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John Bogle, founder of The Vanguard Group, was named one of Fortune magazine's four "investing giants" of the 20th century. Bogle launched the first low-cost index mutual fund in 1975 and has long advocated indexing for everyday investors. We recently had the pleasure of speaking with Bogle to get his thoughts on whether buy-and-hold investing is dead.
What follows is an edited transcript of our interview.
The Motley Fool: Over the past year, a lot of people have questioned the foundations of investing, so let's start with a very basic question in terms of investing in stocks. We all say stocks should be invested for the long term, but in your opinion, how long should the "long term" be? In other words, what time frame should people be thinking about when they are committing money to the market?
John Bogle: I would say forever -- or an investment lifetime. There is no point in doing anything shorter than that. You should be owning stocks -- or much more accurately, owning businesses -- and holding them forever, said to be Warren Buffett's favorite holding period. Trading stocks is obviously a loser's game. Just envision this with me for a second:
Let's assume that each of the stocks in the S&P 500 -- all 500 stocks -- let's assume that half of each stock is owned by traders and half of each stock is owned by holders (long-term investors). So the long-term investors will capture the market return. They own half of the market, they don't trade and they capture, therefore, the entire market return, assuming maybe nominal indexing kinds of costs.
The other half are trading, but they are, of course, trading with each other because the long-term investors aren't trading with them. It follows as the night to the day that the traders will lose by the amount of money paid to the intermediaries, the croupiers in the middle.
It therefore follows logically and mathematically that buying and holding is a winner's game and buying and trading is a loser's game. Simple as that. No way around it.
How long do investors need to be in the market to benefit?
TMF: In terms of an investor's time frame, let's say someone has some money and they plan to retire eventually, what would you say is the amount of time they should be in the market to get the benefits? So let's say they are 50 years old; they plan to retire at 65. Are you talking about money you don't need for five years, 10 years, 15 years?
Bogle: Well, that brings up the obvious question of asset allocation. For stocks, we have a rule that's becoming increasingly popular: that your bond position should equal your age. So your stock position at age 65, say, would be 65% bonds, 35% stocks -- gradually with the stock position going down as you age. That shouldn't change.
You should hold less in stocks as your time horizon shortens, in my conviction, for simple reasons. That is, what happens when you get older? You have got more money at stake, you have got less time for the market to bail you out of your mistakes and you are going to have to rely on investment income rather than human capital income to get by. All of those say "bonds over stocks" as a more important position in the portfolio.
If you said "What kind of a time horizon should I have to be in the stock market?" If you are not in the stock market, I would say 10 years. If you are going to be in the stock market for less than 10 years, I wouldn't do it; it is too unpredictable, too fraught with speculation.
But on the other hand, in my little way of looking at it, the stock market at 15% of your portfolio is a very different thing from the stock market at 100% of your portfolio. Again, when you talk about holding periods, I am talking not about holding stocks; I am talking about holding the entire market. All bets are off if you want to concentrate on a small handful of individual stocks. The risks have never been higher.
The risks have never been higher for some obvious reasons. One, this incredible collapse of our financial system. Two, the increasing power of globalization going back for around 20 years -- which means we have global competition, which will take U.S. companies out in favor of global companies. They will be creatively destroyed rather than being creative destroyers, in the Schumpeterian sense.
Finally, you have this technology revolution, which means that a company that is dumb and happy when the market opens today, may be out of business at the close of the day because someone has a better idea. So with the financial collapse, the global competition with technological innovation, the reasons for holding individual stocks are smaller than they have ever been -- and they have always been small.
And finally, don't forget this: As a group, we are all buy-and-hold investors. That is to say, all of us together own the stock market, so we are buy and holders, but we insist on swapping back and forth with one another. This is an investment system, a marketing system in which our croupiers basically pit one investor against another, knowing that there is only one winner -- and that is the croupier. One sure winner.
Bogle: Know that buy-and-hold investing is not dead, but you have to put the asset allocation factor in there.
Back-tested approaches that beat buy and hold
TMF: One of the challenges nowadays in defending buy and hold is that there are so many articles and even books now coming out showing that some other strategy would have beaten buy and hold, such as using a simple moving average or momentum strategies with ETFs. As an example, there is a new book out by Sam Stovall, chief investment strategist at S&P, which lays out seven different basic strategies based on momentum and ETFs. It has all these charts showing how these strategies would have beaten buy and hold over the last 10, 20, and 30 years, so if someone comes up to you and shows you these back-tested returns and then says, "See, this would have beaten buy and hold" -- what is your response to something like that?
Bogle: It is the easiest thing in the world to look backward on paper and pick out strategies that have won. If you can't do that you are, for the want of a better word, a moron. (Laughter.) Right? So these back-testing things look great in retrospect. I mean, if it doesn't look great, it isn't in the book, right?
Bogle: I would call books like that a cheap shot. I like Sam, but it is not right because the idea that the past is prologue has been disproved time and time and time again. If I can quote Samuel Taylor Coleridge for you, "History is but a lantern over the stern." Showing you where you have been, but not showing you where you were going. Did I make myself clear?
TMF: Very good point. Yes, I think you made yourself very clear. (Laughter.)
Is the index fund actually actively managed?
TMF: You have called index investing the ultimate buy-and-hold investing strategy, and when people think of index investing, they often think of basing an index fund based on the S&P 500, of which the Vanguard 500 (FUND: VFINX ) is the oldest version of that. But some critics would say, well, that is actually an actively managed fund, managed by the S&P Index Committee, which does make changes every once in a while. What's your response to that? And a follow up, is there a better index to be basing an index fund on?
Bogle: Well No. 1, the idea that this prescient committee has anything to do with anything is simply balderdash. The S&P 500 has a correlation of 0.99, if they would simply use the 500 largest stocks in America, OK, no committee.
But when you fall out of the top 500, you are out and when you enter the 500, you are in. If you just did that continuously over the last 50 years, the correlation with the index would be 0.99. That committee isn't picking some funny little stock out of nowhere; they are picking the new big stocks. When old companies go out of business, they pick the newest big companies and if somebody gets very big, they will drop an existing old company. But the committee thing is just hokum, just designed to addle the minds of investors.
No. 2, the S&P is a very imperfect index. By operating the way it does, sometimes those new stocks go in and the stocks that are already in it can fall from the great heights to the great depths, and have. There were a lot of high-tech stocks that were put in that index because they got large. It is a very flawed index and I can see that and then I ask this question: If it is that terrible, how the hell is it beating all these money managers all the time? (Laughter.) Think of what a good index would do, right?
Bogle: Now we do have a good index and that is the index of the total stock market. That is also weighted by larger companies, but it isn't all-encompassing; now the Dow Jones and the Wilshire seem to be at some kind of odds, but it is the Dow Jones Wilshire 5000, or whatever it is called now and it goes back and correlates perfectly with the University of Chicago CRSP Index, going back to 1928. So we have the data on how the total stock market has done and guess what? The S&P has actually done a little bit better than the total stock market.
TMF: That is interesting.
Bogle: You can see the chart on that in my Little Book of Common Sense Investing. But the "betterness" is simply a matter of time-dependence. You knock out a couple of years at the beginning and the total market has done better than the S&P, or a couple of years at the end. You can play games with it, but the correlation I think comes out to be 0.94 between the two indexes because the S&P is pretty consistently around 80% of the market. Yes, it is a flawed index. Nonetheless, it tracks the market well and if someone can design a better index, the poor money managers will all go out of business.
Small caps and international investing
TMF: Building on that, do you see a benefit for adding other types of investments, whether it is an index fund or otherwise, such as tilting your portfolio to small caps or international investing?
Bogle: I do not. I believe that the markets are highly efficient.
Not perfectly efficient, I'd quickly add, but highly efficient and therefore if there is great value out there, it will ultimately be reflected in buying those securities for a higher price.
If you look at the record over a long period of time, you look at something like small caps, you can find 20-year periods when small cap … I freely concede that in the time-dependent period that French and Fama look at, probably going back to 1928, small cap has done better and what can I say? But there are periods that are as long as 20 years in there -- that is a long time to wait -- when large cap has done better.
Going forward, if the evidence is that persuasive, the small-cap bias or value bias is better, well those prices will reflect it. So if it is true that those things are better, then it won't be true, OK? Because the market will reflect that, so I look at the market as a good arbitrageur of the future against the past.
Now international is a little bit different. I have a home country bias because I earn my money in dollars, I spend my money in dollars, and the dollar is probably in for some trouble, but don't forget a weak dollar will create a lot of value for U.S. corporations. They will be doing more business abroad if the dollar is weak. So that should raise the value to at least some offsetting extent of the market cap of U.S. stocks in general because they do probably 40% of their business outside of the U.S., on average; the bigger companies certainly do.
So what worries me is the time we talk about adding to the diversification mix is usually when these kinds of investments have done very well. When did people start to talk about gold? Back when it hit a high. When did people start to talk about commodities? A year-and-a-half ago, when they were on an all-time high. Emerging markets were at an all-time high.
Then they all, of course, collapsed last year and while international isn't doing very much this year, and significantly better than the U.S., the emerging markets really leaped this year, as you know, and I don't know what to do about that. If you have a permanent holding in emerging markets, which is where I would prefer if I were investing, the developed markets don't do too much for me. They are run just like the United States; Europe is kind of sick. Japan is kind of sick. But if you want an international component, I would lean toward emerging, but I would get into it very slowly and the time to get in was when we were all scared to death last October and November. Just average in very slowly, maybe to the point of 10%-15% -- no more than that if you are equities. ...
We have this performance-chasing bias in this business, which just kills us. And we see and we can measure this; I can't give you the exact number, but you can get it out on Morningstar (Nasdaq: MORN ) . Let's take a look at our emerging markets ETF and our emerging markets fund. They both lag the emerging markets over the last five years. Both lagged significantly the return of the emerging markets themselves. The ETFs by a colossal amount. I think the difference are our own emerging markets fund and the Barclay's emerging markets fund lag by the fund's reported performance over the last five years ran 2 or 3% a year and the ETFs lag, our ETFs lag by about 7or 8% a year.
It is astonishing. Investors are their own worst enemies.
For more on the buy-and-hold debate: