Investing FAQ for the Bogleheads® forum

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Introduction

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.

A. Getting started

A1. 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.

A2. How can I best get investing advice from the Bogleheads?

Follow the suggestions in the Asking Portfolio Questions sticky post.

A3. I just received a windfall; what should I do?

Put the money in a 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.)

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.

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 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.

A4. Should I invest a lump sum all at once or gradually?

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.

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 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 .

A5. 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 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 tradeoff.

One way to look at this is to consider the following choices.

1. Invest the money with your preferred allocation. 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.

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.


B. Common requests for information

B1. 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, 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.

B2. 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.


B3. How do I use specific identification of shares when selling?

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.

See Specific Identification of Shares for more details, including an illustration of the potential tax savings.

C. Asset allocation

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.

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).

C2. 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. Small-cap stocks can be held tax-efficiently either as part of a Vanguard Total Stock Market Index Fund or separately in 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.

D. Taxable accounts

D1. Should 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.

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.

D2. 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.

D3. 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. Be sure to turn off reinvestment of diviends and capital gains so that the distributions won't incur additional short-term caiptal gains.

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.

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 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.

D4. Should I reinvest dividends in my taxable account?

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.

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.


E. Asset location

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.

The following graphic provides more detail concerning tax efficiency.

insert graphic

E2. 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.

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.

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 years. The 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.

E4. 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). 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).

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.


F. 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.

F1. Which international index should I use?

Vanguard's main choices for broad international equity exposure are the Total International Stock Index Fund and the FTSE All-World ex-US Index Fund (or 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 Tax-Managed International (or its ETF class) and Emerging Markets Index may be even better in a taxable account.

Detailed comparisons are available in FAQ on Vanguard International Funds.

F2. Should the redemption fee discourage me from using tax-managed funds?

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.

F3. How do I compare bond funds?

Once an investor has decided on the duration and credit quality of their low-cost bond fund options (See 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:

  • 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.

Income Tax Rates are available from the following sources:

  • Federal Tax Rates
  • 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:

Vanguard Bond Funds

F4. Should I use bonds or bond funds?

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.

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 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.

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.

F5. 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. 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.