Do investors become less effective as they get involved in more complex analyses? That was certainly the opinion of John Bogle in chapter four of his book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.” As he said in opening the chapter, “The information age has truly transformed the world of investing.”
Bogle wanted to make a case for a simpler approach, one that does not include the use of tools such as “alpha,” “Sharpe ratio” or “complexity theory.”
He began his case by defining the investor’s challenge: “The central task of investing is to realize the highest possible portion of the return earned in the financial asset class in which you invest—recognizing, and accepting, that that portion will be less than 100 percent.” The return will never reach 100% because of costs, as argued strenuously in the previous chapter.
To get the most of the portion available to you, he recommended following his eight basic rules; they should “help you to capitalize on the advantages that have accounted for the historical ability of an index to provide superior returns. These eight rules are not complex. But they should help you to make intelligent fund selections for your investment program.”
When going through these rules, remember they apply to investors who buy individual stocks as well as investors who buy mutual funds (since a collection of stocks becomes the equivalent of a mutual fund).
- Select low-cost funds: Not a surprise considering he had been hammering this point for many years, writing “A low expense ratio is the single most important reason why a fund does well. Therefore, carefully consider the role of expense ratios in shaping fund returns.” He also argued that investors are most likely to get top-quartile returns if they buy funds with bottom-quartile expenses. Aim, too, for low-turnover funds because their costs are lower and they are more tax efficient.
- Consider the extra costs of advice: Bogle said advisors must earn their keep by providing such valuable services as developing a long-term investment strategy, keeping costs down and helping steer investors away from common pitfalls. But do not pay commissions or extra fees in hopes of getting better returns. If possible, stick with no-load and low-cost funds. The author also emphasized avoiding wrap accounts, groups of funds assembled into a “wrapper,” which are too expensive.
- Don’t overrate past performance: It’s quite likely all of us have seen the promotional ads touting the outstanding track records of specific funds, but it’s this small print that should get the most attention: “Past performance is no guarantee of future results.” Reversion to the mean is a real issue in investing; consider, too, that top performers can lose their edge because popular funds sometimes bring in more clients and cash than they can effectively invest, and other problems.
- Consistency and risk: While past performance may be a dud as a guide to future returns, it can be helpful in evaluating consistency and risk. Bogle said he likes to see funds that have been in the top two quartiles for at least six to nine years and in the bottom quartile no more than one or two years. Turning to risk, he also considered each fund’s Morningstar risk rating, which provides a guide to relative risk (compared to its peers and all equity funds).
- Be wary of stars: This refers to portfolio managers as stars, because very few have staying power. He pointed out the tenure of the average portfolio manager was only five years, and when managers turn over, there is often a change in strategy. That leads to turnover in fund holdings with consequent increase in costs and tax exposure. Watch, too, for star ratings, as in buying a fund because a third-party has given its manager a four- or five-star rating.
- Beware of big funds: As successful funds get bigger, it takes larger and larger commitments to keep growing at the same rate. As a result, many simply become expensive index funds. Bogle found it difficult to define “big” and “too big,” recognizing that different types of funds will have different upper limits. But he did observe that funds generally had their best years when they were small, adding “nothing fails like success”.
- Too many funds spoil the returns: According to Bogle, many investors would be well served with just one balanced index fund comprised of 65% stocks and 35% bonds. Alternatively, investors might pair a stock index fund with a bond index fund and set their own balances. Otherwise, investors should not own more than four or five equity funds. Regarding international funds, he did not see them as a necessity.
- Stay the course: In other words, once investors have chosen their portfolios, based on their individual criteria, they should not do any serious buying or selling. That advice holds even during emotional times such as market crashes. Bogle added that “The key to holding tight is buying right.” Always opt for simplicity, rather than complexity, because complexity will drive up costs.
Those are Bogle’s eight rules for investing successfully in mutual funds and, as noted, applicable to investors in individual stocks as well.
He wound up the chapter by saying he has tried to present both the advantages of passively managed market index funds and the basics of selecting actively managed firms. He added:
“Whichever route you decide to follow—and, happily, you have the ability to follow both routes—you will have acquired 'the gift to be simple' from an investment standpoint, and 'the gift to be free' of the cacophony of information that assaults us, seemingly without remission.”
Summing up, Bogle has made a case for keeping investing simple by embracing eight simple rules rather than trying to juggle many different analytical tools. This pursuit of simplicity is inextricably linked with his core belief that low-cost investing is the best investing.
(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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