An Address by John C. Bogle
Founder and Former CEO, The Vanguard Group
The University of Missouri
October 22, 2002
I am deeply honored by this opportunity to address both your university
community and your local business leaders on the current state of our
financial markets. I feel very much at home here since, by happy coincidence,
both your alma mater and mine share a common mascot: the Bengal tiger.
While that fierce, fast, sleek, and predatory creature of the jungle
symbolizes many things, I like to think of the tiger as representing
a fierce desire to learn, an impatience for achieving things, an unembellished
economy of form and action, and the strength to challenge its foes.
Perhaps you will sense some of those attitudes in my remarks today.
In a real sense, I owe muchin terms of my career, everythingto
my good fortune in attending Princeton University, home of that other
great collegiate tiger. For it was there, almost 53 years ago, that
I happened upon the December 1949 issue of Fortune magazine and
learned for the first time that something called "the mutual fund
industry" existed. When I saw the industry described in the article
as "tiny but contentious," I knew immediately that I had found
the topic for my senior thesis, then as now at Princeton, a requirement
for the Bachelor of Arts degree.
Over the next 18 months, I spent countless hours researching and writing
my thesis. Remarkably little public information was available about
this field, then with about 130 individual funds and managing assets
of about $2 ½ billion. (Today, there are 9,000 funds, and assets
exceed $5½ trillion!) Indeed, much of my research was
a result of pouring over a 3,283 page study by the Securities and Exchange
Commission on what were then called "Investment Trusts and Investment
An Idealistic Senior Thesis
Read today (it's readily available; in 2001 it was published by McGraw-Hill
as part of John Bogle on Investing: The First 50 Years), the
thesis would probably impress you as no more than workmanlike, perhaps
a bit callow, but above all, shamelessly idealistic. On page after page,
my youthful idealism speaks out, calling again and again for the primacy
of the interests of the mutual fund shareholder. At the very opening
of my thesis, I get right to the point: Mutual funds must not "in
any way subordinate the interests of their shareholders to other economic
roles. Their prime responsibility must always be to their shareholders."
Shortly thereafter, "there is some indication that costs are too
high," and "future industry growth can be maximized by concentration
on a reduction of sales charges and management fees." (As it happened,
fees have actually soared to far higher levels. So much for my advice!)
After analyzing mutual fund performance, I conclude that "funds
can make no claim to superiority over the market averages,"
perhaps an early harbinger of my decision to create, nearly a quarter-century
later, the world's first index mutual fund, and in retrospect a tribute
to Alphonse Karr's only citation in Bartlett's Familiar Quotations:
"the more things change, the more they remain the same." Still
later in the thesis, "fund influence on corporate policy . . .
should always be in the best interest of shareholders, not the special
interests of the fund's managers." (Again, my advice fell by the
wayside, and shareholders remain ill-served by the passive governance
policies of most funds.)
My conclusion powerfully reaffirmed the ideals I hold to this day:
Mutual funds should serve"serve the needs of both individual
and institutional investors . . . serve them in the most efficient,
honest, and economical way possible . . . Providing advantages
to the investor is the function around which all others are satellite
. . . The principal function of investment companies is the management
of their investment portfolios. Everything else is incidental."
And the very last sentence of my thesis sets forth the optimum economic
role of the mutual fund: "To contribute to the growth of the economy,
and to enable individual as well as institutional investors to have
a share in this growth."
The Boom and the Bust
Well, despite the fact that this industry has failed to measure up
to the high ideals I expressed all those years ago, grow it did. And
grow massively, as the great bull market in both stocks and bonds
that began in the early 1980s produced the most generous investment
returns in all our nation's history. But these recent years have not
been very happy ones for idealists. The great stock market bubble of
the late 1990s burst, and we have endured the painful experience of
the greatest bear market in stocks since 1929-33. Some $8 trillionnearly
one-half of the total value of U.S. stockshas been erased in the
plunge. But most of the air that inflated the bubble was hot
airenormous investor expectations that could never be fulfilled,
fed by aggressive projections of growth that were self-serving and grossly
But now we are "back to (or at least toward) normalcy" in
valuations. Even after this great bear market, however, the rate of
annual returns on stocks during the 1982-2002 era totaled 13%, surely
an attractive outcome. Through the miracle of compounding, those who
owned stocks in 1982 and still held them in 2002 had multiplied that
capital 13 times over. So for all of the stock market's wild and wooly
extremes, long-term holders of common stocks have been well-compensated
for the risks they assumed. For such investors, the coming of the bubble
and then its goingthe boom and then the bustsimply
did not matter.
But that doesn't mean there weren't winners and losers during the maniaand
lots of both. Simply put, the winners were those who sold their stocks
in the throes of the halcyon era that is now history. The losers were
those who bought them. Let's think first about the winners. A large
proportion of these shares that were sold were those of corporate executives
who had acquired vast holdings of their companies' stocks through options,
and those of entrepreneurs whose companies had gone newly-public as
Wall Street investment banking firms underwrote huge volumes of initial
stock offerings. Fortune magazine recently identified a group
of executives in just 25 corporations in those categories, whose total
share of sales came to $23 billionnearly a billion dollars each.
I don't think it is unreasonable to estimate that the total of such
insider sales came to as much as several hundred billions of dollars.
Other winners included financial intermediariesthe investment
bankers and brokers who sold the high-flying stocks to their clients,
and the mutual fund managers who sold them to the public as money poured
into the funds they managed. Why were they winners? Because the compensation
for their activities reached staggering levels. I've known of individual
investment bankers whose five-year compensation reached into the hundreds
of millions, and owners of fund management companies whose personal
wealth came to exceed $1 billion or more, including one family said
to be at the $30 billion level.
The losers were, of course, those who bought the stocks, the great
American publicoften in their personal accounts, and often through
ever more popular 401-k thrift planssometimes directly,
by buying individual stocks; sometimes indirectly, through mutual
funds. It is not given to us to know the extent to which the public
followed sound investment principles in their decisions, nor the role
played by the absence of common sense, or by naivete, or by salesmanship,
or even by greed. But what does appear clear is that "new economy"
stocksin technology, the internet, telecommunications, and medical
serviceswere the greatest objects of public favor. Witness that
during the peak two years of the bubble, mutual funds favoring those
types of aggressive growth stocks took in nearly $500 billion of investor
capital, compared to just $30 billion that flowed into the "old
economy" value funds.
It is reasonable to conclude, I think, that during the late bubble
there was a massive transfer of wealtha transfer from public investors
to corporate insiders and financial intermediaries. Such transfers,
of course, are not without parallels all through human history. For
when speculation takes precedence over investment, there
is always a day of bounty for the few followed by a day of reckoning
for the many. Speculative bubbles are as old as timeor at least
as old as Ancient Rome. Indeed, it was there, nearly 2200 years ago,
that the orator Cato told us:
There must certainly be a vast Fund of Stupidity in Human Nature,
else Men would not be caught as they are, a thousand times over, by
the same Snare, and while they yet remember their past Misfortunes,
go on to court and encourage the Causes to which they were owing,
and which will again produce them.
As it is said, "while history doesn't repeat itself, it rhymes."
And while the recent bubble bears many resemblances to its predecessorstulips
in Holland, shipping in the South Seas, stocks in 1929it had its
own distinct ethos: A strong economy, a stock market that had experienced
only a single down year (and a mild one at that) since 1982, the excitement
of the new millennium, the coming of the Information Age, and the apparent
rise of a technology-driven "new economy." It is hardly surprising
that rational expectations were replaced by irrational exuberance.
If those had been the only ingredients, I doubt the speculative bubble
would have been so large. But when we simultaneously add in a wave of
deregulation and financial innovation, as Edward Chancellor, author
of Devil Take the Hindmost, has noted, "there is a tendency
for business to be managed for the immediate gratification of speculators
rather than the long-term interests of investors." If there was
a single dominant failing of the recent bubble, it was the market's
overbearing focus on the price of a stock rather than
on the value of a corporation. Nonetheless, the price
of a stock is perception, and acting on that perception is speculation.
The value of a corporation is reality, and acting on that reality
Our, well, flexible financial system cooperated in the madness. Aggressive
earnings guidance from corporate executives, realized by fair means
or foul; manipulation of income, expenses, balance sheets; the debasement
of accounting standards; public auditors who became consultants to management,
in effect, business partners; Wall Street sell-side analysts motivated
by attracting investment banking clients; mutual fund managers who,
succumbing to the spirit of the mania, put aside their training, experience,
and skepticism. The speculative mania, like victory itself, had 1,000
The Role of Stock Options
But if we had to name a single father of the bubble, we would
hardly need a DNA test to do so. That father is the fixed-price stock
option. When executives are paid for raising the price of their
companies' stock rather than for increasing their companies' value,
they don't need to be told what to do: Achieve strong, steady earnings
growth and tell Wall Street about it. Set "guidance" targets
with public pronouncements of your expectations, and then meet your
targetsand do it consistently. First, do it the old-fashioned
way, by increasing volumes, cutting costs, raising productivity, developing
new products and services. But in a competitive economy, these targets
are not easy to meet. So when you can't meet them by making,
you meet them by counting. Push the accounting numbers to the
edgeand sometimes beyond. Undertake mergers, not for business
reasons but because of loopholes in accounting rules that allow such
transactions to provide a short-term boost to earnings. And when all
of that isn't enough, cheat. And, as we now know, a number of
large firms did exactly that.
The stated rationale for such stock options is that they "link
the interests of management with the interest of shareholders."
And if momentary stock prices were reliable indicators of intrinsic
corporate values, that might even have been the case. But only if managers
hold their stocks, just as the long-term shareholders do. But
they don't. Academic studies indicate that nearly all in-the-money
stock options are exercised as soon as they vest, and the stock is sold
immediately. Indeed, the term "cashless exercise"where
the firm lends the money to the executive for the purchase and is repaid
when the proceeds of the sale are deliveredbecame commonplace.
But the transitory nature of the holding period is hardly the only
problem. By rewarding perception rather than reality, stock options
are fundamentally flawed. Stock options are not adjusted for the cost
of capital, thus providing a free-ride even for executives who produce
only humdrum returns. Stock option prices are not adjusted for corporate
dividends, so that there is a perverse incentive to avoid paying dividends.
Stock options reward the absolute performance of a stock rather
than performance relative to peers or to a stock market index,
meaning that bull markets tend to create unworthy centimillionaires
and bear markets tend to eliminate rewards even for worthy performers.
Most of these issues could be resolved by the use of restricted stock,
or by raising the option price each year, or by linking the stock performance
with a market index, in each case requiring an extended holding period.
What accounts for the fact that such incentives were rarely used? The
fact is that all of those alternative schemes require corporations to
expense the costs. (Heaven forbid!) The fixed-price option alone
is conspicuous by its absence on the company's expense statement. (As
the compensation consultants are wont to say, fixed-price stock options
are "free.") I hope that the present move to expense all
options gains momentum, so companies can get about the business of designing
sound compensation programs that, at long last, fairly link the interests
of management with the interests of shareholders. After the present
awful era, surely shareholders deserve no less.
How will we get that linkage? Shareholders will have to start acting
like owners. While too many of our corporate stewards have failed to
earn our faith, we mutual fund managers and our clients have, I fear,
gotten the corporate governance that we deserve. For we have not acted
as owners, focusing on corporate value and investing for the
long-term. Rather, we have acted as traders, turning our portfolios
over at an average of 110% per year, engaging in short-term speculation
in stock prices. (We have been called, accurately I think, the "rent-a-stock
industry.") Partly as a result, in the great bear market fallout,
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. 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.
Actions and Reactions
This process is already beginning. It turns out that Sir Isaac Newton's
third law of motionfor every action there is an equal and opposite
reactioncan also apply to our system of financial markets.
The first reaction to the late bubble is that, like all bubbles, it
burst. The bear market was the inevitable reaction to the bull market.
The "new-economy" NASDAQ Index of unlisted stocks is down
a stunning 78% from its high, and the largely "old economy"
New York Stock Exchange Index is down 38%. (The principal difference
between the two markets is that to be listed on the NYSE a company actually
has to have earnings.) The action of the bubble drove the market value
of NASDAQ stocks from 24% of the NYSE value in 1995 to 73% at the peak
early in 2000. The subsequent reaction has returned it to 21%, just
what it was in 1981, twenty years ago. Equal and opposite reaction indeed,
and almost precisely so.
What is more, a powerful reaction has already begun to the unacceptable
actions of those we trusted to be our corporate stewards, of Wall Street,
and of the accounting profession. Congress has passed the Sarbanes-Oxley
bill, requiring senior corporate managers to attest to the validity
of their companies' financial statements, providing for disgorgement
of profits by executives who sell stocks and later restate earnings,
and replacing self-regulation of accountants with a new federal Public
Company Accounting Oversight Board, as well as other salutary provisions.
The New York Stock Exchange is producing a powerful set of guidelines
for corporate governance, including greater director independence, new
standards for audit committees and compensation committees, and even
a "lead director" who is independent of corporate management.
(I believe that we should go further, and require that the board chairman
be an independent director, separating the powers of governance
from the powers of management.) The newly-formed Conference Board
Blue-Ribbon Commission on Public Trust and Private Enterprise (on which
I'm honored to serve) has already produced a strong set of best practices
on executive compensation, with best practices on corporate governance
and on accounting standards soon to follow. James Madison said, "if
men were angels, we wouldn't need government." To which I would
say to our corporate leaders, "if men were angels, we wouldn't
need governance." And we're on our way to getting better
governance right now.
Investing Today: Look Forward, Not Back
So today, after the fall, how should investors think about investing?
It is a curious fact about financial markets that that they lead us
to act in exactly the opposite direction of our best interests.
As stocks reach new heights, we are exuberant (that's how stocks got
there!) and our instincts tell us to buy. And as stocks tumble to new
lows, we reach the point of maximum pessimism (that's largely how they
get there!) and our instincts tell us to sell before it gets
worse. (And sometimes our depleted balance sheets require us
to sell.) But only a moment of common sense ought to remind us that
buying at the high and selling at the low is no formulation for the
accumulation of wealth.
Let's look at some numbers that might help us to understand what returns
might lie ahead for the stock market, and for the bond market as well.
I, for one, place little credence in simply looking at the historical
experience of these two principal asset classes, though, heaven knows,
we have more than enough data to be confident that the record of the
past is as the numbers tell us. But, as I've said a thousand times,
"stock market returns are not actuarial tables." Whatever
the case, the watchword of investing is uncertainty.
To understand why the past cannot foretell the future, 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 that thesis at Princeton.
Investment Return and Speculative Returns
This dual nature of returns is clearly reflected in stock market history.
Using Keynes' idea, I divide stock market returns into Investment
Return (enterprise), consisting of the initial and dividend yield
on stocks plus their subsequent earnings growth, and Speculative
Return, the impact of charging price/earnings multiple on stock
prices.1 Consider the record of stocks
during the twentieth century. Note first the steady contribution of
dividend yields to total return during each decade; always positive,
only once outside the range of 3% to 5%. Note too that, with the exception
of the depression-ridden 1930s, the contribution of earnings growth
was positive in every decade, usually running between 4% and 7% per
year. Result: Investment returns that only once (again, the 1930s) were
less than 6% annually, and only twice more than 11%.
Enter Speculative Return: Compared with the relative stability
of dividends and earnings growth over the decades, large variations
in speculative return punctuate the chart. While the spread between
the best and worst investment return (again excluding the 1930s)
was less than eight percentage points, the spread between the best and
worst speculative return was twice as large16 percentage
points, from +9% during the 1950s (when the price-earnings ratio soared
from seven to 17 times) to -7% during the 1970s (when it tumbled from
16 times to seven times).
Note, too, a curious phenomenon: Each decade of significantly negative
speculative return was immediately followed by a decade in which it
turned positive by a correlative amountthe quiet 1910s and then
the roaring 1920s, the dispiriting 1940s and then the booming 1950s,
the discouraging 1970s and then the booming 1980s. And then, amazingly,
the booming speculative return repeats itself in the 1990sa
pattern never seen before.
If we had looked at this chart back on December 31, 1999, we would
have observed that the average annual return on stocks during the century
was 10.4%. Of this total, 10% represented investment return,
about 5% from the initial dividend yield and another 5% from earnings
growth. The remaining 0.6% came from the small net increase in the price-earnings
ratio. Conclusion: In the long run, stock returns depend on the reality
of the investment returns earned by business; the perception reflected
by speculative returns counts for little. Put differently, over a long
span of years, economics dominates equity returns; emotions,
so dominant in the short run, dissolves.
Returns in Retrospect, and in Prospect
Looking at past experience based on the structure and composition
of stock returns when 2000 began, as it turns out, would have helped
us recognize a bubble that was about to burst. First, of course, was
that unique two-consecutive-decade expansion in speculative return.
Taken over twenty years, that 7.5% annual increase reflected a rise
in the market's p/e ratio from seven times to 30.5 times, more than
twice the century-long 15 times norm. If one naively believed that "this
time is different," and that such a stratospheric ratio wouldn't
decline, even the realization that any further expansion
was unlikely would have suggested a future speculative return of zero.
Second, the dividend component of investment return had fallen to an
all-time low of 1.1%, eliminating this element as a major driver of
future investment return. So the return on stocks would inevitably depend
largely on earnings growth.
How much might that growth be? Well, the long-term norm is 5%, and
the average of the prior four decades was 6.8%, so a future earnings
growth rate of 6% might have been a reasonable expectation. If so, investment
return would have come to 7.1% for the coming 1999-2009 decade. My guess
on speculative return was that the p/e ratio might drop to the neighborhood
of 18 times, providing a negative contribution of about 5% per
year. Result: An expected average return on stocks of less than 2% per
year might lie ahead.
As I assured anyone who asked, however, we certainly were not facing
ten individual years each with a 2% returnstock markets just don't
behave that way. More likely was a 40% or 50% drop over a few years,
followed by a return to more normal returns, say in the range of 9%
annually. As I've said so often, "while we may know what
may happen in the market, we never know when." While I'd
been uttering that conservative call of "wolf" (or "bear")
over the previous several years, this time it proved correct. Three
months into the new decade, the bear market began.
With stock prices now down some 45% since 2000 began, much, perhaps
all, of the bubble's excesses have been corrected. The dividend yield
has nearly doubled, to almost 1.8%. With the same 6% earnings growth
assumption (it could be higher . . . or lower), the future investment
return could be in the 8% range. And with p/es now at 15 times (based
on "normalized" operating earnings, which is a bit of a stretch),
it's even possible we'll see a slight increaselet's say, to 18
timesperhaps adding a percentage point or so in speculative return
during the next ten years, bringing the annual market return to 9%.
Precision is not the object of the game, so let's say that reasonable
expectations suggest a future average return to stocks in the range
of, say, seven to ten percentbut surely with much higher returns
in some years and much lower, even negative returns, in others. Put
another way, absent good reason, it's unwise to expect stock returns
to behave much differently then they have in the past.
What About Bonds?
Bonds are the customary alternative to stocks, and so let's now consider
what returns they might provide in the future. It is a curious paradox
that while history gives us few clues to what lies ahead, projecting
future bond returns is far less mysterious than doing so for stocks.
Indeed, expectations for bond returns over an extended period are reasonably
easy to establish. Again, Keynes' analysis helps, 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, over the long-run, since bonds have a fixed
maturity date, speculative return plays little role. Result: A remarkably
high proportion of the subsequent ten-year investment return of bonds
is explained simply by the current yield.
The reason for this relationship is not complicated: If interest rates
remain unchanged, the future return would be exactly equal to the current
yield to maturity. If rates rise, bond prices would fall, reducing the
return. But the higher reinvestment rate on each year's interest payment
would have a countervailing impact, increasing the return. (And vice
versa). In fact, the correlation between the initial yield and subsequent
ten-year return of bonds is a healthy 0.91. (Perfect correlation
would be 1.00.) For example, in 1980, the yield on an intermediate-term
U.S. Treasury bond was 12.4%; the return during the subsequent decade
was 12.5%. In 1990, the yield was 7.7%; the return in the following
ten years was 7.5%. Today, with the 10-year Treasury bond yield at about
4%, its return in the coming decade is highly likely to range between,
say, 3% and 5%. So we can be reasonably confident that we are looking
at future bond returns that are, like those of stocks, a pale imitation
of those we have enjoyed in recent decades.
In stocks and bonds alike, it appears likely that future returns of
both asset classes have returned to long-term historical norms. Indeed,
the evidence is compelling that when decade-long real stock returns
are inordinately high by historical standards, returns in subsequent
decades are likely to tumble; when past returns are exceptionally low,
future returns are apt to rise. What it's all about, it seems, is reversion
to the mean. But, again, we can never be sure when the reversion
will come.2 In any event, the sharp stock
market decline, combined with the steep fall in interest rates, also
suggests that we might expect a 3% or 4% equity risk premium, also quite
similar to the historical norm. Of course uncertainty, as ever, rules
the markets and our economy alike. But rational expectations are better
than the emotions of the day in deciding how to allocate our investment
assets between stocks and bonds.
Who Earns the Market Returns?
But whatever returns the financial markets are generous enough
to deliver, don't make the mistake of thinking investors actually earn
those returns. To explain why this is the case we need only to understand
the simple mathematics of investing: All investors as a group
must necessarily earn precisely the market return, but only before
the costs of investing are deducted. After these costs are taken
into accountall of the management fees, the transaction costs,
the distribution costs, the marketing costs, the operating costs, and
the hidden costs of financial intermediationthe returns of investors
mustand willfall short of the market return by an amount
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. 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 managers who would help investors
to beat the market, themselves constitute the reason that they as a
group are destined to fail at the task.
Consider the costs entailed in the ownership of equity mutual funds.
For the average fund, management fees and operating expenses, the "expense
ratio," comes to about 1.6% per year of fund assets. (1.3% if weighted
by fund assets, since larger funds typically have lower fees.) But the
expense ratio is hardly the only cost fund shareholders incur. Indeed,
when we add in sales charges, portfolio transaction costs, and opportunity
cost (funds are rarely fully invested), the total cost of equity fund
ownership roughly doubles, to at least 2½% per year.
Do costs matter? You bet they do! And they matter most in financial
instruments. Why? Because while much of the value of most consumer goods
is measured by intangibles such as taste and tone and prestige and image,
the value of financial products is measured almost entirely by
the most measurable of all assets, dollars. And costs matter
most in those financial instruments for which costs are (1) easily calculable,
(2) directly related to returns, and (3) compounded over time.
It should go without saying that the mutual fund is the paradigm of
How Much Do Costs Matter?
How much do costs matter? Let's look at an example: Since most
individual investors are at a young age when they start their programs
in an IRA or 401(k), they will still be investing, not only 50, but
even 60, years from now, let's see what toll a 2½% annual cost
would take on a 10% stock market return over a half century. When compounded
over 50 years, each $1000 earning the stock market return of 10% would
grow to $117,000. Each dollar in the fund, earning 7½% after
costs, would grow to $37,000an $80,000 dead-weight loss engendered
solely by reason of the costs of financial intermediation. Put
another way, the investor puts up 100% of the capital, takes 100% of
the risk, and receives 32% of the return. The intermediaries put up
0% of the capital, take 0% of the risk, and garner 68% of the return.
It just doesn't seem like a fair deal.
But the story gets worse. Intermediation costs are paid in current
dollars, while the investor's final capital must be measured in constant
dollars. Let's assume a future inflation rate of 2 ½%. Result:
Real annual return for the market, 7.5%; real return for
the fund investor, 5%. The final purchasing power of the initial $1,000
in the stock market falls to $37,000 in real terms, but to $11,000 in
the fund. Just as the growth of $1,000 to $37,000 demonstrates the magic
of compounding returns, so that reduction to $11,000 demonstrates
the tyranny of compounding costs.
But the fund industry's problems transcend these dismal economics.
Our industry's basic principles are being compromised. Fund managers
have moved away from being prudent guardians of their shareholders'
resources and toward being imprudent promoters of their own wares. We
have pandered to the public taste by bringing out new funds to capitalize
on each new market fad, and we have magnified the problem by heavily
advertising the returns earned by our hottest funds.
Fund Returns vs. Fund Investor Returns
The result of this powerful marketing is that mutual fund investors
have fared far worse than mutual funds themselves. They invested infinitely
more of their dollars in equity funds during the period immediately
preceding the peak of the stock market bubble than in earlier years
when values were at far more reasonable levels. What is more, they invested
the overwhelming portion of those dollars in technology funds and technology-oriented
growth funds (including internet funds!) rather than in value funds
which, bless them, both lagged as the bubble inflated and held fairly
steady as it burst. And now, after the fall, equity fund investors are
liquidating their holdings, month after month.
Early in 2001, an independent study showed that while the annual return
of the stock market itself averaged 16% per year during the 1984-2000
period, the return of the average mutual fund averaged 13%, about
the differential one would expect, given that fund costs amounted to
about 2 ½% to 3% per year. But, because of the market timing
and adverse selection issues I've just described, the annual return
of the average mutual fund investor averaged just 5%. Today,
the bear market has reduced that cumulative market return to
about 11%, and the return of the average mutual fund to about
8%. If the previous relationship holdsthe fund investor
lagging the fund return by 8%then the return of the average
fund investor, during this excellent (from point to point!) period for
stocks, was a mere break-even0%! It is not a record of which we
should be proud.
As our industry leaders accurately say, "the mutual fund industry
has never had a major scandal," and certainly nothing like those
we've seen among the corporate malefactors whom I've earlier described.
But it's surely arguable that the astonishing shortfall in return that
we've provided to our fund shareholders is itself scandalous. So we'd
best learn from this recent sorry era in corporate America and put our
own house in order.
That task must begin by honoring the principle set down in the very
first article of the Investment Company Act of 1940, which calls on
mutual funds to be "organized and managed . . . in the interests
of shareholders . . . (rather than) in the interests of investment advisers
and underwriters." Yet we have, I fear, honored that traditional
principle of fiduciary duty more in the breach than in the observance.
So we need, first, a change in attitude and a return to our founding
Second, we need to reduce management fees, little of which (perhaps
no more than 10%) are actually spent on investment management. By far
the largest portion of the fee goes straight to the owners of the management
companies themselves, who are rewarded with pre-tax profit margins in
the 40%-50% range. (It's a living!) We must also reduce costs by reducing
the substantial expense of portfolio turnover by, well, reducing that
inevitably unproductive turnover itself. This change would also serve
to move us toward how we ought to actas owners of stocksand
away from how we act nowas traders of stocksand doubtless
enhance the net returns of our funds as well. As real owners,
we would be forced to observe our responsibilities of corporate citizenship,
another vital step forward. These changes, I believe, will make mutual
funds a far better investment medium for our clients.
Six Rules of Investing
Let me close with a few ideas about what you should think about as
you look ahead, first as investors, and next as citizens. And here I'm
going to speak primarily to the young men and women in the audience.
While the frenzy of the financial markets creates a cacophonous daily
din, most of what happens each day is simply irrelevant to sensible
long-term investing. So as you think about your financial futures, let
me urge you to follow these six simple investment rules:
1. Own Stocks. Whatever returns stocks and bonds are generous
enough to provide over your lifetimes, the economics of capital formation
as well as the record of history give you as much certainty as is
available in this uncertain world that stocks will provide the higher
returns of the two. So for the accumulation of long-term wealth, the
simple magic of compounding calls for an important role for equities.
2. Never Ignore Risk. Stocks fluctuate, and widelya message
forgotten early in the recent era but now etched in our memories.
The boom and the bust were normaljust two more swings
in stock returns over the past century. Reversion to the mean is the
iron rule of the financial markets. By the accident of fate, as the
ten-year moving averages in the earlier chart show, you're beginning
your investment future with equities at far more reasonable values
than at the hyped-up values of a few years ago. You are a blessed
3. Invest Regularly. Dollar-averaging means you need not much
concern yourself with market swings. Indeed, you should hope stocks
remain at today's depressed levels for as long as you are investing,
and then soar as you retire, as one day you will. But, more likely,
you'll see, say, two long bull markets and two big bear markets during
your investment lifetimes. Get ready for them. Accept whatever happens,
and don't try to predict when. Keep economics in investing and
4. Sensible Asset Allocation. I believe you should make your
first investments largelyif not entirelyin stocks, but
only with money you won't need for a long time. As your age
and your assets increase, and the time to invest dwindles and the
time to spend approaches, gradually increase your bond position. (A
very rough rule of thumb: your bond percentage should equal
5. Diversify, Diversify, Diversify! Be sure to rely on widely-diversified
portfolios of both bonds and stocks, simply because the greater the
diversification, the lower the specific security (i.e. non-market)
risk. Market risk is quite large enough, thank you, but you
neither can, nor should, avoid it. So, minimize non-market risk, or
even eliminate it by using a market index fund.
6. Minimize Costs. Mutual funds are expensive, so is trading
individual stocks. Do your fishing in the low-cost-fund pond. Better
yet, invest largely in the lowest-cost all-market (bond or stock)
index fund you can find. It should assure that you will earn nearly
100% of the returns in the respective markets. And don't ignore tax
costs. Put every penny that you can into your IRA and your thrift
Together, these six rules should help you win the investment game.
It turns out that successful investing is about following common sense
principles, and avoiding the myriad potholes that lie along the road
of investing. You win by not losing. There may or may not be better
winning strategies than putting, say, 80% of your investments into an
equity index fund and 20% into a bond index fund when you begin investing
at age 25, gradually reducing the equity ratio over the years so it
is 30% when you're 70. But I can absolutely guarantee you that the number
of worse strategies is infinite. Infinite!
The Character of America
And now to your role as citizens. I began these remarks by telling
you of the idealism I held during my college days, and as I began my
career. I want to close by telling you that even a long career in the
competitive, dog-eat-dog, give-and-take of the mutual fund business
hasn't dimmed my idealism one jot. Indeed, I believe that today there
is even more idealism in my heart and soul than there was all those
51-plus years ago. At Vanguard, I did my best to create a company that
strived to live up to those ideals. While the industry has yet to emulate
them, I'm certain that moving in that direction is only a matter of
Please don't underrate the power of idealism. 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 I have absolutely
no doubt that character does countthe 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." Somehow, in our corporate
governance system at the outset of the 21st century, Smith's great ideal
has been lost in the shuffle.
As you read about the state of capitalism in America each day, I can't
imagine that you young citizens aren't thinking: "Wow! Our parents
and grandparents really screwed it all up!" And you're right.
The mutual fund industry today, charging ever higher costs, investing
as traders rather than owners, and focusing on salesmanship
rather than stewardship is not nearly as good an industry as
it used to be, nor as it could be. And Corporate America today still
has a long way to go to mend the damage done during the awful era that
I believe is at last coming to a close. What should have been "owners'
capitalism," where the idea is to serve the shareholder, was transmogrified
into "managers' capitalism," placing the personal enrichment
of executives as the highest priority.3
By ignoring their role in corporate governance, institutional investors
share considerable responsibility for this debasement of our capitalistic
system, and its high time we fixed it.
And don't you dare get discouraged. You have the opportunity
of a lifetimean opportunity to restore ethics, good practices,
and a touch of altruism to corporate behavior and mutual fund behavior
as well. What has been described as "a pathological mutation in
capitalism" must be reversed, and it is your generation's great
challenge to do so. So carry forward the ideals of your youth into the
vineyards of business and investing. Maintain your optimism about America
and the world. Never lose the exuberance of your college years for learning
and discovery. Have the courage to speak out for what you hold high.
Above all, in your approach to life and career alike, be tigers!
I'll try to help in any way that I can. For, at this stage of my life,
I feel like Ulysses must have felt after returning from his marvelous
. . . Come my friends,
'Tis not too late to seek a newer world.
Push off, and sitting well in order smite
The sounding furrows; for my purpose holds.
To sail beyond the sunset . . . 'til I die.
Tho much is taken, much abides, and 'tho
We are not now that strength which in old days
Moved earth and heaven, that which we are, we are;
One equal temper of heroic hearts,
Made weak by time and fate but strong in will
To strive, to seek, to find, and not to yield.4
1. Caution: Change in price/earnings
ratios are driven in part by changes in interest rates. After all, if
the risk-free Treasury bill rate drops from, say 5% to 3% over a decade,
it would seem logical that the earnings yield on stocks (the reciprocal
of the p/e ratio) might drop from, say 8% to 6%, leaving the equity
risk premium at 3%. (Such a 25% reduction in the earnings yield is the
equivalent of a 25% increase in the p/e ratio, from 12.5 times to 15.6
timesspread over a decade, it would account for an increase of
2.2% per year in stock prices.) But because the pattern has been so
erratic during the past centurythe correlation between earnings
yield and the risk-free rate was only 0.20%I have not incorporated
interest rates into my formula. Back
2. I've updated Chart 7 showing real (inflation-adjusted)
stock returns toreflect a possible 6% annual return over the coming
decade. If so, the moving average will decline to -2% in 2009, and gradually
rise to the 6% level in 2012. Back
3. Journalist William Pfaff, International Herald
Tribune, September 10, 2002. Back
4. Ulysses, by Alfred Lord Tennyson Back
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
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©2006 Bogle Financial Center. All Rights Reserved.