Book Review – The Little Book of Common Sense Investing
This book by John Bogle is a fascinating eye opener about some of the misconceptions in the world of investing and a powerful source of education for new investors. He was the creator of Vanguard and of the world’s first index mutual fund. This edition of the book contains data updated to year 2017 which provides an enriching view of various events that have impacted investors’ decisions and the U.S. economy. Bogle also mentions throughout the book the importance of costs in portfolio’s performance and offers some advice on how to think strategically about it.
The most important messages I learned from this book were:
1. The parable of the Gotrocks Family: the book starts with this brilliant parable about a wealthy family that owned 100% of every stock in the United States and their investments were constantly growing. One some Helpers (brokers) approached some of the family members and convinced them that the Helpers could make larger earnings (beat the market) for them. The growth of the family investments started to decline as they had to pay costs they didn’t have before.
The moral of the parable was that financial intermediation costs can be detrimental to an investment portfolio and the effects gets even worse in the long term. Also, attempting to beat the market can result in performing under the average and this is something he reminds the reader constantly in the book. He favors investing across the whole market with a low cost index fund.
He explains that those in the business industry will persuade their clients with “Don’t just stand there. Do something” but the way to wealth is in fact the opposite “Don’t do something. Just stand there” which means: don’t try to beat the market.
2. Reversion to the mean (RTM): Bogle defines RTM as “the tendency of funds whose records substantially exceed industry norms to return toward the average or below”. He explains that in 2016 a large numbers of investors put cash in funds that were rated four or five stars by Morningstar but according to a study by the Wall Street Journal in 2014 only 14% of five-star funds in 2004 still held that rating a decade later, the rest dropped and some were even closed.
He makes it clear that this is a powerful force on mutual fund returns and that no advisor who promises to beat the market can do so consistently long term. Therefore, making a mutual fund selection based on recent performance has the risk of underperforming, whereas index funds can easily achieve average performance.
3. The importance of costs: throughout the book he constantly emphasises how critical costs are for investors as they can completely change the expected outcome and long-term goals, this what he calls turning a winner’s game into a loser’s game.
After paying management fees, brokerage commissions, sales loads (charges), etc., the returns of investors will go below market return and financial intermediaries get paid regardless of how their client’s portfolios perform, positive or negative.
“Before costs, beating the market is a zero-sum game. After costs, it’s a loser’s game”
Bogle also makes reference to opportunity costs that fund investors pay and he gives the example of a fund with high cash reserves. If they had lower reserve they could invest more and get higher returns.
Financial intermediaries don’t normally encourage investors to analyse these details because that could affect their gains as a business. They sell the illusion that investors can capture 100 percent of the stock market’s return.
“Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy”
I’ve had the experience of seeking financial advice where the recommendation made for Superannuation included references to historical data of funds performance and when asked the financial advisor about real investor performance after costs they said that costs where not factored in, this wasn’t mentioned in the Statement of Advice document at all, however, the financial advice fee they would charge was fixed and predictable. One approach to this is to aim for the lowest cost and to question the existing options and as Bogle says do your own arithmetic.
“You put up 100 percent of the capital and you assume 100 percent of the risk”
4. Financial Advice: in chapter twelve Bogle talks about an interesting study led by 2 Harvard Business School professors that concluded that between 1996 and 2002 the underperformance of funds managed by brokers cost investors $9 billion per year compared to funds that were sold directly to investors. The average return in the first case was 2.9% per year versus 6.6% earned by investors who took charge of their investments.
He does see the value of financial advisors as they can assist in asset allocation according to risk tolerance, understanding tax implications but he recommends making sure that the fee paid is fair as this has an impact in investments returns. He also recommends the inclusion of stock and bond index funds in investor’s portfolio as they provide a very low expense ratio , in the case of Australia the Vanguard Australian Shares Index ETF (VAS) has a management fee of 0.14% per year which is much lower than the cost of financial intermediation.
Bogle highlights this fact "in establishing a trust for his wife’s state, Warren Buffett directed that 90 percent of his assets be invested in a low-cost S&P 500 Index Fund".
5. Asset Allocation: Bogle explains various scenarios of asset allocations that include shares and bonds for US investors and the correlation between that and an investor’s age. He also provides insights about how to think about risk in asset allocation, he makes the distinction between 2 factors:
The ability to take risks: this depends on factors such as financial position, retirement income, children expenses, housing costs, etc. Investors ability to take risks increase as their assets increase relative to their liabilities.
The willingness to take risks: this is a personal preference for each investor because we all have different perceptions of volatility and manage the associated emotions different. Investors must decide the level of volatility they can handle. The combination of the ability and the willingness to take risks constitute the risk tolerance.
This book is a great source of reference for investors at various levels. Bogle admits he’s biased towards index funds not only because he created them but also because their low cost has proven over time to provide higher returns for investors compared to active managed funds. It is also important for investors to think long term and to continue educating themselves because economies change. Bogles has a great perspective on this:
“Authors of books on investing, are, in a real sense, captives of the eras that we [they] have experienced”