David and Tom Gardner recently interviewed Vanguard Mutual Funds founder Jack Bogle on The Motley Fool Radio Show on NPR. Bogle, who is credited with popularizing the index fund, is currently the president of the Bogle Financial Markets Research Center. This is the third of four parts. All previous parts are linked to the right.

TMF: Let's continue with your new metric for measuring mutual funds: the stewardship quotient. The first part on the SQ was -- what does the fund cost? What does it charge per year? Low cost, high SQ; high cost, low SQ. What's the second part?

Bogle: OK, No. 2 is portfolio turnover. Portfolio turnover is costly. It is directly related to the higher costs I discussed earlier so you want low turnover. If you can get a fund under 30% a year, I would say that was good. Probably above 70% is simply unacceptable.

TMF: According to a study you cite during the period 1984-2002, the U.S. stock market, as measured by the S&P 500 index, grew at a yearly rate of 12.2%. The average mutual fund, however, grew at a rate of 9.3% per year. So, the index fund outperformed the average mutual fund by nearly three percentage points per year. Why, specifically?

Bogle: When you add all the costs together, it comes to something like 3% a year, so it gives us a shortfall of 3%. That was all those brilliant mutual fund managers out there; professional and expert and well educated and trained, and most of them are. They have created such a perfect market that good results by one of them offsets bad results from the others. The average mutual fund manager is average.

TMF: So why does this industry exist outside of indexing? Let's say there is a select group that has proven if you take, for example, Jim Gibson at the Clipper Fund...

Bogle: Excellent man.

TMF: ... has outperformed the market consistently and has a theory that underlies his investment approach. Why do the rest of all these thousands of funds that consistently underperform the market, why do they exist?

Bogle: Well, they have a great sales force. Financial services in this country, since the beginning of time all over the world, have grown more by appealing to supply push. That is, go out and pay a lot of people a lot of money to sell your wares and by demand pull. That is to say, make it very attractive to the buyer and the buyers will beat a path to your door.

TMF: Now, Jack, you probably know something about our investment approach. The first step for anyone going into the stock market, we think, is to own index funds. For a lot of people, that is the last step. A nice diversification of different funds, perhaps by sector, but in general, a lot of investors are just served by buying the total stock market index fund, adding to it regularly, paying down their credit card debt, and enjoying the rest of their lives.

However, we also really enjoy following individual companies and investing in individual stocks. Under what circumstances do you think is a good idea for someone to spend time investigating companies and buying shares in stock?

Bogle: I think the decision to do that pretty much lies with the investor. I think an investor should be perfectly comfortable. If he doesn't want to play the games that are involved and have the excitement of the stock market and the romance and being able to talk about his latest victories and perhaps his latest losses, I think an all-index fund portfolio is fine.

For investors who want a little of the fun of the chase and are interested in financial numbers and companies, I think what they should do is divide their investment account into two portions. One is the serious money account: your retirement, your children's college education, your new home, whatever it might be. That should be an index fund.

Then the other portion, the "funny money" account, should be in maybe some speculative mutual funds. Pick a stock or two or three. I think you might get a lot of enjoyment out of it. A lot of people like to gamble. It is an instinct that is hard to do away with so give into it, but don't give into it too much. If I was very, very generous, I would say under no circumstances should the "funny money" account be more than 25% of the total, but the truth is I tell people that the "funny money" account should be no more than 5% of the total.

TMF: Jack, let me ask you, have you ever made any stock investments that you are happy with?

Bogle: I had not invested in individual stocks except for holdings that were companies that I had been a director of. I don't think I have bought an individual stock in 35 years.

TMF: Wow! Do you think that I would be speculating or gambling to purchase shares of Berkshire Hathaway(NYSE: BRK.A)? Does that sound like, because that feels more to me like a mutual fund, a very well-managed mutual fund with no annual expense, run by one of, if not the greatest, money managers in American history?

Bogle: Well, no one can fault Warren Buffett and Berkshire Hathaway. That is the crème de la crème of money management with a record that will stand I think longer than any other record we know of. All the home-run records are going to be broken. All the point totals in basketball are going to be broken sooner or later. Records are made to be broken. His record is going to be a very hard one to break.

On the other hand, it is heavily insurance-oriented. Not particularly diversified. It may have, over time, a good record although Warren Buffett is the first one to say given the size of Berkshire Hathaway, when you look at his past record, his expression is -- he always puts these things so well, at talking about how much money he has to preside over -- a fat wallet is the enemy of superior returns. He would be the first one to say that wallet is fat and therefore I think those superior returns may be hard to come by. So, sure, put it in the "funny money" account, but watch it carefully.

Tomorrow: Investors' most common mistake.