Saving is Easy

It never ceases to amaze me how difficult some people find it to save money when such an activity should be a fact of life. I believe many people assume that the only people who are able to achieve financial independence, and ultimately, a comfortable retirement, are those that are already wealthy or who have extremely high paying jobs. Nothing could be further from the truth!

Saving and investing money is inherently easy on any income and here's why: If you really want to save your money, you will. This boils down to psychology because some people simply do not want to save, even though they should to ensure a comfortable future.

How can this be accomplished? Try cutting out unnecessary discretionary purchases and using that money instead to fund a retirement account that owns a basket of index funds. At this point, many readers might question this strategy since we most often derive much of our satisfaction from these purchases, but it doesn't have to be difficult. Instead, rotate every week, month, or whatever time interval you've chosen to changing which discretionary purchase you swap out for savings funds. If you go out to eat 5 times in an average month, try going out 2 or 3 times instead. For a family of four, you'll likely save well over $100 a month using this strategy. If your family likes to go out to eat, why not go out to eat 5 times again the next month but drink coffee at home each day instead of going to Starbucks? Scaling back these are the activities are one key way in which you will save a lot of money in the long run.

Of course, all of this goes without saying that you should follow the adage of "paying yourself first" and simply save a set percentage of your paycheck, say 10-20%, if possible and devote that to an investment account. You will be amazed at how much you can earn in 30+ years just by investing $100 a paycheck. This is the magic of compounding at work but it's only possible through disciplined saving. Saving money is inherently easy, it's just that many people don't find it fun because the rewards we realize from it do not satisfy us instantaneously.

Opening the Door to New Investors

I was excited to hear news out of Vanguard yesterday that they've lowered their minimum initial investments for their Target Retirement funds to $1,000 from $3,000. This is encouraging news as many young investors find it difficult to invest large amounts of cash at one time. This reduction in initial investment will open up some of Vanguard's most interesting offerings to new investors. 

At their core, target retirement funds set a specified retirement year - 2040 for example - and invest the fund's assets for an investor planning to retire in or around that year. Right now, the 2040 fund has 89.96% of assets invested in stocks, 9.98% in bonds and 0.06% in short-term reserves.

Ultimately, as 2040 approaches, the fund's managers will decrease the amount of equities in the portfolio in order to lower the fund's risk profile. Even better, the Target Retirement funds are funds of funds which own index funds and not individual stocks. This news is a welcome development for investors for another reason: as Vanguard attracts more assets, they benefit from economies of scale and will continue to lower fund expense ratios which benefits all investors.

The Anniversary of the Retail Index Fund

In 1976, Vanguard pioneered the index fund by offering it to retail investors for the first time. The company has not looked back and is now the leading manager of index funds and consistently one of the top 3 investment managers in the world by assets with $1.6 trillion under management as of February 2011. I'd like to take time in this post to reflect on what the availabilty of the index fund has meant to individual investors by posting an interview with two of Vanguard's experts - Sandip Bhagat, head of Vanguard Quantitative Equity Group, and Kenneth Volpert who oversees Vanguard's bond funds.

The whole interview is well worth reading but the best part about the interview is that both experts point out that the rise of new "fundamental" or "intelligent" indexes is not truly passively managed investing. In short, this is just another way for Wall Street to sell us an actively managed product that is likely to fail in its attempt to outperform the true passively managed index fund. As Mr. Bhagat notes, "The point is that any portfolio configuration that goes beyond the size of a company's market-determined value does not represent a passive approach to investing. It brings with it a belief that the market's prices are incorrect, and that some other factors merit more attention. "

This is key because many retail investors assume that a fundamental index offers a better way to capture the "true" value of a basket of stocks. Therein lies the problem - the true value of a company is really what the stock market dictates it is based on its current trading price. Yes, the future value of a company may be drastically different, but we cannot predict or know the future with certainty. The information that is used to create fundamental indexes is often based on earnings reports or other information that happened in the recent past. By attempting to place a fundamental value on stocks, the fundamental "index" winds up becoming nothing more than an actively managed impostor as stocks are changed based on earnings and other data.

Wouldn't it make more sense to simply take the reflection of the collective knowledge of every investor in the world - the price of a stock in the here and now - and build a true index around that? That's precisely what Vanguard did in 1976 and why they have been so successful. Need more proof? Since its inception in 1976, the Vanguard 500 Index (VFINX) has returned 10.79% on average, annually. What has your actively managed fund done for you lately?

A Video Intro to Indexing

Things have been pretty hectic around here so I'm going to offer up a quick video for anyone that wants to see how and why passively managed (indexed) investment strategies outperform actively managed strategies over the long-term. This is a video inspired by the Bogleheads - investors who follow Vanguard founder Jack Bogle's investment philosophy - and is right on the money. While it may seem goofy at first, there are plenty of truisms within that are often overlooked by investors.

Why You Should Turn Off CNBC

Up until yesterday, it had been a long time since I really watched CNBC. The business news network is a ubiquitous presence on trading floors and in the homes of many investors throughout the world. As a younger investor, I was one of those people addicted to the constant flow of information and endless ticker scrolling across the screen. Ultimately, I wised up and turned the channel to something that became more interesting, namely, SportsCenter. The problem with CNBC and other business news networks is that not only do you suffer from information overload, but by being drawn into the constant drone of information, you're more likely to make a rash investment decision as you begin to believe in the madness of crowds and adopt the "herd mentality." You may even think things like, "hey, if everyone is doing it, why am I so late to the party?"

I tried watching yesterday but I felt compelled to turn it off after a half hour. A key afternoon segment focused on gold prices hitting all-time highs and the show highlighted different ways individuals could "profit from rising gold prices". This is precisely the problem with CNBC - where were they when gold prices were at levels much lower than they are now? I fear some investors watching the network may have felt compelled to add a significant gold position to their portfolio at the expense of a more rational thesis (namely, having a plan and sticking to it). Unfortunately, this type of thing happens all the time on business networks. If it's not gold that they're talking about, you can simply insert whatever commodity/market sector/area of the world that's experiencing major out or underperformance and CNBC will have plenty of "experts" on telling you how you can make money off the moves.

This is not to say that I blame CNBC - they're simply catering to an audience who craves business and market news - but therein lies the problem. A financial news network should never dictate what investment decisions you make and the noise that it represents serves as a big distraction when it comes to your overall investment plan. If investors are serious about building wealth, they would realize that you don't build wealth by following what CNBC says. You build wealth by creating an asset allocation plan that works for you and systematically investing in it for the long-term.

Proof That Compounding Works

When thinking about investments, it never ceases to amaze me at how effective compounding investment returns are. As they say, the proof is in the pudding, and by using a simple financial calculator, it's easy to show how beneficial saving and compounding actually is.

One of the things I often hear from young investors - Gen Y in particular - is that they feel that investing for retirement is something that can be put off since it's so far away. I don't like this line of thinking at all because it's self defeating: we save and invest not to retire at an old age, but to have enough of a nest egg built up to retire whenever we want!

Even worse, investors tell me that $100 saved here and there or their small $1,000 savings today won't amount to much so it's not worth investing until they start their careers. This is even worse thinking! Here's proof: If you invest $1,000 in an index fund, assuming a 7% average return and never touch it for 40 years you will wind up with $14,974 due to investment compounding. If the market gets cooking and long-term returns average 10%, you will wind up with $45,259.

Now just imagine what would happen with each additional dollar saved!

Mutual Fund Performance Measures

Much has been made about mutual fund performance figures and how certain pieces of data don't tell the full story when it comes to evaluating a fund. I would advocate not worrying about what a mutual fund's Morningstar Star Rating is because star ratings are assigned based on risk-adjusted past returns which are not indicative of future performance.

Further, it may also be a stretch to compare a fund to a certain benchmark because its mandate and overall investment policy may be drastically different than what the index's is. For example, a bond fund that does not invest in U.S. Treasury securities may be compared to a bond index with a heavy weighting towards Treasury securities. If U.S. Treasuries perform well compared to other global bonds, it may be a stretch to legitimately say the fund "outperformed" the index. On the other hand, a fund investing primarily in small-cap growth stocks may experience style drift and its strategy could begin to include beaten down companies that qualify as small-cap "value" firms.

A recent Wall Street Journal article noted that looking at total returns works best when you understand what a fund's expense ratio is and also when you look at fund returns over longer time periods in order to smooth out the effects of short-term market movements. However, even this approach isn't foolproof as the Journal notes; "even if a fund has outperformed for 10 years, its odds of outperforming over the following three to five years are only about 50-50, research by Vanguard Group suggests."

Overall, investors are best served by focusing on the index rather than on an actively managed fund. If you simply index your money, your index funds will own the entire market rather than cherry-picking certain securities. This strategy is beneficial because not only is it extremely inexpensive, you also won't have to worry about comparing your fund's performance relative to the benchmark because it is the benchmark.