Welcome to Vanguard 101: The Basics of Investing. If you’re just getting started, make sure to check out my Vanguard 101: Account Setup tutorial. Already established your account? Read on!
Important Note: Throughout this entire article I reference VTSAX (Vanguard Total Stock Market Index Fund) and VBTLX (Vanguard Total Bond Market Index Fund). If you have less than $3,000 in your investment account, you will not have access to these mutual funds, but instead, you will invest in their ETF (Exchange-Traded Fund) equivalents.
VTSAX = VTI
VBLTX = BND
If you’re looking for the secret investment formula to get rich overnight, you won’t find it here. Investing is a get-rich-slowly process. What I will teach you is how to create a portfolio that best suits your risk tolerance and investment horizon. Ready? Let’s dive in.
There are two main asset classes: Stocks and Bonds.
What is a stock?
Buying a stock is buying a tiny slice of ownership in a company. If the company performs well, the stock price rises. If the company performs poorly, the stock price drops.
“Okay, I understand what buying a stock means, but what the heck is a mutual fund or ETF?”
Mutual funds and ETFs are an aggregation of a group of stocks or bonds packaged into one security (A “security” is any type of financial instrument: stock, bond, ETF, mutual fund, etc). So what does this mean exactly? Let’s use VTSAX as an example. This is the mutual fund we buy in Vanguard 101: How to Invest.
VTSAX is the Vanguard Total Stock Market Index Fund. Put more simply, VTSAX contains little pieces of EVERY stock on the market. It might contain 0.3% Facebook, 0.2% Google, 0.15% Amazon and so on and so forth. If you were to add up all the tiny pieces of stock within VTSAX, it would equal 100%.
If you buy the mutual fund VTSAX, you are essentially investing in the U.S. economy. The only way you could lose all of your money is if the U.S. economy collapses completely, which is extremely unlikely.
Volatility and Returns
You might have heard someone say “The stock market is so risky, I’d never invest my money there”. But what exactly is risk?
The stock market has averaged an 8.86% annual return over the past 100 years (inflation adjusted). That is inclusive of every stock market crash. If $1,000 was invested in the year 1918 and increased by 8.86% every year, the total value in 2018 = $4,862,202.01. No that is not a typo. You can check it out here if you don’t believe me.
Now, what was that person saying about risk again? When people say that the stock market is “risky”, they are usually mistaking risk with volatility.
Volatility is the day-to-day price fluctuations in the stock market. This volatility can be scary because your portfolio could drop 50% or more in a matter of days, weeks, or months.
“If my portfolio drops by 50%, why shouldn’t I be worried?!”
Great question. Like I mentioned before, investing is a get-rich-slowly process. You will definitely see huge fluctuations in your portfolio during your investing career, but like I highlighted before, the average return through every up and down in the past 100 years is still 8.86%!
Let’s look at volatility vs. return with an example:
Randy has $100,000 invested in VTSAX in 2007. In 2008, the stock market crashes and Randy’s investment is now worth only $50,000. Uh oh! Randy lost all of his money.
Not quite. Using real historical data, if Randy kept his money invested throughout the crash, his investment would have returned to $100,000 in March 2013. By April 2018 Randy’s portfolio is worth $193,126!
You see, volatility can be scary, but if you know you’re investing for the long term, everything will turn out just fine. If you’re investing over a shorter period of time, this is when Bonds can come in handy to reduce volatility while still generating a return.
What is a bond?
A bond is essentially a company’s promise to pay back someone who lent them money. If Company X needed $1,000 dollars, they could sell Dorothy a bond and in exchange, Dorothy would give the company $1,000. The bond is due in a certain amount of time and has a designated coupon rate (Explained in the example below).
Let’s say the bond is due in 5 years with a 5% annual coupon rate. A “coupon rate” is the interest that the bond pays Dorothy every year. At 5% of Dorothy’s $1,000 investment, she will receive $50 in coupon payments every year. In addition, once the 5 years is up (the bond had a 5-year term), Dorothy will get her $1000 back. You see, Dorothy invested $1,000 in Year 0 and ended with $1,250 in Year 5. The $1,250 was calculated by adding each years coupon payment ($50 x 5) plus the initial price of the bond ($1,000).
Not too bad Dorothy! She turned her $1,000 into $1,250 in five years. That’s a $250 gain!
Let’s see what would have happened if Dorothy invested that same $1,000 into the stock market during “average” years. We are assuming a $1,000 investment, and 8.86% returns over the 5 year time horizon.
Wow! Dorothy’s investment increased from $1,000 to $1,529 in five years. That’s a $529 gain!
Now you’re probably thinking to yourself: “Why would I ever invest in bonds if stocks earn me so much more money?”
That’s where volatility comes into play.
Volatility and Returns
You may have heard someone say that “Bonds are less risky than stocks”. Again, this “risk” is usually referring to volatility. Bonds prices are less volatile than stocks because bonds have higher priority in the case of a bankruptcy. If Company X goes bankrupt, it must pay back all of its bondholders before a single penny goes to its stockholders.
Similar to VTSAX (The mutual fund for the Total Stock Market), there is a Vanguard Total Bond Market Index Fund called VBTLX. VBTLX is an aggregate of every publicly traded bond compressed into one security. It might contain 0.1% Ford, 0.3% McDonalds, 0.2% Microsoft, etc. All the little pieces of bonds within VBTLX add up to 100%.
Over the past 100 years, the bond market has returned an average 1.2% annual return (inflation adjusted). This may seem low, but let’s look at a scenario when bonds could be beneficial.
Yvonne vs. Henry
Yvonne has $1,000,000 invested in VBTLX in 2007. She is 65 years old and ready to retire.
Henry has $1,000,000 invested in VTSAX in 2007. He is 65 years old as well and ready to retire.
In 2008, the stock market crashes! VTSAX is down 36.99%. However, VBTLX is up 2.15%!
At the end of 2008:
Yvonne’s portfolio is worth $1,021,500.
Henry’s portfolio is worth $630,100.
Henry might be worried that he doesn’t have enough funds to retire now. Maybe he’ll even have to work a few more years!
As you can see, bonds can be incredibly useful to limit volatility if the investment time horizon is very short.
However, in the long run, Henry crushes Yvonne in annual returns! Let’s assume now that Henry and Yvonne are 35 years old. They plan to retire at age 65 so their time horizon is 30 years. They both have $100,000 invested.
Yvonne’s portfolio (30 years later): $140,921
Henry’s portfolio (30 years later): $1,276,585
Those are real numbers. After 30 years, Henry has $1,135,664 more than Yvonne! That investment decision made a million dollar difference.
Building Your Portfolio
Now that you have a basic understanding of stocks and bonds, let’s figure out how to build the perfect portfolio for your risk tolerance and investment horizon.
What to consider when choosing Mutual Funds and ETFs:
- Expense Ratios
- Risk Tolerance
- Investment Horizon
Let’s tackle these factors one by one and learn what to consider.
Expense ratios are the fees that an investment firm charges you for having your money in their Mutual Fund or ETF. In our case, the investment firm is Vanguard. The reason why I created this Vanguard 101 course is because Vanguard is known for having the lowest expense ratios on the market for all of their funds. That’s why I recommend Vanguard to anyone just starting their investment career!
You’ve heard me mention VTSAX (Vanguard Total Stock Market Index Fund) and VBTLX (Vanguard Total Bond Market Index Fund) quite a bit. Why? Because they have extremely low expense ratios.
What do these ratios mean exactly? Let’s look at an example.
Dom has $100,000 invested in VTSAX and $100,000 invested in VBTLX. Every year, Vanguard charges its expense ratio to Dom. This year, Dom paid $40 for VTSAX and $50 for VBTLX.
The industry average expense ratio for a mutual fund is currently 1.01%. Compare that to Vanguard’s average of 0.18%. If Dom were at an “average” financial institution, he would pay ~$2,000 in expense ratios (~$1,000 for each mutual fund)!
You can see why expense ratios are so important when it comes to building your portfolio. These expense ratios are public and can typically be found with a Google Search or on the company website.
Investing is about more than just the numbers. Emotions come into play, and a devastating loss could potentially cause an investor anxiety or depression. That is why it is important to understand your risk tolerance.
We’ve already discovered that historically, stocks outperform bonds in the long run by a huge margin. However, if you’re not comfortable with your portfolio dropping 50% during a market crash, you may want to consider adding bonds to your portfolio.
Let’s look at three separate investors through a market crash, and then again 20 years later using the 100-year stock and bond market returns of 8.86% and 1.15%, respectively. All three investors have $100,000 invested. Let’s assume that VBTLX does not move up or down during the market crash.
Daring Doug’s Portfolio: 100% VTSAX (Vanguard Total Stock Market Index Fund)
- Portfolio value immediately after the market crash: $50,000.
- Portfolio value 20 years later: $273,109
Mild Mindy’s Portfolio: 50% VTSAX. 50% VBTLX.
- Portfolio value immediately after the market crash: $75,000
- Portfolio value 20 years later: $199,402
Worried Winston’s Portfolio: 100% VBTLX (Vanguard Total Bond Market Index Fund)
- Portfolio value immediately after the market crash: $100,000
- Portfolio value 20 years later: $125,695
As you can see, Worried Winston’s portfolio was unaffected by the market crash, but 20 years later, his portfolio is worth $147,414 less than Daring Doug’s portfolio. Mild Mindy is right in the middle. She didn’t suffer too much of a loss during the market crash and earned a modest return over the next 20 years.
There may be certain circumstances where it might make sense to be a Worried Winston. We’ll talk about that more in the Investment Horizon section.
The time you plan to have your money invested is called your investment horizon. We’ve mainly been focusing on long investment horizons where stocks are clearly the superior choice, but a short investment horizon might call for lower volatility.
Let’s look at some scenarios to see how Investment Horizons could affect your portfolio.
Tyrese plans to buy his first home in three years. He’s looking for a $300,000 home that he will finance with a 20%-down mortgage. He will need $60,000 when he’s ready to purchase ($300,000 * .20).
Tyrese learned about investing and decided he wanted to give it a go. He has $80,000 to invest and decided to invest it all in VTSAX (Vanguard Total Stock Market Index Fund).
After 3 years, Tyrese is ready to buy his home, his $80,000 investment in VTSAX has turned into $103,204! Unfortunately, the stock market crashes by 50% just before Tyrese is ready to pay the down payment. With only $51,602, Tyrese doesn’t have enough money for the down payment on his dream home. If only he took his 3-year investment horizon into consideration.
Tyrese travels back in time after realizing his mistake. Instead of investing all $80,000 in VTSAX, he instead invests $40,000 in VTSAX and $40,000 in VBTLX.
Three years later, Tyrese has $92,997 ( $51,601 in VTSAX and $41,396 in VBTLX). When the market crashes this time, his portfolio is only reduced to $67,197. Phew, good thing he considered his risk tolerance and investment horizon. Now Tyrese has enough money for the down payment.
Ingrid is 65 years old and plans to retire at the end of this year. Her current investment portfolio consists of $500,000 in VTSAX and $500,000 in VBTLX. Just before year-end, the stock market drops by 50%.
Ingrid is now left with $750,000 and has calculated that she needs at least $1,000,000 to retire. Uh Oh! Ingrid thinks that she might have to work a couple more years in order to recuperate her loss.
Ingrid time travels back to the beginning of the year and reallocates her portfolio. She invests all $1,000,000 in VBTLX. When the market crashes, her portfolio is unmoved. Good thing Ingrid built her portfolio with her investment horizon in mind!
Jack has one goal: To grow his investment portfolio to $1,000,000. He is 30 years old with $100,000 invested in VBTLX. He doesn’t like volatility, so he exclusively invested in the Vanguard Total Bond Market Index Fund.
35 years go by and Jack checks his Vanguard account. His balance reads $149,213 and Jack is devastated. He didn’t come anywhere close to his $1,000,000 goal. He didn’t experience any serious volatility over his 35 years of investing, but he only gained $49,213 in his investment account.
Jack warps back in time and decides that he is comfortable with more volatility since his investment horizon is so long. He shifts his $100,000 portfolio into VTSAX. He understands that in the long run, stocks outperform bonds by an enormous margin.
35 years go by and Jack checks his Vanguard account. His balance reads $1,951,603. Holy cow! Jack can’t even believe his eyes. His portfolio is nearly double the value of his $1,000,000 goal.
Understanding your investment horizon is a crucial part of building your portfolio. If you can’t suffer to take a loss in the next couple of years like Tyrese or Ingrid, then invest more heavily in bonds to hedge against volatility.
If you’re like Jack and have decades ahead of you in your investment horizon, invest in stocks! Historical data has proven that stock returns dominate bond returns in the long run.
What is diversification? Diversification is reducing risk by spreading out your investments. In other words, diversification means you aren’t putting all of your eggs in one basket.
The best part about Mutual Funds and ETFs is that they have built-in diversification. Since these securities are an aggregation of thousands of other stocks or bonds, they are inherently diverse.
Let’s see how diversification affects an investor.
Derek invests $100,000 in Tesla stock.
Janine invests $100,000 in VTSAX.
Tesla goes bankrupt the next day. Let’s see how Derek and Janine are doing.
Derek lost his entire $100,000 investment.
Janine’s portfolio value drops from $100,000 to $99,980.
Derek bought Tesla stock which gave him partial ownership in the company in the form of shares. When Tesla went bankrupt, the value of Derek’s shares went to $0.
Janine invested in VTSAX (Vanguard Total Market Index Fund). Tesla makes up 0.02% of VTSAX, so when the company declared bankruptcy, Janine’s VTSAX investment value decreased by only $20.
I always recommend investing in Mutual Funds and ETFs because of their inherent diversification. There’s no point in trying to pick shining stocks if you can achieve 8.86% returns by investing entirely in VTSAX.
Before you start to invest, make sure you understand the tools you need to build your ideal portfolio. If you’d like to expand past VTSAX and VBLTX, there is an entire financial market full of mutual funds and ETFs. Hopefully, now you have the knowledge to decide which securities are right for you.
Investing doesn’t have to be difficult. I have my entire portfolio invested in VTSAX and VBTLX. Don’t let financial advisors trick you into buying the Magical Secret Fund with the 2% expense ratio! Stick to the basics and you’ll set yourself up for a successful investing career. Always remember, investing is a get-rich-slowly process. Persevere through the highs and lows and your account balance will reward you handsomely.
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