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Interview with John Bogle of The Vanguard Group
James Lange, CPA/Attorney
Special Guest: John Bogle, Founder of Vanguard Financial Group
|Click to hear MP3 of this show|
- Introduction of Guest – John Bogle
- Investment vs. Speculation
- Profound Conflict of Interests in Money Management Businesses
- What Bought on the 2008-2009 Financial Crisis?
- Fiduciary Standard and Disclosure of Fees Should Be Enforced
- Index Fund Investing = A Winning Strategy
- Bogle’s Ten Simple Rules for Investment Success
- Don’t Speculate to Get Higher Yields
- The Value of Hiring a True Fiduciary Advisor
|James Lange, CPA/Attorney (left) and Mr. John C. Bogle, Founder – Vanguard Group|
Jim Lange: Hello. This is Jim Lange of the Lange Money Hour: Where Smart Money Talks, and I’m here today in the Vanguard Studio with Mr. John C. Bogle. Mr. Bogle was the founder and now-retired CEO of the Vanguard Group, the world’s largest mutual fund company with $1.7 trillion under management. Mr. Bogle formed the first index fund available to individual investors, now known as the Vanguard S&P 500. In talking about the Vanguard S&P 500, Paul Samuelson said, “I recognize this Bogle invention, along with the invention of the wheel, the alphabet and Gutenberg printing.” Over the course of his sixty-year career, Mr. Bogle has literally changed the face of investing. Fortune magazine ranked Mr. Bogle one of the four investment industry giants of the twentieth century. Mr. Bogle has written ten books, from the 1993 bestseller Bogle on Mutual Funds to this year’s The Clash of the Cultures: Investment vs. Speculation. Many of your previous books strike me as books that were really more of a how-to book. This book takes a much different perspective, a broader perspective, frankly, controversial. Why tell this story at this point in your career?
John Bogle: Well, to begin with, I have a love affair with history, and there are many things in the new book that if I don’t write them down and put them between a couple of covers, they will be gone. They will not be a part of history. So, students of the financial markets, students of financial history, will be greatly enriched by the personal experiences I’ve had going back to 1951 and during my early career with Wellington Fund, a merger that I did that went wrong, a big mistake in my life, the creation of Vanguard, and many of the issues that we face today in the financial sector, including a disgraceful lack of much interest in being active voters among mutual funds. They’re passive. They don’t do anything to fix the corporation and governance itself. So, it’s history, it’s a peek at the past, a peek at the present, and a little investment advice at the end, just a teaser.
Jim Lange: You talk about the difference between investment and speculation, which is obviously the theme of the book. So, maybe I thought that I could just ask you directly what do you see the difference of investment and speculation, and what are some of the problems when we get away from investment and we go towards speculation?
John Bogle: Well, of course, there are a thousand definitions of investment and probably two thousand definitions of speculation, but the fundamental building block of that difference of investing is about owning corporations, businesses that actually exist, focusing on their intrinsic value, their ability to grow over the years through earnings, through paying out dividends, reinvesting the rest in the business, and holding corporations for the long run. That’s where wealth is generated. It is not generated in the stock market. So, when you have, let’s call it, focusing on intrinsic long-term value as the definition of investment, speculation is betting on price, and price is ephemeral. Price is the price of the stock. It’s anything but eternal. You’re betting on price, you buy and sell with great frequency. While investing is a long-term process, speculation is a short-term process, sometimes it seems, Jim, getting shorter every single day. We now have some high frequency traders out there who trade stocks every fifteen seconds, but it may even be an average of fifteen seconds. It may be trading in nanoseconds. Bam, bam, bam. That’s speculation. It’s not investing.
Jim Lange: And how would you see the difference in the culture? Because there’s obviously a completely different way of thinking between speculation investment, and how do you think the culture has changed?
John Bogle: Well, investing is about long-term wealth creation. Speculation is a culture of trading with the other person, which could be another investor or another institution, and we know, we know, Jim, that that is a loser’s game. It has to be a loser’s game because if you bet ‘a’ is gonna go up, let’s say Apple and you’re selling it to someone who believes it’s gonna go down, one of you are gonna be right, one wrong. So, the central fact of that trade is the man in the middle, the croupier, the broker, the money manager are all in the middle, and so it’s not an even bet. It’s a 50/50 bet until costs of the croupier are taken out. If it sounds like I’m talking about Las Vegas, I am. You know, we gamble back and forth trying to get other people’s money, but the house always wins. If it sounds like I’m talking about the racetrack, I am. If it sounds like I’m talking about the state lottery, the worst, biggest, greediest croupier of them all, where they take in, let’s say, $100 million and maybe pay out to the winner $50 million, and the rest goes into the coffers of the state. Totally unproductive. We all think that we are on the winning side, but since there are two people on every side, it’s what people don’t get about investing. It doesn’t create value. It subtracts value, or speculation does, and investing adds value.
Jim Lange: You’ve always been a champion of the everyday investor, and made a case for fairness, transparency and fiduciary duty, which is a continuing theme of yours. I read your book as almost an indictment of some of the culture of speculation, specifically corporate and mutual fund management, and to some extent, Wall Street itself. Is that a fair reading, or is that a fair characterization of some of your thinking right now?
John Bogle: I think you understate my concerns! Wall Street is a mess. Can I say it any more boldly? Our financial system is a mess, heavily based on trading and speculation and not nearly heavily enough based on investments. Let me just give you an interesting example, maybe a little bit unfair, but that’s okay: the basic function which everybody on Wall Street knows, as regulators know, which people that love the system know and people who hate the system know, is the basic function, the classic function of our financial sector is to direct new capital to its highest and best and most profitable uses. New companies, existing companies with new ideas, who needs the capital? We’ll get it to the people that really need it the most and can do the most with it. So, how much of that happens every year? Well, the answer to that is around $250 billion is directed into initial public offerings and secondary public offerings of corporate stock. $250 billion. That’s the investment part of our system. How big is the speculative part? Believe it or not, Jim, we trade $33 trillion with one another all year, gambling back and forth, every gamble creating a winner and a loser, and then that little croupier in the middle, who’s little tiny bit of money turns out to be billions. If you think about it that way, $250 billion versus $33 trillion, it’s fair to say on that basis, and this is, you know, many ways of measuring this, I admit, but on that basis, it means that 99.2% of our financial system is dedicated to speculation, and 8/10ths of one percent is dedicated to investment. Do the math. That’s the number.
Jim Lange: You also talk about the conflict of interest, which is a recurring theme of yours, between corporate and mutual fund management and people who are supposed to have a fiduciary duty towards shareholders. Could you expand on that idea of fiduciary and conflict of interest, and why you think our system is, to some extent, or maybe to a large extent, broken, partly just because of that conflict of interest?
John Bogle: Well, to begin with, you have to think of this as what the economists would call an agency problem. Are the agents representing their principle? In this case, for the first time in human history, we have two sets of agents facing each other. On the one hand, we’ve got corporations, and their agents are their management. The principles are the shareholders. There’s a great temptation for the managers, the chief executives and so on to run the company for their benefit, short-term benefit often, stock options, compensation, bigger to get more money. They do mergers a lot. So, they’re the agents, and the issue that’s raised over there is they really aren’t representing their principles, the shareholders of the corporations. Over here, we have another set of agents, and these agents actually control about 70% of all the stock in America. There are financial institutions, and when I came into this business in 1951, these financial institutions investing money for others controlled about 8% of all shares of stock in America. Today, they control 70%. These agents, these large institutional money managers, for pension funds and mutual funds, I should say more than parenthetically, all firms are in both businesses, you can’t really separate them anymore, are representing too much themselves and not enough for shareholders who have given them money, or the pension beneficiaries who they owe a duty to, to create a retirement fund. They’re looking after their own interests. They’re charging high fees. They don’t want to get into corporate governance. The absenteeism from the corporate owners, from corporate governance issues, how the corporations are being run, is just striking, and in the long run, totally counterproductive because someone has to look out to make sure that these corporations themselves, the big industrial companies of the land, are being operated in the interests of their shareholders, and here we have the agents representing all of these shareholders, only 66% more or less, of the stock of every single corporation have the absolute power to change the system, and they do almost nothing. Zero. They sit back and endorse management proposals, endorse mergers, endorse compensation, and pay little attention to the interests of the shareholders behind that.
Jim Lange: Well, I guess corporate management isn’t the only people that you indict, specifically chapter two, The Double Agency Society and Happy Conspiracy, you name ten, you call them gatekeepers. And they include Congress, the judiciary, the SEC, the Federal Reserve Board, the rating agencies, the financial press, security analysts, corporate directors (who we’ve been talking about), and institutional stockholders, who, in your own words, have played in betting a new culture of speculation, particularly in the period of the great crash of 2008-2009 and it’s aftermath. Is that a fair indictment of so many well-respected institutions?
John Bogle: Well, it’s certainly a broad indictment! I might’ve left somebody out though. I’m not sure who that would’ve been!
Jim Lange: And you can pick anybody who you like, but…
John Bogle: Well, take a good example, is the security analysts of the mutual funds. They should be interested. If the management of a corporation that they follow research for is failing, they should be taking an initiative to get that management changed to vote either to change it by throwing out the board of directors, whatever it might be, and they can do that. They have the power to do that. It may be awkward and cumbersome, but they have the power, and they don’t do anything! They seem to be much more interested, the security analysts, in the price of the stock. That is to say, again, the speculative aspect of it. They want the company to give them earnings guidance. It makes the analysts look good when a company says “I’m gonna earn 87 cents this year” and they earn 88, something like that. They want that guidance to be realized, and there’s no earnings guidance, almost, this is a slight overstatement, that can’t be a target that can’t be reached, because if you get halfway through the year, or ¾ of the way through the year, you start playing financial engineering games and you write off things faster or more slowly, depending on which way you want the earnings to go. Look how you do a merger. That’s the greatest muddier numbers that I know of. So, you really basically cannot trust, in a very fundamental sense, the earnings estimate produced by these corporations. So, that’s why I indict the accountants. Where the heck are they? And let me give you one example of this: corporations, all in their annual report, they have to report on what earnings they expect from the pension plans that they oversee for their employees, and virtually unanimously, they report 8%. That’s kind of what a historical return might have been, but they ignore the fact that history is meaningless. History is yesterday. What’s important in projecting for the next ten years or so, what the pension plan is gonna earn, we have some knowns. The intermediate term government bond yields less than 2%. Don’t forget, we got to get to 8% here, and a reasonable return for stocks might be 7%. So, you got a 4 ½% return on a 50/50 portfolio. Then you take out the costs of investing. One of the fascinating subfacts, fascinating to me, is that all these projections are based on stock market returns without recognizing the obvious. We don’t get the stock market returns. We get the stock market returns, less cost, and they totally ignore cost. I mean, you know, it’s a vested interest. It’s shocking. But I think I can say, unequivocally, you can check me out in ten years, I think it’s fair to say there’s not a prayer that these companies can earn that 8%. Their shortfall is going to be great, they’re gonna have to put up a lot more funding for the pension plan, and it’s a very troubled part of American business.
Jim Lange: And I guess what happens when you understate the pension liability is that you are, in effect, overstating assets, understating liabilities, that would cause a company to be valued higher than it should?
John Bogle: That’s the trick! Corporations have actually done this. If you got a little earnings shortfall, you say “You know what? I think it’s reasonable to assume that my pension plan is going to earn not 7%, but 8%,” and all of a sudden, you made half a billion dollars, or something.
Jim Lange: And I guess it’s just not corporations. I think we’re seeing that at the local, state and federal government.
John Bogle: The federal government, for reasons that I’ll come to in a second, is not that much of a problem. Certainly, the state and local governments are. They’re using the same 8% before the costs of investing, before thinking about current interest rates. I mean, today’s interest rate on a bond has basically a 90%+ probability of being the actual return that bond will deliver you over the next ten years. Not very surprising because all of the return on a bond comes from interest, and the interest doesn’t grow. You’ve got a little contract there to get a coupon twice a year for the next ten years, and the bond will then be, if you’re lucky, retired at par. So, there’s no extra long-term difference. All you have to do is know the yield. So, we know what the bond portfolio’s going to earn, we know, and they seem to ignore all that. So, it’s a very, very games-playing, manufacture the numbers kind of game that the auditors, which is where we started here, ought to say, “Whoa!” Now, they may say, “We don’t have any responsibility for that.” What are they there for? You know, if it’s true that they don’t have any responsibility, they better take some responsibility because the corporate managements are gaming this number.
Jim Lange: They are attesting to the financial statement. If the financial statement isn’t accurate, then they’re not doing their job.
John Bogle: I suppose you could say, “What does this guy Bogle know? I think the returns in the next ten years are gonna be 10%.”
Jim Lange: You could probably spend an hour on each one of those, including Congress, but maybe we should move on. Do you think that some of the problems that you had mentioned earlier, in terms of speculation versus investment, were really the cause of the financial havoc that we had in 2008 and 2009, or at least partly responsible for some of the problems that we’ve had?
John Bogle: I wouldn’t put speculation at the heart of that. Of course, there’s speculation because when someone sells you one of these collateralized debt obligations, you’re speculating that it has a rating agency, or some independent analysis says these things are money good. The basic part of that was a terrible fraud perpetuated by mortgage companies countrywide, Washington Mutual. The system works like this: you got salesmen out there, and their job is to sell money, so they find somebody who makes $20,000 a year, they get them to take on a $200,000 mortgage, and actually give them a $300,000 mortgage so he spends $100,000 before he buys a $200,000 house. This has been known to happen. And why don’t they care? Because they sell the mortgage to a bank. Why doesn’t the bank care? Because they sell it to a collateralized debt underwriting. We sever in that system the essential link between borrower and lender. If there’s no connection between the borrower and the lender, the lender’s gonna be like, “Hey, he doesn’t care about the borrower.” He’s going to get rid of the instrument and give it to somebody else. And the rating agencies have a huge bonus on them for what they did in this area. You know, it was well known that you could kind of buy ratings. I believe these companies were paid to give a AAA rating to a collateralized debt obligation. As far as I know, believe this or not, there were no non-AAAs because you’re going to sell one of the AAAs. So, the underwriter would work with the rating agencies and say, “What do we need to do to make this a AAA?” They all come out AAA, and, of course, we now know that some of the ones that came out were single Zs at best!
Jim Lange: Included in your list of institutions that you indict, you do include Congress. Do you think Congress has a role in trying to change some of these habits of behavior?
John Bogle: Well, poor Congress, you know? They’re a bunch of nice people. The complexities of the financial system are, in fact, rather overwhelming. So, they listen to industry lobbyists and get directed in that direction, unless you get a real crisis as we had in 2008 and 2009, and then they’re following the ancient rules, sometimes a good one, mostly a bad one, don’t just stand there, do something. So, they passed the Dodd-Frank Act and it still got nowhere three years later, I guess, or almost nowhere, sensible things like what we call the Bogle rule, which is designed to keep banks largely out of dealing as underwriters for their own accounts. They’re working on 193 pages of regulation to make that happen. Obviously, what would’ve happened, in a wise world, and without the pressures from these institutions themselves, is we would’ve gone back to what is known as the Glass-Steagall Act, an act that was passed by Congress after the debacle of the Great Depression in, I think, 1934, which said you could be a commercial banker and lend money, or you can be an investment banker and take all the risks of underwriting. Never the twain shall meet. So, we abandoned that in 1999, and instead of putting it back, just saying, “Okay, we made a mistake,” they have this convoluted law intended to accomplish the same thing. I think Paul Volcker did a great job in getting that Volcker amendment in there, but nothing’s been done about it yet. And then, the lobbying pressures are terrible. The banks and their lobbyists fight every regulation with an army of lawyers and look at every comma, and here regulators are completely outmanned and outgunned. So, what we’re going to get out of Dodd-Frank, I think finally, is very, very little.
Jim Lange: And you would just prefer going back to…
John Bogle: No, I’d prefer naming Bogle a czar.
Jim Lange: All right, well, I’ll tell you what. Let’s name you the czar. What would you do right now to fix actually some of the problems that we’ve talked about, in terms of agency, in terms of protecting the public, in terms of conflict of interest?
John Bogle: Well, first of all, essentially, I would pass a federal statute demanding fiduciary duty by money managers, particularly institutional money managers who are managing money that belongs to other people, and that fiduciary duty would have something to do with focusing on prudent long-term investing. It would certainly focus on reasonable costs to the people who are giving you money to invest. It would certainly focus on low turnover instead of high turnover. Some of these things may be difficult to write. It would eliminate conflicts of interest in the business, which is another way of saying that we should no longer tolerate conflicts of interest in the money management business, and they are profound. If you look at the mutual fund business, and many of the institutions, around forty of them have public stock holders, of which around thirty-six are owned by financial conglomerates, great big international banking firms. The conflict there is these firms come in and buy a mutual fund management company, and they buy it at a higher return on there, that is to say the conglomerates capital, and they should be investing. They’re in a higher return on a mutual fund investor’s capital. But when you serve two masters, which I think it was Matthew who warned us against, No man can serve two masters, they serve the one who’s paying, that is, the management company, to which, I concede the fiduciary duty to their own shareholders. But they also have a fiduciary duty to those mutual fund shareholders. That conflict, my judgment, is intolerable. We just ought to demand a mandatory internalization of the mutual fund industry, or spinoff.
Jim Lange: And would that conflict of interest also apply to even people at the retail level, for example, not necessarily mutual fund managers, but actually money managers where Mr. John Q. Public comes and says, “I’m interested in investing my money,” and right now, we have a system where there are fiduciary advisors, but quite a few so-called advisors are actually not working on behalf of the client, and is that something that John Bogle’s czar would also try to eliminate?
John Bogle: Yeah, I’m actually working on a group for, what we’ll call, registered investment advisors. These are people with individual clients directly that’ll require clear fiduciary duty standard for them, and we’re struggling with it a lot because the group that wants to include stockbrokers is having a fiduciary duty as their clients, which I’m afraid is impossible. You know, the stockbroker, how can he be a fiduciary if his boss calls up and says, “There’s a new underwriting at X Corporation and we have taken 10,000 shares, or 100,000 shares, and each of you guys in the room have to sell 1,000 shares. You quit, you’re out. The kids don’t eat. This is a transaction business.” So, it’s going to be very, very difficult to accomplish total fiduciary duty, so I think it’s going to have to finally be accomplished, I’m not sure about this, it has to finally be accomplished by a clear distinction that, in effect, says “I tell you, my brokerage client, I am not your fiduciary.” And that’s going to be tough for people to swallow. On the institutional side, interestingly enough, we already have fiduciary standard. In the1940 act, the Investment Company Act of 1940, our governing statute, and it’s said since 1940 that mutual funds must be organized, operated and managed in the interests of their shareholders, rather than in the interests of their officers, directors, investment managers and marketers. That is not being observed. Unfortunately, in the act, it’s like a principle in the policy section right at the beginning, and they never implement it. So, we actually have the statute if you want to argue it that way, and I would. Let’s just use it. Let’s apply it.
Jim Lange: So, if we’re going back to this fiduciary standard that you want, and you think it’s going to be hard to enforce it on stockbrokers who have a different duty of care and a different master, if you will, do you think disclosure of whether you are a fiduciary to your client or to someone else will be at least part of the solution?
John Bogle: There has to be disclosure. It has to be very sharp, very firm, very terse, quite understandable at first blush. The investor has a right to know that.
Jim Lange: And when you say disclosure, are we not only talking about fiduciary care, but would also be appropriate for full disclosure of fees? I talk to a lot of people that have various investments, and they don’t understand how the person who has sold or worked with them gets paid, and I suspect that they are paying much higher fees and costs than they know. Would disclosure there be important?
John Bogle: Well, we certainly need disclosure, very, very clear disclosure of fees, whether they’re paid as a percentage of assets, whether they’re paid based on cost like a professional fee, per hourly, or whatever it might be in terms of services rendered, and we need that disclosure. We also need the advisor to disclose to the client whether he gets a lot of other revenue sources, for example, is he also making commissions when he sells that client a mutual fund? Does he take those commissions as well as his advisory fee? And how much life insurance commissions are to him? All those kind of things must be disclosed, and they’re very rife in the business.
Jim Lange: Yeah, it’s interesting that you mentioned disclosure because there’s a guy who I’ve actually had on my radio show, Blaine Aikin, and he is all for enforcing a fiduciary standard, and in preparing for today’s talk, I wanted to get an exact quote from him. I looked him up on Google, and what came up…there was a video, and what preceded it was a commercial for a high-cost annuity, which I’m sure he would not have approved. So I was thinking that that was a little bit ironic.
John Bogle: Well, you know, if you understand there’s a great overlap, by the way, between the insurance business now and the mutual fund business because we’re selling in the mutual fund people registered advisors selling annuities, they’re selling variable annuities, a lot of things, and the insurance companies learned long ago, if you want to sell a poor product, pay the salesman a lot of money, which is another way of saying if you want to sell a poor product, raise the price of that product. That’s what brings the salesmen in, their commissions. So it’s got to be clear to people.
Jim Lange: And then, hopefully, people will decline certain products if they understand what the fees and costs are.
John Bogle: I think up to a point only, though, because just about everybody underrates the importance of cost. Looked at in a year, you’re paying 1% or 2%, “Ah, what’s 1% or 2%?” Looked over an investment lifetime, you know, if the stock market, for a crude example, is going to earn 9% and you’re paying 2% for that, a lot of people are paying a lot more than that, you’re gonna actually net 7%, 9% minus 2% cost, okay? And if you look at a long-term compound interest table, you will see that the 7% provides a return about 70% less than the 9% return. In other words, you, the investor, if you’re paying 2% over a lifetime, are going to get 30% of the market’s return, even though you put up 100% of the capital and took 100% of the risk. If investors would only look at the long-term and understand that, the world would change.
Jim Lange: I think the world, to some extent, changed when you founded the Vanguard Group in 1974. I think the idea that passively managed funds could never compete with all the MBAs and all the people who were actively managed. In fact, as I understand it, the Vanguard Index was called Bogle’s Folly. In 1994, Jason Zweig did a study comparing the actively managed mutual funds with the S&P 500, and the index funds outperformed 97% of the time. In more recent studies, every single index, compared to the number of active managers, the active managers almost always, or to a large extent, did worse than the indexes, which obviously has a lot to do with fees. So, do you somewhat feel vindicated that here you were, everybody was calling it Bogle’s Folly, and it looks like history has proven you right?
John Bogle: Well, a humble fellow like me would never say that. But the fact of the matter is history has proved that indexing works. Leave aside whether I’m right or wrong. And it’s actually much, much stronger than the numbers that you see because we see the funds underperforming the index, but often there are many, many statistical ways to look at this, infinite numbers, and everybody picks the ones they like. But the fact is, you’re probably only talking, and most of those comparisons, you say who did best over the last twenty-five years, you need funds that have survived for twenty-five years. So, all the failing funds that do badly and go out of business aren’t even in the comparison. Though that’s one reason that the index superiority is underrated. Another reason is when the fund tells you it’s earned, let me say, an average return of 10% over the last blank years, an average annual return of 10%, it’s investors almost never earn 10%. They put their money in after the fund has a good record, so the good record has built up all of this great performance, and then they put their money in and it goes away. What you need to understand about indexing is not as much compared to statistics, which anybody can manipulate anyway they want to make funds look better or worse. What you need to know is the knowledge of the fundamental way the system works. You know, if the croupier’s cost is 2% (to use that example again), and the market’s is 9%, then everybody is gonna get 7%, not MAY get 7%, WILL get 7%. In other words, the math is there. The index math is undeniable and eternal. I don’t know how to make it any clearer.
Jim Lange: Well, perhaps the…your analogy in the book to the casino where the house is going to get a significant cut, to the gamblers…
John Bogle: As a group.
Jim Lange: …as a group is negative, and the costs, in effect, added to some of the other problems that we were talking about before with agency, makes it pretty rough for investors. Why would somebody invest with everything going against them, or is the answer to go into low-cost index investments?
John Bogle: Let me take the question first. Why, in a system that is this much of a mess, financial system and mutual fund system, why invest at all? And the answer to that is first, invest you must, because if you don’t invest in anything, I can tell you the exact amount of your retirement fund twenty-five years from now. It’s going to be zero. Not very complicated. So, you have to invest. And the question is how? And the index fund is, in many respects, if not all respects, the answer to what to do, because if you want to look at it in terms of croupiers and Las Vegas and all that, in the index fund, you go into the casino, you buy every stock in the casino, or the largest 500 stocks in the casino, and then get the heck out and never darken its doors again. Don’t trade, don’t do anything. The rule for the investor should be, and all think about, in effect, the financial system is built on this, then when something monstrous happens, big, noisy and affects the market greatly on a very short-term basis, the answer is don’t just stand there, do something! But the real answer is don’t do something, just stand there. In other words, don’t get captivated by the emotions of the moment. So, indexing, because of its permanent, in effect, portfolio, managers don’t change all the time as they do in the mutual fund industry every five years for a typical fund. So, if you’re gonna invest for a lifetime, because of its cost, because of its tax efficiency, the index fund, which is not any magic, it’s owning all of the companies in America and holding them forever, and that is and will be and must be the winning strategy.
Jim Lange: Well, speaking of winning strategies, as well as having some wonderful both historical information and providing a direction that you would like to see the investment world go, you also do give…well, let’s call it Bogle’s Ten Simple Rules for Investment Success. Maybe if I could just give them to you one at a time, you could comment on each one. And the first one you just mentioned, you alluded to a minute ago when you said remember reversion to the mean. Could you expand on that one?
John Bogle: Sure.
Jim Lange: That seems to be one of your important…
John Bogle: Well, that’s an eternal rule. It’s like the law of gravity, what goes up must go down. And in the financial markets, it really works. I have an example in the book. The point of all this, Jim, is don’t buy funds on the basis of past performance because they’re not going to continue, or it’s only in the extraordinary case when it’s going to continue. So, people tend to, as I mentioned earlier, put their money into these big winners, and then down it goes. They pick the high because that’s when the fund looks the best. So, in that part of recommendation one, I’ve taken eight of the best known and most successful mutual funds of the modern era and I’ve charted their return year after year accumulatively against the S&P, the Standard & Poor’s 500 Index, and every fund looks the same, although the time periods are different. The fund goes like this, and then it goes like this. This, this. This, this. Over and over and over again, and you see this in the big winners of the age. They go away, their managers leave, the good managers might get fired, the bad ones retire, there just doesn’t seem to be any permanent way to beat the stock market. It’s all fads, fashions, particular time periods, for example, growth does better in value. You want to put your money in a growth fund, and then the value does better than growth. These ten funds, which I list by name in the book, and two of them are Vanguard funds, in fairness. This book is an attempt to be really honest, no matter how painful, and you see that same pattern over and over again. So, when you say, “I ought to buy this fund,” I can tell you where you are in that line, right at the peak. And when the temptation is overwhelming, you put your money in, and then you’re disappointed thereafter. But it’s part of the entire financial business. If the market gets quite out of line, stock prices, for example, get quite out of line with intrinsic values, gets high like this and it goes back and reverts to intrinsic value of the stocks. Discounted future cash flow is what we call it. So, it doesn’t have anything to do with stock prices. It has to do with corporate intrinsic values. And I have a nice chart in there to show that that kind of mean reversion is just the truth of the business and how we deceive ourselves because we all think we’re smarter than everybody else.
Jim Lange: The second rule is Time is your friend, impulse is your enemy. What do you really mean by Time is your friend?
John Bogle: Well, we have the miracle of compound interest working for us, and when you invest over twenty years, thirty years, forty years, fifty years, for today’s young people, an investment lifetime is probably seventy years. Their life expectancy today if you’re twenty is probably ninety. And then, you’re gonna be investing, after you retire, of course, and presumably, that’s in your sixties or seventies, for some people…
Jim Lange: Not you!
John Bogle: Not me. That curve is just a sweeping curve, and it’s the miracle of compounding the returns, and it pays off hugely. Albert Einstein called compound interest the greatest financial miracle of all time, or something like that. So, take advantage of that, focus on the long-term, time is your friend, but if you get distracted by the ups and downs, mostly by the downs, people respond much more nervously to downs than they do ebulliently to the ups, although that happens too. But impulse is going to get you in and out of the markets, and I’ve been thinking about this: when the market is low, it’s low because people like you are really worried, and that’s a good time to buy stocks, essentially. There aren’t any rules for this. And if you’re ebullient and feel very wealthy and want to buy stocks, that’s at the high. In other words, if you’re discouraged and selling at the low, and aggressive and buying at the high, your money isn’t going to last very long.
Jim Lange: And I guess that’s one of the problems that you have to try to resist the impulse, but we are human, but we’re also animals. We are basically bred to run from fear, so when we see the market going low, we want to get out, but we have to resist that. Is that correct?
John Bogle: Yes, correct, and if we just didn’t pay any attention to these silly swings in the market, which are (and I often use this quote from Shakespeare) like a tale told by an idiot full of sound and fury, signifying nothing. That’s what we’re glued to our television sets to watch every day. It makes no sense.
Jim Lange: That leads us to the third simple rule for investment success, Buy right and hold tight.
John Bogle: Buy right means diversifying, diversify, diversify, and then an index fund, which is a great way to invest, for reasons that I talked about earlier, but you’re diversified so the intricate ins and outs of the market, you know, steel stocks are doing better, energy stocks are doing better, healthcare is doing better, or technology is doing better, if you own the whole market, you get your share of all that. That’s the buy right, very diversified, and the hold tight is what we’ve talked a little bit about, and that is, you know, when you get these periods of adversity and fear and greed, don’t do anything.
Jim Lange: Well, speaking of greed, another one of your ten simple rules is to have realistic expectations, and then you talk about the bagel and the doughnut and distinguish the two.
John Bogle: Okay. The bagel and the doughnut is a talk I gave years ago, and I contrast it like the investment world. The bagel is nutritious and good for you and substantive, while the doughnut has a certain sweetness and it kind of breaks up and crumbles when you eat it. So, long-term investing, holding on, which actually I just described, is the bagel, and short-term speculation is the doughnut. It’s just a way of visualizing, you know, which you want and which is the best for you in the long run, and sometimes people may think I’d just as soon have a couple of doughnuts, but they’re not going to do you any good, with all due respect for the doughnut makers of America.
Jim Lange: Your fifth simple rule is Forget the needle, buy the haystack. What do you really mean by that one?
John Bogle: Well, that’s the ultimate argument for indexing: picking stocks or funds, finding that elusive needle that will give you what you think you want in the future, is very difficult. We all know the metaphor of finding a needle in a haystack, it means forget it. It’s not worth trying. And I would argue the same thing here. Owning the haystack means owning the entire U.S. stock market, or the entire world stock market. Everybody has different ideas about that. Don’t do anything once you get the haystack. No more looking for needles.
Jim Lange: All right, and another one of your simple rules is to Minimize the croupier’s take.
John Bogle: Okay. That’s a very good parallel to something I mentioned earlier, and that means get costs out of the equation. I mentioned to you the magic of compounding returns over the long-term, the mathematical magic of it. The problem we have in our society is that that magic, on the record, is overwhelmed by the tyranny of compounding long-term costs. And I gave you that example of 7% of net return, 9% gross return, and it’s cost you 70% of your capital over your lifetime. Be aware of that.
Jim Lange: The next rule is something that a lot of my clients have an enormous problem with, and we could probably talk for a long time about just this, but one of your rules is There is no escaping risk. And this is probably a particular problem for people who are older, retired, no longer bringing money in through their work and their labor, have X dollars of a portfolio, maybe Social Security, maybe a pension. They don’t want to incur risk, but you’re saying there is no escaping risk.
John Bogle: Well, the basic argument there is that inflation, which you have no control over, eats away at the value of your dollars. You may think you’re being safe if you buy a bank CD, or an equivalent instrument, and let’s say over ten years, but that instrument loses 30% of its value conservatively over the next ten years, and you have a little bit of interest to offset that, but if the dollar is worth 30%, which is roughly 2 ½% per year in inflation, that’s gone. You’ve taken a big risk by, in effect, speculating, for the want of a better word, that the dollar will remain unchanged, and it never has, and I don’t think, in our lifetime, that it ever will. Maybe sometime. So, there’s the big risk. So, when you look at, say, stocks and bonds, stocks, at least, have a fighting chance to overcome the ravages of inflation, and the way I look at it, I’ve got some math behind this because with a dividend, the yield of stock’s about 2%, and potential earnings growth should be in the range of 5%. Stocks should give you about 7% over the next ten years gross, gross, gross, before costs, before anything. So that’s a fairly conservative number, but I think it’s realistic. And bonds should probably give you about 2 ½%. So, if you think about inflation, it’s 2 ½% inflation, and the bond gives you 2 ½%, you’re doing a break even investment over the next ten years. And that’s just…you need more than that if you’re going to build a retirement fund.
Jim Lange: And if you have X dollars and you’re getting 0%, and even if you’re living frugally, you’re still reducing the purchasing power of the actual amount of money that you have.
John Bogle: Yeah, and importantly, we live…and in a way, and I’ve said this before, in the most difficult time to invest that I’ve ever seen, and the reason for that is yes, stocks have more volatility risk, they go up and down and bonds stay pretty steady and everything, but you have to take into account not only the risk, but the return, and the return on stocks, I think, is, you know, I’m close to saying destined to, but I won’t go that far, I’ll say highly likely with a 7% expectation, which could be right or wrong, but it’s certainly very likely to be the 2 ½% almost certainty for bonds, and actually, I’m being generous to bonds because the government bonds, the ten year treasury, is yielding 1.6% today. So, you got to take a little bit of risk in corporates, and I would frankly take a bigger risk in corporates. So, ask yourself this question: which is riskier for the next ten years? That bond, which will give you a low return, but probably not very much, or the stocks, which are highly likely to give you a high return, but with volatility along the way. For that reason, I like the idea of a balanced portfolio, some stocks and some bonds, although you have to think about it a little bit differently today with interest rates at these floor, and money market funds are basically not even worth buying. The average yield of a money market fund is, I think, 2/10ths of 1%. People should buy very short-term bond funds, my opinion, high quality, short-term bond funds instead. So, there are ways to do it, but you have to look at not just volatility risk, but the entire picture of investment risk to dividend income, risk to your income. If you’re giving up a 2% stock yield and getting only 1% from a CD, or whatever it might be.
Jim Lange: You talk about beware of fighting the last war. What do you mean by that? The last war?
John Bogle: Well, when we tend to look back, we tend to look at the kind of returns, the kind of economic environment we’ve had. And right now, I mean, I actually wrote quite a bit of this in depth back in the, oh, say mid sixties, and everybody was paralyzed with fear about inflation. We had inflation running at 5 or 6 or 7%. They said, “How can I avoid inflation and do this or that or the other thing?” And, at that point, the inflation was stopped at, I don’t know the exact number, but probably after that high inflation, probably had an inflation rate of 2 to 3%, is all, maybe 4%. So, if you’re fighting against previous inflation, you’re making a tacit assumption that will continue in the future. It doesn’t, or usually doesn’t, or often doesn’t, but we never know when that change is coming. It’s kind of complicated. Today, one of the best examples is return on stocks. The historical return of stocks is 9%. So people say, “I want that 9%, so I’ll go into stocks.” That was the last war. Today, stocks are getting a future return about 2% less, or maybe more than that, a bigger shortfall. Why is that? It’s so obvious! And that is that 9% over 100 years is 4 ½% dividend yield on stocks, and 4 ½% earnings growth. 9% total return from investment. And today, the yield on stocks is 2.1%. So forget that extra 2 ½%. Strike it, and when you go through the math, you’ll see that the future return is going to be, you know, 6 ½% or 7% compared to history. Don’t listen to history. It’s interesting, and it may rhyme, as Mark Twain said, but it doesn’t repeat itself.
Jim Lange: Well, speaking of not listening to history, and the short-term versus the long-term, another one of your simple rules is ‘The hedgehog beats the fox.’
John Bogle: I use that to portray the difference between passive index investing and actively managed fund investing. The saying from Archilochus, a Greek philosopher who left just a few fragments of his work was, The fox knows many things, but the hedgehog knows one great thing. And what the hedgehog knows is that all of this fooling around out there does you no good at all. Own the market, it’s another way of saying that, and the fox, oh my, are they smart! They’re smarter than all the hedgehogs put together. They go down to Wall Street and target all that immensely wealthy brain power, but of course builds nothing because they’re competing with other brainpower. I’m not saying brainpower is wasted. I’m saying the average brainiac is average compared to the other brainiacs. So they can’t win. We know that. You know, all the secrets, I’ve got a tip for you, buy this, sell that, now that’s the fox thing, the foxy way to beat the market. It doesn’t work.
Jim Lange: And the less sexy index funds outperforming the more active brainiac funds…
John Bogle: Yeah, the index fund, in fact, is an act of extreme boredom, and if you don’t peak, another one of my rules that I’m not sure I mentioned in the book, if you don’t look, that’s in your interest not to look. Why open that 401(k) statement, or your IRA statement every quarter and say either “I’m rich” or “I’m ruined?” Just throw it in the wastebasket.
Jim Lange: Yeah, Jeremy Siegel says the same thing, that the more often you look, the worse it is. Well, the other thing that that brings us to is the last simple rule, which is Stay the course.
John Bogle: Well, we kind of talked a little bit about that behind the scenes here, and that is once you set an intelligent asset allocation, taken into account your risk preferences, taken into account your whole financial program, a lot of people, for example, ignore the value of Social Security as a capitalized value for a typical person at the time of their retirement of $400,000 or $500,000. That’s your asset. It produces an income stream. You don’t have the asset, but you have the income stream with a cost-of-living edge. Don’t leave Social Security out of your equation when you look at all that. But just get it all right, and then don’t touch it, except, I would argue, lean toward raising the bond position as you age, and that’s not so easy to do today with bond yields so low. But I probably wouldn’t lean quite as far. And when you take into account Social Security, you know, you may be leaning too far already to the fixed-income side. For example, if your Social Security is worth $400,000 and you have $400,000 all in stocks, that’s a 50/50 equity fixed ratio, with one of the great fixed investments of all time has a cost-of-living clause in it, and the government nicely sends you, as long as they can afford to, a nice check every year. They just raised this year’s payments. My wife said, “Shouldn’t we send some of this back?” To which I, of course, said, “We paid for it.” But take into account everything, and then don’t let yourself get deterred by market changes, by gossip, by CNBC, whatever it might be.
Jim Lange: One of your simple rules is You can’t escape risk. So, what is a risk-averse investor supposed to do if you can’t escape risk, but at the same time, it goes against what they want to do? They just want to be safe. They want to make sure that their money lasts for the rest of their lives.
John Bogle: And they want…they have to earn to do that in this most difficult of yield environments in maybe half a century, with low yields on bonds, and they want to maintain some kind of income to keep themselves going in retirement. And so what’s to be done? First of all, the best general rule, unfortunately, is don’t try and outsmart the market. Bonds are yielding offering you 2 ½% say, and stocks are offering you perhaps 7%. Don’t reach for an 8%, 10%, 20% or a home run in the stock market, and don’t take quality of your bond portfolio way down. You know, you can get higher yields in bonds, but I would avoid junk bonds because the credit risk is high. I would avoid, to some extent, moving bond money into high dividend paying stocks, not so much because I’m worried about the stocks, because they tend to be, the stock market has its own volatility very different from the bond market, and investors should be very sure they can handle that kind of volatility. So, it’s difficult to do that. I should add right here that a large part of the reason that bond yields are so low is U.S. government bonds. They are the lowest they have been, I don’t know, in memory, certainly in my long, long memory, and at one point 6% for the ten-year treasury, they’re you could almost say unacceptable. Yet, the bond market index fund is 70% in treasury. For a holder of the entire bond market or the equivalent index fund, I think they are required almost by common sense to move some portion of that total bond market index fund into a corporate bond market index fund. Not all of it, but 70% in U.S. government securities seems like maybe it ought to be more like 30%. If you could balance it out with investment grade bonds, I’m not talking junk here, and that should be an important consideration to people. Everything has pros and cons. We know that. You may have to get your expenses a little bit under control on the homefront. That’s very painful. You may have to spend a little capital. Don’t limit yourself to income, but spend a little bit from capital, but that can’t go on forever, maybe for a year or two until yields improve, or whatever might happen, and that’s difficult. You could go into very speculative things, I would argue, real estate investment trusts pay a high apparent yield, but it’s all coming out of everything they earn and their accounting is s little funny. You could also think about annuities. There’s nothing in the abstract wrong with annuities except that so many of them are so highly priced, they’re not worth buying, and you don’t have to worry about the costs of the annuity, which are extremely high, even relative to the standards of Wall Street, but you also have to worry is the insurance company gonna be financially sound. If it’s trying to earn more money than the market delivers, and it can’t pay it, they’re going go out of business. And we had a big worry about that with a few annuities. I don’t think any of the big ones did back in 2008 and 2009. So, be very careful of the cost of the annuity, and be very careful of the quality of the company that’s issuing it. And they generally fight against each other a good bit. Higher quality companies are apt to feel a need to pay lower yields because they’re higher quality. So, there aren’t easy answers, but still, you have to go out and invest and make some sacrifice one place or another along the way, and come out with a reasonable return. But to reiterate my basic position, don’t go beyond the level of the market in terms of potential future yields. Don’t speculate to get higher yields. One bad speculation will ruin your entire retirement.
Jim Lange: And that also seems to me that that would have impact on the safe withdrawal rate. So Bill Bengen all those years ago was talking about 4%, and that as you age it could be higher and higher. Are you saying now that we can’t quite expect as much from the market, that maybe we have to re-look at some of those safe withdrawal rates that were in all the literature, say, ten or fifteen years ago?
John Bogle: Well, first, I use the word ‘safe’ at my peril, but I would say most people could afford to do a 4% withdrawal rate. If the combined market return of stocks and bonds is, say, 4 ½%, you ultimately aren’t taking anything out of principle. You’re going to lose something to inflation. But you better observe it, and if markets go the wrong way, you’re going to have to modify it. But I think, under most circumstances, 4%, which means maybe taking a percentage point out of your capital, a percentage point and a quarter out of your capital each year, and your capital will last for a long, long, long time. So, I just have one recommendation for somebody who is sixty. Probably 4% is not the right number. And if you’re ninety, I’d say 4% was a piece of cake. Don’t cheat by living too long.
Jim Lange: Well, actually, I think people might prefer going the other way. I did ask some of our listeners to give them a chance to ask a few questions, and Shawn Burke asked if you think Congress will actually take action, hold brokers accountable, have full disclosures, and hold financial professionals to a fiduciary standard? Is that in our future, or is that in our dreams?
John Bogle: I don’t have a lot of confidence that Congress will act on anything, and whether that’s good or bad, there’s certainly some good elements to it, but I don’t think that they’ll have a hard time acting on anything. But they also have an even harder time acting when there’s not some kind of a crisis going on. We have a crisis in long-term investing in a sense, it’s not going to come home to roost for decades or more than that. And so Congress is apt to say, “Wait a minute. We’ve got so many more important things to do. We’ve got gun control. We’ve got climate change. We’ve got reforming the financial system outside of this. We’ve got the fiscal cliff.” And it’s hard for me to see fiduciary duty climbing to the top of that heap. So, we have to do what I call the Adam Smith solution to the problem. If each investor, each person in your viewing audience or listening audience, just acts in his own best interests, own an index fund, do no trading, have an intelligent asset allocation, keep costs low, he’s gonna change the financial system because that’s not the way particularly most mutual fund companies are structured. They’re marketing companies. They have very little sense of fiduciary duty. In my experience, if someone who holds themselves to a fiduciary standard is going to start to collect all the money. We see that happening today. Everybody knows that almost all, over 100% of the money coming into this industry is, particularly equity funds, is going into index funds and low-cost funds. The last five years, people have put $600 billion in index funds and equity funds, and have taken $400 billion out of actively managed funds. That’s a trillion dollar swing just by the way people are acting. So, eventually, the industry is going to have to adjust.
Jim Lange: And I know we are wrapping up. Are there any words of wisdom…although you just said so for the index funds, but anything that if we want to, for our listeners or readers audience, to take away? Can you give them, let’s say, the short version of Bogle investing, or is the ten simple rules the best way to do it?
John Bogle: Well, use those rules, but they come down to some very simple things: keep costs down, allocate your assets with respect to the amount of risk you’re willing to assume with some focus on your age. You know, if you have an advisor, get a little help with some of the complexities of this system. You know, the financial advisor is a very valuable piece of work for the things that we don’t much think about, helping you with that asset allocation idea, telling you the difference between a Roth IRA and a regular IRA, telling you in your financial position whether you might own municipal bonds as compared to corporate bonds. The system is loaded with nuances. Estate planning is a whole other complexity. So, with this complex world, I think most people need some kind of help.
Jim Lange: I just want to thank you. You have been an inspiration for generations. The Gutenberg press, the wheel, the Vanguard S&P 500, thank you so much for agreeing to come on our show and to provide this wonderful information.
John Bogle: Well, it’s great to be with you.
Jim Lange: Thank you so much.
John Bogle: And I’d just have to add one word: you left out part of Paul Samuelson’s quote when he got the Gutenberg printing and the wheel. He also compared the invention of the index fund to the creation of wine and cheese.
Jim Lange: I can’t think of a better way to end it, so I’m not going to say anything!
James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.