Re: investment advice?

Gordon Irlam (
Tue, 11 Nov 1997 03:31:57 -0800 (PST)

> I guess what I'm really asking is, what's your philosophy on
> investing? Any insights or useful experience?

This is something I've just started learning about over the last 3-6
months. I'll share my thoughts and notes on the topic in the hope
that people's criticisms will allow me to learn more.

Until recently I never had enough money to make it worthwhile to
bother worrying about investing. All of my money was sitting in the
bank, and was slowly earning interest (and losing value). I recently
got to the point where I had saved up enough money to make it
worthwhile to invest more carefully. I was a little slow in doing
this, since I wanted to try and understand everything first and avoid
making any mistakes. There was also a small cutural hurdle to
overcome; originally coming from Australia I had far less of a basic
understanding of investment options than a typical person in the US.

Below are my personal notes on investing (mainly in mutual funds),
interspersed with a little commentary I have just now written.

I'm also starting to learn about investing in stock. If anyone has
any words of wisdom on this I'd be interested in hearing. (My
motivation isn't so much investing, as it is to be able to understand
when to cash in my stock options if/when Cygnus goes public. I'd like
to dable a bit before then to get an idea of how things work, and
how companies are valued.)



The first thing to do is figure out how much time you should be
spending trying to figure out how to invest your money.

For me the figures looked like this (you will need to compute an
equivalent set of figures for yourself):

How much time to spend investigating investment options

Increasing the yield on $100k by around 1% translates into around
$600 per year after tax. Presently, my rate of pay is around
around $30 per hour after tax. Thus, I would be justified in
spending around 20 hours per year if it allowed me to increase the
yield on $100k by just 1%.

As a practical matter, obtaining an expected yield of somewhere
around 12% is relatively easy. Comparing this with a bank, which
might pay around 5.5%, this represents an increase in yield of
around 6%. On $150k, this would translate into around $9k year,
or the equivalent of 7-8 weeks labor. Boosting the yield much
beyond this however becomes extremely difficult. An increase of
0.1% would still however justify spending around 5 hours per year.

Next, you need to get a basic understanding of inflation. This is so
you can understand the actual rates of return you are getting by
investing, rather than nominal non-inflation adjusted returns:


Inflation is the rate at which the value of money decreases. The
Consumer Price Index measures inflation.

1926-1995 CPI 3.2%

In the 1970's, and through to 1981, the CPI was extraordinarily
high. It is now back to historic levels.

1950-1960 CPI 2.1%
1960-1970 CPI 2.7%
1970-1980 CPI 7.8%
1980-1990 CPI 4.7%
1990-1996 CPI 3.1%


The stock market has a lot of variability. Any particular 5, or even
10 year period can offer returns quite a bit higher or lower than
average. To be able to compute expected returns it is necessary to
take a very long term perspective. I found the following long term
data in a magazine I was reading:

Returns on cash versus equity

Cash returns are for short term treasury bills. Equity returns
are for stock.

Real returns are the returns after adjusting for inflation.

The long term return on equity exceeds that of cash. The real
return on cash has been very low in recent times (last 70 years).
In the 1970's when inflation was very high the real returns on
cash were negative. The real returns on equity have been fairly
constant over the last 200 years.

1802-1871 1872-1925 1926-1995
Real return on cash 5.4% 3.3% 0.7%
Real return on equity 8.5% 8.2% 8.9%

Investing in equity entails a higher risk. The variability in the
real returns are far greater:

Cash 1802-1995: 3.1% +- 6.1%
Equity 1802-1995: 8.5% +- 18.1%

However, over a long time period, a loss in the value of equity in
one year tends to be made up for by a gain in another year. This
is less likely to happen for cash. Investing in equity over a 20
year period the variability is slightly less than it is for cash:

Cash 1802-1995: 3.1% +- 2.9% (20 year interval)
Equity 1802-1995: 8.5% +- 2.8% (20 year interval)

Current estimates of the real rate of returns on new short term
government securities, as well as long term government bonds are
3-4%. Equities have historical yielded an 8% return, giving them
a 4% advantage over cash.

[Source: Journal of Economic Perspectives, 11:1, p191, 1997.]

Based on this, to compute expected returns, I have chosen to use the
following data:

Key data 1997

Inflation rate: 3.2%
Expected return on cash: 3.1% real, 6.4% nominal
Expected return on equity: 8.5% real, 12.0% nominal

The next observation to make is one regarding the way the tax system
works. If an asset is held onto for multiple years without any
capital gains being realized, it will be worth more than if any gains
are taxed each year. This is because any gains can themselves be used
to earn further gains, but these overall gains only end up being taxed

For long term investing, this effect is probably far more significant
than you might expect. I wrote a small Perl program to compute it's
significance. Over 30 years it increases a 4.5% annual return to
7.0%. The full results are shown below:


Should hold onto assets long term if possible, so that as much as
possible income doesn't suffer from repeated taxation.

Tax rate = 35.0% Appreciation rate = 12.0% Inflation rate = 3.2%

yearly taxation final year taxation

real real real real
year increase rate increase rate
1 4.5% 4.5% 4.5% 4.5%
5 24.4% 4.5% 27.8% 5.0%
10 54.7% 4.5% 72.9% 5.6%
15 92.3% 4.5% 143.6% 6.1%
20 139.2% 4.5% 252.6% 6.5%
25 197.5% 4.5% 418.7% 6.8%
30 270.0% 4.5% 670.5% 7.0%

[Source: "tax" file]

There is an additional advantage to holding onto assets long term.
You can largely control when capital gains are realized so as to
minimize taxes. (But, I'll spare you my notes on the tax system).

Unless you have a lot of time available to perform market analysis,
and are skilled at doing so, should probably invest in a mutual fund,
rather than investing in stocks directly. If you plan to invest in
stocks directly, you should have a lot of money to invest so that you
can justify the time you are spending making investment decisions.
Otherwise is probably cheaper to pay someone who is a professional at
investing in stocks to make such decisions for you. This is what
mutual funds are all about:

Mutual funds

Mutual funds are pools of money that are invested in stocks or
other securities. The value of the fund is equal to the value of
the securities held by the fund.

In an open ended fund additional securities making up the fund are
bought or sold in direct response to investors purchasing or
redeeming shares in the fund.

Mutual funds always pass through any dividends they receive and
any capital gains that they recognize. When these are paid the
value of the underlying shares is reduced accordingly.

Should invest in a fund that pays minimal dividends and captial
gains, so that it is possible to time when to recognize income as
a long term capital gains, and as a result to time any income to
occur during periods of lower taxation. Also makes it possible to
move to a different state or country to avoid at least the state
tax on long term capital gains.

The next decision to make is a managed versus an index fund. For me
an index fund seemed to make the most sense for the reasons I have
outlined below. There is however one serious caveat. Index funds
won't work for everyone. They only work today, because sufficently
few people seem to use them. In 10 years time if lots and lots of
people are using them, then I would recommend switching to a managed

Managed funds

Managed funds change the stocks making up the fund in an attempt to
seize market opportunities.

Index funds

Index funds simply buy and typically hold onto a basket of funds that
corresponds to a particular market index.

Index funds have several advantages over managed funds:

- lower overheads (0.5% rather than 1.5% per annum)
- lower turnover of stocks, and so lower passed through capital gains
(capital gains must always eventually be realized, but it is
preferable to be able to control when they occur)
- managed funds can't in general beat the market; as the market
grows as many investors must do worse than average as do
better; if managed funds did better than the market average
investors should flock to them until they composed a
sufficient proportion of the market as to represent the
average; index funds are able to at least track the market
- less risk of picking a poor fund, and less time spent trying
to figure out how good a particular fund is

Index funds have one disadvantage:

- If a sufficient proportion of the market ever comprises index funds
then stock investment decisions will cease to be made
rationally, and opportunities will exist to subvert the
operation of index funds; if index funds comprised 15% of
the market for instance a company with very little value
could IPO by only releasing 10% of its stock to the public,
and holding 90% in reserve; this would force the price of
its stock very high as index funds attempted to acquire it;
they could then sell an additional 5% at high rates; and
then dump the rest causing the stock value to plunge; index
funds will still track the market average performance, but
this performance will be bogus, and managed funds will then
be able to exceed the performance of index funds; the
holders of the original stock that IPO'ed will do worse than
the market average, but still profit handsomely

Only an additional $16 billion was invested in index funds in
1996, out of a total additional investment in mutual funds of $222
billion. Thus this problem doesn't appear very likely to occur.

[Source: Consumer Reports, May 1997].

I also estimate the total US stock markets value at roughly $10
trillion (Merck is number 6 on the top 10 companies, these
companies total 13% of the market, and Merk is valued at $111
billion). Consequently index fund investing probably constitutes
less than 1% of the total market.

The present lack of any problem is confirmed by the fact that
today index funds typically appear to beat managed funds, so no
problems seem to be occuring.

[Source: Index Investing, The Vanguard Group pp 8, 13.]

The next question is which index. There are a lot of market indexes
that aren't very meaningful (Dow Jones for instance). I confined
myself to domestic indexes that seemed to be somewhat meaningful.
There are probably also meaningful internation indexes which I didn't


Some common market indexes:

S&P 500 - stock value of the 500 largest US companies
S&P BARRA Value - stock value of the dividend oriented S&P 500 companies
S&P BARRA Growth - stock value of the growth oriented S&P 500 companies
(Each S&P 500 company appears in either the Value or the Growth
index, depending on it's price-to-book ratio and dividend yields)
Wilshire 5000 - stock value of all US companies
Wilshire 4500 - stock value of all but the 500 largest US companies

There doesn't seem to be any apriori advantage of any one index
over any other. It is theoretically plausable that growth
oriented stocks should offer a higher average return in tradeoff
for their higher volatility, but it isn't clear whether this is
born out in practice.

Investing in a growth oriented index, such as the S&P BARRA
Growth, should have the advantage of lower dividends. With such
income instead turning into unrecognized capital gains, at least
until the shares are sold.

Investing in as broad an index as possible, such as the Wilshire
5000, has the advantage that turnover of stocks should be lower,
since companies will be less likely to be entering and leaving the
index. This should reduce any unplanned capital gains.

Investing in indexes including small companies increases the risk
of the shares being misvalued by index investing.

The next question. Which mutual fund company was surprizingly easy for
me to decide on. I turned to Consumer Reports, and learned about the
Vanguard Group.

One of the big advantages to me seemed to be that that they are owned
by the investors who are investing in the mutual fund, rather than by
any outside company. (A bit like a credit union but for mutual
funds). As a result you don't have to invest time guarding against
the risk (and the mutual fund companies goal) of taking as much of the
your gains as possible to line their own pockets.

Mutual fund companies

Vanguard appears the best mutual fund company. It is non-profit, or
rather owned by the investors. It has very low overheads. It was
included in virtually every category of top funds by Consumer Reports.
The annual overheads are around 0.2% on most of Vanguard's index
funds, versus 0.5% for a typical index fund, and 1.5% for a typical
managed fund.

[Source: Consumer Reports, May 1997.]

What are good criteria for deciding between different mutual funds:

Fund stability

Investing in a large established fund has several advanatages:

- the fund is likely to continue to be around for some time
(if a fund ceases to exist, or is merged with another fund
this could result in large unplanned capital gains)
- the overheads of the fund will be lower

Ideally, would want to expect the fund to be around for 20-30
years. For an index fund, this requires the fund be based on an
index that is likely to survive this time period.

Large probably means at least $1 billion in size for an index
fund. Perhaps, $4 billion for a managed fund, where investors are
more likely to switch funds.

Unless you are really hard core I recommend skipping the following
long section. It deals with mutual fund taxation issues. It is very
much my stream of conciousness, and my notes to myself when I was
trying to figure out how mutual funds are taxed. If you are really
hard core, I would mind if you could read it, and let me know where
I am on track, or if I have any confusion.

Taxes and tax managed funds

Some new funds are managed with a goal of reducing unplanned
capital gains. This is an excellent idea. Unfortunately it isn't
clear whether such funds are as yet sufficiently mature to
consider. The largest Vanguard tax managed index fund only
comprises $500 million, and has only existed for a little over two

Consequently tax managed funds, do not presently meet the desired
level of fund stability.

In their current form, tax managed funds do not attempt to prevent
future investors inheriting unplanned capital gains that the fund
incurs as a result of trading underlying securities purchased on
behalf of previous investors. This is a general problem. It is
not specific to tax managed funds. An important consideration
before investing in any fund is the extent of unrealized capital
gains the fund is carrying. These capital gains will be passed on
to future investors.

Mutual funds always pass through any dividends they receive and
any capital gains that they recognize. When these are paid the
value of the underlying shares is reduced accordingly. Both of
these payments are taxed. Mutual funds never pass through capital
losses. Instead these are held onto by the fund to offset future
capital gains. It is normally wise to avoid purchasing into a
mutual fund right before the dividend or capital gains payments
are due, since normally you will not benefit by immediately being
required to pay tax on the returned part of your investment.

If investors start to leave any fund, not just a tax managed fund,
the fund may need to sell of it's assets to be able to redeem it's
shares. As a result the fund could realize significant capital
gains, that must be born by the remaining investors. This could
increase pressure on the remaining investors to leave the fund,
thus further increasing the pressure on investors to leave the
fund. This appears a problem.

(It is possible that a big part of the cause of this problem is
possibly mutual funds may need get to offset the capital gains
realized by investors on the shares they sell. In which case
capital gains by mutual funds end up getting taxed twice. Once by
the person selling the shares in the mutual fund, and once by the
remaining stock holders in the mutual fund when the mutual fund
passes through the capital gains from it's sale of the underlying
securities. I suspect things aren't this stupid, but I haven't
seen anything that actually verifies that this does not occur, so
some caution is required.)

The more likely, less severe, but more general problem is simply
that new investors in a fund are forced to share in the ultimate
realization of capital gains incurred by existing investors.
Money from new investors is not kept separate, and so existing
investors get to offload some of their capital gains to new
investors as the fund turns over. When the fund realizes capital
gains in response to turning its stocks over, it pays the gains
out to all investors, irrespective of the length of time they have
held their stocks. That is, the gains are paid out to investors
whose shares have not appreciated to substantially the same
extent, as the gains that are being paid out.

On more careful consideration things don't really appear all that
bad, because the initial investor still has to recognize their
remaining gains once they finally sell their shares. In addition
a new investor that receives and has to pay tax on an unwanted
gain, will, when they sell their shares, be able to claim the loss
in value in their shares corresponding to the gain they were paid
as a capital loss, that can be offset against future gains.

(For example investor A purchases a share at $10. It appreciates
to $100. Investor B then also purchases a share at $100. Now
imagine the value of the underlying securities doesn't change, but
they are turned over, and both investors A and B each receive a
$45 capital gain payment, corresponding to the $90 capital gain
recognized by the mutual fund companyi (original basis $110, new
basis $200). The two shares are now each worth $55. When A sells
they will realize a $45 capital gain. When B sells they will
realize a $45 capital loss. Thus A's total gain is $90, and B's
total gain is $0, which is the same as what they respectively
realized on the underlying securities).

(In some circumstances this could even be useful. For instance if
you were in a very low tax bracket one year, but expected to be in
a higher tax bracket in a future year, you could purchase shares
known to be about to pay a large capital gain, pay tax on this
gain at a low rate, and then in a future year realize a capital
loss against a capital gain made while in the high tax bracket.)

Ways to avoid this possible problem with mutual funds, are to be
aware of it, and if it appears to be happening possibly leave the
mutual fund. Not having capital gains payments from the fund
automatically reinvested in the fund also helps, since this
ensures investment in the fund will incur undeserved tax on
capital gains at most once, as opposed to the worst case, in which
the payment gets reinvested only to again inherit capital gains
and get taxed again and again. Also, investing in a mutual fund
with a low turn over will reduce the likelyhood of this happening.
Additionally, it is wise to avoid funds with a large capital gains
tax liability.

Note that Vanguard's book on mutual funds and taxes says if you
are using the specific identification method for determining your
taxes on mutual funds, you should notify the mutual fund company
in writing, as well as carefully instructing them on which shares
to sell. This may be a legal requirement, since without this
information, the mutual fund company may not know how, and the
extent to which to, offset the capital gains you realize on the
sales of shares, against the unrecognized gains they are holding.

It is recommended that shares be taxed using the "Specific
Identification" method since this provides the opportunity for the
lowest taxes. To keep the paperwork to a minimum with this method
it thus makes sense that both dividends and recognized capital
gains be paid out in cash, rather than invested in additional
shares. Shares should also be purchased in single large lots,
rather than on an ongoing basis. The mutual fund company should
be informed of this taxation method.

[Sources: Some Mutual Funds Contain Hidden Time Bomb Of Tax Liabilities
For Investors,
Taxes and Mutual Funds, Vanguard.]

Now, onto my examination of the different Vanguard index funds:


*** Vanguard Total Stock Market ***
index: Wilshire 5000
- $3.53b net assets
- $1.5b annual share purchases
- $78m annual share redemptions
- carrying $745m in unrealized capital gains
- ~3% annual portfolio turnover
- ~0.6% annual realized capital gains
- ~2.0% annual income
- ~0.22% expense ratio
- 16.0% average return since 1992
- 0.6% projected realized capital gains (3% x 21%)
- ~2.0% annual income
- 5.2% redemptions to sales ratio ($78m / $1.5b)
(results in low turnover and thus low realization of
capital gains; suggests size of fund will increase and
thus overheads will drop; suggests long term future for
- 21% of assets in unrealized capital gains ($745m / $3.53b)

*** Vanguard 500 ***
index: S&P 500
- $30.3b net assets
- $9.7b annual share purchases
- $1.2b annual share redemptions
- carrying $8.46b in unrealized capital gains
- ~5% annual portfolio turnover
- ~0.4% annual realized capital gains
- ~2.5% annual income
- ~0.20% expense ratio
- 15.0% average return over last 10 years
- 1.4% projected realized capital gains (5% x 28%)
- 12% redemptions to sales ratio ($1.2b / $9.7b)
- ~2.5% annual income
- 28% of assets in unrealized capital gains ($8.46b / $30.3b)

*** Vanguard Extended Market ***
index: Wilshire 4500
- $2.10b net assets
- $692m annual share purchases
- $396m annual share redemptions
- carrying $535m in unrealized capital gains
- ~15% annual portfolio turnover
- ~3.0% annual realized capital gains
- ~1.6% annual income
- ~0.24% expense ratio
- 15.3% average return since 1987
- ~1.6% annual income
- 3.8% projected realized capital gains (15% x 25%)
- 25% of assets in unrealized capital gains ($535m / $2.10b)
- 57% redemptions to sales ratio ($396m / $692m)
- risk of index investing misvalueing stocks

*** Vanguard Small Capitalization Stock ***
index: Russell 2000
- $1.71b net assets
- $890m annual share purchases
- $367m annual share redemptions
- carrying $267m in unrealized capital gains
- ~28% annual portfolio turnover
- ~4.5% annual realized capital gains
- ~1.5% annual income
- ~0.21% expense ratio
- 12.3% average return since 1989
- ~1.5% annual income
- 15% of assets in unrealized capital gains ($267m / $1.71b)
- 4.2% projected realized capital gains (28% x 15%)
- 41% redemptions to sales ratio ($367m / $890m)
- risk of index investing misvalueing stocks
- index may cease to be popular

*** Vanguard Value ***
index: S&P BARRA Value
- $1.02b net assets
- $598m annual share purchases
- $221m annual share redemptions
- carrying $176m in unrealized capital gains
- ~30% annual portfolio turnover
- ~1.4% annual realized capital gains
- ~2.8% annual income
- ~0.20% expense ratio
- 18.6% average return since 1992
- 17% of assets in unrealized capital gains ($176m / $1.02b)
- 5.1% projected realized capital gains (30% x 17%)
- ~2.8% annual income
- 37% redemptions to sales ratio ($221m / $598m)
- small fund size ($1.02b)
- index may cease to be popular

*** Vanguard Growth ***
index: S&P BARRA Growth
- $787m net assets
- $559m annual share purchases
- $148m annual share redemptions
- carrying $144m in unrealized capital gains
- ~28% annual portfolio turnover
- ~0.8% annual realized capital gains
- ~1.7% annual income
- ~0.20% expense ratio
- 15.8% average return since 1992
- ~1.7% annual income
- 18% of assets in unrealized capital gains ($144m / $787m)
- 26% redemptions to sales ratio ($148m / $559m)
- 5.0% projected realized capital gains (28% x 18%)
- small fund size ($787m)
- index may cease to be popular

Summary of fund models / projections

Income Real. Gains Tot. Return Size Turnover
Total Stock Market 2.0% 0.6% 2.6% 16.0% since 1992 $3.5b 3%
500 2.5% 1.4% 3.9% 15.0% last 10 yr $30.3b 5%
Extended Market 1.6% 3.8% 5.4% 15.3% since 1987 $2.1b 15%
Small Cap. Stock 1.5% 4.2% 5.7% 12.3% since 1989 $1.7b 28%
Value 2.8% 5.1% 7.9% 18.6% since 1992 $1.0b 30%
Growth 1.7% 5.0% 6.7% 15.8% since 1992 $0.8b 28%

[Source: Vanguard Index Trust Annual Report 1996,]

And my final decision:

Fund Selection

For a regular investment fund (as opposed to 401k / IRA / pre-tax)
fund the Vanguard Total Stock Market fund stands out as an
excellent fund for my needs. It is based on the Wilshire 5000
IdxTot index of total market capitalization. It should offer a
good return. It appears very stable, both in terms of being a
very robust index that is not likely to plummit, and in terms of
the funds size and likely longevity. It has very low overheads.
It will also likely realizes minimal total income and gains. This
will allow the capital to appreciate by itself, and this
appreciation to largely occur untaxed until redeemed. It also
allows capital gains to be realized strategically, at times of
possible lower capital gains tax. Like most other index funds it
is also a hands off investment, that should require relatively
little time and attention on my part.

Should elect to use the specific identification method for
taxation, and need to inform Vanguard of this at the time shares
are purchased.

Should invest long term if possible (10-20 years, or until the
funds are required), so that capital gains are not repeatedly