Author Topic: Why Do People Prefer To Put Their Roth Funds Into Idexes That Do Poorly?  (Read 3056 times)

NeoGenMike

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Hi there! Im still learning the ropes of Roth IRA and stock investments, but one thing has always bugged me ever since I started learning. EVERYONE always suggests VTIAX or VXUS or something very similar. I know it's good to diversify, but why diversify into something that doesnt make you any money? What exactly am I not seeing yet? Thanks for all your help in advance!

bobechs

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It is ingrained hatred for making real money, I suppose.

What else could it be?

NeoGenMike

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It is ingrained hatred for making real money, I suppose.

What else could it be?

Well I mean, I know I'm wrong, because all I hear is how well it performs and how it is their best stock in their portfolio. Is there more to these stocks than just the apparent value?

bobechs

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Like, maybe ride the cannabis legalization pony ftw?

All upside with no feasible down...

https://forum.mrmoneymustache.com/investor-alley/tip-maybe-)/

MDM

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NeoGenMike

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What exactly am I not seeing yet?
Does Callan periodic table of investment returns - Bogleheads help?

I see, so if im reading that correctly, something like VWO SEEMS  to do bad, but if you time it right its good.

MDM

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What exactly am I not seeing yet?
Does Callan periodic table of investment returns - Bogleheads help?
I see, so if im reading that correctly, something like VWO SEEMS  to do bad, but if you time it right its good.
Imagine you are in mid-2005.  You might be saying "look how great VWO has been doing - why would anyone do anything else?"  And you might continue to say that for another 2.5 years or so, until....

The point is that nobody knows what the next hot sector will be, and chasing the latest high flier is likely to end poorly for the chasers.

human

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I'm going to assume you aren't trolling. People invest in index funds because they realize you can't beat the wntire market itself and over time it rises even with periods of low growth, no growth or negative growth. Eventually the markets will offer better returns than managed funds or trying to time the market on its own.

However if you think you or a hedge funde can do better go for it!

NeoGenMike

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I'm going to assume you aren't trolling. People invest in index funds because they realize you can't beat the wntire market itself and over time it rises even with periods of low growth, no growth or negative growth. Eventually the markets will offer better returns than managed funds or trying to time the market on its own.

However if you think you or a hedge funde can do better go for it!

I see what you mean. Thanks for the post!

Frankies Girl

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Hi there! Im still learning the ropes of Roth IRA and stock investments, but one thing has always bugged me ever since I started learning. EVERYONE always suggests VTIAX or VXUS or something very similar. I know it's good to diversify, but why diversify into something that doesnt make you any money? What exactly am I not seeing yet? Thanks for all your help in advance!


Wait... wat?

Neither of those funds are ones I've seen strongly suggested around these parts. They're both international index funds, so as such they wouldn't be a huge component of anyone's portfolio that was a basic indexer; maybe 10-20% maximum if you were the type to want to hold international at all.

The fund that IS the gold standard and highly recommended is VTSAX or VTI if you're doing ETFs - the Vanguard total stock market index (based in the U.S. market). And it tracks the overall market, so as long at the U.S. market is doing well, so does the fund.

Not sure who is telling you to go all in on international, but they're kind of screwy if so, or else you've got your funds confused maybe? There is a BIG difference in investing in the U.S. market index fund vs international index fund...


NeoGenMike

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Hi there! Im still learning the ropes of Roth IRA and stock investments, but one thing has always bugged me ever since I started learning. EVERYONE always suggests VTIAX or VXUS or something very similar. I know it's good to diversify, but why diversify into something that doesnt make you any money? What exactly am I not seeing yet? Thanks for all your help in advance!


Wait... wat?

Neither of those funds are ones I've seen strongly suggested around these parts. They're both international index funds, so as such they wouldn't be a huge component of anyone's portfolio that was a basic indexer; maybe 10-20% maximum if you were the type to want to hold international at all.

The fund that IS the gold standard and highly recommended is VTSAX or VTI if you're doing ETFs - the Vanguard total stock market index (based in the U.S. market). And it tracks the overall market, so as long at the U.S. market is doing well, so does the fund.

Not sure who is telling you to go all in on international, but they're kind of screwy if so, or else you've got your funds confused maybe? There is a BIG difference in investing in the U.S. market index fund vs international index fund...

Oh I meant certain portfolio suggestions say like 60% VTI/VTSAX and 40% VTIAX, something really high. Thanks for the response, though, Im getting the bigger picture now.


NeoGenMike

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Why put international in a Roth?  Lots of reasons. 

1.) For starters, international funds pay dividends but often a significant portion of these are not qualified dividends, so the ordinary income tax rate applies (for high earners this could be close to 50% when state and federal taxes are taken into account).  Place in a Roth, presto, no more tax on dividends.  There is an argument that owning a foreign stock fund in a taxable account gives you a precious tax credit for foreign taxes paid.  But, I find this argument a bit of a red herring since the portion of dividends withheld as foreign taxes paid are fictitious income.  You never actually get the money that is paid as foreign taxes, its just reported on your 1099-div as such.  So you get a tax credit to use against income that was reported to you, but you never received in the first place.  Big Whoop.  Also, if the amount of the foreign taxes paid goes above $600 the credit cannot be automatically taken, but must be computed.

2.) Foreign markets could experience a lot of gains.  When you buy stocks, you are paying now for a growing stream of future earnings.  The stream of earnings is based on the real economy, the stock price is based in part on investor psychology.  So right now the U.S. Market (S&P) has a P/E (trailing 12 mo. TTM) of 26.44, or essentially, you need to pay $26.44 for each $1 of earnings that American businesses produced last year.  For the EAFE Index the P/E ratio is 19.64.  So you pay $19.64 for each $1 of earnings that large cap foreign companies earned over the last year.  So U.S. stocks are trading at about a 35% premium over international stocks.  Imagine what would happen if earnings growth for international stocks surprise everyone over the next year and earnings goes up 15-20% and investor psychology (including yours) improves on the rest of the world and the P/E ratio for International stocks approaches that for U.S. stocks.  Man, you'd have a lot of gains!  In a Roth, you never pay taxes on those gains.

3.) U.S. Markets could be in for some trouble.  The flip side of the High P/E ratio of the U.S. market is that there is a greater risk you are over paying for that stream of future earnings.  Imagine instead of the U.S. Market had an earnings growth hiccup and investor psychology sours.  If you are buying your $1 stream of earnings for $26.44 and instead earnings go down a bit and investors loose excitement for the U.S. market and decide that the stream of earnings is now only worth $19.50. Well do the math, you just experienced losses.  If you have these losses in a taxable account you can engage in tax-loss harvesting, which is like a consolation prize.  But if they are in a Roth IRA, you get to experience the pain of loosing money as well as the inability to write off your losses for tax purposes.

The Dividends were actually something I was thinking a lot about. Thanks for that and the detailed response!

seattlecyclone

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On the other hand, putting international in taxable can be a good idea because many countries withhold taxes from the dividends. You can claim that money back on your federal tax return in the form of the Foreign Tax Credit, but only if you hold the international funds in a taxable account. For this reason the Bogleheads page on tax-efficient fund placement puts foreign index funds near the top of their list for tax efficiency.

On the other other hand, tax-efficiency should not be the only consideration. Over the long term stocks tend to outperform bonds. This outperformance could easily make bonds in taxable and stocks in Roth be better in the end than vice versa. There's no guarantee here though.