Common Sense on Mutual Funds, Updated 10th Anniversary Edition

by John C. Bogle

The vast majority of investors play an active management game in which they lose two ways. First, they lose by choosing actively managed mutual funds that almost always fail to deliver on the promise of market-beating results. The shortfall comes from wildly excessive, ultimately counterproductive trading (with the attendant market impact and commissions) and from unreasonable management fees (that far exceed the managers ’ value added, if any). And, as Bogle points out, nearly all mutual fund managers behave as if taxes do not matter, thereby imposing an unnecessary and expensive tax burden (that often blindsides the investing public when they deal with the IRS on April 15). Second, investors lose by trading mutual funds with eyes fixed unwaveringly on the rearview mirror. By dumping yesterday’s faded idol and chasing today’s hot prospect, mutual fund investors systematically sell low and buy high (which is a poor approach to making money). Moreover, the frenzied switching of funds often triggers a further tax burden. If investors followed Bogle’s advice to use index funds, by dint of low costs they would beat the vast majority of fund managers. If investors followed Bogle’s advice to take a steady approach to allocating assets, by avoiding perverse timing moves they would benefit from realizing nearly all that the markets have to offer.

I would limit holdings of bonds to full-faith-and-credit issues of the United States government.

After reading Common Sense on Mutual Funds, move on to Malkiel’s A Random Walk Down Wall Street, Ellis’s Winning the Loser’s Game, and my own Unconventional Success.

Ignore Jim Cramer. Pay attention to Jack Bogle!)

As one of only two mutual fund complexes (TIAA-CREF, where I serve on the board, is the other) that operate without a profit motive, Vanguard gives investors a fair shake. Aside from Vanguard and TIAA-CREF, nearly all mutual fund management companies seek to generate profits and purport to serve investors. Unfortunately, when the profit motive comes into conflict with fiduciary responsibility, greed wins and profits triumph.

Despite all the high-minded talk we hear from the corporate spin-masters, conflict of interest between seller and buyer is inherent in our economic system.

The investment management business is extraordinarily profitable. As such, it responds to the iron law of capitalism that capital will flow to those areas where the expected return is the highest.

Indeed, intelligent investing turns out to be little more than common sense and sound reason.

Time makes more converts than reason.

From "Common Sense" by Thomas Paine

I am under no illusions. It won’t be easy, and surely won’t be fully accomplished in my lifetime. But I hardly need to remind you, using Thomas Paine’s most famous words, written one year before General George Washington’s battered army bivouacked in Valley Forge, enduring the bitter winter of 1777-1778: “These are the times that try men’s souls. . . . ’ Tis the business of little minds to shrink; but he whose heart is firm, and whose conscience approves his conduct, will pursue his principles unto death . . . . Tyranny, like hell, is not easily conquered, yet the harder the conflict, the more glorious the triumph.”

Investing for the long term is central to the achievement of optimal returns by investors.

There is little certainty in investing.

For without risk there is no return.

Another word for “risk” is “chance.”

am basically an optimist. I see our economy as healthy and stable. It is still marked by seasons of growth and seasons of decline, but its roots have remained strong. Despite the changing seasons, our economy has persisted in an upward course, rebounding from the blackest calamities.

Figure 1.2, based on a chart created by Professor Siegel for his fine book Stocks for the Long Run,2 demonstrates that stocks have provided the highest rate of return among the major categories of financial assets: stocks, bonds, U.S. Treasury bills, and gold. This graph covers the entire history of the American stock market, from 1802 to 2008. An initial investment of $10,000 in stocks, from 1802 on, with all dividends reinvested (and ignoring taxes) would have resulted in a terminal value of $5.6 billion in real dollars (after adjustment for inflation). The same initial investment in long-term U.S. government bonds, again reinvesting all interest income, would have yielded a little more than $8 million.

the 12 stocks originally listed in the Dow Jones Industrial Average, General Electric alone has survived.

each of the three periods examined by Professor Siegel, the U.S. stock market demonstrated a tendency to provide real (after-inflation) returns that surrounded a norm of about 7 percent, somewhat lower from 1871 to 1925, and somewhat higher in the modern era.

But gold is largely a rank speculation, for its price is based solely on market expectations. Gold provides no internal rate of return. Unlike stocks and bonds, gold provides none of the intrinsic value that is created for stocks by earnings growth and dividend yields, and for bonds by interest payments. So in the two centuries plus shown in the chart, the initial $10,000 investment in gold grew to barely $26,000 in real terms. In fact, since the peak reached during its earlier boom in 1980, the price of gold has lost nearly 40 percent of its real value.

In the modern era, the rate of inflation has accelerated dramatically, averaging 3.1 percent annually, and the gap between real and nominal returns has widened accordingly. Since 1926, the stock market has provided a nominal annual return of 10.6 percent and an inflation-adjusted return of 7.2 percent.

The high rate of inflation in our modern era is in large part the result of our nation’s switch from a gold-based monetary system to a paper-based system. Under the gold standard, each dollar in circulation was convertible into a fixed amount of gold. Under our modern paper-based system, in which the dollar is backed by nothing more (or less) than the public’s collective confidence in its value, there are far fewer constraints on the U.S. government’s ability to create new dollars. On occasion, rapid growth in the money supply has unleashed bouts of rapid price inflation. The effect on real long-term stock returns has nonetheless proved neutral. Even as nominal returns have risen in line with inflation, the rate of real return has remained steady at about 7.0 percent, much as it did through the nineteenth century.

As Stephen Jay Gould put it in Full House: The Spread of Excellence from Plato to Darwin: “Variation stands as the fundamental reality and calculated averages become abstractions.”

Gross market return - Cost = Net market return This syllogism then becomes obvious: 1. All investors own the entire stock market, 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. 2. The management fees and transaction costs incurred by active investors in the aggregate are substantially higher than those incurred by passive investors. 3. Therefore, because active and passive investments together must, by definition, earn equal gross returns, passive investors must earn the higher net return. QED.

But whatever the future may hold, these figures are one more manifestation of one of the great paradoxes of the stock market: 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.

Given this situation as it exists in the modern mutual fund industry, Mr. Buffett quickly comes to the correct conclusion. “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.

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.

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 most important single piece of investment wisdom I can give to you.

Sir William of Occam, a fourteenth-century British philosopher, is responsible for the insight that the simpler the explanation, the more likely it is to be correct.

FIGURE 2.1 Rolling 25-Year Real Stock Returns (1826-2008)

In each of those periods, real annual returns on stocks fell within a positive range of 2 percent to 12 percent. (In no 25-year period were the returns negative.) In two-thirds of the cases, annual returns fell within a range of 4.7 percent to 8.7 percent, two percentage points on either side of the norm, establishing the standard deviation of real annual returns at 2 percent.

We can use the historical data to answer a simple question: Why have stocks provided long-term real returns of 7 percent? Answer: Almost entirely because of the rising earnings and dividends of U.S. corporations.d The sum of real dividend yields and earnings growth generated during 1871-1997, adjusted for inflation, equals 6.7 percent in real terms. In other words, the total long-term real return on stocks derived from dividend yields and earnings is virtually identical to the 7 percent real return actually provided by the stock market itself. All other factors combined have almost inconsequential impact on the returns provided by these two fundamental factors alone.

The events of the recent era demand that we consider the important distinction between two kinds of corporate earnings: (1) operating earnings, the profits earned by a corporation’s ongoing business activities; and (2) reported earnings, the operating results plus or minus (almost always minus!) any asset write-downs (said to be “nonrecurring”) that account for investment losses; mergers that depleted corporate values; erosion of goodwill; and so forth.

So, courtesy of Occam’s Razor, I advance a simple theory. 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.

As Table 2.1 demonstrates, investment, or enterprise, has prevailed over speculation in the long run.

Don’t think you know more than the market. Nobody does.

By definition, a rational model is powerless to forecast stock market bubbles built on “irrational exuberance”—if indeed a bubble is what we are experiencing in the late 1990s, and if Federal Reserve Board Chairman Alan Greenspan’s 1996 warning about stock prices finally holds true.

If we focus on the fundamentals of investment and ignore the dross of speculation, we come to the same conclusion reached by Warren Buffett, quoting Benjamin Graham’s The Intelligent Investor: In the short run, the stock market is a voting machine; in the long run, it is a weighing machine.4

If you have set an intelligent route toward capital accumulation, stay the course—no matter what.

My guidelines also respect what I call the four dimensions of investing: (1) return, (2) risk, (3) cost, and (4) time.

Think of return, risk, and cost as the three spatial dimensions—the length, breadth, and width—of a cube. Then think of time as the temporal fourth dimension that interplays with each of the other three. For instance, if your time horizon is long, you can afford to take more risk than if your horizon is short, and vice versa.

Bonds are best used as a source of regular income and as a moderating influence on a stock portfolio, not as an alternative to stocks.

Remember, the goal of the long-term investor is not to preserve capital in the short run, but to earn real, inflation-adjusted, long-term returns.

Real bond returns have been variable, but they have settled near a long-term average of 3.5 percent—half the 7 percent real return generated by stocks. In other words, stocks have delivered more than twice as much growth in purchasing power as bonds.

Although stocks are extremely volatile in the short run, the long-term investor cannot afford not to take those risks.

And do not forget that even as return grows dramatically over time, so risk diminishes dramatically over time. As Figure 1.3 in Chapter 1 illustrated, the volatility of stock returns quickly falls as the holding period lengthens. The one-year standard deviation on stocks drops from 18.1 percent to 2.0 percent over 25 years, but most of that drop has taken place by the end of just 10 years, when the standard deviation reaches 4.4 percent.

FIGURE 3.1 Basic Asset Allocation Model (Stocks/Bonds)

It would not be imprudent for a highly risk-tolerant young investor (25 years old or so), who is just beginning to invest for retirement, to allocate everything to stocks, provided that the investor has confidence that regular investments could be made through thick and thin.

In the distribution phase, a highly risk-averse older investor who has substantial means could cut the stock allocation to as low as 30 percent.

Asset allocation is not a panacea. It is a reasoned—if imperfect—approach to the inevitable uncertainty of the financial markets.