Keynote Speech by John C. Bogle
Founder and Former CEO, The Vanguard Group
Before the "Changing the Game" Thought Leadership Forum
New York, NY
June 12, 2002
"Investing is an act of faith." So reads the very first
sentence in my Common Sense on Mutual Funds: New Imperatives
for the Intelligent Investor, published in 1999. "When
we purchase Corporate America's stocks and bonds," I pointed
out, "we are professing our faith that the long-term success
of the U.S. economy and the nation's financial markets will continueand
that our corporate stewards will generate high returns on our investments."
We are also, I added, "expressing our faith that our professional
(money) managers will be vigilant stewards of the assets we entrust
Perhaps it goes without saying that in recent years these three
articles of faith, faith in the stock market, faith in the corporate
executives who run our publicly-held enterprises, and faith in the
trustees who manage our moneyhave been tested. And found
wanting. If there is a single over-riding task that lies before
usespecially each one of us in this room todayit is
restoring our citizens' faith in investing.
Today I'd like to examine each of those three key building blocks
of investing and consider: 1) the prospects for future returns on
stocks and bonds in the aftermath of the burst in the technology
bubble; 2) the necessary resolution of the problems borne of financial
manipulation that has clearly taken place in America's corporate
community and in the investment community alike; and 3) the extent
to which our wealth management institutions have provided their
clients with their fair share of financial market returns. In each
case, I'll present some policy recommendations that I believe will
help wealth management firms to serve their clients far more effectively
in the years ahead. With U.S. households owning some $32 trillion
of financial assetsfully one-third of which is held by millionairesthe
wealth management industry, as it were, has a huge stake in doing
1. Faith in the Financial Markets
I'm confident that few, if any, of you in this sophisticated audience
have any doubt that we have moved into a new era for the financial
markets. I expect that it will be an era in which the returns of
stocks and bonds alike will be substantially lower than the unprecedented
double-digit returns we've experienced in the past, indeedunless
you've put in more than two decades in this wonderful businessthe
very past that comprises your entire first-hand experience in the
markets. And you need three decades to have known first-hand
what the 50% market crash in 1973-74 was like. (This one's now at
Suffice it to say that it was almost exactly twenty-years agoon
August 18, 1982, in the aftermath of a nine-year bear marketthat
interest rates turned downward and stock prices leaped upward. The
T-bill rate, 11% when August began, promptly tumbled to 8%. The
Standard & Poor's 500 Stock Composite Index leaped from 103
to 113 during that single week, and to 120 by month's end, in the
blink of an eye, a gain of 17%. We were on the way. In the great
boom, which culminated with a great bubble in March 2000, the Index
was to rise to 1527. By then, the annual return on stocks had reached
a level unprecedented in any comparable period in historyjust
short of 20% per year. And the bond market, which earned a return
of more than 10% annually over this long period, also performed
far better than ever before.
But it's easy to say that we shall not soon again see the recurrence
of such an outpouring of wealth creation. To understand why, we
need only heed Lord Keynes' words, written nearly 70 years ago:
"It is dangerous . . . to apply to the future inductive arguments
based on past experience, unless one can distinguish the broad
reasons why past experience was what it was." But his warning
also suggests that if we can distinguish the reasons why
the past was what it was, we can then apply that very line of reasoning
to the development of reasonable expectations about what may lie
ahead. Keynes helped us make this distinction by pointing out that
the state of long-term expectation is a combination of enterprise
("forecasting the prospective yield of assets over their whole
life") and speculation ("forecasting the psychology
of the market"). I'm well familiar with those words, for 52
years ago I incorporated them in my Princeton University thesis
on mutual funds, then a tiny $2½ billion industry.
Investment Return and Speculative Return
This dual nature of investment returns is clearly reflected in
the stock market history, and remains basic in appraising the state
of the stock market today. I continue to use the term speculative
return to refer to the portion of the stock market's total return
that is derived from "changes in the public valuation"that
is, the changes in the price that investors are willing to pay for
each dollar of earnings per share. But rather than using Keynes'
term enterprise to describe the yield of an investment over
the years, I use the term investment returnthe sum
of the initial dividend yield plus the annual growth rate of earnings;
that is, the return that corporations actually deliver to
investors. Added together, investment return plus speculative return
represent the total stock market return we experience.
History illuminates this division of stock market returns with
great clarity. The reason that stocks returned nearly 20%
per year during the great bull market are clear: The dividend yield
on the S&P 500 Index averaged almost 5%, the subsequent annual
earnings growth was just short of 7%; the combined investment
return, then, was almost 12%. But as the fear of investors at the
outset changed to hope and finally to greed, the price-to-earnings
ratio quadrupledfrom nine to 36adding more than eight
percentage points of speculative return. The math is not
very complicated: An average annual return on stocks of almost 20%.
Make no mistake about it, then: It was speculative return that
drove the Great Bull Market. The fact is that, based solely on investment
return, $1 invested in the S&P 500 at the outset would have
grown to $7a handsome seven-fold enhancement. But the leap
in the P/E multiple alone increased that investment return
to a market return of $24nearly twenty-four times over,
3½ times (!) the hardly inconsequential investment gain.
Yes, we had literally never had it so good.
Can it happen again? I can't imagine how. To understand why, let's
take Lord Keynes' advice and look at the sources of the past returns
on stocks and then apply them to the decade ahead. Today, the S&P
500 Index yields not 5% but 1½%, reducing this key contributor
to stock returns by fully 3½ percentage points. When we add
an assumed 6% earnings growth (corporate earnings, truth told, grow
at about the same pace as our economy), the investment return
on stocks would be just 7½% per year. Will speculative
return add to or detract from this figure? While the 33% decline
in the S&P 500 since the March 2000 high has brought the P/E
ratio down to 21 (based on "normalized" earnings at that),
that's still quite high relative to the long-term norm of 16 times.
So, I think the P/E is unlikely to rise, and could easily decline,
perhaps to 18 to 20 times.
No oneno onecan be confident about how much
investors will pay for a dollar of earnings ten years hence. But
if my expectation is reasonable, the resultant easing of
the P/E from current levels would create a negative speculative
return of about 1% per year, reducing the annual return on stocks
to about 6½%. I'm not much for such precision, however, so
let's assume a wide range of returns on stocks in the years ahead,
say 4% to 9%. In any event, we'd best all count on a coming era
of lower returns in the stock market, and then hope we're wrong.
But I hardly need remind you: Relying on hope is not a sensible
What About Bonds?
How will these returns compare with those of other financial assets?
Bonds are the customary alternative to stocks, and expectations
for bond returns over the coming decade are reasonably easy to establish.
Again, Keynes' analysis helps us here, for the investment
return on bonds"forecasting the prospective yield of
assets over their whole life"depends largely on the interest
payments they generate. And since bonds have a fixed maturity date,
speculative return plays little role over the long-run. Result:
A remarkably high proportion of the subsequent ten-year investment
return of bonds is explained simply by the current yield. In
fact, the correlation between the initial yield and subsequent ten-year
return of bonds is a healthy 0.91. Not bad, once we realize that
perfect correlation is 1.00. The reason for this close correlation
is not complicated: If interest rates remain unchanged, of course
the returns would be identical. But while rising rates would depress
bond prices, the higher reinvestment rate on each year's interest
payment would have a countervailing impact. And vice versa.
In mid-1982, the yield on bondsthe Lehman Aggregate Bond
Index of U.S. Government and investment-grade corporate bondswas
14%; during the subsequent decade the annual return on bonds came
to 13%, and to 10% over the past two decades. Today, with
the bond yield at just over 6%, bond returns in the coming decade
should run between, say, 5% and 7%. What we knowor at least
can be highly confident aboutis that we are looking at future
bond returns that are also a pale imitation of those we have enjoyed
in recent decades.
It is hardly farfetched, then, to expect future bond returns that
are likely to parallel those of stocks. If so, the traditional 3%
equity risk premiumthe amount by which stock returns have
exceeded bond returns over the past centurymay be far smaller,
perhaps even non-existent. There are, of course, those who say that
there is some God-given mandate that an equity premium must exist.
Yet history tells us that bond returns have exceeded stock returns
in one out of every five decades. The reality is that restoring
an equity premium to stocks will require either (a) lower interest
rates, or (b) some combination of higher earnings growth, higher
dividend yields, and lower P/E ratios, which is likely only if there
is another downward leg in the stock market. In any event,
my view is that we are entering an era of lower returns on financial
After a golden era of truly extraordinary returns, investors have
to realize that reality is now the rule of the day. But the faith
of investors in our financial markets will be restored far more
quickly if we do three things: First, encourage our clients to develop
realistic expectations about future market returns. Second, help
them to invest carefully, to increase their savings, and to observe
the time-honored principles of diversification and asset allocation.
And third, be cautious, and make certain each client understands
the role of income as well as the role of capital appreciation,
keeping in mind, not only the probabilities of earning high
stock returns, but the consequences of assuming excessive
2. Faith in Our Corporate Stewards
I would note that caution is the order of the day not only because
of the likelihood that we are facing an era of lower returns in
the financial markets. We are also facing the huge challenge of
helping our clients put their wealth to work productively because,
in the aftermath of the bubble, they have likely lost faith in the
stewards to whom we have entrusted the management of our corporations.
Part of the problem is the mania that resulted in the recent bubble.
As Edward Chancellor, author of "Devil Take the Hindmost: A
History of Speculation," reminded us, manias bring out the
worst aspects of our system: "Speculative bubbles frequently
occur during periods of financial innovation and deregulation .
. . lax regulation is another common feature . . . there is a
tendency for businesses to be managed for the immediate gratification
of speculators rather than the long-term interests of investors."
And surely that's what we've seen. Here's how The New York Times
described the Enron mess: "A catastrophic corporate implosion
. . . that encompassed the company's auditors, lawyers, and directors
. . . regulators, financial analysts, credit rating agencies, the
media, and Congress . . . a massive failure in the governance system."
But while Enron may prove to be the worst failure of our corporate
stewards, I need not tell you it is hardly alone in its failure
to merit the faith of investors.
Lord Keynes warned us long ago of what happens when speculation
achieves predominance over enterprise, and I also quoted some of
these words in my ancient university thesis: "In one of the
greatest investment markets in the world, namely, New York, the
influence of speculation is enormous . . . it is rare for an American
to 'invest for income,' and he will not readily purchase an investment
except in the hope of capital appreciation. This is only another
way of saying that he is attaching his hopes to a favorable change
in the conventional basis of valuation, i.e., that he is a speculator.
But the position is serious when enterprise becomes a mere bubble
on a whirlpool of speculation. When the capital development of
a country becomes a by-product of the activities of a casino, the
job is likely to be ill-done."
The analogy of the casino to the recent era in our financial markets
is hardly far-fetched. Investors have focused on short-term speculation
based on the hope that the price of a stock will rise, rather than
long-term investment based on the faith that value of a corporation
will grow. Wall Street's conflicted sell-side analysts have
lost their objectivity; the buy-side analysts of our large financial
institutions have put aside their skepticism; too many of our corporations
have forced the fulfillment of their aggressive earnings guidance
by fair means or foul; off-balance-sheet special purpose enterprises
have been created largely to conceal debt; and illusory transactions
have raised reported growth in sales.
And that's hardly the end of the list: Enormous compensation from
stock options has enriched corporate executives who have succeeded
in hyping the price of their stocks without increasing
the value of their corporations; auditors have had
important business incentives to be partners of management rather
than independent professional evaluators of management's financial
reporting; and millions of employees have lost faith in their retirement
plan investments. As these forces came together, investors came
to realize that they had assumed risks that were far larger than
those for which they bargained. They are demanding a higher risk
premium, which in turn has raised the cost of capital. Unless we
resolve these nettlesome issues in favor of the stockholder, that
higher cost will ultimately drag down our economy.
A Failure of Character
But there's more at stake than that. This nation's founding fathers
believed in high principles, in a moral society, and in the virtuous
conduct of our affairs. Those beliefs shaped the very character
of our nation. If character countsand, as my book underscores,
I have absolutely no doubt that character does count the failings
of today's business and financial model, the willingness of those
of us in the field of wealth management to accept practices that
we know are wrong, the conformity that keeps us silent, the selfishness
that lets greed overwhelm reason, all erode the character we'll
require in the years ahead, especially in the post-September 11
era. The motivations of those who seek the rewards earned by engaging
in commerce and finance struck the imagination of no less a man
than Adam Smith as "something grand and beautiful and noble,
well worth the toil and anxiety." I can't imagine that anyone
in this room today would use those words to describe our corporate
governance system at the outset of the 21st century.
So, yes, too many of our corporate stewards have failed to earn
our faith. By focusing on short-term speculation at the expense
of long-term investing, we institutional managers have, I fear,
gotten the corporate governance that we deserve. Yet most giant
institutional investors have been conspicuous only by their silence.
If we simply act as good corporate citizens and recognize that ownership
entails not only rights but responsibilities, we will again get
the governance we deserve. And our clients will benefit accordingly.
If we all take the initiative to stand up and be counted, we will
at last return to an era in which the great creative energy of American
business and finance shifts from its short-term focus on the price
of a stockspeculationto a long-term focus on the value
of the corporationenterprise. When we do, our corporate stewards
will respond appropriately, and that change will well-serve both
investors and our nation.
3. Faith In Our Trustees
For in addition to the troubled financial markets and the failings
of the stewards who run our corporations, the trustees of the investment
dollars of American familiesthe pension funds, the mutual
funds, and other financial institutions have also failed to
live up to the faith investors have placed in them. To explain how
this situation has come about, we need first to understand the simple
mathematics of investing: The returns earned by investors in the
aggregate inevitably fall well short of the returns that are realized
in our financial markets. The great paradox of investing is that
the very costs incurred by those who would help investors to beat
the market themselves constitute the reason that investment managers
as a group are destined to fail at the task.
Why? It is only to state the obvious when I point out that all
investors as a group must of necessity earn the market returns-but
only before the costs of investing are deducted. After these
costs are taken into accountafter all of the fees, the transaction
costs, the distribution costs, the marketing costs, the operating
costs, and the hidden costs of financial intermediationinvestors
mustand willincur a loss, indeed a loss precisely equal
to the aggregate amount of those costs. Beating the market before
costs is a zero-sum game; beating the market after
costs is a loser's game.
Management of Embedded Alpha
At long last, this reality has taken root, even among financial
market participants who are not among the lowest-cost players in
the game. Consider the paper entitled Success in Investment Management:
Building the Complete Firm, prepared two years ago by Merrill
Lynch and BARRA Strategic Consulting Group after consultation with
a distinguished list of money managers that included Fidelity, Putnam,
and Citigroup. The study reached this major conclusion: Management
of Embedded Alpha, the frictional costs of running a portfolio,
will emerge as an essential contributor to investment performance.
(It's about time!) Those frictional costs, the study suggests, constitute
a dead-weight burden that detracts from the return that can be theoretically
produced by an investment portfolio in a frictionless securities
market. So firms are urged to "cut those hidden costs,"
- "Tangible Costs . . . management
fees and trading commissions. Each dollar given away for, say,
management fees is a dollar explicitly detracted from the portfolio
- "Managed Costs . . . unintended risk
exposures, tax costs, and Not-Equitized-Cash, an opportunity
cost for not keeping funds fully invested.
- "Invisible Cost . . . the adverse
market impact of trading and the opportunity cost of delaying
Result: "Simply put, every incremental basis point increase
in rate of return translates into competitive advantage (by which)
a firm improves its absolute performance and its ranking relative
to its peers." In the study's words, the firm that "will
lead the way . . . will diligently seek to minimize these performance
detractors." Thus spaketh, I remind you, not Vanguard/BOGLE,
but Merrill Lynch/BARRA.
Perhaps surprisingly, the study presents no data whatsoever on
the dimension of Embedded Alpha. So it won't astonish you to learn
that I've taken it upon myself to do exactly that, examining the
mutual fund business and the costs that fund investors incur. The
Average Equity Mutual Fund
|% of Average Assets
|1. Advisory Fees
|2. Other Operating Expenses
Total Expense Ratio*
|3. Transaction Costs
|4. Opportunity Cost
* Asset-weighted mutual fund ratio.
The unweighted ratio is about 1.6%. Transaction costs
and opportunity costs are estimated.
You don't need me to tell you that 240 basis points is a lot of
Embedded Alpha. And I haven't even taken into account the impact
of fund sales charges and the heavy cost of taxes for non-retirement
plan investors! Embedded alpha is admittedly lower for pension fundsits
estimated at 1.3%but it nonetheless takes a powerful toll
there as well. Indeed, a recent study by a major pension consultant
projected that even costs at the 1.3% level reduce the probability
that a given active manager can beat the market over the long term
at 5%just one chance in twenty.
The Long-Term Toll of Costs
Now let's look long-term. Despite today's environment of frighteningly
short-term investment horizons, most pension funds have seemingly
perpetual lifetimes. And most individual investors now start their
programs in an IRA or 401(k) at a young age, and will still be investing,
not only 50, but even 70, years from now. What toll would a 240
basis point cost have taken on the 12% return earned on the Standard
& Poor's 500 Stock Index over the past 50 years? A mutual fund
incurring these costs would earn 2.4% less than the market, or 9.6%.
When compounded, each dollar in the S&P 500 itself would grow
to $287; each dollar in the fund, after costs, would grow to $96a
$191 dead-weight loss engendered solely by reason of the costs of
But intermediation costs are paid in current dollars, while
the investor's final capital must be measured in constant
dollars. During the past half-century, the inflation rate was 4.2%.
Result: Real annual return for the S&P 500, 7.8%; real
return for the fund investor, 5.4%. The final purchasing power of
each initial dollar falls to $43 in the Index, and to less than
$14 in the fund. Since the mutual fund's annual return before
costs was not the 12.0% stated return earned by the S&P Index,
but a real return of 7.8%, the 2.4% intermediation cost reduced
each year's real return, not by 20%, but by almost 33%!
When we apply to the annual data that remarkable magnifying glass
called compounding, we can describe the investment returns earned
by the average fundon cost assumptions that are hardly excessiveas
shocking. After intermediation costs and inflation (and ignoring
taxes!), the nominal value of $287 had dwindled away to less than
$14, just 5%five percent!of the compound market return
we calculate from the textbook datasay, the Ibbotson tomethat
shows the annual returns of the stock market. Yes, Embedded Alpha
is a powerful destructive force.
Other Destructive Forces
But it turns out that there are other forces that are every bit
as destructive as costs in undermining the returns earned by mutual
fund investors. Indeed, while investment costs of 3% during 1984-2000
(with average fund costs at higher levels than in the 1950s, '60s,
and '70s) reduced the stock market return of 16% for that period
to 13% for the average fund, the average fund investor earned
just 5%. How was that shortfall possible? First, because investors
were victimized by unfortunate market timing, making modest
purchases of equity fund shares when stock prices were cheap during
the early years of the period and then making huge purchases when
prices were dear as the bubble inflated during the later years.
Second, because of adverse fund selection, as investors poured
their savings into technology funds and tech-oriented growth funds
and pulled them out of value funds at precisely the wrong time,
with most of their dollars goings into existing funds with the hottest
records of performance and new funds that promised full participation
in the "exciting Information Age" that supposedly was
To regain the faith of equity investors, the mutual fund industry
must face up to the obvious issue of excessive costs. There's plenty
of room for fee reduction, and if the industry would at last turn
from its focus on short-term speculation that is, I think,
a fair characterization of the average fund's current 111% turnover
rateto long-term investing, transaction costs would tumble
accordingly. If the fund industry doesn't wish to recognize the
need for these changes and reduce its embedded alpha, it is only
a matter of time until investors will recognize itand they
will vote with their feet. Yes, as the theme of this conference
indicates, the economics of wealth are a 'changing.
But it's more than economics. Investors' faith in their fund trustees
has been shaken even more emphatically by the fact that fund managers
have moved away from being prudent guardians of their shareholders'
resources and toward being imprudent promoters of their own wares.
We pander to the public taste by bringing out new funds to capitalize
on each new market fad, and we magnify the problem by heavily advertising
the returns earned by our hottest funds. The first step in restoring
the investing public's faith is to focus far less on salesmanship
and far more on stewardship. If we simply put our clients first,
just imagine how well we can serve investors in the New Era.
In the New Era for wealth management we are facing, restoring
faith must be at the top of the agenda. We have to present to our
clients realistic expectations for future returns, and emphasize
that while emotions can overwhelm economics in the
short runsometimes for the better, sometimes for the worsein
the long run, it is the fundamental economics of the stock
and bond markets that carry the day. We have to press the vested
corporate interests to at last realign the interests of the managers
with those of the owners, and turn their focus to enhancing, not
stock prices, but building corporate values. And our managersour
investment fiduciariesmust get their act together, and focus
not on marketing, but on management.
It's all about wealth management, and it's a tough business.
The competition to provide out-of-the ordinary returns to our clients
is intense, the odds against doing so long, and the competition
to retain current assets and attract new assets fierce. The costs
of operations are rising, in no small part because of rapidly changing
technology and increased service requirements. And in the new era,
the struggle to build the profits of our firms is hardly going to
But the field of wealth management is also a demanding profession.
Our guiding principle must be to put the client first in everything
we do. But the reality is that the dichotomy between maximizing
the returns on our clients' capital and maximizing the returns on
the capital of our own firmsand, so often in this day and
age, the returns on the capital of the financial conglomerates which
own so many of our wealth management firmsis no mean challenge.
While a healthy profit margin is required for any thriving business,
no firm that fails to serve its clients first will long endure.
The secret of success in wealth management, I think, is simple:
We must both make money for our clients, and give them their
fair share of whatever returns the financial markets are generous
enough to favor us with.
We also must recognize our limitations. Wealth management today
is a huge field, with mutual funds, pension and endowment
funds, trust companies, investment counselors, and family offices
managing portfolios holding 60% or more of all U.S. equities. Concentration
is high, with 26 firms managing over $100 billion of equities and
the top ten managers averaging $360 billion . . .each! With less
diversity among our peers and more size to say grace over come greater
market impact and less investment mobility . . . and the eternal
reversion to the mean in investment performance occurs with both
greater certainty and greater rapidity.
In these circumstances, there are many temptations for firms to
try something new. We hear, without any supporting evidence, that
managed separate accounts can offer higher returns and lower risks
than mutual funds. (Certainly they offer higher costs!) We read
about the magic attraction of hedge funds, without explanation of
the often-hidden risks they assume, the diversity of their strategies,
and the enormous diffusion of their returns. We are told about the
magic of private equity and venture capital, but ignore the warnings
from those who have managed them most successfully that their best
days may be behind them. And we accept that all of these so-called
alternative investments are a panacea that will somehow cure the
ills of the more modest returns of stocks and bonds that seem so
likely to lie before us. I'm not so sure.
There are also great temptations to offer new services. We hear
about the magic of technology that facilitates moment-by-moment
account appraisal; about "screen-scraping" that combines
accounts of multiple investment providers and facilitates moving
money around from one provider to another; about Monte Carlo simulations
that, by constructing complex multi-fund asset allocation strategies,
are said to add predictability to forecasts. The whole thrust of
these developments is that our value to investors can be enhanced
by more sophisticated services, and that the greater the investor's
wealth, the more he or she will demand these servicesbut,
I would add with some skepticism, only if these layers of complexity
prove to be true services, and not disservices to
investors. In my experiences, moving money around quickly is not
the preferred route to wealth accumulation, and "don't just
do something, stand there" is not the worst of all advice.
Simplicity, Stewardship and Character
So, I'll continue to have faith in the majesty of simplicity, helping
investors to make uncertain but necessary judgments to determine
their allocation between stockswith all their capital opportunity
and riskand bondswith all of their income productivity
and stabilityand then doing everything in our power to diversify
these investments and minimize the costsmanagement fees, operating
costs, marketing expenses, turnover impactpromising only to
give them their fair share of financial market returns, no more,
no less. And if index funds are the best way to assure the realization
of these goals, so be it.
The ultimate objective of every firm represented in this room,
I think, is to build a company that stands for something.
As one who has been at that task for 28 years this coming September,
I can tell you that it's a tough, demanding never-ending task. My
own goal has been to build a company that stands for stewardship.
Let me be clear, however, that this goal is not without a self-serving
aspect. For only to the extent we adequately serve the human beings
who have trusted us to help manage their wealth will Vanguard itself
survive and prosper.
However each of you chooses to define your own
firm, I hope that stewardship will be at least part of your character,
because it will pay off for you. But, whatever you decide, I believe
that you will succeed in direct proportion to your focus on the
character and values of your firmnot only in your words, but
in your deeds. Above all, your success will depend upon keeping
the faiththe faith of those human beings who have entrusted
you with their precious hard-earned dollars. Then go out and earn
that faith, every single day.
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.