The "Little Book, Big Profit" series of short-but-sweet financial texts continues to offer up an all-star list of authors and tried-and-true investment strategies. What started with Joel Greenblatt's The Little Book That Beats the Market and continued with Christopher Browne's The Little Book of Value Investing has led to John C. Bogle's The Little Book of Common Sense Investing, which was published earlier this year.
Oddly enough, Bogle's contribution to the series contradicts the teachings of the first two readings. Yet Bogle makes a convincing case. His argument: Common sense suggests that investors will fall flat on their faces if they try to beat the stock market. Bogle's logic is sound, he has plenty of data to support his case, and he has the backing of a number of the investing world's heavy hitters. He cites none other than Benjamin Graham and Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) Warren Buffett as supporters of index investing as "the only way to guarantee your fair share of stock market returns." But more on that later.
First off, Bogle explains that an index fund is "simply a basket (portfolio) that holds many, many eggs (stocks) designed to mimic the overall performance of any financial market or market sector." Most investors consider the S&P 500 the quintessential index to track the performance of companies in the United States, and Bogle illustrates that over the long term, S&P 500 returns closely resemble that of all publicly traded domestic securities.
From 1928 through 2006, the stock market returned 10.1% annually, according to data Bogle cites. That's a darn good return on your money, and one would think that financial professionals would be able to help investors earn more than that by passively ponying up for the overall market return, since it can be accomplished by buying a low-cost index fund -- the type that Bogle invented back in 1974, when he started Vanguard, one of the largest asset managers out there and a champion of low-cost, passive investing strategies.
Investment professionals don't earn their keep
Too bad, then, that the investment profession has a horrific track record helping Main Street investors beat the market. Why? "After the deduction of the costs of investing, beating the stock market is a loser's game," according to Bogle. His logic is straightforward: The average of all investment activity is, by definition, the market return, or a zero-sum game, since one investor's gain is a loss to the one on the other side of the trade. With each buyer there has to be a seller, and the combination of all activity shakes out to the performance of the stock market, which literally turns out to be "average."
Chapter 8 is meant to be Bogle's smoking-gun demonstrating the near-impossibility of finding an active manager capable of beating the market over the long term. His study of 355 equity funds that existed in 1970 resulted in 223 that have since gone out of business. Nine became long-term winners, but six of them fell by the wayside because they became too large and popular to keep beating the market. Sad indeed, but is that the whole story?
Well, when you subtract the advisory fees and trading commissions Wall Street charges for managing portfolios, investors do badly lag the market. Throw in the fact that human nature causes us to chase performance and jump on the latest investment fad, and it's easy to see why "the two greatest enemies of the equity fund investor are expenses and emotions." Worse yet, the investment pros buy and sell stocks in rapid-fire fashion, which increases trading costs and can lead to short-term capital-gains taxes. Bogle estimates that the investment profession collectively shaves 3%-3.5% annually off of the stock market return, which they are more than happy to collect and divide among themselves.
What's an investor to do?
Buying an index fund is, in fact, a tough proposition to pass up, and it suits the majority of investors. Bogle refers to it as buying the haystack instead of trying to find the needle, or an actively managed fund that can consistently beat the market. What's more, indexing is cheap, with total expense ratios of about 0.2% during his measurement period. That's still guaranteed underperformance, but it's far less than most active managers charge in aggregate.
The Foolish bottom line
Overall, Bogle's argument is convincing, and it is widely accepted that the vast majority of actively managed funds will underperform the market. However, I found that he glossed over those needle-in-the-haystack investors such as Buffett, Peter Lynch, Bill Miller, David Dreman, John Neff, and the authors of the first two Little Book publications, who all weigh in with their own insight on how investors can beat the market by embracing value-investing philosophies and investigating companies such as Motley Fool Inside Value recommendation Wal-Mart (NYSE:WMT), Income Investor selection Johnson & Johnson (NYSE:JNJ), or General Electric (NYSE:GE).
So while Bogle cited Graham as a proponent of index investing for the vast majority of investors, Graham is actually considered the father of a common-sense investment philosophy that consists of using Mr. Market's manic-depressive tendencies to take advantage of overt fear in the stock market. For further reading on this subject, check out Graham's book The Intelligent Investor, an investment text we here at The Motley Fool consider one of the top investing books of all time.
Again, most investors will find index investing a low-cost, convenient way to benefit alongside the most successful firms in America. Graham referred to the index-investing style as one for those without the time or temperament to devote to locating stocks that trade at a significant margin of safety below their intrinsic values. Index investing is "haystack investing" indeed, but the common traits that successful investors share seem too compelling to simply ignore.
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Fool contributor Ryan Fuhrmann is long shares of J&J but has no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.