Keynote Speech by John C. Bogle
Founder and Former CEO, The Vanguard Group
Before the Morningstar Investment Forum
June 26, 2002
It's always a special privilege
to speak at the Morningstar Forum. Given the deep interests of the
professional financial advisers and informed individuals who come
here, this annual gathering is likely the finest aggregation of
dedicated investors one is likely to find. This year, it's a special
thrill for me, because the Forum is the meeting place for the kick-off
of Diehards III, the third annual gathering of the Vanguard shareholders
who call themselves "the Bogleheads."
As many of you know, during the past few years I've
done much speaking and writing on the profound weaknesses that permeate
much of the mutual fund industry, the recently catalogued, but far
earlier apparent, sins of Corporate America and the Wall Street
community, and the strong likelihood of far lower stock market returns.
Today, I'd like to stand back from those issues and discuss fundamental
investment principles, including (at the close of my remarks) the
principles that govern the equity market. In short, I'm going to
step down from my pulpit and stand before my blackboard.
The first sentence of Edgar Allan Poe's The Telltale
Heart reads: "True!nervousvery, very awfully
nervous I have been and am . . . but will you say that I am mad?"
And I confess to being a tad nervous as I tackle a subject that
I frankly wouldn't dare to tackle before most audiences.
But this congregation of so many avid investors under one roof emboldens
me to address an important subject, and, after the great bull market,
the great bubble, and the great burst we have witnessed, a timely
one as well. And if my guess is right, this is an audience that
can handle it.
I hardly need tell you that the key to whatever success
I may have enjoyed during my long investment career is that the
Lord gave me enough common sense to recognize the majesty of simplicity.
But I've learned that to discover the priceless jewels of simplicity,
it's often necessary to cut through a swath of complexity. Today,
the complex subject I'll discuss is reversion to the mean; the jewel
of simplicity is the telltale chart.
The Telltale Heart, of course, is the story
of a heart that doesn't seem to stop beating (sort of like mine,
come to think of it!). Even after the death of its owner, its steady
drumbeat ticks away like "a watch enveloped in cotton"
and becomes more and more distinct. So reversion to the meanRTM,
the pervasive law of gravity that prevails in the financial marketsnever
stops. While its drumbeat is hardly regular, it never fails. For
the returns of market sectors, of managed investment portfolios,
and even of the market itself mysteriously return, over time, to
norms of one kind or another.
Some of you may recall that RTM was the subject of
Chapter 10 of my 1999 book, Common Sense on Mutual Funds: New
Imperatives for the Intelligent Investor. But few of you know
that the genesis of that chapter was a speech that I gave at Massachusetts
Institute of Technology in 1998, where I had been invited to speak
at its Distinguished Lecture Series at its Lincoln Laboratories
think-tank. It is not insignificant that the audience of scientific
researchers was laced with Ph.Ds. I hope you are complimented that
it is before you that I address the subject again.
Six Manifestations of RTM
Today I'm going to talk about how RTM can help us
to understand financial markets and thereby become more successful
investors. I'll talk first about RTM in market sectors, focusing
first on large-cap and small-cap stocks and second on growth and
value stocks. Next, I'll turn to RTM in the returns of the recently
beleaguered Standard & Poor's 500 Stock Index relative to total
U.S. stock market. Fourth, I'll talk about the reversion of equity
mutual fund returns to the market mean. Thenin part because
the Bogleheads would be disappointed if I didn'tI'll turn
to RTM as it is reflected in the results of what have become known
as "Slice and Dice" portfolios; essentially diversified
portions that seek to outpace the broad market index by systematically
overweighting various sectors. Finally, I'll examine the question
of whether stock market returns themselves revert to one kind of
mean or another.
Giving you this copious stream of information will
require me to flash a total of no less than 18 PowerPoint® charts
up on the screen. That's a tall order, but if you'll just hold in
the back of your minds the remarkable similarity of each of the
charts showing RTMthe irregular swings above and below the
meanwith which I summarize each of these six points, I think
you'll understand my line of argument. For the telltale chart that
demonstrates the tendency of investment phenomenon to revert to
the mean repeats itself in each example. When I conclude, I hope
you'll share my conclusion: The most successful investors will
respect the power of reversion to the mean.
I begin by criticizing the vastly over-simplified
but typical way we look at long-term results. We hear, for example,
that "small-cap stocks outperform large-cap stocks by almost
two percentage points a year," using as evidence the entire
historical record we have available (from, as it happens, 1926 to
2002). Or that the, well, Magic Fund "has beaten the market
by eight-and-a-half percentage points a year over its lifetime."
Or that "stocks provide higher returns than bonds," in
each case without acknowledging that each and every comparison we
see is period-dependent. Whether or not the period has been
selected to prove a point, neither the starting date of a comparison
nor its concluding date are random. Compilations of historical financial
market returns are not actuarial tables, and, as you'll see, the
past is not prologue. Indeed, it is usually, well, anti-prologue.
Each thesis, it turns out, tends to bear the seeds of its own antithesis.
1. RTM - Large-Cap Stocks vs. Small-Cap Stocks
Few investment principles are as unchallenged as
the perennial assertion that over the long-run small-cap stocks
outperform large-cap stocks. The data we have available are unequivocal
on this point: Since 1928, according to the University of Chicago
Center for Research in Securities Prices (CRISP), small stocks have
provided an annual return of 12.5%, vs. 10.8% for large caps. And,
over that 74-year period, the long-term compounding works its magic;
each dollar in small-cap stocks grows to $6,000, while each dollar
in large-cap stocks grows to just $2,000. Bear in mind, of course,
small-caps carried a higher risk (standard deviation of 30% vs.
22%). But after adjustment to that higher risk level the, large-cap
annual return rises to 12.9%, higher than for small-caps.
So never ignore risk.
But that imposing chartlike the proverbial
bikiniconceals more than it reveals. I would strongly urge
you to not accept that conclusion without transforming it into the
telltale chart that is devised simply by dividing the cumulative
returns of one data series into another, year after year-in this
case dividing the cumulative large-cap stock return into the cumulative
small-cap return. Then we see that the long period was punctuated
by a whole series of reversions to the mean. Virtually the entire
small-cap advantage took place during the first 18 years. Then large-cap
(14.2% per year) dominates small-cap (11.7%) from 1945 through 1964;
small-cap through 1968 (32.0% vs. 11.0%); large-cap through 1973
(2.5% vs. -10.8%). Then small-cap through 1983, large through 1990,
and so on. On balance, these to-and-fro reversions have cancelled
each other out, and since 1945 the returns of large-cap stocks and
small-cap stocks have been virtually identical (12.7% vs.
13.3%). So ask yourself whether the evidence to justify the claim
of small-cap superiority isn't too fragile a foundation on which
to base a long-term strategy.
Then, ask yourself too if the data are accurate.
Reconstructing past returns of market segments is no mean task,
especially among small-cap stocks. Ask yourself whether transaction
costs are accurately imputed (or even imputed at all), and whether
survivor bias is present. Together, these issues raise questions
about the validity of even the most responsibly-conducted of academic
studies. And then, even if they're valid, ask yourself whether the
game is worth the 40% increase in investment risk.
Finally, ask yourself the extent to which any of
the results of what are in effect indexes of market sectors can
be replicated in the real world of investing. Investing costs money,
and it is a truismand increasingly a trite onethat all
of the investors in the stock market (or in any discrete market
sector) earn the market return before the costs of
financial intermediation, but actually receive the return
after those costs. If the cost of implementing a small stock
strategy exceeds the costs of a large stock strategy by one percentage
point a year or more, as seems to be the case, even if the alleged
long-term advantage reflected in the data in fact materializes,
the victory may be pyrrhic.
2. RTM - Value Stocks vs. Growth
I won't belabor those important qualifications of
data integrity, risk, and real world costs. But each also comes
into play in the next area that I'll consider, value stocks vs.
growth stocks.1 Here, the long-term
difference is even more dramatic than small vs. large: The
annual return since 1928 is reported as 12.2% for large-cap value
stocks and 9.6% for large-cap growth stocks, a difference of fully
2.6 percentage points. The compounding of those returns results
in a stunning chasm in the final value of an initial dollar: Value
$5,100, Growth $900. Again, higher risk (standard deviation of value
was 27%, vs. 20% for growth) accounts for much of the gap, but even
the increased risk-adjusted return of 11.2% for growth stocks
falls one percentage point short of the value outcome. The data
are so impressive that one wants simply to say: Case closed!
But now let's turn to our telltale chart and carefully
examine the record. While the RTM is hardly as clear as its earlier
counterpart, we can observe some significant things going on. Curiously,
during the first 27 years (!), not much happens. Growth wins by
a bit in the first 12 years, value in the next 11, after
which both series deliver about the same annual returns
through 1961 (16%). Value leads again through 1968, and after a
four-year hiatus rises again through 1977, pauses for four years,
and then surges through 1988. Then comes the heft of the great bull
market, with growth leading value fairly consistently and by a wide
margin (21% vs. 16% annually) through 1999. That sharp dichotomy
was then followed by the sharpest mean reversion in market history,
with growth toppling by -28% in 2000-2001, with value off less than
1%. RTM strikes again! But, perhaps surprisingly, over the entire
period 1984-2001, growth (15.3% per year) retains a fragile grip
on its leadership over value (14.4%).
The data I've shown you, of course, represent the
statistical reconstruction of market sector returns. So, I'd now
like to examine not abstract portfolios, but growth and value mutual
funds that operate in the real world. The data are available
from 1937, and the general patterns parallel those of the French-Fama
study, but with a curious dichotomy. While the average annual return
of the growth mutual funds (11.6%) during this long period
actually exceeded the French-Fama large-cap growth stocks (11.2%),
the value mutual fund return of 11.0% fell far below that
of French-Fama value return of 15.2%, perhaps because the Fama-French
value portfolio has a risk fully 45% above the value funds.
Nonetheless, the French-Fama combined growth and value returns exceed
the combined fund returns by 1.9% per year, a pretty good approximation
of the costs that mutual funds incur. So investors should not ignore
the obvious costs of implementing a strategy that rises, pristinely,
out of academic studies that cannot be precisely replicated in the
The reason for the dichotomy between these markedly
different sets of growth fund and value fund relative returns may
rest on the fact that value managers invest less on the basis of
the statistical criteria that sector indexes use to differentiate
growth stocks from value stocks (usually price-to-book-value) and
more on other factors. But in any event, the validity of the growth
and value index statistics rests on the soundness of the indexes
used in measuring the sectors they purport to represent. Consider,
for example, the S&P/Barra Growth Index. Based on relative price-to-book
ratios, this Index categorizes 50% of the weight of the S&P
500 Index as growth stocks. When their prices soared during the
1990s, the number of growth stocks in the index tumbled from 220
to 106 in 1999114 erstwhile growth stocks were unceremoniously
shoved into the Value Index. Then, when growth stocks stumbled,
51 "value" stocks returned to the Growth Index, bringing
the present total to 157and rising! With the huge asset write-downs
we're currently seeing, many former growth stocks are now defined
as value stocks. So differences in both management costs and index
composition should make us extremely cautious about the application
of abstract data to the real world.
In any event, place me squarely in the camp of the
contrarians who don't accept the inherent superiority of value strategies
over growth strategies. I've been excoriated for my views, but I'm
comforted by this reported exchange between Dr. Fama and a participant
at a recent investment conference: "What do you say to otherwise
intelligent people like Jack Bogle who examine this same data and
conclude that there is no size or value premium?" His response:
"How far are they from the slide? If I get far enough away,
I don't see it either . . . Whether you decide to tilt towards
value depends on whether you are willing to bear the associated
risk . . . The market portfolio is always efficient . . . For
most people, the market portfolio is the most sensible decision."
3. RTM in the Market Portfolio
Like Dr. Fama, I believe that the market portfolio
is the most sensible decision. It takes the need for judgement
out of your decision making; it reduces cost; it increases tax-efficiency;
it avoids the need to pore over past market data to figure out why
the data are what they are. Then, if you accept the data, you have
to decide whether or not the patterns it has revealed will persist
during the span of years remaining on your investment horizon.
In a temporal sense, the all-market portfolio is consistent
with the spiritual argument about the existence of God put forth
by Pascal three centuries ago. If you bet God is, you live
a moral life at puny cost of giving up a few temptations. But that's
all you lose. If you bet God is not and give in to
all your temptations, you're forever dammed. Consequences,
Pascal concluded, must outweigh possibilities. Similarly
in the stock market, if you bet the market is efficient and hold
the market portfolio, you'll earn the market's return. But if you
bet against it and are wrong, the consequences could be painful.
Why would you run the risk of losing, perhaps badly, when the market
return, earned by so few over the long-run, is there for the taking?
Still, we are faced with the question of how to define
the market portfolio. When I started the first index mutual fund
27 years ago, the Standard & Poor's 500 Composite Stock Price
Index was generally considered to be the appropriate market portfolio.
Of course it represented only 80% of the market, but there were
few other indexes from which to choose. (The Wilshire 5000 Total
Market Index, dating to 1970, was little-known and untested.) Today,
the Wilshire is readily available and widely accepted, its validity
as a proxy for the total U.S. stock market confirmed by both CRISP
and French-Fama, which take the data as far back as 1926. The three
indexes share correlations of something like 0.999, so there can
be little doubt about their validity. An all-market index fund is
clearly the optimal way to hold the U.S. stock market.
But I must spring to the defense of index funds linked
to the Standard & Poor's 500 Index. While the 500 Index has
been excoriated by Morningstar ("500 Index Funds Losing Their
Allure?"), by Money magazine ("Is the S&P 500
Rigged?"), and by Institutional Investor ("Is Time
Running Out for the S&P 500?"), I would answer those questions,
"No," "No" and "No." The criticism
has been greatly overdone. Yes, the 500 is heavily weighted by large
stocks. But so is the U.S. stock market. Yes, during the great bubble,
the 500 was dominated by overpriced technology stocks. But so was
the U.S. stock market. Yes, many of the additions of large tech
stocks in the 500 in recent years seem, in retrospect, absurd. But
these companies were already major factors in the market itself.
Yes, its composition changes substantially over the years, but so
does the composition of investors' portfolios. And yes, the 500
didn't even become the 500 until 1955. From its inception
in 1926, it had been comprised of just 90 stocks. In all of these
respects, the S&P 500 is a flawed index. But for all of the
criticism heaped on it, the S&P 500 works.
So now the most important "yes" of all.
For all of its real and imagined failings, yes, the S&P 500
has provided a truly remarkable representation of what we now know
to be the returns of the total U.S. stock market. What is more,
with a 10.7% annual return since 1926 it has actually outperformed
the broader market's 10.3% return. But yet another telltale chart
warns us not to look to the 500 for excess returns. This entire
excess arose during 1926-1932. Since then, the 12.2% annual return
of the S&P 500 has been exactly the same as the return
of the total stock market. But overall, the RTM has been remarkably
small; almost trivial. Yes, when large-caps dominate, as in most
of the 1982-2000 bull market, the S&P 500 will dominate. And
yes, when small-caps dominate (as in 1975-1980), the S&P will
lag. But since the S&P continues to represent more than 75%
of market's capitalization, it would seem a bit naïve to doubt
that it will continue to revert to the market mean in the years
ahead. One more valuable lesson from our telltale chart: Investors
in 500 index funds need feel no compulsion to change horses and
switch to a total market portfolioespecially if it would result
in a taxable capital gain. Over the long haul, the S&P 500 will
do the same job of matching the market that it has always done.
4. RTM in Equity Mutual Funds
The telltale chart also helps us to observe the important
role played by RTM in the returns of mutual funds. How much more
we can learn if we look, rather than at a simple summary of a fund's
long-term record, at a chart showing its market-related returns
over time! Consider the remarkable record of one of America's greatest
mutual fund success stories. I'll call it the "Magic Fund,"
for its long-term record is probably as good as a record as we can
find. Formed in 1964, the annual return of Magic Fund averaged 19.7%
per year, fully 8.5 percentage points ahead of the Standard &
Poor's 500 Index. Result: $10,000 invested at the outset, with all
dividends reinvested, would have been worth $9.3 million(!) as 2002
began. The same investment in the index would have been valued at
just $560,000. It sounds like a marvelous record. And it is!
But now let's convert those figures to an RTM chart.
Like so many funds, the record was sensational in the early years
when assets were small, and, in this case, before the fund ever
became available to the public. From 1964 through 1981, Magic Fund's
return averaged 22% a year, putting to shame the relatively dismal
9% return of the S&P 500. By the time it was first offered to
the public in 1981, it had soared to 10 times the market
return. And in the first five years thereafter, it rose to almost
14 times the market's return. Even as assets grew into the billions,
and the tens of billions, and then over the $30 billion mark, it
continued to prosper, rising to nearly 19 times in 1993. From such
lofty heights, of course, RTM becomes a virtual certainty, and accelerates
as the fund gets larger and larger, its portfolio inevitably more
and more marketlike. By 1993, the game was over. It lost one-sixth
of its edge by 1997, and since then, it has been in lock-step with
the S&P 500. As the telltale chart shows us, Magic Fund's return
has been virtually identical to that of the Index (14%). Indeed
the chart suggests that it has now become a closet index fund, its
old magic long gone. But the magic of the telltale chart
remains, making obvious that the old order hath changeth, more than
a dozen years ago.
I'll put up just two more RTM charts to reinforce
the message that the telltale chart is almost essential in appraising
the records of individual funds. In retrospect such charts might
have protected fund investors from the ghastly penalties they paid
for adverse fund selection during the late bubble. One is a well-managed,
low-cost, value-oriented equity fund. Despite its low-risk strategy,
it tracked the bull market nicely in 1986-1997, only to fall back
during the technology mania. But when the day of reckoning came,
it showed its staunch character. The other pattern is just the reverse:
An aggressive growth fund is not particularly impressive during
the early part of the period, but then soars as its high-risk strategy
pays off in 1991-1995. Attracting large assets, it falters badly
during 1996-1998, only to make one last surge in 1999. Then comes
the bust that always follows the boom, and the fund collapses again.
No, higher risk doesn't necessarily equate to higher returns. Such
charts would have helped investors avoid the perils of the recent
Years ago, I suggested that Morningstar replace its
traditional chart with one that included the RTM that is so clearly
illustrated by these telltale charts. Alas, the editors decided
against it. In fairness, however, by showing quarterly returns relative
to peer funds, the revised charts Morningstar now provides do
capture some of the spirit of the idea. But, ever the optimist (if
the seemingly ungrateful recipient of today's free lunch!), I still
hold out hope that Morningstar will reconsider and decide to employ
telltale charts on its fund pages.
5. RTM and "Slice and Dice"
"Slice and Dice"S&D to
the Bogleheadsis often talked about not only on the Morningstar
website, but among financial engineers, including those at (dare
I admit it!) Princeton University. In its simplest form, the idea
is to garner excess returns by holding a portfolio that a) adds
to the market portfolio those asset classes that are deemed likely
to deliver superior returns; b) introduces assets having a low correlation
with the stock market; and c) periodically rebalances each asset
class to its original weight.
Let's quickly examine two such portfolios. First,
a conventional one, one-quarter each in the S&P 500 Index, large
value stocks, small value stocks, and stocks in the smallest two
decilesi.e. a portfolio that overweights value and small-cap
shares. Over history, it has clearly delivered: An annual return
of 12.9% vs. 10.3% for the S&P Index, albeit with a 41% higher
riska standard deviation of 28%, versus 20% for the S&P
500. When we bring the telltale chart into play, however, we see
period-dependency and RTM at work. Note, for example, how much of
its success came in the 1942-45 bull market, when it rose by 410%(!),
nearly three times the 150% return of the S&P Indexdoubtless
a non-recurring event. Note too that the returns of the Index and
S&D portfolios were virtually identical (13.8% and 14.0% annual
return) for the next two decades, ending in 1964. Then the S&D
portfolio surges intermittently through 1983, only to falter over
the following 17 (!) years (annual return of 13.9%, vs. 16.3% for
the S&P)meaning that there was virtually no gap for 32
yearsa pretty long horizon when you think about it. For the
full period, of course, the S&D portfolio dominated, but if
we simply levered the S&P 500 to equalize its risk with the
S&D portfolio, its risk-adjusted return would have risen to
12.4%. Surely a shortfall of 0.5% is mere rounding error in a numerical
exercise of this nature.
It is not insignificant, of course that the value/small-cap
tilted S&D portfolio we've examined was chosen largely in hindsight,
reflecting the all-too-human temptation to rely on sectors that
commend themselves by their past success. So, let's take a look
at what an investor might have done 30 years ago. We'll hold a 25%
S&P 500 position and then add three 25% alternative classes
that might have been popular at the time: Small-cap, international,
and, because it is the single asset class that most diversifies
an equity portfolio (i.e., has the lowest correlation to the stock
market of any asset class), gold (it didn't look silly then!).
Now let's examine the record of this alternative portfolio. Obviously,
this chart tells a different story. While the S&D portfolio
again wins, it wins by only a modest amounta 12.8% annual
return for the 4x25 portfolio versus 12.3% for the S&P 500.
Still, the value of $1 grew to $42 in the 4x25 portfolio, compared
to $36 for the Index, a nice payoff for what proved to be, on balance,
a smart selection of sectors.
But now see what the telltale chart reveals. First,
the entire excess return-and then some!appears in the first
nine years, when gold boomed. Second, strength in the international
sector pretty well maintained that gain through 1988, after which
international stocks lagged the S&P 500, often by double-digit
amounts, for seven of the next ten years. Yet, despite the recovery
of this alternative 4x25 portfolio during the past two years, its
cumulative average return of 10% since 1979 pales by comparison
with the S&P 500 return of 15%. The telltale chart then, tells
us two distinctly contradictory tales about this version of the
S&D strategy: Yes, it wins during the first 8 years; no, it
loses during the last 22.
So Slice and Dice is what you make it. Like all other
investment strategies ever devised by the mind of man, sometimes
it works and sometimes it doesn't. Uncertainty rules. Even if the
overall program appears to outpace the Index, over a long inevitably
period-dependent span of years, don't forget how little (!) it costs
to emulate the total stock market in the real world nor how much
(!) it costs to use active funds to fill the S&D boxes, and
even to use passive funds to do so. If we take the extra risk into
account, there's a real question about whether the game is worth
the candle. And even if you don't accept my challenge to S&D,
I urge you, before you plunge into a 4x25 portfolio, to put more
than 25% in the total marketsay 55%. Then put just 15% in
the three slices that you dice, thereby taking much of the risk
out of your decision. Think then, about a 1 x 55% + 3 x 15%
portfolio. If it is true, as Dr. Fama (and most other academics,
to say nothing of many, many practitioners) says, that "for
most people, the market portfolio is the most sensible decision,"
you might as well make the most of it.
6. RTM and The Stock Market
And, yes, reversion to the mean is the rule, not only
for stock sectors, for individual equity funds, and for investment
strategies that mix asset classes, it is also the rule for the returns
provided by the stock market itself. If we go back through a century
of stock market history (using Jeremy Siegel's data), it's easy
enough to chart it: The real (inflation-adjusted) return on stocks
has averaged 6.6% per year, but with considerable extremes.
This powerful panorama shows that the highest ten-year annual returns
have ranges around 15%, coming in the mid-1900s, the late 1920s,
the early 1960s, and the late 1990s. Then, in the late 1910s, the
late 1930s, and the late 1970's, returns tumbled to 2% or less,
sometimes even negative. Since the market's 15% return in the decade
ended in 1998 was the third highest in all history, one can only
hope that the full might of RTM does not strike again.2
Why do stocks provide such high returns in some periods
and such loweven negativereturns in others? Part of
the reason is that the course of our economy is not smooth. We have
prosperity and recession, even boom and bust. Those are simply the
economics of enterprise, and while they may be tamer
than in the past, they are not tamed. But there is more:
The emotions of investors, whose greed leads them to value
stocks too dearly at one moment and whose fear leads them to value
stocks too cheaply at another. It is this combination of economics
and emotions that shapes stock market returns.
Economics is reflected in investment return
(earnings and dividends), emotions are reflected in the speculative
return (the impact of changing price-to-earnings ratios). During
the past century, the real investment return was 6.5%, accounting
for the lion's share of the market's 6.6% real return, with speculative
returns contributing just 0.1%. Clearly, the cumulative investment
return is the piper that plays the tune, with earnings and dividends
climbing year after yearsometimes faster, sometimes slower,
sometimes even falling. While stock market returns dance assiduously
to the investment tune, but periodically move above or below, seemingly
independently. But the iron law of investing is apparent: In
the short run, speculative return drives the market. In the long
run, investment return is all that matters.
While only our faith that our nation's capitalistic
economy will continue to thrive can give us confidence in the long-term
course of dividends and earnings, it is not faith but common sense
that tells us when stock prices get substantially misaligned with
corporate values. When the stock market's cumulative total return
diverges significantly from the market's investment return,
then it is only a matter of time until the two converge again. Here
is where RTM comes into play. This final telltale chart reflects
the division of the cumulative investment return into the actual
market return at the end of each year. Result: These aberrations
between investment return and market return are dramatically highlighted.
Thus, the misalignment of prices with values at the 1929 peak was
followed by the crash of the 1930s. On the other hand the low valuations
of the late 1940s and early 1950s laid the foundation for the go-go
era of the mid-1960s and the "Favorite Fifty" craze of
the early 1970s. The resulting bust set the stage for the great
bull market that began in August 1982 and ended abruptly in March
At that point as the chart shows, the disjunction
between market returnsstock pricesand investment
returnsenterprise valuesonly once before had been wider,
so predicting a subsequent decline was no great challenge. But while
we may know a lot about what will happen in the financial
market, we never know when it will happen. Indeed the ratio
was at 120a clear warning signat the end of 1997. Yet
the ratio continued to rise until it hit 150 at the end of 1999,
and rose even further to 160 at what proved to be the 2000 peak.
Yet despite the subsequent 40% market drop we have so far endured,
the ratio remains at 110, still above the baseline. Where it goes
next, nobody knows. But history and the iron rule of RTM
strongly suggest caution, since valuations remain high today. The
future will depend on subsequent earnings growth. So we'd best hope
American business turns its attention away from the ghastly financial
manipulation of recent yearsfocused on hyping stock prices
in the short-termand to its traditional characterfocusing
on building corporate values over the long-term. That's a
far harder job, for innovation, productivity, efficiency, economyyes,
and leadership and character tooare tough standards to measure
up to in a competitive global economy. But it is what our society
must demand of our corporate stewards.
This Too Shall Pass Away
The message of the telltale chart is universal. Unlike
the regular, louder, ever more distinct pulsations of the telltale
heart in Poe's frightening story, however, reversion-to-the-mean
in the financial markets is irregular and unpredictable sometimes
fast and sometimes slow, sometimes distinct and sometimes almost
invisible. Just when we despair of its universality it strikes again.
And so there is always hopetoday, for those who await the
almost inevitable recovery in stock prices. But I remind you that
while we may know what will happen, we never know when.
So rather than relying on hopenever a particularly good idea
in the stock marketrely on an asset allocation that focuses
not only on the probability of reward, but the consequences of risk.
It occurs to me that the best advice I can leave you
with today came in my first book, written ten years ago. It was
a Caveat Emptor entitled, "This Too Shall Pass Away,"
the advice given to an Eastern monarch that would be "true
and appropriate in all times and situations." I described it
as wise advice for investors in the financial markets, who "feel
richer when the market rises and poorer when it declines . . . although
the underlying value of the business enterprises that comprise the
market may have changed not a whit." I cautioned investors
not to give way to a bull market atmosphere and become infected
with the enthusiasm and greed of the great public, any more than
you should give way to a bear market atmosphere and become
infected with the negativism and fear displayed by the great public.
Your success in investing, I wrote, "will depend on your ability
to realize, at the heights of ebullience and the depths of despair
alike that 'This too shall pass away.'"
I can hardly wait!
1. The data for these charts are provided in
the famously comprehensive studies undertaken by Professor Kenneth
French of Dartmouth and Eugen Fama of the University of Chicago.
2. I've often addressed the issue of expected
stock returns during the first decade of the 21st centuryat
length in Common Sense (especially in the appendix that compares
1999 with 1929), in The First 50 Years, (especially Chapter
4), and in numerous speeches over
the past three years. Back
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.