The Little Book of Common Sense Investing
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The Little Book of Common Sense Investing, authored by the father of index funds, John Bogle.
John is widely known as being the founder of Vanguard and for creating the very first index fund.
He favoured investing over speculation and heavily emphasized the importance and impact of low costs. This led to the creation of several Vanguard investments which offered low cost investing to the masses.
We look at the key statistics (updated to 2020) and general wisdom from the book.
We can summarise John’s thoughts with his comment: -
“The two greatest enemies of the equity fund investor are expenses and emotions.”
He believed the impact of expenses and emotions could be reduced considerably, by buying a portfolio of shares of every business and holding it forever.
I particularly like his comment when he said, “don’t look for the needle in the haystack, buy the haystack”. Alluding that you do not need to look for that one special stock, rather diversify and let the market do its thing.
In essence, John was all about simplicity, and suggested to avoid the over complication of management fees, commissions and portfolio turnover costs, and said:-
“Before costs, beating the market is a zero-sum game. After costs, it’s a loser’s game”.
Before we look at the returns of a Vanguard portfolio, let us look at a chart provided which shows the impact of costs over time.
Assuming the long-term average return for an index is 8%, but a managed fund with similar returns has costs of 2.5%, we can determine a net return of 5.5% for the managed fund.
Over a 50-year period a $10,000 account invested in an index would have returned $469,000, whereas a managed fund would have achieved $145,000.
Therefore, costs of just 2.5%, may at first seem insignificant, but these costs are compounded against you over time and have a huge impact on the final balance.
John said:-
“Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy”.
Managed funds (or mutual funds) have been popular for several years, quite often due to the huge amount of advertisement promoting the most recent, best performing funds.
The reality however may surprise you; this chart shows all 355 funds that existed between 1970 and 2005. The chart compares the performance of a managed fund against a passive index fund tracking the S&P 500 index.
Notice that 223 mutual funds no longer exist due to poor performance.
Another 60 funds performed worse than the Index by between 1 and 4%.
48 funds only managed to match the S&P 500 index, and just 24 mutual funds managed to beat the index by between 1 and 4%.
If we break this down further, only 9 funds achieved an improved performance of 2% or more. This equated to just 2.5% of managed funds being able to outperform the index.
To further exaggerate the inferior performance of an actively managed fund, John provided another chart.
This shows us the odds of an actively managed fund outperforming an index fund tracking the S&P 500.
Notice how there is only a 29% chance of a managed fund outperforming in the 1st year, and how the odds continue to decrease over time.
For someone with a 25-year investment horizon, they have just a 5% chance of outperforming the index should they decide to invest in a managed fund. Not very appealing to say the least.
Despite these poor statistics, investors continue to pour money into managed funds, and although money flowing into index funds is creeping up, they still lag. Clearly the promotional costs aimed at less educated investors, are unfortunately still paying off.
If at this point you decide index funds are the best option, John reminds us that not all index funds are equal, referring to the costs of managing such a fund.
Here we can see another exhibit from the book, showing five index funds with the lowest costs and five with the highest costs. Again, the comparative annual costs may seem insignificant, but over a longer-term horizon the difference is considerable.
In fact, $10,000 invested into a Vanguard 500 Index fund would have turned into $122,700 over 25 years, whereas the Wells Fargo fund tracking the same index would have returned $99,100 over the same period. A 23-percent difference from seemingly insignificant cost differences.
John reinforced his point regarding costs when he said; -
“Your index fund should not be your manager’s cash cow. It should be your own cash cow.”
Let us see how John’s preference towards index funds rather than managed mutual funds has faired since the book was last published in 2007.
Courtesy of some online research, we have been able to breakdown managed fund performance into large, mid, and small cap stocks, and compare each to the performance of passive index funds.
From the year 2008 to 2018 we found the following.
Only 14.9% of Fund managers focusing on large cap stocks outperformed a passive index.
12% focusing on mid cap stocks outperformed a passive index, and just 14.3% of fund managers focused on small cap stocks outperformed a passive index.
In summary, a passive index fund outperformed an actively managed fund 86% of the time over the 10-year period since the book was published. This reinforces John Bogle’s message suggesting that a managed fund (with associated costs) is clearly not the best option.
Considering that John created the Vanguard investments, it would be wise at this stage to show the performance of a portfolio using a low-cost Vanguard index fund. Each of the portfolios will be based on the individuals risk profile, and we will then summarise the statistics to determine the best portfolio balance.
In this first group we have low risk portfolios based on 100% bonds, 80% bonds and 70% bonds.
The ‘stocks’ portion relates to the Vanguard index fund tracking the S&P 500.
As an example, we can see here the 100% bonds portfolio gave an average annual return of 5.3% from 1926 to 2018, and the worst year showed a loss of 8.1%, with 14 of the 93 years showing a loss. This portfolio is considered to hold the least risk of them all.
Next, we have the portfolios considered to be of medium risk.
In this example we can see that a portfolio of 50% bonds and 50% stocks gave an average return of 8.2% per year, and the worst performing year gave a negative 22.5% return. 18 of the 93 years ended in a loss.
The final group is classed as the highest risk, all the way up to 100% stocks (or index fund).
Here we can see the average return was 10.1% per year, a maximum loss of 43.1%, and 29 of the 93 years ending in a loss.
Let us put all these portfolios into a pareto chart to help us determine which portfolio suits our risk over return profile.
Here we have the average annual returns.
Here the worst drawdowns.
And here, the percentage invested in an index fund, with the remaining percentage invested in bonds.
Therefore, if you are happy to have an annual drop of perhaps 10% and an average return of just under 7% you may want to be 20% invested in an index fund and 80% in bonds.
Or if you have a maximum risk tolerance of 30% in a given year, with an average return of 9%, you may want to be 70% invested in an index fund and 30% bonds.
Hopefully, this will give you a guide on how to balance your own portfolio in accordance to your risk profile.
For those interested, my personal strategy is generally 10% bonds, 10% cash, and 30% index funds, the remaining 50% is used for my trading account. Although, in the current climate (July 17th 2020) I’m actually 90% cash and 10% bonds.
For those of you still undecided on the benefits of an index fund in comparison to an actively managed fund, John provides another great example from the book.
This exhibit shows the result of an experiment initiated by the New York Times, where 5 highly respected fund advisers gave advice to an investor with a 20-year time horizon, and $50,000 to invest. The benchmark chosen was the Vanguard 500 index and the results were published in the year 2000 after a 7-year period.
We can see here the average return achieved was $88,500, whereas the Vanguard index returned a far better $138,750.
The contest was abruptly ended some months later…….
In summary, John said: -
“Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains”.
There is no doubt from the evidence provided in the book, that a low-cost index fund like the Vanguard 500, is far more favourable than an actively managed fund.
We know the impact that only a 2.5% annual management fee has over the long term, and we know the chances of a managed fund outperforming the index is very small indeed.
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