Investment strategy, said John C. "Jack" Bogle, should top investors’ considerations.
That is the core message of part one of the second edition (2010) of his landmark book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.” Bogle is a pioneer in mutual funds. He was among the first to apply academic research to funds, in which he specialized and made the subject of his thesis, at Princeton University. From Princeton, he went to Wellington Funds and then, in 1974, founded his own firm, the Vanguard Company. Two years later, he created the first index fund available to the public.
Since then, he has become internationally famous for his the success of his funds, his writing on funds and his thoughts (often caustic) on the investment community. Still, he has been one of the most respected giants of the industry; Fortune magazine called him “one of the four investment giants of the twentieth century” in 1999.
Chapter one of his book focused on long-term investing and began with this simple message: “Investing is an act of faith.” Faith, that is, in corporate stewards who determine the success of companies and industries.
An investment in a mutual fund is an expression of faith in professional fund managers. We expect them to be “vigilant stewards” of the assets we entrust to them. At the same time, we are recognizing the value of diversification because a mutual fund, by definition, is comprised of multiple assets or types of assets.
Along with faith comes risk; as Bogle said, “There is little certainty in investing. As long-term investors, however, we cannot afford to let the apocalyptic possibilities frighten us away from the markets. For without risk there is no return.”
He likes to use gardening as an analogy for investing, as it goes through seasons of growth and seasons of decline. To develop the analogy further, Bogle noted America’s gross national product had grown an average of 3.5% per year annually over the course of the 20th century, and at 2.9% annually in the 50 years following World War II.
Bogle added that a review of this historical data would drive home one very important conclusion: “To invest with success, you must be a long-term investor.” Further, that a study of historical stock and bond returns, along with common sense, is the “intelligent investor’s best resource.”
Citing the work of Jeremy Siegel in “Stocks for the Long Run,” he reported that stocks had grown at an average real rate (after inflation) of 7% annually, while bonds grew at exactly half that rate: 3.5%.
And while the long-term rate of return has been relatively steady for stocks, it has varied significantly in shorter terms. Indeed, that variation, one standard deviation, was 16.9%, meant the average annual returns ranged from -9.9% to +23.9% (based on an average 7% real return). Like gardening, investing has its seasons.
The longer the duration of a time period, the lower the volatility. After just five years, the standard deviation falls by half, and after 10 years, by half again. Investors who can hold on for 50 years will experience volatility of just 1%.
Taking these long-term risks and rewards together sets the stage for Bogle’s “common sense” conclusion: Make a significant commitment to stocks because they will provide higher returns over the years, but also have some bonds to withstand adversity.
Bogle said this picture is not complete, however, because it is theoretical and does not include the costs of investing: i.e., what you pay your broker or mutual fund company. These will have the effect of reducing an investor’s gross returns by as much as 3%, and on average by 2% per year.
The noxious effects of fees, expenses and taxes goes even deeper: Assume a mutual fund with industry average costs earns a 10% average annual return. From there:
- Inflation is 3%, reducing the real return to 7%.
- Taxes are paid on the nominal returns (which are higher than real returns).
- The all-in cost of a mutual fund with 2% fees could end up costing investors four-tenths, or 40%, of their net real return after taxes.
The conclusion to draw, then, is the long-term investor who pays the least in fees likely will earn the most real return available in the stock market.
Staying with the effects of costs, Bogle offered this formula: “Gross market return - Cost = Net market return.” From that, he went on to offer this syllogism:
- The stock market is owned by all investors, and so the returns of both active investors and passive investors must equal the gross return of the stock market.
- Active investors must incur greater fees and transaction costs than those incurred by passive investors.
- Therefore, since active investors and passive investors must earn equal gross returns, passive investors must earn the higher net return.
Bogle referred to this conclusion as a “QED” result (an abbreviation at the end of a mathematical equation to indicate it is complete). I find it difficult to accept or understand some of the assumptions and conclusions within the syllogism (but perhaps that reflects a lack of knowledge on my part).
Next, he addressed an obvious divergence: The ideal is a long-term investment in a “sensible” balance of stocks and bonds, kept through the market ups and down and with minimal costs. However, many investors do not heed that advice: “Investors, professional and individual, are not ignorant of the lessons of history; rather, they are unwilling to heed them.”
In that context, he goes on to attack a couple of common short-term strategies:
- Market timing: The idea of shifting the allocation of stocks and bonds, in an attempt to avoid downturns or capture more upside, is the first problem. He said investors are likely to find they get just the opposite.
- Rapid turnover: Frequently trading assets in a portfolio in an attempt to catch an updraft or avoid a downdraft. This strategy, practiced by both fund managers and investors, is a form of market timing that generally yields poor results.
Bogle added that the market is very unpredictable in the short-term, so avoid the “impulses inspired by the conventional wisdom of the day.” He also pointed to what he called 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.”
In summary, as one might expect from Bogle, the man who invented low-cost, passive investing, the key to getting ahead in the stock market is to keep the costs down and avoid the perils of short-term commitments. That’s the opening note in his exposition of an investing strategy.
One final note: Normally, value investors would expect to hold their stocks for many years, as suggested by Bogle; however, a GuruFocus article by Thomas Macpherson makes the case that if a company begins to drift away from its core mission, that would be reason to sell rather than stick with the stock.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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