chakravyuha

This is a follow-up to a previous post of mine. John Bogle is the father of the indexed fund and the founder of the largest mutual fund organization in the world – Vanguard). Russ Roberts interviewed him about a year back on his podcast EconTalk and here’s the gist of what he said. For wherever he does offer opinion, you can take it as unbiased and honest because I did not find him pushing any agenda beyond advocating something he really believes in.

• Bogle calls the stock market a “a giant distraction”. His main argument is for owning businesses as opposed to owning stocks. Buying into the indexed fund model of investing is a way to achieve that. Potential investors invest in businesses and they enjoy returns on their capital via the dividends (which investors can re-invest, put in the bank etc.) that these businesses are supposed to pay on their earnings.

• The idea rests on the following premise. Economics has very little to do with the stock market. Economics and stock market are not correlated, however, economics and businesses are. In terms of earnings per share, the businesses can be shown to grow at the same rate as the economy which is a historical 6% nominal growth rate per annum.

• Bogle is (conservatively) invested 60% bonds (fixed income) and 40% stocks (equity), all at Vanguard. He mentions that he follows a self imposed rule of “do not peek at your portfolio”. Since this is not the stock market, investors do not need to obsessively track their stocks.

• The secret to investing is that there is no secret. Investing is locking and tackling – making sure your costs are low, asset allocation is right, making sure your risks are commensurate with your ability to deal with risk, diversifying, and investing for the long term.

• Bogle says, most of the bond funds are not “worth the powder to blow them to smithereens”. The main reason being that in the bond market the returns are pretty much predictable from one manager to another, so a managed fund is not really adding any value. If the bond market deliver a (say) 7% return (on, let’s say investment quality bonds – treasury, investment grade corporate etc.) you are not going to have managers presiding over returns of (say) 0% or 15%. Managers add very little value to bond funds, so why pay them any money. Bond market is very homogeneous so most of the returns center in a very narrow band. Managers can, in fact, detract from value.

• All bond funds are load funds (sales commission). The load fees is approximately 5% per year which is about what the yield is these days. So your first year income is gone. Besides, bond funds have expense rations of 1% per year on average. Add to that the transaction costs (trading bonds), it implies another hidden costs of a ¼% per year. So in now you are seeing actual returns of 3 and 3¼%. One side affect of all this is that the managers might take more risks with the portfolio to compensate for the costs.

• If you do want to buy bond funds, buy lost cost offered by reputable organizations. The first thing you think about then is the maturity, short term (maturity of about 5 years), intermediate term (maturity of about 6-8 years) or long term (with maturity of about 15-16 years). If you have money in the bank, a short term bond fund with a maturity of about 5 year will be a good idea. Their value will fluctuate but over a few years the fluctuations will inevitably be overwhelmed by the higher return over a money market account. Intermediate term bond finds involve a little more risk to the principle but the records show you get a small premium for the longer term you sign up for.

• Bonds are very sensitive to interest rate fluctuation but they should not concern a long term bond investor. On the contrary, one of the things that you want to pray for as a bond investor is for interest rates to go up! Sure, your principle will go down for a year or so but they will gradually come back up because the bonds will be retired at their maturity for their par value, but the re-investment rate for your bond portfolio will also go up.

• A typical fund investor earns about 3 percentage per year points less than the typical fund. So if we are looking at a fund with returns of about 5½% a year, the typical fund investor will actually earn 2½% per year. Adjusting to inflation of about (a projection from historical data into the next decade) 2½% per year, the real return is approx 0 for the coming decade!, and that’s not taking into account taxes on the mutual funds.

• A good fund will under perform one year out of three. It has been observed that after the two good years the money pours in and after the one bad year money pours out. So buying a fund when it’s high and selling it when it’s low is not exactly a very profitable strategy.

• Bogle’s says that investors are terrible stock pickers because they (inevitably) look backwards and that’s why he wants investors to steer clear of the stock market. He cites an example of how the best 10 mutual finds of 1996 and 1999 ranked roughly from 790 to 800th when the market went down. So performance chasing is the investors worst enemy, because you can never predict the future. Never think you know more than the market.. nobody does. At this point they cite Bill Miller and how he has incredibly beaten the odds for a long time. (You can read more about Bill Miller here if you are interested).

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