The Little Book of Common Sense Investing

The average return earned by stock investors (before expenses) must exactly equal the average return of the stock market. This is the “humble arithmetic” founder of Vanguard, John Bogle, writes about in The Little Book of Common Sense Investing. Collectively, we can’t be above average because we are the average. To be above average, you have to take money away from someone who ends up below average. However, stock trading is dominated by sharks looking to take your money.

Bogle’s simple advice is to give up trying to beat the professionals who dominate stock trading and just buy and hold broad-based index funds. The best index mutual funds and ETFs give you the market average returns at extremely low cost. To beat the market, you have to outsmart professional traders by enough to cover the much higher expenses of active investing. This is a fool’s errand for all but a few of the best investors. Even most professionals can’t succeed at this game.

So, why do we try? It seems to be human nature. Through selective memory we tend not to admit to ourselves that we fail at active investing. Bogle understands that we have a hard time accepting that simple index investing is the best approach for almost all of us. So, he looks at it from many angles and shoots down arguments for active investing.

In an attempt to make us accept market returns, Bogle says “the index fund is indeed the only investment that guarantees you will capture your fair share of the returns that business earns.” The message is simple. Don’t be greedy. Accept your fair share with indexing.

There are many ways investors seek to get around Bogle’s “humble arithmetic,” including finding winning fund managers. “Fund investors are confident that they can easily select superior fund managers. They are wrong.”

Bogle makes a strong case that a critical factor in fund selection is fees. He drives this home with a play on the “you get what you pay for” expression saying “We investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.”

“The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.” Even those who accept indexing as the right strategy often sell after market declines. It may seem counter-intuitive to just hold on through a crash, but most investors who try to avoid losses end up avoiding gains instead.

A quote from Jonathan Clements explains why we should think well of active investors. “We shouldn’t discourage fans of actively managed funds. With all their buying and selling, active investors ensure the market is reasonably efficient.” Active investors lose money so the rest of us can index.

Mutual funds report returns that are higher than the returns earned by their investors. This is because investors pile into last year’s winning fund only to be disappointed. So some funds perform well while they are small, and tend to perform poorly after swelling. In one extreme example from 1996 to 2002, a group of 10 funds had a net reported gain of 13%, but their investors lost 57%.

At one point, Bogle lost some of his patience with investors who are oblivious to costs. “Why would investors pay more than a 0.50 percent annual cost for a money market fund? The answer is beyond me. (They should probably have their heads examined.)” That bit in parentheses is Bogle’s, not mine.

Bogle isn’t much of a fan of ETFs because “Their use by long-term investors is minimal.” He allows that broad-based index ETFs can work well for long-term buy-and-hold investors, but the truth is that ETFs are traded hyperactively.

In a harsh quote, David Swensen, chief investment officer of Yale University, says “The mutual fund industry is a colossal failure.” This is a fair criticism given that a typical mutual fund’s fees consume more than half of investors’ money over a lifetime.

Recognizing that people just can’t stay away from active investing, Bogle allows that investors can carve off a small slice of their portfolios for some fun, “but not with one penny more than 5 percent of your investment assets.” He goes on to list what he thinks are acceptable ways to invest this 5%. He’s okay with individual stocks, actively managed mutual funds, ETFs, and commodity funds. But he says no to closet index funds (high-fee funds that are close to owning an index) and hedge funds.

“We know that neither beating the market nor successfully timing the market can be generalized without self-contraction. What may work for the few cannot work for the many.” We’d all like to think we’re the special flower who can beat the market, but in almost all cases, we’re not.

Bogle uses deceptively simple but relentless logic to demonstrate why indexing is the way to invest. Anyone with the active investing itch should read and understand this book before risking a single penny trying to beat the market.