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Bogle reveals his key to getting more out of investing: low-cost index funds. While the stock market has tumbled and then soared since the first edition of The Little Book of Common Sense Investing was published in April , Bogle's investment principles have endured and served investors well. This tenth anniversary edition includes updated data and new information but maintains the same long-term perspective as its predecessor.
Bogle has also added two new chapters designed to provide further guidance to investors: one on asset allocation, the other on retirement investing. A portfolio focused on index funds is the only investment that effectively guarantees your fair share of stock market returns.
This strategy is favored by Warren Buffett, who said this about Bogle: 'If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultralow-cost index funds. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned.
He is a hero to them and to me. This new edition of The Little Book of Common Sense Investing offers you the same solid strategy as its predecessor for building your financial future. Build a broadly diversified, low-cost portfolio without the risks of individual stocks, manager selection, or sector rotation. Forget the fads and marketing hype, and focus on what works in the real world.
Understand that stock returns are generated by three sources dividend yield, earnings growth, and change in market valuation in order to establish rational expectations for stock returns over the coming decade. Today, many of the wisest and most suc- cessful investors endorse the index fund concept, and among academics, the acceptance is close to universal.
Listen to these indepen- dent experts with no axe to grind except for the truth about investing. Listen, for example, to this endorsement by Paul A. Then, at last, whatever returns our businesses may be generous enough to deliver in the years ahead, reflected as they will be in our stock and bond markets, you will be guaranteed to earn your fair share.
JOHN C. Mu- tual funds charge two percent per year and then bro- kers switch people between funds, costing another three to four percentage points. The poor guy in the general public is getting a terrible product from the professionals. Only a fool takes on the additional risk of doing yet more damage by failing to diver- sify properly with his or her nest egg. Avoid the problem—buy a well-run index fund and own the whole market.
Over long periods of time, hardly any fund managers have beaten the market averages. They encourage in- vestors, rather than spread their risks wisely or seek the best match for their future liabilities, to put their money into the most modish assets going, often just when they become overvalued. And all the while they charge their clients big fees for the privilege of losing their money. One specific lesson. It is better to invest in an indexed fund that promises a market return but with significantly lower fees.
May their com- mon sense, perhaps even more than my own, make you all wiser investors. Perhaps this homely parable—my ver- sion of a story told by Warren Buffett, chairman of Berkshire Hathaway Inc. A wealthy family named the Gotrocks, grown over the gen- erations to include thousands of brothers, sisters, aunts, uncles, and cousins, owned percent of every stock in the United States.
Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they dis- tributed. These Helpers convince the cousins to sell some of their shares in the companies to other family members and to buy some shares of others from them in return. The Helpers handle the transactions, and as bro- kers, they receive commissions for their services.
The ownership is thus rearranged among the family members. To their surprise, however, the family wealth begins to grow at a slower pace. They recognize that their foray into stock-picking has been a failure and conclude that they need profes- sional assistance, the better to pick the right stocks for themselves.
So they hire stock-picking experts—more Helpers! These money managers charge a fee for their services. So when the family ap- praises its wealth a year later, it finds that its share of the pie has diminished even further. They retain the best investment consultants and financial planners they can find to advise them on how to select the right man- agers, who will then surely pick the right stocks.
The consultants, of course, tell them they can do exactly that. Then our family will again reap percent of the pie that Corporate America bakes for us. Alarmed at last, the family sits down together and takes stock of the events that have transpired since some of them began to try to outsmart the others. Go back to square one, and do so immediately. Get rid of all your brokers. Get rid of all your money managers.
Get rid of all your consultants. Then our family will again reap percent of however large a pie that corporate America bakes for us, year after year. That is exactly what an index fund does. Accurate as that cryptic statement is, I would add that the parable reflects the profound conflict of interest between those who work in the investment business and those who invest in stocks and bonds. Do something. Just stand there. When any business is con- ducted in a way that directly defies the interests of its clients in the aggregate, it is only a matter of time until change comes.
The higher the level of their investment activity, the greater the cost of financial intermediation and taxes, the less the net return that the business owners as a group receive. The lower the costs that investors as a group incur, the higher rewards that they reap. So to realize the winning returns generated by businesses over the long term, the intelligent investor will minimize to the bare bones the costs of financial intermediation. Most people think they can find managers who can outperform, but most people are wrong.
I will say that 85 to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are delet- ing value. First, get diversified. Come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low.
That means avoid- ing the most hyped but expensive funds, in favor of low-cost index funds. And finally, invest for the long term. No doubt about it. Active management as a whole cannot achieve gross returns exceeding the market as a while and therefore they must, on average, underper- form the indexes by the amount of these expense and transaction costs disadvantages. Many people will find the guarantee of playing the stock-market game at par every round a very attractive one.
Yet the record is clear. History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U. Think about that certainty for a mo- ment. Can you see that it is simple common sense? Need proof? Just look at the record since the twenti- eth century began Exhibit 2.
The average annual total return on stocks was 9. That tiny difference of 0. Depending on how one looks at it, it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earn- ings at the end of the period than at the beginning. Compounding these returns over years produced accumulations that are truly staggering.
Each dollar ini- tially invested in at an investment return of 9. But increasing real wealth nearly times over is not to be sneezed at. Sometimes, as in the Great Depression of the early s, these bumps are large. But we get over them. So, if you stand back from the chart and squint your eyes, the trend of business fundamentals looks al- most like a straight line sloping gently upward, and those periodic bumps are barely visible.
Stock market returns sometimes get well ahead of business fundamentals as in the late s, the early s, the late s. But it has been only a matter of time until, as if drawn by a magnet, they soon return, al- though often only after falling well behind for a time as in the mids, the late s, the market lows. In our foolish focus on the short-term stock market distractions of the moment, we, too, often overlook this long history.
We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely be- cause of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the rea- son that annual stock returns are so volatile is largely be- cause of the emotions of investing. Back and forth, over and over again, swings in the emotions of investors momentar- ily derail the steady long-range upward trend in the eco- nomics of investing.
So, while in- vestors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock re- turn component are a deeply flawed guide to what lies ahead. Exhibit 2. Note first the steady contribution of dividend yields to total return during each decade; always positive, only once outside the range of 3 percent to 7 per- cent, and averaging 4.
Result: Total investment returns the top line, combining dividend yield and earnings growth were negative in only a single decade again, in the s. These total investment returns—the gains made by business—were remarkably steady, gener- ally running in the range of 8 percent to 13 percent each year, and averaging 9.
Enter speculative return. Curiously, without excep- tion, every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount—the quiet s and then the roaring s, the dispiriting s and then the booming s, the discouraging s and then the soaring s—reversion to the mean RTM writ large. Reversion 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.
Then, amazingly, there is an unprecedented second consecutive exuberant increase in speculative re- turn in the s, a pattern never before in evidence. As a result, speculative return has added just 0. When we combine these two sources of stock re- turns, we get the total return produced by the stock mar- ket Exhibit 2.
The average annual total return on stocks of 9. The message is clear: in the long run, stock returns depend al- most entirely on the reality of the investment returns earned by our corporations. The perception of investors, reflected by the speculative returns, counts for little. It is economics that controls long-term equity returns; emo- tions, so dominant in the short-term, dissolve. But forecasting the long-term economics of investing carries remarkably high odds of success.
After more than 55 years in this business, I have ab- solutely no idea how to forecast these swings in investor emotions. In fact, 70 years of financial re- search show that no one has done so. Put another way, while illusion the momentary prices we pay for stocks often loses touch with reality the intrinsic values of our corpora- tions , in the long run it is reality that rules. To drive this point home, think of investing as consisting of two different games. Where real com- panies spend real money to make and sell real products and services, and, if they play with skill, earn real profits and pay real dividends.
This game also requires real strategy, deter- mination, and expertise; real innovation and real foresight. In the short-term, stock prices go up only when the expectations of investors rise, not necessarily when sales, margins, or profits rise. The expectations market is about speculation. The real market is about investing. The only logical conclusion: the stock market is a giant distraction that causes investors to focus on transitory and volatile in- vestment expectations rather than on what is really impor- tant—the gradual accumulation of the returns earned by corporate business.
My advice to investors is to ignore the short-term noise of the emotions reflected in our financial markets and focus on the productive long-term economics of our corporate businesses. He should always remember that market quo- tations are there for his convenience, either to be taken advantage of or to be ignored. One of your part- ners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.
Sometimes his idea of value appears plausible and justified by business developments and prospects. Often, on the other hand, Mr. Market lets his enthu- siasm or his fears run away with him, and the value he proposes seems little short of silly. Only in case you agree with him or in case you want to trade with him. The true investor. Simply by buying a portfolio that owns the shares of every business in the United States and then holding it forever. It is a simple concept that guarantees you will win the invest- ment game played by most other investors who—as a group—are guaranteed to lose.
By far the simplest way to own all of U. It is essentially composed of the largest U. The beauty of such a cap-weighted index is that it automatically adjusts to changing stock prices and never has to buy and sell stocks for that reason. With the enormous growth of corporate pension funds between and , it was an ideal measurement stan- dard, the benchmark or hurdle rate that would be the com- parative standard for how their professional managers were performing.
In , an even more comprehensive measure of the U. However, because its component stocks also are weighted by their market cap- italization, those remaining 4, stocks account for only about 20 percent of its value. Nonetheless, this broadest of all U. The two indexes have a similar composition. Exhibit 3. Given the similarity of these two portfolios, it is hardly surprising that the two indexes have earned returns that are in lockstep with one another.
The Center for Research in Se- curity Prices at the University of Chicago has gone back to and calculated the returns earned by all U. Its data since have provided a virtually perfect match to the Total Stock Market Index. In fact, returns of the two indexes parallel one another with near precision.
From , the beginning of the measurement period, through , you can hardly tell them apart Exhibit 3. Exxon Mobil 3. Exxon Mobil 2. General Electric 3. General Electric 2. Citigroup 2. Citigroup 1. Bank of America 1. Microsof t 1. Pfizer 1. American International Group 1. Altria Group 1. Morgan 1. Chevron 1. American International Group 0. This represents what we call a period dependent outcome—everything depends on the starting date and the ending date.
If we were to begin the comparison at the beginning of instead of , the re- turns of the two would be identical: 9. But in recent years to , small- and mid-cap stocks did bet- ter, and the Total Stock Market Index return of 3. But with a long-term correlation of 0. Whichever measure we use, it should now be obvious that the returns earned by the publicly held corporations that compose the stock market must of necessity equal the aggregate gross returns earned by all investors in that market as a group.
Equally obvious, as discussed in Chap- ter 4, the net returns earned by these investors must of necessity fall short of those aggregate gross returns by the amount of intermediation costs they incur. Such an all-market fund is guaranteed to outpace over time the returns earned by equity investors as a group. Once you recognize this fact, you can see that the index fund is guaranteed to win not only over time, but every year, and every month and week, even every minute of the day. If the data do not prove that indexing wins, well, the data are wrong.
That is because there is no pos- sible way to calculate the returns earned by the millions of diverse participants, amateur and professional alike, Amer- icans and foreign investors, in the U. Since there are many small-cap and mid-cap funds, usually with rel- atively modest asset bases, they make a disproportion- ate impact on the data.
When small- and mid- cap funds are leading the total market, the all-market index fund seems to lag. When small- and mid- cap stocks are lagging the market, the index fund looks formidable indeed. Nonetheless, the exercise of calculating how the re- turns earned by the stock market compare with returns earned by the average equity fund is both illuminating and persuasive Exhibit 3.
The Index has outpaced the average fund in 26 of the remaining 35 years, including 11 of the past 15 years. Its average ranking was in the 58th percentile outperforming 58 percent of the comparable actively managed funds , leading, as we will show in Chapter 4, to enormous superiority over time.
It is hard to imagine that even a single one of the large-cap core eq- uity funds has a similar record of consistency. Consistency matters. A fund that is good or very good in the vast majority of years produces a far larger long- term return than a fund that is superb in half the years and a disaster in the remaining half.
In the next chapter, the impact of that long-term consistency is catalogued over the past 25 years. These annual data are what we call survivor-biased; they exclude the records of the inevitably poorer perform- ing funds that regularly go out of business. As a result of this noise in the data, the chart further understates the success of the market-owning index strategy.
While the criticism is valid, the excellent long-term record of the flawed Index belies the existence of a sig- nificant problem. In fact, since the market peaked early in as shown in Exhibit 3. I imagine that the vast majority of money managers would have been ec- static with such an outcome. Equally important, it is consistent with the age-old principle expressed by Sir William of Occam: instead of joining the crowd of investors who dabble in complex machinations to pick stocks and try to outguess the stock market two inevitably fruitless tasks for investors in the aggregate , choose the simplest of all solutions—buy and hold the market portfolio.
Of the equity mutual funds then in exis- tence, only remain. The 96 percent of funds that fail to meet or beat the Vanguard Index Fund lose by a wealth-destroying margin of 4. 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. All contributions and earnings are tax-deferred until withdrawal, much like the corpo- rate k thrift plans.
Overcoming what must have been some serious reservations, even the Bush administration determined to follow the TSP model in its plan for Personal Savings Accounts as an op- tional alternative to our Social Security program. Since , the Vanguard index fund has produced a compound annual return of 12 percent, better than three- quarters of its peer group.
Yet even 30 years on, ig- norance and professional omerta still stand in the way of more investors enjoying the fruits of this un- sung hero of the investment world. To understand why they do not, we need only to recognize the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs o f investing are deducted. In a market that returns 10 per- cent, we investors together earn a gross return of 10 per- cent.
But after we pay our financial intermediaries, we pocket only what remains. And we pay them whether our returns are positive or negative! The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. How much do those costs come to? For individual investors holding stocks directly, trading costs average about 1.
That cost is lower about 1 percent for those who trade infrequently, and much higher for in- vestors who trade frequently for example, 3 percent for investors who turn their portfolios over at a rate above percent per year. In equity mutual funds, management fees and operat- ing expenses—combined, called the expense ratio—aver- age about 1.
If the shares are held for five years, the cost would be twice that figure—1 percent per year. But then add a giant additional cost, all the more per- nicious by being invisible. I am referring to the hidden cost of portfolio turnover, estimated at a full 1 percent per year. At that rate, brokerage commissions, bid-ask spreads, and market impact costs add a major layer of additional costs. So if we pay nothing, we get everything. Most equity funds hold about 5 percent in cash reserves.
If stocks earn a 10 percent return and these reserves earn 4 percent, that cost would add another 0. Brandeis first published in , I came across a wonderful passage that illustrates this sim- ple lesson. Brandeis, later to become one of the most in- fluential jurists in the history of the U. Supreme Court, railed against the oligarchs who a century ago controlled investment America and corporate America alike.
Because the relentless rules of the arith- metic of investing are so obvious. Indeed, the self-interest of the leaders of our financial system almost compels them to ignore these relentless rules. Their self-interest will not soon change. But as an investor, you must look after your self- interest.
Only by facing the obvious realities of investing can the intelligent investor succeed. How much do the costs of financial intermediation matter? 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 fact, they incur a loss equal to the transaction costs they pay to those Helpers that Warren Buffett warned us about in Chapter 1.
Investors pay far too little attention to the costs of in- vesting. Perhaps an example will help. Result: a net annual return of just 5. In the early years, the line showing the growth at a 5. But ever so slowly, the lines begin to diverge, finally at a truly dramatic rate. It makes them worse. Where returns are concerned, time is your friend. And by the end of the invest- ment period, costs have consumed nearly 70 percent of the potential accumulation available simply by holding the market portfolio.
Add that mathematical certainty to the relentless rules of hum- ble arithmetic described earlier. But enough of theory and hypothetical examples. The return on the average mu- tual fund averaged just That 2. Never forget: Market return, minus cost, equals investor return. Fund investors, inevitably at the bot- tom of the food chain, have been left with too small a share. Investors need not have incurred that loss. Such a fund actually returned That is an annual margin of superiority of 2.
On first impression, that annual gap may not look large. But when compounded over 25 years, it reaches staggering proportions. Both of these accumulations are overstated because they are based on dollars, which have less than half the spending power they enjoyed in During this period, inflation eroded the real buying power of these returns at an average rate of 3. Now, the average fund produced barely one-half ac- tually 53 percent of the profit earned by the stock market through the simple index fund—a return that was there for the taking.
It is in the nature of arithmetic that de- ducting the same inflation rate from both figures further increases the comparative advantage of the investment with the higher return, in this case the index fund. Yes, costs matter! Indeed, costs make the difference between investment success and investment failure. You can add and subtract for yourself. It equals you guessed it only 6. Do your own arithmetic.
Realize that you are not consigned to playing the hyperac- tive management game that is played by the overwhelming majority of individual investors and mutual fund owners alike. The index fund is there to guarantee that you will earn your fair share of whatever returns our businesses earn and our stock market delivers. That is a four-bagger. The general equity funds are up percent. The public would be better off in an index fund.
Even hyperactive investors seem to believe in in- dexing strategies. It is what we should all own in theory and it has delivered low-cost eq- uity returns to a great mass of investors. But the idea that fund investors themselves actually earn those returns proves to be a grand illusion. Not only an illu- sion, but a generous one. The reality is considerably worse.
During the year period examined in Chapter 4, the returns we presented were based on the traditional time-weighted returns reported by the funds—the change in the asset value of each fund share, adjusted to reflect the reinvestment of all income dividends and capital gains distributions. But that fund return does not tell us what return was earned by the average fund investor. And that return turns out to be far lower.
To ascertain the return earned by the average fund in- vestor, we must consider the dollar-weighted return, which accounts for the impact of capital flows from in- vestors, into and out of the fund. In fairness, the index fund investor, too, was enticed by the rising market, and earned a return of Yes, during the past 25 years, while the stock market index fund was providing an annual return of Compounded over the full period, as we saw in Chapter 4, the 2.
But the dual penalties of faulty tim- ing and adverse selection were even larger. Exhibit 5. And once again, the value of all those dollars tumbles because we must take inflation into account. The index fund real return drops to 9. While the data clearly indicate that fund investor returns fell well short of fund returns, there is no way to be precise about the exact shortfall.
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. What explains this shocking lag? Simply put, counter- productive market timing and fund selection. First, share- holders investing in equity funds paid a heavy timing penalty. They invested too little of their savings in equity funds during the s and early s when stocks repre- sented good values.
Then, inflamed by the heady optimism and greed of the era and enticed by the wiles of mutual fund marketers as the bull market neared its peak, they poured too much of their savings into equity funds. Sec- ond, they paid a selection penalty, pouring their money into the market not only at the wrong time but into the wrong funds.
In both failures, investors simply failed to practice what common sense would have told them. This lag effect was amazingly pervasive. Then, the fund industry or- ganized more and more funds, usually funds that carried considerably higher risk than the stock market itself, and magnified the problem by heavily advertising the eye- catching past returns earned by its hottest funds. As the market soared, investors poured ever larger sums of money into equity funds.
While only 20 percent of their money went into risky ag- gressive growth funds in , they poured fully 95 per- cent into such funds when they peaked during and early They also pulled their money out of growth funds and turned, too late, to value funds. During those five years, these aggressive funds pro- vided spectacular records—annual returns averaging 21 percent per year, well above even the outstanding return of But during the five years that followed, in through , retribution followed.
While the index fund eked out a small gain less than 1 percent per year , the returns of these aggressive, risk-laden funds tumbled into negative territory. For the full 10 years, taking into account both their rise and their fall, the returns reported by these aggressive funds were actually quite acceptable—an average of 7. But woe to the shareholder who chose them. For while the fund returns were acceptable, the re- turns of their shareholders were, well, terrible.
Their average return came to minus 0. For the record, the annual return of the index fund share- holder, at 7. When the annual returns of these aggressive funds are compounded over the full period, the deterioration is stunning: a cumulative fund return averaging more than percent; a cumulative shareholder return averaging negative 4. This astonishing penalty, then, makes clear the perils of fund selection and timing.
It also illus- trates the value of indexing and the necessity of setting a sound course and then sticking to it, come what may. Fund investors have been chasing past performance since time eternal, allow- ing their emotions—perhaps even their greed—to over- whelm their reason. But the fund industry itself has played on these emotions, bringing out new funds to meet the fads and fashions of the day, often supercharged and spec- ulative, and then aggressively advertising and marketing them.
It is fair to say that when ever-counterproductive in- vestor emotions are played on by ever-counterproductive fund industry promotions, little good is apt to result. The fund industry will not soon give up its promo- tions. 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 beauty of the index fund, then, lies not only in its low expenses, but in its elimination of all those tempting fund choices that prom- ise so much and deliver so little. Unlike the hot funds of the day, the index fund can be held through thick and thin for an investment lifetime, and emotions need never enter the equation. The winning formula for success in invest- ing is owning the entire stock market through an index fund, and then doing nothing.
Just stay the course. The predictability is so high. Why would you screw it up? As described in Chapter 4, the index fund has provided excellent protection from the penalty of these costs. While its real returns also were hurt by inflation, the cumulative impact was far less than on the actively managed equity funds.
The fact is that most managed mutual funds are astonishingly tax-inefficient, a result of the short- term focus of their portfolio managers, usually frenetic traders of the stocks in the portfolios they supervise. The turnover of the average equity fund now comes to about percent per year. In fairness, based on total assets rather than number of funds, the turnover rate of actively managed funds is 61 percent.
Industrywide, the average stock is held by the average fund for an average of just 12 months. Based on equity fund total assets, only 20 months. Hard as it is to imagine, from to , the turnover rate averaged just 16 percent per year, an av- erage holding period of six years for the average stock in a fund portfolio.
This huge increase in turnover and its attendant transaction costs have ill-served fund investors. The other half are held in tax- deferred accounts such as individual retirement accounts IRAs and corporate savings, thrift, and profit-sharing plans. If your fund holdings are solely in the latter category, you need not be concerned with the discussion in this chapter.
But the index fund follows pre- cisely the opposite policy—buying and holding forever, and incurring transaction costs that are somewhere be- tween infinitesimal and zero. With the high portfolio turnover of actively managed funds, their taxable investors were subject to an estimated effective annual federal tax of 1.
Despite the higher returns that they earned, in- vestors in the index fund were actually subjected to lower taxes—in fact, at 0. When we calculate the accumulated wealth in terms of real dollars with buying power, investor wealth again contracts dramati- cally.
The annual real return of the average equity fund now drops to 4. Even with the more subdued returns earned in the postbubble era, actively managed funds persist in foisting this extraordinarily costly tax inefficiency on their share- holders. While the net annual return of the average equity fund was 8.
But surely the final straws include 1 high costs, 2 the adverse investor selections and counterproductive market timing described in Chapter 5, and 3 taxes. But the very last straw, it turns out, is inflation. It is truly remarkable—and hardly praise- worthy—that this devastation is virtually ignored in the in- formation that fund managers provide to fund investors. A paradox: While the index fund is remarkably tax- e fficient in managing capital gains, it turns out to be rela- tively tax-inefficient in distributing dividend income.
Here is the unsurprising and ever relentless arith- metic: the annual gross dividend yield earned by the typi- cal active equity fund before deducting fund expenses is about the same as the dividend yield of the low-cost index fund—1.
But after deducting the 1. Fund operating costs and fees confiscate fully 80 percent of its dividend income, a sad reaffirmation of the eternal position of fund investors at the bottom of the mu- tual fund food chain. The result: a net yield of 1. For taxable shareholders, that larger dividend is subject to the current 15 percent federal tax on dividend income, consuming about 0. Para- doxically, the active fund, with an effective tax rate of just 0. But the reality is that the tax imposed by the active managers in the form of the fees it deducts before paying those dividends has already consumed 80 percent of the yield.
If the Vanguard Index Fund could have de- ferred all of its realized capital gains, it would have ended up in the To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration be- cause 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. How- ever, I must warn you that during the past 25 years—the period examined in the three preceding chapters—the A mere 0. A dividend yield averaging 3. But, illustrat- ing the difficulty of forecasting changes in the amount that investors are willing to pay for each dollar of corporate earnings, the speculative return was anything but normal.
Thus we can expect a dead-weight loss of 2. If it re- mains at that level a decade hence, speculative return would neither add to nor detract from that possible 8 percent investment return. If you think it will leap to 25 times, add 3 percentage points, bringing the total re- turn on stocks to 11 percent.
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 en- vironment, simply remember the humble arithmetic of fund investing: nominal market return, minus investment costs, minus taxes reduced to reflect lower capital gains realiza- tion , minus an assumed inflation rate of 2.
It may seem absurd to project such a low return for the typical equity fund investor. But the numbers are there. Again, feel free to disagree and to project the future using your own rational expectations. In summary, the future outlook for stock returns is far below the long-term real return on U. My projection of a future real return of 4. The real long-term rate of per share earnings growth of U.
As suggested earlier, some experts put the figure at only 1 percent on an earn- ings per share basis. The fact is that lower returns harshly magnify the relentless arithmetic of excessive mutual fund costs, even ignoring all those unnecessary taxes. While costs of 2. The 1. What can equity fund investors do to avoid being trapped by these relentless rules of arithmetic, so devastating when applied to future returns that are likely to be well below long-term norms?
There are at least five options for improving on it: 1 Select winning funds on the basis of their long-term past records. Or 5 Select a low-cost index fund that simply holds the stock market portfolio. In the latter part of , in a speech before these professionals at their Chicago conven- tion, I polled the audience. The clear consensus: stock returns of 6. When Henry McVey, market strategist for Morgan Stan- ley, polled the chief financial officers of the largest corporations in the United States, they ex- pected a future return on stocks of 6.
Other highly regarded investment strategists also share my general view that we are facing a new era of subdued investment returns. Gary P. With an inflation assumption of 2. What can- not be explained is why people are willing to pay the considerable fees involved. Perhaps they are paying for historical returns, for hope, or out of desperation Aggregate fees for the active managers should thus be, at most, the fees associated with- passive management.
Yet, these fees are several times larger than fees that would be associated with passive management. This illogical conun- drum will ultimately have to end. Yet, we live with a legacy of that era: histori- cally high fee structures brought on by trillions upon trillions of dollars seeking growth during the boom and shelter in its aftermath. Second, facing the dual challenge of market efficiency and high costs, investors will continue to shift assets from active to passive management.
Impetus for this move will be the growing realization that high fees sap the performance poten- tial of even skillful managers. Sure, there are always some winners that survive over the years. And if we pore over records of past performance, it is easy to find them. The mutual funds we hear the most about are those that have lit up the skies with their glow of past success. And when they falter, they often go out of business, consigned to the dustbin of mu- tual fund history. Exhibit 8.
The first and most obvious surprise awaits you: fully of those funds—almost two- thirds—have gone out of business. You can safely assume it was not the best performers that have gone to their well-earned demise; it was the lag- gards that disappeared. The average fund portfolio manager, in fact, lasts just five years.
There are many reasons that funds disappear, few of them good. Even funds with solid long-term records go out of business. The funds have simply outlived their usefulness. In other cases, a few years of faltering performance does the job. Sadly, the second oldest fund in the entire mutual fund industry was a recent victim of these attitudes, put out of business by a new owner of its management company.
After surviving all the tempestuous markets of the past 80 years: State Street Investment Trust, —, R. In any event, of the equity funds of are gone, mostly the poor performers. Together, then, funds—nearly 80 percent of the funds among those origi- nal —have, one way or another, failed to distinguish themselves. That leaves just 24 mutual funds—only one out of e very 14—that outpaced the market by more than one percentage point per year.
That still leaves us with nine solid long-term winners. It is a tremendous accomplishment to outpace the market by 2 percentage points or more of annual return over 35 years. Make no mistake about that. But, here a curious— perhaps almost obvious—fact emerges Exhibit 8. Six of those nine winners achieved their superiority many years ago, often when they were of small size.
As they grew, the records of six of them turned lackluster. One fund reached its performance peak way back in , 24 long years ago. On balance, it has lagged ever since. Two others peaked in The remaining three peaked no more recently than , more than a decade ago. That leaves just three funds. Identified in Exhibit 8. Hail to the victors! Significantly, while the portfolio managers for these three funds have changed over the years, the changes have been infrequent.
Succeeding his father Shelby C. Will Danoff has been the lead manager of Fidelity Contrafund since , and Michael Price managed Franklin until , followed by a successor who ran the fund until But before you rush out to invest in these three funds with such truly remarkable long-term records, think about the next 35 years. Think about the odds that they will con- tinue to outperform. Think about their present size.
Think about the fact that within that time frame they are all virtually certain to have at least several new managers. It is a changing and competitive world out there in mutual fund land, and no one knows what the fu- ture holds. But I wish these managers and the sharehold- ers of the funds they run the very best of luck.
Conspicuous by its absence from this list of winning funds is Legg Mason Value Trust, managed since its inception by legendary investment professional supreme, Bill Miller. Since the fund did not begin operations until , it is not on my list. But it provides several lessons about fund performance. But by , the gap had shrunk to 1. Unsurprisingly, the major inflows of investor capital did not begin until , the seventh year of the streak. Will the fund be afflicted with the same malaise that attacked six of those nine long-term winners just discussed?
Or is it merely a brief interval of bad luck. Who can know? Whatever the case, the odds in favor of owning a con- sistently 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 man- agers and records of consistent excellence are the excep- tion rather than the rule in the mutual fund industry. Just buy the hays tack! The haystack, of course, is the entire stock market portfolio, readily available through a low-cost index fund.
The return of such a fund would have roughly matched or exceeded the returns of of the funds that began the year competition described earlier in this chapter. And I see no reason that the same fund cannot achieve a roughly commensurate achievement in the years to come—not through any legerdemain, but merely through the relentless rules of arithmetic that you now must know so well.
In fund performance, the past is rarely prologue. With his customary wisdom, Paul Samuelson sums up the difficulty of selecting superior managers in this parable. A tad delusional? I think so. With all their buying and selling, active investors ensure the market is reason- ably efficient.
That makes it possible for the rest of us to do the sensible thing, which is to index. Want to join me in this parasitic behavior? To build a well-diversified portfolio, you might stash 70 per- cent of your stock portfolio into a Dow Jones Wilshire index fund and the remaining 30 percent in an international-index fund.
Every single firm in the fund industry acknowledges my conclusion that past fund performance is of no help in projecting the future returns of mutual funds. Exhibits 5. Studies show that 95 percent of all investor dollars flow to funds rated four or five stars by Morningstar, the statistical service most broadly used by investors in evaluating fund returns. How successful are fund choices based on the num- ber of stars awarded for such short-term achievements? Not very!
Sadly, the orientation of fund investors toward recent short-term returns works worst in strong bull markets. Exhibit 9. The relative performance of the four- and five-star funds has improved since then. Rydex OTC RS Emerging Growth MorganStanley Capital Op Janus Olympus Janus Twenty Managers Capital Appreciation Janus Mercury Fidelity Aggressive Growth Van Wagoner Emerging Growth WM Growth Focused on Internet, telecom, and technology stocks, these funds generated an average return of 55 per- cent per year during the upswing—a cumulative return of percent for the full three years.
Well, you can guess what came next. Fund 9 on the upside actually was last— on the downside. Fund 1 dropped in rank to ; fund 2 dropped to , and fund 3 tumbled to On aver- age, the one-time 10 top funds in the bull market were out- performed by 95 percent of their peers in the bear market that followed. For investors who believed that the past would be prologue, it was not a pretty result. More like 2 percent. Do the arithmetic. And with 3 years of average annual gains of 55 percent on the upside and annual losses averaging 34 percent on the downside Exhibit 9.
Yet while that return was not particularly satisfactory in terms of the traditional returns reported by the average equity fund, it was hardly a disaster. But for the shareholders of the funds, it was a disas- ter. By investing after seeing those mouth-watering cumu- lative returns that had averaged almost percent, achieved in a soaring bull market, nearly all the buyers of these funds had missed the upside.
Then, not a moment too soon, they caught the full force of the downside. Result: While the funds themselves achieved a net gain of 13 percent, the in- vestors in these funds incurred a loss of 57 percent. By in- vesting in these once high-flying funds, more than half of the capital that investors had placed in these hot funds had gone up in smoke. The message is clear: avoid per- formance chasing based on short-term returns, especially during great bull markets. As it hap- pened, the top 20 funds of that ranked number one in each year had a subsequent average ranking of among the list EXHIBIT 9.
During that period, the highest achievement on the fund list was turned in by the number one funds, which averaged a rank of in the subsequent year. The clear reversion to the mean suggested by that single test represented powerful evidence that winning performance by a mutual fund is unlikely to be repeated. But there was no reason except common sense to as- sume that the to experience would recur.
So, just for fun, I repeated the test in , beginning with the top-performing 20 funds in and the top 20 funds in each of the nine subsequent years. I then checked the rank of each fund in the following year, just as before. In general, the results were remarkably similar. The average subsequent rank of the top 20 funds from through was , outpacing 57 percent of their peers and barely above the average fund among the 1, fund total—just as in the prior test.
In an interesting rever- sal of fortune, however, the number one funds of that era turned out to have, not the highest subsequent ranking, but the lowest ranking among the top These champi- ons subsequently earned an average ranking of among the 1,fund total, outpacing only 34 percent of their peers. 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 remem- ber 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. With each passing year, the reality is increasingly clear. Fund returns seem to be random.
And by then, you might ask yourself questions like these: 1 How long will that manager, with that staff and with that strategy, remain on the job? In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund. We run [the contest] for the first year [for 10, managers].
Now we run the game a second year. Again, we can expect 2, managers to be up two years in a row; another year, 1,; a fourth one, ; a fifth, We have now, simply in a fair game, managers who made money for five years in a row. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business in place of going to dental school , rather than on their ability to produce profits.
What do you mean? Under normal circumstances, it takes between 20 and years [of monitoring performance] to statistically prove that a money manager is skillful, not lucky. Investors need to know how the money management business really works. The game is unfair. Where do you invest? In Vanguard index funds. Once you throw in taxes, it just skewers the argument for active management. Personally, I think indexing wins hands-down.
Professional investment advisers provide many other services including asset allocation, information on tax considerations, and advice on how to save while you work and on how to spend when you retire; and they are always there to con- sult with you about the financial markets. Experienced advisers can also help you avoid the potholes along the investment highway.
Put more grossly, they may help you avoid making such dumb mistakes as chasing past performance or trying to time the market. At their best, these impor- tant services can enhance the implementation of your investment program.
The remaining 40 million families rely on profes- sional helpers. That is, their advice on equity fund selection produces re- turns for their clients that are probably not measurably different from those of the average fund, some 2.
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|Little book of common sense investing epub gratis||It is in the nature of arithmetic that de- ducting the same inflation rate from both figures further increases the comparative advantage of the investment with the higher return, in this case the index fund. Even including this recent advantage, the long-term margins of superiority achieved by these theoretically constructed back-tested portfolios are not large—between 1 percent and 2 percent per year. Bogle has also added two new chapters designed to provide further guidance to investors: one on asset allocation, the other on retirement investing. To their surprise, however, the family wealth begins to grow at a slower pace. Sie stock price funds have simply outlived their usefulness. During the past five years alone, an astonishing 28 percent of all general eq- uity funds have gone out of business. ETFs are clearly a dream come true for entrepreneurs, stock brokers, and fund managers.|
|Learning about value investing vs growth||When you do, you, too, will want to join the revolution and invest in a new, more eco- nomical, more efficient, even more honest way, a more pro- ductive way that will put your own interest first. In this new book, I reiterate that proposition. The average fund portfolio manager, in fact, lasts just five years. These annual data are what we call survivor-biased; they exclude the records of the inevitably poorer perform- ing funds that regularly go out of business. Their average return came to minus 0. For you can be sure that no one would have the temerity to promote a new strategy that has lagged the traditional index fund in the past.|
|Ether falling||However, because its component stocks also are weighted by their market cap- italization, those remaining 4, stocks account for only about 20 percent of its value. Such data do not con- vince me that X is likely to outperform in the future. Well, you can guess what came next. The case for the success of indexing in the past is compelling and unarguable. I urge investors not to be tempted by the siren song of paradigms that promise the ac- cumulation of wealth that will be far beyond the rewards of the classic here fund. If you consider the selection of an adviser, please take heed of these findings. But before you rush out to invest in these three funds with such truly remarkable long-term records, think about the next 35 years.|