Bogleheads Investment Philosophy Flaws: Problems with a Popular Approach

This week’s blog post discusses five flaws I see in the Bogleheads investment philosophy.

Two are pretty significant, I think.

The other three flaws? Well, the other flaws are me picking nits.

But first some background and then a few stipulations so this post doesn’t mislead anyone.

Bogleheads Investment Philosophy

So what is the Bogleheads investment philosophy?

We could probably argue about this. But here’s my take. The Bogleheads forum and wiki promote and teach investors how to use low-cost passive investing and tax-deferred or tax-advantaged accounts to prepare for their retirements.

More specifically, the Bogleheads investment philosophy promotes low-cost, do-it-yourself investing using nearly-free index funds (like those supplied by Vanguard) and simple asset allocation formulas (such as the forum’s home grown Bogleheads Three Funds formula, 34% in US stocks, 33% in international stocks and 33% in US bonds).

Some Stipulations about Bogleheads Investment Philosophy

A really important point: The Bogleheads do-it-yourself approach absolutely can work for people.

And just to say this: I’ve recommended the same basic approach in my own books for twenty-five years or so.

But here’s the problem: Despite the simplicity of the core Bogleheads investment philosophy, the philosophy suffers from at least five flaws. And you should know about those flaws if you’re going to use the Bogleheads strategy or any similar strategy.

Flaw #1: Practically Impossible for Most People

A first practical flaw which you can almost miss if you’re looking for a good investment strategy… Most everybody fails to get the approach to work (at least in relative terms).

No, no, wait a minute, I agree. The Bogleheads approach should work.

No one who can do the math questions the power of compound interest nor the wisdom of a broadly-diversified portfolio of stocks and bonds.

Further, as counter-intuitive as it might seem, you absolutely can do a great job investing your own retirement savings. A better job, probably, than anyone you could hope to hire.

But here’s the problem. Relatively few people save the money needed to run the Bogleheads plan. As a result, few people build wealth by employing a Bogleheads-style investment approach.

Another way to say this same thing? The assumption that people can regularly save and invest seems terribly optimistic.

I talk about this issue quite a bit more in my free downloadable e-book, Thirteen Word Retirement Plan. But let me share a couple of bits of data.

First, most retirees and near-retirees hold zero retirement savings according to a recent Federal Government study (available here)…

Second, when people do have retirement savings, the averages run a little over $100,000 for folks in the 55 to 64 age group and about $150,000 for those in the 65 to 74 age group. That level of retirement savings means maybe $4,000 to $7,000 in annual retirement income.

The upshot: Though the Bogleheads approach works if someone can regularly save—the math says it does—most people don’t actually save. And that impracticality may mean someone should look at other options.

Maybe, for example, someone should go to work for an employer with a sturdy defined benefit pension.

And another option? Maybe someone should use direct real estate (which can become a form of forced savings.)

And yet a third option? Maybe the first steps someone needs to take are getting spending under control following the strategies and tactics promoted by Mr. Money Mustache and Dave Ramsey.

Flaw #2: Lake Woebegone Investment Club Thinking

Another very subtle flaw you can see with the Bogleheads investment philosophy? Too little attention paid to the variability in investor outcomes. But let me explain what I mean.

The Bogleheads investment philosophy and similar strategies basically assume you’ll earn a median return over the decades you save and invest. And this optimism isn’t surprising, really.

On whole, the stock market’s thirty-year returns have been great to investors for decades.

Nearly every current retiree applying the Bogleheads formula earned 6% or so annually in real terms over the years they saved.

But you and I shouldn’t use only a median return in our planning. The median only tells us that half the returns will be above and half below the median amount.

And actual returns vary widely from the median when you’re saving for decades. History says a compound average growth rate over 30 or 35 years can also easily run  4% or 5%. And while that doesn’t sound very different from the 6% average, that lower return delivers a strikingly different outcome.

Note: I did a series of blog posts on this topic earlier this year. The first post is Retirement Plan B: Why You Need One.

Can I add one other editorial point here? I suspect at least a few Bogleheads don’t realize that some of what they attribute as the “goodness” of their investment philosophy is really just the great luck that long-term investors have enjoyed over the last 35 years.

Flaw #3: Inattention to Asset Class Correlations

I have three quibbles with the Bogleheads investment philosophy, and here’s the first one…

The community as a whole pays too little attention to asset class correlations—and when they do pay attention, that attention often comes in the form of antagonism. But asset class correlations matter.

If you pay attention to asset class correlations, you should be able to either increase your returns without increasing your risk… or you should be able decrease your risks without decreasing your returns… or you should be able to enjoy some nice combination of lower risks and higher returns.

If this all sounds a little too theoretical, consider this: By dampening your risk, you  may be able to nicely nudge up your safe withdrawal rate (a point explored at the www.PortfolioCharts.com website here).

By the way, in practical returns, “paying attention” to asset class correlations doesn’t change the Bogleheads formula very much at all. Adding riskless assets like U.S. Treasury bonds (including inflation protected bonds) and then holding international stocks and REITs should do it. But many in the community shy away from these choices.

But back to the inattention and antagonism. I think I understand the inattention and antagonism. The math of Modern Portfolio Theory (which explains how you work with these asset class correlations) gets complicated. The math works better in theory than in practice. Finally, when you most want the math to work its magic—like during a financial crisis—the hoped for risk reduction comes up short.

William J. Bernstein does a good job of making these all these points in his well-crafted book, “Rational Expectations,” sharing this comment:

If you want to reduce your portfolio risk, it is far more efficient to simply substitute riskless assets for risky ones rather than try to inoculate your risky assets with other risky and noncorrelating ones.

I agree or mostly agree with Bernstein here about the profitability and practicality of using asset class correlations.

However, I still see it as a flaw that a majority of the community pays little attention to how the returns and risks of the asset classes in a portfolio correlate. And I see it as a flaw that some very vocal members of the community regularly display antagonism to thinking about asset class correlation.

Regularly and over the long run, paying attention should help an investor enjoy either better returns or lower risks, a point the Vanguard Group itself makes in a free whitepaper you can download here. Sure, you and I can’t rely on diversification to eliminate risks. As Vanguard notes in its paper, correlations show the same sort of volatility as returns. But you and I still should consider asset class correlations when we build portfolios.

Lots more can be said about all this, but let me quickly share a comment from another expert. David Swensen, in his excellent book for individual investors, “Unconventional Success: A Fundamental Approach to Personal Investment,” shares this perspective on this business of trying to build portfolios with asset classes that lack correlation:

Ultimately, the behavioral benefits of diversification loom larger than the financial benefits. Investors with undiversified portfolios face enormous pressures, both internal and external, to change course when the concentrated strategy produces poor results… Unfortunately, diversification provides no guarantee that investors will stay the course through adverse conditions. But, when only a portion of the portfolio suffers from dramatically adverse price moves, investors face a higher likelihood of riding out the storm.

Enough said on this subject… for now.

Flaw #4: Dangerous Do-it-yourself-ness

Another quibble… The whole “do-it-yourself” philosophy makes great sense when it comes to saving for retirement. The Bogleheads founders, Taylor Larimore and Mel Lindauer, deserve much credit for promoting this possibility.

But passive investing using index funds works pretty simply. I’ve pointed out elsewhere at this blog that you can literally boil down such a plan to about thirteen words.

Further, a single, rather short, entry-level book like John Bogle’s The Little Book of Common Sense Investing easily covers everything–everything–you need to know to run such a plan.

Given this simplicity, no reason exists for giving away ten to twenty percent of your investment income to some outside adviser for work that you can do yourself. (An adviser fee calculated as a half a percent or a percent of your savings may equal ten or twenty percent of your investment income.)

But do-it-yourself doesn’t work with everything. And outside the area of passively investing using index funds, the do-it-yourself-ism of the Bogleheads sometimes goes off the rails.

An example of this: Coincidentally, the community regularly discusses an area of corporate tax law, Subchapter S taxation, that I specialize in. Just so you have context, our CPA firm serves a couple hundred Subchapter S corporations. And our work in this specialty means we regularly collaborate with other accountants and attorneys both in the business world and from federal and state revenue agencies. Lots of experience in other words.

And here’s what I have to tell you. Regularly, Bogleheads discussions reach conclusions about Subchapter S taxation that are catastrophically wrong. Regularly, forum discussions include bad advice from well-intended amateurs that anyone with a year or two of relevant work experience would know enough not to utter.

The problem more generally is the community assumes since crowd-sourced do-it-yourself-ism works for simple financial tasks, it works for more complex financial tasks. But, oh my gosh, that’s just not true.

Two quick tangential comments about this particular flaw. First, just for the record, I believe that the average individual tax return falls into the “simple financial task” category and should be a do-it-yourself project (an argument I’ve made here: Your CPA versus TurboTax.)

Second, absolutely online forums can perform complex problem solving (see the blog post Using the Delphi Method for Small Business Problem Solving). But success seems to require a format very different from that used by the Bogleheads.

Flaw #5: Antagonism Toward Active Management Tactics

A final, special case quibble with the Bogleheads investment philosophy: The philosophy looks at the performance of active managers investing in traditional asset classes like stocks and bonds and then correctly points out that with traditional asset classes, active management loses over time as compared to passive management.

Note: An active management approach means an investor tries to pick good investments and avoid bad investments. A passive management approach means an investor buys everything and accepts the average. Active management costs lots of money as compared to passive management, unfortunately. And those extra costs almost always destroy an investor’s long-run returns.

This all amounts to a bulletproof argument when you’re talking about traditional asset classes like stocks and bonds. And it’s easy to assume the same general rule might apply outside of the traditional asset classes.

Unfortunately, once you get outside of traditional asset classes and look at alternative asset classes like private equity, direct real estate investment, and absolute return investments like hedge funds, the landscape changes. Passive management doesn’t seem to work and active management can work reliably for some participants and some alternative asset classes. But Bogleheads often miss this reality.

Now, yes, you and I may hope to stick with traditional asset classes.

But three comments about that position. First, we may be forced into alternative asset classes. Do you own your own business? Or an interest in a professional services partnership or corporation? Are you directly investing in real estate? In these cases, you’re going to need tools and thinking that help you make smart active management choices.

Tip: A great place to begin learning about active management and investing in alternative asset classes is David Swensen’s masterpiece book, “Pioneering Portfolio Management” which I discussed earlier this year here. Swensen, by the way, says individuals should avoid actively managed investments… And I agree with this general advice.

Second, you ought to know that people can do really well with some of these alternative investments. (I’m thinking here about something like your own small business. Or direct leveraged real estate investment.)

And then this third comment about an awkward set of statistics highlighted in the last big IRS wealth study. The wealthy invest in lots of alternative asset class investments that require active management, something I’ve discussed in more detail in another post, Smart Wealth Strategies of the Top One Percent.

We can’t know for certain, but it sure looks as if the wealthy often enjoy better outcomes with alternative asset class investments like an interest in a small business or like direct leveraged real estate than they do with traditional asset classes .

You have to wonder, therefore, if all this doesn’t mean yet another way to build savings for retirement is through actively managed investments such as small business ownership or direct real estate investment.

Final Comments about Bogleheads Investment Philosophy

Two final quick comments in closing.

First, let me again say that the basic theory of the Bogleheads approach works really well. Low-cost index funds and a common sense asset allocation formula work better than most new investors realize. As a result, if you can run a savings and investment plan based on the Bogleheads investment philosophy, well, I don’t think there’s any simpler or surer way to invest successfully in traditional asset class investments. (I’ve used such a strategy myself for decades and have no plan to stop. Ever.)

Second, though that basic theory works well, reality shows the philosophy is impractical for many… and then incomplete. To get to the point where the theory can work its magic, for example, you and I must get the savings thing going right. And then even after that, we need to recognize that the orthodoxy of the Bogleheads investment philosophy means there are holes and blindspots in the strategy.

Other Blog Posts You Might Find Interesting

Retirement Plan B: Why You Need One

Real Estate vs IRA and 401(k) Accounts: Part I

Portfolio Leverage Modeling with cFIREsim and FIREcalc

Bear Market Survival Tactics from David Swensen