The Little Book of Common Sense Investing

The Little Book of Common Sense Investing The Smart Investor’s Guide. A reliable way to make a profit in the stock market: Awesome summary by ebookhike

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Author: John Bogle 

The Little Book of Common Sense Investing
The Little Book of Common Sense Investing

The truth of the stock market (The Little Book of Common Sense Investing)

The Little Book of Common Sense: All investors as a group receive some common income from the stock market. You need to understand that if one investor makes a profit on the stock market, then the other investor loses the same amount. Only financial intermediaries who receive high commissions from their clients benefit from the hectic trading in the stock market. John Bogle is convinced that it is impossible to beat the stock market, especially if you deduct the associated costs from investment income. The less money flows into the pockets of Wall Street bankers, the more return on investment the average investor gets.

As simple arithmetic suggests and history confirms, the winning strategy for investing in stocks is to become the owner of the shares of all public companies, spending the minimum amount of money. Implementing this strategy is simple: buy a stake in a mutual index fund, which is designed to mimic the behavior of the entire US stock market (any other market or segment of the market).  

For the past 90 years, the S&P 500 index has served as the best reflection of the stock market in America. It includes the 500 largest US corporations, and they account for approximately 85% of the market value of all stocks in the US market. To date, the S&P 500 remains the best standard for comparing returns generated by professional pension and mutual fund managers 1.   

Over the past 15 years, index funds  have consistently outperformed actively managed mutual funds across all investment categories. $15,000 invested in 1976 in the world’s first Vanguard 500 Index Fund, created by John Bogle, turned into $913,340 in 2016. 

The Little Book of Common Sense Investing

Benefits of an index fund: 

• broad portfolio diversification; • minimum expenses; • portfolio stability; • tax efficiency; • focus on long-term strategy; • minimization of risks associated with the behavior of individual shares or bonds, market segments, and the choice of a fund manager. 

A sensible investor will choose an index fund with the lowest costs.

Vanguard’s first index fund has an operating cost of 0.04%, while the Wells Fargo Equity Index Fund has an operating cost of 0.45%. In addition, Wells Fargo charges a 5.5% commission on sales. In 33 years (beginning in 1984, when Wells Fargo was created), $10,000 invested in the Vanguard fund turned into $294,900, while the same $10,000 invested in the Wells Fargo fund grew to only $232,100. 

The Little Book of Common Sense Investing

There is an opinion that index funds are good only for a separate segment of the market – the shares of large American companies. If you invest in small-cap stocks or foreign stocks, actively managed funds will perform better. John Bogle does not share this opinion. 

Index funds perform better than 89-90% of actively managed funds investing in the international market or emerging markets. 

The Little Book of Common Sense Investing

Great Conflict of Interest

Bogle notes a fundamental conflict of interest between those who work in the investment business and those who invest in stocks and bonds. The path to success for professional financial intermediaries is to coax the client into as many transactions as possible in the market. At the same time, the only way for a client to avoid losing money in the stock market is to refrain from unnecessary movements. The higher the level of investment activity, the higher the costs of financial intermediaries and taxes, and the lower the profitability of the stock market investors receive. 

Is there any point in speculation?

Stock market returns can be divided into two parts:

• investment income, consisting of dividends and the increase in the company’s profit per share; 

• speculative income, reflecting changes in the market value of shares (P / E ratio, that is, changes in the indicator of the market value of a share to annual earnings per share). 

Bogle shows that the speculative component of investment returns fluctuated sharply up and down over different periods of the 20th century. But! 

On average, a total return on the stock market of 9.5% was the result of an increase in investment income, and only 0.5% came from speculative income. 

The Little Book of Common Sense Investing

The clear implication from this is that, in the long run, the returns on stocks depend almost entirely on the returns of the corporations issuing those stocks. 

It is necessary to distinguish between the real market, where businesses compete with each other, where products and services are produced, where revenue is earned and dividends are paid, and the speculative market, where market speculators try to guess what other investors are thinking and how they will act, having received this or that information. It is necessary to invest in the real market, and speculation in the stock market only distracts investors from what is really important – the gradual increase in the profitability of business entities. Therefore, you should not pay attention to the fleeting emotions of the financial market, but rather focus on the long-term economic prospects of the business. 

Why are ordinary mutual funds dangerous?   

Virtually all investors, their advisors, pundits, and journalists tend to judge the performance of a mutual fund by its past performance. For some reason, everyone forgets that past performance tells what has already happened, but they cannot predict what will happen in the future. A fund’s performance may be better or worse, but the costs associated with investing in funds are always the same. 

Financial advisors seeking to “sell” a client a particular mutual fund will draw the client’s attention to the fund’s historical return of 9.5%, giving the client the impression that this is the return he will receive (ceteris paribus). However, if a sensible investor were to figure out a cost of 2% and inflation of 3%, he would find that the true return of the fund to him would be only 4.5%.   

If the market yield is 7% per year, then we, investors, should receive this 7%. But after we pay our financial intermediaries, we can only get what’s left. Bogle is convinced that investors trying to beat the market is a no-win game, trying to beat the market after all costs are deducted is a losing game. 

The cost of a traditional index fund is minimal – 0.1% per year. If the management companies do not take anything for themselves, then the investor receives all the income. The only correct criterion for choosing a fund for investment is the indicator of its expenses.

Where does investment income go?

The investor of a managed mutual fund pays the management company a management and administration fee of an average of 1.3% per annum of asset value plus 0.5-1% (depending on the number of years the investor owns the fund) selling fees plus approximately 1% (usually hidden from the eyes of the investor) of the costs associated with the circulation of shares held in the mutual fund’s portfolio. Total ownership of a mutual fund that invests in stocks costs the average investor about 2-3% per year. 

The cost of financial intermediation plays a huge role in reducing the income of an ordinary investor. It is because of them that the return on investment in mutual funds lags behind the return on index funds. 

For example, if we take a return on investment in the stock market of $10,000 over 50 years and assume that the annual return was 7% per annum, then thanks to the cumulative growth, we get an amount of $294,000. If we take the same investment, but taking into account the cumulative expenses over the same period of time, you get an amount of $114,700. The difference is a mind-boggling $179,900! 

The Little Book of Common Sense Investing

Simply put, fund managers confiscate in their favor a significant part of the profitability of the financial market. Expenses are what can turn investment success into failure. 

Expenses eat into dividend income 

Dividends are the most important source of returns from the stock market in the long run. Since 1926, dividends have averaged 42% of the total stock market returns. However, mutual fund management fees are set as a percentage of the fund’s net asset value, not the dividend yield. If the fund’s dividend income falls (as has been the case in recent years), it turns out that up to 100% of the fund’s dividend income is eaten up by expenses. 

If you invest in low-expenditure index funds that do not have an active management company, then they will provide a fair share of dividend income.

The fund’s income is not yet the investor’s income 

Not only is the return of any actively managed mutual fund lower than the return of index funds that mimic the S&P 500, but the return of investors in such a mutual fund is always lower than the return of the fund itself. 

Over the past 25 years, the average investor in the average mutual fund has not returned the 7.8% that the fund claims, but only 6.3%, which is 1.5% less than the fund. Over the same period, the average index fund investor earned 8.8% in returns, just 0.2% less than the index fund itself.     

The Little Book of Common Sense Investing

The author explains this gap in returns, in part, by the fact that, firstly, investors invested in equity mutual funds at the peak of the bull market, and, secondly, they incorrectly chose the fund to invest in based on the past performance of the fund. which are not confirmed in the future. 

Thus, in the 1990s, when shares were valued low, $18 billion was invested in the stock market as a whole. And in 1999 and 2000, when shares were significantly overvalued, $420 billion was invested in the market. Moreover, most investments were directed to trendy high-profile new technology funds, and traditional conservative asset growth funds were all but ignored. 

When the bubble burst, frightened investors began exiting fashion funds. Bogle points out that nothing good happens when counterproductive investor emotions are superimposed on counterproductive advertising for the investment industry. 

The Little Book of Common Sense Investing

The advantage of index funds is not only their low costs but also that they free the investor from having to choose among the many “hot” funds that promise so much and deliver so little. 

An index fund should be owned for life and ignored by the “emotional noises” of the market. The formula for success is to invest in an index fund and do nothing else. Warren Buffett fully agrees with John Bogle when he says that “Investors’ biggest enemies are emotions and costs.” 

Taxes get in the way

In addition to investment expenses, unreasonable behavior of the investor in the market, and the promotion of fashion funds, income tax is involved in reducing the potential income of the investor. Managed mutual funds are completely taxed inefficient. This is due to the fact that portfolio managers are interested in short-term speculation, and therefore they trade stocks in their portfolio with crazy activity. 

The average mutual fund holds any stock in its portfolio for only 19 months on average. 

The Little Book of Common Sense Investing

When there is significant stock turnover in a mutual fund portfolio, investors earn short-term capital gains that are taxed at rates higher than long-term capital gains. The policy of a traditional index fund is completely the opposite – buy stocks and hold. 

The result is, on average, that an investor in a managed mutual fund has an annual tax burden of 1.5% of the value of their investment, while an investor in an index fund has a tax burden of only 0.45% per year. Accordingly, taxes are a significant financial factor affecting the size of an investor’s net income. 

Should I look for a mutual fund to invest in?

When choosing mutual funds, investors usually look at their past performance. However, as we have already said, successes in the past are not necessarily repeated in the future. Moreover, there is no guarantee that a mutual fund will last long enough to be “invested and forgotten.” 

Of the 355 mutual funds that were on the market in 1970, 281 have now ceased to exist. Of the “survivor” funds, 29 funds performed well below the S&P 500 index; the other 35 funds performed within plus or minus 1% of the S&P 500. Bogle concludes that only 10 funds out of 355 managed to outperform the S&P 500, and then by no more than 2%. 

The Little Book of Common Sense Investing

This kind of margin could be achieved not so much as a result of the professionalism and skills of the fund’s investment portfolio manager, but due to luck. Finding a winning mutual fund in the market is about as difficult as finding a needle in a haystack. Therefore, Bogle suggests not to suffer, but to buy the whole “stack”, that is, to invest in an index fund.   An actively managed mutual fund simply cannot be more efficient and stable than an index fund. The secret of successful investments is simplicity, low costs, and stability.

Who needs consultants?

Bogle is highly skeptical about the ability of advisors to find a stock mutual fund that will outperform an index fund investment. 

The weighted average return of equity funds selected by investors on the advice of advisers was 2.9% per year, while the return of investors who made their own investment decisions was 6.6% over the same period.

The Little Book of Common Sense Investing

However, professional consultants can provide other useful services. 

• advise how best to allocate investments among different groups of assets;
• provide information on the procedure for taxation of different categories of income;
• make recommendations about how much of your income should be saved while you work and how much you can spend when you retire; • in general, help to avoid catastrophic mistakes when choosing an investment object. 
 

What will the future show?

The average return over the last 40 years of the S&P 500 has been 10.9% per year. However, today’s low dividends and slow growth in corporate earnings do not leave hope that the same high stock market returns will be repeated in the next 40 years. 

The Little Book of Common Sense Investing

In the near future, we are waiting for a period of reduced returns on the securities market. As we remember, the profitability of the stock market consists of investment and speculative profitability. An analysis of economic statistics shows that in the next decade, the investment return on shares will be in the range of 6-7%. At the same time, there will be a decrease in the P / E ratio (from 23.7 to 20), which will reduce the speculative return on shares by 2%. Accordingly, the total annual return of the US stock market can be no more than 4%. Bogle suggests that a balanced bond portfolio could generate a return of 3.1% per annum over the next decade, well below the historic norm of 5.3%. 

If we combine all these reasonable expectations into a balanced portfolio of stocks and bonds (60% stocks, 40% bonds), then over the next decade it will bring a total nominal annual return of 3.6%. If this nominal return is subtracted from investment costs and an estimated inflation rate of 2%, then the average investor will earn only 0.1% per year. Ceteris paribus, an index fund will earn the average investor a return of 1.5%. 

The Little Book of Common Sense Investing

Asset distribution

Bonds

Common sense and simple arithmetic apply just as much to investing in bonds as it does to investing in stocks. Historically, stocks generate higher returns than bonds. 

Why invest in bonds: 

• in the short term, bonds can generate higher returns than stocks;
• the presence of bonds in the portfolio reduces its volatility and protects the investor from ill-considered actions when the stock market collapses;
• despite the historically low bond yield of 3.1%, it is still above the average dividend yield of 2%. 

According to Bogle, bond index funds outperform most actively managed bond mutual funds. The benefits of bond index funds stem from the same factors as for equity index funds—wide diversification, minimal spending, portfolio stability, tax efficiency, and a focus on long-term strategy. 

How many stocks, how many bonds? 

There is no simple answer to this question because each investor has his own ideas about the purpose of investing, tolerance for risks, and behavior. But this is an important question since the difference in the return of a particular portfolio is more than 90% dependent on the distribution of assets in the portfolio. 

The ratio of stocks to bonds in an investor’s portfolio depends on two factors: 

• the ability to accept risk;
• willingness to take risks. 

The ability to take risks depends on the life situation of the investor, in particular, on his financial obligations in the future and the amount of time for their implementation. If obligations do not arise soon, then there are more opportunities to take risks. 

An investor who has children on his nose or buying a house has little opportunity to take risks. 

The Little Book of Common Sense Investing

How to allocate assets based on the life situation:

• Young investors – 80% of the shares. Young investors have a lot of time ahead of them and are generally not dependent on investment income. If they believe in higher stock returns over the long term, they should be more aggressive and have up to 80% equity in their portfolio. 

• Elderly investors – 25% of the shares. Older retired investors are usually not willing to take risks. They are most often willing to sacrifice capital gains for a stable income, so they can hold up to 75% of bonds in their portfolio.

A low-cost portfolio of conservative index fund investments can generate higher returns than a portfolio of high-risk investments. A portfolio that is 75% bonds and 25% stocks can be more profitable than a portfolio that is 75% stocks and 25% bonds. Index funds have changed the conventional approach to the allocation of assets in the investment portfolio.

The Little Book of Common Sense Investing

• Restless or lack of time investors – 60% of the shares. If your time to invest is limited or you are overly nervous about stock market fluctuations, then regardless of age, the best choice is to invest in a balanced index fund, which is 60% stocks and 40% bonds. 

• Universal 3  X  33%. Another viable alternative is to split assets into three portfolios: 33% in an index bond fund, 33% in an index fund investing in US stocks, and 33% in an index fund investing in foreign stocks. 

Any asset allocation strategy is subject to numerous market and macroeconomic risks. The best we can hope for is to be well informed and adapt to changing market conditions. 

ETFs

An ETF is an index fund whose shares (shares) are traded on an exchange. The first ETF was created in 1993. Since then, the ETF market has grown to $2.5 trillion and makes up about half of the total index fund market. The largest participants in the ETF market are banks, liquidity managers, hedge funds, and professional traders who trade their shares non-stop. The incredible growth of the ETF market testifies to the tremendous energy of Wall Street financial entrepreneurs and the success of brokerage firms’ marketing efforts, as well as the desire of investors to follow complex strategies and aggressive trading policies in the vain hope of beating the market. 

An active ETF market is a dream come true for brokers, mutual fund managers, and other stock market professionals. However, are ETFs good for the average individual investor? The two main enemies to an investor’s wealth – cost and emotion – are clearly present when trading ETFs. In addition, ETFs are much more specialized than traditional index funds, which can be detrimental to inexperienced investors. Therefore, ETF investments should be approached with caution.   

Top 10 Thoughts

1. All investors as a group receive income from the stock market. But if one investor makes a profit, others lose just as much. Financial intermediaries benefit from intensive trading, as they charge a commission for servicing each transaction.

2. There is a conflict of interest between stock market professionals and investors. The cost of financial intermediaries significantly reduces the return on investment. The fewer unnecessary movements the investor makes, the more he learns and the less the intermediary earns. 

3. The two main enemies of an investor are expenses and emotions. Frantic trading in an attempt to beat the market is always doomed to failure in the long run. In the long run, financial intermediation costs, taxes, and rewarded risks eat up most of the investment income. 

4. Mutual funds can significantly reduce the costs and risks of a private investor, but they, if actively managed, lose money on intensive trading. Mutual funds also have low tax efficiency because they generate income in the form of short-term capital gains, which are taxed at a higher rate. 

5. The high yield of a mutual fund does not guarantee success in the future , and the real income of the investor is always lower than the income of the fund itself. 

6. An index fund is a kind of passively managed mutual fund that uses a market index following strategy. The fund’s portfolio consists of the same assets that are part of the index it reproduces, such as the S&P 500. The main advantages of an index fund are low expense and diversification, which in the long run provide the investor with a higher return than all other instruments. 

7. The presence of bonds in the investment portfolio reduces its volatility and protects the investor from ill-considered actions made under the influence of emotions when the stock market collapses. The same logic applies to investing in bonds as to equity investments. There are also indices for bonds. 

8. The ratio of stocks and bonds in the portfolio depends on the life situation of the investor and his willingness to take risks. Financial advisors can help you evaluate these factors and help you allocate assets in your portfolio correctly, reduce your tax burden, and figure out how to make the most of your income. However, you should not resort to the services of consultants to choose a profitable fund. 

9. Over the next decade, the stock market returns on investments in a balanced portfolio of stocks and bonds (60% stocks, 40% bonds) will be approximately 3.6%, and after deducting investment costs and adjusting for inflation, no more than 0.1% per year. Other things being equal, the index fund will bring the investor 1.5% of income. 

10. ETF is an index fund whose units (shares) are traded on the stock exchange. Active trading in shares leads to the same costs and risks. In addition, ETFs are much more specialized than traditional index funds. This can be detrimental to an inexperienced investor, so ETF investments should be approached with caution. 

1  A mutual fund or mutual investment fund is a portfolio of stocks selected and purchased by professional financiers for the investments of many small investors. The value of a fund share is equal to the value of its total investment divided by the number of shares

2  An Index Fund is a type of passively managed mutual fund that follows a market index. The fund’s portfolio consists of the same assets that are part of the index it reproduces. For example, an S&P 500 index fund mimics the performance of the US stock market. By purchasing one unit (share), the investor buys 500 shares included in this broad market index.

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