Investing Lessons to Live By

Here are some of John C. Bogle’s, former CEO of the Vanguard Group and founder of the “index” fund, timeless investing lessons and market philosophies. I know it reaffirmed some of my changing views around investing and saving for retirement.

1) Beware of market forecasts, even by experts. As the new year begins, strategists from Wall Street’s major firms forecast the end-of-the-year closing level and earnings of the Standard and Poor’s 500 (S&P 500) Stock Index. For example a few years ago the average forecast was for the year-end S&P 500 index was 1,640 and earnings of $97. There was remarkably little disparity of opinion among these Wall Street sages. Reality: the S&P closed the year at 903, with reported earnings estimated at $50.

>> Learning : Ignore the forecasts of inevitably bullish strategists. Bearish strategists on Wall Street’s payroll don’t survive for long.

2) Never underrate the importance of asset allocation. Investing is not about owning only common stocks. Nor are historical stock returns a sound guide to future returns. Virtually all investors should keep some “dry powder” in their portfolios in the form of high-grade short- and intermediate-term bonds. Investors who failed to learn that lesson fell on especially hard times . How much in bonds? A good place to start is a bond percentage that equals your age. So a 40 yr old would have 40% in bonds.

>> Learning : With all the focus on historical returns that greatly favor stocks, don’t ignore bonds. Consider not only the probabilities of future returns on stocks, but the consequences if you are wrong.

3) Mutual funds with superior performance records often falter. Funds managed by proven long-term pros felt the pain — Dodge and Cox Stock down 43%; Third Avenue Value down 46%; CGM Focus down 48%; Clipper down 50%; Longleaf Partners down 51%. (Full disclosure: Four of Vanguard’s actively-managed equity funds also lagged the market by wide margins.) Only time will tell whether the disappointing shortfalls experienced by these and other funds will be recovered in the future, whether the skills of their managers have atrophied, or whether their luck has run out.

>> Learning : Whatever the case, chasing past performance is all too often a loser’s game. Managers of funds seeking market-beating returns should make it clear to investors that they must be prepared to trail the market – perhaps substantially – in at least one year of every three.

4) Owning the market remains the strategy of choice. Such a strategy guarantees a return that lags the market return by a minuscule amount, and exceeds the return captured by active equity-fund managers as a group by a substantial amount. Why? Because the heavy costs incurred by investors in actively managed equity funds can easily amount to 2% to 3% annually. Typical expense ratios run from 1% to 1.5%; the hidden costs of portfolio turnover often come to 0.5% to 1.0%; a 5% front-end sales load, amortized over a holding period of five to 10 years, adds another 0.5% to 1.0% per year in costs.

Indexing has won by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks. This continues the pattern — with some variations — that goes back to the start of the first index fund 33 years ago. The bond index fund did even better. Its return of 5% for 2008 outpaced more than 80% of all taxable bond funds.

>> Learning : In sum, active management strategies as a group lose because they are expensive. Passive indexing strategies win because they are cheap.

5) Look before you leap into alternative asset classes. During 2006-07, equity mutual funds focused on developed international markets and emerging markets provided strong relative returns to U.S. stocks. During that period, U.S. investors made net purchases of $285 billion in mutual funds investing in non-U.S. stocks, and liquidated on balance some $35 billion from funds focused on U.S. stocks. This extreme example of “performance chasing” at its worst is hardly defensible. But, disingenuously, it was touted by fund marketers as adding “non-correlated assets,” or “reducing volatility risk.” In 2008 – with non-U.S. developed market funds falling by 45% and emerging market funds tumbling by 55%, we learned once again that, just when we need it the most, international diversification lets us down. Commodities were no different. As the global recession developed, commodity funds sank, the largest such fund tumbled 50%.

>> Learning : Always keep in mind: When the investment grass looks greener on the other side of the fence, look twice before you leap.

6) Beware of financial innovation. Why? Because most of it is designed to enrich the innovators, not investors. Just think of the multiple layers of fees to the salespersons, servicers, banks, underwriters and brokers selling mortgage-backed debt obligations. These new products (credit default swaps are another example) enriched their marketers during 2005-07, only to impoverish the clients who held them in 2008.

>> Learning : Our financial system is driven by a giant marketing machine in which the interests of sellers directly conflict with the interests of buyers. The sellers, having (as ever) the information advantage, nearly always win.

Some simple, yet brilliant observations.

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