The Little Book of Common Sense Investing

04/01/2007 12:00 am EST

Focus:

John Bogle

Founder, Vanguard Group

John Bogle founded Vanguard Mutual Fund Group in 1974 and created the first index mutual fund in 1975. He served as Chairman and CEO of the company until 1996 and Senior Chairman until 2000.

In this book, Mr. Bogle’s aims are two-fold. His primary purpose is to convince investors that they need to change the way they think about investing. And secondarily, he wants to persuade investors that index funds are the key to long-term successful investing.

First, he introduces the notion of common sense investing, explaining how the true winning strategy to market success is owning all of the nation’s publicly-held businesses at a very low cost. In that manner, investors can capture almost the entire returns of a company by participating in its dividend and earnings growth. And the best way to guarantee that success is by purchasing classic index funds – well-diversified funds that aim to track the broad stock markets, and then holding them for the long-term, allowing the magic of compounding to do its work.

Mr. Bogle explains how the returns earned by businesses (profits) are ultimately translated into the returns earned by the stock market (dividends and appreciation).

What many investors, and sometimes investment professionals forget, is that over the long run, growing earnings are the building blocks that support share appreciation. Agreeing with this theme, Mr. Bogle states that over time, the aggregate gains made by shareholders must of necessity match the business gains of the company. Sure, once in awhile, a stock’s return may get ahead or behind its earnings performance, but it eventually returns to normal. In other words – in the long-term, reality rules.

Therefore, trying to beat the average stock market return by choosing individual stocks is a zero-sum game. And when you add in the expenses, or costs of investing, it turns into a loser’s game.

Portfolio turnover, caused by too much trading, radically reduces investors’ returns and can doom a trader to failure. Mr. Bogle cites a study whose results demonstrate that the most active one-fifth of traders turned their portfolio more than 21% each month during a strong market uptrend, resulting in annual returns one-third less than the average returns of the broad market.

Additionally, fund investors are plagued by high expense ratios and sales fees. And for investors who rely on professional money managers, advisory fees can substantially eat into their returns.

But the expenses of investing are not the only reason to avoid individual stocks or traditional mutual funds. Mr. Bogle cites the abysmal returns of money managers as well as fund managers.

It’s a sad truth that most financial advisors as well as mutual fund managers underperform the broad market indexes. But even worse, as Mr. Bogle states, the true returns of funds are even worse than those underperforming rates of returns that are published. When the timing of capital inflows and outflow are taken into consideration, the gains decrease substantially. Consequently, one study showed that in 198 of 200 of the most popular equity funds, returns were less than those reported to investors.

As if high expenses and lower returns weren’t enough to discourage investors away from individual stocks and traditional mutual funds, Mr. Bogle refers to one more wrench in the works: the inherent conflict of interest between those who work in the investment business and the investors they serve.

That conflict, of course, is about returns. Investors are concerned about the return from their investments. Professionals are more interested in their returns – either fees or commissions – that they earn from advising the investor, and one doesn’t necessarily have any point of correlation with the other.

Therefore, Mr. Bogle sees a simple solution: buy index funds. You will then approximate the market’s return and gains a few other advantages: minimal expenses, no advisory fees, small portfolio turnover, and often, tax-efficiency.

But he has a few last cautions.

Not all index funds are created equal. Mr. Bogle warns investors to stick with diversified index funds that aim to track the broad markets, capturing the gains of corporations across America. Avoid sector funds. He says, ‘don’t look for the needle; buy the haystack’.

Focus on low-cost index funds. Many investors may not be aware that the range of expenses may vary widely with different index funds, so make sure you choose the lower-cost versions.

Exchange-Traded Funds (ETFs) are wolves in sheep’s clothing. Mr. Bogle doesn’t believe their returns will ultimately approach those of the index mutual funds. And again, he cautions to avoid sector ETFs.

Avoid fancy index funds weighted by factors other than market capitalization weighting. Today, some index funds are weighted by parameters such as revenues, cash flows, profits or dividends, none of which Mr. Bogle deems suitable for long-term investing.

In a market as volatile as we have seen lately, Mr. Bogle sounds like the voice of reason. And his formula for investment success – diversify, focus on low-cost, and invest for the long-term makes a lot of sense, common sense, that is.

Related Articles on