In a speech at Princeton University in 2002, Vanguard Group founder Jack Bogle cautioned his audience against "ascribing certitude to history," i.e. extrapolating out historical data and expecting the future to mimick it. Far too many policy decisions, both inside and outside the investing world, are built on the assumption that the future will look like that past. Bogle’s core argument was that investors place far too much faith in numbers.
In this article, we will look at the second part of Bogle's argument, which is that investors tend to be far too optimistic about the future and view the past through rose-tinted glasses.
The past was not as good as you think
Bogle argued that investors as a group suffer from excess optimism for a number of reasons. Firstly, they think of returns in nominal, rather than real, dollars. They tend to conveniently omit inflation from their calculations of past returns.
For example, in 2002, the average annual return on stocks for the previous 50 years had been 11.3%. In nominal terms, this meant that a $1,000 investment in 1952 would have compounded to over $211,000 - a huge return. However, when one takes into account the fact that inflation averaged 4.2% annually over the same period, in real terms that 11.3% becomes 7.1%. Invested for the same period of time, a $1,000 investment would be worth just under $31,000 in real terms - quite a bit less than $211,000.
Moreover, the assumption that investors as a group will earn these average returns in the first place is a very questionable one, because even after inflation you still need to take into account costs like trading commissions, management fees and capital gains and income taxes.
Individual investors might not have to pay management fees, and commissions may have come down in the last decades since Bogle gave this speech, but the cost of taxation remains high. Bogle estimated these costs to consume 40% of the market’s nominal value:
“Costs and taxes are taken out each year in nominal dollars, but final values reflect real, spendable dollars. In an environment of 3% annual inflation, a nominal stock return of 10% would be reduced to a real return of just 7%. When intermediation costs and taxes of 4% are deducted, the investor’s real return tumbles to 3% per year. Costs and taxes have consumed, not 40%, but 57% of the market’s real return.”
Bogle’s partial solution to these issues was to revolutionise investing with his low-cost, low-turnover Vanguard index funds. I think that every investor has the right to decide individually whether they think they can beat the index, but they must go into this task with clear eyes and with full appreciation of the real costs associated with investing. Always beware of overly optimistic forecasts, and always take a sober view of the past.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett: Know When to Cut Your Losses
- Jack Bogle: Don't Attribute Certitude to History
- Bill Ackman on the Importance of Free Cash Flow
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