In this week’s Five Minute read, we review Jack Bogle’s The Little Book of Common Sense Investing, which gives you all you need to know about index funds.
Jack Bogle is nothing short of a legend in the world of finance. Though you may not know it, if you’ve ever had a 401k or any other retirement plan, chances are you’ve been a customer of his!
Bogle was born in 1929 and his family suffered through the Great Depression. After his parents divorced, he excelled at school (particularly in maths) and went on to work at Wellington Fund – one of America’s oldest mutual funds. Bogle showed great talent in his job, and was quickly promoted through the ranks, eventually being named chairman. However, he oversaw and approved a merger that turned sour, and he was fired from the position.
At the age of 45, he went onto found the Vanguard Company – now the largest provider of mutual funds in the world with over $3.6 trillion in assets under management. That success was a direct consequence of Bogle launching the Vanguard 500 Index Fund.
The Vanguard 500 Index Fund
Bogle observed that most mutual funds failed to outperform the broader market when taxes and management fees were taken into account.
Instead, Bogle wanted to create a fund that at simply matched the market by buying all the underlying stocks in the S&P 500. This fund would take very little to manage – meaning the investor is the main benefactor, not the fund manager. The Vanguard 500 Index Fund, which Bogle launched in 1976, was the first index fund available to the individual investor.
Since then, the Vanguard 500 Index Fund has been a juggernaut in the world of investing, returning 10.83% annually since its inception. To put that into perspective… a $10,000 investment back in 1976 would be worth over $600,000 today!
Bogle became the most prominent voice in the world of finance in favor of indexing. He wrote many books on the subject, the most famous of which are Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor and The Little Book of Common Sense Investing.
The Little Book Of Common Sense Investing
This is one of 16 “Little Books” on investing that was published by Wiley Publishing. We recently reviewed another in the series – The Little Book That Beats The Market by Joel Greenblatt.
The Little Book of Common Sense Investing starts with parable that was first presented by Warren Buffett in 2005. In it, Buffett introduces ‘The Gotrocks’ – a family that owns every American corporation.
Every year the Gotrocks family wealth continues to increase because all the money they spend goes back into the businesses they own, meaning they continue to grow.
One year, a bunch of ‘Helpers’ arrive. The Helpers convince some members of the Gotrocks family that they should trade some of the bad business they own for better ones so they end up having more money than the rest of their family. The Helpers explain that they know what the best businesses are, and for a small fee they will help execute these trades.
No one wants to end up with the bad business, so suddenly every family member is hiring their own Helpers to ensure they get the best deal.
Though the family still owns every business in America, their money is actually decreasing. This incredible cycle that was supporting the family for generations has now been infiltrated from outsiders. The Helpers are eroding the family’s wealth by taking a cut out of every transaction they make. After a while, more Helpers arrive charging higher fees for better services and more complex transactions.
This, of course, is a metaphor for the financial services industry. Everyone has the opportunity to buy into the US stock market and take an even share of the wealth that accumulates. But some people want a bigger slice of the pie, and so they pay money managers high fees to try to beat the market.
The Cost of the Game
As Bogle explains, the performance of the overall market is the average. Therefore, for every stock that beats the market, another stock will not beat the market.
When you pick individual stocks, you are betting that you pick the right ones and that someone else is picking the wrong ones. So the average investor should end up matching the market right?
They should, but they don’t. The average investor actually ends up underperforming the market, because of the fees and taxes that come with trading.
Therefore, the main objective of the average investor should be to keep fees low.
And this is the main point that Bogle makes throughout the book – the more active you are, the more likely you are to underperform the market. This applies to taxes as well, as the more you trade, the more capital gains tax you will end up having to pay.
Managed funds which actively trade incur these high taxes, which again erode investor returns. Meanwhile, index funds do very little trading as the S&P 500 changes so little year over year.
The Emotional Rollercoaster
Human emotions are one of the biggest issues that are faced by the individual investor. This is why so much of behavioral psychology focuses on the stock market.
Though everyone knows the old adage “buy low, sell high”, most investors do the complete opposite. They see that a stock is performing really well and they buy it, hoping it will continue to go up. When it goes down, they lose confidence in the stock and sell it.
Bogle argues that this happens with mutual funds as well and only the most disciplined and diligent managers can avoid this.
Meanwhile, index funds eliminate all human emotion as long as you buy and hold for the long term. Why would you take a gamble on controlling your own emotions when you can just buy the index and eliminate this risk?
Index funds also don’t get attached to specific industries. During the late 1990s, individual investors and money managers piled their money into technology stocks as that was the hot industry of the moment.
When the tech bubble burst, those investors saw their portfolios collapse. Although index funds also took a big hit, it was far less painful because they were spread out across other industries and sectors.
So Bogle recommends that most investors should opt for an index fund rather than attempting to beat the market. However, he also gives some good advice on choosing other funds that could cover bonds or property or any other financial asset.
Finally, he recommends that every investor should keep some “funny money” (about 5%) that they can invest in individual stocks that take their fancy.
Should I Buy This Book?
We’re a big fan of Jack Bogle here. Whether or not you like the idea of index funds, this is a great book for anyone who wants to learn more about investing in general. Bogle is a terrific writer who explains his points concisely and eloquently.
Though we believe owning a basket of great companies can beat the market over the long term, we also think index funds are a great way to get started investing, or to diversify your holdings. That’s why when we added the Vanguard S&P 500 Index to our Showroom back in March.
So if you’re still on the fence about whether to start investing or not, the S&P 500 Index is a low-risk way of getting started and will give you exposure to the 500 largest companies in America.
If we can’t convince you, I’m sure Jack Bogle will!