Sunday, October 26

Week 173 - Why Vanguard?

Situation: Warren Buffett, in his Annual Report to Berkshire Hathaway investors this spring, included a “letter” to his relatives. It recommended that they structure investments in their “trusts” as follows: 90% in the Vanguard index fund dedicated to the S&P 500 Index (VFINX) or the index fund dedicated to the total US stock market (VTSMX), and 10% in the Vanguard managed fund dedicated to short-term US Treasury Notes (VFISX). His main concern was to minimize their investment costs while tracking stock market returns.

Our readers aren’t as rich as his relatives. So, we suggest that you back your stock investments 1:1 with US Treasury Notes & Bonds, other AAA-rated bonds, Savings Bonds, or the Vanguard Intermediate-term Treasury Fund (VFITX). In other words, the most prudent long-term investment balances large-capitalization US stocks with risk-free AAA bonds. And by “long-term”, we mean that you intend to hold your investment for at least 20 yrs in anticipation of using it for retirement purposes. Our benchmark for “Risk-On” investors is the Vanguard Balanced Index Fund (VBINX), which is composed 60% of a capitalization-weighted index of the total US stock market and 40% of an investment-grade US bond index (mainly US Treasuries). For “Risk-Off” investors, our benchmark is Vanguard’s Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks. “Risk-Off” investors are those who have moved closer to drawing on retirement income and have less investment time available to recover from market fluctuations.

When calculating your 1:1 stock:bond balance, remember to include the present value of your Social Security account, which would be $164,000 if you were to qualify today for a beginning payout of $2000/mo and were to receive monthly payouts for the next 11 yrs, assuming a discount rate of 5.6%. That discount rate is the sum of the “risk-free” rate (2.6% interest on a 10-yr Treasury Note) and “risk” (i.e., inflation, as reflected in a 3.0%/yr estimated annual cost-of-living adjustment). Total payments would amount to almost $305,000 over 11 yrs, with a monthly payment of $2636 in the 11th yr.

We need to draw attention now to the costs that are associated with investment accounts. How important are those costs? Well, the standard rule of thumb for business accountants is to note any cost as being “material” if it represents more than 5% of revenues or earnings. Upon noting said cost, the accountant will delve deeper to determine whether it is justified. Using that guideline, let’s look at the past 100 yrs of returns from owning 10-yr Treasury Notes and reinvesting interest payments vs. owning shares of the S&P 500 Index and re-investing dividend payments. Over that 100 yr period of time, the key facts  are:

        1) Inflation averaged 3.22%/yr;

        2) Total returns on 10-yr Treasury Notes averaged 5.05%/yr (1.83% after inflation);

        3) Total returns on the S&P 500 Index averaged 10.16%/yr (6.94% after inflation);

        4) Total after inflation returns for our recommended 50:50 allocation averaged 4.39%/yr;

        5) Therefore, transaction costs (expenses) become material when the expense ratio reaches 0.22%/yr, which would bring the after inflation total return down to 4.17%/yr; 

        6) The relevant Vanguard funds are VFITX (intermediate-term Treasuries) with an expense ratio of 0.20%/yr, and VFINX (S&P 500 Index) with an expense ratio of 0.17%. Both of those expense ratios are less than 0.22%/yr, so transaction costs are immaterial. 

Vanguard index funds were invented by John Bogle to provide retail investors with market-tracking investments that have immaterial transaction costs. (The only remaining costs are taxes and inflation.) The issue that concerns Mr. Bogle is that the average retail investor has an expense ratio of 2.2%/yr, which is 10 times too much! That is the reason why Warren Buffett thinks so many investors are being disappointed. Half of their after-inflation returns are being eaten up by costs, 90% of which can be eliminated by sticking to Vanguard index funds. 

Treasury Notes don't provide interest payouts that grow faster than inflation, but Vanguard's S&P 500 index fund (VFINX) has grown its dividend payout 4.7%/yr since 1980, which is 1.5%/yr faster than inflation over that 34-yr period. However, those payouts bounce around a lot because ~150 companies don’t pay a dividend. Only about 150 increase their dividend annually. 

Now you have the explanation why the purpose of this blog is to interest you in buying stock monthly (online) in selected companies that have increased their payout for at least 10 yrs at a rate 3-4 times faster than inflation. Some of those companies charge no transaction costs for automatic monthly investments (see Week 162). Examples include NextEra Energy (NEE), Abbott Laboratories (ABT), and ExxonMobil (XOM) for shares purchased through computershare.

Bottom Line: Here at ITR, we stress two things: minimizing transaction costs and maximizing retirement income. For this week’s Table, we’ve used our “Risk-On” benchmark (VBINX) supplemented with Vanguard’s intermediate-term Treasury fund (VFITX) to construct a 50:50 stock:bond fund, i.e., 75% VBINX and 25% VFITX. By having 25% invested in a Treasury bond fund, you’ll have an investment that goes up in value during a recession, and also provide a way to pay for unforeseen emergencies that often crop up during a recession. Alternatively, you can invest in the Vanguard Wellesley Income Fund, or a 50:50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Intermediate-term Treasury Fund (VFITX). All 3 of these options are worry-free and track the markets in a manner that gives you protection from a crash in the stock market. Plus, you don’t have to fiddle with picking stocks and the added complexity they bring to paying taxes.

Risk Rating: 4.

Full Disclosure: I invest monthly in inflation-protected Savings Bonds at and in NEE and ABT.

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