Thursday, January 6, 2011

6 Enduring Investing Insights from Jack Bogle

Jack Bogle is the pioneering founder of the Vanguard 500 fund, the granddaddy of all modern passive index funds. Here are some excerpts from his recent interview with Money Magazine.

1. "In 2008 we had one of the largest cuts in dividends in the history of the S&P 500. Now the dividends don't seem to be coming back, even though the earnings have. What are the corporations trying to tell us? I don't know. Maybe they're trying to tell you that these earnings are phony, and we don't have money to pay you dividends."

Dividends are an important source of information for investors: a reliable, constant stream of dividends reflects the stability of a firm's earnings, while falling dividends may signal bad prospects for the firm. When dividends fail to go up when earnings do, it's a sign that the rise in earnings may just be "phony," or a product of "creative accounting."

2. "Don't reach for more than the market return (which he estimates at around 8% per year). You could try leverage (borrowing money for investment), or buying commodities and gold. And maybe you'll do well -- but who really knows? Those alternative investments have no internal return. They are 100% speculation. You are speculating you can sell to someone for more than you paid. They're like stocks that pay you no dividends and offer no earnings growth."

Here, Bogle refers to the Greater Fool Theory of Speculative Investing: you buy something for 100 pesos only because you believe you can later sell it for 150 to a "greater fool"; unfortunately, sometimes you'll find that there's no fool greater than you.

3. "I don't rely on the efficient-markets hypothesis. I go by the 'cost matters' hypothesis: Whatever the market returns, on average you will beat your rivals if you lower your costs. And that's what index funds do."

Investing is like playing poker in a casino in that even if you bet against other players, everyone loses since the house skims a little something off the top. Minimizing costs -- by not paying fund managers and investing in index funds -- increases your probability of winning.

4. "If you're not indexing, you've got problems. First, a stock selection problem -- maybe you'll pick good stocks, maybe you won't. Then a market sector problem -- will growth do better than value? Finally a manager selection problem, which is the worst because the only way people have found to pick good managers is to look at past performance. That's not a reliable gauge."

You can try doing it yourself, but what makes you so sure that you can do better than the next guy? Okay, you can pay someone to do it for you, but what makes him or her so great? Well, you can take a look at how his or her fund has performed in the past. But what does past performance tell us, really?

5. "We're all buy-and-hold investors because collectively we all own the market. So, as a group, investors are buying and holding. The only question is: Can I out-trade the other guy? Am I really smarter than the guy I'm selling Microsoft to or planning to buy it from? Well, one of you is going to prove to be smarter. And I'd say that was a flip of the coin -- except for the cost of trading."

Active buying and selling of stocks is really a zero-sum game: if you gain 100 pesos by selling a share of stock, then the buying party is set to lose the same amount; of course it could go the other way and you find yourself at the losing end of the transaction. But with trading costs, management fees, and taxes, the game becomes less than zero-sum and everyone loses. Therefore, the best long-term strategy is to pay as little in fees and costs as you can.

6. Stock-picking pros aren't stupid. They're just expensive.

I couldn't have said it any better.
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