Top 10 takeaways from The little book of common sense investing

What’s the easiest way to become wealthy over time?

In “The little book of common sense investing”, John C. Bogle, author and former chief executive of The Vanguard Group (investment management company), explains this. More precisely he explains an investment strategy, probably the simplest possible one, which beats 80 % of investors.

Today I will summarize the 10 most important points that Bogle makes in his book.

Before we continue to the takeaways I want to mention that this book contains a lot of interesting research regarding the stock market, for instance, average returns over the past few decades. Even including which portion of those returns that could be considered speculative.

Now. Let’s start with a quote to lay out the groundwork for the upcoming takeaways:

“The alchemists of active management cannot turn their own lead, copper, or iron into gold.”

Here are the most important points in a summarized format:

  1. Don’t let anyone have a piece of your cake.
  2. Stay passive.
  3. Investing in the aggregated return of the national corporations is the ultimate winner’s game.
  4. As a group, fund managers can never beat the market.
  5. Get emotions out of the equation.
  6. Selecting short-term winning funds is not a winning strategy.
  7. Luck will always produce a few successful money managers.
  8. Letting a professional money manager pick funds for you is not a winning strategy.
  9. All index funds are not equal.
  10. Compare your own strategy to the index strategy.

And here come the takeaways in an expanded format. As always, my notes are in italic.

1. Don’t let anyone have a piece of your cake.

One thing that is devastating for a solid yield is fees. If you invest in a managed fund, you’ll pay maybe 1-3% of your capital yearly to the fund manager. Since most funds aren’t beating the index anyway, why would you do this?

“Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultant.”

2. Stay passive.

Warren Buffet probably explains this in the most creative way:

“For investors as a whole, returns decrease as motion increases.”

The more active you are, or the more active your money manager is, the more you’ll have to pay in taxes. And the more you try to time the market, the more problematic it gets. There is an underlying principle-agent problem here as well, the incentives of the money managers are not the same as the incentives of the investors. Money managers promotes activity because they are rewarded from it – “Don’t just stand there. Do something!”. On the other hand, the investor is rewarded from passivity, and should be taking the opposite advice – “Don’t do something. Just stand there.”.

3. Investing in the aggregated return of the national corporations is the ultimate winner’s game.

Only in one decade, during the great depression of 1930, the stock market has been performing negatively. On average, it has performed a total return (dividends included) of 9,5 % (this was during the period 1900-2005, I think it is a little bit less nowadays). To invest regularly in the corporations through a cheap product, i.e. an index fund, is the ultimate winner’s game. No fees paid, and no timing required if done over time. And the expected compounded return over time is incredible.

“While such an index-driven strategy may not be the best investment strategy ever devised, the number of investment strategies that are worse is infinite.”

Here are a few examples for you, to realize the power of compounded returns. In our calculations, we have used 9 % as an average return, which is, according to historical data, not unlikely.

With $0 as a starting capital, and $100 saved every month, you’ll get:

  • In 10 years: $19,400
  • In 20 years: $66,800
  • In 30 year: $183,000
  • In 40 years: $468,000

With $50,000 as a starting capital, and $300 saved every month, you’ll get:

  • In 10 years: $181,000
  • In 20 years: $501,000
  • In 30 year: $1,286,000
  • In 40 years: $3,210,000

 4. As a group, fund managers can never beat the market.

As a group, fund managers own a great portion of the entire market. To think that they, as a group, could outperform it would therefore be unwise. Since the fund managers, as a group, can’t beat the market, investors investing in funds, as a group, will lose to the market. This is because of the fees that funds have.

In fact, it seems as if fund managers can’t even keep up with the market. During 1968-2006 the market (S&P 500 index) beat 58 % of the comparable publicly managed funds in America on average every year. Another eye-opener is that during the period, only 1/14 funds managed to outperform the index. To be fare though, this is because a lot of funds closed. If they closed because they have given bad returns (probably) or because of something else, the story doesn’t foretell. Among the surviving funds, the performance looked like this:

Not surprisingly, this is a normal distribution. But it is skewed to the left, meaning that underperforming the market is more common.

5. Get emotions out of the equation.

Investors have proven over and over again that they can’t time the market, and neither can they pick the winning funds. In 1999 and 2000, when stocks were overvalued, $420 billion poured into funds. Yet, in 1990, they invested only $18 billion, and therefore missed a great opportunity. The same goes for fund-picking. During 1990, 20 % of the invested capital ended up in aggressive growth funds, but during 1999-2000, 95 % ended up there instead.

Therefore, emotions must be constrained! The simplest way is to automatically transfer a certain amount of your salary straight into an index fund with low costs every month. A fitting example in the Swedish market is a passively managed index fund called Avanza Zero. This one follows the index of the 30 stocks with the largest market cap on the Swedish stock exchange and has an annual fee of 0%.

6. Selecting short-term winning funds is not a winning strategy.

During 1995-2005, selecting the top 20 funds one year, would give you a just above average performance in the year following. The same goes for the period 1982-1992. In bull markets, this is not just an average strategy, it’s a devastating one. If you would have selected the top 10 performers between 1997 and 1999, you would have been outpaced by 95 % of the market in 2000-2002. The author uses the term RTM, reversion to the mean, to describe this phenomenon.

“Please remember that the stars produced in the mutual fund field are rarely starts; all too often they are comets, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth.”

7. Luck will always produce a few successful money managers.

“Toss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. We run the contest for 10,000 managers.” After 5 years, 313 of these managers will have won money every year (comparable with beating the market), out of pure luck. Even a population consisting solely of bad managers can therefore produce a small number of winners. “The number of managers with great track record in a given market depends far more on the number of people who started in the investment business (in place of going to, for instance, dental school), rather than on their ability to produce profits”.

The book is built around this argument, and for the most part, I agree. What I don’t agree with though, is that randomness can produce investors such as Warren Buffet. I will probably write a post about this in the future, because it requires far more attention than 1/10 of a blog post.

8. Letting a professional money manager pick funds for you is not a winning strategy.

According to a study by two Harvard professors, adviser-sold funds cost investors $9 billion per year, compared to buying funds directly. During the period of the research, 1996-2002, the average fund made 6,6 % per year while the funds recommended by “professionals” made only 2,9 %. These “professionals” chased market trends and advised funds with higher upfront changes, leading their picks to be way below the average.

9. All index funds are not equal.

Pick the one with the lowest management fee. For instance, investing $10,000 in the Vanguard 500 Index Fund in 1984, keeping it until 2005, would produce a profit of $122,700. For another index fund, the Wells Fargo Equity Index Fund, the profit would be “only” $99,100. A small difference in management fee is what, after years of compounding interest, leads to this difference.

In choosing between mutual funds and ETFs, you should probably go with the latter. Their management fees are usually lower, and their tax efficiency is also greater.

10. Compare your own strategy to the index strategy.

Maybe some of you want to invest on your own (and rightly so, I’d say). Then at least put some money every month into an index fund. See over time which account, your actively managed one, or the passive index one, performs the best. Start putting more and more of your monthly salary into the one performing better.

Is there anything missing? What do you think are the top 10 takeaways from “The little book of common sense investing”? Do you want me to develop on any of the subjects? Let us know in a comment!

Do you want to read the full book? I can advise you to buy the book here, and unlike the money managers, I won’t charge you for that guidance (but I will charge Amazon, which is a fairer deal right?).

For more investment tips delivered from Switzerland …

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