The Little Book of Common Sense Investing - Book Review

Subtitled: The Only Way to Guarantee Your Fair Share of Stock Market Returns.

For those equity investors that read the compelling message provided by this book and follow author John Bogle's advice, the book might have several other compelling subtitles, such as "Relentless arithmetic proves it's almost impossible to outperform a low-cost index fund", or "Equity investors: find a less expensive/more profitable hobby! Like investing in a low-cost index fund!", or, more simply, "Most mutual funds suck!".

This book, by the father of the index-investing movement and founder and former head of the Vanguard Group uses "relentless arithmetic" to prove exactly why individual investors will, as an average, dramatically underperform the market averages (about 9.5% annually over long periods of time, according to the book). Bogle has been a persistent critic of traditional mutual funds, which have an excessive average cost of 2.5% annually, compared, for instance, to the Vanguard index fund cost of just 0.19%. Bogle has been a critic because, despite the high cost of a conventional mutual fund, it doesn't, on average, outperform a low-cost index fund.

Just considering the mutual fund cost portion of the drag (about 2.5% annually), this book shows that, compared to investing in the index, after 30 years, the typical mutual fund equity investor will only get about 50% of the market advance. After 50 years, this will decline even further, to only 31% of the total advance.

These dismal averages don't even consider the propensity of investors to trade in and out various funds, ETFs, or stocks (transactional costs), nor the further drag of picking the wrong funds. These are significant sources of further underperformance.

Bogle punctuates this message by regularly providing quotes from famous value investors and business school professors, to further support low-cost index investing. In some ways, I felt like the book was a form of Chinese water torture: at the end, it was all but impossible to dismiss its message. And that message is that low-cost index-fund investing is the "only way" to get your fair share of market returns. As the book puts it, "by aiming for the average, you can beat the average".

In summary, the book shows the three sources of underperformance - which are very significant in their totality - which is likely for average equity investors:

1. Excessive costs of conventional mutual funds;
2. Transactional or trading costs as investors trade in and out of various funds/stocks etc. and;
3. The costs of picking the wrong funds (investor pile into funds which have risen lately, and history shows most of these are poised for a period of underperformance; and visa-versa).

Overall, this is a great book with a fabulous message for most investors, and most investors couldn't do wrong by following the approach espoused here.

In a separate future posting, I am, however, going to take on one of Mr. Bogle's final messages: that some of the new products and new market indices aren't likely to provide superior returns any better than tracking conventional market capitalization-weighted indices (S&P 500 is one such index, and most widely-quoted indices are of this type). I believe this to be false, and hope to explain why I think so, using mostly Mr. Bogle's own words to explain why.

No matter this relatively small dispute, I recommend that all investors unfamiliar with the huge advantages of low-cost index investing buy and read this book.


JW

The Confused Capitalist

Conundrum solved

The other day, I was challenging some conventional wisdom, and it seems that a more elaborate answer was recently discussed by a Legg Mason manager, Michael Mauboussin, who the Legg Mason site advises is the ... "Chief Investment Strategist of Legg Mason Capital Management (LMCM), Legg Mason's cornerstone equity fund management subsidiary."

Here are his comments, directly:

"Jack Bogle provides what may be the most sobering statistic in the investment industry: from 1983-2003, index funds tracking the S&P 500 returned 12.8 percent and the average mutualfund gainedd 10.0 percent annually. Meanwhile, the average investor only earned 6.3 percent annual returns. This seemingly impossible result is attributable to one crucial variable: market timing.

The Bogle data refer to average percentage changes, not dollar-weighted changes. When you consider the extraordinary proclivity for investors to invest in the wrong place at the wrong time, the data start to make sense.

For example, at the height of the technology and telecom bubble in the first quarter of 2000, investors poured a record $140 billion into growth funds while pulling $40 billion out of value funds. In the subsequent five years, value funds substantially outperformed growth funds. Using over twenty years of market data, Evergreen Capital Management paired mutual fund flows with a valuation measure to generate buy and sell signals.

High inflows and high valuation triggers a sell signal, while large outflows and cheap valuations mean buy. Following a sell signal across various investment styles, the return of the investment strategy underperformed the S&P 500 by an average of 490 basis points over the subsequent two-year period. Buy signals generated an even more impressive 870 basis points of excess returns in two years. As noteworthy, the sell signal was reliable nearly 80 percent of the time, while the buy
signal was accurate over 90 percent of the time.

Why do investors make this mistake? The most likely explanation is the recency bias, which says individuals tend to extrapolate recent outcomes without giving full weight to the full time series or prevailing circumstances. This bias defines one of the most reliable sources of inefficiency in the market.

Recent academic research, spanning twenty years of data, shows the buying and selling patterns of individual investors provide a hard-to-beat contrary indicator. More specifically, researchers found heavy buying leads to above-average short-term results and below-market returns in the subsequent year. The mirror image holds true for stocks individuals sell. "

Thinking about buying or selling one of your investments? Sobers one, doesn't it?


JW

The Confused Capitalist