Bob Pisani’s book “Shut Up & Keep Talking”
(Below is an excerpt from Bob Pisani’s new book “Shut Up & Keep Talking: Lessons on Life and Investing from the Floor of the New York Stock Exchange.”)
In 1997, just as I was becoming on-air stocks editor for CNBC, I had a telephone conversation with Jack Bogle, the founder of Vanguard.
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That conversation would end up changing my life.
Jack was by then already an investing legend. He had founded Vanguard more than 20 years before and had created the first indexed mutual fund in 1976.
CNBC had been in the regular habit of having investing “superstars” like Bill Miller from Legg Mason, Bill Gross from Pimco or Jim Rogers on the air. It made sense: let the people who had been successful share their tips with the rest of us.
Bogle, in our brief conversation, reminded me that these superstar investors were very rare creatures, and that most people never outperformed their benchmarks. He said we were spending too much time building up these superstars and not enough time emphasizing long-term buy-and-hold, and the power of owning index funds. He reiterated that most actively managed funds charged fees that were too high and that any outperformance they might generate was usually destroyed by the high fees.
His tone was cordial, but not overly warm. Regardless: I started paying much more attention to Bogle’s investment precepts.
From the day it opened on May 1, 1975, Vanguard Group was modeled differently from other fund families. It was organized as a mutual company owned by the funds it managed; in other words, the company was and is owned by its customers.
One of Vanguard’s earliest products proved to be the most historic: the earliest ever index mutual fund, the First Index Investment Trust, which began operation on Aug. 31, 1976.
By then, the academic community was aware stock pickers — both those that picked individual stocks and actively managed mutual funds — underperformed the stock market. The search was on to find some cheap way to own the broad market.
A tribute to Jack Bogle, founder and retired CEO of The Vanguard Group, is displayed on the bell balcony over the trading floor of the New York Stock Exchange in New York, January 17, 2019.
Brendan McDermid | Reuters
In 1973, Princeton professor Burton Malkiel published “A Random Walk Down Wall Street,” drawing on earlier academic research that showed that stocks tend to follow a random path, that prior price movements were not indicative of future trends and that it was not possible to outperform the market unless more risk was taken.
But selling the public on just buying an index fund that mimicked the S&P 500 was a tough sell. Wall Street was aghast: not only was there no profit in selling an index fund, but why should the public be sold on just going along with the market? The purpose was to try to beat the market, wasn’t it?
“For a long time, my preaching fell on deaf ears,” Bogle lamented.
But Vanguard, under Bogle’s leadership, kept pushing forward. In 1994, Bogle published “Bogle on Mutual Funds: New Perspectives for the Intelligent Investor,” in which he argued the case for index funds over high-fee active management and showed that those high costs had an adverse impact on long-term returns.
Bogle’s second book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” came out in 1999 and immediately became an investment classic. In it, Bogle made an extended case for low-cost investing.
Bogle’s main message was that there are four components to investing: return, risk, cost and time.
Return is how much you expect to earn.
Risk is how much you can afford to lose “without excessive damage to your pocketbook or your psyche.”
Cost is the expenses you are incurring that eat into your return, including fees, commissions and taxes.
Time is the length of your investment horizon; with a longer time horizon, you can afford to take more risk.
While there are some periods when bonds have done better, over the long term stocks provide superior returns, which makes sense because the risk of owning stocks is greater.
The longer the time period, the better chance stocks would outperform. For 10-year horizons, stocks beat bonds 80% of the time, for 20-year horizons, about 90% of the time and, over 30-year horizons, nearly 100% of the time.
Vanguard signage at a Morningstar Investment Conference.
M. Spencer Green | AP
Other key Bogle precepts:
Focus on the long term, because the short term is too volatile. Bogle noted that the S&P 500 had produced real (inflation-adjusted) returns of 7% annually since 1926 (when the S&P 500 was created), but two-thirds of the time the market will average returns of plus or minus 20 percentage points of that.
In other words, about two-thirds of the time the market will range between up 27% (7% plus 20) or down 13% (7% minus 20) from the prior year. The other one-third of the time, it can go outside those ranges. That is a very wide variation from year to year!
Focus on real (inflation-adjusted) returns, not nominal (non-inflation adjusted) returns. While inflation-adjusted returns for stocks (the S&P 500) have averaged about 7% annually since 1926, there were periods of high inflation that were very damaging. From 1961 to 1981, inflation hit an annual rate of 7%. Nominal (not adjusted for inflation) returns were 6.6% annually during this period, but inflation-adjusted returns were -0.4%.
The rate of return on stocks is determined by three variables: the dividend yield at the time of investment, the expected rate of growth in earnings and the change in the price-earnings ratio during the period of investment.
The first two are based on fundamentals. The third (the P/E ratio) has a “speculative” component. Bogle described that speculative component as “a barometer of investor sentiment. Investors pay more for earnings when their expectations are high, and less when they lose faith in the future.”
High costs destroy returns. Whether it is high fees, high trading costs or high sales loads, those costs eat into returns. Always choose low cost. If you need investment advice, pay close attention to the cost of that advice.
Keep costs low by owning index funds, or at least low-cost actively managed funds. Actively managed funds charge higher fees (sometimes including front-end charges) that erode outperformance, so index investors earn a higher rate of return.
As for the hopes of any consistent outperformance from active management, Bogle concluded, as Burton Malkiel had, that the skill of portfolio managers was largely a matter of luck. Bogle was never against active management, but believed it was rare to find management that outpaced the market without taking on too much risk.
Very small differences in returns make a big difference when compounded over decades. Bogle used the example of a fund that charged a 1.7% expense ratio versus a low-cost fund that charged 0.6%. Assuming an 11.1% rate of return, Bogle showed how a $10,000 investment in 25 years grew to $108,300 in the high cost fund but the low-cost fund grew to $166,200. The low-cost fund had nearly 60% more than the high-cost fund!
Bogle said this illustrated both the magic and the tyranny of compounding: “Small differences in compound interest lead to increasing, and finally staggering, differences in capital accumulation.”
Don’t try to time the markets. Investors who try to move money into and out of the stock market have to be right twice: once when they put money in, and again when they remove it.
Bogle said: “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
Don’t churn your portfolio. Bogle bemoaned the fact that investors of all types traded too much, insisting that “impulse is your enemy.”
Don’t overrate past fund performance. Bogle said: “There is no way under the sun to forecast a fund’s future absolute returns based on its past records.” Funds that outperform eventually revert to the mean.
Beware of following investing stars. Bogle said: “These superstars are more like comets: they brighten the firmament for a moment in time, only to burn out and vanish into the dark universe.”
Owning fewer funds is better than owning a lot of funds. Even in 1999, Bogle bemoaned the nearly infinite variety of mutual fund investments. He made a case for owning a single balanced fund (65/35 stocks/bonds) and said it could capture 97% of total market returns.
Having too many funds (Bogle believed no more than four or five were necessary) would result in over-diversification. The total portfolio would come to resemble an index fund, but would likely incur higher costs.
Stay the course. Once you understand your risk tolerance and have selected a small number of indexed or low-cost actively managed funds, don’t do anything else.
Stay invested. Short term, the biggest risk in the market is price volatility, but long term the biggest risk is not being invested at all.
More than 20 years later, the basic precepts that Bogle laid down in “Common Sense on Mutual Funds” are still relevant.
Bogle never deviated from his central theme of indexing and low-cost investing, and there was no reason to do so. Time had proven him correct.
Just look at where investors are putting their money. This year, with the S&P 500 down 15%, and with bond funds down as well, more than $500 billion has flowed into exchange traded funds, the vast majority of which are low-cost index funds.
Where is that money coming from?
“Much of the outflows we have seen are coming from active [ETF] strategies,” Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors, a major ETF provider, told Pension & Investments magazine recently.
Today, Vanguard has more than $8 trillion in assets under management, second only to Blackrock. While Vanguard has many actively managed funds, the majority of its assets are in low-cost index funds.
And that first Vanguard index fund? Now known as the Vanguard 500 Index Fund (VFIAX), it charges 4 basis points ($4 per $10,000 invested) to own the entire S&P 500. All major fund families have some variation of a low-cost S&P 500 index fund.
Jack Bogle would be pleased.
Bob Pisani is senior markets correspondent for CNBC. He has spent nearly three decades reporting from the floor of the New York Stock Exchange. In Shut Up and Keep Talking, Pisani shares stories about what he has learned about life and investing.