{"id":90266,"date":"2023-02-11T11:40:00","date_gmt":"2023-02-11T15:40:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=90266"},"modified":"2023-02-14T16:54:13","modified_gmt":"2023-02-14T20:54:13","slug":"the-little-book-of-common-sense-investing-by-jack-bogle","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/the-little-book-of-common-sense-investing-by-jack-bogle\/","title":{"rendered":"The Little Book of Common Sense Investing by Jack Bogle"},"content":{"rendered":"\n

What is Jack Bogle’s The Little Book of Common Sense<\/a> Investing<\/em> about? What’s the key message to take away from the book?<\/p>\n\n\n\n

In The Little Book of Common Sense Investing<\/em>, Jack Bogle outlines the reasons why investors typically make more money<\/a> with index funds than actively managed mutual funds. Because the costs of mutual funds vastly outstrip those of index funds, Bogle argues that mutual funds deliver reduced returns, and those relative losses compound over time.<\/p>\n\n\n\n

Below is a brief overview of The Little Book of Common Sense Investing<\/em> by John Bogle. <\/p>\n\n\n\n\n\n\n\n

The Little Book of Common Sense Investing<\/em><\/h2>\n\n\n\n

Investing can feel overwhelming. There are various companies vying to manage investors\u2019 money while platforms like Robinhood that encourage expedient day trading entice investors with the possibility of quick profits and beating the market<\/a>.\u00a0<\/p>\n\n\n\n

Amidst this chaos, The Little Book of Common Sense Investing<\/em> by Jack Bogle argues that the winning strategy for novice investors is simple: Invest in traditional index funds and hold them indefinitely.<\/strong> <\/p>\n\n\n\n

As the founder of the Vanguard Group<\/a>, one of the world\u2019s largest investment firms, Bogle himself created the world\u2019s first index fund in 1975, which tracked the S&P 500\u2014a stock market index containing stocks of the 500 largest companies in the US. Labeled one of the \u201cfour investment giants of the 20th century\u201d<\/a> by Fortune <\/em>magazine, Bogle brings his years of experience evaluating investment strategies into this book, which conveys the views that he put into practice for over 50 years.<\/p>\n\n\n\n

In this guide, we\u2019ll first introduce the concept of equity investing and clarify the distinctions between index funds and actively managed mutual funds. Next, we\u2019ll discuss areas where mutual funds cost investors more than index funds, followed by statistics showing the higher returns that index funds deliver. Finally, we\u2019ll examine Bogle\u2019s suggestions about incorporating bonds into your portfolio. Throughout this guide, we\u2019ll dig deeper into the data that underlie Bogle\u2019s arguments and examine how the book\u2019s predictions have panned out since its publication.<\/p>\n\n\n\n

Introduction to Equity Investing<\/strong><\/h3>\n\n\n\n

To begin, we\u2019ll discuss equity more generally\u2014what it is, its role in the US stock market, and how to own it via equity index funds and actively managed mutual funds.<\/p>\n\n\n\n

Equity and the US Stock Market<\/strong><\/h4>\n\n\n\n

Broadly speaking, equity is the part of a company that belongs to its owners<\/strong>. When companies are publicly traded, investors can acquire partial equity in them by purchasing shares of their stock<\/em>. <\/p>\n\n\n\n

In the US, investors can purchase stocks traded on the US stock market\u2014basically, the market containing all of the US\u2019s publicly traded companies. Consequently, investors gain wealth when stock prices rise and lose wealth when stock prices fall.<\/p>\n\n\n\n

According to Bogle, stock market investors earn profit from three factors: dividends, earnings growth, and speculative returns.<\/p>\n\n\n\n

1. Dividends are payments that a company makes to its shareholders.<\/strong> For instance, in 2022, the energy company Phillips 66 made quarterly payments of 67 cents per share<\/a> to shareholders. <\/p>\n\n\n\n

2. Earnings growth is the yearly rate of increase in a company\u2019s earnings.<\/strong> Because stock prices reflect earnings growth, companies with higher earnings growth will see their stock price rise more quickly. <\/p>\n\n\n\n

3. Speculative returns are the change in stock price caused by investors\u2019 speculation about a company.<\/strong> Bogle measures speculative returns by the price\/earnings ratio <\/em>(P\/E)\u2014how many dollars investors are willing to pay for each dollar of a company\u2019s earnings. When P\/Es are high, it indicates that speculative returns are also high.<\/p>\n\n\n\n

Historically, Bogle observes that the US stock market has grown an average of 9.5% annually since 1900<\/strong>. Of this growth, Bogle notes that 4.4% came from dividends, 4.6% came from earnings growth, and 0.5% came from speculative return.<\/p>\n\n\n\n

Index Funds vs. Mutual Funds<\/strong><\/h4>\n\n\n\n

To invest in the stock market, index funds are one option available to investors. Put simply, index funds allow investors to purchase portfolios\u2014collections of stocks\u2014that represent large portions of the stock market. <\/strong>In other words, investors can invest money into index funds, which is then used to purchase a portfolio representative of the stock market.<\/p>\n\n\n\n

Bogle observes that Traditional Index Funds (TIFs) essentially represent the entire <\/em>stock market. For example, some TIFs own shares of the entire S&P 500, which tracks the stock performance of the 500 largest companies in the US. Because they represent the entire market, TIFs\u2019 goal is to generate returns in line with the market\u2019s average returns. <\/p>\n\n\n\n

Because index funds reflect the stock market\u2019s long-term growth, Bogle notes that investors are supposed to hold them indefinitely. In light of this strategy, index fund managers play a relatively small role and incur fewer fees and commissions. <\/p>\n\n\n\n

By contrast, actively managed mutual funds (or \u201cmutual funds,\u201d for short) are overseen by financial managers, assisted by large teams of analysts, who try to beat stock market returns by purchasing and selling stocks at opportune moments<\/strong>.<\/p>\n\n\n\n

Because they attempt to outperform the market, mutual fund managers can\u2019t follow the same strategy as index funds, which attempt to generate market-average returns. For one, mutual fund portfolios contain far fewer stocks than index funds. Additionally, because mutual fund managers are constantly purchasing and selling stocks, Bogle observes that mutual funds have much greater portfolio turnover than index funds.<\/p>\n\n\n\n

The Problem With Mutual Funds: Everyone Can\u2019t Win<\/h5>\n\n\n\n

Although mutual funds attempt to beat the market average, Bogle notes that doing so is a zero-sum game: For every investor whose returns are above-average, there must be another whose returns are below-average<\/strong>. After all, it\u2019s mathematically impossible for everyone <\/em>to enjoy above-average returns. <\/p>\n\n\n\n

Furthermore, as we\u2019ll discuss in the next section, mutual funds have much higher costs than index funds. So, after deducting the costs of investing, this zero-sum game becomes a loser\u2019s game: Because the average investor\u2019s gross returns (their returns before deducting investment costs) match the market average, the additional costs of investing cause investors\u2019 net returns (their actual returns minus investment costs) to fall below market average. So, funds with the highest investing costs typically fall furthest below the market average.<\/p>\n\n\n\n

Why Mutual Funds Cost Investors More Than Index Funds<\/strong><\/h3>\n\n\n\n

Since index funds are typically held indefinitely, while mutual funds are actively managed, Bogle claims that index funds are much more cost-effective for investors<\/strong>. In this section, we\u2019ll examine three areas where mutual funds cost more than index funds: expense ratios, sales charges, and portfolio turnover.<\/p>\n\n\n\n

Cost 1: Expense Ratios<\/strong><\/h4>\n\n\n\n

Mutual funds and index funds alike have expense ratios<\/em>\u2014the percentage of the fund\u2019s assets that goes to operating expenses, like marketing, administration, and portfolio management. Because they require active intervention, Bogle claims that mutual funds\u2019 expense ratios are substantially higher than those of index funds<\/strong>.<\/p>\n\n\n\n

In particular, Bogle asserts that the average mutual fund\u2019s expense ratio is about 1.3% annually. So, if a mutual fund had $100 million in assets, $1.3 million is dedicated to operating expenses\u2014leaving $98.7 million to actually invest. Conversely, the TIF\u2019s average expense ratio is about 0.1% annually. So, if the TIF had $100 million in assets, only $100,000 would be dedicated to operating expenses, leaving $99.9 million to invest. This means that about 1.3% of the average mutual fund investor\u2019s assets, compared to 0.1% of the average index fund investor\u2019s assets, is deducted for operating expenses.<\/p>\n\n\n\n

Bogle concedes that not all mutual funds are created equal. For example, between 1991 and 2016, mutual funds in the lowest-cost decile had expense ratios of 0.32%. On the other hand, mutual funds in the highest-cost decile had expense ratios of 2.4%. Still, while there\u2019s variance in mutual funds\u2019 expense ratios, TIFs have lower expense ratios than mutual funds across the board.<\/p>\n\n\n\n

Cost 2: Sales Loads<\/strong><\/h4>\n\n\n\n

In addition to higher expense ratios, mutual funds also often have sales loads<\/em>\u2014charges that investors pay to agents who sell the mutual funds. Though Bogle doesn\u2019t provide exact data, he estimates that sales loads can easily cost mutual fund investors 0.5% per year<\/strong>. This means that if you invest $100,000 in a mutual fund over a year, $500 would be deducted as a sales charge\u2014even if your stocks decreased.<\/p>\n\n\n\n

By contrast, TIFs typically don\u2019t have any sales loads. So, while many mutual fund investors spend around 0.5% of their assets on sales loads each year, investors in index funds aren\u2019t saddled with these costs. <\/p>\n\n\n\n

Cost 3: Portfolio Turnover<\/strong><\/h4>\n\n\n\n

Another difference between mutual funds and index funds is portfolio turnover<\/em>\u2014basically, the ratio of a portfolio\u2019s total assets to its total purchases and sales. Because higher portfolio turnover creates more fees, such as commissions to stockbrokers, Bogle claims that mutual funds cost investors more money due to their higher turnover rates<\/strong>.<\/p>\n\n\n\n

In particular, Bogle suggests that turnover costs are approximately 1% of turnover rate. To illustrate, a mutual fund with 40% turnover would cost investors about 0.4% in associated fees. Moreover, Bogle observes that in 2016, sales and purchases within mutual funds totaled $6.6 trillion, or 78% of the total $8.4 trillion in mutual fund assets. Consequently, he concludes that the average mutual fund costs another 0.78% to its investors.<\/p>\n\n\n\n

By contrast, because index funds are held indefinitely, they have little-to-no turnover costs. In fact, Bogle states that the TIF\u2019s annual portfolio turnover is about 3%, costing investors a minuscule 0.03% of their assets. <\/p>\n\n\n\n

The Hidden Cost of Taxes<\/h5>\n\n\n\n

In addition to turnover fees, Bogle also argues that mutual funds lose more money to taxes because of their high turnover rates<\/strong>. <\/p>\n\n\n\n

Mutual funds are tax-inefficient, Bogle claims, because stocks held for less than a year are considered short-term gains<\/a>. Further, because short-term gains are susceptible to personal income tax, mutual funds with high turnover rates can leave investors on the hook for personal income tax\u2014up to 37% for the highest tax bracket.<\/p>\n\n\n\n

Profit from index funds, on the other hand, is considered a long-term gain, since index funds are normally held for longer than a year. Consequently, index fund investors only pay a capital gains tax, which is normally 15%. So, Bogle concludes that mutual funds cost investors more in taxes than index funds.<\/p>\n\n\n\n

How Index Funds Statistically Outperform Mutual Funds<\/strong><\/h3>\n\n\n\n

Despite their higher costs, mutual funds could nonetheless be superior to index funds if they generated proportionately higher returns. In this section, however, we\u2019ll examine Bogle\u2019s arguments to the contrary: Mutual funds generate significantly lower returns for investors than index funds<\/strong>.<\/p>\n\n\n\n

Historical Data <\/strong><\/h4>\n\n\n\n

First, Bogle examines historical data to see whether mutual funds have outperformed index funds in the past. In this regard, the data are clear: Low-cost index funds have consistently outperformed the vast majority of mutual funds since 1970<\/strong>.<\/p>\n\n\n\n

To show as much, Bogle turns to the records of the 355 mutual funds that existed between 1970 and 2016. Of these 355 funds, 281 of them\u2014about 80%\u2014are no longer in business. Because you can\u2019t invest for the long term in funds that don\u2019t exist for the long term, Bogle concludes that low-cost index funds\u2014which don\u2019t go out of business\u2014have been superior to these 281 funds. <\/p>\n\n\n\n

Of the 74 remaining funds, Bogle notes that 29 of them significantly underperformed relative to the market, with returns that were more than 1% below <\/em>the S&P 500\u2019s returns. Moreover, 35 of those funds essentially matched the market average, with returns that were within 1% of the S&P 500 in either direction. <\/p>\n\n\n\n

Consequently, Bogle concludes that only 10 of the original 355 funds in 1970 outperformed the S&P 500 by over 1%. In other words, only 3% of the mutual funds that existed since 1970 delivered clearly above-market returns. <\/p>\n\n\n\n

(Shortform note: Since The Little Book of Common Sense Investing<\/em>\u2019s publication in 2017, the historical trend of mutual funds underperforming has continued. Indeed, a 2022 study from the S&P Dow Jones Indices found that no actively managed funds consistently beat the market<\/a> from 2017 to 2022.)<\/p>\n\n\n\n

The TIF, conversely, delivered returns that were only 0.1% below the market average\u2014a result of its substantially lower operating costs. So, the TIF delivered returns equal to or greater than 97% of mutual funds since 1970<\/strong>. Rather than searching for the few high-performing mutual funds, Bogle concludes that investing in index funds<\/a> is the superior strategy.<\/p>\n\n\n\n

Compound Interest<\/h5>\n\n\n\n

Moreover, Bogle notes that these small differences in returns between mutual funds and index funds yield outsized long-term results because interest compounds over time<\/strong>\u2014in other words, it grows exponentially instead of linearly. <\/p>\n\n\n\n

To see the effects of compound interest, imagine two funds: a mutual fund that earns 8% annually, and an index fund that earns 9% annually. If you initially invested $100,000 in each fund, they would deliver the following returns over time:<\/p>\n\n\n\n