The Little Book of Common Sense Investing (by John C. Bogle)
Written by Vanguard founder John Bogle, "The Little Book of Common Sense Investing" talks about why investing in index funds is better than investing in actively managed mutual funds.
Published in 2007, it gives timeless advice on how to get your fair share of stock market returns without betting on high returns that come with actively managed funds, which often have high fees.
Bogle's main idea is to own a wide variety of the nation's publicly traded companies at very low costs.
This way, you can get most of the returns these companies make through dividends and growth.
Bogle says that trying to beat the market is a losing game.
So, why are index funds better than actively managed mutual funds, and why did Bogle focus his career on them?
Lower Cost Means Higher Returns
Warren Buffett says that more trading leads to lower returns and higher fees.
If more trading in the fund means lower returns, why pay experts extra to manage your money?
Remember, these highly paid managers are controlling your money, and their paychecks come from your fees.
Instead of earning money for you, they are actually costing you money.
Some actively managed funds can do better than the market, but they are hard to find and their performance needs to be balanced with their expenses.
Successful investing is about owning businesses and getting dividend payments and capital growth as companies grow and earn money.
Actively managed mutual funds are also worse for taxes compared to the average index fund, which many people don't realize.
This is because mutual fund stocks are bought and sold throughout the year, leading to taxes on gains.
Index funds, with their fixed investments, don't buy and sell often, so investors don’t have to pay as much in taxes.
The less active management in a fund, the better it is for investors in terms of taxes.
Index funds only need enough management to match the index, so they rarely incur the taxes that actively managed mutual funds do.
The Impact Of Investment Fees
Before we look at how a Vanguard portfolio grows, let's check out a chart that shows how costs affect your investments over time.
If an index fund has an average return of 8%, but a managed fund with similar returns has costs of 2.5%, the managed fund's net return would be 5.5%.
Over 50 years, $10,000 invested in an index fund would grow to $469,000, but the managed fund would only reach $145,000.
This means that even small costs of 2.5% can really lower your final balance over time because of compounding.
The Truth About Mutual Funds
Managed funds, or mutual funds, have been popular for many years, often because of lots of ads showing off the newest and best-performing funds.
But the reality is surprising.
This chart shows all 355 funds from 1970 to 2005.
The chart compares managed funds to a simple index fund that tracks the S&P 500.
It shows that 223 mutual funds are gone because they did poorly.
Another 60 funds did worse than the index by one to four percent, 48 funds did just as well as the S&P 500, and only 24 funds did better by one to four percent.
Looking closer, just nine funds did better by two percent or more, which is only 2.5 percent of all the managed funds.
To show how poorly these actively managed funds perform, John showed another chart.
This shows how likely it is for an actively managed fund to do better than an index fund that follows the S&P 500.
In the first year, there's only a 29% chance of a managed fund doing better.
Over time, these chances get worse.
If you plan to stay invested for 25 years, there's just a 5% chance of a managed fund beating the index.
Those aren’t good odds.
Even with these bad chances, people keep putting money into managed funds.
More money is going into index funds, but not as much.
Sadly, advertising to people who don’t know a lot about investing is still working.
If at this point, you think index funds are the best choice, John reminds us that not all index funds are the same, especially in terms of costs.
Here's an example from the book showing five index funds with the lowest costs and five with the highest.
The yearly costs might seem small, but over a long time, they make a big difference.
For example, $10,000 invested in a Vanguard 500 index fund would grow to $122,700 over 25 years.
The same amount in a Wells Fargo fund tracking the same index would only grow to $99,100.
That's a 23% difference just because of those "small" cost differences.
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Avoid Paying High Fees
So, why pay high fees to a fund manager who might not always get good returns?
A fund manager might do well for a few years with a 14% return, but there's no guarantee it will keep happening.
In fact, the opposite might happen.
You could be happy with an 18% return one year but not so happy with a 6% return the next year, while still paying the same 2% fees.
With index funds, there's less guesswork because you're tracking the overall market.
Not all index funds are the same, so Bogle suggests investing in a fund that includes the whole stock market, like the S&P 500.
A fund like this covers all parts of the market, so if one part does well, you gain.
If one part does poorly, it doesn't hurt your portfolio too much.
Another option is a total stock market fund, which includes companies of all sizes, not just big ones like in the S&P 500.
This spreads the risk across different parts of the market.
This way, you can make money when things go well and have smaller losses when some companies or parts of the market don't do as well.
Where The Real Money Is Made
The real way to make money is by investing in and owning companies for a long time, not by buying and selling quickly.
Short-term trading might work sometimes, but it's not reliable over many years.
Famous investors like Benjamin Graham and Warren Buffett agree that broad market index funds are the best.
Warren Buffett suggests putting most of your money in an S&P 500 index fund.
He said that if you invested $10,000 in the S&P 500 in 1942, it would be worth over $50 million today.
You should listen to Buffett, who started buying stocks at age 11 and is now worth over $130 billion, as he might know a thing or two about investing.
Choosing the cheapest index fund can make you the most money.
It's easy to pick index funds based on cost because an S&P 500 fund is the same whether it's from Vanguard, Fidelity, iShares, or other companies.
Actively managed mutual funds are harder to compare because many things affect their performance, like market trends, holdings, costs, and management.
Mutual fund expenses often don’t match their returns like index funds do.
For example, an expense ratio of 2% on a $1 million nest egg is $20,000 per year, while the average index fund would only charge $2,000 per year.
Think of the $18,000 saved as extra money in your account.
A Little Bit Of “Fun” Money
John Bogle says to put most of your money in low-cost index funds for long-term investing.
He suggests keeping only 5% of your money in individual stocks, gold, and other risky investments.
This small part, called "fun money," lets you take chances without risking all your savings on the next big stocks that guarantees you a Lambo the moment you buy it.
It’s okay to have a tiny part of your portfolio for these exciting investments because index funds won't make you a millionaire overnight.
But if you have $1 million saved, don't put a single penny more than $50,000 in these riskier things.
Thank you for reading, cheers!
- Ivan
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