|Investing With Simplicity|
Speech by John C. Bogle, Senior Chairman and Founder,
The Vanguard Group
The Personal Finance Conference, The Washington Post
January 30, 1999
Many of you have heard the ancient Chinese cursecurse, mind youthat says, "may you live in interesting times." Curse or not, surely this is as interesting a time as it is possible to imagine. The extraordinary volatility in the financial markets is just one example of the stepped-up pace of our lives in an eraa new era, to be surein which the technology revolution, the information explosion, and the rise of global interdependence have altered almost every activity in our daily lives.
In important measure, it is these developments that have brought most investors unprecedented prosperity and wealth accumulation, and helped make mutual funds the investment of choice among American families. You now have all the information you could possibly needexcept, of course, information about the future course of events and marketsto make investment decisions. But you should not mistake information for knowledge ... nor should you ever, ever mistake knowledge for wisdom, the ultimate weapon of the intelligent investor.
During this "Personal Finance" conference, you'll hear a lot of good common sense. Pay attention to it. But you'll also hear a considerable amount of investment wizardry, financial legerdemain, and tempting solutions, often from the apparently omniscient. Disregard it.
My keynote message this morning, I suspect, will be the most basic: To earn the highest returns that are realistically possible, you should invest with simplicity. Rely on the ordinary virtues that intelligent human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance. Call them "character." And in investing, over the long run, character will be rewarded.
The great paradox of this remarkable age is that the more complex the world around us becomes, the more simplicity we must seek in order to realize our financial goals. Please underrate neither the majesty of simplicity nor its proven effectiveness as a long-term strategy for productive investing. Simplicity is the master key to financial success. The old Shaker ballad got it just right:
"Tis the gift to be simple;This morning let me give you some ideas that should help you "to come down where you ought to be" in your quest for investment success. Given both the nervousness you doubtless felt in last summer's sharp stock market decline, and the excitement you likely felt in the splendid fourth quarter, I want to begin by reaffirming four fundamental investment principlesfour principles designed to keep you from the dangerous practice of acting on those emotions. First principle: Balance. The simple idea that investors should balance their stock holdings with bond holdings was drummed into me by the dean of the mutual fund industry, Walter L. Morgan, who founded Wellington Fund in 1928 and lived to see it become America's largest balanced fund. The recent death, at age 100, of my hero, my mentor who gave me the job that began my mutual fund career in 1951, and my great friend for nearly half a century(!) was heartbreaking for me. But Wellington's successand his long lifeserve as a testament to the durability of his investment principles.
The bear market of last summerone of only three 20+ percent drops in the past 20 yearshas been reversed with a 25 percent gain that has now taken the market to new all-time highs. Surely we've never had it so good! But these spasms themselves remind us of something vital to recognize. The second principle: Markets Fluctuate. Many mutual fund investors seem to forget that fundamental reality. When stocks tumble, they push the proverbial panic button. Net cash flow into equity mutual funds, previously running at $18 billion a month, turned negative in August, with outflows of $11 billion, the first month of outflow since 1990. Those billions missed the recoveryand even at the lower stock prices of August and September, fund investors continued to pull money out of stock funds, albeit in smaller amounts. But after stock prices snapped back by 25% in the fourth quarter, large inflows began again in January. Taking money out of the market at lows and putting back in at highs is not the best way to make money.
What was in truth not much more than a short-term blip on the stock chartand a blip that was certainly long overdueseemed to change investor confidence in a meaningful way. In addition, the decline increased investor activity in stock funds to a level even higher than the microscopic three-year average holding period prevailing earliera shocking short-term orientation for investors in what I believe is the finest medium for long-term investing ever devised. So, I remind fund investors, and the fund industry, both so focused on short-term returns, of the need for long-term thinking. The third principle: Invest for the Long Term. It applies to mutual funds and investors alike, but in both cases it is honored more in the breach than in the observance.
The wild and woolly decline and the subsequent powerful recovery, I think, have got fund investors focusing on the short term when they should be focusing on the long term. So I'd now like to take a look at what might be realistic expectations for long-term returns on stocks.
To begin with, stocksby all traditional measuresare very highly valued. Consider these valuations, measured today vs. the start of the great long-term bull market: Prices have risen from 7.9 times earnings to 28 times earnings; dividend yields have fallen from 6% to 1.3%. While, yes, interest rates have tumbled from 13% to 5%, the earnings yieldabout equal to the 13% bond yield at the outsetis now only 3.6%about two-thirds as high as the interest rate (i.e., the ratio has dropped from 0.96 to 0.70).
The Great Bull Market August 1982December 1998
In this context, then, let's examine the source of the market's astonishing near 21% annual total return during the great, long bull market. Well, 6.0% came from the very high initial yield, some 7% came from earnings growth, and 8% per year came from the increase in the price-earnings ratio alone. How much does this change impact the total? Let's just say that if the price-earnings ratioa measure, not of reason, but simply of emotionhad remained unchanged, the Standard & Poor's® 500 Index would today be reposing at a level, not of 1239, but of ... 345. Almost 1,000 points lower!
As we look ahead for, say, a decade, we knowwe knowthat the future contribution of dividend yield will begin at, not 6%, but 1.3%. As to future earnings growth, perhaps it will be better than the rate of 7% for the past 40 years, but I would not bet the ranch on much more than thatand maybe even less. Together, those fundamentals would lead to a market return of 8.3% annually. To do better would require the price-earnings ratio to rise well above its present all-time historic high of 28 times.
So, let's play a little game. With an unchanged P/E ratio, we know that the market return ought to be about 8%perhaps 1 or 2 percentage points more or less. If the price-earnings ratio falls to, say, 18 times, the total return on stocks would be not 8%, but 4%. And if the ratio rose to 71, the total annual return on stocks would be 18%.
Looking Ahead 10 Years
*Current P/E = 28
I use 18% because that is the return the market must provide over the next decade to meet investor expectations (if we are to believe what mutual fund investors told a Gallup Poll last autumn). I, for one, can't imagine it. But I should tell you that your afternoon keynotera man for whom I have the most profound respecthas suggested that a price-earnings ratio of 50 times would not be excessive, and that even a 100 times(!) price-earnings ratio, "using a simple and accepted formula," in his words, might be justified. (His talk will explain "Why the Dow may quadruple" from herewhich it would do in year eight if the annual return on stocks turns out to be 18%. And, of course, he might just be rightbut I wouldn't bank on it.
However, no matter what the markets give us, my conviction remains steadfast that common stocks should remain the principal asset class in a long-run investment program. If your own program was soundly balanced before the bear marketas it should have beenand you were strong enough to resist the temptation to sell stocks at the bottom of the bear market, there should be no need to change the balance now. Fourth simple principle: Stay the Course.
Reliance on the fundamentals of investing means investing in corporate businesses for the long run. Reliance on speculation, and gambling on changes in the price-earnings ratio, means investing in stock certificatespieces of paperfor the short run. Sadly, most mutual funds preach the long run, but practice the short run, turning over their portfolios at a costly and grotesquely tax-inefficient rate of some 90% per year. I urge you to ignore the practices mutual funds follow ... and attend to the practices they preach.
For the long-term investor who wants to stay the course, reliance on a sensible balance of stocks and bonds is essentialmore important today, I believe, than for as far back in market history as most of you here can remember. (I'm older!) Such a course will mitigate emotion in investing and emphasize reason and common sense. Simplicity, then, above all: Balance. Markets Fluctuate. Invest for the Long Term. Stay the Course.
Simplicity also gives us a surprising rule for measuring investment success. The central task of investing is to realize the highest possible portion of the return earned in the financial asset class in which you investrealizing, and accepting, that that portion will be less than 100%.
Why? Because of cost. To state the obvious, we know intuitively that our cash reserves will inevitably earn less than the going short-term market rate. Our CDs and money market funds will yield less simply because the costs of financial intermediariestransaction costs, information costs, and the cost of conveniencewill be deducted from the interest rates paid by the government or corporate borrower.
Similarly, we do notnor should weexpect our bond funds to provide us with higher yields than the average yield of the bonds held in a fund's portfolio. In fact, in bond funds as a group, because of grossly excessive fund fees, most bond funds providenot 100% but only 75%. The fact is that nearly all bond funds are distinctly inferior investments.
Yes, and even in the equity arena, it is simply a mathematical impossibilitya definitional contradictionfor all investors as a group to reach 100% of the stock market's annual returnsmaybe 85% on average. Indeed, given the excessive costs of equity mutual funds, it is a mathematical certainty that, over a lifetime of investing, only a relative handful of investors can succeed in doing so by any significant margin. If this is iconoclasm, so be it. Accepting this realitythat investors as a group will inevitably capture less than 100% of the rates of return provided in any asset classis the first step in simplifying your investment decisions.
Where should you begin? Consider that the ultimate in simplicity comes with the additional virtue of low cost. For the simplest of all approaches is to invest solely in a single balanced market index fundjust one fund. And it works. Such a fund offers a broadly diversified middle-of-the-road investment program for a typical conservative investor, allocating about 65% of assets to large growth and value stocks and 35% to high-grade bonds. Over the past 15 years, it would have captured 99% of the rate of return of the combined stock and bond markets. It doesn't get much better than that.
Let me prove the point by comparing the cumulative returns of this industry's balanced mutual fundsa group whose portfolios tend to be quite homogeneous, composed as they are primarily of large stocks with both value and growth characteristics, and good quality bonds with intermediate-to-long maturities. This chart compares the returns of the average balanced fund with the no-load balanced index fund, using the S&P 500 Index with its annual return reduced by estimated costs of 0.2%. Here are the results, based on an initial investment of $10,000 in 1983.
Owning a Single Balanced Fund
($10,000 Investment15 Years)
*65%/35% S&P 500/Lehman Ag0.2%.
Three key conclusions:
The fact is that the unmanaged index fund had, at the end of this long period, outperformed all but one of the 29 managed balanced funds in the list. This almost universal failure of expensive professional managers to earn precost returns sufficient to pay their keep relative to a passively managed index fund suggests how tough it is to break par in the financial markets.
Nonetheless, like most investors, you may well prefer to control your own investment balance, and you may well prefer tax-exempt bonds to the taxable bonds held in nearly all balanced fund portfolios. Fair enough. So I turn to a second example of the value of simplicitya single equity index fund for your stock portfolio. The identical conclusions we found in our balanced fund analysis prevail again:
Owning a Single Equity Fund
($10,000 Investment15 Years)
It is fair, of course, for you to say: "Well, the index fund is always fully invested in stocks, so why not hire a manager, who can reduce stock holdings in anticipation of market declines?" It's a sound principle, but a failed practice. In fact, fund managers have done precisely the reverse. For example, equity funds held an average cash position equal to about 12% of assets at the start of the great bull market. Near the recent market highs, fund cash had been cut to only 5% of assets, providing little protection against the decline that ensued. Being bearish when you should be bullish, and bullish when you should be bearish, is not a formula for investment success!
But, I'm a realist. I recognize that in the real world, lots of all-too-human traits get in the way of a simple, all-encompassing index fund approach. "I'm better than average"; "I can pick the best funds"; "Even if the game is expensive, it's fun"; "It can't be that simple"are all too common refrains in the minds of investorsam I speaking for you?who choose to pursue the conventional strategy of relying entirely on actively managed funds to implement their investment strategies. "Hope springs eternal."
But if the beginning of simplicity is the index fund, it need not be the end. After all, in a given decade, about one of every five actively managed funds has outpaced the total market index (after taxes, only one of nine). These are powerful, but not insurmountable odds. And there are some simple commonsense principles that should help you to select funds that can earn a generous portion of the market's return, although, all too likely, less than 100%and maybe a lot less. If there are long odds against outpacing the market, at least going about the task of fund selection intelligently can help to ensure against a significant failure. Even master investor Warren Buffett, a strong proponent of the index approach, concedes that there may be other ways to construct an investment portfolio:
Most investors, both institutional and individual will find that the best way to own common stocks is through an index fund that charges minimal fees. They are sure to beat the net results delivered by the great majority of investment professionals.
Should you choose to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy.
The Prussian General Clausewitz has said, "the greatest enemy of a good plan is the dream of a perfect plan." And I believe that an index strategy is a good strategyand a very good one at that. But many of you, I'm confident, seek a better plan, if not a perfect plan, no matter how great the challenge, no matter how overpowering the odds against implementing it with extraordinary success. So, much as I would not hesitate to urge you to commit your investments to an all-index-fund approachor at least to follow an approach using index funds as the core of your portfolioI'm going to offer you another simple approach"a few thoughts worth remembering," eight basic rules to make it easier for you to make intelligent fund selections for your investment program. Here we go:
Rule 1. Select Low-Cost Funds. I've said "costs matter" for so long that the portfolio manager for one of our funds gave me a Plexiglas pillar with the Latin translation: Pretium Refert. But costs do matter. If you don't believe me, hear Warren Buffett again:
Seriously, costs matter .... Equity mutual funds incur operating expenseslargely payments to funds' managersthat average about 100 basis points (1%), a levy likely to cut the returns their investors earn by 10% or more over time.
Sadly, Mr. Buffett was misinformed. The average equity fund now carries total annual expenses not of 100 basis points, but of upwards of 200 basis points (2%), "a levy," if I may revise the master's words, "likely to cut the returns their investors earn by 20% or more over time." Such costs are, well, unacceptable. And bond fund all-in costsunbelievablyaverage some 1.2%, a simply unjustified levy on any gross interest yield. In fact, such costs would cut today's yield of 5.1% on the long U.S. Treasury bond to 3.9%, or nearly 25%. Why would anyone buy a high-cost bond fund?
Expense Ratios: A low expense ratio is the single most important reason why a fund does well. If you select actively managed funds, emulate the index advantage by choosing funds with low operating expense ratios. In fact, the surest route to top-quartile returns is bottom-quartile expenses, a fact reaffirmed in all investment equity stylessmall- or large-cap, growth or valueand all bond fund maturity ranges as well. Lower expense ratios are the handmaiden of higher returns. Once again, "little things mean a lot."
Transaction Costs: In addition, with today's average fund portfolio turnover at an absurd 85% per year, transaction costs reduce returns by as much as 1/2 to 2.0 percentage points over and above fund expenses. What is more, it carries enormous tax costs. So favor low turnover funds. Taxes: If your fund holdings are in taxable accounts (i.e., other than in a tax-deferred IRA or a thrift plan), high turnover can not only cause you to pay full income taxes on short-term gains, but also deprive you of the extraordinary value of the deferral of capital gains taxes. (By the way, while high fund turnover hurts taxable investors, there is no evidence whatsoever that it helps tax-deferred investors). The odds against active managers outpacing the after-tax returns of index funds become enormous for taxable investors. So, never forget that taxes are costs too.
Rule 2. Consider Carefully the Added Costs of Advice. It is the essence of simplicity for the self-reliant, intelligent, informed investor to purchase shares without an intermediary salesman or financial adviser. Their costs should consume the lowest possible proportion of your future returns.
But millions of investors require guidance. If you do, you can use either registered advisers or brokerage account executives, and some good ones are available at a fair price. Select them with care! Good advisers give you their personal attention, help you avoid some of the pitfalls of investing, and provide worthwhile asset allocation and fund selection services. But, like any of us, they must earn their keep, providing services of sufficient value to you to make it worth your while to invest through them. You should know exactly how much their services will cost. But I do not believe that they can pick, in advance, the top-performing managersno one can!and I'd avoid those who make extravagant claims of future performance.
The Added Costs of Advice
*First year only.
How much does it cost? "Fee only" investment advisers. Their brokerage firms usually charge an annual fee beginning at 1% of assets. Typically, they charge sales commissions of 6% or more on fund purchasesokay for a long-term investor, but devastating if you hold your shares for short periods and switch funds around. (A bad idea, anyway!)
You should know that there are lots of hidden loads out there. 12b-1 Fees. Even some apparently no-load funds have sales charges known as 12b-1 fees that are deducted from your returns each year. These fees are used to promote a fund's sale by aggressive advertising and marketing programs. The fund shareholders pay the freight, but they receive no benefit whatsoever in return. Caveat emptor of 12b-1 fees!
There is still one final cost you must understand. "Funds-of-funds" and "wrap accounts." These fund-pickers charge additional annual fees of up to 2% over and above those paid by the underlying funds. Don't go therecategorically. The fact is that there is no there there. It's just too expensive a package. Combined costs of up 4% a year simply destroy even the most remote chance you have of reaching 100% of the market's return. Too much dead weight.
My third rule comes to grips with the first element that catches the eye of most investorswhether experienced or novicethe fund's past "track record." (The implied analogy to a horse race is presumably unintentional!) But track records, helpful as they may be in appraising how thoroughbred horses will run, are usually hopelessly misleading in helping you appraise how money managers will perform. There is simply no way under the sun to forecast a fund's future returns based on its past record. Rule 3. Do Not Overrate Past Fund Performance.
Now, I must contradict myself ever so slightly. For exceptional funds with exceptional past returns that are substantially superior to the market will regress toward, and usually below, the market in the future. Regression to the meanI call it the law of gravity in the financial marketsis measurable and apparently almost inevitable. For example, in two studies of returns over consecutive decades, a remarkable 99% of top-quartile funds moved closer toand even belowthe market mean from the first 10-year period to the subsequent 10-year period. There was only one single, solitary exception to the rule, a fund that ruled the world during the 1970s and 1980s alike. But so far in the 1990s, it has regressed magnificently, falling far below the market's return. Sometimes mean reversion requires patience!
Make no mistake about it: the record is clear that top-performing funds inevitably lose their edge. This industry is well aware of that certainty. Yet fund sponsors persist in promoting their most successful (past) performers. Such a strategy defies all reason except for this one: Promotion of such funds brings in lots of new money, and lots of new fees to the adviser. But such promotions, finally, lead investors in precisely the wrong direction. Ignore them.
So, be sure to disregard "lump sum" performance comparisons. But follow the next rule. Rule 4. Performance to Determine Consistency and Risk. Studying the nature of past returns enables you to determine consistency. Look at a fund's ranking among peer funds with similar policies and objectives (i.e., a large-cap value fund with other large-cap value funds, a small-cap growth fund with other small-cap growth funds, and so on).
Morningstar makes this easy. It shows, in a simple chart, whether a fund was in the first, second, third, and fourth quartile of its group during each of the past 12 years. For a fund to earn a top performance rating means, in my mind, at least six to nine years in the top two quartiles and no more than one or two in the bottom quartile. This informationshown in this example of two real-world funds that reflect the standards I've set forthis ignored by too many investors.
Careful analysis of past performance can also tell us a lot about risk. Risk is a crucial element in investing. The Morningstar risk rating gives you a rough guide to how much risk the fund typically assumes relative to its objective group and relative to all equity funds. This table shows, for example, that the average large-cap value fund has carried but one-half of the risk of its small-cap growth fund counterpart.
Morningstar Risk Profile, December 1998
(Average fund = 100)
I should note that while, over time, relative fund returns vary randomly from one period to the next, relative fund risks carry a healthy degree of consistency. So, especially in these volatile, speculative days, ignore risk at your peril.
Given the recent emergence of fund portfolio managers as stars, I now turn to the next rule. Rule 5. Beware of Portfolio Manager "Stars." Alas, the fact is that this industry, as it painfully happens, has had precious fewif anysuperstar managers who have had the staying power of Michael Jordan or Jack Nicklaus or, yes, Mark McGwire (though it's not clear that he'll repeat his feats over thenext 15 years). And the precious few managers who may have fit into this category were never, as far as I know, identified in advance of their accomplishments. Who had ever heard of Peter Lynch or John Neff or Michael Price in 1972, before their splendid records had been achieved?
To make matters worse, even our industry's temporary superstars seem to have a limited longevity with a given fund. The average portfolio manager in this business lasts but five years at the helm of a fund, and when the new manager takes over, the result is high portfolio turnover, costly and tax-inefficient. Fund stars, in truth, are more like comets: they brighten the firmament for a moment in time, only to burn out and vanish into the dark universe. Seek good managers if you will, but rely on workmanlike professionalism, experience, and steadfastness rather than stardom.
Be careful too about "Morning-Stars." We exist today in a system in which funds want you to think that if their fund has 4 or 5 "Morning-stars" it is a success. But star systems don't always work. Indeed, the editors of Morningstar candidly acknowledge that their star ratings have little short-term predictive value. Higher star ratings oftenbut not alwayscan give clues to future success, but for sensible investors Morningstars are the beginning of fund analysis, not the end.
Funds can get too big for their own britches. It is as simple as that. Rule 6. Beware of Asset Size. So, avoid large fund organizations that have no history of closing funds to new investors, and those that seem willing to let their funds grow to seemingly infinite size, beyond their power to differentiate their investment results from the crowd and irrespective of their investment goals.
What is "too big" is complex. It relates to fund style, fund management philosophy, and fund portfolio strategy. A broad-based market index fund should be able to grow without any size limits whatsoever. A giant fundsay $20 billioninvesting in large-cap stocks, with very little portfolio turnover, can be managed effectively, albeit not for truly exceptional returns. For a fund investing aggressively in micro-cap stocks, $300 million might be too large. A multimanager fund can be successful at larger asset levels than a fund supervised by a single manager. There are no easy answers.
Often, checking the fund's quartile rankings over time can reveal this impact. One of today's large funds, for example, has had four top-quartile rankings in its first five years, when its assets were as low as $3 million(!). But in each of the past three years, as assets moved past $2 billion and reached $6 billion, it fell into the fourth quartile. While its discredited "momentum" strategy accounted for part of the problem, size also proved a major handicap.
The record is clear that, for the overwhelming majority of funds, their best years came when they were small. "Small was beautiful" ... but "nothing fails like success." When funds catch the public fancyand are vigorously hawked to a public unsuspecting of their potential exposure to the problems of sizetheir best years are behind them. Unbridled growth should be a warning to any intelligent investor.
How many funds should you own? If a single ready-made 65% stock/35% bond index fund can meet the needs of many investors and if a pair of stock and bond index funds with a custom-made balance can meet the needs of many more, what is the optimal number of funds for investors who elect to use actively managed funds? Probably no more than four or five equity funds. Owning too many funds can easily result in a dangerous combination of overdiversification and excessive cost.
A recent study by Morningstarto its credit, one of the few publications to systematically take on issues like this oneconcluded essentially that owning more than three funds, randomly chosen, didn't reduce risk appreciably. Rule 7. Don't Own Too Many Funds. As shown in this chart, risk remains fairly constant all the way from 3 funds to 30 funds (an unbelievable number!). Note also that owning only a single large blend fundgiven its lower riskcould provide a lower standard deviation risk measure than any of the multiple fund portfolios. So could a single all-market index fund.
This portfolio would be somewhat riskier than an all-market balanced index fundless in large caps, more in small caps, perhaps a specialty fund (in health care, or technology, or real estate), and some international stocks. Because of costs, the odds are against its adding value. But it might, provided you select the funds on a rational basis. (These rules I've presented should help.)
Sample Balanced Portfolio
Nonetheless, don't assume that successfully selecting a portfolio of a limited number of funds is easy. Five expert investment advisers have been picking equity funds for an initial $50,000 model portfolio for The New York Times during the past five years, and not one of them has even come close to matching the record of a low-cost S&P index fund. (The standard chosen by The Times.) The advisers' portfolios provided an annual return of 14.1%, capturing only 60% of the market return, compared to 23.1% for the index, capturing 99.5%. The final, astonishing, capital accumulation: $103,000 for managed funds picked by knowledgeable advisers, and $156,000 for merely picking a nonmanaged fund without any advice at all. Clearly, wisely selecting a winning portfolio of funds, even by persons of intelligence and experience, following sensible policies, is a tough challenge.
The Experts SpeakFive Advisors Select Equity Funds
©2006 Bogle Financial Center. All Rights Reserved.