John Bogle: The 3 Sources of Future Investment Returns

“When we subject financial realities to reasoned analysis, we gain insights into the sources and patterns of the long-term returns produced by stocks and bonds in the past. Those insights can provide a sound basis for determining the nature of future returns. What is more, they can form the basis for rational discourse about investing in the years ahead.”

In chapter two of John Bogle’s book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” the author delved into the nature of financial returns. In doing so, he makes frequent reference to Occam’s Razor, the idea that the simpler the explanation, the more likely it is to be the correct one.

Using Occam’s Razor as his rationale, he pared the sources of investment return down to three elements: the dividend yield when the stock was first purchased, the rate of earnings growth after that purchase and the difference between price-earnings ratios while the stock was held.

Bogle said, “The total of these three components explains nearly all of the stock market’s returns over extended holding periods.” He added that by analyzing the contributions of each factor to the total return, investors could arrive at a reasoned estimate of future values.

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This is what an investor would be working with:

1. The initial dividend yield, which is straightforward.
2. The rate of earnings growth, which is relatively predictable.
3. The change in in the price-earnings ratio, which is speculative.

For example:

1. A stock with an initial dividend yield of 3%.
2. Earnings growth averaging 7% per year over the coming 10 years.
3. Together, these two elements sum to a 10% nominal return.

To those points, we must add (or subtract) an amount for changes in the price-earnings ratio. If the stock in this hypothetical case had a price-earnings ratio of 15 at the beginning of the period and a price-earnings of 18 at the end of the period, Bogle would add 2% to the total (now 12%). These are nominal returns and will become real returns after the costs of inflation are considered. Bogle said he used nominal terms throughout this chapter.

Bogle also used Occam’s Razor to distinguish between investment and speculation, a treatment he said was similar to that of John Maynard Keynes, the eminent British economist. He made the distinction this way:

• Investment means forecasting the potential yield of an asset over its whole life span, based on the assumption the current situation will continue indefinitely. Specifically, it refers to the combination of initial dividend yield and prospective 10-year earnings growth.
• Speculation means forecasting the psychology of the market in the hope it will change favorably. For speculators, the key is change in the price-earnings ratio because of investor sentiment.

He emphasized that speculation plays only a small part in investors’ returns, arguing that over the seven decades before 1996, the nominal dividend yield averaged 4.5% while earnings growth had averaged 4.2%, for a total of 8.7%. That total is 1.8% less than the nominal average return of 10.5% over the same term and so 1.8% is the average long-term return on speculation.

To Bogle, that means investors with long-term horizons, such as retirement, have favorable odds if they focus on dividends and earnings, rather than speculating about the psychology of the market. Further, short-term strategies have “almost nothing to do with investment.”

In a bid to make this knowledge more practical, Bogle set himself the task of developing better forecasts. Forecasts mean the future, which he knew he could not divine in advance, so he opted for another approach.

He would start with the known average initial yield, then add the average earnings growth rate—as experienced in the past. He then assumed the terminal price-earnings ratio would equal the market’s past average price-earnings ratio. In backtesting, he found this method worked reasonably well (in statistical terms, the coefficient of correlation was +0.54, about halfway between no correlation at all and perfect correlation).

To test his methodology, he predicted an average annual return for the 1990s of about 10%. He subsequently sharpened this forecast in 1991, based on an initial dividend yield of 3.1% plus assumed average annual earnings growth of 6.6% less a speculation loss (price-earnings falling from 15.5 to 14.1) for a total of 8.7%. That’s an average of 8.7% per year for the decade.

As it turned out, he was “exactly on the mark” for the first five years of the 1990s, which had an average return of 8.7% per year.

Of course, Bogle had included a qualification with his forecasts: They would lose their accuracy if a “wild aberration” occurred—and one did: “As proof that forecasting returns is a fallible and humbling profession, stocks took off as 1995 began, and, in an amazing sequence that lasted more than three years, returns averaged 31 percent annually.”

That wild aberration was, of course, the dot-com boom, which took the markets on a wild upward ride for about five years before collapsing on itself in the bust of 2000. Bogle explained it by referring to two “extraordinary developments.”

The first was an increase in the earnings growth rate. The second was a surprising “resurgence” in corporate earnings; in his words, “the speculative element of stock prices leaped to the fore. From the start of 1990 to mid-1998, the stock market’s price-earnings ratio ballooned from 15.5 times earnings to 27 times earnings—a level that had been exceeded only once since 1926.”

Unfortunately, Bogle did not update this account, originally published in 1999, when he published the second edition in 2010. However, in the bigger picture that may not matter; as Bogle said in ending the chapter:

“You are free to disagree with my conclusions, particularly because, to reiterate, we know that anything can happen in the financial markets. And it usually does! There is no reason for slavish adherence to even a rational forecasting methodology, for markets are not always rational. Judgment is not only permitted, but encouraged. But the thrust of the theoretical exercise we have now completed is that disagreement must be fact-founded and data-based, not merely intuitive. Going through the Occam’s Razor exercise should help investors make intelligent decisions about where to invest their assets.”

Summing up, in chapter two of “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” Bogle has instructed value investors on the importance of three key metrics—initial dividend yield, the rate of earnings growth and differences in price-earnings ratios. In addition, he has offered his Occam’s Razor exercise to make forecasts more objective and less subjective.

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

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