing else. No endowment, no regular returns...Nada, Zilch. Just plain and pure Insurance cover. This works out to be the cheapest option for almost anybody at any age. The agent commissions on Term Insurance are measly and hence don't expect your agent to sell this to you.

(There are insurance companies offering term plans which you can buy on the internet. You should check it out.)

Chapter 22, the penultimate chapter in the book, talks about Estate Planning. The key points are about the documents required to be planned (A living will, a Living Trust, Powers of Attorney, Advance Healthcare Directive, Letter of Instruction etc). Other considerations include Gifting and the most important of them all, Taxes (How to reduce)

Chapter 23 winds off the book by telling you about the various ways in which Bogleheads' can help you as an investor. You can check out the details at

This completes my review of the book.

My thoughts after reading this book were as follows.

Through 23 chapters, the book covers the end to end information that an investor will need to start and maintain their investments. Part 1 covers the technical, data part of Investment and Part 2 covers the advisory aspect of Investments. As I mention below, this book adds value not only to novices, but also to Investors with a bit of knowledge like yours truly

Investment success calls for self discipline. Be it in shutting out the noise, investing regularly and consistently through market ups and downs, re-balancing your portfolio by selling off your winners and buying current losers....all these calls for dogged determination and exceptional self discipline. Even a regular portfolio review without blaming yourself for the losers and being detached about the winners takes tremendous amount of will power. Finally, you require self discipline to start a learning program and continue with it.

Even you need a lot of self-discipline to read this blog post !.

Importance of knowing Math cannot be overstated when it comes to investments. Investment is about analyzing numbers to find the underlying story or theme. The better you are at using Math, the better the insights the numbers provide and hence the better you will become as an investor. The area of finance and investing is based on a solid foundation of mathematical research. If you think you can't pick up math, find an adviser who can. It is worth it.

While I am knowledgeable when it comes to Finance and Investments, I learned a few new things after reading this book. One is the importance of investing in Index Funds. While I had previously invested regularly in Index funds, I found that my investments were going nowhere and I also found that managed funds were giving me better returns and hence I stuck with manged funds. After reading this book, I think I will take a re-look at Index Funds and ETFs.

I also realized the importance of considering taxes before making any investment decisions. Taxes, like inflation, is omnipresent and can significantly lower the return on your investment in the long-term. Most of us intuitively understand it and that is why tax-free bonds are so popular. But the point is this. There are tax-free options and then there are tax deferred options. We should also look into tax deferred options more closely. There may be bargains available there.

Another learning was about investing in Bond Index Funds and Inflation Indexed Bonds. I am not sure if any bond index fund exist in India and what are the taxation implications. I will need to check it out. In addition, IIBs have just been launched in India and they are yet to pick up. I will need to take a look.

I also learned about investing in ETFs. By the look of it, ETFs seem to be a better way to invest in mutual funds than the traditional MFs. Costs are apparently low, but I am not clear of the taxation implications.

Another point is that there is a need for such a book in the Indian Context. It may be there, I don't know, I have to check. I have included two books related to Indian Markets in my list of books to review. Hopefully I will be able to find more.

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