John C. Bogle is the founder of The Vanguard Group and “father” of the index fund – two remarkable things that helped revolutionize the world of investing.
His book has only one theme – that everyone should be investing in low-cost index funds instead of trying to beat the market by picking and choosing stocks. He explains the inner workings of the market, showing why these low cost, passively managed funds can bring higher returns to investors. The book also includes provocative quotes from other experts that support his claims, such as:
“The investment business is a giant scam. Most people think they can find managers who can outperform, [but] because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value.”
Jack R. Meyer, former president of Harvard Management Company
I won’t deny it – the language of the book is fairly technical. If you are new to investing I’d just stick with reading this review (and take advantage of the “investing basics” portion of my coaching sessions). But if you are comfortable with investment jargon, it is a fascinating book full of information about the market, how index funds work, and why other funds don’t work – at least according to John Bogle.
What Is An Index Fund?
Before I get into the book, perhaps the first question is, what is an index fund?
An “index” is really just a list of stocks. The S&P 500, for example, is an index (i.e. a list) of the 500 largest companies. So when you hear on the news that the S&P 500 has gone up or down, they are talking about the value of this list of 500 companies.
An index fund is something that allows you to invest in all the companies in a certain index (or list) with just one purchase. What makes index funds different is that they are “passively managed”, which means that you don’t have some guy actively buying and selling based on what’s hot and what’s not – the index fund is set to buy whatever is on this list and that’s it.
It seems like a simple concept, but when Bogle introduced the first index fund available to the general public in 1975, people thought it would be a huge failure. They thought that there was no way that this simple concept could do better than a stock broker’s expertise.
But they were wrong. Since then, study after study has shown that in the long run, passively managed index funds will beat actively managed investment portfolios, sometimes by a large margin.
“The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.”
David Swensen, chief investment officer of the Yale University Endowment Fund
To encourage wider acceptance of this concept, Bogle published his first book about investing in 1994, and then published The Little Book of Common Sense Investing in 2007. The 10th Anniversary edition, which is the subject of this review, came out in 2017 and included some added chapters. John “Jack” C. Bogle passed away in January of 2019.
The Gotrocks Family: A Parable
The book begins with a parable of the Gotrocks family, a wealthy family whose wealth continues to grow over the years, until a few “Helpers” come along who offer to help manage it for a fee. Their fee grows and grows, and the family’s wealth declines. When the family realizes this, they hire yet more Helpers to try and fix it, and pay yet more fees, and their wealth goes down even faster.
“Then a wise old uncle says ‘Go back to square one, and do so immediately. Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultants. Then our family will again reap 100 percent of however large a pie corporate America bakes for us, year after year.’
They follow the old uncle’s wise advice, returning to their original passive but productive strategy, holding all the stocks of corporate America, and standing pat.
That is exactly what an index fund does.”
And with this Bogle begins, step by step, to walk us through why he believes that index funds are the superior investment.
“The whole investment management business together gives no value added to all buyers combined. That’s the way it has to work. Mutual funds charge 2 percent per year and then brokers switch people between funds, costing another 3 to 4 percentage points. The poor guy in the general public is getting a terrible product from the professionals.”
Charles Munger, partner of Warren Buffet at Berkshire Hathaway
Why You Should Stop Trying to Predict the Market
Bogle states that the average annual total return on stocks since 1900 was 9.5 percent. There are ups and downs along the way, but it always goes back to that average.
He breaks these stock market returns into two categories:
- “Investment returns” which have to do with actual business growth, such as earnings and dividends, and
- “Speculative returns” which have to do with the psychology of the market.
Over the long term, he says that almost all stock market growth has come from “investment returns”, and only a tiny fraction from “speculative returns”. But it is this speculation, which adds almost nothing to the value of the market, that causes stock prices to swing so wildly.
He writes, “Accurately forecasting short-term swings in investor emotions is not possible. But forecasting the long-term economics of investing has carried remarkably high odds of success. […] My advice to investors: ignore the short-term sound and fury of the emotions reflected in our financial markets, and focus on the productive long-term economics of our corporate businesses.”
In other words, you can’t predict emotions, so don’t even try.
He also notes that investors tend to want to buy funds that are “hot”, in part because these “hot” stocks and funds are relentlessly promoted by fund managers. But they are usually at their peak, which is the absolute wrong time to buy them.
To support this, Boggle cites the fact that people invested a net total of $18 billion in 1990 when stocks were cheap, compared to $420 billion in 1999 and 2000 when we were at the peak of the dot com bubble. Those “hot stocks” fell, and people stopped buying – once again the exact wrong decision.
To quote Bogle: “Investor emotions plus industry promotions equals trouble.”
How Fees and Costs Rob You
Bogle talks about how many investors are basically robbed of what they should be earning by fees and costs.
He gives the example of someone who invests $10,000 for 50 years. That seems like a long time, but if you start investing at age 22, and you live to 72, you will have investments that are 50 years old.
- With a 5% return you end up with $114,700
- At 7% you end up with $294,600
That small 2% difference costs you $179,900 – over 60% of the money!
You put up 100% of the money and assumed 100% of the risk, but you got only 40% of the potential return – your fund manager got the other 60%.
These numbers seemed so shocking that I actually had to go and calculate them myself to believe them – but they are true.
To explain part of where the fees are coming from, Bogle says that if you are actively trading individual stocks, the fees will be between 1.5% and 3% per year. If you are using actively managed mutual funds, the expense ratio will average about 1.3% per year, with maybe an additional 0.5% to 1% in sales charges (loads) per year. There can also be the hidden costs of portfolio turnover, which can be as much as 1% per year. He provides other examples throughout the book of hidden costs that can drag down earnings.
To put it simply, the less we pay in fees, the more of our returns we get to keep.
He notes that not all index funds are created equal. He gives the following examples of two index funds with vastly different fees:
- Vanguard 500 Index Admiral: Expense Ratio 0.04%, Load 0.0%
- JP Morgan Equity Index: Expense Ratio 0.45%, Load 4.80%
So, even if you decide to invest in index funds, you still need to pay attention to fees. He says you should only select index funds with no loads (a type of fee for trading), and a low expense ratio.
Reversion to the Mean
Bogle says that if you look at the best and worst performing funds, they basically switch places over a five-year period.
Many people invest in funds rated with 4 or 5 stars by Morningstar, but those ratings are usually based on recent performance, and funds that did well recently are not likely to continue to do well. In fact, only 14% of 5-star funds still held that rating a decade later. Funds tend to revert to the mean.
Therefore, instead of trying to choose the best performing stocks, his advice is to buy the whole market with an index fund. Or as he puts it, “don’t look for the needle, buy the haystack.”
If you invest in an index fund that follows the S&P 500, you will be investing in about 85% of the total market, since those 500 companies represent that share of the total market’s value. You can also invest in a “total market” index fund if you want to make sure you are invested in that other 15% that is not represented by the S&P 500.
He talks a bit about professional investment advisors, and says that you are better off going to them for services than for choosing investments – services such as information on tax considerations, knowing how much to save for retirement while you work, how to build a fund for your children’s education, asset allocation, etc. But their advice on choosing investments is probably the same or worse than if you just choose index funds.
ETFs
The chapter on ETFs (exchange-traded funds) is one of the chapters that he added for the 10th Anniversary edition. These are funds that are set up so you can easily trade them. But if your investment philosophy is to buy and hold, as Bogle recommends, then there is really no point to having something you can easily trade.
He says, “The early advertisements [for one of these EFTs] said, ‘Now you can trade the S&P 500 all day long, in real time.’ And so you can. But to what avail?”
Also, “There is nothing wrong with investing in those indexed EFTs that track the broad stock market, just so long as you don’t trade them.” (emphasis his)
He also states that “The amazing growth of EFT’s certainty says something about the […] willingness of investors to favor complex strategies and aggressive trading, continuing to believe, against all odds, that they can beat the market. “
Bond Funds and Portfolio Allocation
Although in general bonds return less than stocks, Bogle recommends having both in your portfolio, simply because there are some years when bonds do better and so it provides some security during those years.
He says there are two factors that determine how you should make the split between bonds and stocks:
- Your ability to take risk and
- Your willingness to take risk.
He recommends an upper range of 80% stocks for younger investors accumulating assets over a long time frame, to 25% stocks for older investors late in their retirement years.
He points out that with lower cost and higher performing index funds, you can have a portfolio with more bonds (therefore less risk) and still do better than someone who is paying a lot of fees via actively managed funds.
He says that he himself has about 50/50 indexed stocks and indexed bonds. “At my age of 88, I’m comfortable with that allocation. But I confess that half the time I worry I have too much in equities [stocks], and the other half of the time that I don’t have enough in equities.” He says that in the end we are all just human beings who have to rely on our circumstance and common sense to make the best choice we can.
He also states, “For investors who have a very long time horizon, and considerable grit and guts – investors who have the courage to be unintimidated by periodic market crashes – clearly an allocation of 100 percent to the S&P 500 Index fund would be nearly always the better choice.”
But if you have a limited time horizon, or low risk tolerance, he says that a 60/40 balanced index fund is worth considering.
Social Security and Target Date Retirement Funds
He also mentions that Social Security, since it provides steady income that goes up with the rate of inflation, can be treated almost like a bond fund in terms of deciding how to split your investments between stocks and bonds. For example, if you project that you will get $200,000 in Social Security during your lifetime, you could reduce your investment in bonds by $200,000 and still have a balanced portfolio.
He briefly mentions Target Date Retirement Funds, which is an increasingly popular type of fund that automatically rebalances your investments based on a planned retirement date. He says that they can be good “set it and forget it” options, but that you need to “look under the hood.” Many of them rely on actively managed funds that will erode your earnings with fees, while others use low-cost index funds.
Common Sense Realities
He ends the book talking about the parallels between his advice and that of Benjamin Franklin, and also offers a list of what he calls some “common sense realities”:
- We must start to invest as early as possible, and continue to put money away regularly.
- Investing entails risk, but not investing dooms us to financial failure
- We know the sources of returns in stocks and bonds, and that’s the beginning of wisdom.
- We know that the risk of selecting individual stocks can be eliminated by the total diversification of the traditional index fund.
- We know that costs [fees] matter and we must minimize them.
- We know that taxes matter and we must minimize them.
- We know what we don’t know – we can’t predict the future, but with good choices we can be prepared for the inevitable bumps along the road.
All in all, it was a good, though technical, read. I was only able to summarize the high points of this fascinating book. I highly recommend reading the whole thing if you want a dive deep into the “common sense realities” of the market, and the factors that make index funds able to so often beat all other investments.
NOTE: This book review is for information purposes only, and is not intended to be investment advice. Seek a duly licensed professional for investment advice.
