In defence of the ‘Boglehead’ index-fund investing philosophy

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Earlier this week, a column appeared on Globeinvestor.com that many readers feel was riddled with questionable assertions.

I agree.

As quoted in "Can a 'Boglehead' Approach to Investing Work?" two financial services professionals challenged a portfolio strategy known as the Bogleheads' investment philosophy. ("Bogleheads" take their name from Vanguard Group founder John Bogle and favour index investing.) This philosophy is mainly composed of the following simple principles:

1. Live below your means
2. Save to a portfolio early and often
3. Choose an asset allocation that has some risk, but not too much
4. Diversify
5. Use low-cost index funds
6. Minimize taxes
7. Don’t try to time the market
8. Invest with simplicity
9. Stick to the plan.

While the Boglehead philosophy encompasses more than just investing with simplicity, the column partially focused on the idea of the three-fund portfolio. The typical three-fund portfolio might consist of allocations to U.S. stocks, international stocks, and fixed income for American Bogleheads.

For Canadian investors, a popular allocation would be 20 per cent Canadian stocks, 40 per cent U.S. and international stocks, and 40 per cent fixed income (see CanadianCouchPotato.com for some model portfolios).

The number of funds is actually somewhat irrelevant. It just so happens that many hardline couch-potato proponents (essentially the equivalent of a Boglehead), need only three index funds to capture the benefits of many of the other principles. If you can achieve your portfolio objectives with three funds instead of five, you would pick the three funds. If you can achieve them with two, you would pick two.

The quotes from the professionals seemed to steer the column into beating the now dead horse argument of active versus passive investment management. Defenders of active management tend to avoid citing facts and instead often extend unsupported claims. One professional that was quoted likened exchange-traded fund investments in 2008 to train wrecks. Assuming he meant index funds (since ETFs can be either passively or actively managed), it's worth repointing out that the average passively managed dollar beats the average actively managed dollar in bull markets, bear markets, and sideways markets since all active investors collectively are the market. And since the index investors pay lower fees for the same gross market returns on average, as a group they win.

This doesn't preclude some managers from outperforming their benchmarks, but we're looking to identify those outperformers in advance. The same quoted professional acknowledged the difficulty in forecasting, noting "we don't know what the winners or losers are going to be in the future." When asked for a hypothetical three-fund solution, he then provided only actively managed funds.

The other quoted professional in that column describes index investors using a three-fund approach as being drastically overdiversified. This isn't really possible for an index investor. Assuming costs are kept low and tracking error is tight, more holdings aren't really a concern at all. More holdings can even reduce tracking error.

There are more debatable items in that column, but it might be best to suggest the overarching reason. One quote excerpt indicated "buying three index funds won't be the answer to making money for clients in these market conditions." Replace "clients" with "intermediaries" and you'll know why.

The Bogleheads' approach and professional financial advice are not mutually exclusive. In fact, the best bang for your buck when working with a financial adviser is likely to be with one who espouses most, if not all, of the principles of the Boglehead investment philosophy.