“The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns” by John C. Bogle
Published by Wiley, October 2017
Pages: 216
ISBN-10 : 1119404509 (ISBN-13: 978-1119404507)
Date Finished: Dec 30, 2022
How strongly I recommend it: 9/10 (for those with an interest in investing)
Find it at Amazon or BookShop.org
My Notes:
The index fund is simply a basket (portfolio) that holds many, many eggs (stocks) designed to mimic the overall performance of any financial market or market sector. Classic index funds, by definition, basically represent the entire stock market basket, not just a few scattered eggs. Such funds eliminate the risk of individual stocks, the risk of market sectors, and the risk of manager selection, with only stock market risk remaining (which is quite large enough, thank you).
Over the past century, our corporations have earned a return on their capital of 9.5 percent per year. Compounded at that rate over a decade, each $1 initially invested grows to $2.48; over two decades, $6.14; over three decades, $15.22; over four decades, $37.72; over five decades, $93.48. The magic of compounding is little short of a miracle. Simply, put, thanks to the growth, productivity, resourcefulness, and innovation of our corporations, capitalism creates wealth, a positive-sum game for its owners. Investing in equities is a winner's game.
After the deduction of the costs of investing, beating the stock market is a loser's game.
Most investors in stocks think that they can avoid the pitfalls of investing by due diligence and knowledge, trading stocks with alacrity to stay one step ahead of the game. But while the investors who trade the least have a fighting chance of capturing the market's return, those who trade the most are doomed to failure.
Fund investors are confident that they can easily select superior fund managers. They are wrong.
This book will tell you why you should stop contributing to the croupiers of the financial markets, who take in something like $400 billion each year from you and your fellow investors. It will also tell you how easy it is to do just that: simply buy the entire stock market. Then, once you have bought your stocks, get out of the casino and stay out. Just hold the market portfolio forever. And that's what the index fund does.
This investment philosophy is not only simple and elegant. The arithmetic on which it is based is irrefutable.
[Thomas Paine, 1776 Common Sense] Inspired by his words, I titled my 1999 book Common Sense on Mutual Funds, .. in this new book, I reiterate that proposition.
The driving dream (of the idealist) is that if he could only explain things to enough people, carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone would see, and then everything would be fixed. [late journalist Michael Kelly]
In the early years of indexing, my voice was a lonely one. But there were a few other thoughtful and respected believers whose ideas inspired me to carry on my mission. Today, many of the wisest and most successful investors endorse the index fund concept, and among academics, the acceptance is close to universal.
Adding a fourth law to Sir Isaac Newton's three laws of motion, the inimitable Warren Buffett puts the moral of the story this way: For investors as a whole, returns decrease as motion increases.
Stock market returns sometimes get well ahead of business fundamentals (as in the late 1920s, the early 1970s, the late 1990s). But it has been only a matter of time until, as if drawn by a magnet, they soon return, although often only after falling well behind for a time (as in the mid-1940s, the late 1970s, the 2003 market lows).
We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely because of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing. We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely because of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing.
We can measure these emotions buy the price/earnings (P/E) ratio, which measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall. When greed holds sway, we see very high P/Es. When hope prevails, P/Es are moderate. When fear is in the saddle, P/Es are very low. Back and forth, over and over again, swings in the emotions of investors momentarily derail the steady long-range upward trend in the economics of investing.
(Revision to the mean can be thought of as the tendency for stock returns to return to their long-term norms over time—periods of exceptional returns tend to be followed by periods of below average performance, and vice versa.)
"In the short run the stock market is a voting machine... (but) in the long run it is a weighing machine." Ben Graham, legedary investor, author of The Intelligent Investor and mentor to Warren Buffett.
Indexing is also the predominant strategy for the largest of them all, the retirement plan for federal government employees, the Federal Thrift Savings Plan (TSP).
In equity mutual funds, management fees and operational expenses—combined, called the expense ratio—average about 1.5 percent per year of fund assets.
Result: the "all-in" cost of equity fund ownership can come to as much as 3 percent to 3.5 percent per year. So yes, costs matter.
Brandeis described their self-serving financial management and their interlocking interests as, "trampling with impunity on laws human and divine, obsessed with the delusion that two plus two make five."
Indeed, the self-interest of the leaders of our financial system almost compels them to ignore these relentless rules. Paraphrasing Upton Sinclair: It's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.
When you think about it, how could it be otherwise? By and large, these managers are smart, well-educated, experienced, knowledgeable, and honest. But they are competing with each other. When one buys a stock, another sells it. There is no net gain to fund shareholders as a group.
In the investment field, time doesn't heal all wounds. It makes them worse. Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.
The investor, who put up 100 percent of the capital and assumed 100 percent of the risk, earned only 31 percent of the market return. The system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 70 percent of that return—surely the lion's share.
When he retired here's what Peter Lynch, the legendary manager who steered Fidelity Magellan Fund to such great success during his 1977 to 1990 tenure, had to say in Barron's: "The S&P is up 342.8 percent for 10 years. That is a four-bagger. The general equity funds are up 283 percent. So it's getting worse, the deterioration by professionals is getting worse. The public would be better off in an index fund."
Here's what James J. Cramer, money manager and host of CNBC's Mad Money says: "After a lifetime of picking stocks, I have to admit that Bogle's arguments in favor of index fund have me thinking of joining him rather than trying to beat him. Bogle's wisdom and common sense [are] indispensable...
Whatever the precise data, the evidence is compelling that equity fund returns lag the stock market by a substantial amount, largely accounted for by their costs, and that fund investor returns lag fund returns by an even larger amount.
The fund industry will not soon give up its promotions. But the intelligent investor will be well advised to heed not only the message in Chapter 4 about minimizing expenses, but the message in this chapter about getting emotions out of the equation.
The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.
The wise Warren Buffett shares my view, in what I call his "four E's." "The greatest Enemies of the Equity investor are Expenses and Emotions."
Charles Schwab: "It's fun to play around.. it's human nature to try to select the right horse... (But) for the average person, I'm more of an indexer."
Let's be clear: Most fund managers, once focused on long-term investments, are now focused on short-term speculation. But the index fund follows precisely the opposite policy—buying and holding forever, and incurring transaction costs that are somewhere between infinitesimal and zero.
Taxes are a crucially important financial consideration because the earlier realization of capital gains will substantially reduce net returns. Index funds do not trade from security to security and, thus, they tend to avoid capital gains taxes." [D. Malkiel]
Remember the unfailing principle described in Chapter 2: in the long run it is the reality of business—the dividend yields and earnings growth of corporations—that drives the returns generated by the stock market.
As investor confidence rose, so did the price/earnings (P/E) ratio rise—from 9 times to 18 times, an amazing 100 percent increase, adding fully 2.7 percentage points per year—almost 30 percent—to the solid 9.8 percent fundamental return. (Early in 2000, the P/E ratio had actually risen to an astonishing 32 times, only to plummet to 18 times as the new economy bubble burst.)
Since it is unrealistic to expect the P/E ratio to double in the coming decade, a similar 12.5 percent return is unlikely to recur. Common sense tells us that we're facing an era of subdued returns in the stock market (Exhibit 7.1).
Now assume that 7 percent is a rational expectation for future stock market returns. To calculate the return for the average actively managed equity mutual fund in such an environment, simply remember the humble arithmetic of fund investing: nominal market return, minus investment costs, minus taxes (reduced to reflect lower capital gains realization), minus an assumed inflation rate of 2.3 percent (the rate the financial markets are now expecting over the coming decade) equals just 1.4 percent per year.
Add third, some of active management's true believers will shift assets from expensive products to more reasonably priced products. Impetus for this move will be the growing realization that high fees sap the performance potential of even skillful managers."
[See if these still exist] Davis New York Venture, Fidelity Contrafund, and Franklin Mutual Shares. [the victors!]
Whatever the case, the odds in favor of owning a consistently successful equity fund are less than one out of a hundred. However one slices and dices the data, there can be no question that funds with long-serving portfolio managers and records of consistent excellence are the exception rather than the rule in the mutual fund industry. The simple fact is that selecting a mutual fund that will outpace the stock market over the long term is, using Cervantes' wonderful observation, like "looking for a needle in the haystack." So I offer you Bogle's corollary: "Don't look for a needle in the haystack. Just buy the haystack!"
In fund performance, the past is rarely prologue.
"Still, I figure we shouldn't discourage fans of actively managed funds. With all their buying and selling, active investors ensure the market is reasonably efficient. That makes it possible for the rest of us to do the sensible thing, which is to index.
The message is clear: reversion to the mean (RTM)—in this case, the tendency of funds whose records substantially exceed industry norms to return to average or below—is alive and well in the mutual fund industry.
So please remember that the stars produced in the mutual fund field are rarely stars; all too often they are comets, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth.
Listen to Nassim Nicholas Taleb, author of Fooled by Randomness: "Toss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. We run [the contest] for the first year (for 10,000 managers). At the end of the year, we expect 5,000 managers to be up $10,000 each, and 5,000 to be down $10,000. Now we run the game a second year.. 2,500 managers... fourth 625, fifth 313... and in 10 years, just 10 of the original 10,000 managers.
Under normal circumstances, it takes between 20 and 800 years (of monitoring performance) to statistically prove that a money manager is not just lucky, it can easily take nearly a millennium...
Finally, Money magazine columnist and author Jason Zweig sums up performance chasing in a single pungent sentence: "Buying funds based purely on their past performance is one of the stupidest things an investor can do."
"You will want to ensure that your adviser is choosing your investments purely on their investment merit and not on the basis of how the vehicles reward him. The warning signs here are recommendations of load funds, insurance products, limited partnerships, or separate accounts."
The more money managers take, the less the investors make.
Common sense tells us that performance comes and goes, but costs go on forever.
It's a paradox of fund investing today: Gunning for average is your best shot at finishing above average.
Your index fund should not be your manager's cash cow. It should be your own cash cow.
For example, when Vanguard created the industry's first Growth Index Fund and Value Index Fund in 1992, the former was designed for younger investors who focused on wealth accumulation, were seeking tax-efficiency, and were willing to assume larger risks. The latter was designed for older investors who focused on wealth preservation, were seeking higher income, and were happy to reduce their risks. pg 134
Always avoid bond funds with sales loads.
Over a ten-year period 1988-1998, US bond index funds returned 8.9 per cent a year against 8.2 per cent for actively managed bond funds (with) index funds beating 85 per cent of all active funds. This differential is largely due to fees."
The only way to beat the market portfolio is to depart from the market portfolio. And this is what active managers strive to do, individually. But collectively, they can't succeed.
A "double-whammy": betting on hot sectors (emotions) and paying heavy costs (expenses) are sure to bee hazardous to your wealth.
While I can't say that classic indexing is the best strategy ever devised, your common sense should reassure you that the number of strategies that are worse is infinite.
But it's important for us to keep our eyes on the ball and remember what makes indexing, well, indexing. Low fees, broad diversification, hold hold hold. Don't believe the hype. Try to beat the market—in any manner—and you're likely to get beat... by about the cost of doing it."
"Unsoundly managed funds can produce spectacular but largely illusionary profits for a while, followed inevitably by calamitous losses."
The real money in investment will be made not out of buying and selling but of owning and holding securities.
All these years later, the idea that earning your fair share of the stock market's return is the winning strategy is the central theme of this Little Book. Only the classic index fund can guarantee that outcome.
Here Mr. Buffett: "A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham took this position many years ago and everything I have seen since convinces me of its truth."
As John Maynard Keynes warned earlier in a different context, historical returns are of no value unless we can explain the source of those returns. In this context, let me reiterate the two basic sources of the superior returns achieved by the index fund: (1) the broadest possible diversification, eliminating individual stock risk, style risk, and manager risk, with only market risk remaining; and (2) the tiniest possible cost and minimal taxes. Together, they enable the index fund to provide the gross return earned in the stock market, minus a scintilla of cost.
Over the long term, stock market returns are created by real investment returns earned by real businesses—the annual dividend yield on publicly held U.S. corporations, plus their subsequent rate of earnings growth.
While investors earn the market's entire return, they do not capture the market's entire return. Rather, they capture the market's return only after the costs of financial intermediation are deducted—commissions, management fees, marketing costs, sales loads, administrative expenses, legal expenses and custodial fees, and so on. Unnecessary taxes simply enlarge the gap.
.. the "4 Es": The two greatest enemies of the equity fund investor are expenses and emotions.
Then listen to Nobel Laureate in Economics and Princeton professor Daniel Kahneman. His life's work explains that investors are prone to overconfidence, and that overconfidence causes us to misinterpret information and let our emotions warp our judgement. When it comes to investing, "I don't try to be clever at all. The idea that I could see what no one else can is an illusion." So he sticks with, yes, index funds.
But in the Serious Money account. Whatever the case, don't speculate in ETFs. Invest in them.
If you decide to have a Funny Money Account, be sure to measure your returns after one year, after five years, and after ten years. Then compare those returns with the returns you've earned in your Serious Money Account. I'm betting that your SM will win in a landslide.
Warren Buffett: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professions.
Our task remains: earning our fair share of whatever returns that our business enterprises are generous enough to provide in the years to come. That, to me, is the definition of investment success.
He that would catch Fish, must venture his Bait... Great Estates may venture more, but little Boats should keep near shore... Tis easy to see, hard to foresee... Industry, Perseverance, and Frugality make Fortune yield." [Cliff Asness]
But even I would never have had the temerity to say what Dr. Paul Samuelson of M.I.T. said in a speech to the Boston Society of Security Analysts in the autumn of 2005: "The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel and the alphabet." Those two essentials of our existence that we take for granted every day have stood the test of time. So will the classic index fund.
For more… find it at Amazon or BookShop.org