Difference between revisions of "Investing FAQ for the Bogleheads® forum"

From Bogleheads
Jump to navigation Jump to search
m (Text replacement - "{{FAQ}}" to "{{Bogleheads FAQ}}")
Tags: Mobile edit Mobile web edit
 
(164 intermediate revisions by 12 users not shown)
Line 1: Line 1:
==Introduction==
+
'''{{PAGENAME}}''' provides short answers, and links to longer answers, for questions which often come up in the Bogleheads forum, in order to avoid repetitive discussions and to provide a quick reference for common answers.  If you would like to ask one of these questions but have follow-up questions or an unusual situation which may not be covered by the FAQ, feel free to ask it.
  
This is a working page which I would like to develop into the FAQ for the on-line forum.  If possible, I would like to begin each answer with a one-line summary, and an answer of one or two paragraphs so that the FAQ isn't too long.  A few links to longer articles elsewhere are encouraged; for example, if there is a Wiki article, that would be a natural link.
+
If you would like to propose an addition to this FAQ, it should be a question which is asked frequently, and which can be answered reasonably well in one or two paragraphs.  A longer answer is also useful; make it a separate Wiki page and link from the FAQ.
  
==A. Getting started==
+
==Getting started==
 
   
 
   
===A1.  Why is Vanguard special?===
+
===Why is Vanguard special===
 +
{{Main| The Vanguard Group}}
 
Unlike other investment fund companies, Vanguard is owned by, and thus run entirely for the benefit of, its investors.  Partly as a result, Vanguard has very low costs (see [[Vanguard FAQ]]).
 
Unlike other investment fund companies, Vanguard is owned by, and thus run entirely for the benefit of, its investors.  Partly as a result, Vanguard has very low costs (see [[Vanguard FAQ]]).
 
   
 
   
 
From [https://personal.vanguard.com/us/content/Home/WhyVanguard/AboutVanguardWhyInvestContent.jsp Vanguard's Why invest with us] webpage:
 
From [https://personal.vanguard.com/us/content/Home/WhyVanguard/AboutVanguardWhyInvestContent.jsp Vanguard's Why invest with us] webpage:
  
'''''Your interests are the only interests we serve'''''
+
{{quotation|'''''Your interests are the only interests we serve'''''<br>Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. Helping our investors achieve their goals is literally our sole reason for existence. With no other parties to answer to and therefore no conflicting loyalties, we make every decision—like keeping investing costs as low as possible—with only your needs in mind.}}
 +
 +
The [[Mutual Funds and Fees |low costs]] are important because of the power of compounding. Paying 0.2% costs (typical for a Vanguard investor) for 30 years means that you lose 6% of your investment to costs. Paying 1.2% costs (common for many investors) means that you lose 30% to costs.
  
''Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. Helping our investors achieve their goals is literally our sole reason for existence. With no other parties to answer to and therefore no conflicting loyalties, we make every decision—like keeping investing costs as low as possible—with only your needs in mind.''
+
===How can I best get investing advice from the Bogleheads?===
+
 
The low costs are important because of the power of compounding.  Paying 0.2% costs (typical for a Vanguard investor) for 30 years means that you lose 6% of your investment to costs. Paying 1.2% costs (common for many investors) means that you lose 30% to costs.
+
Follow the suggestions in the [http://www.bogleheads.org/forum/viewtopic.php?t=6212 Asking Portfolio Questions] sticky post.
  
===A2.  How can I best get investing advice from the Bogleheads?===
+
===I just received a windfall; what should I do?===
 +
{{Main|Managing a windfall}}
  
Follow the suggestions in the [http://diehards.org/forum/viewtopic.php?t=6212 Asking Portfolio Questions] sticky post.
+
Put the money in a [[Money Markets|money market]] fund or other cash investment (such as an FDIC or NCUA-insured savings account), and don't do anything else substantial with it for several months while you learn about what to do. You may, of course, need to use some of the windfall money to pay any taxes due on the windfall, and you might also want to pay down high-interest debt such as credit cards.
  
===A3I just received a windfall; what should I do?===
+
A windfall, by definition, changes your financial situation substantially.  In addition, it usually comes with an emotional event such as a divorce, death, or buy-out, and that event may also change your financial situationTherefore, it is best to let the money sit in something which cannot lose value, such as a money-market fund, while you take time to learn what you can do with it and deal with your emotions. This protects you against making an inappropriate investment which will be expensive to sell, or making an investment which is too risky and then shows its risk, or spending more of the windfall than you can afford.
  
Put the money in a [http://diehards.org/wiki/index.php/Money_Markets money market] fund, and don't do anything else substantial with it for several months while you learn about what to do. (You will, of course, need to use the windfall money to pay any taxes due on the windfall, and you might also want to pay down high-interest debt such as credit cards.)
+
This will be a good time to seek professional advice, particularly if you have never managed a substantial amount before.  If you move the money to Vanguard (even to a money-market fund), you may qualify for a free or low-cost plan from [[Vanguard Financial Planning Services]]. You may also want to meet with an independent fee-only planner; as with Vanguard, such a planner does not receive a commission from directing you to specific funds.  Again, don't try to make a quick decision.
  
A windfall, by definition, changes your financial situation substantially.  In addition, it usually comes with an emotional event such as a divorce, death, or buy-out, and that event may also change your financial situation.  Therefore, it is best to let the money sit in something which cannot be seriously wrong, such as a money-market fund, while you take time to learn what you can do with it and deal with your emotions.  This protects you against making an inappropriate investment which will be expensive to sell, or making an investment which is too risky and then shows its risk, or spending more of the windfall than you can afford.
+
===Should I invest a lump sum all at once or gradually?===
 +
{{Main|Lump sum vs DCA}}
  
This may be a good time to seek professional advice, particularly if you have never managed a substantial amount before.  If you move the money to Vanguard (even to a money-market fund), you may qualify for a free or low-cost plan from [https://personal.vanguard.com/us/accounttypes/advice/ATSAdviceCompFinPlanContent.jsp Vanguard Financial Planning Services], You may also want to meet with an independent fee-only planner; as with Vanguard, such a planner does not receive a commission from directing you to specific funds.  Again, don't try to make a quick decision.
+
===I have a loan; should I pay it down or invest the money?===
 +
{{See also|Paying down loans versus investing}}
 +
Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a low-risk, long-term bond investment, and you can pay the loan down without any liquidity problems.
  
===A4Should I invest a lump sum all at once or gradually?===
+
Paying down the loan earns you a guaranteed return equal to the after-tax interest rate; it is a long-term return because you won't actually be able to use the benefit until the loan is paid off (when you no longer make payments, or have a smaller final payoff amount). Investing in a risky asset may earn you more, but only by taking more risk, just as investing in stocks rather than bonds may earn you moreIn both cases, you have a risk-return trade-off. Therefore, a bond investment gives a fair comparison.
  
If the lump sum is your first investment or will substantially increase the amount you have invested in stock, you may want to invest it gradually, adding a fixed amount every month over a period of several months.  This is known as dollar-cost averaging.
+
==Common requests for information==
 +
===Why did my fund price suddenly drop in value?===
 +
{{Main|Why did my fund unexpectedly drop in value}}
  
On the average, it doesn't make much difference whether you invest your money all at once or over several months. However, if you are new to investing, you probably aren't sure of your risk tolerance.  By starting with a small amount, you can get used to the market movements before all your money is at risk, and thus you will be more likely to stick with your investment plan. A common strategy for getting to an allocation of 80% stock would be to invest 20% in stock immediately, and then move another 10% into stock every month for six months.
+
If your [[Mutual fund|fund]] suddenly dropped in value, check the fund's website to see if a distribution has been declared. A fund's price reflects the amount invested in the fund. Returning some of that investment back to the investors reduces the amount remaining in the fund - which is reflected by a drop in the share price.
  
If you are already an experienced investor, you know your risk tolerance, and thus have no need for dollar-cost averaging unless you are planning a substantial increase in your stock allocation. In particular, if you are moving money which is already in stock into another stock fund, such as rolling over a 401(k) into an IRA, you should do it all at once .
+
If your fund is paying out a [[dividend]] and/or [[capital gains distribution]], (sometimes quarterly, often annually) the [[Net asset value|net asset value]] (NAV) of the fund will drop by the per share amount of the distributions on the ex-dividend date. The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.
  
===A5.  I have a loan; should I pay it down or invest the money?===
+
===Why did my fund price drop so much more than the market?===
 +
{{See also|Why did my fund unexpectedly drop in value}}
 +
The most common reason investors ask this question is that the fund paid out a distribution of dividends or capital gains; you received in cash, or had reinvested in the fund, an amount equal to the drop, so you did not lose anything as a result of the distribution.  There are also other possible reasons.
  
Usually, you should pay down the loan if the after-tax interest rate on the loan is higher than the after-tax rate you can earn on a low-risk, long-term bond investment, and you can pay the loan down without any liquidity problems.
+
*If you are holding an actively managed fund, the manager's style (size and value/growth) and /or security selection weightings can be quite different from market weighting. Thus the return can vary from that of the market.
 +
*If you are holding an international stock fund, you should be aware that Vanguard employs a practice known as [[Fair value pricing | "fair value pricing"]] to determine a fund's closing [[Net asset value | NAV]]. Foreign bourses close early in relation to the US market, and there are times in which a great deal of market moving information comes to the market during the time lag. One feature of the mutual fund timing scandals of the early 2000's were certain investors who attempted to arbitrage the expected change from the "stale" foreign closing NAV prices of an international mutual fund into its expected closing US NAV. Fair value pricing  is employed in instances where news indicates a substantive change in market value from the closing home market price. The adjusted price is used to more accurately reflect the "true" market price for US investors, thus foiling would-be [[market timing]] arbitrageurs.
 +
*If your fund is paying out a dividend and/or capital gains distribution(sometimes quarterly, often annually), the NAV of the fund will drop by the per share amount of the distributions on the ex-dividend date. The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial  drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.
  
Paying down the loan earns you a guaranteed return equal to the after-tax interest rate; it is a long-term return because you won't actually be able to use the benefit until the loan is paid off (when you no longer make payments, or have a smaller final payoff amount).  Investing in a risky asset may earn you more, but only by taking more risk, just as investing in stocks rather than bonds may earn you more. In both cases, you have a risk-return tradeoff.
+
===The stock market had a significant drop, what should I do?===
 +
{{See also|Behavioral pitfalls}}
 +
First, do not act emotionally. Think things through before making any changes.
  
One way to look at this is to consider the following choices.
+
Second, if you decide to make a radical change, don't do it until next week. Chances are you will change your mind again by then.
  
*1. Invest the money with your preferred allocation.
+
See this {{Forum post|t=79939|title=A time to EVALUATE your jitters}}.
*2. Invest the money in bonds.
 
*3. Pay down the loan and move an equal amount of money from bonds to your preferred allocation.
 
*4. Pay down the loan and leave the investments unchanged.
 
  
The choice between 3 and 4, while difficult, is one you have already made; you decided how much risk you were willing to take, and chose your stock/bond allocation.  And the choice between 1 and 3, or between 2 and 4, is much simpler; if you pay a higher interest rate on the loan than you would by investing in bonds (in Treasury bonds in a 401(k) or IRA if you aren't maxing out contributions, or in high-quality municipal bonds if any additional investment would go in a taxable account), you will come out ahead by paying down the loan.  If you prefer 3 to 1 (higher rate on the loan), then you prefer 4 to 1 also and should pay down the loan.  If you prefer 2 to 4 (higher rate on bonds), then you should invest the money according to whichever of 1 or 2 you prefer.
+
===Does it matter that different share classes have different prices?===
  
If the decision is close, it may be better to keep the loan, because you can refinance your mortgage if interest rates fall,, but the Treasury can't refinance its bonds.
+
No. Share class net asset value (NAV) is entirely arbitrary. If you invest $5,000 and the NAV is $10, you'll get 500 shares. If the NAV is $20, you'll get 250 shares. Either way, you bought five thousand dollars' worth.
  
==B.  Common requests for information==
+
===How do I use specific identification of shares when selling?===
===B1Why did my fund price drop so much more than the market?===
+
{{See also|Specific identification of shares}}
 +
If you sell a Vanguard mutual fund, then send Vanguard a secure Email with a text such as, "I am about to place an order to sell 234.456 shares of the XYZ Fund.  Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email." You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you.  (You still need to follow this procedure for selling shares purchased before 2012; for shares purchased in 2012 or later, Vanguard keeps track of shares for you.)
  
The most common reason investors ask this question is that the fund paid out a distribution of dividends or capital gains; you received in cash, or had reinvested in the fund, an amount equal to the drop, so you did not lose anything as a result of the distribution.  There are also other possible reasons.
+
If you have "non-covered" shares of stocks or ETFs in your Vanguard brokerage account (purchased before 2011 for stocks, before 2012 for ETFs), you can enter the lot information yourself and then use specific identification when you sell online.
  
*If you are holding an actively managed fund, the manager's style (size and value/growth) and /or security selection weightings can be quite different from market weighting. Thus the return can vary from that of the market.
+
==Asset allocation==
*If you are holding an international stock fund, you should be aware that Vanguard employs a practice known as "fair value pricing" to determine a fund's closing NAV. Foreign bourses close early in relation to the US market, and there are times in which a great deal of market moving information comes to the market during the time lag. One feature of the mutual fund timing scandals of the early 2000's were certain investors who attempted to arbitrage the expected change from the "stale" foreign closing NAV prices of an international mutual fund into its expected closing US NAV. Fair value pricing  is employed in instances where news indicates a substantive change in market value from the closing home market price. The adjusted price is used to more accurately reflect the "true" market price for US investors, thus foiling would-be market timing arbitrageurs.
+
{{Main|Asset allocation}}
*If your fund is paying out a dividend and/or capital gains distribution, the NAV of the fund will drop by the per share amount of the distributions on the payment date (sometimes quarterly, often annually). The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial  drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.
+
===Asset allocation is a complicated process; which parts are most important?===
  
===B2. Does it matter that different share classes have different prices?===
+
The most important decision to make in your asset allocation is the percentage you hold in stock. This is the primary factor in determining the risk of your portfolio; in a severe bear market as in 1973-1974 or 2007-2009, your loss would probably be about half the percentage you have in stock.
  
No. Share class net asset value (NAV) is entirely arbitrary. If you invest $5,000 and the NAV is $10, you'll get 500 shares. If the NAV is $20, you'll get 250 shares. Either way, you bought five thousand dollars' worth.
+
Therefore, you want to get the correct stock allocation before worrying about finer details, and you should be willing to pay some extra cost to get the correct allocation. For example, it is worth paying an extra tax cost if you must hold bonds in your taxable account, or using a higher expense bond fund in your 401(k).
  
 +
===Most of my investments are taxable; how should this affect my allocation?===
  
===B3. How do I use specific identification of shares when selling?===
+
You should still try to get the correct bond allocation, even if you must hold bonds in a taxable account, because this controls the risk of your portfolio. Compare after-tax yields to see whether municipal bonds or taxable bonds make sense.
  
Send Vanguard a secure Email with a text such as, "I am about to place an order to sell 234.456 shares of the XYZ Fund. Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email."  You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you.
+
For other parts of your allocation, you should try to find tax-efficient alternatives. If you don't have room in your tax-deferred accounts, you should probably avoid active funds and [[Real estate investment trust|REIT]]s, and possibly avoid value stocks. Index ETFs, [[index fund]]s with ETF classes, and [[Tax-managed fund comparison|tax-managed]] stock funds, are usually tax-efficient. Even in an index fund, value stocks have an extra tax cost because of their higher dividend yield; you have to decide whether the extra tax cost is worthwhile. (REITs, even with the index fund, should still be avoided in taxable because they have a high yield in non-qualified dividends.)
  
See [[Specific Identification of Shares]] for more details, including an illustration of the potential tax savings.
+
==Taxable accounts==
 +
===Should an active stock fund be held in a taxable account?===
  
==CAsset allocation==
+
NoAn actively managed fund tends to distribute capital gains, for which you have to pay tax if the fund is held in a taxable account. The extra tax cost of most active funds is over 1%, and you want to avoid a fund with an extra 1% tax cost for the same reason you want to avoid a fund with an extra 1% in expenses. In addition, even if the fund has a low tax cost now, it might change managers and the new manager could sell most of the old manager's picks for a gain, or you could decide that you no longer like the new manager and have to sell the fund yourself for a gain.
===C1. Asset allocation is a complicated process; which parts are most important?===
 
  
The most important decision to make in your asset allocation is the percentage you hold in stock. This is the primary factor in determining the risk of your portfolio; in a severe bear market as in 1973-1974, your loss would probably be about half the percentage you have in stock.
+
If you already have an active fund with very low turnover (around 10% or less) and low costs, and you would have a large capital gain if you sell it, then it may be worth keeping the fund rather than paying the tax cost to sell it.  
  
Therefore, you want to get the correct stock allocation before worrying about finer details, and you should be willing to pay some extra cost to get the correct allocationFor example, it is worth paying an extra tax cost if you must hold bonds in your taxable account, or using a higher expense bond fund in your 401(k).
+
===Should a balanced fund be held in a taxable account?===
+
{{Main|Balanced fund}}
===C2. Most of my investments are taxable; how should this affect my allocation?===
+
NoIn a taxable account, it is better to hold bonds and stocks separately, even if you cannot move the bonds into a tax-deferred account.
  
You should still try to get the correct bond allocation, even if you must hold bonds in a taxable account, because this controls the risk of your portfolio.  Compare after-tax yields to see whether municipal bonds or taxable bonds make sense.
+
If you have a balanced fund, you can only sell bonds and stocks simultaneously. If you want to sell only bonds, in order to hold fewer bonds or a different type of bonds, you will have to sell the stock as well and pay a capital-gains tax.
  
For other parts of your allocation, you should try to find tax-efficient alternatives.  If you don't have room in your tax-deferred accounts, you should probably avoid active funds and REITs, and possibly avoid value stocks.  Small-cap stocks can be held tax-efficiently either as part of a [[Vanguard Total Stock Market Index Fund]] or separately in [https://personal.vanguard.com/us/FundsSnapshot?FundId=0116&FundIntExt=INT Tax-Managed Small-Cap] if you want to hold more. Even in an index fund, value stocks have an extra tax cost because of their higher dividend yield; you have to decide whether the extra tax cost is worthwhile.
+
===I have the wrong fund in my taxable account, but it will cost me to switch; should I do it?===
 +
{{See also|Paying a tax cost to switch funds}}
 +
Usually, it is worth switching even if you pay a capital-gains tax to switch; if you have significant short-term gains, wait for them to become either losses or long-term gains for the tax savings. Meanwhile, consider turning off reinvestment of dividends and capital gains to avoid buying even more shares of the wrong fund.
  
==D. Taxable accounts==
+
If the annual difference in taxes and costs is more than 10% of the tax you would pay, you should almost always switch. If the difference is less, multiply the amount saved per year by the number of years you expect to hold the fund, and if that is equal to, or even close to, the tax cost, then you should come out ahead by switchingHere is a [http://remarque.org/~grabiner/switchtaxable.html spreadsheet] which you can use to make the comparison.
===D1Should an active fund be held in a taxable account?===
 
  
No.  An actively managed fund tends to distribute capital gains, for which you have to pay tax if the fund is held in a taxable account.  The extra tax cost of most active funds is over 1%, and you want to avoid a fund with an extra 1% tax cost for the same reason you want to avoid a fund with an extra 1% in expenses.  In addition, even if the fund has a low tax cost now, it might change managers and the new manager could sell most of the old manager's picks for a gain, or you could decide that you no longer like the new manager and have to sell the fund yourself for a gain.
+
===Should I reinvest dividends in my taxable account?===
 +
{{See also|Reinvesting dividends in a taxable account}}
 +
Directing the dividends to a money-market fund, rather than reinvesting them, can give you readily-available cash to use for rebalancing. If you reinvest the dividends in a fund which is over its target weight at the time, you may later need to sell shares to rebalance, thereby creating a taxable event. Automatic reinvestment of dividends in any fund will make accounting more complicated (more tax lots and possible [[wash sale|wash sales]]), particularly if you use [[Specific identification of shares]] to minimize taxes.
  
If you already have an active fund with very low turnover (around 10% or less) and low costs, and you would have a large capital gain if you sell it, then it may be worth keeping the fund rather than paying the tax cost to sell it.  
+
You might want to reinvest in a fund which charges a [[purchase fee]] if you are still in the accumulation phase so that you can rebalance with new money; you do not pay the purchase fee on reinvested dividends.
  
===D2.  Should a balanced fund be held in a taxable account?===
+
==Asset location==
 +
===Which funds should I place in my taxable account?===
 +
{{See also|Principles of tax-efficient fund placement}}
 +
As a basic rule, broad based market-weighted equity [[Indexing | index funds]] are tax-efficient, so they are appropriate for a taxable account. Good choices include the Vanguard Total Stock Market Index Fund and the Vanguard Total International Stock Index Fund (or their ETF versions). Similarly, tax-managed stock funds are excellent choices for a taxable account if they fit your allocation.
  
NoIn a taxable account, it is better to hold bonds and stocks separately, even if you cannot move the bonds into a tax-deferred account.
+
While municipal bond funds are exempt from Federal taxes, there is an implicit tax cost to holding them, as their yields are lower than the yields on corporate bonds of comparable riskTherefore, you should try to hold bonds in your tax-deferred account if you can fill your taxable account with tax-efficient stock funds.  If you run out of tax-deferred room, you may need to hold bonds in your taxable account.
  
If you have a balanced fund, you can only sell bonds and stocks simultaneously.  If you want to sell only bonds, in order to hold fewer bonds or a different type of bonds, you will have to sell the stock as well and pay a capital-gains tax.
+
The following chart provides a handy graphic illustration of a tax-efficient asset location hierarchy:
 +
{{Tax efficiency ranking of major asset classes}}
 +
===I have a Roth and a 401(k); what should I place where?===
 +
First select the best (usually lowest-cost) funds in your [[401(k)]] plan, Complete your asset allocation plan by selecting appropriate funds and placing them in your Roth.
  
===D3.  I have the wrong fund in my taxable account, but it will cost me to switch; should I do it?===
+
If all else is equal (for example, both funds are with Vanguard), it is slightly better to have higher-returning funds in the Roth IRA, because it is protected against potential changes in tax rates, has more flexible rules for [[Required Minimum Distribution vs annuitization | required minimum distributions]], and is not counted as income for making Social Security taxable.
  
Usually, it is worth switching even if you pay a capital-gains tax to switch; if you have significant short-term gains, wait for them to become either losses or long-term gains for the tax savings.  Be sure to turn off reinvestment of diviends and capital gains so that the distributions won't incur additional short-term caiptal gains.
+
===I have a bad 401(k); should I invest in it or in a taxable account?===
 +
{{main|401(k)#Expensive_or_mediocre_choices|l1=401(k) - Expensive or mediocre choices}}
 +
See linked article for guidance on how to make the most of a 401(k) plan with high-expense and/or mediocre fund choices, including a formula on when you might be better off investing in a taxable account over a 401(k) plan without an employer match, as well as suggestions on how to improve your company's plan.
  
If the annual difference in taxes and costs is more than 10% of the tax you would pay, you should almost always switch.  If the difference is less, multiply the amount saved per year by the number of years you expect to hold the fund, and if that is equal to, or even close to, the tax cost, then you should come out ahead by switching.
+
===Should I invest in a Roth or traditional IRA or 401(k)?===
 +
{{main|Traditional versus Roth}}
 +
Your first choice is to always contribute to your 401(k) up to the company match.  Whether you should invest in a [[Roth]] or [[Traditional IRA]], or Roth or traditional 401(k), primarily depends on whether you expect to be in a higher or equal income tax bracket at retirement (pick the Roth) or a lower income tax bracket at retirement (pick the Traditional IRA if you are eligible for a deduction). After maximizing your IRAs, and if your 401(k) plan is satisfactory, contribute the maximum 401(k) deferral amount ($19,500 in 2021<ref>[https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2021 IRS announcement of 2021 pension limits], from the IRS</ref>) into the 401(k).
  
The reason that you should come out ahead even if the savings don't quite cover the tax cost is that keeping the old fund doesn't avoid the capital-gains tax; it only postpones the tax.  If you sell a fund for a $10,000 gain and pay $1,500 in tax, your basis in the new fund will be $8,500 higher, so you will pay less tax when you sell the new fund than if you had kept the old fund even if the final values are close.
+
If you can max out your 401(k) or IRA, and expect to be in about the same tax bracket at retirement, the Roth is better because it allows you to effectively tax-defer more moneyFor example, if you are in a 25% tax bracket, you can invest $6,000 in a Roth IRA, or $6,000 in a traditional IRA (of which the IRS owns 25%, so it is only worth $4,500 to you) and have $1,500 in tax savings which you must invest in a taxable account.
  
If you do decide to keep the old fund, turn off reinvestment of dividends and capital gains from the fund and take them in cash. This way, you can prevent your undesirable fund from growing too fast.
+
==Choosing specific funds==
 +
This section discusses only the comparisons between similar funds. It is not intended to give asset allocation recommendations, which are strongly dependent on your individual situation and too complex to give a general answer.  
 
   
 
   
===D4.  Should I reinvest dividends in my taxable account?===
+
===Which international index fund should I use?===
 +
Vanguard's main choices for broad international equity exposure are the Vanguard Total International Stock Index Fund and the Vanguard FTSE All-World ex-US Index Fund. The primary difference is that Total International includes small-cap stocks as well, so it is a more complete index; if you use the FTSE fund and also want to add small-caps, you will need to add the Vanguard FTSE All-World Ex-US Small-Cap Index Fund. Both funds cover almost all of the world except for the US, both have ETF classes, and both are suitable for a taxable account because they are eligible for the [[foreign tax credit]].
 +
 
 +
Detailed comparisons are available in [[FAQ on Vanguard international funds]].
  
If you are planning to use [[Specific Identification of Shares]], it may be a good idea to take dividends in cash to avoid creating a lot of small tax lots.  You can invest dividends along with new money.  Also, if you are planning to do [[Tax Loss Harvesting]], automatic reinvestments of dividends may accidentally trigger a wash sale.  For this reason, you may not want to automatically reinvest dividends.
+
===How do I create a total stock market fund?===
 +
If Vanguard's Total Stock Market Index Fund (US stocks) is not available, one can approximate the fund by allocating percentages of small-, mid- and large-cap funds as described in [[Approximating total stock market]].
  
If you are planning to use average cost basis, and you might want to sell some of the fund soon (to rebalance, for example), you will pay extra taxes to sell the shares you just bought. If you know that you will continue to add to the fund, it doesn't matter whether you reinvest.
+
International (non-US) stocks are broken down differently. See [[Approximating total international stock market]] for more information.
  
==E.  Asset location==
+
===How do I compare bond funds?===
===E1.  Which funds should I place in my taxable account?===
 
As a basic rule, broad based market-weighted equity index funds are tax-efficient, so they are appropriate for a taxable account. Good choices include the [[Vanguard Total Stock Market Index Fund]] and the [[Vanguard FTSE All World ex US Index Fund]] (or their ETF versions).  Similarly, tax-managed stock funds are excellent choices for a taxable account if they fit your allocation.
 
  
While municipal bond funds are exempt from Federal taxes, there is an implicit tax cost to holding them, as their yields are lower than the yields on corporate bonds of comparable risk.  Therefore, you should try to hold bonds in your tax-deferred account if you can fill your taxable account with tax-efficient stock funds. If you run out of tax-deferred room, you may need to hold bonds in your taxable account.
+
Once an investor has decided on the duration and credit quality of their low-cost [[Bond Basics|bond]] fund options,<ref>See [[John Bogle]],(April 17, 2007) [http://johncbogle.com/wordpress/wp-content/uploads/2007/05/FIASI_4-07.pdf Stewardship vs. Salesmanship - Bond Funds Gone Awry], FIASI Hall of Fame Speaker Series
 +
Fixed Income Analysts Society, New York, NY</ref> a decision must be made about tax expense. For taxable account bond holdings the after-tax return of the fund portfolio can be a determining factor in fund selection. In general bonds face the following taxes:
 +
* [[Corporate bonds]] are subject to federal and state tax;
 +
* [[Treasury bonds]] are subject to federal tax but are exempt from state tax;
 +
* [[Municipal bonds]] are generally exempt from federal tax, but are subject to state tax (unless the bond is issued in one's state of residence, in which case it is generally tax-free income). Some types of municipal bonds are subject to the alternative minimum tax.
 +
 
 +
The [http://files.thefinancebuff.com/calculators/Bond-Funds-Yield-Calculator.html Bond Fund Yield Calculator] courtesy of The Finance Buff can be used to compare the after tax yields of a bond fund.
  
The following graphic provides more detail concerning tax efficiency.
+
Income Tax Rates are available from the following sources:
  
insert graphic
+
*[http://www.taxfoundation.org/taxdata/show/151.html Federal Tax Rates]
 +
*[http://www.taxfoundation.org/taxdata/show/228.html State Tax Rates]
  
===E2.  I have a Roth and a 401(k); what should I place where?===
+
The fund provider can give you the percentage of a tax-exempt money-market or bond fund's assets held in securities subject to the alternative minimum tax, and the percentage of a taxable money-market or bond fund's assets which are held in Treasury bonds exempt from state tax; note that some states have a minimum percentage of Treasuries for deductibility. Information from Vanguard can be obtained at the Vanguard web site:
First select the best (usually lowest-cost) funds in your 401(k) plan, Complete your asset allocation plan by selecting appropriate funds and placing them in your Roth.
 
  
If all else is equal (for example, both funds are with Vanguard) it is slightly better to have higher-returning funds in the Roth IRA, because it is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
+
[https://personal.vanguard.com/us/funds/vanguard/bytype#4 Vanguard Bond Fund Link]
 
===E3.  I have a bad 401(k); should I invest in it or in a taxable account?===
 
  
Even in a bad 401(k), you should contribute up to the company match. Choose the lowest-cost funds; many bad 401(k)'s have a few lower-cost funds.  If you are eligible, additional contributions should usually go into a Roth or Tradtional IRA. But unless your 401(k) is very bad and you expect to stay a very long time with the same employer, investing unmatched money in the 401(k) is likely to be better than taxable investing, because you can roll over your 401(k) to a low-cost IRA when you leave.
+
===Should I use bonds or bond funds?===
 +
{{See also|Individual bonds vs a bond fund}}
 +
For most investors, buying a bond fund is better than buying individual bonds unless you are buying Treasury bonds and you have a need to control your own allocation to bonds of different maturities. You do pay a small management fee to hold a bond fund; for most of Vanguard's bond funds, the expense is about 0.2% for Investor shares and 0.1% for Admiral shares. In return, you get diversification and more liquidity.
  
A reasonable rule of thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds 30%.  That is, if you pay 1.7% expenses rather than 0.20%, you should still invest in the plan unless you are reasonably certain that you will stay with the employer for more than 20 yearsThe reason is that a long-term investment, even in a tax-efficient stock fund, is likely to lose 30% or more of its value to taxes on the dividends and capital-gains tax when you sell.
+
===Should I use Total Stock Market or tax-managed funds for US stocks?===
+
{{See also|Tax-managed fund comparison}}
===E4.  Should I invest in a Roth or traditional IRA or 401(k)?===
+
Vanguard Total Stock Market Index Fund, being very tax-efficient, is the natural choice for broad US equity exposure, and the US stock index funds with ETFs are also tax-efficientTax-Managed Capital Appreciation and Tax-Managed Small-Cap may save a bit in taxes over non-tax-managed large-to-mid-cap and small-cap funds if you must hold such funds separately. There is relatively little benefit to holding a combination of Vanguard Tax-Managed Small-Cap Fund and Vanguard Tax-Managed Capital Appreciation to approximate the total stock market; any tax savings will likely be canceled by the lower expenses of Total Stock Market.
  
Your first choice is to always contribute to your 401(k) up to the company match.  Whether you should invest in a Roth or Traditional IRA, or Roth or traditional 401(k), primarily depends on whether you expect to be in a higher or equal income tax bracket at retirement (pick the Roth) or a lower income tax bracket at retirement (pick the Traditional IRA). After maximizing your IRA's, and if your 401K plan is satisfactory, contribute the maximum 401(k) deferral amount ($15,500 in 2008) into the 401(k).   
+
===Should I use target retirement funds?===
 +
The [[Vanguard Target Retirement Funds]] are excellent choices if your portfolio is entirely tax-deferred and entirely in target retirement funds; in particular, they are an ideal way to get started investing for retirement because they cover many types of investments with a single fund.  You can also use non-Vanguard target retirement funds in the same way; if your 401(k) is not with Vanguard but has a target retirement fund which holds reasonable funds and does not add any extra costs, you can use it in your 401(k) and a Vanguard fund in your IRA.   
  
If you can max out your 401(k) or IRA, and expect to be in about the same tax bracket at retirement, the Roth is better because it allows you to effectively tax-defer more money.  For example, if you are in a 25% tax bracket, you can invest $5,000 in a Roth IRA, or $5,000 in a traditional IRA (of which the IRS owns 25%, so it is only worth $3750 to you) and have $1250 in tax savings which you must invest in a taxable account.  
+
You should not use target retirement funds if they are not all, or almost all, of your portfolio.  The target retirement funds are designed to adjust your portfolio automatically to a reasonable allocation given your time to retirement. If you have other funds, your whole portfolio will not keep the correct allocation unless you adjust your non-target-retirement portfolio on your own, and once you have done that, you no longer gain anything from the simplicity of the target retirement funds.
  
 +
If you have both tax-deferred and taxable accounts, there is a tax cost for using target retirement funds, or any balanced funds. You want to hold tax-efficient assets such as stock index funds in your taxable account, and tax-inefficient assets such as bonds in your tax-deferred account; using a target retirement fund in both accounts will lead to a higher tax bill than necessary. 
  
==F.  Choosing specific funds==
+
If you have only a taxable account and will always be in a reasonably low tax bracket (so that corporate bonds are not too costly for your bond holdings), the simplicity of the target retirement funds may be worth the slight additional tax cost.
This section discusses only the comparisons between similar funds.  It is not intended to give asset allocation recommendations, which are strongly dependent on your individual situation and too complex to give a general answer.
 
 
===F1.  Which international index should I use?===
 
Vanguard's main choices for broad international equity exposure are the [https://personal.vanguard.com/us/FundsSnapshot?FundId=0113&FundIntExt=INT Total International Stock Index Fund] and the [[Vanguard FTSE All World ex US Index Fund]] (or [https://personal.vanguard.com/us/FundsSnapshot?FundId=0991&FundIntExt=INT ETF]).  In a taxable account, the FTSE fund is preferable because it is eligible for the foreign tax credit; in a tax-deferred account, Total International is less expensive.  If you are willing to manage two separate funds, and don't expect to sell anything within five years, a combination of [https://personal.vanguard.com/us/FundsSnapshot?FundId=0127&FundIntExt=INT Tax-Managed International] (or its [https://personal.vanguard.com/us/funds/snapshot?FundId=0936&FundIntExt=INT ETF class]) and [https://personal.vanguard.com/us/FundsSnapshot?FundId=0533&FundIntExt=INT Emerging Markets Index] may be even better in a taxable account.
 
  
Detailed comparisons are available in [[FAQ on Vanguard International Funds]].
+
==Exchange-Traded Funds (ETFs)==
 +
===What is an ETF?===
 +
An [[ETF]] is a fund which is not bought or sold from the mutual fund company, but bought or sold from another shareholder on the stock exchange. The ETF provider also allows investors to convert a specified large block of shares of the ETF into shares of the securities the ETF holds, or vice versa. Therefore, the price of an ETF tends to stay close to the price of the underlying securities; if an institution can convert 100,000 shares of an ETF into $5,000,000 worth of stock, then it will want to buy the ETF if the price drops significantly below $50 so that it can profit from the conversion.
  
===F2Should the redemption fee discourage me from using tax-managed funds?===
+
Vanguard's ETFs are a share class of the index funds (See [[Vanguard ETF/fund ratios]] for details)Therefore whether you buy the index fund directly from Vanguard or the corresponding ETF on the stock exchange, you have the same holdings. If you hold the index fund and would prefer to hold the ETF, you can convert the fund shares to ETF shares; this does not require selling or buying shares, and thus you do not pay tax on any gains.
It should not, unless it is likely that you will sell the fund within five years. The fee goes back to the fund, so it has no cost to the average investor in the fund; you gain the direct benefit of fees paid by other participants, and the indirect benefit that the fees reduce the fund's trading costs and taxable gains.
 
  
You might look at the potential fee as an extra expense, which is likely to be much less than the tax advantage of using the tax-managed fund.  If there is a 40% chance that you will pay a 1% fee in the first five years of your investment (for tax-loss harvesting or an unexpected need of the funds), you expect to pay 0.40% of your initial investment, which is 0.08% extra annualized cost over five years, or 0.02% if you expect to hold the fund for 20 years. And that is a cost only on your early investments; once you have held the fund for five years, you are unlikely to pay a fee on any money you add later, because Vanguard charges the fee assuming you sold fee-free shares (from reinvested dividends) first and then other shares on a first-in-first-out basis, even if you use a different accounting method for tax purposes.  
+
===Should I use mutual funds or ETFs?===
+
{{See also|ETFs vs Mutual Funds}}
===F3.  How do I compare bond funds?===
+
Use whichever is more convenient and lower in cost for your own situation. The choice has no effect on your investment philosophy, as mutual funds and ETFs are two different ways of holding the same type of investments.  
  
Once an investor has decided on the duration and credit quality of their low-cost [http://diehards.org/wiki/index.php/Bond_Basics bond] fund options (See [http://johncbogle.com/wordpress/wp-content/uploads/2007/05/FIASI_4-07.pdf John Bogle]}, a decision must be made about tax expense. For taxable account bond holdings the after-tax return of the  fund portfolio can be a determining factor in fund selection. In general bonds face the following taxes:
+
ETFs often have a lower expense ratio than mutual funds, but you must have a brokerage account to hold ETFs, and the brokerage has its own costs, both for the account and the commissions and [[bid-ask spread]]s you pay when trading. Most Vanguard ETFs have the same expense ratio as Admiral shares, so the cost savings goes away if you qualify. ETFs avoid the [[purchase fee|purchase]] and [[redemption fee]]s charged by some funds, and are thus particularly attractive alternatives to mutual funds which charge those fees.
* Corporate bonds are subject to federal and state tax;
 
* Treasury bonds are subject to federal tax but are exempt from state tax;
 
* Municipal bonds are generally exempt from federal tax, but are subject to state tax (unless the bond is issued in one's state of residence, in which case it is generally tax-fee income). Some types of municipal bonds are subject to the alternative minimum tax.
 
  
The Bond Fund Yield Calculator courtesy of The Finance Buff can be used to compare the after tax yields of a bond fund.
+
If you have a 401(k), you will be restricted to the mutual funds available there, and cannot buy ETFs unless your 401(k) has a brokerage option. If you have a non-Vanguard brokerage account, you probably want to hold Vanguard funds as ETFs rather than mutual funds (or else buy the mutual funds directly from Vanguard), as most brokerages charge a larger fee for buying Vanguard mutual funds than the commission for buying ETFs.
  
Income Tax Rates are available from the following sources:
+
===Do ETFs have a tax advantage?===
*Federal Tax Rates
+
Most stock ETFs have a potential tax advantage over similar mutual funds. However, Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF.
*State Tax Rates
 
  
The fund provider can give you the percentage of a tax-exempt bond fund's assets held in securities subject to the alternative minimum tax. Information from Vanguard can be attained at the Vanguard web site:
+
When a mutual fund or ETF sells a stock, it has a taxable capital gain (or loss) equal to the difference between what it received and what it paid. If an institutional investor converts shares of an ETF to stock, the ETF provider can give away the shares of stock with the lowest purchase price; these are the shares which would have the highest gain if sold. Thus ETFs can often reduce the capital gains they must distribute.  The ETF conversion process does not reduce dividends; therefore, taxable bond and REIT ETFs, asset classes with total returns comprised primarily of [[Non-qualified dividends | non-qualified dividend]] income, still have a high tax cost.
  
Vanguard Bond Funds
+
Some ETFs have distributed capital gains in their early years, but few have distributed gains later. For example, only three Vanguard stock ETFs have ever distributed a capital gain, and only one of those three (REIT Index) distributed a gain after its second year. Refer to [[:Category:Balanced funds distributions | Vanguard Funds: Distributions]] for detailed tax data on individual funds.
  
===F4.  Should I use bonds or bond funds?===
+
===How should I place orders to buy and sell ETFs?===
For most investors, buying a bond fund is better unless you are buying Treasury bonds and have a need to control your own allocation to bonds of different maturities.  Vanguard Investment Counseling and Research has a detailed discussion.
+
{{See also|Orders}}
 +
The least risky way to buy or sell an ETF is to place a [[Orders#Limit_Order|limit order]] matching the best available offer. For example, if your broker's data shows that someone is offering to sell shares at $20.02, you can place a limit order to buy at $20.02. You will buy at that price unless the offer to sell was taken or withdrawn before your placed your order to buy; if it was withdrawn, you do not automatically buy at the next-best offer (which could be at a much higher price), as you would if you placed a [[Orders#Market_Order|market order]].
  
If you buy individual bonds, you pay no management costs, and you can control your allocation precisely; a fund has a management fee, and has an allocation set by the manager.  However, you will pay a commission to buy bonds, unless you buy Treasury bonds from [http://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm Treasury Direct], and another commission to sell before maturity.  Bond funds also have trading costs not reflected in their expenses, but the costs are likely to be very low.  And the costs of the funds themselves can also be low; Vanguard's bond funds have expenses of about 0.2% for Investor shares and 0.1% for Admiral shares.
+
==References==
 +
{{Reflist}}
  
But the main advantages of bond funds are diversification and liquidity.  A corporate-bond fund can be diversified; it is much harder for an individual investor to hold a diversified portfolio of corporate bonds.  (Diversification is irrelevant for Treasuries, which have no credit risk.)  You can buy and sell a bond fund in any amount, and reinvest interest payments in the fund; if you hold individual bonds, you can only sell a whole bond, and any interest received cannot be automatically reinvested unless it is enough to buy a new bond.
+
{{Bogleheads FAQ}}
  
===F5.  Should I use Total Stock Market or tax-managed funds for US stocks?===
+
[[Category:FAQ]]
[[Vanguard Total Stock Market Index Fund]], being very tax-efficient, is the natural choice for broad US equity exposure. Tax-managed funds are not usually necessary, unless you are looking specifically for a small-cap fund to place in your taxable account. Most small cap funds can be quite tax-inefficient, but Vanguard Tax-Managed Small-Cap Fund fills the role admirably.  There is relatively little benefit to holding a combination of Vanguard Tax-Managed Small-Cap Fund and Vanguard Tax-Managed Growth and Income Fund to approximate the total stock market.
+
[[Category:Pages requiring annual tax updates]]

Latest revision as of 16:59, 15 February 2021

Investing FAQ for the Bogleheads® forum provides short answers, and links to longer answers, for questions which often come up in the Bogleheads forum, in order to avoid repetitive discussions and to provide a quick reference for common answers. If you would like to ask one of these questions but have follow-up questions or an unusual situation which may not be covered by the FAQ, feel free to ask it.

If you would like to propose an addition to this FAQ, it should be a question which is asked frequently, and which can be answered reasonably well in one or two paragraphs. A longer answer is also useful; make it a separate Wiki page and link from the FAQ.

Getting started

Why is Vanguard special

Unlike other investment fund companies, Vanguard is owned by, and thus run entirely for the benefit of, its investors. Partly as a result, Vanguard has very low costs (see Vanguard FAQ).

From Vanguard's Why invest with us webpage:

Your interests are the only interests we serve
Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. Helping our investors achieve their goals is literally our sole reason for existence. With no other parties to answer to and therefore no conflicting loyalties, we make every decision—like keeping investing costs as low as possible—with only your needs in mind.

The low costs are important because of the power of compounding. Paying 0.2% costs (typical for a Vanguard investor) for 30 years means that you lose 6% of your investment to costs. Paying 1.2% costs (common for many investors) means that you lose 30% to costs.

How can I best get investing advice from the Bogleheads?

Follow the suggestions in the Asking Portfolio Questions sticky post.

I just received a windfall; what should I do?

Put the money in a money market fund or other cash investment (such as an FDIC or NCUA-insured savings account), and don't do anything else substantial with it for several months while you learn about what to do. You may, of course, need to use some of the windfall money to pay any taxes due on the windfall, and you might also want to pay down high-interest debt such as credit cards.

A windfall, by definition, changes your financial situation substantially. In addition, it usually comes with an emotional event such as a divorce, death, or buy-out, and that event may also change your financial situation. Therefore, it is best to let the money sit in something which cannot lose value, such as a money-market fund, while you take time to learn what you can do with it and deal with your emotions. This protects you against making an inappropriate investment which will be expensive to sell, or making an investment which is too risky and then shows its risk, or spending more of the windfall than you can afford.

This will be a good time to seek professional advice, particularly if you have never managed a substantial amount before. If you move the money to Vanguard (even to a money-market fund), you may qualify for a free or low-cost plan from Vanguard Financial Planning Services. You may also want to meet with an independent fee-only planner; as with Vanguard, such a planner does not receive a commission from directing you to specific funds. Again, don't try to make a quick decision.

Should I invest a lump sum all at once or gradually?

I have a loan; should I pay it down or invest the money?

Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a low-risk, long-term bond investment, and you can pay the loan down without any liquidity problems.

Paying down the loan earns you a guaranteed return equal to the after-tax interest rate; it is a long-term return because you won't actually be able to use the benefit until the loan is paid off (when you no longer make payments, or have a smaller final payoff amount). Investing in a risky asset may earn you more, but only by taking more risk, just as investing in stocks rather than bonds may earn you more. In both cases, you have a risk-return trade-off. Therefore, a bond investment gives a fair comparison.

Common requests for information

Why did my fund price suddenly drop in value?

If your fund suddenly dropped in value, check the fund's website to see if a distribution has been declared. A fund's price reflects the amount invested in the fund. Returning some of that investment back to the investors reduces the amount remaining in the fund - which is reflected by a drop in the share price.

If your fund is paying out a dividend and/or capital gains distribution, (sometimes quarterly, often annually) the net asset value (NAV) of the fund will drop by the per share amount of the distributions on the ex-dividend date. The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.

Why did my fund price drop so much more than the market?

The most common reason investors ask this question is that the fund paid out a distribution of dividends or capital gains; you received in cash, or had reinvested in the fund, an amount equal to the drop, so you did not lose anything as a result of the distribution. There are also other possible reasons.

  • If you are holding an actively managed fund, the manager's style (size and value/growth) and /or security selection weightings can be quite different from market weighting. Thus the return can vary from that of the market.
  • If you are holding an international stock fund, you should be aware that Vanguard employs a practice known as "fair value pricing" to determine a fund's closing NAV. Foreign bourses close early in relation to the US market, and there are times in which a great deal of market moving information comes to the market during the time lag. One feature of the mutual fund timing scandals of the early 2000's were certain investors who attempted to arbitrage the expected change from the "stale" foreign closing NAV prices of an international mutual fund into its expected closing US NAV. Fair value pricing is employed in instances where news indicates a substantive change in market value from the closing home market price. The adjusted price is used to more accurately reflect the "true" market price for US investors, thus foiling would-be market timing arbitrageurs.
  • If your fund is paying out a dividend and/or capital gains distribution(sometimes quarterly, often annually), the NAV of the fund will drop by the per share amount of the distributions on the ex-dividend date. The investor's economic position is not changed by the distributions, regardless of whether the distributions are re-invested in the fund or taken in cash. Substantial drops in NAV from distributions most often occur in December, when many funds are paying annual dividend and capital gains distributions, especially if the distributions are large.

The stock market had a significant drop, what should I do?

First, do not act emotionally. Think things through before making any changes.

Second, if you decide to make a radical change, don't do it until next week. Chances are you will change your mind again by then.

See this Bogleheads® forum topic: A time to EVALUATE your jitters.

Does it matter that different share classes have different prices?

No. Share class net asset value (NAV) is entirely arbitrary. If you invest $5,000 and the NAV is $10, you'll get 500 shares. If the NAV is $20, you'll get 250 shares. Either way, you bought five thousand dollars' worth.

How do I use specific identification of shares when selling?

If you sell a Vanguard mutual fund, then send Vanguard a secure Email with a text such as, "I am about to place an order to sell 234.456 shares of the XYZ Fund. Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email." You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you. (You still need to follow this procedure for selling shares purchased before 2012; for shares purchased in 2012 or later, Vanguard keeps track of shares for you.)

If you have "non-covered" shares of stocks or ETFs in your Vanguard brokerage account (purchased before 2011 for stocks, before 2012 for ETFs), you can enter the lot information yourself and then use specific identification when you sell online.

Asset allocation

Asset allocation is a complicated process; which parts are most important?

The most important decision to make in your asset allocation is the percentage you hold in stock. This is the primary factor in determining the risk of your portfolio; in a severe bear market as in 1973-1974 or 2007-2009, your loss would probably be about half the percentage you have in stock.

Therefore, you want to get the correct stock allocation before worrying about finer details, and you should be willing to pay some extra cost to get the correct allocation. For example, it is worth paying an extra tax cost if you must hold bonds in your taxable account, or using a higher expense bond fund in your 401(k).

Most of my investments are taxable; how should this affect my allocation?

You should still try to get the correct bond allocation, even if you must hold bonds in a taxable account, because this controls the risk of your portfolio. Compare after-tax yields to see whether municipal bonds or taxable bonds make sense.

For other parts of your allocation, you should try to find tax-efficient alternatives. If you don't have room in your tax-deferred accounts, you should probably avoid active funds and REITs, and possibly avoid value stocks. Index ETFs, index funds with ETF classes, and tax-managed stock funds, are usually tax-efficient. Even in an index fund, value stocks have an extra tax cost because of their higher dividend yield; you have to decide whether the extra tax cost is worthwhile. (REITs, even with the index fund, should still be avoided in taxable because they have a high yield in non-qualified dividends.)

Taxable accounts

Should an active stock fund be held in a taxable account?

No. An actively managed fund tends to distribute capital gains, for which you have to pay tax if the fund is held in a taxable account. The extra tax cost of most active funds is over 1%, and you want to avoid a fund with an extra 1% tax cost for the same reason you want to avoid a fund with an extra 1% in expenses. In addition, even if the fund has a low tax cost now, it might change managers and the new manager could sell most of the old manager's picks for a gain, or you could decide that you no longer like the new manager and have to sell the fund yourself for a gain.

If you already have an active fund with very low turnover (around 10% or less) and low costs, and you would have a large capital gain if you sell it, then it may be worth keeping the fund rather than paying the tax cost to sell it.

Should a balanced fund be held in a taxable account?

No. In a taxable account, it is better to hold bonds and stocks separately, even if you cannot move the bonds into a tax-deferred account.

If you have a balanced fund, you can only sell bonds and stocks simultaneously. If you want to sell only bonds, in order to hold fewer bonds or a different type of bonds, you will have to sell the stock as well and pay a capital-gains tax.

I have the wrong fund in my taxable account, but it will cost me to switch; should I do it?

Usually, it is worth switching even if you pay a capital-gains tax to switch; if you have significant short-term gains, wait for them to become either losses or long-term gains for the tax savings. Meanwhile, consider turning off reinvestment of dividends and capital gains to avoid buying even more shares of the wrong fund.

If the annual difference in taxes and costs is more than 10% of the tax you would pay, you should almost always switch. If the difference is less, multiply the amount saved per year by the number of years you expect to hold the fund, and if that is equal to, or even close to, the tax cost, then you should come out ahead by switching. Here is a spreadsheet which you can use to make the comparison.

Should I reinvest dividends in my taxable account?

Directing the dividends to a money-market fund, rather than reinvesting them, can give you readily-available cash to use for rebalancing. If you reinvest the dividends in a fund which is over its target weight at the time, you may later need to sell shares to rebalance, thereby creating a taxable event. Automatic reinvestment of dividends in any fund will make accounting more complicated (more tax lots and possible wash sales), particularly if you use Specific identification of shares to minimize taxes.

You might want to reinvest in a fund which charges a purchase fee if you are still in the accumulation phase so that you can rebalance with new money; you do not pay the purchase fee on reinvested dividends.

Asset location

Which funds should I place in my taxable account?

As a basic rule, broad based market-weighted equity index funds are tax-efficient, so they are appropriate for a taxable account. Good choices include the Vanguard Total Stock Market Index Fund and the Vanguard Total International Stock Index Fund (or their ETF versions). Similarly, tax-managed stock funds are excellent choices for a taxable account if they fit your allocation.

While municipal bond funds are exempt from Federal taxes, there is an implicit tax cost to holding them, as their yields are lower than the yields on corporate bonds of comparable risk. Therefore, you should try to hold bonds in your tax-deferred account if you can fill your taxable account with tax-efficient stock funds. If you run out of tax-deferred room, you may need to hold bonds in your taxable account.

The following chart provides a handy graphic illustration of a tax-efficient asset location hierarchy:

Approximate Tax Efficiency Ranking for Major Asset Classes
Most Tax Efficient

Place Anywhere
Tax Efficient Fund Placement - Arrow.png
Least Tax Efficient
Place in Tax-Free
or Tax-Deferred

Assets

Efficient

  • Low-yield money market, cash, short-term bond funds
  • Tax-managed stock funds
  • Large-cap and total-market stock index funds
  • Balanced index funds
  • Small-cap or mid-cap index funds
  • Value index funds

Moderately inefficient

  • Moderate-yield money market, bond funds
  • Total-market bond funds
  • Active stock funds

Very inefficient

  • Real estate or REIT funds
  • High-turnover active funds
  • High-yield corporate bonds

I have a Roth and a 401(k); what should I place where?

First select the best (usually lowest-cost) funds in your 401(k) plan, Complete your asset allocation plan by selecting appropriate funds and placing them in your Roth.

If all else is equal (for example, both funds are with Vanguard), it is slightly better to have higher-returning funds in the Roth IRA, because it is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.

I have a bad 401(k); should I invest in it or in a taxable account?

See linked article for guidance on how to make the most of a 401(k) plan with high-expense and/or mediocre fund choices, including a formula on when you might be better off investing in a taxable account over a 401(k) plan without an employer match, as well as suggestions on how to improve your company's plan.

Should I invest in a Roth or traditional IRA or 401(k)?

Your first choice is to always contribute to your 401(k) up to the company match. Whether you should invest in a Roth or Traditional IRA, or Roth or traditional 401(k), primarily depends on whether you expect to be in a higher or equal income tax bracket at retirement (pick the Roth) or a lower income tax bracket at retirement (pick the Traditional IRA if you are eligible for a deduction). After maximizing your IRAs, and if your 401(k) plan is satisfactory, contribute the maximum 401(k) deferral amount ($19,500 in 2021[1]) into the 401(k).

If you can max out your 401(k) or IRA, and expect to be in about the same tax bracket at retirement, the Roth is better because it allows you to effectively tax-defer more money. For example, if you are in a 25% tax bracket, you can invest $6,000 in a Roth IRA, or $6,000 in a traditional IRA (of which the IRS owns 25%, so it is only worth $4,500 to you) and have $1,500 in tax savings which you must invest in a taxable account.

Choosing specific funds

This section discusses only the comparisons between similar funds. It is not intended to give asset allocation recommendations, which are strongly dependent on your individual situation and too complex to give a general answer.

Which international index fund should I use?

Vanguard's main choices for broad international equity exposure are the Vanguard Total International Stock Index Fund and the Vanguard FTSE All-World ex-US Index Fund. The primary difference is that Total International includes small-cap stocks as well, so it is a more complete index; if you use the FTSE fund and also want to add small-caps, you will need to add the Vanguard FTSE All-World Ex-US Small-Cap Index Fund. Both funds cover almost all of the world except for the US, both have ETF classes, and both are suitable for a taxable account because they are eligible for the foreign tax credit.

Detailed comparisons are available in FAQ on Vanguard international funds.

How do I create a total stock market fund?

If Vanguard's Total Stock Market Index Fund (US stocks) is not available, one can approximate the fund by allocating percentages of small-, mid- and large-cap funds as described in Approximating total stock market.

International (non-US) stocks are broken down differently. See Approximating total international stock market for more information.

How do I compare bond funds?

Once an investor has decided on the duration and credit quality of their low-cost bond fund options,[2] a decision must be made about tax expense. For taxable account bond holdings the after-tax return of the fund portfolio can be a determining factor in fund selection. In general bonds face the following taxes:

  • Corporate bonds are subject to federal and state tax;
  • Treasury bonds are subject to federal tax but are exempt from state tax;
  • Municipal bonds are generally exempt from federal tax, but are subject to state tax (unless the bond is issued in one's state of residence, in which case it is generally tax-free income). Some types of municipal bonds are subject to the alternative minimum tax.

The Bond Fund Yield Calculator courtesy of The Finance Buff can be used to compare the after tax yields of a bond fund.

Income Tax Rates are available from the following sources:

The fund provider can give you the percentage of a tax-exempt money-market or bond fund's assets held in securities subject to the alternative minimum tax, and the percentage of a taxable money-market or bond fund's assets which are held in Treasury bonds exempt from state tax; note that some states have a minimum percentage of Treasuries for deductibility. Information from Vanguard can be obtained at the Vanguard web site:

Vanguard Bond Fund Link

Should I use bonds or bond funds?

For most investors, buying a bond fund is better than buying individual bonds unless you are buying Treasury bonds and you have a need to control your own allocation to bonds of different maturities. You do pay a small management fee to hold a bond fund; for most of Vanguard's bond funds, the expense is about 0.2% for Investor shares and 0.1% for Admiral shares. In return, you get diversification and more liquidity.

Should I use Total Stock Market or tax-managed funds for US stocks?

Vanguard Total Stock Market Index Fund, being very tax-efficient, is the natural choice for broad US equity exposure, and the US stock index funds with ETFs are also tax-efficient. Tax-Managed Capital Appreciation and Tax-Managed Small-Cap may save a bit in taxes over non-tax-managed large-to-mid-cap and small-cap funds if you must hold such funds separately. There is relatively little benefit to holding a combination of Vanguard Tax-Managed Small-Cap Fund and Vanguard Tax-Managed Capital Appreciation to approximate the total stock market; any tax savings will likely be canceled by the lower expenses of Total Stock Market.

Should I use target retirement funds?

The Vanguard Target Retirement Funds are excellent choices if your portfolio is entirely tax-deferred and entirely in target retirement funds; in particular, they are an ideal way to get started investing for retirement because they cover many types of investments with a single fund. You can also use non-Vanguard target retirement funds in the same way; if your 401(k) is not with Vanguard but has a target retirement fund which holds reasonable funds and does not add any extra costs, you can use it in your 401(k) and a Vanguard fund in your IRA.

You should not use target retirement funds if they are not all, or almost all, of your portfolio. The target retirement funds are designed to adjust your portfolio automatically to a reasonable allocation given your time to retirement. If you have other funds, your whole portfolio will not keep the correct allocation unless you adjust your non-target-retirement portfolio on your own, and once you have done that, you no longer gain anything from the simplicity of the target retirement funds.

If you have both tax-deferred and taxable accounts, there is a tax cost for using target retirement funds, or any balanced funds. You want to hold tax-efficient assets such as stock index funds in your taxable account, and tax-inefficient assets such as bonds in your tax-deferred account; using a target retirement fund in both accounts will lead to a higher tax bill than necessary.

If you have only a taxable account and will always be in a reasonably low tax bracket (so that corporate bonds are not too costly for your bond holdings), the simplicity of the target retirement funds may be worth the slight additional tax cost.

Exchange-Traded Funds (ETFs)

What is an ETF?

An ETF is a fund which is not bought or sold from the mutual fund company, but bought or sold from another shareholder on the stock exchange. The ETF provider also allows investors to convert a specified large block of shares of the ETF into shares of the securities the ETF holds, or vice versa. Therefore, the price of an ETF tends to stay close to the price of the underlying securities; if an institution can convert 100,000 shares of an ETF into $5,000,000 worth of stock, then it will want to buy the ETF if the price drops significantly below $50 so that it can profit from the conversion.

Vanguard's ETFs are a share class of the index funds (See Vanguard ETF/fund ratios for details). Therefore whether you buy the index fund directly from Vanguard or the corresponding ETF on the stock exchange, you have the same holdings. If you hold the index fund and would prefer to hold the ETF, you can convert the fund shares to ETF shares; this does not require selling or buying shares, and thus you do not pay tax on any gains.

Should I use mutual funds or ETFs?

Use whichever is more convenient and lower in cost for your own situation. The choice has no effect on your investment philosophy, as mutual funds and ETFs are two different ways of holding the same type of investments.

ETFs often have a lower expense ratio than mutual funds, but you must have a brokerage account to hold ETFs, and the brokerage has its own costs, both for the account and the commissions and bid-ask spreads you pay when trading. Most Vanguard ETFs have the same expense ratio as Admiral shares, so the cost savings goes away if you qualify. ETFs avoid the purchase and redemption fees charged by some funds, and are thus particularly attractive alternatives to mutual funds which charge those fees.

If you have a 401(k), you will be restricted to the mutual funds available there, and cannot buy ETFs unless your 401(k) has a brokerage option. If you have a non-Vanguard brokerage account, you probably want to hold Vanguard funds as ETFs rather than mutual funds (or else buy the mutual funds directly from Vanguard), as most brokerages charge a larger fee for buying Vanguard mutual funds than the commission for buying ETFs.

Do ETFs have a tax advantage?

Most stock ETFs have a potential tax advantage over similar mutual funds. However, Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF.

When a mutual fund or ETF sells a stock, it has a taxable capital gain (or loss) equal to the difference between what it received and what it paid. If an institutional investor converts shares of an ETF to stock, the ETF provider can give away the shares of stock with the lowest purchase price; these are the shares which would have the highest gain if sold. Thus ETFs can often reduce the capital gains they must distribute. The ETF conversion process does not reduce dividends; therefore, taxable bond and REIT ETFs, asset classes with total returns comprised primarily of non-qualified dividend income, still have a high tax cost.

Some ETFs have distributed capital gains in their early years, but few have distributed gains later. For example, only three Vanguard stock ETFs have ever distributed a capital gain, and only one of those three (REIT Index) distributed a gain after its second year. Refer to Vanguard Funds: Distributions for detailed tax data on individual funds.

How should I place orders to buy and sell ETFs?

See also: Orders

The least risky way to buy or sell an ETF is to place a limit order matching the best available offer. For example, if your broker's data shows that someone is offering to sell shares at $20.02, you can place a limit order to buy at $20.02. You will buy at that price unless the offer to sell was taken or withdrawn before your placed your order to buy; if it was withdrawn, you do not automatically buy at the next-best offer (which could be at a much higher price), as you would if you placed a market order.

References

  1. IRS announcement of 2021 pension limits, from the IRS
  2. See John Bogle,(April 17, 2007) Stewardship vs. Salesmanship - Bond Funds Gone Awry, FIASI Hall of Fame Speaker Series Fixed Income Analysts Society, New York, NY