Introduction

I have dedicated my longcareer to building a better financial world for investors. Whether it was creating the nation's only truly mutual mutual fund company or creatingthe index fund, I've done my utmost to keep the best interests of investors as my chief priority. I've now written 10 books covering a wide range of topics-attempts to help individual investors make sense of the financial markets, the creation of The Vanguard Group, the failures of our nation's financial system, and the wisdom of long-term investment and the folly of short-term speculation. But the theme of fiduciary duty to investors-the idea that the client's interests must always come first-has been at the heart of all of my books, and the three included in this e-Book bundle are no exception. Why bundle these three books together? The Little Book of Common Sense Investing provides a simple, straightforward approach to investing; Common Sense on Mutual Funds is more complex, but reinforces many of the same themes; and Don't Count on It! puts those themes in a broader context while giving the reader the ability to browse through a variety of speeches on different topics.

The Little Book of Common Sense Investing

We know that in every investment transaction, there is a winner and a loser.One party is (relatively) enriched, while the other is (relatively) impoverished.But the financial intermediaries in the middle-the croupiers, as it were-take their share of every trade.So, in aggregate, investing is a zero-sumgame before costs, but it is a loser's game after costs. The only way to guarantee your fair share of the market's return is to minimize costs and own the entire market, thereby diversifying away the risks associated with individual stocks, sectors, and styles.

Clearly, low-cost, broad-market index funds are the easiest and most efficient way to implement this strategy. They take full advantage of the magic of compounding returns by keeping intermediation costs at rock-bottom, thereby avoiding the tyranny of compounding costs. These ideas are at the heart of my 2007 book,The Little Book of Common Sense Investing.In it, I attempt to explain the workings of the financial system in a way that will transform how readers approach investing. Those investors who leave the financial casino and opt for broadly diversified, long-term, low-cost index funds are virtually guaranteed to receive their fair share of the market's returns.By minimizing the drag caused by unnecessary intermediation costs and diversifying away uncompensated risks, we allow the productive power of our nation's economy to work its magic in gradually building the intrinsic value of our investments.

Common Sense on Mutual Funds-Fully Updated 10thAnniversary Edition

The first edition of Common Sense on Mutual Funds was published in 1999.In that original book, my primary goal was to help readers become more successful investors. I'd like to think that I largely achieved that goal. The fundamentals of investing that I set forth have been confirmed-and then some. The keys to investment success that I outlined-focusing on low-cost, broadly diversified index funds as the core of your portfolio, making intelligent asset allocation decisions, keeping it simple, understanding that the intrinsic value of corporate business drives investment success over the long term-remain true today. Well into the future, these "relentless rules of humble arithmetic" are bound to hold true.

In this fully updated and revised edition of Common Sense on Mutual Funds, I had the audacity to leave the text of the original 1999 edition essentially untouched, and brought it up to date with refreshed data and additional commentary throughout. The rules I offered in the original had been surely reaffirmed, even though it was written near the stock market's high in 2000 and the new edition was penned shortly after the market's low in 2009. Assets managed by the mutual fund industry now exceed $12 trillion and the industry has become the dominant vehicle for individual investors and those saving for retirement. But the old rules of long-term prudent investing remain intact.

My secondarygoal was to make the mutual fund industry a better place for investors. Alas, that goalremains out of reach. We've seen marketing and salesmanship continue to dominate stewardship. We've seen fiduciary duty too often ignored.And our nation's corporate governance structure continues to serve the interests of corporate managers and investment managers, rather than investors.The rules for investment success remain clear, and I am confident that, in the long-run, the interests of investors will again be paramount. For, as Winston Churchill reminds us, Americans always do the right thing, "but only after they've tried everything else."

Don't Count on It!

As the fiduciary principles on which the mutual fund industry was founded have eroded, we moved from a professional culture focused on the interests of investors to a business culture in which the "bottom line" is all that matters. In today's bottom line society, too often we seek the wrong bottom line: money over achievement, form over substance, charisma over character, prestige over virtue, the ephemeral over the enduring. I explore these topics in my 2011 anthology Don't Count on It!I also explore the shortcomings of the mutual fund industry, the proven success of indexing, my views on entrepreneurship and idealism, and tributes to four of my personal heroes and mentors. The book is a collection of 35 speeches and essays that I've written over the years.While it may seem intimidating, the book gives browsers the ability to seek out those areas in which they have a particular interest.

Our society's focus on and trust in numbers, with little regard to how easy they are to manipulate, is a common theme throughout the book. Far too often, we focus on momentary, fleeting stock prices-which can be measured precisely-rather than durable, intrinsic value-which is as real as it is difficult to measure. I'm reminded of Einstein's observation that "Not everything that counts can be counted, and not everything that can be counted counts." I describe the catastrophic consequences that occur when we place too much emphasis on these illusory numbers and let ourselves be fooled into thinking that past market returns are prologue; that mutual funds, on average, can be above average; and that corporate financial reports actually represent economic reality.

Timeless Wisdom

The themes expressed in these three books are timeless. They were critical when I first wrote them, they are still critical today, and they will remain critical tomorrow and well into the future. The importance of observing fiduciary duty, putting the interests of clients first, and the fundamental soundness of indexing are the foundation upon which I've built my career. As Confucius said, "By three methods may we learn wisdom.First, by reflection, which is noblest; second, by imitation, which is easiest; and third, by experience, which is bitterest." Let us not forget the wisdom we have gained through the bitter experience of recent years, for only then can we set our financial system and our society in general on a path to continued prosperity.

Contents

Table of Contents

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Little Book Big Profits Series

In the Little Book Big Profits series, the brightest icons in the financial world write on topics that range from tried-and-true investment strategies we’ve come to appreciate to tomorrow’s new trends.

Books in the Little Book Big Profits series include:

The Little Book That Beats the Market, where Joel Greenblatt, founder and managing partner at Gotham Capital, reveals a “magic formula” that is easy to use and makes buying good companies at bargain prices automatic, giving you the opportunity to beat the market and professional managers by a wide margin.

The Little Book of Value Investing, where Christopher Browne, managing director of Tweedy, Browne Company, LLC, the oldest value investing firm on Wall Street, simply and succinctly explains how value investing, one of the most effective investment strategies ever created, works, and shows you how it can be applied globally.

The Little Book of Common Sense Investing, where Vanguard Group founder John C. Bogle shares his own time-tested philosophies, lessons, and personal anecdotes to explain why outperforming the market is an investor illusion, and how the simplest of investment strategies—indexing—can deliver the greatest return to the greatest number of investors.

To Paul A. Samuelson, professor of economics at Massachusetts Institute of Technology, Nobel Laureate, investment sage. In 1948 when I was a student at Princeton University, his classic textbook introduced me to economics. In 1974, his writings reignited my interest in market indexing as an investment strategy. In 1976, his Newsweek column applauded my creation of the world’s first index mutual fund. In 1993, he wrote the foreword to my first book, and in 1999 he provided a powerful endorsement for my second. Now in his ninety-second year, he remains my mentor, my inspiration, my shining light.

Introduction

Don’t Allow a Winner’s Game to Become a Loser’s Game.

SUCCESSFUL INVESTING IS ALL about common sense. As the Oracle has said, it is simple, but it is not easy. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return that they generate in the form of dividends and earnings growth.

The best way to implement this strategy is indeed simple: Buying a fund that holds this market portfolio, and holding it forever. Such a fund is called an index fund. The index fund is simply a basket (portfolio) that holds many, many eggs (stocks) designed to mimic the overall performance of any financial market or market sector. Classic index funds, by definition, basically represent the entire stock market basket, not just a few scattered eggs. Such funds eliminate the risk of individual stocks, the risk of market sectors, and the risk of manager selection, with only stock market risk remaining (which is quite large enough, thank you). Index funds make up for their short-term lack of excitement by their truly exciting long-term productivity.

Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.

This is much more than a book about index funds. It is a book that is determined to change the very way that you think about investing. For when you understand how our financial markets actually work, you will see that the index fund is indeed the only investment that guarantees you will capture your fair share of the returns that business earns. Thanks to the miracle of compounding, the accumulations of wealth over the years generated by those returns have been little short of fantastic.

I’m speaking here about the classic index fund, one that is broadly diversified, holding all (or almost all) of its share of the $15 trillion capitalization of the U.S. stock market, operating with minimal expenses and without advisory fees, with tiny portfolio turnover, and with high tax efficiency. The index fund simply owns corporate America, buying an interest in each stock in the stock market in proportion to its market capitalization and then holding it forever.

Please don’t underestimate the power of compounding the generous returns earned by our businesses. Over the past century, our corporations have earned a return on their capital of 9.5 percent per year. Compounded at that rate over a decade, each $1 initially invested grows to $2.48; over two decades, $6.14; over three decades, $15.22; over four decades, $37.72, and over five decades, $93.48. The magic of compounding is little short of a miracle. Simply put, thanks to the growth, productivity, resourcefulness, and innovation of our corporations, capitalism creates wealth, a positive-sum game for its owners. Investing in equities is a winner’s game.

The returns earned by business are ultimately translated into the returns earned by the stock market. I have no way of knowing what share of these returns you have earned in the past. But academic studies suggest that if you are a typical investor in individual stocks, your returns have probably lagged the market by about 2.5 percentage points per year. Applying that figure to the annual return of 12 percent earned over the past 25 years by the Standard & Poor’s 500 Stock Index, your annual return has been less than 10 percent. Result: your slice of the market pie, as it were, has been less than 80 percent. In addition, as explained in Chapter 5, if you are a typical investor in mutual funds, you’ve done even worse.

If you don’t believe that is what most investors experience, please think for a moment, about the relentless rules of humble arithmetic. These iron rules define the game. As investors, all of us as a group earn the stock market’s return. As a group—I hope you’re sitting down for this astonishing revelation—we are average. Each extra return that one of us earns means that another of our fellow investors suffers a return shortfall of precisely the same dimension. Before the deduction of the costs of investing, beating the stock market is a zero-sum game.

But the costs of playing the investment game both reduce the gains of the winners and increases the losses of the losers. So who wins? You know who wins. The man in the middle (actually, the men and women in the middle, the brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system) is the only sure winner in the game of investing. Our financial croupiers always win. In the casino, the house always wins. In horse racing, the track always wins. In the powerball lottery, the state always wins. Investing is no different. After the deduction of the costs of investing, beating the stock market is a loser’s game.

Yes, after the costs of financial intermediation—all those brokerage commissions, portfolio transaction costs, and fund operating expenses; all those investment management fees; all those advertising dollars and all those marketing schemes; and all those legal costs and custodial fees that we pay, day after day and year after year—beating the market is inevitably a game for losers. No matter how many books are published and promoted purporting to show how easy it is to win, investors fall short. Indeed, when we add the costs of these self-help investment books into the equation, it becomes even more of a loser’s game.

Don’t allow a winner’s game to become a loser’s game.

The wonderful magic of compounding returns that is reflected in the long-term productivity of American business, then, is translated into equally wonderful returns in the stock market. But those returns are overwhelmed by the powerful tyranny of compounding the costs of investing. For those who choose to play the game, the odds in favor of the successful achievement of superior returns are terrible. Simply playing the game consigns the average investor to a woeful shortfall to the returns generated by the stock market over the long term.

Most investors in stocks think that they can avoid the pitfalls of investing by due diligence and knowledge, trading stocks with alacrity to stay one step ahead of the game. But while the investors who trade the least have a fighting chance of capturing the market’s return, those who trade the most are doomed to failure. An academic study showed that the most active one-fifth of all stock traders turned their portfolios over at the rate of more than 21 percent per month. While they earned the market return of 17.9 percent per year during the period 1990 to 1996, they incurred trading costs of about 6.5 percent, leaving them with an annual return of but 11.4 percent, only two-thirds of the return in that strong market upsurge.

Fund investors are confident that they can easily select superior fund managers. They are wrong.

Mutual fund investors, too, have inflated ideas of their own omniscience. They pick funds based on the recent performance superiority of fund managers, or even their long-term superiority, and hire advisers to help them do the same thing. But, the advisers do it with even less success (see Chapters 8, 9, and 10). Oblivious of the toll taken by costs, fund investors willingly pay heavy sales loads and incur excessive fund fees and expenses, and are unknowingly subjected to the substantial but hidden transaction costs incurred by funds as a result of their hyperactive portfolio turnover. Fund investors are confident that they can easily select superior fund managers. They are wrong.

Contrarily, for those who invest and then drop out of the game and never pay a single unnecessary cost, the odds in favor of success are awesome. Why? Simply because they own businesses, and businesses as a group earn substantial returns on their capital and pay out dividends to their owners. Yes, many individual companies fail. Firms with flawed ideas and rigid strategies and weak managements ultimately fall victim to the creative destruction that is the hallmark of competitive capitalism, only to be succeeded by others. But in the aggregate, businesses grow with the long-term growth of our vibrant economy.

This book will tell you why you should stop contributing to the croupiers of the financial markets, who rake in something like $400 billion each year from you and your fellow investors. It will also tell you how easy it is to do just that: simply buy the entire stock market. Then, once you have bought your stocks, get out of the casino and stay out. Just hold the market portfolio forever. And that’s what the index fund does.

This investment philosophy is not only simple and elegant. The arithmetic on which it is based is irrefutable. But it is not easy to follow its discipline. So long as we investors accept the status quo of today’s crazy-quilt financial market system; so long as we enjoy the excitement (however costly) of buying and selling stocks; so long as we fail to realize that there is a better way, such a philosophy will seem counterintuitive. But I ask you to carefully consider the impassioned message of this little book. When you do, you, too, will want to join the revolution and invest in a new, more economical, more efficient, even more honest way, a more productive way that will put your own interest first.

It may seem farfetched for me to hope that any single little book could ignite the spark of a revolution in investing. New ideas that fly in the face of the conventional wisdom of the day are always greeted with doubt, scorn, and even fear. Indeed, 230 years ago the same challenge was faced by Thomas Paine, whose 1776 tract Common Sense helped spark the American Revolution. Here is what Tom Paine wrote:

Perhaps the sentiments contained in the following pages are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason.

In the following pages, I offer nothing more than simple facts, plain arguments, and common sense; and have no other preliminaries to settle with the reader, than that he will divest himself of prejudice and prepossession, and suffer his reason and his feelings to determine for themselves; that he will put on, or rather that he will not put off, the true character of a man, and generously enlarge his views beyond the present day.

As we now know, Thomas Paine’s powerful and articulate arguments carried the day. The American Revolution led to our Constitution, which to this day defines the responsibility of our government, our citizens, and the fabric of our society. Inspired by his words, I titled my 1999 book Common Sense on Mutual Funds, and asked investors to divest themselves of prejudice and to generously enlarge their views beyond the present day. In this new book, I reiterate that proposition.

If I “could only explain things to enough people, carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone would see, and then everything would be fixed.”

In Common Sense on Mutual Funds, I also applied to my idealistic self these words of the late journalist Michael Kelly: “The driving dream (of the idealist) is that if he could only explain things to enough people, carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone would see, and then everything would be fixed.” This book is my attempt to explain the financial system to as many of you who will listen carefully enough, thoroughly enough, and thoughtfully enough so that you will see, and it will be fixed. Or at least that your own participation in it will be fixed.

Some may suggest that, as the creator both of Vanguard in 1974 and of the world’s first index mutual fund in 1975, I have a vested interest in persuading you of my views. Of course I do! But not because it enriches me to do so. It doesn’t earn me a penny. Rather, I want to persuade you because the very elements that formed Vanguard’s foundation all those years ago—all those values and structures and strategies—will enrich you.

In the early years of indexing, my voice was a lonely one. But there were a few other thoughtful and respected believers whose ideas inspired me to carry on my mission. Today, many of the wisest and most successful investors endorse the index fund concept, and among academics, the acceptance is close to universal. But don’t take my word for it. Listen to these independent experts with no axe to grind except for the truth about investing. You’ll hear from some of them at the end of each chapter.

Listen, for example, to this endorsement by Paul A. Samuelson, Nobel Laureate and professor of economics at Massachusetts Institute of Technology, to whom this book is dedicated: “Bogle’s reasoned precepts can enable a few million of us savers to become in twenty years the envy of our suburban neighbors—while at the same time we have slept well in these eventful times.”

Put another way, in the words of the Shaker hymn, “Tis the gift to be simple, tis the gift to be free, tis the gift to come down where we ought to be.” Adapting this message to investing by simply owning an index fund, you will be free of almost all of the excessive costs of our financial system, and will receive, when it comes time to draw on the savings you have accumulated, the gift of coming down just where you ought to be.

The financial system, alas, won’t be fixed for a long time. But the glacial nature of that change doesn’t prevent you from looking after your self-interest. You don’t need to participate in its expensive foolishness. If you choose to play the winner’s game of owning businesses and refrain from playing the loser’s game of trying to beat the market, you can begin the task simply by using your own common sense, understanding the system, and investing in accordance with the only principles that will eliminate substantially all of its excessive costs. Then, at last, whatever returns our businesses may be generous enough to deliver in the years ahead, reflected as they will be in our stock and bond markets, you will be guaranteed to earn your fair share. When you understand these realities, you’ll see that it’s all about common sense.

JOHN C. BOGLE

Valley Forge, Pennsylvania
January 5, 2007

Don’t Take My Word for It

Charles T. Munger, Warren Buffett’s partner at Berkshire Hathaway, puts it this way: “The general systems of money management [today] require people to pretend to do something they can’t do and like something they don’t. [It’s] a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That’s the way it has to work. Mutual funds charge two percent per year and then brokers switch people between funds, costing another three to four percentage points. The poor guy in the general public is getting a terrible product from the professionals. I think it’s disgusting. It’s much better to be part of a system that delivers value to the people who buy the product.”

William Bernstein, investment adviser (and neurologist), and author of The Four Pillars of Investing, says: “It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem—buy a well-run index fund and own the whole market.”

Here’s how the Economist of London puts it: “The truth is that, for the most part, fund managers have offered extremely poor value for money. Their records of outperformance are almost always followed by stretches of underperformance. Over long periods of time, hardly any fund managers have beaten the market averages. They encourage investors, rather than spread their risks wisely or seek the best match for their future liabilities, to put their money into the most modish assets going, often just when they become overvalued. And all the while they charge their clients big fees for the privilege of losing their money. . . . (One) specific lesson . . . is the merits of indexed investing . . . you will almost never find a fund manager who can repeatedly beat the market. It is better to invest in an indexed fund that promises a market return but with significantly lower fees.”

The Little Book readers interested in reviewing the original sources for the “Don’t Take My Word for It” quotes, found at the end of each chapter, and other quotes in the main text, can find them on my website: . I wouldn’t dream of consuming valuable pages in this book with a weighty bibliography, so please don’t hesitate to visit my website. It’s really amazing that so many giants of academe and many of the world’s greatest investors, known for beating the market, confirm and applaud the virtues of index investing. May their common sense, perhaps even more than my own, make you all wiser investors.

Chapter One

A Parable

The Gotrocks Family

 

 

 

 

EVEN BEFORE YOU THINK about “index funds”—in their most basic form, mutual funds that simply buy all the stocks in the U.S. stock market and hold them forever—you must understand how the stock market actually works. Perhaps this homely parable—my version of a story told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 Annual Report—will clarify the foolishness and counterproductivity of our vast and complex financial market system.

Once upon a Time . . .

A wealthy family named the Gotrocks, grown over the generations to include thousands of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game.

But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members and to buy some shares of others from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members.

To their surprise, however, the family wealth begins to grow at a slower pace. Why? Because some of the return is now consumed by the Helpers, and the family’s share of the generous pie that U.S. industry bakes each year—all those dividends paid, all those earnings reinvested in the business—100 percent at the outset, starts to decline, simply because some of the return is now consumed by the Helpers.

To make matters worse, while the family had always paid taxes on their dividends, some of the members are now also paying taxes on the capital gains they realize from their stock-swapping back and forth, further diminishing the family’s total wealth.

The smart cousins quickly realize that their plan has actually diminished the rate of growth in the family’s wealth. They recognize that their foray into stock-picking has been a failure and conclude that they need professional assistance, the better to pick the right stocks for themselves. So they hire stock-picking experts—more Helpers!—to gain an advantage. These money managers charge a fee for their services. So when the family appraises its wealth a year later, it finds that its share of the pie has diminished even further.

To make matters still worse, the new managers feel compelled to earn their keep by trading the family’s stocks at feverish levels of activity, not only increasing the brokerage commissions paid to the first set of Helpers, but running up the tax bill as well. Now the family’s earlier 100 percent share of the dividend and earnings pie is further diminished.

“Well, we failed to pick good stocks for ourselves, and when that didn’t work, we also failed to pick managers who could do so,” the smart cousins say. “What shall we do?” Undeterred by their two previous failures, they decide to hire still more Helpers. They retain the best investment consultants and financial planners they can find to advise them on how to select the right managers, who will then surely pick the right stocks. The consultants, of course, tell them they can do exactly that. “Just pay us a fee for our services,” the new Helpers assure the cousins, “and all will be well.” Alas, the family’s share of the pie tumbles once again.

Get rid of all your Helpers. Then our family will again reap 100 percent of the pie that Corporate America bakes for us.

Alarmed at last, the family sits down together and takes stock of the events that have transpired since some of them began to try to outsmart the others. “How is it,” they ask, “that our original 100 percent share of the pie—made up each year of all those dividends and earnings—has dwindled to just 60 percent?” Their wisest member, a sage old uncle, softly responds: “All that money you’ve paid to those Helpers and all those unnecessary extra taxes you’re paying come directly out of our family’s total earnings and dividends. Go back to square one, and do so immediately. Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultants. Then our family will again reap 100 percent of however large a pie that corporate America bakes for us, year after year.”

They followed the old uncle’s wise advice, returning to their original passive but productive strategy, holding all the stocks of corporate America, and standing pat. That is exactly what an index fund does.

. . . and the Gotrocks Family Lived Happily Ever After

Adding a fourth law to Sir Isaac Newton’s three laws of motion, the inimitable Warren Buffett puts the moral of the story this way: For investors as a whole, returns decrease as motion increases.

Accurate as that cryptic statement is, I would add that the parable reflects the profound conflict of interest between those who work in the investment business and those who invest in stocks and bonds. The way to wealth for those in the business is to persuade their clients, “Don’t just stand there. Do something.” But the way to wealth for their clients in the aggregate is to follow the opposite maxim: “Don’t do something. Just stand there.” For that is the only way to avoid playing the loser’s game of trying to beat the market. When any business is conducted in a way that directly defies the interests of its clients in the aggregate, it is only a matter of time until change comes.

The moral of the story, then, is that successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s—and, for that matter, the world’s—corporations. The higher the level of their investment activity, the greater the cost of financial intermediation and taxes, the less the net return that the business owners as a group receive. The lower the costs that investors as a group incur, the higher rewards that they reap. So to realize the winning returns generated by businesses over the long term, the intelligent investor will minimize to the bare bones the costs of financial intermediation. That’s what common sense tells us. That’s what indexing is all about. And that’s what this book is all about.

Don’t Take My Word for It

Listen to Jack R. Meyer, former president of Harvard Management Company, the remarkably successful wizard who tripled the Harvard endowment fund from $8 billion to $27 billion. Here’s what he had to say in a 2004 Business Week interview: “The investment business is a giant scam. Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value.” When asked if private investors can draw any lessons from what Harvard does, Mr. Meyer responded, “Yes. First, get diversified. Come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low. That means avoiding the most hyped but expensive funds, in favor of low-cost index funds. And finally, invest for the long term. [Investors] should simply have index funds to keep their fees low and their taxes down. No doubt about it.”

In terms that are a bit more academic, Princeton professor Burton G. Malkiel, author of A Random Walk Down Wall Street, expresses these views: “Index funds have regularly produced rates of return exceeding those of active managers by close to 2 percentage points. Active management as a whole cannot achieve gross returns exceeding the market as a while and therefore they must, on average, underperform the indexes by the amount of these expense and transaction costs disadvantages.

“Experience conclusively shows that index-fund buyers are likely to obtain results exceeding those of the typical fund manager, whose large advisory fees and substantial portfolio turnover tend to reduce investment yields. Many people will find the guarantee of playing the stock-market game at par every round a very attractive one. The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense.”

Chapter Two

Rational Exuberance

Business Reality Trumps Market Expectations.

 

 

 

 

THAT WONDERFUL PARABLE ABOUT the Gotrocks family in Chapter 1 brings home the central reality of investing: “The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns,” in the words of Warren Buffett. Illustrating the point with Berkshire Hathaway, the publicly owned investment company he has run for 40 years, Buffett says, “When the stock temporarily overperforms or underperforms the business, a limited number of shareholders—either sellers or buyers—receive out-sized benefits at the expense of those they trade with. [But] over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company.”

“Over time, the aggregate gains made by shareholders must of necessity match the business gains of the company.”

How often investors lose sight of that eternal principle! Yet the record is clear. History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense?

Need proof? Just look at the record since the twentieth century began (). The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year arose from what I call speculative return. Depending on how one looks at it, it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the period than at the beginning.

Investment Return versus Market Return—Growth of $1, 1900 - 2005

Compounding these returns over 106 years produced accumulations that are truly staggering. Each dollar initially invested in 1900 at an investment return of 9.5 percent grew by the close of 2005 to $15,062. Sure, few (if any) of us have 106 years in us, but, like the Gotrocks family over the generations, the miracle of compounding returns is little short of amazing—it is perhaps the ultimate winner’s game.

As makes clear, there are bumps along the way in the investment returns earned by our business corporations. Sometimes, as in the Great Depression of the early 1930s, these bumps are large. But we get over them. So, if you stand back from the chart and squint your eyes, the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.

Stock market returns sometimes get well ahead of business fundamentals (as in the late 1920s, the early 1970s, the late 1990s). But it has been only a matter of time until, as if drawn by a magnet, they soon return, although often only after falling well behind for a time (as in the mid-1940s, the late 1970s, the 2003 market lows).

In our foolish focus on the short-term stock market distractions of the moment, we, too, often overlook this long history. We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely because of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing.

We can measure these emotions by the price/earnings (P/E) ratio, which measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall. When greed holds sway, we see very high P/Es. When hope prevails, P/Es are moderate. When fear is in the saddle, P/Es are very low. Back and forth, over and over again, swings in the emotions of investors momentarily derail the steady long-range upward trend in the economics of investing.

“It is dangerous . . . to apply to the future inductive arguments based on past experience.”

What shows is that while the prices we pay for stocks often lose touch with the reality of corporate values, in the long run, reality rules. So, while investors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock return component are a deeply flawed guide to what lies ahead. To understand why past returns do not foretell the future, we need only heed the words of the great British economist John Maynard Keynes, written 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 if we can distinguish the reasons the past was what it was, then, we can establish reasonable expectations about the future. Keynes helped us make this distinction by pointing out that the state of long-term expectation for stocks 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 55 years ago I incorporated them in my senior thesis at Princeton, written (providentially for my lifetime career that followed) on the mutual fund industry. It was entitled, “The Economic Role of the Investment Company.”

This dual nature of returns is reflected when we look at stock market returns over the decades. Using Keynes’s idea, I divide stock market returns into two parts: (1) Investment Return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth, which together form the essence of what we call “intrinsic value”; and (2) Speculative Return, the impact of changing price/earnings multiples on stock prices.

Let’s begin with investment returns. shows the average annual investment return on stocks over the decades since 1900. Note first the steady contribution of dividend yields to total return during each decade; always positive, only once outside the range of 3 percent to 7 percent, and averaging 4.5 percent. Then note that the con-tribution of earnings growth to investment return, with the exception of the depression-ridden 1930s, was positive in every decade, usually running between 4 percent and 7 percent, and averaging 5 percent per year. Result: Total investment returns (the top line, combining dividend yield and earnings growth) were negative in only a single decade (again, in the 1930s). These total investment returns—the gains made by business—were remarkably steady, generally running in the range of 8 percent to 13 percent each year, and averaging 9.5 percent.

Investment Return by the Decade (Percentage/ Year)

Enter speculative return. Compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart as price/earnings ratios (P/Es) wax and wane (). A 100 percent rise in the P/E, from 10 to 20 times over a decade, would equate to a 7.2 percent annual speculative return. Curiously, without exception, every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount—the quiet 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and then the soaring 1980s—reversion to the mean (RTM) writ large. (Reversion to the mean can be thought of as the tendency for stock returns to return to their long-term norms over time—periods of exceptional returns tend to be followed by periods of below average performance, and vice versa.) Then, amazingly, there is an unprecedented second consecutive exuberant increase in speculative return in the 1990s, a pattern never before in evidence.

Speculative Return by the Decade (Percentage/ Year)

By the close of 1999, the P/E rate had risen to an unprecedented level 32 times, setting the stage for the return to sanity in valuations that soon followed. The tumble in stock market prices gave us our comeuppance. With earnings continuing to rise, the P/E currently stands at 18 times, compared with the 15 times level that prevailed at the start of the twentieth century. As a result, speculative return has added just 0.1 percentage points to the annual investment return earned by our businesses over the long term.

When we combine these two sources of stock returns, we get the total return produced by the stock market (). Despite the huge impact of speculative return—up and down—during most of the individual decades, there is virtually no impact over the long term. The average annual total return on stocks of 9.6 percent, then, has been created almost entirely by enterprise, with only 0.1 percentage point created by speculation. The message is clear: in the long run, stock returns depend almost entirely on the reality of the investment returns earned by our corporations. The perception of investors, reflected by the speculative returns, counts for little. It is economics that controls long-term equity returns; emotions, so dominant in the short-term, dissolve.

Total Stock Return by the Decade (Percentage/Year)

Accurately forecasting swings in investor emotions is not possible. But forecasting the long-term economics of investing carries remarkably high odds of success.

After more than 55 years in this business, I have absolutely no idea how to forecast these swings in investor emotions. But, largely because the arithmetic of investing is so basic, I can forecast the long-term economics of investing with remarkably high odds of success. Why? Simply, it is investment returns—the earnings and dividends generated by American business—that are almost entirely responsible for the returns delivered in our stock market. Put another way, while illusion (the momentary prices we pay for stocks) often loses touch with reality (the intrinsic values of our corporations), in the long run it is reality that rules.

To drive this point home, think of investing as consisting of two different games. Here’s how Roger Martin, dean of the Rotman School of Management of the University of Toronto, describes them. One is “the real market, where giant publicly held companies compete. Where real companies spend real money to make and sell real products and services, and, if they play with skill, earn real profits and pay real dividends. This game also requires real strategy, determination, and expertise; real innovation and real foresight.”

Loosely linked to this game is another game, the expectations market. Here, “prices are not set by real things like sales margins or profits. In the short-term, stock prices go up only when the expectations of investors rise, not necessarily when sales, margins, or profits rise.”

The stock market is a giant distraction.

To this crucial distinction, I would add that the expectations market is not only a product of the expectations of active investors but the expectations of active speculators, trying to guess what these investors will expect, and how they will act as each new bit of information finds its way into the marketplace. The expectations market is about speculation. The real market is about investing. The only logical conclusion: the stock market is a giant distraction that causes investors to focus on transitory and volatile investment expectations rather than on what is really important—the gradual accumulation of the returns earned by corporate business.

My advice to investors is to ignore the short-term noise of the emotions reflected in our financial markets and focus on the productive long-term economics of our corporate businesses. Shakespeare could have been describing the inexplicable hourly and daily—sometimes even yearly or longer—fluctuations in the stock market when he wrote, “[It is] like a tale told by an idiot, full of sound and fury, signifying nothing.” The way to investment success is to get out of the expectations market of stock prices and cast your lot with the real market of business.

Don’t Take My Word for It

Simply heed the timeless distinction made by Benjamin Graham, legendary investor, author of The Intelligent Investor and mentor to Warren Buffett. He was right on the money when he put his finger on the essential reality of investing: “In the short run the stock market is a voting machine . . . (but) in the long run it is a weighing machine.” Ben Graham continues, using his wonderful metaphor of “Mr. Market.” “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.

“Imagine that in some private business you own a small share which cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems little short of silly.

“If you are a prudent investor will you let Mr. Market’s daily communication determine your view as the value of your $1,000 interest in the enterprise? Only in case you agree with him or in case you want to trade with him. Most of the time you will be wiser to form your own ideas of the value of your holdings. The true investor . . . will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

Chapter Three

Cast Your Lot with Business

Rely on Occam’s Razor to Win by Keeping It Simple.