(Below is an excerpt from Bob Pisani’s new book “Shut up and keep talking: Life and investing lessons from the floor of the New York Stock Exchange.”)
In 1997, just as I was becoming on-air equities editor for CNBC, I had a phone conversation with Jack Bogle, the founder of Vanguard.
This conversation would eventually change my life.
By then, Jack was already an investment legend. He founded Vanguard more than 20 years ago and launched the first indexed mutual fund in 1976.
CNBC was used to having investing “superstars” like Legg Mason’s Bill Miller, Pimco’s Bill Gross or Jim Rogers on the airwaves. It made sense: let the people who were successful share their tips with the rest of us.
Bogle reminded me in our brief conversation that these superstar investors were very rare creatures and that most people never beat their benchmarks. He said we spend too much time building these superstars and not enough time emphasizing long-term buy-and-hold and the power of owning index funds. He reiterated that most actively managed funds charge excessive fees and that any outperformance they might achieve has usually been wiped out by the high fees.
His tone was cordial but not overly warm. Regardless, I started paying a lot more attention to Bogle’s investment rules.
The birth of avant-garde
Since opening on May 1, 1975, the Vanguard Group has been modeled differently than other fund families. It was organized as a mutual owned by the funds it managed; In other words, the company was and is owned by its customers.
One of Vanguard’s earliest products proved to be its most historic: the very first index mutual fund, the First Index Investment Trust, which began operations on August 31, 1976.
By this time, the academic community was aware that stock pickers — both those picking individual stocks and actively managed mutual funds — were lagging behind the stock market. It was sought to find a cheap way to own the broad market.
In 1973, Princeton professor Burton Malkiel published “A Random Walk Down Wall Street,” drawing on previous academic research showing that stocks tend to follow a random path, that past price movements were not indicative of future trends, and that this was not possible to outperform the market unless a higher level of risk was taken.
But convincing the public to just buy an index fund that mimicked the S&P 500 was a tough sell. Wall Street was appalled: not only was there no profit in selling an index fund, but why should the public be persuaded to just go with the market? The purpose was to try to beat the market, right?
“For a long time my sermon fell on deaf ears,” Bogle regretted.
But Vanguard kept pushing forward under Bogle’s leadership. In 1994, Bogle published Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, arguing for index funds and showing that these high costs had a negative impact on long-term returns.
Bogle’s second book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, was published in 1999 and became an instant investment classic. In it, Bogle pleaded extensively for cost-effective investments.
Bogle’s four components to investing
Bogle’s main message was that there are four components to investing: return, risk, cost, and time.
Yield is how much you expect to earn.
Risk is how much you can afford to lose “without undue damage to your wallet or psyche”.
Charges are the expenses you incur that affect your returns, including fees, commissions and taxes.
Time is the length of your investment horizon; With a longer time horizon, you can afford to take more risk.
Stocks beat bonds in the long run
While there have been some periods when bonds have performed better, stocks offer superior returns over the long term, which makes sense given the greater risk of stock ownership.
The longer the period, the greater the chances that the stocks will outperform. On 10-year horizons, stocks beat bonds 80% of the time, on 20-year horizons about 90% of the time, and on 30-year horizons almost 100% of the time.
Other important Bogle principles:
Focus on the long term because short term is too volatile. Bogle noted that the S&P 500 has produced real (inflation-adjusted) returns of 7% annually since 1926 (when the S&P 500 was created), but two-thirds of the time the market will produce average returns of plus or minus 20 percentage points.
In other words, about two-thirds of the time, the market will be up 27% (7% up 20) or down 13% (7% down 20) year-over-year. The other third of the time it may be outside of these ranges. That’s a very big variation from year to year!
Focus on real (inflation-adjusted) returns, not nominal (non-inflation-adjusted) returns. While inflation-adjusted returns for stocks (the S&P 500) have averaged about 7% annually since 1926, there have been periods of high inflation that have been very damaging. From 1961 to 1981, inflation reached an annual rate of 7%. Nominal (non-inflation-adjusted) returns over the period were 6.6% annually, but inflation-adjusted returns were -0.4%.
Stock returns are determined by three variables: the dividend yield at the time of investment, the expected earnings growth rate and the price/earnings ratio change during the investment period.
The first two are based on fundamentals. The third (P/E) has a “speculative” component. Bogle described this speculative component as “a barometer of investor sentiment. Investors pay more for earnings when their expectations are high and less when they lose faith in the future.”
High costs destroy returns. Whether it’s high fees, high trading costs, or high sales loads, these costs eat into returns. Always choose low cost. If you need investment advice, pay close attention to the cost of that advice.
Keep costs down by owning index funds or at least low-cost actively managed funds. Actively managed funds charge higher fees (sometimes including an initial charge) that detract from outperformance, allowing index investors to earn higher returns.
As for hopes for consistent outperformance from active management, Bogle, like Burton Malkiel, concluded that portfolio manager skills are largely a matter of luck. Bogle has never been against active management, but believed that management rarely outperforms the market without taking on too much risk.
Very small yield differences make a big difference when compounded over decades. Bogle gave the example of a fund charging an expense ratio of 1.7% versus a low-cost fund charging 0.6%. Assuming an 11.1% return, Bogle showed how a $10,000 investment grew to $108,300 in the high-cost fund over 25 years, while the low-cost fund grew to $166,200 . The low cost fund had almost 60% more than the high cost fund!
Bogle said this illustrates both the magic and the tyranny of compound interest: “Small differences in compound interest lead to increasing and eventually amazing differences in capital accumulation.”
Don’t try to time the markets. Investors trying to swap money on and off the exchange have to be right twice: once when they put money in and again when they take it out.
Bogle said, “After almost 50 years in this business, I don’t know anyone who has done it successfully and consistently. I don’t even know anyone who knows anyone who has done it successfully and consistently.”
Don’t mess up your portfolio. Bogle bemoaned the fact that investors of all stripes were overtrading, insisting that “impulse is your enemy.”
Don’t overestimate past fund performance. Bogle said, “There’s no way under the sun to predict a fund’s future absolute returns based on its historical records.” Funds that outperform eventually revert to the mean.
Beware of following investment stars. Bogle said, “These superstars are more like comets: they light up the firmament for a moment, only to burn out and disappear into the dark universe.”
Having less money is better than having a lot of money. As recently as 1999, Bogle lamented the near-endless variety of mutual fund investments. He advocated owning a single balanced fund (65/35 stocks/bonds) and said he could capture 97% of total market returns.
Having too many funds (Bogle believed no more than four or five is necessary) would lead to over-diversification. The overall portfolio would be similar to an index fund but likely incur higher costs.
Stay the course. Once you understand your risk tolerance and select a small number of indexed or low-cost actively managed funds, do nothing.
Stay invested. In the short term, the biggest risk in the market is price volatility, but in the long term, the biggest risk is not investing at all.
Bogle’s legacy
More than 20 years later, the ground rules Bogle laid down in Common Sense on Mutual Funds are still relevant.
Bogle has never strayed from its core theme of indexing and low-cost investing, and there’s been no reason to. Time had proved him right.
Just look at where investors are putting their money. This year with the S&P500 Down 15%, and with bond funds also falling, more than $500 billion has flowed into exchange-traded funds, the vast majority of which are low-cost index funds.
where does the money come from
“A lot of the drains we’ve seen come from the active area [ETF] Strategies,” Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors, a major ETF provider, recently told Pension & Investments magazine.
Today, Vanguard second-to-none has more than $8 trillion in assets under management Blackrock. While Vanguard has many actively managed funds, the majority of its assets are in low-cost index funds.
And that first Vanguard index fund? Now known as the Vanguard 500 Index Fund (VFIAX)it charges 4 basis points ($4 per $10,000 invested) to own the entire S&P 500. All major fund families have some variation of a low-cost S&P 500 index fund.
Jack Bogle would be delighted.
Bob Pisani is senior market correspondent for CNBC. He has spent nearly three decades reporting from the floor of the New York Stock Exchange. In Shut Up and Keep Talking, Pisani shares stories about what he’s learned about life and investing.
