Some timeless lessons from a recently revised investing classic.
Vanguard founder John C. "Jack" Bogle recently published an updated, 10th anniversary edition of his mutual fund investing manifesto, Common Sense on Mutual Funds.
The tome holds up well. Bogle hasn't altered the original text; he just added data and text boxes to show where he was on or off the mark.
Guess what? The combative father of the first index mutual fund doesn't offer many mea culpas. When he does, he hardly dons sackcloth. Indeed, Bogle often leaves you with the impression that the first edition's faults lie less with what he originally wrote than with an industry that misunderstood him or failed to heed his recommendations. For instance, when surveying the state of mutual fund marketing, Bogle says, "During the past decade, the fund industry has moved in precisely the opposite direction from the direction I urged."
The book is still essential reading for investors, though. Whether you're an indexer or not, it's filled with simple, powerful advice that can help improve your odds of long-term financial success. Here are some of its more important lessons, as well as a couple of points where you might dare to differ from St. Jack.
Set Reasonable Expectations
Too many investors assume past trends will continue. Bogle stresses portfolio decisions should be based on not the market's historic returns, but rather the sources of those results. For bonds, their current yield gives you a good idea of future returns. With stocks, returns can be broken down into investment return, or the dividend yield plus earnings growth rate, and speculative return, or changes in what investors are willing to pay for $1 of earnings.
These aren't perfect indicators, but heeding them in the midst of the late 1990s' euphoria may have at least sobered you up enough to keep from doubling down on Pets.com. Bogle's models predicted stock returns in the 5% to 8% range were still too high, but far lower than the double-digit expectations that were common back then.
Bogle predicted bond returns of 5% "give or take a percentage point or so, during the coming decade" based on the yield of long-term Treasuries when he was writing. That wasn't too far off the mark. Vanguard Total Bond Market Index
Bogle's revised expectations indicate stocks may be a better deal. With the 10-year Treasury yielding around 3.5%, people flocking to fixed income are bound to be disappointed. Meanwhile, Bogle guesses, "that from our current levels some combination of slightly higher earnings growth and/or slightly higher P/Es and/or a swift recovery of corporate dividends could bring the nominal return on equities--to between 7% and 10% during the decade ending in 2019."
It's the Costs, Stupid
Some people lump Bogle with academics and investors who posit the market is efficient. Bogle doesn't spend much time arguing about market efficiency, though. To him, costs trump all. He contends the logic is irrefutable: Active and passive investors together make up the market; active investors incur more fees and transaction costs; so on average, passive investors must earn a higher return.
Even if you don't follow Bogle's logic all the way to his conclusion that investors hoping to beat the market with actively managed funds "are leaning on a weak reed," it's hard to argue with the strong case he makes against high fees. The price you pay is the one thing you can control. Don't ignore it.
Set the Bar High for Active Funds
Ironically, the apostle of index funds laid out some good criteria for choosing actively managed funds. Bogle thinks the pursuit of winning funds is futile but is resigned to the fact that people will continue to do it anyway. So, he laid out a few simple rules for fund selection: Choose low-cost funds; don't chase hot returns or managers; look for consistency, tax efficiency, and evidence of risk control; beware of funds with big asset bases; keep your portfolio small and simple; and invest for the long term.
It's impressive how few funds pass muster when you demand they have below-average costs, turnover and volatility; experienced, disciplined managers; and long records of consistent, strong performance. Rigidly adhering to such standards means missing some big winners that don't clear all the hurdles, like the fast-trading CGM Focus
Who Needs International Stocks?
Bogle writes in his original and updated book that U.S. investors really don't need to own any international stocks, but, if they must have some, they should limit their foreign exposure to no more than 20% of their portfolio. Emerging markets are fueling global growth, but most big, domestic companies in the S&P 500 or total stock market indexes operate all over the globe, Bogle contends. Furthermore, the stability and valuations of many of those countries are questionable, he writes.
Perhaps, but international exposure can still diversify a portfolio. Vanguard's own research has shown foreign stakes of 20% to 40% can reduce volatility and enhance return of a U.S.-equity-heavy portfolio. There also is a psychological benefit. When foreign stocks rollick, you may be less likely to chase hot markets if you know you already own some of them via diversified international exposure.
The Feeling's Not Always Mutual
Bogle still takes fund directors to task for acting more like Shih Tzus than Dobermans but implies that his way of fund governance is the only way. Vanguard's mutual ownership structure impels the organization to put investors first. But when Bogle laments that "the firm has yet to find its first follower" he seems to forget that private and public firms like Dodge & Cox, Capital Group, Longleaf Partners, Davis Selected Advisors, and T. Rowe Price have found ways to be exemplary fiduciaries. Mutual ownership clearly isn't the only way. Incentives, culture, and possessing a "stewardship gene" can help firms with more traditional ownership setups attain the same goal.
A version of this article originally ran in Morningstar's Vanguard Fund Family Report.
Dan Culloton is an associate director of fund analysis for Morningstar.