Index funds represent a truly excellent financial product. They result in ultra-low-cost investing, provide massive diversification, and operate with razor-sharp tax efficiency.
Further, if you couple good quality index funds with a sound asset allocation formula, you get an almost unbeatable strategy over any long investing horizon.
Note: An asset allocation formula just specifies how you break down your investment portfolio into categories. Putting 60% of your money into a stock index fund and 40% into a bond index fund is one simple asset allocation, for example. You can get good discussions of several other sturdy asset allocation formulas at the Bogleheads website (click here).
But you know what? While index funds and asset allocation formulas work well for just about anybody, one can argue the combination works especially well for high income and high net worth investors.
In other words, those movies, television shows, and books that talk up the idea that wealthy folk invest in all sorts of crazy stuff? That’s maybe true. (See here for some insights we’ve gleaned from IRS statistical studies about the way the wealthy invest.) But that sort of active, hands-on investing may not be any smarter or better than index-based-asset-allocation investing.
Why? Because in addition to the benefits that everybody gets from indexing and allocating, high income and high net worth investors also gain some other notable advantages that matter a lot when the numbers grow large.
Easy Scalability
For example, a first advantage to note? The combination of index funds and asset allocation formulas provides easy scalability—which is a big benefit when you talk big dollars.
Consider this hypothetical situation: You and I happen to guess the right numbers for a giant lottery and find ourselves each holding a $10,000,000 check. Assume we both show enough discipline and common sense to save the entire windfall.
If I’m investing actively in something like rental properties or small businesses or individual stocks—anything like that—deploying the windfall will take me at least weeks and maybe months. Gosh, maybe even years.
If you, in comparison, are simply using a combination of index funds based on a decent asset allocation, you can write one or two checks and be done with the deployment. Boom.
If you’re using the 60/40 formula mentioned earlier, for example, you could write one $10,000,000 check to Vanguard and deposit the money into their balanced index fund.
Even if you’re using a slightly more complicated asset allocation formula, you can probably be done with your asset deployment is less time that it takes to make a pot of coffee. No kidding.
This scalability matters when you’re talking bigger numbers. Yet the benefit isn’t always appreciated.
Easier Successions
And here’s another benefit to using index funds and asset allocation formulas if you’re talking about a lot of money: Easier successions.
With a simple index-funds-and-asset-allocation-formula approach, you’ve got a strategy that will continue to work pretty darn well even as your life changes and even when your heirs find themselves managing the money.
This makes sense, right? You may make great money with a farm or rental property or some active investment category. But you can’t be sure your spouse will do as well or want to shoulder the burden if something happens to you.
Further, at some point obviously, you may pass your wealth to heirs who will probably be less interested or less able to deal with a specialized active investment strategy.
Indexing and allocating, however, should be pretty transferable skills. Someone could probably read a book or two and be ready to take the reins. And note that with an indexing-based approach, taking a few weeks or even a few months to read through these books shouldn’t cause any problem. An index funds approach will probably very nearly be on autopilot during any learning curve ramp up.
Note: I would recommend someone interested in using indexing and allocating read John Bogle’s Common Sense on Mutual Funds book (click here) and then, if more information is desired, read David Swensen’s Unconventional Success (click here).
A side note: The reason that succession is maybe a bigger issue with bigger dollar portfolios is that the bigger dollar investment portfolio may more likely remain intact. A modest portfolio might very reasonably be liquidated and then consumed by heirs.
Systematic and Procedural
At least one other benefit, I think, occurs when a high income or high net worth investor selects the index-funds-and-asset-allocation-formula approach. That benefit is that the approach more easily allows the investor to systematize and procedural-ize investment management.
This idea maybe sounds a little funny at first. But let me share what I’ve observed.
If you or I only need to worry about a modest amount of money, we probably don’t need to be that efficient. Sure, efficiency is good. But in many cases, saving X percent in costs here or reducing the annual time requirement by Y percent doesn’t make all that noticeable a difference.
Furthermore, if a modest portfolio is a little messy, hey, a small mess is easy enough to deal with.
If the numbers get big, however, you have to manage your investment portfolio the same way a well-run business is managed. You want to use systems to keep costs down and work quality high or at least adequate.
You possibly also need to use procedures and policies to assure that what you want to happen actually happens.
Now if you are using some active investment strategy—like rental real estate just for example—you can design and then set up these systems and procedures yourself. That works.
But most people will probably find it easier to systematize and procedural-ize a portfolio of index funds than a collection of active investments like rental properties, investment partnership interests, or small businesses.
Think a bit about the systematization baked into the index-funds-and-asset-allocation-formula approach.
The index funds approach means a computer system makes investment decisions. Automatically.
The index funds approach means that bookkeeping for the investment income, deductions, gains, and losses gets totally outsourced to a low-cost, back-office operation at some mutual fund company. Automatically.
Furthermore, the mutual fund management companies, regulators, and public accounting firms implement procedures at a bunch of different places in the process to safeguard your investments. Without any intervention required on your part.
In summary, an index funds approach way more easily lets someone create a clean, cookie cutter process. And that process should mean you’ve got a much more robust process and system to deal with a large portfolio.
Final Clarification
So does the foregoing mean that high income high net worth investors shouldn’t engage in active investments?
No, heavens no, I’m not saying that. We need these people to make the sorts of active investments they do. Their active investment activities power our economy and provide the rest of us with products and services we want.
But I am saying the indexing and allocating approach works really well for the high income and high net worth investor—often better than these people understand. And probably this approach should be the default choice made by more high income and high net worth investors.
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Great post! I would add that the ultra-wealthy also benefit much more from the additional tax-efficiency inherent in income funds. Low-income investors don’t even pay taxes on qualified dividends and long term capital gains. But for a high-income investor, becoming more tax-efficient really boosts the only returns that matter.
Important point White Coat Investor, thank you. I totally agree that with higher marginal tax rates, that tax efficiency matters even more.
That should have been another benefit I mentioned. Er, is it ironic that an emergency physician is one who needs to make this point in a blog post written by tax CPA? Oh-oh.
When I read your heading, I thought the main point of the article would be about the tax efficiency. Probably the biggest point because tax planning and simplicity two major things affluent investors want.
I’m not sure if I’m understanding your point–sorry–but to paraphrase the blog post a bit, index funds give high income high net worth investors a way to easily scale up, to more easily deal with succession and to cleanly systematize their portfolio.
This stuff doesn’t matter that much when you’re talking average investor. But if the dollars get big, scalability, succession and systemization do matter.
Excellent article, Steve.
With regard to succession, I would note that even a moderately complicated asset allocation (say 4 to 12 asset classes) is more than some heirs will want to keep up with. Therefore, it’s good policy to offer heirs an ultra-simple fallback position. For example, “move all the money to Vanguard Wellington Admiral shares with dividend reinvestment.” Or if you want to stick with the index fund model, “move all the money to Vanguard Balanced Index Admiral shares with dividend reinvestment.”
It wouldn’t hurt to talk with heirs about this in advance to see whether they grasp basic investment principles, or whether they may need additional guidance to stay out of trouble.
Good points, Art. Thank you.
In your hypothetical, would you be concerned about having all $10 million at one place (i.e., Vanguard)? (This is what I’m literally doing re indexing and single location, though not as much as $10 mil. I have to fight at times the feeling of oh *#&@, what if that goes down. Keep myself from imitating a squirrel putting its nuts in multiple places. I guess if Vanguard goes down, there’s likely to be bigger problems though.)
Good question… Here’s my feeling: I don’t think you or I need to worry much about having all of our stuff at Vanguard (or Fidelity or Schwab or any other big, closely watched institution).
This big guys are very visible in what they do for one thing. And for another thing, lots of big other sophisticated players carefully watch over the big guys like Vanguard et. al.
BTW there are also some risks and hassles to have accounts scattered about even a small handful of places even if doing so sort of diversifies some sort of “custodian” risk…
One of the problems we as tax accountants regularly pull our hair out about, for example, is dealing with stuff like wash sale rules when some investor has seven different accounts at six different investment firms. Yikes. Another problem is that it is more work to keep track of a bunch of different investment accounts.
Final comment related to your comment: It probably is important for all of us to keep a careful eye on our custodians.
Your question seems to be coming from the “don’t put all your eggs in one basket” mantra. Some investors let that confuse them. You could spread you assets over 10 custodians. But if they are all in one stock, say Apple, or one category, such as small cap, you would be closer to putting ” all your eggs in one basket” than if you were properly diversified at one major custodian. Even if Vanguard went down, chances are your money wouldn’t be gone. The assets are yours, not Vanguards. If Vanguard were public and you could buy their stock, then you would have problems if they “went down”.
@Brandon – I think the risk of even the biggest, blue-est chip providers like Vanguard failing is very real. I had a bad experience with MF Global, for instance (run by the former head of Goldman Sachs, after all – more fool me). I’ve written about the risks I worry about, and what I do about them, at http://firevlondon.com/2015/05/27/whats-the-worst-that-can-happen/
I would not describe MF Global as big or blue-chip.
That said, and to your point, John Corazine (the former Goldman Sachs CEO and former US Senator running MF Global) was certainly not a Bernie Madoff clone.
I think you overlook three important considerations: 1. when buying an index you wind up owning companies you may not otherwise be comfortable with and wouldn’t buy if you invested in individuals stocks, 2. if you invest all your funds at once you have to accept the valuation of the underlying stocks, and 3. if you needed to rely on the portfolio for income (as opposed to have to liquidate holdings to fund living expenses) it is rather difficult to earn enough of a yield to make that work using index funds (maybe most funds other than closed-ended funds) and the dividend distribution is subject to more volatility then if you held held the shares directly.
Not one approach fits all investor profiles.
I agree with you that no one approach fits everyone (e.g, see last paragraphs of post)… No argument there.
Where we disagree, obviously, is that I think passive investing makes more sense for most people… and then that passive investing makes “more” more sense for a wealthy or high income person.
Thanks for the reply Steve.
I wasn’t suggesting that what you articulated doesn’t make sense, I just think it would be worthwhile for people to appreciate the downside as well as the upside. I use index funds/ETF’s to diversify into areas I don’t understand well, such as small cap and international so, I appreciate the argument you make.
Sparky…-
Sparky, Fair enough! And thanks for your perspective.
Regarding your third point, you wouldn’t live off just your dividend or even bonds. Many investors now realize that they can live off total return. You ‘manufacture dividends’ by selling long term shares to supplement your dividend yields. This enables you to get the cash flow you need, and possibly at a lower long term capital gain rate.