The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns

The summary

Every dollar American business earns belongs to the people who own it. Bogle opens with a parable borrowed from Warren Buffett: a vast family called the Gotrocks owns every stock in the United States and collects all the dividends and earnings those thousands of companies produce. Then the Helpers arrive. Brokers persuade the smarter cousins to trade shares with each other for a commission; managers are hired to pick better stocks, consultants to pick better managers. Nothing about the underlying businesses changes, yet the family’s share of the pie slides from 100 percent to 60. The old uncle’s advice: fire everyone, own everything, sit still. That is exactly what an index fund does.

The arithmetic isn’t a theory. Investors as a group must earn precisely the market’s gross return, because collectively they are the market — subtract the fees, commissions and taxes they pay and the group must trail it by exactly that amount. Beating the market before costs is a zero-sum game; after costs it’s a loser’s game. Buffett’s addition to Newton: for investors as a whole, returns decrease as motion increases.

The tyranny of compounding costs

Actively managed equity funds carry expense ratios averaging about 1.3 percent a year. Add sales charges, then the invisible cost of turnover — these funds trade roughly 78 percent of their portfolios annually — and the all-in bill runs 2 to 3 percent.

Assume the market returns 7 percent a year for fifty years and a fund takes 2 percent of it. Ten thousand dollars in the market grows to $294,600; in the fund, to $114,700. Costs consumed 61 percent of the potential accumulation. You put up all the capital and took all the risk, and kept under 40 percent of the return.

The evidence sorts cleanly: over 25 years the cheapest quartile of equity funds returned 9.4 percent a year net, the priciest 8.3 — while their gross returns were nearly identical, 10.3 against 10.6. The gap is the fees and nothing else. Performance comes and goes; costs go on forever. Bogle’s sharpest illustration is dividends: in 2016, expenses swallowed 100 percent of the dividend income earned by actively managed growth funds and 58 percent in value funds. The index equivalents gave up 4 percent and 2.

Don’t look for the needle — buy the haystack

Fine, you think, I’ll pick the good ones. Of the 355 equity funds in business in 1970, 281 — nearly 80 percent — had ceased to exist by 2016. Of the survivors, ten beat the S&P 500 by more than a point a year and only two by more than two: Fidelity Magellan and Fidelity Contrafund. Both then reverted. Magellan’s assets swelled to $105 billion by 1999, then it trailed the index for two decades. A fat wallet, as Buffett says, is the enemy of superior returns.

Short records predict even less. Only 14 percent of the funds Morningstar rated five stars in 2004 still held five stars a decade later. Rank every active US equity fund by its 2006–2011 return and check the next five years: 13 percent of the top quintile stayed on top and 27 percent fell all the way to the bottom, while 17 percent of the previous losers finished at the top. That’s noise, not skill. Ted Aronson reckons it takes between 20 and 800 years of data to prove a manager is skilled rather than lucky; his own money sits in Vanguard index funds.

Your behavior costs more than the fees

Now the part that stings. Over those same 25 years the S&P 500 returned 9.1 percent a year, the average equity fund 7.8, and the average fund investor just 6.3. The second gap is self-inflicted: money pours in after good performance and runs out after bad. Investors put a net $18 billion into equity funds in 1990, when stocks were cheap, and $420 billion in 1999 and 2000, when they weren’t — and by then 95 percent of it was going into aggressive growth funds, against 20 percent a decade earlier.

Taxes finish the job. Active funds hold the average stock for 19 months and pass the gains through; after federal taxes their 7.8 percent falls to 6.6 while the index fund’s climbs to 8.6 — on $10,000 invested in 1991, a profit of $39,700 rather than $68,300.

Plan for thinner returns

Bogle refuses to project past returns forward. Stock returns come from dividend yield plus earnings growth, plus whatever the price/earnings multiple does. Writing in 2017, with the yield at 2 percent and the P/E already at 23.7, his sum came to about 4 percent a year for stocks. A 60/40 portfolio grossing 3.6 percent, minus 1.5 percent in active-management costs and 2 percent inflation, leaves 0.1 percent real. Costs and inflation eat a quarter of a 15 percent return but all of a 4 percent one.

On allocation he starts where Benjamin Graham did — 50/50 stocks and bonds, never outside 75/25 either way — then bends it toward your appetite for risk: up to 80 percent stocks while you’re accumulating, as low as 25 percent late in retirement. A low-cost 25/75 portfolio can out-earn a high-cost 75/25 one, 3.66 percent against 3.50, at far less risk. At 88, Bogle held half stocks and half bonds, all indexed, and admitted that half the time he thought he had too much in equities and the other half too little.

The bottom line

The market’s whole return is available to anyone willing to buy all of it and then leave it alone, and the same arithmetic that guarantees this guarantees that most people who try to do better will do worse. Costs are the one variable you fully control, which makes them the only dependable edge on offer. Read it if you want the case for indexing in numbers rather than slogans — and skip it if you already index, because Bogle makes the point twenty times with a founder’s stubbornness.