Monday, September 21, 2015

The Little Book of Common Sense Investing

The average return earned by stock investors (before expenses) must exactly equal the average return of the stock market. This is the “humble arithmetic” founder of Vanguard, John Bogle, writes about in The Little Book of Common Sense Investing. Collectively, we can’t be above average because we are the average. To be above average, you have to take money away from someone who ends up below average. However, stock trading is dominated by sharks looking to take your money.

Bogle’s simple advice is to give up trying to beat the professionals who dominate stock trading and just buy and hold broad-based index funds. The best index mutual funds and ETFs give you the market average returns at extremely low cost. To beat the market, you have to outsmart professional traders by enough to cover the much higher expenses of active investing. This is a fool’s errand for all but a few of the best investors. Even most professionals can’t succeed at this game.

So, why do we try? It seems to be human nature. Through selective memory we tend not to admit to ourselves that we fail at active investing. Bogle understands that we have a hard time accepting that simple index investing is the best approach for almost all of us. So, he looks at it from many angles and shoots down arguments for active investing.

In an attempt to make us accept market returns, Bogle says “the index fund is indeed the only investment that guarantees you will capture your fair share of the returns that business earns.” The message is simple. Don’t be greedy. Accept your fair share with indexing.

There are many ways investors seek to get around Bogle’s “humble arithmetic,” including finding winning fund managers. “Fund investors are confident that they can easily select superior fund managers. They are wrong.”

Bogle makes a strong case that a critical factor in fund selection is fees. He drives this home with a play on the “you get what you pay for” expression saying “We investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.”

“The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.” Even those who accept indexing as the right strategy often sell after market declines. It may seem counter-intuitive to just hold on through a crash, but most investors who try to avoid losses end up avoiding gains instead.

A quote from Jonathan Clements explains why we should think well of active investors. “We shouldn’t discourage fans of actively managed funds. With all their buying and selling, active investors ensure the market is reasonably efficient.” Active investors lose money so the rest of us can index.

Mutual funds report returns that are higher than the returns earned by their investors. This is because investors pile into last year’s winning fund only to be disappointed. So some funds perform well while they are small, and tend to perform poorly after swelling. In one extreme example from 1996 to 2002, a group of 10 funds had a net reported gain of 13%, but their investors lost 57%.

At one point, Bogle lost some of his patience with investors who are oblivious to costs. “Why would investors pay more than a 0.50 percent annual cost for a money market fund? The answer is beyond me. (They should probably have their heads examined.)” That bit in parentheses is Bogle’s, not mine.

Bogle isn’t much of a fan of ETFs because “Their use by long-term investors is minimal.” He allows that broad-based index ETFs can work well for long-term buy-and-hold investors, but the truth is that ETFs are traded hyperactively.

In a harsh quote, David Swensen, chief investment officer of Yale University, says “The mutual fund industry is a colossal failure.” This is a fair criticism given that a typical mutual fund’s fees consume more than half of investors’ money over a lifetime.

Recognizing that people just can’t stay away from active investing, Bogle allows that investors can carve off a small slice of their portfolios for some fun, “but not with one penny more than 5 percent of your investment assets.” He goes on to list what he thinks are acceptable ways to invest this 5%. He’s okay with individual stocks, actively managed mutual funds, ETFs, and commodity funds. But he says no to closet index funds (high-fee funds that are close to owning an index) and hedge funds.

“We know that neither beating the market nor successfully timing the market can be generalized without self-contraction. What may work for the few cannot work for the many.” We’d all like to think we’re the special flower who can beat the market, but in almost all cases, we’re not.

Bogle uses deceptively simple but relentless logic to demonstrate why indexing is the way to invest. Anyone with the active investing itch should read and understand this book before risking a single penny trying to beat the market.


    In The Little Book that Beats the Market—a New York Times bestseller with 300,000 copies in print—Greenblatt explained how investors can outperform the popular market averages by simply and systematically applying a formula that seeks out good businesses when they are available at bargain prices.

    1. @Anonymous: Bogle's "humble arithmetic" makes it clear that only a small minority of investors could succeed at outperforming the market this way, and most who try will fail and end up getting lower returns than the market for their trouble. I'll just stick to indexing.

    2. I tried Greenblatt's method for a few years and slightly lagged the market. Some of the stocks in his screen turned out to be frauds (hence the low price), some were manufacturers of fad products that had already peaked. My luck may have been poor, there seemed to be a lot of variability in returns among the stocks in the screen.

    3. @ MJ: Greenblatt's method is just another mechanical model that indexes based on undervaluation. Greenblatt is Bogle in a newer suit, but it's an index all the same.

    4. @Anonymous: If Greenblatt's method is mechanical and leads to very low turnover, then it could reasonably be called an index-type method similar to fundamental indexing. If the turnover is higher, then I'd just call it active investing -- no "index" label. However, I doubt Bogle would think much of the idea that "Greenblatt is Bogle in a newer suit." Bogle is no fan of fundamental indexing or any of its variants. Personally, I doubt whether investing based on undervaluation will lead to risk-adjusted market-beating returns, particularly after factoring the higher trading costs.

  2. I don't understand intuitively how most people lag the market. Shouldn't a decent stock picker who knows the pitfalls of buying high and selling low be able to beat the masses of people whose emotions cause big losses? If everyone is below average, then who is above? Surely not only the pros, who have their own foibles and short-term pressures to outperform every single quarter.

    1. @Gene: Good questions. First, we have to define "masses" correctly. The bulk of trading is done by professionals, over 90% by some estimates. So, the masses you are competing against are almost all pros, and the average return is almost the same as the average among pros.

      The number one reason active investors lag the market is costs. A 2% drag each year turns into a 40% drag after 25 years. Another reason is the distribution of returns. For every 10-bagger (a 900% return above the market average), there have to be 90 cases where investors trail the market by 10% to keep the average, well, average. There tend to be a few investors who do quite well by skill or luck, and a throng who are somewhat sub-par.

  3. Seems as though Beat The Market is once again making the rounds on PF blogs. Not sure why this is still even a topic as it really is as nonsensical as can be, and for high profile identities such as Bogle to keep it in the light does retail investors a disservice.

    There is so much wrong with Beat The Market that retail investors, everyone actually, needs to clear their heads of this meaningless concept. They would be much better off to focus on figuring out what rate of return they need/want and construct a portfolio to achieve that goal.

    1. @SST: I haven't read "Best the Market" but I agree with you that the vast majority of investors should not be trying to beat the market. Just to be clear, there was no mention of this other book in the Bogle book I reviewed in this post. This other book was mentioned by a commenter.

    2. Michael, sorry to confuse. BTM is not a publication (as far as I know), but a personal finance concept brought up, once again, in Bogle's book and the original article, e.g. " and understand this book before risking a single penny trying to beat the market."

      It is a near-hollow theory (on many fronts) and I'm not sure why it still lingers. I guess financial sector people such as Bogle need something to market to keep their product/business alive.

    3. @SST: The concept of beating the market isn't just lingering; it's what almost all investors are trying to do, from pros to amateur stock pickers to fund pickers to financial advisor shoppers. I see Bogle as one of the first (and still few) voices telling investors to stop trying to beat the market. If these voices of reason go quiet, the idea of beating the market won't go away; it will just continue to dominate by even more than it does now.

  4. The issue I have with Bogle* et al is their approach to kill BTM, they simply say "You'll never do it so stop trying and buy an index fund. Period!".

    The popular "voices of reason" never go to any length to educate the retail investor as to WHAT exactly "The Market" is and WHY it is almost completely irrelevant. Without this root knowledge, the BTM weed just keeps growing every time they think they've squashed it with yet another "common sense" rant. If investors understood that the supposed link between their money and "The Market" is irrational, they might just cease some of their irrational behaviour.

    Merely telling people not to do something only reinforces the desire to do just that thing. Investor education falls short once again.

    *(there's a conflict of interest with Bogle telling us we can't BTM so we should just buy an index fund and forget about it. Index funds are his business, so his advice is basically a sales pitch, albeit good intentioned. I think he truly does want the best for investors, but business is business.)

    1. @SST: I have to disagree with much of what you've said. The market is not irrelevant; it is the sum total of all stocks in a country. I don't think the beat-the-market "weed" has much to do with people's idea about what "market" means. People seem driven to try to make more money than the next guy. Bogle has more money than he'll ever spend. He says what he believes. I see no reason to fear a conflict of interest with him.

    2. Actually, Bogle said that he gets no penny if we purchase mutual funds or ETFs from Vanguard. I believe him.

  5. SST, Bogle advises investors to buy the market (index funds) because that's what the evidence in the financial literature shows gives better results than stock picking and timing the market. You could call that activity trying to beat or equal the market, but there is a price to pay for investing that way.

  6. 'Bogle isn’t much of a fan of ETFs because “Their use by long-term investors is minimal.” '

    Eh? That's a bit of a clanger. Where would he get that idea?

    1. @Anonymous: Serious indexers in Canada prefer ETFs because they are so much cheaper than the index mutual funds we have available to us. But, Americans indexers have some great low-cost mutual funds available.

      Even the best broad-market index ETFs in the U.S. are hyper-actively traded. Bogle had some stats to back up his claim. Most holders of index ETFs in the U.S. are very short-term holders.

      I don't worry about all this for my own portfolio. I own low-cost index ETFs in Canada and the U.S. and plan to hold until I need the money.

    2. Bogle was specifically talking about ETFs that track a sector or a commodity. These ETFs he doesn't like due to constant trading; it is similar to how you'd trade a stock where you're gambling.

    3. @R: It's true that Bogle had deeper criticisms of narrower ETFs, but he was also wary of what I consider the best ETFs because they get traded so heavily. Even VTI won't help an investor who turns it over multiple times per year.

  7. re: "The market is not irrelevant; it is the sum total of all stocks in a country."

    Great example of investor dis-education and why "The Market" is mostly irrelevant to the individual retail investor. Within Canada, which market should be my benchmark? The TSE? Venture? The CSE? And why am I investing only in Canadian stocks?

    As a modern investor, I face exceptionally few trade borders, thus "The market is...the sum total of all stocks in a country" is an incorrect statement. Using that definition, I merely have to invest in a different market in order to beat the market.

    The article quotes Bogle as saying, "The winning formula for success in investing is owning the entire stock market...". There are roughly 50,000+ listed companies world wide -- THAT is "The Market". Do you own them ALL?

    Not only that, but 'winning' and 'success', by definition means 'to beat'; since you won't beat the market, are we to use other investors as our benchmark for success? Perhaps it's just the USA-centric viewpoint of old, white American financiers to consider "The Market" to be ONLY the S&P 500. Invest in 1% of available stocks? Seems like exceptionally active stock picking to me. But what do I know, I don't even try to "Beat The Market" (whatever that means).

    How does an investor choose the correct market as a benchmark for their portfolio?
    What if their portfolio isn't 100% public equity, should they simply eschew a total return approach and just compare all against stocks?

    The only way to beat the market is not to invest in the market, that is, to deviate from exact market replication, either through weight or concentration/omission. But once you deviate, is "The Market" still the most appropriate benchmark? Perhaps someone needs to develop a standard deviation for benchmarking.

    And what time span should an investor use to gauge benchmark returns? 1-5-10 years? Thirty or even sixty years? Surely a 90 or 150 year average return measurement is completely useless. Only your first dollar will be invested "for the long run", every subsequent dollar is going to have a shorter market life. Hoping for that warm 10%/yr? Good luck, the go-to "Market", the S&P 500, has handed out negative returns (aka you lost money) for 1/3 of its duration. Better hope you are born like Buffett, in the right place at the right time!

    "The Market" is an impractical theory for the retail investor. Investing in ALL markets will give you a base line risk and return (which might not match your personal risk profile, so do you still invest?); deviate from that and there will always be a market beating yours (e.g. ASX vs S&P). Thus, an investor's only true benchmark is their own desired rate of return and risk.

    On a more abstract point, there is really no way for any investor -- especially the average retail investor -- to beat the market on a total return basis. This is because our real return is on our human capital asset (aka job) and stock purchases are only a fraction of the resultant. Ask for a raise if you want to truly beat the market.

    re: "People seem driven to try to make more money than the next guy."
    Are you saying Bogle isn't a Capitalistic human? He's spent his life working in the financial sector, of course he's driven to try to make more money than the next guy!

    re: "Bogle has more money than he'll ever spend. He says what he believes."
    Bill Gates has a lot of money, too, doesn't stop him from trying to sell as much Microsoft product as possible and saying what he believes (and being hyper-altruistic) at the same time.

    Thanks for the space to let me ramble; mistakes aplenty, I'm sure. :)

    1. @SST: It's true that "the market" doesn't mean the same thing in all contexts, but it is still a crucial concept for active investors. If you choose among Canadian stocks, then the TSX is a good "market" to compare your returns. If you choose among large American stocks, then the S&P 500 is an appropriate market. Back when I was picking stocks, I used a blend of Canadian and US indexes as my benchmark market. It's certainly possible to go shopping for a market to make your track record look good. People who do this are either fooling themselves or trying to fool others.

  8. Good review Michael. I read the book maybe 18 months ago.

    I'm glad I saw the light some time even before that.

  9. re: " "The Market" almost completely irrelevant. [Investors] would be much better off to focus on figuring out what rate of return they need/want and construct a portfolio to achieve that goal." - SST

    And interesting find:
    Desired return vs. required return
    ( )

    "...a return objective or benchmark that has been selected based on external factors or influences, rather than those specific to clients' stated objectives and erroneous, but it is also irrelevant."

    Bogle should expand his scope of common sense education like this Vangaurd employee.

    1. @SST: The article you point to is saying that stock indexes are not relevant to the bond portion of portfolios. It makes no sense to use just the S&P 500 as a benchmark for your portfolio if it is half bonds. However, stock indexes are very relevant to the stock portion of portfolios.