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By Christine Benz | 10-15-2010 06:36 PM

Bogle: Keep Bonds for the Bumps in the Road

Stocks should outperform bonds in the coming decade, but investors need a significant allocation to fixed income for stability in today's troubled market, says Vanguard founder Jack Bogle.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We're at the Bogleheads Reunion outside of Philadelphia, and it's a real privilege to be here today with Jack Bogle.

He is founder of the Vanguard Group and also the main person at this event.

Jack, thanks so much for being with us.

Jack Bogle: Good to be with you, Christine.

Benz: So, Jack I have a lot questions for you, but one thing I'd like to start out with is your expectation for returns of stocks and bonds going forward. You have a very common-sensical approach at arriving at projected returns. I wonder if you can talk us through it and also talk about where you are coming down in terms of what you expect to see from stocks and bonds?

Bogle: Certainly. Number one, there is no point in looking out for a day or a week or a month or a year. I happen to like to look at five-year periods, because markets are crazy, they are highly speculative. But in the long run, it is investment value that creates returns in the stock market. It's how our corporations do that produces the returns. The stock market produces nothing. It reflects those returns, but then subtracts its croupiers' take, like the people out in Las Vegas or at the race track or state lotteries; they exact their toll.

So the stock market is basically for losers in the game of capturing returns. Let's call it here now American business earnings. So what does American business earn? How do you calculate that?

Well, first there is a dividend yield, and today that dividend yield is around 2%, let's call it 2.25%. Then the second component of that fundamental return, investment return, is earnings growth, and nobody knows what earnings growth is going to be. But we do know this, and it's an important thing to know, that corporate earnings grow at the same rate as America grows, as our gross domestic product grows.

So it's a very, very stable number--not the same every year but in the range of--corporate profits usually run in the range of 4% to 8% of GDP and average about 6%, a remarkably stable economic statistic.

So let's say that America is going grow at a nominal rate of 5% in the future, so corporate earnings should grow at 5%. They're not going to grow a lot faster, they're not going to grow a lot slower as far as anything we know, and so that's about a 7% investment return and that's it.

Now, speculative return, how much people will pay for $1 of earnings, the price to earnings ratio, can take that up or down. If the P/E goes from 15 to 30, that's a double and that will add 7% a year to your return. Now, that's not going to happen, but just to make the point. So the P/E now looks to me to be about 18 times, and I would expect that that would more or less neutral. It might come down a little bit over the next 10 years.

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