Common Sense on Mutual Funds, Updated 10th Anniversary Edition

by John C. Bogle

Long-run averages gleam like beacons, or perhaps like sirens, continually luring the investor to a long-run future that is expected to resemble these average returns, more or less. [The wide variations in returns that take place in the interim] tend to diminish over the long run, and so average returns define our expectations. But these variations are not a pool of inconsequential happenstances, nor are the individual episodes a set of accidents. Each episode is equally telling and significant in helping us understand how markets function. Each episode is also the consequence of the preceding episode—and you can define “episode” as everything from what happened yesterday to what happened last quarter to what happened seventy or a hundred years ago.

As Mr buffet says if long run averages had to repeat then all the librarians would have been billioniares.

the risk is the possibility that, in the long run, stock returns will be terrible.

Although changes in the rate of inflation from period to period have done little to alter the real rate of returns in the stock market, they have had a profound impact on the real returns provided by bonds.

A bond’s interest payment is fixed for the number of years specified until it matures and is repaid. In times of rapidly rising prices, the real value of this fixed interest payment declines sharply, diminishing the real return provided by the bond.

First, the long-term investor should make a significant commitment to stocks.

The data make clear that, if risk is the chance of failing to earn a real return over the long term, bonds have carried a higher risk than stocks.

If you have faith that our economic garden is basically healthy and fertile, the best way to reap long - term rewards is to plant seeds with prospects for growth, as investing in common stocks clearly allows.

in the 187 rolling 10-year periods since the establishment of our securities markets, bonds have outperformed stocks in 38 periods—one out of every five.

As insurance against the possibility of short-term, or even extended, weakness in stocks, then, long-term investors should also include bonds in their portfolios.

Include Bonds in your portfolio just as a back up.

As a group, investors earn less because the market return is inevitably reduced by the costs of investing.

In the mutual fund industry, the range of investment costs is extremely wide. In

an aggressively managed small-cap equity fund, total asset-related charges, including operating expenses and transaction costs, might be as high as 3 percent. The lowest range is set by a market index fund, a passively managed fun...

Because it entails no advisory fees or transaction costs and only minimal operating expenses, costs can be held to 0.2...

On average, a common stock mutual fund, managed by a professional adviser who buys and sells securities in an effort to outperform the market, incurs annual operating expenses equal to about...

With portfolio transaction costs conservatively estimated at 0.5 percent, total costs reduce gross returns by at least two percentage points each year.

Expense ratio (Operating expenses to handle the fund) + Transaction costs

When estimating expected levels of future returns, the long-term investor must be aware of the portion of investment return that will be consumed by these expenses.

Costs lop the same number of percentage points off both nominal and real returns, but, given persistent inflation, it nearly always consumes a proportionally larger share of real returns.

Here is one example, assuming a nominal annual return of 10 percent on stocks. An equity mutual fund incurring annual expenses at the industry average would lop off some two percentage points—fully one-fifth of the market’s annual return. Now let’s say that inflation is 3 percent; then the market’s real return is 7 percent, and costs would consume nearly one-third of the market’s reward. And taxes must be paid—sooner or later—by the investor. Fair or not, taxes are assessed, not on real returns, but on the (higher) nominal returns. If taxes on fund income and capital gains distributions are assumed to reduce pretax returns by, say, another 2 percent to 5 percent (a rather modest assumption), that 2 percent all-in cost of a mutual fund could consume fully four-tenths of the market’s net real return after taxes. To state the obvious, the long-term investor who pays least has the greatest opportunity to earn most of the real return provided by the stock market.

Costs paid by the Investor = Expense ratio + Transaction costs + Taxes on Income and LTCG. Considering inflation and Market returns which cannot be controlled. An investor who pays least cost gets the best return.

Let’s now consider the real-world effect of costs. Assume that the stock market as a whole provides the nominal rate of return of about 11 percent enjoyed by investors during the modern era of the stock market that began in 1926.

The pie analogy is hardly revolutionary. It entails nothing more than simple second-grade arithmetic: Gross market return - Cost = Net market return

so both active investors (as a group) and passive investors—holding all stocks at all times—must match the gross return of the stock market.

The management fees and transaction costs incurred by active investors in the aggregate are substantially higher than those incurred by passive investors.

passive investors must earn the higher net return.

An investor who pays least costs that is a passive investor will always earn a higher net return.

in the serious game of accumulating financial assets, simplicity trumps complexity.

Less is more. Simplicity beats Complexity.

Everybody talks about long-term investing, but nobody does anything about it.

Investors, professional and individual, are not ignorant of the lessons of history; rather, they are unwilling to heed them.

Everybody has the knowledge. Every child knew that the Mrshmellow should not be eaten. Yet hew ate and few didnt. Train your self for delayed gratification.

The first is market timing—the attempt to shift assets from stocks to bonds or cash in hopes of escaping a stock market dip, then to shift the assets from bonds or cash back to stocks in an attempt to ride the next stock market wave. For most practitioners, market timing is apt to bring the opposite result: they are in the market for the dips, but out of the market for the rallies. The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently. Yet market timing appears to be increasingly embraced by mutual fund investors and the professional managers of fund portfolios alike. The second short-term strategy is the rapid turnover of long-term investment portfolios. It too is evident in the actions of both mutual fund investors and fund managers. It is a costly practice, predicated, much like market timing, on the belief that investors can invest in a particularly attractive stock or mutual fund, watch it grow, and then eject the investment from their portfolio as it crests. As with market timing, the record provides no evidence that rapid turnover enhances the returns earned by fund investors or by fund managers.

Too much activity doesnt work ie market timing etc.

Market Timing in the Press—“The Death of Equities”

those wonderful sources whose advice is so consistently wrong that we can count on profits simply by doing the opposite.

The market is simply unpredictable on any short-term month-to-month or even year-to-year basis. We should not expect it to be predictable, nor should we base our investment decisions on impulses inspired by the conventional wisdom of the day. Whether they come in large headlines in respected publications or arise from our own daily hopes and fears, these calls to action generally have a short-term focus that muddles our view of the long pull.

When stock prices are high, investors want to jump on the bandwagon; when stocks are on the bargain counter, it is difficult to give them away.

Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his view on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?

“An investor who does not understand the economics of specific companies but wishes to be a long-term owner of American industry,” he says, should “periodically invest in an index fund.” In this way, “the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” Money invested for the long term, like the proverbial plodding tortoise, wins the race over speculative money, analogous to the fits and starts of the hare. The mutual fund industry is ignoring this truism.

For the industry as a whole, it cannot be.

A recent study by Morningstar found that few managers were able to improve returns significantly through portfolio turnover, but that on balance, the tiny increases in return that turnover may have engendered were gained only by buying riskier stocks. The study hardly serves as an encouraging defense of the industry’s high-turnover policies.

Whatever the cause, professional managers have fallen further behind the market averages with today’s high-turnover practices than with the low-turnover practices that were long an industry hallmark. I suggest that the high costs imposed by their manic trading are in part responsible for this growing gap.

Stay away from mutual funds engaging in high turnover practices.

Market timing has thus far been a singular failure, and the rapid turnover of investment port folios has been no more effective. As costly and tax-inefficient turnover accelerates—for funds and fund investors alike—this practice seems destined to become ever more damaging.

Mistakes made by Fund Managers :- >>>> Market timing >>>> Rapid turnover of investment portfolios

In total, the industry has abandoned the wisdom of long-term investing in favor of the folly of short-term speculation.

The art of investing in mutual funds, I would argue, rests on simplicity and common sense.

If individual stocks derive their values from the businesses that issue them, then the broad stock market obviously represents not a mere collection of paper stock certificates but the tangible and intangible net assets of American business in the aggregate. Before taking costs into account, investors will inevitably earn long-term returns that approximate the earnings and dividends produced by corporate America. Rapid turnover can ultimately produce no value for investors as a group, for it does nothing to increase the level of corporate earnings and dividends. Nor can market timing have any effect on the intrinsic value of corporate America. The ideal for the long-term investor remains a sensible balance of stocks and bonds held through the market’s seasons of growth and decline.

Markets depend on earnings and dividends of company. Frequent turnovers will not help.

The key to fund selection is to focus not on future return—which the investor cannot control—but on risk, cost, and time—all of which the investor can control.

Control the controllables.

To exploit the full power of compounding in real markets, pay particular attention to the negative implications of cost—the cost of investment advice, portfolio management and administration, buying and selling investments, and taxes.

Pay a close watch on the costs that your paying for your investment.

Give your portfolio plenty of time to benefit from the magic of compounding, and minimize the costs you incur. Never forget that costs, like weeds, impede the garden’s growth.

Investment Maxim.

The relentless pursuit of unrealistic performance, practiced through costly short-term strategies, distracts them from one of the most important secrets of investment success: simplicity.

Follow a simple plan, and let the cycles of the market take their course. The secret of investing is, finally, that there is no secret.

prospect. In the long run, however, your investments will survive and prosper if you rely on a few simple rules: • Invest you must. The biggest risk is the long-term risk of not putting your money to work at a generous return, not the short-term—but nonetheless real—risk of price volatility. • Time is your friend. Give yourself all the time you can. Begin to invest in your 20s, even if it’s only a small amount, and never stop. Even modest investments in tough times will help you sustain the pace and will become a habit. Compound interest is a miracle. • Impulse is your enemy. Eliminate emotion from your investment program. Have rational expectations about future returns, and avoid changing those expectations as the seasons change. Cold, dark winters will give way to bright, bountiful springs. • Basic arithmetic works. Keep your investment expenses under control. Your net return is simply the gross return of your investment portfolio, less the costs you incur (sales commissions, advisory fees, transaction costs). Low costs make your task easier. • Stick to simplicity. Don’t complicate the process. Basic investing is simple—a sensible asset allocation to stocks, bonds, and cash reserves; a selection of middle-of-the-road funds that emphasize high-grade securities; a careful balancing of risk, return, and (lest we forget) cost. • Stay the course. No matter what happens, stick to your program. I’ve said “Stay the course” a thousand times, and I meant it every time. It is the m...

Simple rules for long term investing.

Don’t let short-run fluctuations, market psychology, false hope, fear, and greed get in the way of good investment judgment.

Investment maxim.

The application of Occam’s Razor to the financial markets is most appropriate for investors who select broadly diversified mutual funds run at modest cost, and who hold them for the long term.

The best policy when it comes to mutual fund.

These three variables determine stock market returns over the long term: 1. The dividend yield at the time of initial investment. 2. The subsequent rate of growth in earnings. 3. The change in the price-earnings ratio during the period of investment.

future. When stocks are priced at a multiple of 21 times earnings (or higher), the mood is exuberance. At 7 times earnings, the mood approaches despair.

High PE ratio indicates high speculation.