How did a passive fund manager like Vanguard come to manage nearly $5 trillion worth of assets via passive investing in stock market? In fact, John Bogle of Vanguard has never believed in the ability of markets to consistently generate alpha. Over time, active managers only perform marginally better than the passive managers. Even within the active managers, the number of fund managers who underperform the index are substantially larger than those who outperform. That means it is not only difficult to beat the market but it is more difficult for the investors to identity and bet on a fund manager who can consistently beat the index. That is the crux of Vanguard passive investing.
To overcome this challenge, Vanguard has a 7 point model for passively investing in the market..
How does this 7 point Vanguard model work in practice?
Step 1: Vanguard advises that individuals must always start building their portfolios by identifying the right mix of asset types. That way, investors will have a lot more control over the entire asset allocation process and also over their investments. Asset allocation is a detailed process. It begins with broad asset classes and then becomes as granular as possible. Within equity funds there are diversified funds, thematic funds, sectoral funds, global funds etc. Within debt funds you have credit opportunities funds, long term funds, G-Sec funds, floating rate funds etc. These choices are part of your asset allocation.
Step 2: No asset allocation process is complete unless you make diversification the basis of your asset allocation. As a long term financial plan the focus should be to minimize the risk to the extent possible and that can be done through diversification. Of course, the returns will then take care of themselves. You do not need to make an effort.
Step 3: Most investors do not realize but transaction costs, impact costs, liquidity costs, tax costs, statutory costs all eat away a substantial portion of your returns. This impact is more visible over longer periods. Just as your returns compound over time, similarly your costs also compound over time. This makes earning above average returns all the more difficult for the investor.
Step 4: One of the guiding principles of Vanguard is that the longer you have to meet your goals and for your investments to grow, the less you need to worry about the performance of your portfolio on a short to medium term basis. In other words, the time at your hand and the need to monitor short term performance are inversely related. Vanguard also highlights the importance of proper benchmarking. According to Vanguard, majority of fund manages fail to beat the broad-based indices like the Dow Jones, Nikkei and Nifty. But if you consider factors like higher risk taken by fund managers and the Total Returns Index then hardly a handful of fund managers can beat the index. If you have time at hand then a passive strategy will work equally well for you.
Step 5: According to Vanguard, a very critical part of their method is to continuously monitor the portfolio and rebalance if required. What most investors fail to realize is that there are two kinds of risk here. Firstly, your own risk appetite may go up or come down based on circumstances. Secondly, the risk of your portfolio may change either due to too much concentration or due to overvaluation of the market index. This calls for appropriate rebalancing. Vanguard believes that these rebalancing activities should be as automated and rule-driven as possible.
Step 6: Vanguard adequately emphasises investing at regular intervals rather than invest in lump-sum. The regular investing automatically gives you the benefit of rupee cost averaging and therefore reduces your overall cost of holding investments. This will help you reach your goals much faster than you may have originally envisaged. Secondly, Vanguard emphasises that the beauty of passive investing is that it is a lot more about discipline rather than about stock selection or fund selection.
Step 7: The most important phase according to Vanguard is to actually prioritize your goals. You have multiple goals and hence you need to decide which you need to focus on first and how to proceed. Vanguard actually provides a 4 step prioritization plan. Firstly, you need to plan your retirement as you are better off starting off as early as possible. Secondly, you need to pay off your debt, especially the high cost debt that can push you towards a financial bankruptcy. Thirdly, your priority is to create an emergency fund to see you through in tough times and as insurance against exigencies. Lastly, you can save for college and education needs. Once you get these priorities right, goal selection is hardly a problem.
Summing up the Vanguard way..
If one were to sum up the Vanguard approach there are 3 things that come out very clearly in terms of action inputs for investors..
Firstly, you need to adopt a financial planning approach to your investments. Never undertake investments as a stand-alone activity and always let it be built into the superstructure of your financial plan.
Timing the market is pointless and hence investors may focus more on discipline and regularity. If these two principles are adopted then the investor automatically gets the benefit of rupee cost averaging.
Thirdly, since the focus is to keep costs low a passive approach or indexing approach will work best for investors. That, in a way, is the essence of the Vanguard way of investing for the future!