Investment Advice From Mutual Fund Legend John C. Bogle
John C. Bogle is founder, former chief executive and former chairman of Vanguard Group. Inc., one of the largest mutual fund groups in the world. He helped create the first index mutual fund in 1975. He is president of Bogle Financial Markets Research Center in Malvern. Pennsylvania. In 2004, Time named Bogle one of the 100 “Most Influential People in the World,” and in 1999, Fortune named him one of four “investment giants of the 20th century.
For four decades, Vanguard founder John C. Bogle has been a hero to small investors. He also has been a gadfly to the mutual fund industry which, he says, too often charges fees that are too high while delivering lackluster performance. Bogle, 77, has remained active on mutual fund issues since he retired from Vanguard in 1999. He lobbied in Washington, DC. for tighter regulation of mutual fund advertising and recently authored his sixth book, The Little Book of Common Sense Investing (Wiley).
Bottom Line/Personal asked Bogle to expand on his recent warnings to investors that danger signs surround the US economy and that investment returns will drop. He also discussed how investors can prepare for the future…
How do you expect stocks to perform in the next several years?
I predict annualized returns of 7% to 8% for the Standard & Poor’s 500 stock index over the next decade. 1 know that’s not what investors want to hear, and it’s certainly not what stockbrokers will tell them. But I base my predictions on the numbers, which I call the “relentless rule of humble arithmetic.”
Stock market returns are created by the growth of actual businesses. In the past century, those businesses have paid dividends averaging 4.5% of stock prices, and their earnings have grown an average of 5% - a total of 9.5% per year. However, since 1980. the S&P 500 - my proxy for the market - has provided total returns of 12.5% a year. Those extra three percentage points each year reflect a premium in the price investors were willing to pay for each dollar of earnings. That increase has kept returns artificially inflated for a long, long time. In effect, investors were convinced each year that the US economy would continue to do better and better.
Why can’t returns remain high for many years to come?
There are two basic reasons. First, even if companies continue to grow their earnings at the long-term average of 5% per year, their dividend yields - which are part of total returns - are nowhere near 4.5% now. In fact, they average less than 2%.
Second, the current price-to-earnings ratio (P/E) is about 18. To continue to get annualized returns of 12.5% a year from stocks, the market’s P/ E would need to rise to 25. That’s just not sustainable. It wasn’t sustainable back in the giddy days of 1999, and it won’t be sustainable over the next decade.
How can fund investors prepare for years of lower returns?
For starters, they should control what they have control over when choosing mutual fund investments - costs, expense ratios and tax efficiency.
Next, consider having a large chunk of foreign equity in the portfolio. I’m well known for ignoring overseas investments - I thought they were too expensive and too full of speculative accounting practices. However, I’m worried about the US economy now - our excessive borrowing for costly wars, an underfinanced pension system and the dollar’s weakness. In the next few years, I’m planning to put as much as 20% of my equity holdings into foreign stocks. That includes 10% in developed countries and 10% in emerging markets.
Third, don’t equate simplicity with stupidity. Warren Buffett likes to say that for investors as a whole, returns decrease as motion increases. In other words, more trades won’t necessarily boost returns. In fact, the less trading investors do, the better off they tend to be.
How do you pick investments?
I allocate my assets in such a way that I have to peek at how they are doing only once a year, and I probably won’t change that formula for the rest of my life. It provides decent returns in both good and bad market years.
My portfolio now includes 60% equities and 40% bonds. In the equity portion, I have 80% in Vanguard Total Stock Market Index Fund (VTSMX) and 20% in several other Vanguard funds, including Explorer (small-cap growth stocks, VEXPX)…PRIMECAP (large-cap blend of growth and value stocks, VPMCX)…Wellesley Income (high-yielding stocks and bonds, VWINX)… Wellington (stocks and bonds, VWELX)…and Windsor (large-cap value stocks, VWNDX). In the bond portion, I have 50% in Vanguard Total Bond Market Index Fund (VBMFX) and 50% in Vanguard Intermediate Term Tax Exempt Fund (VWITX).
You favor index funds, but indexing peaked at about 10% of all mutual fund assets in 2000. Why hasn’t its popularity grown?
Broad stock market returns have not been great, so people are not content to just match broad indices by investing in traditional index funds. There are new index funds that give more weight to small-cap and value stocks, which have had a stellar run for the past seven years - but they don’t have enough of a track record to attract many investors.
I don’t think traditional index funds need to be fixed - they’re not broken. Not only do they work beautifully in hull markets, but they also hold up well in periods of modest returns, when investment management fees, transaction costs and taxes take a disproportionate bite out of most funds. These costs don’t take as much out of index funds, because they trade less frequently.
Even though S&P 500 index funds have returned only 8.3% per year this decade, on average, they have beaten 69% of all large-cap funds. And as foreign stocks beat domestic stocks over the past five years the Vanguard Total International Stock Index Fund (VGTSX) beat 90% of the funds in its category.
But there are still plenty of actively managed funds doing much better than index funds.
Agreed, but will the managers responsible for superior returns stick around for the next 10 years? Will the funds become so popular that they get bloated and their returns revert to the mean?
I tell investors who are sick of hearing me tout the benefits of index funds that they must, at least, be disciplined. Keep 95% of your portfolio in index funds, and use the rest to pick stocks or actively managed funds. Choose managers who invest in their own funds and I follow distinctive, long-term philosophies without hugging benchmarks.
