What does financial success look like for your clients? Is saving and investing about becoming wealthy, or is it really about securing a reasonable retirement, putting children through college, or buying that first home? Whatever your clients' definition, how do you define the process by which they can succeed?

Andy Clarke, author of Wealth of Experience: Real Investors on What Works and What Doesn't,1 recently sat down for an interview to explain Vanguard's Principles for Investing Success.

Clarke, a principal and senior investment strategist in Vanguard Investment Strategy Group, explained how these principles can apply to all types of clients, from beginning investors to institutional portfolio managers. Below is an excerpt from the interview:

Question: Please explain the principles.

Andy Clarke: There are four principles. The first is goalscreate clear, appropriate investment goals. The second is balancedevelop a suitable asset allocation using broadly diversified funds. The third is costminimize cost. And the fourth is disciplinemaintain perspective and long-term discipline.

We first published these principles in 2013, but they've been around in some form since Vanguard opened its doors in 1975. And you can actually trace them back even further, to Vanguard Wellington™ Fund, the nation's first balanced fund, which was launched in 1929.

Q: Why would these principles be important today?

Andy Clarke: While they are timeless, I think what changes is how you apply them to the current environment. So today we're in the middle of a stock bull market, and conversations about balance, for example, are about remembering why you have bonds in your portfolio. Stocks are returning double digits; bonds are returning about 2 percent. Why would you want to hold bonds? Well, we have to remember that bonds are there to play a role in the portfolio. They can cushion the portfolio against the stock market's occasional and inevitable downturns.

If you go back to 2008 and 2009, during the global financial crisis, the principle is the same, but the conversation is very different. Back then, the conversation was about sticking with an allocation to stocks even though stock prices were tumbling.

Q: These principles sound pretty intuitive, but there is more to them. Let's discuss each one briefly. What does it mean to have investment goals?

Andy Clarke: A goal is what the client hopes to accomplish with investing. So for individuals, common goals include helping to finance a child's education or, for all of us, saving for retirement.

Q: Let's talk about retirement, Andy. That's a big one for everyone. The first step in there seems to be, how to figure out how much you're going to need? How can advisors help clients estimate that?

Andy Clarke: Retirement can be challenging. I mean some goals, like education, are relatively straightforward. You know what tuition is today. It's easy enough to estimate what it'll be by the time your child is ready for college, but retirement can be a lot more complex. If we're 20, 25 years from retirement, we're not really sure what we'll need. So the best approach, and it's a good approach, is just to start with a ballpark estimate.

So let's say you estimate your client will need $65,000 a year in retirement. You help her check the Social Security website, get a sense that she'll probably receive $25,000 a year from Social Security, maybe she has $10,000 from rental income or a guaranteed income source, such as a pension. Now she realizes she'll need to generate an additional $30,000 from her investment portfolio. How much in assets will she need to generate that amount of income each year in retirement? I'd use the 4 percent rule just to get you in the ballpark. I'd divide $30,000 by 4 percent and come up with an estimated portfolio target of $750,000.

Q: The 4 percent rule means you intend to take 4 percent of your portfolio out every year to pay for expenses.

Andy Clarke: Right, you take 4 percent of the initial portfolio's value out and then adjust that amount for inflation every year. There are more complicated and helpful analyses advisors can provide, but this simple rule of thumb, historically at least, has been a reliable means of figuring out how much you can withdraw while limiting the risk of running out of money during retirement.

Q: Let's talk about the next principle, balance. Balance sounds easy, but let's be honest, many people are afraid of the stock market. Others like to chase hot returns. How can advisors explain balance to their clients?

Andy Clarke: Balance means that we want to combine assets that behave differently in different market environments. Some people are scared of the stock market; others are not scared enough. Balance is about reminding clients that we need to have some balance between growth-oriented assets, namely stocks, and assets that can provide some cushion against the downturns, namely bonds.

Tell clients they should hold something in their portfolios that makes them uncomfortable.

Q: Is there more to asset allocation than just allocating between stocks and bonds?

Andy Clarke: Stocks and bonds are the important ones, but you should emphasize to clients that we're not talking about just, say, large-cap U.S. stocks—an S&P 500 Index fund, for example. We're talking about diversifying broadly across big stocks, small stocks, U.S. stocks, international stocks, and we're talking about the same broad diversification across the bond market: government bonds, corporate bonds, international bonds. Asset allocation is the decision that drives investment returns, as our, and others', research has shown.2

Investment outcomes are largely determined by the long-term mixture of assets in a portfolio

Note: Calculations are based on monthly returns for 709 U.S. funds from January 1990 to September 2015. For details of the methodology, see the Vanguard research paper The global case for strategic asset allocation and an examination of home bias. (Scott et al., 2017).


Q:
How can an advisor set return expectations for a balanced portfolio?

Andy Clarke: My go-to resource for this question is Vanguard's economic and investment outlook,3 available on the Vanguard advisors website. In this outlook, we projected a range of likely returns, or possible returns, over the next decade. Your client can look at these returns in a bell curve, and in the middle is what we call the central tendency, where we think returns are most likely to fall.

But when we looked at these central tendencies for a balanced fund, what we saw over the next ten years was a real, inflation-adjusted return of between roughly 3 percent and 5 percent. A nominal return was expected to be between 5 percent and 7 percent.

Q: Now, we've come to the principle of cost, that is, the need to keep costs low. What does this mean for advised clients?

Andy Clarke: Costs are a constant, but they are an anchor on a portfolio. Costs pull down the returns of your portfolio whether the financial markets are rallying or collapsing. What advisors can do to maximize their clients' share of the market return is to minimize costs on investment products.

Q: Certainly Vanguard research, and other research, has found that lower costs allow you to keep more of any returns you may earn. But what about the cost of advice?

Andy Clarke: Vanguard research4 has shown that advisors do add value to net returns over time, and there are many ways to do that. Financial planning strategies, estate planning, tax planning—those are services that can be well worth paying for.

Q: That brings us to the final principle, which is discipline.

Andy Clarke: Discipline in our principles is about remaining committed to your plan and resisting the impulse to make changes in the face of these powerful emotions we all feel. And that can be very challenging.

All investors look at the headlines, and they'll see stories about maybe a particular group of stocks or strategies that are delivering exceptional returns, and many feel the impulse to chase those returns. Or maybe they turn on the TV and see some smart, persuasive analyst painting a very bleak picture of the future. They get scared and think, it's time to pull money out of the market. Discipline is about trying to resist those impulses.

There's a famous essay by Charley Ellis called "The Loser's Game,"5 in which Ellis drew this interesting analogy between tennis and investment management. He wrote this in the 1970s, and he was looking at professional tennis players such as Björn Borg, Chris Evert, and John McEnroe. When he looked at the pros, he saw that they were playing a winner's game. They won by serving aces and hitting unreturnable shots. But when Ellis looked at the recreational game, he didn't see people serving aces or cracking atomic forehands. He saw them dumping the ball in the net or hitting the ball against the fence. In the recreational game, he saw people winning by not losing.

And he saw a parallel between this recreational tennis game and professional investment management. Professional investment management had become so competitive that if you tried to outperform by making aggressive purchases and sales or making aggressive changes to your asset allocation, you were more likely over time to make a mistake and lose. So Ellis's recommendation was: Don't play that game. Simply minimize your mistakes and passively accept the market's returns, and you'll more likely be a winner.

Now, Ellis's essay was about index investing, but I think it applies to this principle of discipline too. The key point is to minimize mistakes. Once you've developed a sensible investment plan with a client, you want to keep that portfolio in play and minimize mistakes, such as reacting emotionally to what's happening in the market. Keep the focus on the long term. As we demonstrate in the principles, this strategy has proved a key to investment success over decades.

1 Andrew S. Clarke, 2003. Wealth of Experience: Real Investors on What Works and What Doesn't. Hoboken, N.J.: John Wiley & Sons Inc.

2 Brian J. Scott, James Balsamo, Kelly N. McShane, and Christos Tasopoulos, 2017. The global case for strategic asset allocation and an examination of home bias. Valley Forge, Pa.: The Vanguard Group.

3 2017 economic and market outlook: Stabilization, not stagnation, 2016. Valley Forge, Pa.: The Vanguard Group.

4 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, Yan Zilbering, and Donald G. Bennyhoff, 2016. Putting a value on your value: Quantifying Vanguard Advisor's Alpha®. Valley Forge, Pa.: The Vanguard Group.

5 Charles D. Ellis, 1975. The loser's game. Financial Analysts Journal 31(4):19–26.


To learn more, read Vanguard's Principles for Investing Success.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Diversification does not ensure a profit or protect against a loss.