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Vanguard’s investment philosophy Southern California Permanente Medical Group

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Agenda 1. Saving and investing are different. 2. Diversification reduces risk. 3. Determining your asset mix is key. 4. Consistent outperformance is unlikely. 5. Costs affect results. 6. Knowing how and why is essential. 7. Risks come in different varieties. 8. Timing and chasing don’t work. 9. Reasonable expectations provide perspective.

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1. Saving and investing are different

• Investing is for meeting long-term goals. • Saving is for meeting short-term goals.

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Save or invest based on your time horizon

• Less than two years. – Consider short-term reserves. • More than two years – Consider a mix of stocks and bonds.

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Saving versus investing, 1926-2010 $10,000 over 85 years $35,000,000

$32,989,670

$30,000,000 $25,000,000 $20,000,000 $15,000,000

$10,000,000 $5,000,000 $10,000

$219,378

Short-term reserves

Stocks

The performance data shown represent past performance, which is not a guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Returns for stocks are based on the Standard & Poor’s 500 Index from 1926 to 1970, the Dow Jones Wilshire 5000 Index from 1971 through April 22, 2005, and the MSCI US Broad Market Index thereafter. Returns for short-term reserves are based on the Citigroup 3-Month Treasury Bill Index. Source: Vanguard. Vanguard’s investment philosophy > 5

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Saving versus investing, January 1–December 31, 2008 $10,000 over one year

$$35,000,000 $12,000 $30,000,000 $10,000

$10,180

$25,000,000 $8,000 $20,000,000 $6,000 $15,000,000

$6,300

$4,000

$10,000,000 $2,000 $5,000,000 $10,000 0

Short-term reserves

Stocks

The performance data shown represent past performance, which is not a guarantee of future results. The performance of an index isnot an exact representation of any particular investment, as you cannot invest directly in an index. Returns for stocks are based on the MSCI US Broad Market Index. Returns for short-term reserves are based on the Citigroup 3-Month Treasury Bill Index. Source: Vanguard. Vanguard’s investment philosophy > 6

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2. Diversification reduces risk

• Broad diversification, with exposure to all parts of the stock and bond markets, reduces risk.

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Diversification reduces risk

• Diversification in bonds. – A broad range of maturities and credit quality. • Diversification in stocks. – Both growth and value. – Large-cap, mid-cap, and small-cap. – International.

Diversification does not ensure a profit or protect against a loss in a declining market. Also, just as stock investing entails various risks, investments in bond funds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Vanguard’s investment philosophy > 8

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Risk versus potential reward Model portfolios, 1926–2010 Average annual benchmark return

Number of years with a loss

100% bonds 20% stocks, 80% bonds

5.5% 6.7%

13 of 85 12 of 85

–3.1% –4.0%

30% stocks, 70% bonds

7.3%

14 of 85

–4.9%

40% stocks, 60% bonds

7.8%

16 of 85

–5.9%

50% stocks, 50% bonds 60% stocks, 40% bonds

8.3% 8.7%

17 of 85 21 of 85

–7.4% –7.7%

70% stocks, 30% bonds

9.1%

22 of 85

–9.2%

80% stocks, 20% bonds 100% stocks

9.4% 10.0%

23 of 85 25 of 85

–10.6% –13.2%

Growth

Balanced

Income

Your asset allocation

Average loss

Average annual benchmark returns are calculated for the designated time period using applicable index returns (as noted below) that are weighted based on the suggested mix. When determining which index to use and for what period, we selected the index that we deemed to fairly represent the characteristics of the referenced market, given the available choices. For U.S. stock market returns, we use the Standard & Poor’s 90 from 1926 to March 3, 1957; the Standard & Poor’s 500 Index from March 4, 1957 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. For U.S. bond market returns, we use the Standard & Poor’s High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Lehman U.S. Long Credit Aa Index from 1973 to 1975; and the Barclays Capital U.S. Aggregate Bond Index thereafter. For U.S. cash reserve returns, we use the Ibbotson U.S 30-Day Treasury Bill Index from 1926 to 1977, and the Citigroup 3-Month Treasury Bill Index thereafter. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Index performance is not illustrative of any particular investment because you cannot invest in an index. Past performance cannot be used to predict future returns. Asset allocation and index performance are not illustrative of fund performance.

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Source: Vanguard.

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3. Determining your asset mix is key

• An investor’s most important decision is selecting the mix of assets to be held in a portfolio, not selecting the individual investments themselves.

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Determining your asset mix is key • Choose a mix of stocks, bonds, and short-term reserves. – Goal. – Time horizon. – Risk tolerance. • Periodically review and rebalance your portfolio as needed. – Both growth and value. – Large-cap, mid-cap, and small-cap. – International. Vanguard’s investment philosophy > 11

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4. Consistent outperformance is unlikely

• Consistently outperforming the financial markets is extremely difficult.

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In 1970

by 2010

355 stock mutual funds

How many still existed? How many beat the S&P 500 from 1970–2010?

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In 2010 108 funds were left. 42 beat the S&P 500.

Source: Vanguard. Vanguard’s investment philosophy > 14

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5. Costs affect results

• Minimizing the costs of investing is vital for long-term investment success.

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6. Knowing how and why are essential

• Investors should know how each investment fits into their plans and why they own that particular asset.

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Knowing how and why are essential

• Some questions to consider about any investment: – Is it suitable, considering my goals, time horizon, and risk tolerance?

– Are the risk/return characteristics acceptable to me? – Does it further diversify my overall portfolio? – Will I be comfortable holding it for the long term? – Have I done enough homework to reduce the likelihood of unpleasant surprises?

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7. Risks come in different varieties • Risk has many dimensions, and investors should weigh “shortfall risk”—the possibility that a portfolio will fail to meet longer-term financial goals—against “market risk,” or the chance that returns will fluctuate.

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Three asset classes Short-Term Reserves

Bonds

Stocks

Objective

Stability

Income

Growth

Volatility

Low

Moderate/high

High

Inflation risk

High

Moderate/high

Low

All investing is subject to risk. Investment in bond funds are subject to interest rate, credit, and inflation risk.

Book reference: page 102 Live the life you imagined as you reach retirement > Section 5: Investing during retirement > 19

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Investment returns 1926–2010 10.0%

Average annual return

7.0%

Return after inflation

3.0%

Inflation rate

Short-term reserves Bonds Stocks 5.5% 3.7% 0.7%

2.5%

3.0%

3.0%

The performance data shown represent past performance, which is not a guarantee of future results. When determining which index to use and for what period, we selected the index that we deemed to fairly represent the characteristics of the referenced market, given the available choices. For U.S. stock market returns, we use the Standard & Poor’s 90 Index from 1926 to March 3, 1957; the Standard & Poor’s 500 Index from March 4, 1957, to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. For U.S. bond market returns, we use the Standard & Poor’s High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Lehman U.S. Long Credit Aa Index from 1973 to 1975; and the Barclays Capital U.S. Aggregate Bond Index thereafter. For U.S. short-term reserves, we use the Ibbotson U.S. 30-Day Treasury Bill Index from 1926 to 1977, and the Citigroup 3-Month Treasury Bill Index thereafter. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Index performance is not illustrative of any particular investment because you cannot invest in an index. All investing is subject to risk. Investments in bond funds are subject to intereste rate, credit, and inflation Source: Vanguard.

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Risk versus return 1926–2010 60% Short-term reserves

Bonds

Stocks

0%

–60% 1926

1936

1946

1956

1966

1976

1986

1996

2006 2010

The performance data shown represent past performance, which is not a guarantee of future results. When determining which index to use and for what period, we selected the index that we deemed to fairly represent the characteristics of the referenced market, given the available choices. For U.S. stock market returns, we use the Standard & Poor’s 90 Index from 1926 to March 3, 1957; the Standard & Poor’s 500 Index from March 4, 1957, to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. For U.S. bond market returns, we use the Standard & Poor’s High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Lehman U.S. Long Credit Aa Index from 1973 to 1975; and the Barclays Capital U.S. Aggregate Bond Index thereafter. For U.S. short-term reserves, we use the Ibbotson U.S. 30Day Treasury Bill Index from 1926 to 1977, and the Citigroup 3-Month Treasury Bill Index thereafter. All investing is subject to risk. Investments in bond funds are subject to intereste rate, credit, and inflation Source: Vanguard.

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Reduction of risk over time U.S. stock market 1926–2010 60 Best Worst

+54.2%

50 40 +27.1%

30

+19.9%

20

+17.2%

10 0 -10 10

–12.1%

-20 20

–0.9%

+3.1%

10 years

20 years

5 years

-30 30 -40 40 -50 50

–43.1% 1 year

The performance data shown represent past performance, which is not a guarantee of future results. When determining which index to use and for what period, we selected the index that we deemed to fairly represent the characteristics of the referenced market, given the available choices. For U.S. stock market returns, we use the Standard & Poor’s 90 Index from 1926 to March 3, 1957; the Standard & Poor’s 500 Index from March 4, 1957, to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. Index performance is not illustrative of any particular investment because you cannot invest in an index. All investing is subject to risk. Source: Vanguard.

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8. Timing and chasing don’t work

• Market-timing and performance-chasing are losing strategies.

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Chasing performance Three market sectors in 2008 One of few strong sectors Long-term Treasury bonds

Two of many weak sectors 24.0%

Mid-cap growth

–44.3%

Emerging markets

–53.3%

The performance data shown represent past performance, which is not a guarantee of future results. Long-term Treasury: Barclays US Long Treasury Index. Mid-cap growth: MSCI US Mid Cap Growth Index. Emerging markets: MSCI Emerging Markets Index. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Index performance is not illustrative of any particular investment because you cannot invest in an index. Source: Vanguard. All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. The market values of government securities are not guaranteed and will fluctuate. Prices of mid-cap stocks often fluctuate more than those of large-company stocks. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Fine-tuning your portfolio > 24

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Chasing performance Three market sectors in 2009 Two of many strong sectors

One of few weak sectors

Mid-cap growth

46.3%

Emerging markets

78.5%

Long-term Treasury bonds

–12.9%

The performance data shown represent past performance, which is not a guarantee of future results. Long-term Treasury: Barclays US Long Treasury Index. Mid-cap growth: MSCI US Mid Cap Growth Index. Emerging markets: MSCI Emerging Markets Index. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Index performance is not illustrative of any particular investment because you cannot invest in an index. Source: Vanguard. All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. The market values of government securities are not guaranteed and will fluctuate. Prices of mid-cap stocks often fluctuate more than those of large-company stocks. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Fine-tuning your portfolio > 25

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Trying to time the market

• Reliability of signals. • Perfect timing—twice. • Cost of trading.

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Trying to time the market You would need to be right twice Decline, duration, and rally (1956–2009) Percent decline and duration

One-year rally

1/11/73–10/3/74 (21 months) 3/24/00–10/9/02 (31 months) 10/9/07–3/9/09 (17 months) 11/29/68–5/26/70 (18 months) 8/25/87–12/4/87 (3 months) 12/12/61–6/26/62 (6 months) 1/6/81–8/12/82 (19 months) 2/9/66–10/7/66 (8 months) 8/2/56–10/22/57 (15 months) 7/16/90–10/11/90 (3 months) 9/21/76–5/6/78 (18 months) –60%

–50%

–40%

–30%

–20%

–10%

0%

0%

10%

20%

30%

40%

50%

60%

70%

Source: Standard and Poor’s 500 Index and Vanguard calculations. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Fine-tuning your portfolio > 27

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Three decades, three dramatically different results 22.0%

Large-cap company U.S. stocks (S&P 500 Index).

18.2%

17.9%

Small-cap company U.S. stocks (Russell 2000 Index). International stocks (EAFE Index).

14.5% 13.4%

7.0% 3.5% 1.2% –0.1% 1980–1989

1990–1999

2000–2009

The performance data shown represent past performance, which is not a guarantee of future results. Index performance is not illustrative of any particular investment because you cannot invest in an index. Prices of small-cap stocks often fluctuate more than those of large-company stocks. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Vanguard’s investment philosophy > 28

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9. Reasonable expectations provide perspective

• An investor should not expect future long-term returns to be significantly higher or lower than long-term historical returns for various asset classes and subclasses.

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Reasonable expectations provide perspective

• Have realistic expectations about future returns. • Think and plan with a perspective of decades, not months or a few years. • Avoid making drastic moves in asset allocations, even in periods of market turbulence. • Look at longer time periods (three, five, ten years, or more) when evaluating fund performance.

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Stock market returns demonstrate “reversion to the mean” Average annual returns 1926 - 2010

10.0%

1990 -1999

18.2%

2000 -2009

0.1%

1990 -2009

8.7%

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Review 1. Saving and investing are different. 2. Diversification reduces risk. 3. Determining your asset mix is key. 4. Consistent outperformance is unlikely. 5. Costs affect results. 6. Knowing how and why is essential. 7. Risks come in different varieties. 8. Timing and chasing don’t work. 9. Reasonable expectations provide perspective. Vanguard’s investment philosophy > 32

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