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LittleBookBigProfitsSeries
IntheLittleBookBigProfitsseries,thebrightesticonsinthefinancialworldwriteontopicsthatrangefromtried-and-trueinvestmentstrategiestotomorrow’snewtrends.Eachbookoffersauniqueperspectiveoninvesting,allowingthereadertopickandchoosefromtheverybestininvestmentadvicetoday.
BooksintheLittleBookBigProfitsseriesinclude:
TheLittleBookThatStillBeatstheMarket byJoelGreenblatt
TheLittleBookofValueInvesting byChristopherBrowne
TheLittleBookofCommonSenseInvesting byJohnC.Bogle
TheLittleBookThatMakesYouRich byLouisNavellier
TheLittleBookThatBuildsWealth byPatDorsey
TheLittleBookThatSavesYourAssets byDavidM.Darst
TheLittleBookofBullMoves byPeterD.Schiff
TheLittleBookofMainStreetMoney byJonathanClements
TheLittleBookofSafeMoney byJasonZweig
TheLittleBookofBehavioralInvesting byJamesMontier
TheLittleBookofBigDividends byCharlesB.Carlson
TheLittleBookofBulletproofInvesting byBenSteinandPhilDeMuth
TheLittleBookofCommodityInvesting byJohnR.Stephenson
TheLittleBookofEconomics byGregIp
TheLittleBookofSidewaysMarkets byVitaliyN.Katsenelson
TheLittleBookofCurrencyTrading byKathyLien
TheLittleBookofMarketMyths byKenFisherandLaraW.Hoffmans
TheLittleBookofVentureCapitalInvesting byLouGerken
TheLittleBookofStockMarketCycles byJeffreyA.HirschandDouglasA.Kass
TheLittleBookofStockMarketProfits byMitchZacks
TheLittleBookofBigProfitsfromSmallStocks byHilaryKramer
TheLittleBookofTrading byMichaelW.Covel
TheLittleBookofAlternativeInvestments byBenSteinandPhilDeMuth
TheLittleBookofValuation byAswathDamodaran
TheLittleBookofBull’sEyeInvesting byJohnMauldin
TheLittleBookofEmergingMarkets byMarkMobius
TheLittleBookofHedgeFunds byAnthonyScaramucci
TheLittleBookoftheShrinkingDollar byAddisonWiggin
BooksbyJohnC.Bogle1994 BogleonMutualFunds:NewPerspectivesfortheIntelligentInvestor
—ForewordbyPaulA.Samuelson1999 CommonSenseonMutualFunds:NewImperativesfortheIntelligent
Investor—ForewordbyPeterL.Bernstein
2001 JohnBogleonInvesting:TheFirst50Years—ForewordbyPaulA.Volcker,IntroductionbyChancellorWilliamT.Allen
2002 CharacterCounts:TheCreationandBuildingoftheVanguardGroup2005 TheBattlefortheSoulofCapitalism
—ForewordbyPeterG.Peterson2007 TheLittleBookofCommonSenseInvesting:TheOnlyWayto
GuaranteeYourFairShareofStockMarketReturns2008 Enough.TrueMeasuresofMoney,Business,andLife
—ForewordbyWilliamJeffersonClinton,ProloguebyTomPeters2010 CommonSenseonMutualFunds:FullyUpdated10thAnniversary
Edition—ForewordbyDavidF.Swensen
2011 Don’tCountonIt!ReflectionsonInvestmentIllusions,Capitalism,“Mutual”Funds,Indexing,Entrepreneurship,Idealism,andHeroes—ForewordbyAlanS.Blinder
2012 TheClashoftheCultures:Investmentvs.Speculation—ForewordbyArthurLevitt
2017 TheLittleBookofCommonSenseInvesting:10thAnniversaryEdition|Updated&Revised
THELITTLEBOOKOFCOMMONSENSEINVESTING
TheOnlyWaytoGuaranteeYourFairShareofStockMarketReturns
10thAnniversaryEdition|Updated&Revised
JOHNC.BOGLE
Coverdesign:Wiley
Copyright©2017byJohnC.Bogle.Allrightsreserved.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.
Firsteditionpublished2007byJohnWiley&Sons,Inc.
PublishedsimultaneouslyinCanada.
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TothememoryofthelatePaulA.Samuelson,professorofeconomicsatMassachusettsInstituteofTechnology,NobelLaureate,investmentsage.
In1948whenIwasastudentatPrincetonUniversity,hisclassictextbookintroducedmetoeconomics.In1974,hiswritingsreignitedmyinterestinmarketindexingasaninvestmentstrategy.In1976,hisNewsweekcolumnapplaudedmycreationoftheworld’sfirstindexmutualfund.In1993,hewrotetheforewordtomyfirstbook,andin1999heprovidedapowerful
endorsementformysecond.Whilehedepartedthislifein2009,heremainsmymentor,myinspiration,myshininglight.
ContentsIntroductiontothe10thAnniversaryEdition
NotesChapterOneAParable
NoteChapterTwoRationalExuberance
NotesChapterThreeCastYourLotwithBusiness
NotesChapterFourHowMostInvestorsTurnaWinner’sGameintoaLoser’sGame
NoteChapterFiveFocusontheLowest-CostFunds
NoteChapterSixDividendsAretheInvestor’s(Best?)FriendChapterSevenTheGrandIllusion
NotesChapterEightTaxesAreCosts,Too
NotesChapterNineWhentheGoodTimesNoLongerRollChapterTenSelectingLong-TermWinners
NoteChapterEleven“ReversiontotheMean”
NoteChapterTwelveSeekingAdvicetoSelectFunds?ChapterThirteenProfitfromtheMajestyofSimplicityandParsimony
NoteChapterFourteenBondFundsChapterFifteenTheExchange-TradedFund(ETF)
NotesChapterSixteenIndexFundsThatPromisetoBeattheMarket
Note
ChapterSeventeenWhatWouldBenjaminGrahamHaveThoughtaboutIndexing?
NoteChapterEighteenAssetAllocationI:StocksandBonds
NotesChapterNineteenAssetAllocationII
NoteChapterTwentyInvestmentAdviceThatMeetstheTestofTimeAcknowledgmentsEULA
ListofIllustrationsChapter2
EXHIBIT2.1InvestmentReturnversusMarketReturn.Growthof$1,1900–2016
EXHIBIT2.2TotalStockReturnsbytheDecade,1900–2016(PercentAnnually)
Chapter3
EXHIBIT3.1S&P500versusTotalStockMarketIndex:PortfolioComparison,December2016
EXHIBIT3.2S&P500andTotalStockMarketIndex,1926–2016
EXHIBIT3.3PercentagesofActivelyManagedMutualFundsOutperformedbyComparableS&PIndexes,2001–2016
Chapter4
EXHIBIT4.1TheMagicofCompoundingReturns,theTyrannyofCompoundingCosts:Growthof$10,000over50Years
EXHIBIT4.2TheTyrannyofCompounding:Long-TermImpactofLaggingtheMarketby2Percent
Chapter5
EXHIBIT5.1EquityMutualFunds:ReturnsversusCosts,1991–2016
Chapter6
EXHIBIT6.1S&PPriceReturnversusTotalReturn
EXHIBIT6.2S&P500—DividendsperShare
EXHIBIT6.3DividendYieldsandFundExpenses,2016
Chapter7
EXHIBIT7.1S&PIndexFundversusAverageLarge-CapFund:ProfitonInitialInvestmentof$10,000,1991–2016
EXHIBIT7.2TheTimingandSelectionPenalties:NetFlowintoU.S.EquityFunds
Chapter9
EXHIBIT9.1CumulativeInvestmentReturnandSpeculativeReturn,1900–2016
EXHIBIT9.2TotalReturnonStocks,PastandFuture
EXHIBIT9.3InitialBondYieldsandSubsequentReturns
EXHIBIT9.4TotalReturnonBonds,PastandFuture
EXHIBIT9.5TotalReturnon60/40Stock/BondBalancedPortfolio,PastandFuture
Chapter10
EXHIBIT10.1Winners,Losers,andFailures:Long-TermReturnsofMutualFunds,1970–2016
EXHIBIT10.2FidelityMagellan:Long-TermRecordversusS&P500,1970–2016
EXHIBIT10.3FidelityContrafund:Long-TermRecordversusS&P500,1970–2016
Chapter11
EXHIBIT11.1ReversiontotheMean,FirstFiveYears2006–2011versusSubsequentFiveYears2011–2016
EXHIBIT11.2ReversiontotheMean,FirstFiveYears2001–2006versusSubsequentFiveYears2006–2011
Chapter13
EXHIBIT13.1OddsofanActivelyManagedPortfolioOutperformingPassiveIndexFund
EXHIBIT13.2CostsofSelectedS&P500IndexFunds
Chapter14
EXHIBIT14.1PercentageofActivelyManagedBondFundsOutperformedbyS&PIndexes,2001–2016
Chapter15
EXHIBIT15.1TraditionalIndexFundsversusExchange-TradedIndexFunds
EXHIBIT15.2CompositionofTIFAssetsandETFAssets,December2016
Chapter16
EXHIBIT16.1“SmartBeta”Returns:10-YearPeriodEndedDecember31,2016
Chapter18
EXHIBIT18.1ByReducingCosts,YouCanEarnHigherReturnwithLowerRisk
Chapter19
EXHIBIT19.1TheLow-CostBalancedIndexPortfolioversusItsHigh-CostPeers,1992–2016
EXHIBIT19.2AssetAllocationsofVariousBalancedFunds
Introductiontothe10thAnniversaryEdition
Don’tAllowaWinner’sGametoBecomeaLoser’sGame.SUCCESSFULINVESTINGISALLaboutcommonsense.AsWarrenBuffett,theOracleofOmaha,hassaid,itissimple,butitisnoteasy.Simplearithmeticsuggests,andhistoryconfirms,thatthewinningstrategyforinvestinginstocksistoownallofthenation’spubliclyheldbusinessesatverylowcost.Bydoingsoyouareguaranteedtocapturealmosttheentirereturnthatthesebusinessesgenerateintheformofdividendsandearningsgrowth.
Thebestwaytoimplementthisstrategyisindeedsimple:Buyafundthatholdsthisall-marketportfolio,andholditforever.Suchafundiscalledanindexfund.Theindexfundissimplyabasket(portfolio)thatholdsmany,manyeggs(stocks)designedtomimictheoverallperformanceoftheU.S.stockmarket(oranyfinancialmarketormarketsector).1Thetraditionalindexfund(TIF),bydefinition,basicallyrepresentstheentirestockmarketbasket,notjustafewscatteredeggs.Iteliminatestheriskofpickingindividualstocks,theriskofemphasizingcertainmarketsectors,andtheriskofmanagerselection.Onlystockmarketriskremains.(Thatriskisquitelargeenough,thankyou!)Indexfundsmakeupfortheirlackofshort-termexcitementbytheirtrulyexcitinglong-termproductivity.TheTIFisdesignedtobeheldforalifetime.
Theindexfundeliminatestherisksofindividualstocks,marketsectors,andmanagerselection.Onlystockmarketriskremains.
Thisismuchmorethanabookaboutindexfunds.Itisabookthatisdeterminedtochangetheverywaythatyouthinkaboutinvesting.Itisabookaboutwhylong-terminvestingservesyoufarbetterthanshort-termspeculation;aboutthevalueofdiversification;aboutthepowerfulroleofinvestmentcosts;abouttheperilsofrelyingonafund’spastperformanceandignoringtheprincipleofreversion(orregression)tothemean(RTM)ininvesting;andabouthowfinancialmarketswork.
Whenyouunderstandhowourfinancialmarketsactuallywork,youwillseethattheindexfundisindeedtheonlyinvestmentthatessentiallyguarantees
thatyouwillcaptureyourfairshareofthereturnsthatbusinessearns.Thankstothemiracleofcompounding,theaccumulationsofwealththataregeneratedbythosereturnsovertheyearshavebeenlittleshortoffantastic.
Thetraditionalindexfund(TIF).
I’mspeakinghereaboutthetraditionalindexfund.TheTIFisbroadlydiversified,holdingall(oralmostall)ofitsshareofthe$26trillioncapitalizationoftheU.S.stockmarketinearly2017.Itoperateswithminimalexpensesandwithnoadvisoryfees,withtinyportfolioturnover,andwithhightaxefficiency.Thattraditionalindexfund—thefirstonetrackedthereturnsoftheStandard&Poor’s500Index—simplyownssharesofthedominantfirmsincorporateAmerica,buyinganinterestineachstockinthestockmarketinproportiontoitsmarketcapitalization,andthenholdingitforever.
Themagicofcompoundinginvestmentreturns.Thetyrannyofcompoundinginvestmentcosts.
Pleasedon’tunderestimatethepowerofcompoundingthegenerousreturnsearnedbyourbusinesses.Let’sassumethatthestocksofourcorporationsearnareturnof7percentperyear.Compoundedatthatrateoveradecade,each$1.00initiallyinvestedgrowsto$2.00;overtwodecades,to$4.00;overthreedecades,to$7.50;overfourdecades,to$15.00,andoverfivedecades,to$30.00.2
Themagicofcompoundingislittleshortofamiracle.Simplyput,thankstothegrowth,productivity,resourcefulness,andinnovationofourcorporations,capitalismcreateswealth,apositive-sumgameforitsowners.Investinginequitiesforthelongtermhasbeenawinner’sgame.
Thereturnsearnedbybusinessareultimatelytranslatedintothereturnsearnedbythestockmarket.Ihavenowayofknowingwhatshareofthesemarketreturnsyouhaveearnedinthepast.Butacademicstudiessuggestthatifyouareatypicalinvestorinindividualstocks,yourreturnshaveprobablylaggedthemarketbyaroundtwopercentagepointsperyear.
Applyingthatfiguretotheannualreturnof9.1percentearnedoverthepast25yearsbytheStandard&Poor’s500StockIndex,yourannualreturnhaslikelybeenintherangeof7percent.Result:investorsasagrouphavebeen
servedonlyaboutthree-quartersofthemarketpie.Inaddition,asexplainedinChapter7,ifyouareatypicalinvestorinmutualfunds,you’vedoneevenworse.
Azero-sumgame?
Ifyoudon’tbelievethatreturnrepresentswhatmostinvestorsexperience,pleasethinkforamomentabout“therelentlessrulesofhumblearithmetic”(Chapter4).Theseironrulesdefinethegame.Asinvestors,allofusasagroupearnthestockmarket’sreturn.
Asagroup—Ihopeyou’resittingdownforthisastonishingrevelation—weinvestorsareaverage.Foreachpercentagepointofextrareturnabovethemarketthatoneofusearns,anotherofourfellowinvestorssuffersareturnshortfallofpreciselythesamedimension.Beforethedeductionofthecostsofinvesting,beatingthestockmarketisazero-sumgame.
Aloser’sgame.
Asinvestorsseektooutpacetheirpeers,winners’gainsinevitablyequallosers’losses.Withallthatfeverishtradingactivity,theonlysurewinnerinthecostlycompetitionforoutperformanceisthepersonwhositsinthemiddleofourfinancialsystem.AsWarrenBuffettrecentlywrote,“WhentrillionsofdollarsaremanagedbyWallStreeterscharginghighfees,itwillusuallybethemanagerswhoreapoutsizeprofits,nottheclients.”
Inthecasino,thehousealwayswins.Inhorseracing,thetrackalwayswins.InthePowerballlottery,thestatealwayswins.Investingisnodifferent.Inthegameofinvesting,thefinancialcroupiersalwayswin,andinvestorsasagrouplose.Afterthedeductionofthecostsofinvesting,beatingthestockmarketisaloser’sgame.
LesstoWallStreetcroupiersmeansmoretoMainStreetinvestors.
Successfulinvesting,then,isaboutminimizingtheshareofthereturnsearnedbyourcorporationsthatisconsumedbyWallStreet,andmaximizingtheshareofreturnsthatisdeliveredtoMainStreet.(That’syou,dearreader.)
Yourchancesofearningyourfairshareofthemarket’sreturnsaregreatly
enhancedifyouminimizeyourtradinginstocks.Oneacademicstudyshowedthatduringthestrongbullmarketof1990–1996themostactiveone-fifthofallstocktradersturnedtheirportfoliosoverattherateofmorethan21percentpermonth.Whiletheyearnedtheannualmarketreturnof17.9percentduringthatbullmarketperiod,theyincurredtradingcostsofabout6.5percent,leavingthemwithanannualreturnofbut11.4percent,onlytwo-thirdsofthemarketreturn.
Mutualfundinvestors,too,haveinflatedideasoftheirownomniscience.Theypickfundsbasedontherecentperformancesuperiority—oreventhelong-termsuperiority—ofafundmanager,andoftenhireadviserstohelpthemachievethesamegoal(WarrenBuffett’s“Helpers,”describedinthenextchapter).ButasIexplaininChapter12,theadvisersdoitwithevenlesssuccess.
Obliviousofthetolltakenbycosts,toomanyfundinvestorswillinglypayheavysalesloadsandincurexcessivefundfeesandexpenses,andareunknowinglysubjectedtothesubstantialbutundisclosedtransactioncostsincurredbyfundsasaresultoftheirhyperactiveportfolioturnover.Fundinvestorsareconfidentthattheycanconsistentlyselectsuperiorfundmanagers.Theyarewrong.
Mutualfundinvestorsareconfidentthattheycaneasilyselectsuperiorfundmanagers.Theyarewrong.
Contrarily,forthosewhoinvestandthendropoutofthegameandneverpayasingleunnecessarycost,theoddsinfavorofsuccessareawesome.Why?Simplybecausetheyownsharesofbusinesses,andbusinessesasagroupearnsubstantialreturnsontheircapital,payoutdividendstotheirowners,andreinvestwhat’sleftfortheirfuturegrowth.
Yes,manyindividualcompaniesfail.Firmswithflawedideasandrigidstrategiesandweakmanagementsultimatelyfallvictimtothecreativedestructionthatisthehallmarkofcompetitivecapitalism,onlytobesucceededbyotherfirms.3Butintheaggregate,businesseshavegrownwiththelong-termgrowthofourvibranteconomy.Since1929,forexample,ournation’sgrossdomesticproduct(GDP)hasgrownatanominalannualrateof6.2percent;annualpretaxprofitsofournation’scorporationshavegrownatarateof6.3percent.ThecorrelationbetweenthegrowthofGDPandthegrowthofcorporateprofitsis0.98.(1.0isperfect.)Iassumethatthislong-termrelationshipwillprevailintheyearsahead.
Getoutofthecasinoandstayout!
Thisbookintendstoshowyouwhyyoushouldstopcontributingtothecroupiersofthefinancialmarkets.Why?Becauseduringthepastdecadetheyhaverakedinsomethinglike$565billioneachyearfromyouandyourfellowinvestors.Itwillalsotellyouhoweasyitistoavoidthosecroupiers:SimplybuyaStandard&Poor’s500Indexfundoratotalstockmarketindexfund.Then,onceyouhaveboughtyourstocks,getoutofthecasino—andstayout.Justholdthemarketportfolioforever.Andthat’swhatthetraditionalindexfunddoes.
Simplebutnoteasy.
Thisinvestmentphilosophyisnotonlysimpleandelegant.Thearithmeticonwhichitisbasedisirrefutable.Butitisnoteasytofollowitsdiscipline.Solongasweinvestorsacceptthestatusquooftoday’scrazy-quiltfinancialmarketsystem,solongasweenjoytheexcitement(howevercostly)ofbuyingandsellingstocks,andsolongaswefailtorealizethatthereisabetterway,suchaphilosophywillseemcounterintuitive.ButIaskyoutocarefullyconsidertheimpassionedmessageofthisLittleBook.Whenyoudo,youtoowillwanttojointheindexrevolutionandinvestinanew,“moreeconomical,moreefficient,evenmorehonestway,”4amoreproductivewaythatwillputyourowninterestsfirst.
ThomasPaineandCommonSense.
Itmayseemfarfetchedformetohopethatanysinglebookcouldignitethesparkofarevolutionininvesting.Newideasthatflyinthefaceoftheconventionalwisdomofthedayarealwaysgreetedwithdoubtandscorn,evenfear.Indeed,240yearsago,thesamechallengewasfacedbyThomasPaine,whose1776tractCommonSensehelpedsparktheAmericanRevolution.HereiswhatTomPainewrote:
Perhapsthesentimentscontainedinthefollowingpagesarenotyetsufficientlyfashionabletoprocurethemgeneralfavor;alonghabitofnotthinkingathingwrong,givesitasuperficialappearanceofbeingright,andraisesatfirstaformidableoutcryindefenseofcustom.Butthetumultsoonsubsides.Timemakesmoreconvertsthanreason....Ioffernothing
morethansimplefacts,plainarguments,andcommonsense.
Aswenowknow,ThomasPaine’spowerfulandarticulateargumentscarriedtheday.TheAmericanRevolutionledtoourConstitution,whichtothisdaydefinestheresponsibilitiesofourgovernmentandourcitizens,theveryfabricofoursociety.
Similarly,Ibelievethatinthecomingera,myownsimplefacts,plainarguments,andcommonsensewillcarrythedayforinvestors.TheIndexRevolutionwillhelpusbuildanewandmoreefficientinvestmentsystemforournation,asysteminwhichservinginvestorsisitshighestpriority.
Structureandstrategy.
Somemaysuggestthat,asthecreatorbothofVanguardin1974andoftheworld’sfirstindexmutualfundin1975,Ihaveavestedinterestinpersuadingyouofmyviews.OfcourseIdo!Butnotbecauseitenrichesme.Itdoesn’tearnmeapenny.Rather,IwanttopersuadeyoubecausethosetworocksonwhichVanguardwasfoundedallthoseyearsago—ourtrulymutual,fund-shareholder-ownedstructureandourindexfundstrategy—willenrichyouoverthelongterm.
Don’ttakemywordforit!
Intheearlyyearsofindexing,myvoicewasalonelyone.Buttherewereafewotherthoughtfulandrespectedbelieverswhoseideasinspiredmetocarryonmymission.Today,manyofourwisestandmostsuccessfulinvestorsendorsetheindexfundconcept;amongacademics,theacceptanceisclosetouniversal.Butdon’ttakemywordforit.Listentotheseindependentexpertswhohavenoaxtogrindexceptforthetruthaboutinvesting.You’llhearfromsomeofthemattheendofeachchapter.
Listen,forexample,tothisendorsementbythelatePaulA.Samuelson,NobellaureateineconomicsciencesandprofessorofeconomicsattheMassachusettsInstituteofTechnology,towhosememorythisbookisdedicated:“Bogle’sreasonedpreceptscanenableafewmillionofussaverstobecomeintwentyyearstheenvyofoursuburbanneighbors—whileatthesametimewehavesleptwellintheseeventfultimes.”
Itwilltakealongtimetofixourfinancialsystem.Buttheglacialpaceofthatchangeshouldnotpreventyoufromlookingafteryourownself-interest.You
don’tneedtoparticipateinitsexpensivefoolishness.Ifyouchoosetoplaythewinner’sgameofowningsharesofbusinesses,andtorefrainfromplayingtheloser’sgameoftryingtobeatthemarket,youcanbeginthetasksimplybyusingyourowncommonsense,understandingthesystem,andeliminatingsubstantiallyallofitsexcessivecosts.Then,atlast,youwillbeguaranteedtoearnyourfairshareofwhateverreturnsourbusinessesmaybegenerousenoughtodeliverintheyearsahead,reflectedastheywillbeinourstockandbondmarkets.(Caution:You’llalsoearnyourfairshareofanyinterimnegativereturns.)Whenyouunderstandtheserealities,you’llseethatit’sallaboutcommonsense.
The10thAnniversaryEditionofTheLittleBookofCommonSenseInvesting.
WhenthefirsteditionofTheLittleBookofCommonSenseInvestingwaspublished10yearsago,myhopewasthatinvestorswouldfinditusefulinhelpingthemtoearntheirfairshareofwhateverreturns—positiveornegative—ourfinancialmarketsdeliver.
ThatoriginalLittleBookof2007wasadirectsuccessortomyfirstbook,BogleonMutualFunds:NewPerspectivesfortheIntelligentInvestor,publishedin1994.Bothbookssetforththecaseforindexinvesting,andbothbecamethebest-sellingmutualfundbooksever,withinvestorspurchasingacombinedtotalofmorethan500,000copies.
Duringthenearquarter-centurysincethepublicationofmyfirstbook,indexfundshavecomeintotheirown.Assetsofequityindexfundshaverisen168-fold,from$28billionto$4.6trillioninmid-2017.Inthepastdecadealone,U.S.investorshaveadded$2.1trilliontotheirholdingsofequityindexfundsandwithdrawnmorethan$900billionfromtheirholdingsofactivelymanagedequityfunds.Suchahuge$3trillionswingininvestorpreferencessurelyrepresentsnolessthananinvestmentrevolution.
Inretrospect,itseemsclearthatmypioneeringcreationofthefirstindexmutualfundin1975providedthesparkthatignitedtheindexrevolution.Anditalsoseemsreasonabletoconcludethatmybooks,readbyanestimated1.5millionreaders,playedamajorroleinfuelingtheextraordinarypoweroftherevolutionthatfollowed.
Thecreativedestructionreapedbyindexfundshas,byandlarge,servedinvestorswell.Asyoureadthis10thAnniversaryEditionofTheLittleBookofCommonSenseInvesting,you’llseethatitstandsfirmlybehindthesound
principlesofitspredecessors,withnewchaptersondividends,assetallocation,andretirementplanningfocusedontheimplementationofthoseprinciples.
Learn!Enjoy!Act!
JOHNC.BOGLE
ValleyForge,Pennsylvania
September1,2017
Don’tTakeMyWordforItCharlesT.Munger,WarrenBuffett’sbusinesspartneratBerkshireHathaway,putsitthisway:“Thegeneralsystemsofmoneymanagement[today]requirepeopletopretendtodosomethingtheycan’tdoandlikesomethingtheydon’t.[It’s]afunnybusinessbecauseonanetbasis,thewholeinvestmentmanagementbusinesstogethergivesnovalueaddedtoallbuyerscombined.That’sthewayithastowork.Mutualfundscharge2percentperyearandthenbrokersswitchpeoplebetweenfunds,costinganotherthreetofourpercentagepoints.Thepoorguyinthegeneralpublicisgettingaterribleproductfromtheprofessionals.Ithinkit’sdisgusting.It’smuchbettertobepartofasystemthatdeliversvaluetothepeoplewhobuytheproduct.”
***
WilliamBernstein,investmentadviser(andneurologist),andauthorofTheFourPillarsofInvesting,says:“It’sbadenoughthatyouhavetotakemarketrisk.Onlyafooltakesontheadditionalriskofdoingyetmoredamagebyfailingtodiversifyproperlywithhisorhernestegg.Avoidtheproblem—buyawell-runindexfundandownthewholemarket.”
***
Here’showtheEconomistofLondonputsit:“Thetruthisthat,forthemostpart,fundmanagershaveofferedextremelypoorvalueformoney.Theirrecordsofoutperformancearealmostalwaysfollowedbystretchesofunderperformance.Overlongperiodsoftime,hardlyanyfundmanagershavebeatenthemarketaverages....Andallthewhiletheychargetheirclientsbigfeesfortheprivilegeoflosingtheirmoney....[One]specificlesson...isthemeritsofindexedinvesting...youwillalmostneverfindafundmanagerwhocanrepeatedlybeatthemarket.Itisbettertoinvestinanindexedfundthatpromisesamarketreturnbut
withsignificantlylowerfees.”
***
It’sreallyamazingthatsomanygiantsofacademia,andmanyoftheworld’sgreatestinvestors,knownforbeatingthemarket,confirmandapplaudthevirtuesofindexinvesting.Maytheircommonsense,perhapsevenmorethanmyown,makeyouallwiserinvestors.
NOTE:LittleBookreadersinterestedinreviewingthesourcesforthe“Don’tTakeMyWordforIt”quotesfoundattheendofeachchapter,otherquotesinthemaintext,andthesourcesoftheextensivedatathatIpresentcanfindthemonmywebsite:www.johncbogle.com.Iwouldn’tdreamofconsumingvaluablepagesinthissmallbookwithaweightybibliography,sopleasedon’thesitatetovisitmywebsite.
Notes1Keepinmindthatanindexmayalsobeconstructedaroundthebond
market,oreven“roadlesstraveled”assetclassessuchascommoditiesorrealestate.Today,ifyouwish,youcouldliterallyholdallyourwealthinadiversifiedportfoliooflow-costtraditionalindexfundsrepresentingeveryassetclassandeverymarketsectorwithintheUnitedStatesoraroundtheglobe.
2Overthepastcentury,theaveragenominalreturnonU.S.stockswas10.1percentperyear.Inrealterms(after3.4percentinflation)therealannualreturnwas6.7percent.Duringthenextdecade,bothreturnsarelikelytobesignificantlylower.(SeeChapter9.)
3“Creativedestruction”istheformulationofJosephE.Schumpeterinhis1942bookCapitalism,Socialism,andDemocracy.
4“Economical,”“efficient,”and“honest”arethewordsIusedinmy1951PrincetonUniversitythesis,“TheEconomicRoleoftheInvestmentCompany.”Someprinciplesareeternal.
http://www.johncbogle.com
ChapterOneAParable
TheGotrocksFamilyEVENBEFOREYOUTHINKabout“indexfunds”—intheirmostbasicform,mutualfundsthatsimplybuysharesofsubstantiallyallofthestocksintheU.S.stockmarketandholdthemforever—youmustunderstandhowthestockmarketactuallyworks.Perhapsthisfolksyparable—myversionofastorytoldbyWarrenBuffett,chairmanofBerkshireHathaway,Inc.,inthefirm’s2005AnnualReport—willclarifythefoolishnessandcounterproductivityofourvastandcomplexfinancialmarketsystem.
OnceuponaTime...AwealthyfamilynamedtheGotrocks,grownoverthegenerationstoincludethousandsofbrothers,sisters,aunts,uncles,andcousins,owned100percentofeverystockintheUnitedStates.Eachyear,theyreapedtherewardsofinvesting:alloftheearningsgrowththatthosethousandsofcorporationsgeneratedandallofthedividendsthattheydistributed.1Eachfamilymembergrewwealthieratthesamepace,andallwasharmonious.Theirinvestmentcompoundedoverthedecades,creatingenormouswealth.TheGotrocksfamilywasplayingawinner’sgame.
Butafterawhile,afewfast-talkingHelpersarriveonthescene,andtheypersuadesome“smart”Gotrockscousinsthattheycanearnalargersharethantheirrelatives.TheseHelpersconvincethecousinstoselltheirsharesinsomeofthecompaniestootherfamilymembers,andtobuysharesofothercompaniesfromtheminreturn.TheHelpershandlethetransactionsand,asbrokers,theyreceivecommissionsfortheirservices.Theownershipisthusrearrangedamongthefamilymembers.Totheirsurprise,however,thefamilywealthbeginstogrowataslowerpace.Why?BecausesomeoftheinvestmentreturnisnowconsumedbytheHelpers,andthefamily’sshareofthegenerouspiethatU.S.industrybakeseachyear—allofthosedividendspaid,allthoseearningsreinvestedinthebusinesses—100percentattheoutset,startstodecline,simplybecausesomeofthereturnisnowconsumedbytheHelpers.
Tomakemattersworse,inadditiontothetaxesthefamilyhasalwayspaidontheirdividends,someofthemembersarenowalsopayingcapitalgainstaxes.
Theirstock-swappingbackandforthgeneratescapitalgainstaxes,furtherdiminishingthefamily’stotalwealth.
Thesmartcousinsquicklyrealizethattheirplanhasactuallydiminishedtherateofgrowthinthefamily’swealth.Theyrecognizethattheirforayintostock-pickinghasbeenafailure,andconcludethattheyneedprofessionalassistance,thebettertopicktherightstocksforthemselves.Sotheyhirestock-pickingexperts—moreHelpers!—togainanadvantage.Thesemoneymanagerschargefeesfortheirservices.Sowhenthefamilyappraisesitswealthayearlater,itfindsthatitsshareofthepiehasdiminishedevenfurther.
Tomakemattersstillworse,thenewmanagersfeelcompelledtoearntheirkeepbytradingthefamily’sstocksatfeverishlevelsofactivity,notonlyincreasingthebrokeragecommissionspaidtothefirstsetofHelpers,butrunningupthetaxbillaswell.Nowthefamily’searlier100percentshareofthedividendsandearningspieisfurtherdiminished.
“Well,wefailedtopickgoodstocksforourselves,andwhenthatdidn’twork,wealsofailedtopickmanagerswhocoulddoso,”thesmartcousinssay.“Whatshallwedo?”Undeterredbytheirtwopreviousfailures,theydecidetohirestillmoreHelpers.Theyretainthebestinvestmentconsultantsandfinancialplannersthattheycanfindtoadvisethemonhowtoselecttherightmanagers,whowillthensurelypicktherightstocks.Theconsultants,ofcourse,tellthemthattheycandothejob.“Justpayusafeeforourservices,”thenewHelpersassurethecousins,“andallwillbewell.”Alas,withthoseaddedcosts,thefamily’sshareofthepietumblesonceagain.
GetridofallyourHelpers.Thenyourfamilywillagainreap100percentofthepiethatcorporateAmericabakesforyou.
Alarmedatlast,thefamilysitsdowntogetherandtakesstockoftheeventsthathavetranspiredsincesomeofthembegantotrytooutsmarttheothers.“Howisit,”theyask,“thatouroriginal100percentshareofthepie—madeupeachyearofallthosedividendsandearnings—hasdwindledtojust60percent?”Theirwisestmember,asageolduncle,softlyresponds:“Allthatmoneyyou’vepaidtothoseHelpersandallthoseunnecessaryextrataxesyou’repayingcomedirectlyoutofourfamily’stotalearningsanddividends.Gobacktosquareone,anddosoimmediately.Getridofallyourbrokers.Getridofallyourmoneymanagers.Getridofallyourconsultants.Thenourfamilywillagainreap100percentofhoweverlargeapiecorporateAmericabakesforus,yearafteryear.”
Theyfollowedtheolduncle’swiseadvice,returningtotheiroriginalpassivebutproductivestrategy,holdingallthestocksofcorporateAmerica,andstandingpat.
Thatisexactlywhatanindexfunddoes.
...andtheGotrocksFamilyLivedHappilyEverAfterAddingafourthlawtoSirIsaacNewton’sthreelawsofmotion,theinimitableWarrenBuffettputsthemoralofhisstorythisway:Forinvestorsasawhole,returnsdecreaseasmotionincreases.
Accurateasthatcrypticstatementis,Iwouldaddthattheparablereflectstheprofoundconflictofinterestbetweenthosewhoworkintheinvestmentbusinessandthosewhoinvestinstocksandbonds.Thewaytowealthforthoseinthebusinessistopersuadetheirclients,“Don’tjuststandthere.Dosomething.”Butthewaytowealthfortheirclientsintheaggregateistofollowtheoppositemaxim:“Don’tdosomething.Juststandthere.”Forthatistheonlywaytoavoidplayingtheloser’sgameoftryingtobeatthemarket.
Whenabusinessisconductedinawaythatdirectlydefiestheinterestsofitsclientsintheaggregate,itisonlyamatteroftimeuntiltheclientsawakentoreality.Then,thechangecomes—andthatchangeisdrivingtherevolutioninourfinancialsystemtoday.
ThemoraloftheGotrocksstory:Successfulinvestingisaboutowningbusinessesandreapingthehugerewardsprovidedbythedividendsandearningsgrowthofournation’s—and,forthatmatter,theworld’s—corporations.Thehighertheleveloftheirinvestmentactivity,thegreaterthecostoffinancialintermediationandtaxes,thelessthenetreturnthatshareholders—asagroup,theownersofourbusinesses—receive.Thelowerthecoststhatinvestorsasagroupincur,thehighertherewardsthattheyreap.Sotoenjoythewinningreturnsgeneratedbybusinessesoverthelongterm,theintelligentinvestorwillreducetothebare-bonesminimumthecostsoffinancialintermediation.That’swhatcommonsensetellsus.That’swhatindexingisallabout.Andthat’sthecentralmessageofthisbook.
Don’tTakeMyWordforItListentoJackR.Meyer,formerpresidentofHarvardManagementCompany,theremarkablysuccessfulwizardwhotripledtheHarvardUniversityendowmentfundfrom$8billionto$27billion.Here’swhathehadtosayina2004BusinessWeekinterview:“Theinvestmentbusinessisagiantscam.Mostpeoplethinktheycanfindmanagerswhocan
outperform,butmostpeoplearewrong.Iwillsaythat85to90percentofmanagersfailtomatchtheirbenchmarks.Becausemanagershavefeesandincurtransactioncosts,youknowthatintheaggregatetheyaredeletingvalue.”
WhenaskedifprivateinvestorscandrawanylessonsfromwhatHarvarddoes,Mr.Meyerresponded,“Yes.First,getdiversified.Comeupwithaportfoliothatcoversalotofassetclasses.Second,youwanttokeepyourfeeslow.Thatmeansavoidingthemosthypedbutexpensivefunds,infavoroflow-costindexfunds.Andfinally,investforthelongterm.[Investors]shouldsimplyhaveindexfundstokeeptheirfeeslowandtheirtaxesdown.Nodoubtaboutit.”
***
Intermsthatareabitlesscontentious,PrincetonUniversityprofessorBurtonG.Malkiel,authorofARandomWalkDownWallStreet,expressestheseviews:“Indexfundshaveregularlyproduced[annual]ratesofreturnexceedingthoseofactivemanagersbycloseto2percentagepoints.Activemanagementasawholecannotachievegrossreturnsexceedingthemarketasawhole,andthereforetheymust,onaverage,underperformtheindexesbytheamountoftheseexpenseandtransactioncosts.
“Experienceconclusivelyshowsthatindex-fundbuyersarelikelytoobtainresultsexceedingthoseofthetypicalfundmanager,whoselargeadvisoryfeesandsubstantialportfolioturnovertendtoreduceinvestmentyields....Theindexfundisasensible,serviceablemethodforobtainingthemarket’srateofreturnwithabsolutelynoeffortandminimalexpense.”
Note1Tocomplicatemattersjustabit,theGotrocksfamilyalsopurchasedthenew
publicofferingsofsecuritiesthatwereissuedeachyear.
ChapterTwoRationalExuberance
ShareholderGainsMustMatchBusinessGains.THATWONDERFULPARABLEABOUTtheGotrocksfamilyinChapter1bringshomethecentralrealityofinvesting:“ThemostthatownersinaggregatecanearnbetweennowandJudgmentDayiswhattheirbusinessesinaggregateearn,”inthewordsofWarrenBuffett.IllustratingthepointwithBerkshireHathaway,thepubliclyownedcorporationthathehasrunfor46years,pleaseheedcarefullyMr.Buffett’sstatement:
Whenthestocktemporarilyoverperformsorunderperformsthebusiness,alimitednumberofshareholders—eithersellersorbuyers—receiveoutsizedbenefitsattheexpenseofthosetheytradewith....Overtime,theaggregategainsmadebyBerkshireshareholdersmustofnecessitymatchthebusinessgainsofthecompany.
“Overtime,theaggregategainsmadeby...shareholdersmustofnecessitymatchthebusinessgainsofthecompany.”
Howofteninvestorslosesightofthateternalprinciple!Yettherecordisclear.History,ifonlywewouldtakethetroubletoexamineit,revealstheremarkable,ifessential,linkagebetweenthecumulativelong-termreturnsearnedbyU.S.business—theannualdividendyieldplustheannualrateofearningsgrowth—andthecumulativereturnsearnedbythestockmarket.Thinkaboutthatcertaintyforamoment.Canyouseethatitissimplecommonsense?
Needproof?Justlookattherecordsincethebeginningofthetwentiethcentury(Exhibit2.1).Theaverageannualtotalreturnonstockswas9.5percent.Theinvestmentreturnalonewas9.0percent—4.4percentfromdividendyieldand4.6percentfromearningsgrowth.
EXHIBIT2.1InvestmentReturnversusMarketReturn.Growthof$1,1900–2016
Thatdifferenceof0.5percentagepointsperyeararosefromwhatIcallspeculativereturn.Speculativereturnmaybeaplusoraminus,dependingonthewillingnessofinvestorstopayeitherhigherorlowerpricesforeachdollarofearningsattheendofagivenperiodthanatthebeginning.
Theprice/earnings(P/E)ratiomeasuresthenumberofdollarsinvestorsarewillingtopayforeachdollarofearnings.Asinvestorconfidencewaxesandwanes,P/Emultiplesriseandfall.1Whengreedholdssway,veryhighP/Esarelikely.Whenhopeprevails,P/Esaremoderate.Whenfearisinthesaddle,P/Esaretypicallyverylow.Backandforth,overandoveragain,swingsintheemotionsofinvestorsarereflectedinspeculativereturn.Theymomentarilyderailthesteadylong-rangeupwardtrendintheeconomicsofinvesting.
AsreflectedinExhibit2.1,theinvestmentreturnonstocks—dividendyieldplusearningsgrowth—trackscloselywiththetotalmarketreturn(includingtheimpactofspeculativereturn)overthelongterm.Anysignificantdivergencesbetweenthetwoareshort-lived.
Compoundingthesereturnsover116yearsproducesaccumulationsthataretrulystaggering.Eachdollarinitiallyinvestedinstocksin1900atareturnof9.5percentgrewbythecloseof2015to$43,650.2Sure,few(ifany)ofushave116yearsinus!Butourdescendantsfollowus,and,liketheGotrocksfamily,enjoythemiracleofcompoundingreturns.Thesereturnshavebeen
littleshortofamazing—theultimatewinner’sgame.
AsExhibit2.1makesclear,therearebumpsalongthewayintheinvestmentreturnsearnedbyourbusinesscorporations.Sometimes,asintheGreatDepressionoftheearly1930s,thesebumpswerelarge.Butwegotoverthem.So,ifyoustandbackfromthechartandsquintyoureyes,thetrendofbusinessfundamentalslooksalmostlikeastraightlineslopinggentlyupward,andthoseperiodicbumpsarebarelyvisible.
Reversiontothemean.
Tobesure,stockmarketreturnssometimesgetwellaheadofbusinessfundamentals(asinthelate1920s,theearly1970s,andthelate1990s,perhapseventoday).Butithasbeenonlyamatteroftimeuntil,asifdrawnbyamagnet,theyultimatelyreturntothelong-termnorm,althoughoftenonlyafterfallingwellbehindforatime,asinthemid-1940s,thelate1970s,andthe2003marketlows.It’scalledreversion(orregression)tothemean(RTM),whichwe’lldiscussindepthinChapter11.
Inourfoolishfocusontheshort-termstockmarketdistractionsofthemoment,weinvestorsoftenoverlookthislonghistory.Whenthereturnsonstocksdepartmateriallyfromthelong-termnorm,weignoretherealitythatitisrarelybecauseoftheeconomicsofinvesting—theearningsgrowthanddividendyieldsofourcorporations.Rather,thereasonthatannualstockreturnsaresovolatileislargelybecauseoftheemotionsofinvesting,reflectedinthosechangingP/Eratios.
“Itisdangerous...toapplytothefutureinductiveargumentsbasedonpastexperience.”
WhatExhibit2.1showsisthatwhilethepriceswepayforstocksoftenlosetouchwiththerealityofcorporatevalues,inthelongrunrealityrules.So,whileinvestorsseemtointuitivelyacceptthatthepastisinevitablyprologuetothefuture,anypaststockmarketreturnsthathaveincludedahighspeculativestockreturncomponentaredeeplyflawedguidestowhatliesahead.Tounderstandwhypastreturnsdonotforetellthefuture,weneedonlyheedthewordsofthegreatBritisheconomistJohnMaynardKeynes.Here’swhathewrote81yearsago:
Itisdangerous...toapplytothefutureinductiveargumentsbasedonpast
experience,unlessonecandistinguishthebroadreasonswhypastexperiencewaswhatitwas.
Butifwecandistinguishthereasonsthepastwaswhatitwas,thenwecanestablishreasonableexpectationsaboutthefuture.Keyneshelpedusmakethisdistinctionbypointingoutthatthestateoflong-termexpectationforstocksisacombinationofenterprise(“forecastingtheprospectiveyieldofassetsovertheirwholelife”)andspeculation(“forecastingthepsychologyofthemarket”).
I’mwellfamiliarwiththosewords,for66yearsagoIincorporatedthemintomyseniorthesisatPrincetonUniversity.Itwasentitled,“TheEconomicRoleoftheInvestmentCompany.”Itled,providentially,tomylifetimecareerinthemutualfundindustry.
Thedualnatureofstockmarketreturns.
Thisdualnatureofreturnsisclearlyreflectedwhenwelookatstockmarketreturnsoverthedecades(Exhibit2.2).PuttingmyownnumberstoKeynes’sidea,Idividestockmarketreturnsintotwoparts:(1)investmentreturn(enterprise),consistingoftheinitialdividendyieldonstocksplustheirsubsequentearningsgrowth(together,theyformtheessenceofwhatwecall“intrinsicvalue”),and(2)speculativereturn,theimpactofchangingprice/earningsmultiplesonstockprices.Let’sbeginwithinvestmentreturns.
EXHIBIT2.2TotalStockReturnsbytheDecade,1900–2016(PercentAnnually)
ThetopsectionofExhibit2.2showstheaverageannualinvestmentreturnonstocksovereachofthedecadessince1900.Notefirstthesteadycontributionofdividendyieldstototalreturnduringeachdecade:alwayspositive,onlytwiceoutsidetherangeof3percentto7percent,andaveraging4percent.
Thennotethatthecontributionofearningsgrowthtoinvestmentreturn,withtheexceptionofthedepression-ridden1930s,waspositiveineverydecadeandabove9percentinseveraldecades,butusuallyranbetween4percentand7percent,andaveraged4.6percentperyear.
Result:Totalinvestmentreturns(thetopsection,combiningdividendyieldandearningsgrowth)werenegativeinonlyasingledecade(again,inthe1930s).Whilethesedecade-longtotalinvestmentreturns—thegainsmadebybusiness—varied,Iconsiderthemremarkablysteady.Theygenerallyranintherangeof8percentto13percentannually,andaveraged9percent.
Enterspeculativereturn.
Enterspeculativereturn,showninthemiddlesectionofExhibit2.2.Comparedwiththerelativeconsistencyofdividendsandearningsgrowthoverthedecades,trulywildvariationsinspeculativereturnpunctuatethechart.P/Eswaxandwane,oftenwitharemarkableimpactonreturns.Forexample,a100percentriseintheP/E,from10to20timesoveradecade,wouldequatetoa7.2percentannualspeculativereturn.
Asyoucansee,withoutexceptioneverydecadeofsignificantlynegativespeculativereturnwasimmediatelyfollowedbyadecadeinwhichitturnedpositivebyacorrelativeamount:thenegative1910sandthentheroaring1920s;thedispiriting1940sandthenthebooming1950s;thediscouraging1970sandthenthesoaring1980s.
Thispatternisreversiontothemeanwritlarge.RTMcanbethoughtofasthetendencyforthoseP/Estoreturntotheirlong-termnormsovertime.Periodsofsubparperformancetendtobefollowedbyperiodsofrecovery,andviceversa.Then,amazingly,duringthe1990s,therewasanunprecedentedsecondconsecutiveexuberantincrease,apatternneverbeforeinevidence.
Areturntosanity.
InApril1999,theP/Eratiohadrisentoanunprecedentedlevelof34times,settingthestageforthereturntosanityinvaluationsthatsoonfollowed.Thetumbleinstockmarketpricesgaveusourcomeuppance.Withearningscontinuingtorise,theP/Ecurrentlystandsat23.7times,comparedwiththe15timeslevelthatprevailedatthestartofthetwentiethcentury.Asaresult,speculativereturnhasaddedjust0.5percentagepointstotheannualinvestmentreturnearnedbyourbusinessesoverthelongterm.3
Combininginvestmentreturnandspeculativereturn:totalstockmarketreturns.
Whenwecombinethesetwosourcesofstockreturns,wegetthetotalreturnproducedbythestockmarket.(ThelowersectionofExhibit2.2.)Despitethehugeimpactofspeculativereturn—upanddown—duringmostoftheindividualdecades,thereisvirtuallynoimpactoverthelongterm.Theaverageannualtotalreturnonstocksof9.5percent,then,hasbeencreated
almostentirelybyenterprise,withonly0.5percentagepointcreatedbyspeculation.
Themessageisclear:Inthelongrun,stockreturnsdependalmostentirelyontherealityoftheinvestmentreturnsearnedbyourcorporations.Theperceptionofinvestors,reflectedbythespeculativereturns,countsforlittle.Itiseconomicsthatcontrolslong-termequityreturns;theimpactofemotions,sodominantintheshortterm,dissolves.
Accuratelyforecastingshort-termswingsininvestoremotionsisnotpossible.Butforecastingthelong-termeconomicsofinvestinghas
carriedremarkablyhighoddsofsuccess.
Evenaftermorethan66yearsinthisbusiness,Ihavealmostnoideahowtoforecasttheseshort-termswingsininvestoremotions.4But,largelybecausethearithmeticofinvestingissobasic,Ihavebeenabletoforecastthelong-termeconomicsofinvestingwithremarkablyhighoddsofsuccess.
Why?Simplybecauseitisinvestmentreturns—theearningsanddividendsgeneratedbyAmericanbusinesses—thatarealmostentirelyresponsibleforthereturnsdeliveredinourstockmarketoverthelongterm.Whileillusion(themomentarypriceswepayforstocks)oftenlosestouchwithreality(theintrinsicvaluesofourcorporations),itisrealitythatrulesinthelongrun.
Therealmarketandtheexpectationsmarket.
Todrivethispointhome,thinkofinvestingasconsistingoftwodifferentgames.Here’showRogerMartin,deanoftheRotmanSchoolofManagementoftheUniversityofToronto,describesthem.Onegameis“therealmarket,wheregiantpubliclyheldcompaniescompete.Whererealcompaniesspendrealmoneytomakeandsellrealproductsandservices,and,iftheyplaywithskill,earnrealprofitsandpayrealdividends.Thisgamealsorequiresrealstrategy,determination,andexpertise;realinnovationandrealforesight.”Looselylinkedtothisgameisanothergame,theexpectationsmarket.Here,“pricesarenotsetbyrealthingslikesalesmarginsorprofits.Intheshortterm,stockpricesgouponlywhentheexpectationsofinvestorsrise,notnecessarilywhensales,margins,orprofitsrise.”
Thestockmarketisagiantdistractiontothebusinessofinvesting.
Tothiscrucialdistinction,Iwouldaddthattheexpectationsmarketislargelyaproductoftheexpectationsofspeculators,tryingtoguesswhatotherinvestorswillexpectandhowtheywillactaseachnewbitofinformationfindsitswayintothemarketplace.Theexpectationsmarketisaboutspeculation.Therealmarketisaboutinvesting.Thestockmarket,then,isagiantdistractiontothebusinessofinvesting.
Toooften,themarketcausesinvestorstofocusontransitoryandvolatileshort-termexpectations,ratherthanonwhatisreallyimportant—thegradualaccumulationofthereturnsearnedbycorporatebusinesses.
WhenShakespearewrotethat“itisataletoldbyanidiot,fullofsoundandfury,signifyingnothing,”hecouldhavebeendescribingtheinexplicabledaily,month-by-month,orevenannualswingsinstockprices.Myadvicetoinvestors:ignoretheshort-termsoundandfuryoftheemotionsreflectedinourfinancialmarkets,andfocusontheproductivelong-termeconomicsofourcorporatebusinesses.Thewaytoinvestmentsuccessistogetoutoftheexpectationsmarketofstockpricesandcastyourlotwiththerealmarketofbusiness.
Don’tTakeMyWordforItSimplyheedthetimelessdistinctionmadebyBenjaminGraham,legendaryinvestor,authorofTheIntelligentInvestor,andmentortoWarrenBuffett.Hewasrightonthemoneywhenheputhisfingerontheessentialrealityofinvesting:“Intheshortrunthestockmarketisavotingmachine...inthelongrunitisaweighingmachine.”
Usinghiswonderfulmetaphorof“Mr.Market,”BenGrahamsays,“Imaginethatinsomeprivatebusinessyouownasmallsharewhichcostyou$1,000.Oneofyourpartners,namedMr.Market,isveryobligingindeed.Everydayhetellsyouwhathethinksyourinterestisworthandfurthermoreofferseithertobuyyououtortosellyouanadditionalinterestonthatbasis.Sometimeshisideaofvalueappearsplausibleandjustifiedbybusinessdevelopmentsandprospectsasyouknowthem.Often,ontheotherhand,Mr.Marketletshisenthusiasmorhisfearsrunawaywithhim,andthevalueheproposesseemslittleshortofsilly.
“Ifyouareaprudentinvestor...willyouletMr.Market’sdailycommunicationdetermineyourviewasthevalueofyour$1,000interestintheenterprise?Onlyincaseyouagreewithhim,orincaseyouwanttotradewithhim....Buttherestofthetimeyouwillbewisertoformyour
ownideasofthevalueofyourholdings....Thetrueinvestor...willdobetterifheforgetsaboutthestockmarketandpaysattentiontohisdividendreturnsandtotheoperatingresultsofhiscompanies.(Italicsadded.)...
“Theinvestorwithaportfolioofsoundstocksshouldexpecttheirpricestofluctuateandshouldneitherbeconcernedbysizabledeclinesnorbecomeexcitedbysizableadvances.Heshouldalwaysrememberthatmarketquotationsarethereforhisconvenience,eithertobetakenadvantageofortobeignored.”
Notes1Changesininterestratesalsohaveanimpact,uneventhoughitmaybe,on
theP/Emultiple.So,I’moversimplifyingabithere.
2Butlet’sbefair.Ifwecompoundthatinitial$1,notatthenominalreturnof9.5percentbutattherealrateof6.3percent(after3.2percentinflationduringtheperiod),$1growsto$1,339,butafractionoftheaccumulationinnominalterms.Butincreasingrealwealthmorethan1,300timesoverisnottobesneezedat.
3OurmeasureoftheP/Eratioatthecloseof2016isbasedontheyear-endpriceof2247fortheS&P500relativetoreportedearningsfor2016of$95pershare—aP/Eof23.7.WallStreetanalyststendtorelyonoperatingearnings(beforewrite-offsandothernegatives)thatareforecastforthecomingyear($118pershare).ResultingP/E:17.4times.
4I’mnotalone.Idon’tknowanyonewhohasdonesoconsistently,norevenanyonewhoknowsanyonewhohasdoneso.Infact,70yearsoffinancialresearchfindsnoonewhohasdoneso.
ChapterThreeCastYourLotwithBusiness
WinbyKeepingItSimple—RelyonOccam’sRazor.HOWDOYOUCASTyourlotwithbusiness?SimplybybuyingaportfoliothatownssharesofeverybusinessintheUnitedStatesandthenholdingitforever.Thissimpleconceptguaranteesyouwillwintheinvestmentgameplayedbymostotherinvestorswho—asagroup—areguaranteedtolose.
Pleasedon’tequatesimplicitywithstupidity.Waybackin1320,WilliamofOccamnicelyexpressedthevirtueofsimplicity,essentiallysettingforththisprecept:Whentherearemultiplesolutionstoaproblem,choosethesimplestone.1AndsoOccam’srazorcametorepresentamajorprincipleofscientificinquiry.ByfarthesimplestwaytoownallofU.S.businessesistoholdthetotalstockmarketportfoliooritsequivalent.
Occam’srazor:Whentherearemultiplesolutionstoaproblem,choosethesimplestone.
Forthepast90years,theacceptedstockmarketportfoliohasbeenrepresentedbytheStandard&Poor’s500Index(theS&P500).Itwascreatedin1926astheCompositeIndex,andnowlists500stocks.2Itisessentiallycomposedofthe500largestU.S.corporations,weightedbythevalueoftheirmarketcapitalizations.Inrecentyears,these500stockshaverepresentedabout85percentofthemarketvalueofallU.S.stocks.Thebeautyofsuchamarket-cap-weightedindexisthatitneverneedstoberebalancedbybuyingandsellingsharesduetochangingstockprices.
Withtheenormousgrowthofcorporatepensionfundsbetween1950and1990,theS&P500wasanidealmeasurementstandard,thebenchmark(orhurdlerate)thatwouldbethecomparativestandardforhowtheprofessionalmanagersofpensionfundswereperforming.Today,theS&P500remainsavalidstandardagainstwhichtocomparethereturnsearnedbytheprofessionalmanagersofpensionfundsandmutualfunds.
TheTotalStockMarketIndex
In1970,anevenmorecomprehensivemeasureoftheU.S.stockmarketwasdeveloped.OriginallycalledtheWilshire5000,itisnownamedtheDowJonesWilshireTotalStockMarketIndex.3Itnowincludessome3,599stocks,includingthe500stocksintheS&P500.Becauseitscomponentstocksalsoareweightedbytheirmarketcapitalization,thoseremaining3,099stockswithsmallercapitalizationsaccountforonlyabout15percentofitsvalue.
ThisbroadestofallU.S.stockindexesisthebestmeasureoftheaggregatevalueofstocks,andthereforeasuperbmeasureofthereturnsearnedinU.S.stocksbyallinvestorsasagroup.Asjustindicated,bothindexesholdtheverysamelargestocks.Exhibit3.1showsthe10largeststocksineach,andtheirweightsintheconstructionofeachindex.
EXHIBIT3.1S&P500versusTotalStockMarketIndex:PortfolioComparison,December2016
S&P500 TotalStockMarketIndexRank Weighting Rank WeightingAppleInc. 3.2% AppleInc. 2.5%MicrosoftCorp. 2.5 MicrosoftCorp. 2.0AlphabetInc. 2.4 AlphabetInc. 2.0ExxonMobilCorp. 1.9 ExxonMobilCorp. 1.6Johnson&Johnson 1.6 Johnson&Johnson 1.3BerkshireHathawayInc.
1.6 BerkshireHathawayInc.
1.3
JPMorganChase&Co. 1.6 JPMorganChase&Co. 1.3Amazon.comInc. 1.5 Amazon.comInc. 1.3GeneralElectricCo. 1.4 GeneralElectricCo. 1.2FacebookInc. 1.4 FacebookInc. 1.1Top10 19.1% Top10 15.6%Top25 33.3 Top25 27.3Top100 63.9 Top100 52.9Top500 100.0 Top500 84.1Totalmarketcap $19.3
trillion$22.7trillion
http://Amazon.comhttp://Amazon.com
Giventhesimilarityofthesetwoportfolios,itishardlysurprisingthatthetwoindexeshaveearnedreturnsthatareinlockstepwithoneanother.TheCenterforResearchinSecurityPricesattheUniversityofChicagohasgonebackto1926andcalculatedthereturnsearnedbyallU.S.stocks.ThereturnsoftheS&P500IndexandtheDowJonesWilshireTotalStockMarketIndexparalleloneanotherwithnearprecision.From1926,thebeginningofthemeasurementperiod,through2016,youcanhardlytellthemapart(Exhibit3.2).
EXHIBIT3.2S&P500andTotalStockMarketIndex,1926–2016
Forthefullperiod,theaverageannualreturnontheS&P500was10.0percent;thereturnontheTotalStockMarketIndexwas9.8percent.Thiscomparisoniswhatwecallperioddependent—everythingdependsonthestartingdateandtheendingdate.Ifweweretobeginthecomparisonatthebeginningof1930insteadof1926,thereturnsofthetwowouldbeidentical:9.6percentperyear.
Yes,therearevariationsovertheinterimperiods:theS&P500wasmuchthestrongerfrom1982to1990,whenitsannualreturnof15.6percentoutpacedtheTotalStockMarketIndexreturnof14.0percent.Butsincethen,small-andmid-capstockshavedoneabitbetter,andtheTotalStockMarketIndexreturnof10.2percentperyearnarrowlyexceededthe9.9percentreturnoftheS&P500.Butwithalong-termcorrelationof0.99betweenthereturnsofthetwoindexes(1.00isperfectcorrelation),thereislittletochoosebetweenthetwo.4
Returnsearnedinthestockmarketmustequalthegrossreturnsearnedbyallinvestorsinthemarket.
Whichevermeasureweuse,itshouldnowbeobviousthatthereturnsearnedbythepubliclyheldcorporationsthatcomposethestockmarketmustofnecessityequaltheaggregategrossreturnsearnedbyallinvestorsinthatmarketasagroup.Equallyobvious,aswillbediscussedinChapter4,thenetreturnsearnedbytheseinvestorsmustofnecessityfallshortofthoseaggregategrossreturnsbytheamountofintermediationcoststheyincur.Ourcommonsensetellsustheobvious,justwhatwelearnedinChapter1:Owningthestockmarketoverthelongtermisawinner’sgame,butattemptingtobeatthestockmarketisaloser’sgame.
Alow-costall-marketfund,then,isguaranteedtooutpaceovertimethereturnsearnedbyequityinvestorsasagroup.Onceyourecognizethisfact,youcanseethattheindexfundisguaranteedtowinnotonlyovertime,buteveryyear,andeverymonthandweek,eveneveryminuteoftheday.Nomatterhowlongorshortthetimeframe,thegrossreturninthestockmarket,minusintermediationcosts,equalsthenetreturnearnedbyinvestorsasagroup.Ifthedatadonotprovethatindexingwins,well,thedataarewrong.
Ifthedatadonotprovethatindexingwins,well,thedataarewrong.
Overtheshortterm,however,itdoesn’talwayslookasiftheS&P500(stillthemostcommonbasisofcomparisonformutualfundsandpensionplans)ortheTotalStockMarketIndexiswinning.Thatisbecausethereisnopossiblewaytocalculatepreciselythereturnsearnedbythemillionsofdiverseparticipants,amateurandprofessionalalike,Americansandforeigninvestors,intheU.S.stockmarket.
Inthemutualfundfield,wecalculatethereturnsofthevariousfunds,countingeachfund—regardlessoftheamountofitsassets—asasingleentry.Sincetherearemanysmall-capandmid-capfunds,usuallywithrelativelymodestassetbases,attimestheymayhaveadisproportionateimpactonthedata.Whensmall-andmid-capfundsareleadingthetotalmarket,theall-marketindexfundseemstolag.Whensmall-andmid-capstocksarelaggingthemarket,theindexfundlooksformidableindeed.
Activefundsversusbenchmarkindexes.
TheobvioussolutiontothechallengeofcomparingactiveequityfundsofalltypeswiththeS&P500Indexistomeasurefundsagainstotherindexesthatmorecloselyreflecttheirowninvestmentstrategies.Someyearsago,theS&PIndicesversusActive(SPIVA)reportbegantodoexactlythat.Thereportprovidescomprehensivedatacomparingactivemutualfundsgroupedbyvariousstrategieswithrelevantmarketindexes.Inits2016year-endreport,SPIVAextendedthelongesttimehorizonevaluatedinthereportto15years(2001–2016)andreportedthepercentageofactivelymanagedfundsthatwereoutperformedbytheirrelevantbenchmarkindexes.Theresultswereimpressive(Exhibit3.3).Onaverage,anastonishing90percentofactivelymanagedmutualfundsunderperformedtheirbenchmarkindexesoverthepreceding15years.Theindexsuperioritywasconsistentandoverwhelming.
EXHIBIT3.3PercentagesofActivelyManagedMutualFundsOutperformedbyComparableS&PIndexes,2001–2016
FundCategory Growth Core ValueLarge-Cap 95% 97% 79%Mid-Cap 97 99 90Small-Cap 99 95 81
TheS&P500outpaced97percentofactivelymanagedlarge-capcorefunds.TheS&P500GrowthandValueindexesareusedascomparisonsforfundsinthoselarge-capcategories,andsoonforthethreemid-capcategoriesandthethreesmall-capcategories.Thesweepingacross-the-boardsuperiorityoftheindexescanleavelittledoubtthatindexfundsareheretostay.
In1951,IwroteinmyseniorthesisatPrincetonUniversitythatmutualfunds“canmakenoclaimtosuperiorityoverthemarketaverages.”Sixty-sixyearslater,thathasproventobeahugeunderstatement.
Therecordofaninvestorinthefirstindexmutualfund:$15,000investedin1976;valuein2016,$913,340.
Therecenteranotonlyhasfailedtoerode,buthasnicelyenhancedthelifetimerecordoftheworld’sfirstindexfund—nowknownastheVanguard500IndexFund.ItbeganoperationsbackonAugust31,1976.Letmebespecific:ataluncheononSeptember20,2016,celebratingthe40thanniversaryofthefund’sinitialpublicoffering,thecounselforthefund’sunderwritersreportedthathehadpurchased1,000sharesattheoriginalofferingpriceof$15pershare—a$15,000investment.Heproudly
announcedthevalueofhisholdingthatday(includingsharesacquiredthroughreinvestingthefund’sdividendsanddistributionsovertheyearsinadditionalshares):$913,340.5Now,there’sanumberthatrequiresnoembellishment.Butitdoesdemandonecaveatandonecaution.
Acaveatandacaution.
Thecaveat:Ofthe360equitymutualfundsinexistencewhenthefirstindexfundwasformedin1976,only74remain.Activelymanagedfundscomeandgo,buttheindexfundgoesonforever.Thecaution:Duringthatfour-decadeperiod,theS&P500Indexgrewatanannualrateof10.9percent.Withtoday’slowerdividendyields,theprospectoflowerearningsgrowth,andaggressivemarketvaluations,itwouldbefoolishintheextremetoassumethatsuchareturnwouldrecuroverthenextfourdecades.SeeChapter9,“WhentheGoodTimesNoLongerRoll.”
ThepastrecordconfirmsthatowningAmericanbusinessthroughabroadlydiversifiedindexfundisnotonlylogicalbut,tosaytheleast,incrediblyproductive.Equallyimportant,itisconsistentwiththeage-oldprincipleofsimplicityexpressedbySirWilliamofOccam:Insteadofjoiningthecrowdofinvestorswhodabbleincomplexalgorithmsorothermachinationstopickstocks,orwholooktopastperformancetoselectmutualfunds,orwhotrytooutguessthestockmarket(forinvestorsintheaggregate,threeinevitablyfruitlesstasks),choosethesimplestofallsolutions—buyandholdadiversified,low-costportfoliothattracksthestockmarket.
Don’tTakeMyWordforItHearDavidSwensen,thewidelyrespectedchiefinvestmentofficeroftheYaleUniversityEndowmentFund.“[Overthefifteenyearsending1998,a]minuscule4percentof[mutual]fundsproducedmarket-beatingafter-taxresultswithascant0.6percent[annual]marginofgain.The96percentoffundsthatfailtomeetorbeattheVanguard500IndexFundlosebyawealth-destroyingmarginof4.8percentperannum.”
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Thesimpleindexfundsolutionisusednotonlybyinvestorsofaveragemeans.Ithasbeenadoptedasacornerstoneofinvestmentstrategyformanyofthenation’spensionplansoperatedbyourgiantcorporationsandstateandlocalgovernments.Indexingisalsothepredominantstrategyfor
thelargestplanofthemall,theretirementplanforfederalgovernmentemployees,thefederalThriftSavingsPlan(TSP).Theplannowholdssome$460billionofassetsforthebenefitofourpublicservantsandmembersofourarmedservices.Allcontributionsandearningsaretax-deferreduntilwithdrawal,muchlikethecorporate401(k)thriftplan.6
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IndexingisalsopraisedacrosstheAtlantic“pond.”ListentothesewordsfromJonathanDavis,columnistforLondon’sTheSpectator:“NothinghighlightsbetterthecontinuinggapbetweenrhetoricandsubstanceinBritishfinancialservicesthanthefailureofprovidersheretoemulateJackBogle’sindexfundsuccessintheUnitedStates.EveryprofessionalintheCityknowsthatindexfundsshouldbecorebuildingblocksinanylong-terminvestor’sportfolio.Since1976,theVanguardindexfundhasproducedacompoundannualreturnof12percent,betterthanthree-quartersofitspeergroup.Yeteven30yearson,ignoranceandprofessionalomertastillstandinthewayofmoreinvestorsenjoyingthefruitsofthisunsungherooftheinvestmentworld.”
Notes1WilliamofOccamexpresseditmoreelegantly:“Entitiesshouldnotbe
multipliedunnecessarily.”Butthepointisunmistakable.
2Until1957,theS&PIndexincludedjust90companies.
3Fulldisclosure:Vanguardcreatedthefirstindexmutualfund,trackingtheStandard&Poor’s500Index,in1975.ThefirmalsocreatedthefirstTotalStockMarketIndexFundin1992.
4Youshouldknowthat,inestablishingatrustforhiswife’sestate,WarrenBuffettdirectedthat90percentofitsassetsbeinvestedinalow-costS&P500Indexfund.
5Thisinvestorpaidseparatelythetaxesdueondividendsandcapitalgainsdistributions.
6TheTSPalsooffersRothcontributions,whicharetreatedsimilarlytoRothIRAsfortaxpurposes.Rothcontributionsaremadewithafter-taxincome,butallsubsequentgrowthiscompletelytaxfree.I’llexpandonthesubjectofsavingforretirementinChapter19.
ChapterFourHowMostInvestorsTurnaWinner’sGameintoaLoser’sGame
“TheRelentlessRulesofHumbleArithmetic”BEFOREWETURNTOthesuccessofindexingasaninvestmentstrategy,let’sexploreinabitmoredepthjustwhyitisthatinvestorsasagroupfailtoearnthereturnsthatourcorporationsgeneratethroughtheirdividendsandearningsgrowth,whichareultimatelyreflectedinthepricesoftheirstocks.Why?Becauseinvestorsasagroupmustnecessarilyearnpreciselythemarketreturn,beforethecostsofinvestingarededucted.
Whenwesubtractthosecostsoffinancialintermediation—allthosemanagementfees,allofthatportfolioturnover,allofthosebrokeragecommissions,allofthosesalesloads,allofthoseadvertisingcosts,allofthoseoperatingcosts,allofthoselegalfees—thereturnsofinvestorsasagroupmust,andwill,anddofallshortofthemarketreturnbyanamountpreciselyequaltotheaggregateamountofthosecosts.Thatisthesimple,undeniablerealityofinvesting.
Inamarketthatreturns7percentinagivenyear,weinvestorstogetherearnagrossreturnof7percent.(Duh!)Butafterwepayourfinancialintermediaries,wepocketonlywhatremains.(Andwepaythemwhetherourreturnsarepositiveornegative!)
Beforecosts,beatingthemarketisazero-sumgame.Aftercosts,itisaloser’sgame.
Thereare,then,thesetwocertainties:(1)Beatingthemarketbeforecostsisazero-sumgame.(2)Beatingthemarketaftercostsisaloser’sgame.Thereturnsearnedbyinvestorsintheaggregateinevitablyfallwellshortofthereturnsthatarerealizedinourfinancialmarkets.Howmuchdothosecostscometo?Forindividualinvestorsholdingstocksdirectly,tradingcostsmayaverage1.5percentormoreperyear.Thatcostislower(maybe1percent)forthosewhotradeinfrequently,andmuchhigherforinvestorswhotradefrequently(forexample,3percentforinvestorswhoturntheirportfoliosoveratarateabove200percentperyear).
Inactivelymanagedequitymutualfunds,managementfeesandoperatingexpenses—combinedinwhatwecallafund’sexpenseratio—averageabout1.3percentperyear,andabout0.8percentwhenweightedbyfundassets.Thenadd,say,another0.5percentinsalescharges,assumingthata5percentinitialsaleschargewerespreadovera10-yearholdingperiod.Iftheshareswereheldforfiveyears,thesaleschargecostwouldbetwicethat0.5percentfigure—1percentperyear.(Manyfundscarrysalesloads,nowoftenspreadoveradecadeormore.About60percentoffundsare“no-load”funds.)
Butthenaddagiantadditionalcost,allthemoreperniciousbybeinginvisible.Iamreferringtothehiddencostsofportfolioturnover,whichIestimateaverageafull1percentperyear.Activelymanagedmutualfundsaresaidtoturntheirportfoliosoveratarateofabout80percentperyear,meaning,forexample,thata$5billionfundbuys$2billionofstockseachyearandsellsanother$2billion,atotalof$4billion.Atthatvolume,brokeragecommissions,bid-askspreads,andmarketimpactcostsaddamajorlayerofadditionalcoststhatarebornebyfundinvestors,perhaps0.5to1.0percent.
Weinvestorsasagroupgetpreciselywhatwedon’tpayfor.Ifwepaynothing,wegeteverything.
Result:the“all-in”costofequityfundownershipcancometoasmuchas2percentto3percentperyear.1Soyes,costsmatter.Thegrimironyofinvesting,then,isthatweinvestorsasagroupnotonlydon’tgetwhatwepayfor.Wegetpreciselywhatwedon’tpayfor.Soifwepaynothing,wegeteverything.It’sonlycommonsense.
AfewyearsagowhenIwasrereadingOtherPeople’sMoney,byLouisD.Brandeis(firstpublishedin1914),Icameacrossawonderfulpassagethatillustratesthissimplelesson.Brandeis,latertobecomeoneofthemostinfluentialjuristsinthehistoryoftheU.S.SupremeCourt,railedagainsttheoligarchswhoacenturyagocontrolledinvestmentAmericaandcorporateAmericaalike.
“Therelentlessrulesofhumblearithmetic.”
Brandeisdescribedtheirself-servingfinancialmanagementandtheirinterlockinginterestsas“tramplingwithimpunityonlawshumananddivine,obsessedwiththedelusionthattwoplustwomakefive.”Hepredicted
(accurately,asitturnedout)thatthewidespreadspeculationofthaterawouldcollapse,“avictimoftherelentlessrulesofhumblearithmetic.”Hethenaddedthisunattributedwarning(I’mguessingit’sfromSophocles):“Remember,OStranger,arithmeticisthefirstofthesciences,andthemotherofsafety.”
Brandeis’swordshitmeliketheproverbialtonofbricks.Why?Becausetherelentlessrulesofthearithmeticofinvestingaresoobvious.(It’sbeensaidbymydetractorsthatallIhavegoingformeis“theuncannyabilitytorecognizetheobvious.”)
Thecuriousfactisthatmostinvestorsseemtohavedifficultyrecognizingwhatliesinplainsight,rightbeforetheireyes.Or,perhapsevenmorepervasively,theyrefusetorecognizetherealitybecauseitfliesinthefaceoftheirdeep-seatedbeliefs,biases,overconfidence,anduncriticalacceptanceofthewaythatfinancialmarketshaveworked,seeminglyforever.
It’samazinghowdifficultitisforamantounderstandsomethingifhe’spaidasmallfortunenottounderstandit.
What’smore,itishardlyintheinterestofourfinancialintermediariestoencouragetheirinvestor/clientstorecognizetheobviousreality.Indeed,theself-interestoftheleadersofourfinancialsystemalmostcompelsthemtoignoretheserelentlessrules.ParaphrasingUptonSinclair:It’samazinghowdifficultitisforamantounderstandsomethingifhe’spaidasmallfortunenottounderstandit.
Oursystemoffinancialintermediationhascreatedenormousfortunesforthosewhomanageotherpeople’smoney.Theirself-interestwillnotsoonchange.Butasaninvestor,youmustlookafteryourself-interest.Onlybyfacingtheobviousrealitiesofinvestingcananintelligentinvestorsucceed.
Howmuchdothecostsoffinancialintermediationmatter?Hugely!Infact,thehighcostsofequityfundshaveplayedadeterminativeroleinexplainingwhyfundmanagershavelaggedthereturnsofthestockmarketsoconsistently,forsolong.Whenyouthinkaboutit,howcoulditbeotherwise?
Byandlarge,thesemanagersaresmart,well-educated,experienced,knowledgeable,andhonest.Buttheyarecompetingwithoneanother.Whenonebuysastock,anothersellsit.Thereisnonetgaintofundshareholdersasagroup.Infact,theyincuralossequaltothetransactioncoststheypaytothose“Helpers”thatWarrenBuffettwarnedusaboutinChapter1.
Investorspayfartoolittleattentiontothecostsofinvesting.It’sespecially
easytounderratetheirimportanceundertoday’sthreeconditions:(1)whenstockmarketreturnshavebeenhigh(since1980,stockreturnshaveaveraged11.5percentperyear,andtheaveragefundhasprovidedanontrivial—butclearlyinadequate—returnof10.1percent);(2)wheninvestorsfocusonshort-termreturns,ignoringthetrulyconfiscatoryimpactofcostsoveraninvestmentlifetime;and(3)whensomanycostsarehiddenfromview(portfoliotransactioncosts,thelargelyunrecognizedimpactoffront-endsaleschanges,andtaxesincurredonfunddistributionsfromcapitalgains,oftenrealizedunnecessarily).
Perhapsanexamplewillhelp.Let’sassumethatthestockmarketgeneratesatotalreturnaveraging7percentperyearoverahalfcentury.Yes,thatmayseemalongtime.Butaninvestmentlifetimeisnowactuallyevenlongerthanthat—65or70yearsforaninvestorwhogoestoworkatage22;beginstoinvestimmediatelyandworksuntil,say,age65;andthencontinuestoinvestoveranactuariallifeexpectancyof20ormoreyearsthereafter.Nowlet’sassumethattheaveragemutualfundoperatedatacostofatleastanassumed2percentperyear.Result:anetannualreturnofjust5percentfortheaveragefund.
$10,000growsto$294,600...orto$114,700.Wheredidthat$179,900go?
Basedontheseassumptions,let’slookatthereturnsearnedon$10,000over50years(Exhibit4.1).Assuminganominalannualreturnof7percent,thesimpleinvestmentinthestockmarketgrowsto$294,600.Why?Themagicofcompoundingreturnsoveraninvestmentlifetime.Intheearlyyears,thelineshowingthegrowthata5percentannualratedoesn’tlookallthatdifferentfromthegrowthinthestockmarketitself.
EXHIBIT4.1TheMagicofCompoundingReturns,theTyrannyofCompoundingCosts:Growthof$10,000over50Years
But,eversoslowly,thelinesbegintodiverge,finallyresultinginatrulydramaticgap.Bytheendofthe50-yearperiod,thevalueaccumulatedinthefundtotalsjust$114,700,anastoundingshortfallof$179,900tothecumulativereturnearnedinthemarketitself.Why?Thetyrannyofcompoundingcostsoverthatlifetime.
Intheinvestmentfield,timedoesn’thealallwounds.Itmakesthemworse.Wherereturnsareconcerned,timeisyourfriend.Butwherecostsareconcerned,timeisyourenemy.Thispointispowerfullyillustratedwhenweconsiderhowmuchofthevalueofthe$10,000investmentiserodedwitheachpassingyear(Exhibit4.2).
EXHIBIT4.2TheTyrannyofCompounding:Long-TermImpactofLaggingtheMarketby2Percent
Bytheendofthefirstyear,onlyabout2percentofthepotentialvalueofyourcapitalhasvanished($10,700vs.$10,500).Bythe10thyear,17percenthasvanished($19,700vs.$16,300).Bythe30thyear,43percenthasvanished($76,100vs.$43,200).Andbytheendofthe50-yearinvestmentperiod,costshaveconsumed61percentofthepotentialaccumulationavailablesimplybyholdingthemarketportfolio,leavingonly39%fortheinvestor.
Youputup100percentofthecapitalandyouassume100percentoftherisk.Butyouearnlessthan40percentofthepotentialreturn.
Inthisexample,theinvestor,whoputup100percentofthecapitalandassumed100percentoftherisk,earnedlessthan40percentofthepotentialmarketreturn.Oursystemoffinancialintermediation,whichputupzeropercentofthecapitalandassumedzeropercentoftherisk,essentiallyconfiscated60percentofthatreturn.
Irepeat:Whatyouseeinthisexample—andpleasedon’teverforgetit!—isthatoverthelongterm,themiracleofcompoundingreturnshasbeenoverwhelmedbythetyrannyofcompoundingcosts.Addthatmathematicalcertaintytotherelentlessrulesofhumblearithmeticdescribedearlier.
Simplyput,ourfundmanagers,sittingatthetopoftheinvestmentfoodchain,haveconfiscatedanexcessiveshareofthereturnsdeliveredbyourfinancialmarkets.Fundinvestors,inevitablyatthebottomofthefoodchain,havebeen
leftwithashockinglysmallshare.Investorsneednothaveincurredthatloss,fortheycouldhaveeasilyinvestedinasimple,verylow-costindexfundtrackingtheS&P500.
Costsmakethedifferencebetweeninvestmentsuccessandinvestmentfailure.
Inshort,thehumblearithmeticofinvesting—thelogical,inevitable,andunyieldingpenaltyassessedbyinvestmentcosts—hasdevastatedthereturnsearnedbymutualfundinvestors.UsingJusticeBrandeis’sformulation,ourmutualfundmarketersseem“obsessedwiththedelusion”thatinvestorscapture100percentofthestockmarket’sreturn—andarefoistingthatdelusiononinvestors.
Whenourfundmarketerscitethestockmarket’shistoricalannualreturnof9.5percentsince1900andignorefundexpensesof2percentandinflationof3percent,theysuggestthatinvestorscanexpectareal,after-costreturnof9.5percent.Well,tostatetheobvious,theyshouldn’t.Youneedonlyaddandsubtractforyourself.Thetruthisthattherealreturntoinvestorsequals(youguessedit!)only4.5percent.
Fundinvestorsdeserveafairshake.
Unlessthefundindustrygivesitsinvestorsafairshakeandimprovesthenetreturnthatitdeliverstofundshareholders,itwillfalterandfinallyfail—avictim,yes,oftherelentlessrulesofhumblearithmetic.Werehelookingoveryourshoulderasyoureadthisbook,JusticeBrandeissurelywouldbewarningyou,“Remember,Oreader,thatarithmeticisthefirstofthesciencesandthemotherofsafety.”
Costsmakethedifferencebetweeninvestmentsuccessandinvestmentfailure.So,sharpenyourpencils.Doyourownarithmetic.Realizethatyouarenotconsignedtoplayingthehyperactivemanagementgamethatisplayedbytheoverwhelmingmajorityofindividualinvestorsandmutualfundownersalike.Thelow-costindexfundistheretoguaranteethatyouwillearnyourfairshareofwhateverreturns—positiveornegative—ourbusinessesearnandtheirstockpricesanddividendsdeliver.
Don’tTakeMyWordforItTheinnatesuperiorityoftheindexfundhasbeenendorsed(perhapsgrudgingly)byawiderangeofmutualfundindustryinsiders.Whenheretired,here’swhatPeterLynch,thelegendarymanagerwhosteeredFidelityMagellanFundtosuchgreatsuccessduringhis1977to1990tenure,hadtosayinBarron’s:“TheS&Pisup343.8percentfor10years.Thatisafour-bagger.Thegeneralequityfundsareup283percent.Soit’sgettingworse,thedeteriorationbyprofessionalsisgettingworse.Thepublicwouldbebetteroffinanindexfund.”
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NowhearindustryleaderJonFossel,formerchairmanoftheInvestmentCompanyInstituteandoftheOppenheimerFunds,intheWallStreetJournal:“Peopleoughttorecognizethattheaveragefundcanneveroutperformthemarketintotal.”(Italicsadded.)
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Evenhyperactiveinvestorsseemtobelieveinindexingstrategies.Here’swhatJamesJ.Cramer,moneymanagerandhostofCNBC’sMadMoney,says:“Afteralifetimeofpickingstocks,IhavetoadmitthatBogle’sargumentsinfavoroftheindexfundhavemethinkingofjoininghimratherthantryingtobeathim.Bogle’swisdomandcommonsense[are]indispensable...foranyonetryingtofigureouthowtoinvestinthiscrazystockmarket.”(Sofar,Mr.Cramerdoesn’tseemtohavetakenhisownadvice.)
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Andevenmanagersofalternativeinvestmentsjointhechorus.Oneofmoneymanagement’sgiants,CliffordS.Asness,managingandfoundingprincipalofAQRCapitalManagement,addshisownwisdom,expertise,andintegrity:“Market-capbasedindexingwillneverbedrivenfromitsdeservedperchascoreanddeservedkingoftheinvestmentworld.Itiswhatweshouldallownintheoryandithasdeliveredlow-costequityreturnstoagreatmassofinvestors...thenowandforeverking-of-the-hill.”
Note1I’veignoredthehiddenopportunitycostthatfundinvestorspay.Most
equityfundsholdabout5percentincashreserves.Ifstocksearnareturnof7percentandthesereservesearn2percent,thatcostwouldaddanother0.25percentagepointstotheannualcost(5percentofassetsmultipliedbythe5percentdifferentialinearnings).
ChapterFiveFocusontheLowest-CostFunds
TheMoretheManagersTake,theLesstheInvestorsMake.NEARLYALLFUNDEXPERTS,adviserstoinvestors,thefinancialmedia,andinvestorsthemselvesrelyheavily—indeedalmosttotheexclusionofotherinformation—onselectingfundsbasedontheirpastperformance.Butwhilepastperformancetellsuswhathappened,itcannottelluswhatwillhappen.Indeed,asyouwilllaterlearn,emphasisonfundperformanceisnotonlynotproductive;itiscounterproductive.Ourowncommonsense,deepdown,tellsus:Performancecomesandgoes.
Butthereisonepowerfulfactorinshapingfundreturns,oftenignored,thatisessentialtoknow:Youcanbemoresuccessfulinselectingwinningfundsbyfocusing,notontheinevitableevanescenceofpastperformance,butonsomethingthatseemstogoonforeveror,morefairly,afactorthathaspersistedinshapingfundreturnsthroughoutthefundindustry’slonghistory.Thatfactoristhecostofowningmutualfunds.Costsgoonforever.
Fundperformancecomesandgoes.Costsgoonforever.
Whatarethesecosts?Thefirstandbestknownisthefund’sexpenseratio,andittendstochangelittleovertime.Althoughsomefundsscaledowntheirfeeratesasassetsgrow,thereductionsareusuallysufficientlymodestthathigh-costfunds(averageexpenseratioofthehighest-costdecilefunds,2.40percent)tendtoremainhigh-cost;lower-costfundstendtoremainlower-cost(fourthdecileaverageexpenseratio,0.98percent),andthefewverylow-costfundstendtoremainverylow-cost(lowest-costdecileaverageexpenseratio,0.32percent).Theaverage-costfundsinthefifthandsixthdeciles(1.10percentand1.24percent)alsotendtopersistinthatcategory.
Thesecondlargecostofequityfundownershipisthesaleschargepaidoneachpurchaseofshares.Thedragofsalesloadsisalmostinvariablyignoredinthepublisheddata,althoughit,too,tendstopersist.Loadfundsrarelybecomeno-loadfunds,andviceversa.1(Icanrecallnolargefundorganizationmakingtheimmediateconversionfromaloadtoano-load
distributionsystemsinceVanguardtookthatunprecedentedstepwaybackin1977.)
Thethirdmajorcostincurredbyfundinvestorsisthecostofthepurchaseandsaleofportfoliosecurities.Thesetransactionscostmoney.Weestimatethatturnovercostsareroughly0.5percentoneachpurchaseandeachsale,meaningthatafundwith100percentportfolioturnoverwouldcarryacosttoshareholdersofabout1percentofassets,yearafteryear.Similarly,50percentturnoverwouldcostabout0.50percentperyearofafund’sreturns.A10percentturnoverwouldslashthecostto0.10percent,andsoon.
Ruleofthumb:assumethatafund’sturnovercostsequal1percentoftheturnoverrate.In2016,purchasesandsalesofportfoliosecuritiesinequitymutualfundstotaled$6.6trillion,equalto78percentofaverageequityfundassetsof$8.4trillion.Thecostofallthattrading,oftenamongcompetitors,cametosomethinglike$66billion,anannualcostequalto0.8percentoffundassets.
Costsarelarge,andtoooftenignored.
Mostcomparisonsoffundcostsfocussolelyonreportedexpenseratios,anduniformlyfindthathighercostsareassociatedwithlowerreturns.Thispatternholdsnotonlyforequityfundsasagroup,butineachofthenineMorningstarstyleboxes(large-,mid-,andsmall-capfunds,eachsortedintothreefundgroupswitheithergrowth,value,orblendedobjectives).
Whilefewindependentcomparisonstakeintoaccounttheadditionalcostoffundportfolioturnover,asimilarrelationshipexists.Fundsinthelowest-turnoverquartilehaveconsistentlyoutperformedthoseinthehighest-turnoverquartileforallequityfundsasagroup,andineachoftheninestyleboxes.
Addingtheseestimatedturnovercoststoeachfund’sexpenseratiomakestherelationshipbetweenfundcostsandfundreturnssheerdynamite.Takingintoaccountbothcosts,wefindthatall-inannualcostsofactivelymanagedequityfundsrangefrom0.9percentofassetsinthelowest-costquartileto2.3percentinthehighest-costquartile,asshowninExhibit5.1.(Thisexerciseignoressaleschargesandthereforeoverstatesthenetreturnsearnedbythefundsineachquartile.)
Costsmatter.Alot.
EXHIBIT5.1EquityMutualFunds:ReturnsversusCosts,1991–2016
AnnualRateCosts
CostQuartile
GrossReturn
ExpenseRatio
Turnover(est.)
TotalCosts
NetReturn*
CumulativeReturn
Risk**
One(lowestcost)
10.3% 0.71% 0.21% 0.91% 9.4% 855% 16.2%
Two 10.6 0.99 0.31 1.30 9.3 818 17.0Three 10.5 1.01 0.61 1.62 8.9 740 17.5Four(highestcost)
10.6 1.44 0.90 2.34 8.3 632 17.4
500IndexFund
9.2% 0.04% 0.04% 0.08% 9.1% 783% 15.3%
*Thisanalysisincludesonlyfundsthatsurvivedthefull25-yearperiod.Thus,thesedatasignificantlyoverstatetheresultsachievedbyequityfundsduetosurvivorshipbias.
**Annualstandarddeviationofreturns.
Costsmatter!Exhibit5.1showsa1.4percentdifferencebetweentheaverageexpenseratiooffundsinthehighest-costquartileandthelowest-costfunds.Thiscostdifferentiallargelyexplainstheadvantageinreturnsamongthelowest-costfundsoverthehighest-costfunds.Duringthepast25years:averagenetannualreturnoflowest-costfunds,9.4percent;netannualreturnofhighest-costfunds,just8.3percent,anenhancementinreturnachievedsimplybyminimizingcosts.
Note,too,thatineachofthefundquartiles,whenweaddbackfundcoststothefunds’reportednetreturns,thegrossannualreturnsearnedineachcategoryarevirtuallyidentical.Thosegrossreturns(beforecosts)fallintoanarrowrange:10.6percentforthehighest-costquartileand10.3percentforthelowest-costquartile,justwhatwemightexpect.Ineachquartilecostsaccountforessentiallyallofthedifferencesintheannualnetreturnsearnedbythefunds.
Thereisyetanothersignificantdifference.Ascostsincrease,sodoesrisk.Usingthevolatilityofannualreturnsasthemeasureofrisk,thelowest-costfundscarriedsignificantlylessrisk(averagevolatilityof16.2percent)than
theirhighest-costpeers(17.4percent).Whenwetakethatreductioninriskintoaccount,therisk-adjustedannualreturnforthelowest-costquartilecomesto8.9percent,fully1.5percentagepointshigherthanthe7.4percentrisk-adjustedreturnofthehighest-costquartile.
Themagicofcompounding,again.
That1.5percentannualadvantageinrisk-adjustedreturnmaynotseemlikemuch.Butwhenwecompoundthoseannualreturnsovertime,thecumulativedifferencereachesstaggeringproportions.Thecompoundreturnfortheperiodis855percentforthelowest-costfundsand632percentforthehighest-costfunds,anincreaseofmorethan35percent,asuperiorityarisingalmostentirelyfromthecostdifferential.Talkabouttherelentlessrulesofhumblearithmetic!
Inotherwords,thefinalvalueofthelowest-costfundsmultipliedtheoriginalinvestmentmorethaneightfold,whilethehighest-costquartilereturnsweremultipliedaboutsixfold.Surely“fishinginthelow-costpond”shouldenhanceyourreturns,andbyawidemarginatthat.Again,yes,costsmatter!
Areweoverstatingtheimportanceoffundcosts?Ithinknot.ThesenextfewparagraphsfromarespectedanalystatMorningstarconfirmmyconclusions,andthensome:
Ifthere’sanythinginthewholeworldofmutualfundsthatyoucantaketothebank,it’sthatexpenseratioshelpyoumakeabetterdecision.Ineverysingletimeperiodanddatapointtested,low-costfundsbeathigh-costfunds.
Expenseratiosarestrongpredictorsofperformance.Ineveryassetclassovereverytimeperiod,thecheapestquintileproducedhighertotalreturnsthanthemostexpensivequintile.
Investorsshouldmakeexpenseratiosaprimarytestinfundselection.Theyarestillthemostdependablepredictorofperformance.Startbyfocusingonfundsinthecheapestortwocheapestquintiles,andyou’llbeonthepathtosuccess.
Lowcostsandindexfunds.
Butifyouarepersuadedbythispowerfulaffirmationthat,yes,costsmatter,
anddecidetofocusonthelowest-costgroupoffunds,whylimitthesearchtoactivelymanagedfunds?Traditionalindexfunds(TIFs)hadthelowestcostsofall:expensesaveragingjust0.1percentduringthisperiod.Withnomeasurableturnovercosts,itstotalall-incostswerebut0.1percent.ThegrossreturnoftheS&P500Indexfundwas9.2percentperyear;thenetreturn,9.1percent.Carryingalowerriskthananyofthefourcostquartiles(volatility15.3percent),itsrisk-adjustedannualreturnwasalso9.1percent,acumulativegainthatrankedtheindexfundaheadofeventhelowest-costquartilefundsby0.2percentperyear.
Ifthemanagerstakenothing,theinvestorsreceiveeverything:themarket’sreturn.
Caution:Theindexfund’sannualrisk-adjustedreturnof9.1percentoverthepast25yearsisallthemoreimpressivesincethereturnsoftheactiveequityfundsareoverstated(asalways)bythefactthatonlythefundsthatweregoodenoughtosurvivethedecadeareincludedinthedata.Adjustedforthis“survivorshipbias,”thereturnoftheaverageequityfundwouldfallfrom9.0percenttoanestimated7.5percent.
What’smore,selectingtheindexfundeliminatedtheneedtosearchforthoserareneedlesinthemarkethaystackrepresentedbytheveryfewactivefundsthathaveperformedbetterthanthathaystack,intheoften-vainhopethattheirwinningwayswillcontinueoverdecadesyettocome.
AsMorningstarsuggests,ifinvestorscouldrelyononlyasinglefactortoselectfuturesuperiorperformersandtoavoidfutureinferiorperformers,thatfactorwouldbefundcosts.Therecordcouldhardlybeclearer:Themorethemanagersandbrokerstake,thelesstheinvestorsmake.Again,ifthemanagersandbrokerstakenothing,theinvestorsreceiveeverything(i.e.,thetotalreturnofthestockmarket).
Don’tTakeMyWordforItAsfarbackas1995,TylerMathisen,nowManagingEditorofCNBCBusinessNews,deservescreditforbeingamongthefirstjournalists—ifnotthefirst—torecognizetheimportantrolethatmutualfundcosts(expenseratios,turnovercosts,andunnecessarytaxes)playinerodingthereturnsdeliveredtomutualfundshareholders.Mathisen,thenexecutiveeditorofMoney,concededthesuperiorityofthelow-cost,low-turnover,
tax-efficientindexfund:
“Fornearlytwodecades,JohnBogle,thetart-tonguedchairmanoftheVanguardGroup,haspreachedthevirtuesofindexfunds—thoseboringportfoliosthataimtomatchtheperformanceofamarketbarometer.Andformuchofthattime,millionsoffundinvestors(nottomentiondozensoffinancialjournalistsincludingthisone)basicallyignoredhim.
“Sure,werecognizedtheintrinsicmeritsofindexfundssuchaslowannualexpensesandbecausethefundskeepturnovertoaminimum,tinytransactioncosts.Moreover,becauseindexfundmanagersconvertpaperprofitsintorealizedgainslessfrequentlythandotheskippersofactivelymanagedfunds,shareholderspaylesstaxeachyeartoUncleSam.Tobesure,thosethreeadvantagesformatrioasimpressiveasDomingo,Pavarotti,andCarreras.
“Well,Jack,wewerewrong.Youwin.Settlingforaverageisgoodenough,atleastforasubstantialportionofmostinvestors’stockandbondportfolios.Infact,moreoftenthannot,aimingforbenchmark-matchingreturnsthroughindexfundsassuresshareholdersofabetter-than-averagechanceofoutperformingthetypicalmanagedstockorbondportfolio.It’stheparadoxoffundinvestingtoday:Gunningforaverageisyourbestshotatfinishingaboveaverage.
“We’vecomearoundtoagreeingwiththesometimesprickly,alwaysprovocative,fundexecknowntoadmirersanddetractorsalikeasSaintJack:Indexingshouldformthecoreofmostinvestors’fundportfolios.Sohere’stoyou,Jack.Youhavearighttocallit,asyourecentlydidinabookletyouwrote,TheTriumphofIndexing.”
(Thanks,Tyler!)
Note1Theuseoffront-endloadshasdiminishedinrecentyears,oftenreplacedby
“spreadloads”thatsharplyincreasefundexpenseratios.Forexample,theAshareclassofferedbyoneofthelargestmutualfunddistributorscarriedafront-endloadof5.75percentin2016,andanexpenseratioof0.58percent.ThedistributornowoffersanewT-shareclassofitsfunds,carryingafront-endloadof2.5percentplusanannualmarketingcostofanadditional0.25percentperyearthatmustbepaidforaslongastheinvestorownstheshares.Thisannualfeewillraisethefund’sexpenseratiostoanestimated0.83percent.
ChapterSixDividendsAretheInvestor’s(Best?)Friend
ButMutualFundsConfiscateTooMuchofThem.DIVIDENDYIELDSAREAvitalpartofthelong-termreturngeneratedbythestockmarket.Infact,since1926(thefirstyearforwhichwehavecomprehensivedataontheS&P500Index),dividendshavecontributedanaverageannualreturnof4.2percent,accountingforfully42percentofthestockmarket’sannualreturnof10.0percentfortheperiod.
Anastonishingrevelation.
Compoundedoverthatlongspan,dividendsmadeacontributiontothemarket’sappreciationthatisalmostbeyondbelief.Excludingdividendincome,aninitialinvestmentof$10,000intheS&P500onJanuary1,1926,wouldhavegrowntomorethan$1.7millionas2017began.Butwithdividendsreinvested,thatinvestmentwouldhavegrowntosome$59.1million!Thisastonishinggapof$57.4millionbetween(1)marketpriceappreciationaloneand(2)totalreturnwhendividendsarereinvestedsimplyreflects(onceagain)“themagicofcost-freecompounding”(Exhibit6.1).
EXHIBIT6.1S&PPriceReturnversusTotalReturn
ThestabilityoftheannualdividendspershareoftheS&P500istrulyremarkable(Exhibit6.2).Overthe90-yearspanbeginningin1926,therewereonlythreesignificantdrops:(1)a55percentdeclineduringthefirstyearsoftheGreatDepression(1929–1933);(2)a36percentdeclineintheDepression’saftermathin1938;and(3)a21percentdeclineduringtheglobalfinancialcrisisof2008–2009.Thismostrecentdeclineoccurredlargelybecausebankswereforcedtoeliminatetheirdividends.Dividendspershareonthe500Indexfellfrom$28.39in2008to$22.41in2009,butreachedanewhighof$45.70in2016,60percentabovetheearlierpeakin2008.
Mutualfundmanagersgivedividendincomealowpriority.
EXHIBIT6.2S&P500—DividendsperShare
Giventheobviouspowerofcompoundingdividendsoverthelongtermandtherelativestabilityofcorporatedividendpayouts,activelymanagedmutualfundsmustgivedividendincomeahighpriority.Right?
Wrong!Becausemutualfundmanagementcontractsconsistentlycallforadvisoryfeesthatarebasedonafund’snetassets—notonitsdividendincome.Whenstockmarketdividendyieldsarelow(asinrecentyears),fundexpensesconsumeahugeshareofthetotaldividendincomeearnedbyfunds.
Theresult:astaggeringproportionofequityfunddividendincomeisconsumedbyexpenses.“Staggering”isnooverstatement.Inactivelymanagedgrowthfunds,expensesactuallyconsume100percent(!)offund
income.Inactivelymanagedvaluefunds,expensesconsume58percentofdividendincome.
Thecontrastbetweenactivelymanagedfundsandcomparableindexfundsisstark.Thecomparablevalueindexfundexpensesconsumed2percentoffundincomein2016;theexpensesonalow-costgrowthindexfundconsumedjust4percent(Exhibit6.3).
Activelymanagedequityfundsconfiscateyourdividendincome.
EXHIBIT6.3DividendYieldsandFundExpenses,2016
ActivelyManagedFunds
GrossYield
ExpenseRatio
NetYield
ShareofGrossYieldConsumedbyExpenses
Growthfunds 1.3% 1.3% 0.0% 100%Valuefunds 2.1 1.2 0.9 58Low-CostIndexFundsGrowthfunds 1.4% 0.1% 1.3% 4%Valuefunds 2.5 0.1 2.4 2
Source:Morningstar.
Despitethepowerfulimpactofdividendsonlong-termreturns,you,likenearlyallinvestors,arelikelyunawareofthisastonishingconfiscationofdividendincome.Howcouldyouknow?Whileitmaybepossibletocalculatethesedatafromafund’sfinancialstatements,thosestatementsarehardlybeaconsoffull,clear,andforthrightdisclosure.
Sowhynotconsideralow-costindexfund,whichhasnoactiveportfoliomanager;hasanannualexpenseratioaslowas0.04percent;whichdeliversyourfairshareofthefund’sdividendincome;anddoesvirtuallynotradingofstocksthroughthoseHelpersmentionedattheoutset?Whynot,indeed?Chapter13exploresthisideafurther.
Don’tTakeMyWordforItAbloggerwhogoesbythename“DividendGrowthInvestor”pickeduponmymessageabouttheimportanceofdividendsandwroteanarticlethatechoesmydividendphilosophy.
“JohnBogleisaninvestinglegend....Ihavereadseveralofhisbooks,andreallyenjoyedhissimplemessages.IreallylikedBogle’smessageonkeepingcostslow,keepingturnoverlow,stayingthec
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