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The Motley Fool recently had a chance to talk to Vanguard Founder John Bogle, the man behind the first index mutual fund. He's the author of seven books, including the recently published Enough: True Measures of Money, Business, and Life. In this final of three installments, Bogle talks with Motley Fool retirement expert Robert Brokamp about the big question every investor should ask.
You can also access the audio version of this interview.
Robert Brokamp: What would you say are the top three changes that need to be made on Wall Street to make it a better place for the individual investor?
Jack Bogle: Well, the beginning is one change that we simply have to have, and it is amazing to me how few investors have considered this question. We have to have every single human being who is a participant in our markets ask himself or herself this fundamental question: Am I an investor or am I a speculator? An investor is someone who owns business and relies on business to produce returns on the capital they have invested over the long term. And since businesses individually are quite unpredictable, owning a huge segment of all of American business seems to me to be the winning strategy. Buy American business and hold it forever, Warren Buffett's favorite holding period. So investors will do that.
Speculators are basically saying, "I think I can sell this stock or get out later on when someone will pay a higher price for it than I will." Speculation is a bet on price rather than on corporate value. Speculators lose, by definition, by mathematics, by tautology, and investors win.
I like to visualize that by saying: Let's think about dividing every stock, by assuming that every stock in the S&P 500 has two constituencies. Half of the shares of GE, for example, are held by speculators and half are held by investors. So that half of the S&P 500 list that is held by investors doesn't trade, they are long-term investors. They are in there to own the businesses and they capture the returns those corporate institutions earn -- our big, productive U.S. corporations. If they earn 8%, you will capture 8% if you are a pure investor. Maybe a little tiny bit less if you do it through an index fund.
The speculators, on the other hand, have no one to trade with but each other, so there is no trading that goes back and forth, by definition, by the investors, but all trading is focused on the speculators. They trade, Peter trades with Paul and Paul trades with Peter, and that is, by definition, not a way to capture the market return, but a way to lose some of the market return because of those croupiers in the middle: the Wall Street investment bankers, the brokerage firms, the mutual fund money managers, the deal makers, the attorneys -- everybody. The accountants -- everybody who is subtracting value from the investment food chain. And to understand that, you just have to realize that it is the investor who sits at the bottom of the food chain of investing. Everybody else gets paid before you do. You have a residual claim, as an economist would probably say.
Second, you want to think about asset allocation, which we have talked about earlier. Having a bond position, at least you think about a starting point. A rule of thumb is to start with how old you are and have that much of your assets in bonds. We all think stocks do better over the long run. You would be amazed how many times you read that, but I have never allowed that when I was running this place, Vanguard. I never allowed that to be said. I said, "You know what you really mean is stocks have done better than bonds most decades in the past. In fact, in one out of every six past decades, bonds have done better than stocks, so you should never put a future connotation around how stocks and bonds have done, but only in the past."
So I think if investors would think in that way, try and insulate themselves, immunize themselves, against the wiles of the mutual fund industry and the hedge fund industry, which are always creating new hot products and lure you in by showing past records that won't be repeated in the future. So think for yourself and don't let a marketing business persuade you it is a management business.
So this comes back to the real change that I think we need. We have let speculation not be half of the market, as in the example I mentioned a moment ago, but probably five times as much speculation as long-term investment is going on in our stock markets in these volatile days, and that is the cause of much of the volatility. Not an opinion on price, but an opinion on prices other people will put on price. And so we have, this year, it looks to me like the stock market turnover will be about 340% with a two month, two-and-a-half month holding period or something, for the average stock, where the previous high and the previous speculative boom was 140% in 1929. When I came into this business for the first 20 years, it was 30% a year, actually less than 30% a year for 15 years. So you don't need all this speculation, but speculation is feeding the croupiers, the gamblers be damned.
Brokamp: When you talk about stocks and bonds, are you talking about basically the total stock market and the total bond market funds?
Bogle: Yeah, although I wouldn't want to say that the S&P 500 Index Fund, that first index fund that I created back in 1975, is virtually as good as the total U.S. Stock Market Index Fund that we created later on. It was easier to start with the 500; everybody knew the 500 Index in those days, those ancient days, but they track each other very closely. I am talking about an S&P 500 Index Fund or a Total Stock Market Index bought and held forever with the default position being the total stock market fund.
In the stock market, the S&P 500 is outpacing, in very round numbers, probably two out of every three large-cap, similar large-cap type funds, U.S. equity funds that are balanced, more or less, between growth and value. The S&P 500 is ... actually outperforming almost 80% of all mutual funds because so many of them were in international developed countries, in emerging markets, in small stocks, particularly small growth stocks, which have not done well. That group of investment strategies has done rather poorly this year, much worse than the 500.
So it is the 500 Index and the total stock market index funds are outperforming pretty close to 80% of all equity funds. So it's a great year to give the lie to the fact that managers can outmanage index funds because of all the flexibility that they have on the downside --- that they can get ready for these declines and beat the index by their greater smartness. The evidence that they have that greater smartness is zero. In fact, the cash position of the average managed-equity fund is around 4% to 4.5%, just what it was at the market's high and mutual fund managers don't or can't or won't time the market.
On the bond side, the news is even better because total bond market index funds, because of its combination of both Treasuries and high-grade corporates, have outperformed almost every bond fund around. At least I am particularly amused by the fact that our bond index fund is even doing a little bit better, at least as of today, year to date, than the PIMCO Bond Funds, and they are very smart fund managers, probably the best in the business and so a great year for stock indexing, a great year for bond indexing and encouragement to get on this simple bandwagon of ownership and investment, rather than speculation and trading. So my convictions are, and I am sure this won't surprise you a lot, have even been strengthened by the events of 2008.
Brokamp: What is the one thing you know about investing that you wish you knew when you first started?
Bogle: I guess the fragility of expecting managers to outmanage the market. I hinted at it in my Princeton thesis -- that mutual funds can make no claim to superiority over the market averages -- but I didn't document it, and nor did I have the actual experience. When we start a new fund at Vanguard, when I was running this place, our idea is to have a fund that investors make money in. I care much more about that than the fund's record because for years and years I have observed that funds that have good records don't attract capital until those good records have appeared. So we are always chasing performance. And if I had realized the extent to which investors were chasing performance, I would have thought much more seriously much earlier about starting the index fund, which is going to have the market performance, just clean and clear.
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