The late Jack Bogle was known as the father of index investing. His Vanguard Group pioneered the idea that the most efficient way for ordinary investors to compound their wealth was to invest in a broad basket of securities that tracked the overall movement of the stock market - in a sense, to own everything.
By taking active decision-making out of the investment process, Bogle was able to insulate investors from the various psychological challenges inherent to stock picking, and also to charge very low fees, which meant that investors could reinvest far more of their returns than they could when putting their money with active managers. In his book, "The Little Book of Common Sense Investing," Bogle explained why he believed passive investing is the only way for ordinary investors to access the power of compound interest.
Don’t be a loser
Bogle began by doing some simple arithmetic to illustrate the point that even a small sum of money will, over time, compound to a significant amount if it is reinvested at a good rate:
“Over the past century, our corporations have earned a return on their capital of 9.5% per year. Compounded at that rate over a decade, each $1 initially invested grows to $2.48; over two decades, $6.14; over three decades , $15.22; over four decades, $37.72, and over five decades, $93.48. The magic of compound is little short of a miracle. Simply put, thanks to the growth, productivity, resourcefulness and innovation of our corporations, capitalism creates wealth, a positive-sum game for its owners. Investing in equities is a winner’s game.”
Of course, most investors do not achieve such excellent returns. In fact, the average investors tends to underperform market averages:
“Academic studies suggest that if you are a typical investors in individual stocks, your returns have probably lagged the market by about 2.5 percentage points per year. Applying that figure to the annual return of 12 percent earned over the past 25 years by the Standard & Poor’s 500 Stock Index, your annual return has been less than 10%. Result: your slice of the market pie, as it were, has been less than 80 percent.”
Why is this? One reason why the average investor loses money is simply that investing is very hard, and only those at the head of the pack win. Another is that the stock market as a whole is a zero-sum game. Each dollar made by one participant is a dollar lost by another. This does not, however, explain why the average investor underperforms the market, as opposed to being in line with it. The reason for this systemic underperformance is fees, as Bogle illustrated:
“The costs of playing the game both reduce the gains of the winners and increase the losses of the losers. So who wins? You know who wins. The man in the middle (actually the men and women in the middle, the brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system) is the only sure winner in the game of investing. Our financial croupiers always win. In the casino, the house always wins. In horse racing, the track always wins. In the powerball lottery, the state always wins. Investing is no different. After the deduction of the costs of investing, beating the stock market is a loser’s game.”
Every percentage point of your returns that you fork over to an investment manager is a point that you cannot reinvest back into the market. Don’t let your retirement savings go into a loser’s game.
Read more here:
- Paul Tudor Jones: These 3 Things Drive the Markets
- Why Buffett’s Berkshire Hathaway Bought Stocks in the 1970s
- Howard Marks: This Behavior Characterizes Almost Every Bubble
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