Bogle, Don’t Count on It!

Don’t Count on It!: Reflections on Investment Illusions, Capitalism, “Mutual” Funds, Indexing, Entrepreneurship, Idealism, and Heroes (Wiley, 2011) is an anthology of recent writings and speeches by John C. Bogle, the venerable founder of Vanguard. It is a substantial book, over 600 pages long, and, as its subtitle indicates, covers a range of topics. Here I’m going to confine myself to two. I’ll begin by exploring three principles that underlie Bogle’s well-known case for low cost passive index funds. Then I’ll jump to the lecture he gave to the Risk Management Association in October 2007: “Black Monday and Black Swans.”

Why, according to Bogle, is it preferable to invest in broad index funds rather than actively manage a portfolio? First, “the past is not prologue” (p. xxiii) or, put another way, “historic stock market returns have absolutely nothing in common with actuarial tables.” Bogle continues, quoting Keynes: “’It is dangerous to apply to the future inductive arguments based on past experience [that’s the bad news] unless one can distinguish the broad reasons for what it was’ [that’s the good news]. For there are just two broad reasons that explain equity returns . . . (1) economics and (2) emotions.” (p. 7) The math here is blissfully elementary. Add earnings growth and dividend yield to get investment return. Calculate the percentage increase in the P/E ratio to get the speculative return. Add investment return and speculative return to get total return. “In the short run,” Bogle writes, “speculative return drives the market. In the long run, investment return is all that matters.” (p. 66)

Second, actual investor returns and theoretical market returns are miles apart. About 98 percent of the theoretical return of $212,000 on a $1,000 investment 50 years ago would have gone up in smoke as a result of inflation, intermediation costs, and taxes (and here Bogle assumes a hit of only 2% for taxes). We end up not with $212,000 but a mere $4,300.

Third, we should respect the power of reversion to the mean: “reversion to the mean is the rule, not only for stock sectors, for individual equity funds, and for investment strategies that mix asset classes, it is also the rule for the returns provided by the stock market itself.” (p. 65) A chart showing the investment real return of $1 versus the market real return (1900-2009) nicely illustrates this point.

Now on to Bogle’s lecture given on the twentieth anniversary of Black Monday (October 19, 1987). In this lecture Bogle reviewed the literature on risk and uncertainty: Popper, Knight, Mandelbrot, Keynes, and Minsky. Elaborating on Minsky’s prediction that the financial economy would come to overwhelm the productive economy, Bogle said: “When investors—individual and institutional alike—engage in far more trading—inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. While the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market—for all of us as a group—is a zero-sum game before those costs are deducted. After intermediation costs are deducted, beating the market becomes, by definition, a loser’s game.” (pp. 177-78)

In this lecture he also pointed to the staggering growth of the financial sector. Financials accounted for only about 5 percent of the earnings of the S&P 500 25 years ago; in 2007 that figure was 27%. Adding in the likes of GE Capital and the auto-financing arms of GM and Ford, he figured that financial earnings probably exceeded one-third of S&P 500 annual earnings. This growth was spurred by the explosion in intermediation costs and the boom in complex financial instruments.

By October 2007 banks were beginning to cut the values of their mortgage-backed portfolios, a clear sign that systemic risks were rising. But how, Bogle asked, “can it be that risk premiums on stocks are at less than one-half the historic average?” He quoted Alan Greenspan, who said in 2005: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” (pp. 182-83) Indeed.

Don’t Count on It! is a wise book. As most traders and investors remain convinced that they can beat the market, it’s always sobering to hear a compelling voice from the other side.