The Dream of a Perfect Plan October 16, 1999

Keynote Speech by John C. Bogle, Senior Chairman and Founder, The Vanguard Group
Money Matters Conference, The Boston Globe
Boston, Massachusetts
October 16, 1999

Good morning. It's especially wonderful to be in the fair city of Boston, from whence came, almost exactly 50 years ago, my inspiration to enter the mutual fund industry. In December 1949, I read an article in Fortune magazine entitled "Big Money in Boston," introducing me to this industry for the first time. Thus inspired, I wrote my senior thesis at Princeton University on "The Economic Role of the Investment Company," joined the industry when I graduated in 1951, and have been around ever since. It was also in Boston in early 1974 that I got fired from the company I'd joined at the outset of my career, which led to my founding of Vanguard in September 1974, just 25 years ago. I've had an exciting career.

Over the years, I've often cited Von Clausewitz' epigram, "the greatest enemy of a good plan is the dream of a perfect plan." This morning I'm going to use that profound thought as the theme of my keynote speech to you investors who are here today. My theme will echo the fact, not only that "Money Matters," but that your money matters. We are all trying to make sense out of our volatile financial markets, our U.S. economy that is each day becoming more a part of the global village, and the implications of our present revolution—and it is no less than that—in information technology and communications. In these wild days in the markets, deciding on an intelligent investment plan must seem both complex and confusing. What, you must wonder, is the best way to allocate your assets among stocks and bonds and cash, and even other kinds of assets? Once you make those decisions, how do you implement your plan? What role should mutual funds play? Which funds should you select from among the 7,500 that exist today? These are all tough decisions, especially since the world of investing may well be at a sort of inflection point today, and it is never easy to see around the corner.

In this conference, you'll be exposed to a lot of commonsense ideas for dealing with these complexities and uncertainties, and I urge you to consider them with care. I imagine you'll also hear many ideas that don't comport with at least my concept of common sense, and I urge you to disregard each one of them in direct proportion to its complexity, its decibel level, and the conviction of its advocates that a favorable outcome is assured. Avoid complex strategies that seem to provide temptingly easy solutions to eternally complex problems. I warn you that complexity—which I call "witchcraft"—may seem to offer a perfect plan, but it rarely delivers on the dream it promises. What is more, complexity is expensive. The simplicity of a good plan, on the other hand, can work not only effectively, but economically. The good plan works, not despite being inexpensive, but because it is inexpensive.

Asset Allocation

My remarks today will focus on equity mutual funds, but I want to begin with a brief word about asset allocation, for it is one of the most important investment decisions you make. While there are complex systems that offer precise formulas for implementing the perfect asset allocation plan, the good asset allocation plan simply assumes that these nuances of investing are unpredictable. The good plan relies primarily on a straightforward and conventional balance between stocks and bonds. How much in each category? As ever, your investment balance must depend largely on your own needs and circumstances. Typically, the allocation might range from something as crude as, say, 50% in stocks and 50% in bonds for older, moderately risk-averse investors who have accumulated substantial capital, have reached normal retirement age, and need to draw down income. Or up to 100% stocks for young, confident investors who are just beginning to accumulate their first investments in a 401(k) retirement plan and have scores of years before drawing down income. In an uncertain world—and it will be ever thus—getting your allocation almost right may be better than getting it precisely wrong.

The fact is that we know little about the future returns that stocks and bonds will provide. But we must rely primarily on stocks for capital appreciation and on bonds for income, and we have to realize that stocks involve substantial risks. No matter what you read about the historical returns of common stocks, I assure you that the stock market is not an actuarial table. But, the common stock portion of your allocation provides the only sensible approach to building your capital over the long term. So the question becomes: Which equity mutual funds will build your capital with the greatest effectiveness?

Investing the Stock Allocation

The perfect plan would be to identify one or more mutual funds that may provide a return significantly greater than that of the stock market. And the lesson of history shows us that some mutual funds have in fact outpaced the market. But that lesson also shows us that the odds against doing so are long. In fact, even among those 145 equity mutual funds that have in fact survived the past three decades, only 15 have outpaced the stock market as a whole. That is, the fund investor had only about one chance out of ten to surpass the market's return.

By how much? An interesting question. Only eight funds outpaced the market by more than one percentage point per year. Thus, when we eliminate the likely statistical noise involved in a margin of plus or minus one percentage point to the market, the odds of success now drop to just one chance out of 18. And the chances of picking a loser are far higher. A total of 108 funds fell one percentage point or more behind the market, 13 losers for each winner. And fully 37 funds—one of every four—fell short of the market by more than three percentage points per year, surely a deep disappointment to their owners. Clearly, the odds against implementing a perfect plan by selecting winning funds are long and the penalties for failure disproportionately large.

It is simply a mathematical impossibility—a definitional contradiction—for all investors as a group to reach 100% of the stock market's returns. 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 will succeed in doing so by any significant margin, just as we have seen. If this is iconoclasm, so be it. But accepting this reality—that investors as a group will inevitably capture less than 100% of the stock market's rate of return—is the first step toward a good plan for equity investing.

There is an obvious—and optimal—way to closely approach this 100% target: Simply own the market. It is easy. An all-stock-market index fund, in substance, owns shares in every publicly held business in America, and holds it for as long as the business exists. By slashing the croupiers' take, such ownership is available at extremely low cost. There is no advisory fee, for there is no adviser; no sales charges, for there need be no broker; nominal fund transaction costs, for there is almost no portfolio turnover; with so little turnover, few realized gains and minimal taxes. It is fair to say that the all-market index fund is the croupier's worst nightmare. And, therefore, the investor's sweetest dream. The simplest of all approaches to equity investors, then, is to invest solely in the shares of a single, all-market equity index fund—just one fund. It is a good plan. And it works.

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 too smart for that," you may think. "Even if the game is expensive, it's fun." "It can't be that simple." These are the all-too-common refrains in the minds of investors—am 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," as Alexander Pope reminded us. But his full couplet reads: "Hope springs eternal in the human breast; Man never is, but always to be blest." Just as the dream of the perfect plan has little chance of coming true, so the anticipation of being blessed, Pope tells us, inevitably falls short of realization.

It occurs to me that the main factor that causes investors to ignore the good plan of indexing is not just that it is boring—the market return is only, well, the market return—but that the index strategy seems dumb. In a sense, of course, it is. Perhaps it is also deaf and blind. But, as it turns out, the dumb strategy leads to a smart, even brilliant, decision. Hear Warren Buffett on this subject:

But if the index fund strategy is a good plan—maybe even the best plan available to most of us mere mortals—it need not be the end. While the odds against picking a superior mutual fund have been powerful, they have not been insurmountable. In a given decade, perhaps one fund in five has beaten the market (before taxes). 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 they, too, are all too likely to fall short of 100%. If there are long odds against outpacing the market, at least going about the task of fund selection intelligently can help you to insure against a significant failure. So let me give you nine rules that may help you to do just that.

Rule 1. Select Funds With Low Expense Ratios

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, and their impact will likely grow in importance in the years ahead. It is costs, pure and simple, that have accounted for—and will continue to account for—the lion's share of the shortfall of the typical mutual funds in the stock market. The industry's estimated 2.5% annual cost, for example, would consume fully 14% of a market return of 17.5%, leaving 86% for you. That portion will rise when returns revert to lower levels. That same cost would consume 25% of a market return of 10%. And if the going got really tough, say, in a 5% market, fund costs of 2.5% would confiscate fully 50% of the market return, leaving only 50% for the investor.

Source: Vanguard Research (estimates).

As these costs are raked from the table of the market casino, the croupiers with the largest rakes are the fund managers. The fees and expenses you pay to them are rising even faster than the industry's soaring asset base. Since 1980, the expense ratio of the average equity fund has risen from 0.96% to 1.52%—a 58% increase. But, yes, larger fund groups have lower costs. For example, in the fair city of Boston, the expense ratios of the three largest fund managers—together managing a cool $1 trillion of fund assets—average 1.08%. But despite the awesome growth of these firms, that figure is far higher than their 0.64% average expense ratio in 1980, a leap of nearly 70% that is even larger than the 58% increase for the industry as a whole. "Big Money in Boston" all over again, 50 years later! It is high time that this industry does something to reverse this steady uptrend. And it's not impossible. During that same 20-year span, one large fund firm has in fact gradually, but substantially, reduced the costs paid by its investors. There ought to be a lot more firms doing precisely that. You owe it to yourself to select from among funds where the manager-croupiers exercise at least some restraint, evidenced by expense ratios that are well below industry norms.

Once your money is invested in a fund, the rake of the next croupier begins to sweep. Most funds continue to buy and then sell securities unremittingly, and then sell them and buy them over and over again. Believe it or not, fund portfolio turnover has risen to an all-time high of 112% this year, meaning that the average fund held onto a stock for just 326 days. That holding period is far more akin to short-term speculation than to long-term investing, which, not so many years ago, is what this industry was all about. The rake wielded by the brokers, investment bankers, and institutional traders is also a wide one. To pay for this staggering transaction activity, turnover typically rakes off 0.5% to 1.0% of fund assets each year. Consider a $1 billion stock fund with 112% turnover: It sells $1.12 billion of stocks in a year, and reinvests the $1.12 billion proceeds in other stocks, total transactions of $2.24 billion, even higher if the fund draws cash inflow from investors.

This high turnover is in part the product of trading by hyperactive portfolio managers, anxious to garner a performance edge on their peers, however fruitless the quest. But there is also turnover among the managers themselves. All too often when a manager departs, the new manager's broom sweeps clean, as he reorders the portfolio to comport with his own strategies. Believe it or not, the average mutual fund manager lasts just five years. For one giant firm, the average tenure is but 2.5 years, as the croupiers come and go. So, be aware, not only of a fund's turnover rate (it's shown in the prospectus), but also both its management company's propensity to move managers around, sometimes seemingly at the drop of a hat. Turnover costs can cut your long-term returns by a meaningful amount, so do your best to find funds both with portfolio holdings and portfolio managers that will stay the course.

Rule 3. Realize That Taxes Are Fund Costs Too

There is yet a third croupier in the fund casino. And in this bull market era, it happens to be the greediest croupier of them all: the federal government. Make no mistake about it, Uncle Sam loves the mutual fund industry. For as impatient, aggressive fund managers buy and sell stocks at a furious rate, they pay virtually no attention whatsoever to the taxes such activity will require you to pay. They can ignore taxes, but you can't.

There is awesome value in deferring taxes—and deferring them for as long as you can. When you pay taxes today, that money can't compound to your benefit tomorrow. Deferring a capital gain for 15 years reduces the present value of each one dollar of taxes to just 41 cents; in 25 years, to 23 cents. Yet fund managers not only require you to pay the 20% tax far too early, realizing long-term capital gains far too prematurely. They also have been realizing some one-third of all capital gains on a short-term basis, thus forcing you to pay taxes at rates up to the 40% maximum on dividend income. Many state taxes—and Massachusetts, I need not remind you, is hardly the most tax-friendly state—consume even more of these unnecessary fund gains. So look for tax-efficient funds—not only those that have been so in the past, but those that have policies that emphasize ongoing tax-efficiency.

Rule 4. Be Careful About What You Pay for Fund Selection Advice

Many investors need sensible advice in fund selection and asset allocation—and many do not. If you are convinced you do not need advice, it is unwise to pay for it, either in the form of front-end sales commissions (about 5% of the amount invested), or 12b-1 sales fees included in a fund's expense ratio (up to 1% of assets), or fees paid to registered investment advisers and financial planners, usually beginning at about 1% of assets and paid directly by the investor.

I have no hesitancy in saying that some of these providers of fund selection advice can be characterized as croupiers. How else to describe firms which are collectively spending up to $500 million annually of their shareholder's hard-earned money on the advertising campaigns you see incessantly on television, in the press, even on billboards. Remember this: Those are your dollars the managers are spending to bring in new investors, and there is simply no way under the sun that they can bring any benefit whatsoever to you. Consider whether you want to contribute to this cost: If not, tell them about it.

I also have no hesitancy in saying that there are many investment advisers and brokerage executives for whom the term "croupier" is in no way appropriate. Indeed, the best advisers are exactly the opposite: They can help you minimize the costs of the croupiers in the stock market casino by steering you toward funds with low expenses, low turnover, and high tax-efficiency. Equally important, they can also help you to minimize the many pitfalls of fund selection, provide you with sound asset allocation guidance, and give you personal attention. If you are among the many investors who need this sort of advice, get it. But be sure to carefully select your adviser and know exactly the fees involved.

Rule 5. Add Up the Costs and Values in the Market Casino

You owe it to yourself to consider the sum total of the costs of the market casino, in the light of the financial values you seek there. During the past 15 years, the diminution in returns has been staggering—and unnecessary, almost entirely the result of the take of the croupiers. The average pretax return of the total U.S. stock market was 16.4% per year. But after the costs of all of the croupiers—fund sellers, fund managers, stock brokers, and the federal government—the return for the average fund investor was just 10.3% per year. By way of contrast, a low-cost, no-load, low-turnover all-market index fund would have provided an annual rate of return of 15.2% to the investor—nearly 50% higher.

And as both returns and costs compound, the difference widens. The value of an initial $10,000 investment at the end of the period: managed equity fund, $43,500; index fund, $83,500. In short, in search of the perfect plan, the investor in the equity fund relinquished 55% of the market's gain to the croupiers, with but 45% left for himself. On the other hand, by holding the croupiers' share to 14% of the market's cumulative return, the investor who relied on the good plan of a market index fund retained 86%. His $73,000 profit was more than double the $33,000 profit of the regular investor.

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