Investors severely underestimate the excessive and punishing financial intermediary costs in investing. The only sensible way to play is to buy ultra-low fee simple index funds. The godfather of index investing, Bogle convincingly lays out an impassioned and well-supported case for the intelligence in index investing. As an index believer myself, I found the arguments to be very persuasive and clear. I think even laymen or beginner investors will easily see the overwhelming logic and hopefully will follow its prudent advice.
- Capitalism creates wealth. Investing in this prosperity via the stock market is a positive sum game—a winner’s game. However, trying to beat the markets, before costs, is a zero-sum game; after costs, it is a loser’s game.
- Financial intermediaries, like casinos, always win. They have a conflict of interest with investors. They encourage more trading activity whereas less activity is more prudent.
- Academic studies suggest investors in individual stocks lag the market return by 2.5%; mutual fund investors fare even worse. Consequently, active investors as a group, achieve less than 80% of market returns.
- The appeal of low cost index investing is simple, elegant, sensible, and mathematically irrefutable.
- Market Return = Investment Return (dividend yield and earnings growth) + Speculative Return (fluctuating P/E multiples). Over the long term (from 1900 to 2005), Investment Return (9.5%/ year) converges to Market Return (9.6%/ year); Speculative Return is trivial (0.1%/ year). Over the long-term, economics dominate; over the short-term, emotions dominate.
- Financial intermediary costs are excessive. For the typical mutual fund investor, gross market returns are diminished by fund operating expenses, sales charge, trading costs, taxes, and even inflation. Costs compound—negatively—over time. At a hypothetical 2.5% annual costs, in 30 years, the investor achieves only 50% of market’s cumulative returns. Investors further compound their costs, on average by another 2.7%, but sometimes greatly (e.g. tech bubble), by ill-timing and poor fund selection.
- Warren Buffett’s “four E’s”: “the greatest enemies of the equity investor are expenses and emotion”.
- Average equity fund turnover is 100%. Sixty years ago (1945-1965), the average turnover rate was only 16%.
- Taxes (federal) of active funds claim 1.8%/ year; index funds’ tax cost average 0.6%/ year.
- Historically, dividend yield is 3.5% – 4.5%, and (nominal) earnings growth is 5% – 6% (real earnings growth is around 1.5%).
- Selecting a consistently outperforming fund with a long-serving manager is like searching for a needle in the haystack (only 1% over 30 years, ex-post). And success often begets failure as winning funds attract too many assets. Successful ex-ante manager selection is nigh impossible.
- Statistically, to be 95% sure that a manager is skilled rather than lucky, one would need almost a millennium’s worth of performance data. To be even 75% sure, would require some 16 to 115 years.
- While financial advisers can add value with risk, estate planning, tax advisory, and peace of mind, etc., they have shown no ability to add value with investment selection.
- Performance persistence (and beating the market) is grossly overestimated by average investors. However, costs persist, and explain the majority of performance differences. Paradox of fund investing: shooting for average (index), gives the best chance of being above-average.
- Index funds perform very well in less efficient markets also: small cap, international, and emerging markets. They perform decisively better in more efficient ones: bonds.
- “The greatest enemy of a good plan is the dream of a perfect plan.” Index funds will provide satisfactory, though never the greatest, results. However, it will do so with certainty. Fundamental indexing may or may not be better, but will surely have higher costs.
- ETFs, an innovative vehicle for indexing, are advanced tools that are risky for less sophisticated investors. They promote speculation, increased trading, and for most ETFs, reduced diversification.
- To appease an investors animal spirts for excitement, one may choose to invest up to 5% in a “Funny Money” account, comprised of individual stocks.
- Investing is simple but not easy. Like dieting, the basic rules for success are known: diversify widely, keep costs low, rebalance with discipline, reduce activity, stop watching the markets, be very skeptical of free lunches, and spend less/ save more.
Finished: 23-Feb-2011; re-read: 8-Feb-2018. Rating: 8/10.