Fortune For Future
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Fortune For Future

Book Summary: Little Book of Common Sense Investing by John C. Bogle

Principles of Index Funds

In Little Book of Common Sense Investing, the author John C. Bogle states that owning an index fund that is broadly diversified and charges minimal fees and holding it for the long term is the only way to guarantee your fair share of the stock market returns.

John C. Bogle is the founder of the Vanguard Group and the creator of the first index fund. The book is great if you want to know the reasons and evidence behind passive/index investing.

Main Ideas

  • Over the long term, stock market returns are created by real investment returns earned by real businesses — the annual dividend yield plus their subsequent rate of earnings growth. In investing, the winning strategy is owning businesses, not trading stocks.
  • Individual businesses come and go. Given the rapid changes and competitions we face, the failure rate of individual business is high. There is no way to assure success by picking the funds that will beat the market. The best protection is the broadest possible diversification through an all-market index fund.
  • As a group, all investors in the stock market earn its gross returns minus the costs of financial intermediations (e.g. commissions, management fees etc.) and taxes.
  • Market timing and fund selection often lead investors to do much worse than the market.
book cover of Little Book of Commen Sense Investing
The Little Book of Common Sense Investing

Now, let’s look at his ideas more closely.

Costs Are the Enemy of Investing

All investors as a group must necessarily earn the market return, but only before the costs of investing are deducted.

From 1980 to 2005, the return of the S&P 500 Index averaged 12.5% per year. During that period, the average mutual fund returned 10% while an index fund tracking S&P 500 returned 12.3%.

Bogle argued that the difference in investing costs are the main reason that the average mutual funds lagged the index fund.

So what are the costs associated with investing in actively managed funds and index funds?

If you invest in actively managed funds, you will pay approximately 3% — 3.5% annually. These costs include expense ratio, cost of portfolio turnover and tax on realised gains. Some managed funds might have additional sales charges. If you invest in index funds, the costs are around 1% annually. These costs are:

  • Expense ratio: It measures the fees paid for the fund’s management fees and operating expenses. These fees are deducted from the total assets of the fund. So if a fund delivers a return of 10% with a 1% expense ratio, your actual return will be 9%. As you might have guessed, index funds tend to have a much lower expense ratio as they do not require active management.
  • Cost of portfolio turnover: Portfolio turnover is defined as the percentage of a portfolio that has been replaced in a given year. For example, a 50% turnover rate means half of the assets were sold and then bought. A high turnover rate means more transactions, and transactions incur fees such as commissions, bid-ask spreads etc.
  • As a rule of thumb, transaction costs are roughly 0.5% on each purchase and sales. So costs of turnover equal to approximately 1% of the turnover rate (2 * transaction costs * turnover rate). Similarly, the costs of turnover are taken from the fund.
  • Capital gain tax: Tax on capital gains is triggered when an asset is sold and profits are generated. This can happen when you sell your fund or when the fund manager sells securities in your fund. As index funds do not trade often, they tend to avoid capital gain taxes. Bogle estimated the capital gain tax to be 1.8% for active funds and 0.6% for index funds.

You can find the above information about a fund on its description page. For example, the fund below has an expense ratio of 0.79% and a turnover rate of 49%. Also be aware that the stated performance often does not include some or all of the fees, so the actual investors’ return would be lower (investors’ return = fund return minus costs minus taxes).

An Example of a Fund’s Expenses

All investors as a group earn the market return minus the costs and taxes. Since index funds have lower costs than actively managed funds, index funds outperform actively managed funds as a whole. This explains the difference between the 12.3% and 10% we’ve seen earlier.

For an up-to-date comparison between the average fees for actively managed funds and index funds, see the table below:

Fee Comparison

If you want to invest by yourself rather than in mutual funds, the costs are about 1.5% per year. These include brokerage fee and tax on realised gains. Similarly, the cost will be higher if you trade frequently.

“Beating the market before costs is a zero-sum game. Beating the market after costs is a loser’s game.”

— Bogle

Reversion to the Mean

How likely will the top-performing funds of the year repeat their records in the future?

Bogle compared the top 20 funds in each year with their records in the subsequent year from 1982 to 1992 and from 1995 to 2005. Here’s what he found:

Reversion to the Mean: Top 20 Funds, 1982–1992 and 1995–2005

The top 20 funds in each year had a subsequent average ranking of only 58 percentile (i.e. outpacing 58% of the others).

The short term winning performance didn’t repeat. Bogle noted that funds whose records substantially exceed industry norms tend to return to average or below.

On the other hand, as we will see soon, if we just buy an index fund and hold it for the long term, we will most likely to beat most of the other funds.

Index Fund Outperforms 80% in the Long Run

How does index fund compare against the others in the long run?

The chart below compared the performance of 355 equity funds with that of the S&P 500 from 1970 to 2005.

60 funds underperformed the S&P 500, 223 funds went out of the business before 2005 (79.7% combined). 48 funds (13.5%) just matched the performance of the S&P 500 and only 24 (6.8%) outperformed it.

Winners, Losers and Failures: Long-Term Returns of Mutual Funds, 1970–2005

You can achieve market performance by investing in an index fund. By contrast, if you find a fund manager to invest for you, you will only have a 20% chance of beating the market.

Index Fund v.s. Financial Advisers

In 1993, the New York Times started a test of the ability of financial advisers to outpace the S&P 500 Index.

The editors asked 5 respected financial advisers how they would invest $50,000 with a time horizon of at least 20 years. The returns would be compared to the return of the Vanguard 500 Index Fund, which tracks the performance of the S&P 500 Index.

The result? Funds chosen by the advisers earned 40% less than the index fund.

Fund Advisers versus the Vanguard 500 Index, July 1993-June 2000

As you can see from above, the average final return of the advisers was $88,500, whereas that of the Vanguard 500 Index Fund was $138,750.

In another study, Mark Hulbert, editor of the Hulbert Financial Digest, tracked the performance of recommendations from 35 financial advisers’ newsletters from 1980 to 2006. Here’s what he found:

  • Of the 35 newsletters in 1980, 13 are still in business, only 3 outperformed the market.
  • Of the 22 advisers that went out of business, only 2 were ahead of the S&P 500 when they discontinued publication.
  • An initial $100,000 in S&P 500 would be worth nearly $2,500,000 today. By contrast, a similar investment by the advisers’ portfolio would be worth only about $1,400,000.

Hulbert’s conclusion —

“You can outperform more than 80% of your fellow investors over the the several decades simply by investing in an index fund — and doing nothing else.”

Advice on the Exchange Traded Funds (ETFs)

Due to the structure of ETFs and the tax regulation, when held for the long term, ETFs can be more tax-efficient compared to the traditional index funds. In addition, their annual expense ratios are usually slightly lower than the traditional index funds.

However, Bogle warns that if you trade ETFs frequently, the commissions and the capital gain taxes will erode any advantage, and may even overwhelm it.

Also be careful of specialized ETFs such as sector ETFs, they are against the principles of the traditional index fund — — broadest diversification and minimal costs.

For a detailed comparison between classic index funds and the different ways of using ETFs, see the table below:

Classic Index Funds versus Index Funds Nouveau

To use ETFs the right way —

“If you are making a single initial purchase of either of those two versions of classic indexing — — the Spider or the Vanguard Total Stock Market ETF — — at a low commission rate and holding them for the long term, you’ll profit from their low expense ratios and may even enjoy a bit of extra tax efficiency.”

—Bogle

Problem With Market Sector Funds/ETFs

Recently, sector funds/ETFs have gained popularity. There are index funds/ETFs for a particular industry such as the real estate industry or a particular region such as the emerging market.

Bogle thinks that although sector index funds/ETFs are diversified within their sectors, they are still too specialised.

Sector funds/ETFs will earn a net return equal to the gross return of that sector, minus intermediation costs. By buying a particular sector instead of the whole market, you are betting on that sector to outperform the others in the future.

But betting is a loser’s game. First, in today’s highly efficient market, the sectors that catch your attention are unlikely to be still undervalued.

Second, we can never be certain how the economy will be like in the future, especially in the long term.

“I don’t try to be clever at all. The idea that I could see what no one else can is an illusion.”

— Daniel Kahneman, Nobel Laureate in Economics who sticks with index funds.

By sticking to an all-market index fund, you avoid making bets and you will receive a fair share of the profit generated by the whole economy.

But Betting Is Fun!

Life is short. If you want to enjoy the fun, enjoy! If you crave excitement, Bogle encourages you to go ahead and pick your favourite stocks and try out different strategies. But you should do this with less than 5% of your investment asset.

This 5% can be your Funny Money Account. Make sure that at least 95% of your investment assets are in a Serious Money Account. And stick with index funds in your Serious Money Account.

Funny Money v.s. Serious Money

ƒAfter a few years, compare returns between the 2 accounts and then decide whether all that fun was worth the potential wealth you’ve given up.

Summary

I know it has been a long read and thank you for reading till the end! 👏

Let’s quickly go over the key points:

  • We’ve learned that as a whole, investors as a group earn the market return minus costs and taxes. Index funds outperform the average mutual fund because of its low costs.
  • We’ve learned different types of investing costs— expense ratio fees, costs of portfolio turnover and capital gain taxes — and where to find out about them.
  • History has shown that the funds whose performance substantially exceed the industry norm often return to average or below.
  • We’ve seen that the index fund outperformed 80% of the other equity funds in the long run.
  • We’ve learned that to make the most of ETFs, we should buy the classic indexing version of ETFs and hold them for the long term.
  • In investing, we cannot predict the future. If we really want to make bets we should set a clear limit — less than 5% of our investable assets.
Quote from John Bogle

I hope this post has explained index investing and encouraged you to think about investing for the future. Again, thanks for reading. 🎉

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