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Bogle: Tough Decade Ahead for Equity Investors

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference, and I'm joined today by the event's namesake, Jack Bogle.

Jack, thank you so much for being here.

Jack Bogle: It's an annual event.

Benz: It is.

Bogle: Great to be with you.

Benz: Jack, one of the topics we always cover at this conference is your expected return forecast for various asset classes. Let's start with U.S. equities.

Bogle: Well, for U.S. equities, I have a simple formula, as you know. It says divide it up into two segments: One is investment return and the other is speculative return. Investment return is the present dividend yield--a little over 2%--and the earnings growth that follows. And I think it's going to be a little bit of a push for that earnings growth to get to 6%--but I'm going to use 6%. So, that would be an 8% investment return on stocks.

Now, when you get to speculative return, that's whether the P/E ratio go up and pump that up or go down and deflate it. And I look at the P/E from the perspective of past reported earnings--GAAP earnings, as we say it--at being about 20 times. Wall Street looks at it through forward earnings, but forward expected earnings. So, they're using about a 17 P/E, and I'm using about a 20. I'm going to stick to my guns. To go from 20 to 17, that would be about a 2% annual loss. So, I think the best thing we can expect--and this is higher than I'm going to talk about tomorrow--is that 8%, [or 2% dividend yield and 6% earnings growth]. But in fact, I don't think earnings growth is going to be that good, and so I think the P/E could easily get to a more normal long-term range of 15. So, that would be 3% from that number. So, you'd have an investment return of 2% and 5% for 7%, minus 3% for speculative return. That would be 4% for stocks, and that's not a very good number.

And if you look at bonds, the mathematics is a little bit different. If you look at the current yield--as always--you can probably put a pretty good bond portfolio together. I bet you almost have to do better than the 2% or 2.2% on the 10-year Treasury. That's a high-quality relatively short, intermediate-term bond. But if you went a little bit longer--maybe instead of 10 years, you went 12 years--and had a bigger corporate position, which I think most people should have, you might be able to get a 3% yield out of the bonds. So, we've got a 4% return for stocks--maybe a little bearish, but we just don't know--and a 3% return for bonds. That's a 3.5% return on a balanced 50-50 portfolio.

Some important caveats: That's a nominal return.

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Benz: So, not inflation-adjusted.

Bogle: For inflation, the numbers would suggest a little bit lower than this, but I think you can probably pretty accurately use a 2% inflation number for the next 10 years. So, all of a sudden, 3.5% is 1.5%, and then we have mutual fund expenses.

Benz: Fees.

Bogle: And the industry gets a break because people think expenses are accurately measured by the fund's expense ratio. The fund's expense ratio is OK as far as it goes, but it is nowhere near complete. Bill Sharpe happens to use a number of about 1.1% for fund expense ratio. And I did some work in an article following his in the Financial Analysts Journal. I said there's not only the expense ratio, but there are portfolio transaction costs. Funds turn over at a very rapid rate--over 100% a year. So, that's going to cost maybe another 80 basis points. We also have a cash drag. Funds have a cash position, and in 10 years that's going to be a drag on returns, in all likelihood. So, we're now up to another 1%.

And then there's sales charges and RIA fees--I'll just use a little number there like 0.5%. So, we can easily add 1.5% to the expense ratio number of 1%. That's unweighted, in fairness. So, that's 2.5% that comes out of what you had left--which was, I guess, 3.5% minus 2%, so 1.5%. Now we're down to minus 1%. I have left out taxes, which is another consideration--outside of [tax-deferred] retirement plans. (Retirement plans will have to ultimately pay them, of course.) But on those kinds of returns, they're probably going to be maybe 100 basis points. You're probably getting worn down, Christine, but I've got to take one more thing out, and that is investor behavior.

And your Morningstar data show that around 1.5% is the gap between the returns that funds report and the returns investors realize because they buy hot funds and switch at the wrong time and get out of the market at the wrong time and back into the market at the wrong time. So, you're talking about a really tough decade for equity investors.

I don't think there's any way around that conclusion. My numbers may be wrong; but I think when investors are doing their financial planning and their IRAs or their 401(k)s, predicting a 7.5% or 8.5% return is just silly. Let me add: How can an individual investor, under these circumstances, be so dumb as to think that 7.5% might be possible? You probably figured out what I'm going to say next. That's what the smartest pension-fund managers--corporate, state, and local--are using for their assumed returns in their pension plans, 7.5%. It's just not going to happen. Another big concern is that I suppose it could reach--and maybe is likely to reach--crisis proportions, because these funds are around 65% funded. And as we go into the great future, what they're doing is that assuming a return far higher than they will get.

I won't say they'll get only 1.5% or 2% or 3%. But I will say they are not going to get anywhere near 7.5%. I just don't know how it can keep going on. The reason it does in corporate America is that the expenses for the corporations would go way up if they used, say, a 4% or 5% number. And in state and local government pension plans--a huge part of the pension-plan market--what we'd be looking at there is either reduced benefits or higher taxes. You're Chicagoan. I don't think you'd [like to have higher taxes], and I don't think anybody else would like them either. They're going to be very hard to accomplish. But ultimately, they will be accomplished. The math will tell.

Benz: So, Jack, if someone were to listen to you and hear your fairly pessimistic forecasts for equity and bond returns as well as the way that these other costs can chip away at that return, I think the gut reaction might be, "Why bother investing?" So, is not investing the answer?

Bogle: Well, not investing will guarantee you will have no retirement plan. I don't think that's the aim of most families in America. You have to take the markets for what they are. You really don't have a cash option because the return on a money market fund is 0.1% or something like that, just barely above zero. The return on money that's in that mattress of yours is zero. We will have some inflation, too, so that will be eroded. So, invest we must. The returns will be, I believe, above zero--well above zero. And I could be wrong, by the way.

The one thing I like about my system is if you think I'm wrong, don't argue with me; put your numbers in. You start with a 2% yield--you can't change that. You can say Bogle is crazy; earnings are going to grow at 10%. I can't say that's wrong. It's beyond historical precedent in most ways, but put it in. Then, you're at 12%. You say that you think the P/E is going from 20 to 30. That may seem absurd to us; that's a 50% decline. That's probably 3.5% a year or more. So, all of a sudden, we're in a 15.5% market return. So, if you want to be bullish, use that. But if I'm wrong, if I'm too low, if I'm too conservative--and I've always taken the conservative line--that means you're going to save too much and you're going to have too much (if there is such a thing) in your retirement plan when you get to age 65 or 70 ... or 86.