Common Sense

I finally read "Common Sense on Mutual Funds" by the late, great John ("Jack") Bogle. I feel like I've been reading around this book for a decade, poking away at Bogle's shorter works and various books by other authors that occupy similar spaces and quote from it. I've enjoyed actually going to the source and directly experiencing it.

 

I read the second edition, published in 2009, and really loved how it's structured: it has the exact same text as the original edition from 1999, but with all of the tables and graphs extended to the right to show the next 10 years of data. He also includes periodic boxes labeled "10 Years Later", within which he adds new commentary on how the additional evidence of the last 10 years has affected his earlier analysis. In nearly every case it confirms his earlier assertions: sometimes he regrets being too cautious in his initial pronouncements, but I can't think of a single instance where he was wildly off the mark. It's especially interesting because the 1999-2009 period was basically the reverse of the 1989-1999 period: the 90s were a period of huge and largely uninterrupted growth, while the 2000s were bracketed by two major bear markets and overall resulted in flat or negative returns. And yet, the overall principles Bogle lays down remained as true in the "winter season" of the future as they had in the "summer season" of the past.

I think that this second-edition update is structured basically like how Burton Malkiel's "A Random Walk Down Wall Street" went in the later editions: he updates the relevant figures and charts, but the overall argument has remained identical over the last five decades. And that's really remarkable for both books! As many others have observed, it's easy to sift through past data and invent a model that would have made money in the past. It's significantly harder to work with "real money", anticipating strategies that will work in the future. Both Malkiel and Bogle have the appropriate humility to recognize the limits of what we know, and solid mathematically-backed arguments for their strategies, with a healthy dose of prior data that generally aligns with their recommendations and that continue to mostly hold true into the future.

This is a big book, but well structured and readable. I enjoyed reading it cover-to-cover, but you could probably dip into specific chapters based on your interest. This is one of the more comprehensive financial books I've read, covering the fundamental theory behind investing, where earnings come from, how the industry is structured, and a strong focus on the cultural and ethical principles at play. Much of the material was already familiar to me, but even the "old stuff" was often treated in more depth or with a new perspective that I found helpful.

For example, he spends a fair amount of time writing about the equity risk premium. This is a term I've heard about a lot in my recent financial reading, and I think I'm finally getting it. In The Four Pillars of Investing, William Bernstein illustrates this principle with the example of a falafel vendor raising money for a restaurant, comparing the option of taking a loan from a bank (low risk to the bank, high risk to the entrepreneur) or finding an investor who will buy an equity stake (low risk to the entrepreneur, high risk to the investor). To entice an investor, the business needs to plausibly offer a return on the investment high enough to offset the risk of losing everything. When Bogle introduces the equity risk premium, he goes right to the real-world example of buying a Treasury versus investing in a stock. If two investments offered the same average return, but one is risk-free and the other is risky, investors would always prefer the risk-free one. In order to attract investors, the riskier investment needs to offer a higher expected (not guaranteed!) return. The difference between the risk-free rate (like a Treasury's interest rate) and the expected return on the riskier investment is the equity risk premium. (To these examples, I'm adding my own of choosing to play a game where you can either get $1M outright, or flip a coin to get either $0M or $2M. The average result of these two choices is identical, but pretty much anyone would choose the $1M guaranteed return. In order to accept the coin flip, you'd need an extra incentive.)

As I read more finance stuff, I've gradually come to realize that some things are pure mathematical relationships, like the inverse relationship between current interest rates and the value of existing bonds. Other things describe trends we have observed over time but that aren't bound to natural laws, such as the P/E ratio, the Equity Risk Premium, and so on. Knowing these general trends and relationships is helpful in understanding the range and probabilities of possible outcomes, but they do not offer any guarantees. One of my favorite sayings in investment is "the market can remain irrational for longer than you can remain solvent." We can recognize that something is out of whack and is overdue for a return to the mean, but there's no way to predict when or how that return will occur.

Anyways, Bogle makes an interesting, nuanced point that I don't think I would have followed if I wasn't already primed for following this from other recent readings. Bogle makes the point in the context of his argument that seemingly small fees can make a huge impact; for example, a 0.2% versus a 2.0% expense ratio for a fund. If a fund has gross returns of 10% annually, then netting 9.8% versus 8% doesn't seem like a huge difference until after you've compounded for several years. But if a T-bill returned 6% over the same period, then you're talking about an equity risk premium of 3.8% versus 2%: essentially a doubled premium for the lower-cost fund. Given a certain (reasonable, though definitely not guaranteed) set of assumptions, he shows how an 80/20 stock/bond portfolio using an actively managed fund may have the same expected return as a 20/80 stock/bond portfolio using indexed funds. The difference is that the 20/80 portfolio bears significantly less risk than the 80/20 portfolio. I'm very used to just looking at (average, expected) returns, and it was cool to see a similarly analytical approach to quantifying the impact of costs on risk and not just reward. Anyways, I think that's neat!!

This idea connects well with William Bernstein's argument for purchasing a liability-matching portfolio. If you have a specific goal, and you can achieve that goal with no risk, then boom: you're done, and can spend the rest of your life assured that you'll never run out of money. Alternatively, you can choose to take on more risk to maximize the growth of your portfolio. Over the very long run (which may be longer than your lifetime!), the latter approach will generate more money. So, yeah: once again, risk is an important thing to consider, and fortunately something that we can think discretely about as opposed to just a hand-waving "being able to sleep at night" attitude.

Returning to mathematical certainties versus empirically-derived correlations: I think Bogle does a good job at describing when he's dealing with one type of relationship versus the other, and is especially forceful with the former and appropriately cautionary with the latter. On the mathematical side, he's insistent that, by definition, all investors as a whole must earn the average return of the market: for every manager who manages to beat the market average, there must be another investor who loses to the market average by the same amount. So (comparatively speaking) "beating the market" is a zero-sum game before costs, and once you take costs into account, more expensive actively-managed funds must, by definition, as a group, under-perform the market average.

What the market average does over time, on the other hand, is empirical, not deductive. Going back to 1820, the stock market has consistently trended upward over the long run. There's no guarantee that it will continue to do so, definitely not during a short term and possibly not over a very long term. So there is risk that investing in the market will result in a loss. But it is a certainty that low-cost (generally indexed) funds will perform better than the average actively-managed fund, whether the market is going up or not.

Bogle has a sense of pride, which I think is pretty well-earned, in creating the first commercially-available index fund, and for being generally correct about how the market works, thanks to insights like predicting long-run market returns based on the current dividend yield plus the growth rate. He claims these wins but isn't obnoxious about it.

The biggest outlier between Bogle and the contemporary Boglehead movement is definitely international investments. Pretty much everyone besides him believes in a significant international exposure; the most common belief today is probably reflecting overall global market capitalization, while many (including myself) overweight the US equity markets while still having a significant minority share of international equities. Bogle argues pretty strongly towards having an all-US portfolio, and grudgingly concedes that you might include up to 20% international for diversification purposes. I've read (and heard) his arguments before, though I think this book handles them at more length and in more depth. They include:

• The US has significantly better legal protections, liquidity, transparency, regulations, and other helpful aspects to its financial markets.
• The US has been and remains the global leader in innovation, both creating new successful businesses and growing existing ones.
• Contrarily, given the demographics of the other fully developed markets (Europe and Japan), he doesn't see much opportunity for future growth: they're already built out, and have aging populations and minimal immigration. More growth is possible in emerging markets, but also significant risk, and it's hard to say with certainty that future returns would be worth it.
• The largest US companies already have significant international exposure (earning overseas revenue, using overseas labor, etc.), so you already get some diversification while holding only US stocks.
• Everyone reading this book is a US investor spending US dollars in the US, and international investing exposes you to significant currency risk: a rising dollar will cut into international returns while a weakening dollar will boost them. As with most things in finance, he identifies a long-term reversion to the mean in relative currency strengths. At the time of publication, international stocks had provided great returns; but he notes that this was mostly due to a weakening dollar, and if you correct for the exchange rate, they actually underperformed US markets.

I think it's interesting that the one argument that he seems to (grudgingly) accept as legitimate is diversification, the idea that holding international equities will soften the blow of a broad decline in the US stock market, somewhat like bonds. I think that the diversification hypothesis has been declared dead and buried in the last 15 years: now that we're in a fully globalized world, markets are so interconnected that everything falls when the US does; I'm reminded of the phrase "When America sneezes, the rest of the world catches a cold." We saw this in 2008 (though it may not have been obvious at the time of the second edition) and has continued to hold true since. (Interestingly, the converse has not recently held true, as the US market strongly rebounded from the COVID-19 recession while Europe and Japan continued to languish.)

Pretty much everyone (including modern Bogleheads) disagrees with the rest of his points on international stocks. Taking a crack at summarizing the major counter-arguments I've heard:

• Reversion to the mean applies to the US as well as everyone else. Outperformance can't last forever.
• It's mathematically impossible for US outperformance to continue indefinitely, as it would eventually result in a US capitalization of over 100% of global markets.
• US market strength in the 20th and early 21st century has reflected US dominance (political, military, and economically) over the world. If and when these strengths decline, our market share will as well. In particular, it will be very challenging for the US to remain dominant over countries with significantly larger populations once those countries are fully developed.

It may be worth noting that Bogle wrote this book in the late 90s, and the ~25 years that have passed since then have been pretty friendly to US-only investors; in more recent years, China has emerged as a bigger long-term rival to US supremacy. So Bogle's original advice was very good to people who were reading at the time during their 10-40 year investing journeys, but it's less clear if that will continue for the rest of the century, as he briefly acknowledges in passing.

I also have been enjoying comparing Bogle's arguments with William Bernstein's "Birth of Plenty" thesis. Bernstein identifies a cluster of ingredients (including social norms as well as technology) that create significant and self-sustaining growth. Those are obviously present in the US, were present in Britain before, have been spreading to other advanced economies. But they aren't something you can flip on at will in a developing country: it requires generations of local acceptance and integration. Anyways, if Bernstein is right, then it isn't a slam-dunk that emerging markets will outperform within our lifetimes, or even our children's lifetimes. And, to be a bit more pessimistic, the best we can hope for in the future may be a sustained real growth of ~2% per year in the most advanced countries, including the US, in which case we will be no better but also not significantly worse than anyone else.

I periodically remember how things have changed. At the time that Bogle wrote the first edition of this book, mutual funds (let alone index funds) were still somewhat of an anomaly; most stocks were individually held. By the second edition nearly half of all shares were owned through mutual funds or ETFs; I assume even more are today but am too lazy to look it up. The change is primarily due to higher participation in 401ks, 403bs and IRAs, but I think the diversification and ease of use probably also contribute. I think that the shift towards mutual funds makes his arguments even more relevant, since he's mostly comparing indexed vs. actively managed mutual funds, not so much indexed vs. individual stocks.

The chapter on taxes is really interesting. One thing I hadn't thought of before is how a fund as a whole could have unrealized capital gains thanks to appreciation of its underlying stocks; in his example, if you buy a $100 mutual fund share but there's an unrealized capital gain, then you may only be getting something like $78 worth of stocks for your purchase after accounting for the tax. This tax liability reduces with additional shares, though (since the pre-existing gain is divided among more people), which gives an incentive to grow the fund. He also makes some good points about the value of deferring capital gains; that is not relevant in a tax-advantaged retirement account, but for regular taxable accounts, you can get significant benefits by compounding tax deferrals over a decade or longer. That isn't possible in funds with high turnover, as those gains must be realized when the underlying shares are sold. It seems like tax deferral isn't as relevant for dividend taxes, which must be paid the same year.

Interestingly, both Bogle and Bernstein say it's safest to own the entire market, but Bernstein likes tilting towards value while Bogle seems to slightly prefer tilting towards growth. Over very very very very long periods of time, value stocks have historically returned a bit more than growth; and they don't usually dip as far as growth stocks during downturns, so they're a bit safer to hold in a retirement portfolio. But value stocks tend to return relatively more in dividends, while growth stocks return more in capital appreciation, and Bogle likes how that gives you more control over when and how (or even if) to realize those gains.

Index funds are praised, but are a smaller part of the book than you might think. Bogle would prefer a low-cost managed fund over a high-cost indexed fund, and owning appropriate asset classes is a lot more important than being indexed. He often toys with the idea of directly owning a basket of stocks, and I suspect that he would favor that approach for very wealthy people: mutual and indexed funds are more of a convenience for those of us with extra money to invest but not the deep pockets or professional acumen to assemble our own broadly diversified portfolios. He even supports the idea of very talented managers beating the market; his concern is that you can't identify them in advance, and either they'll close their funds to maintain quality, or expand the fund and practically guarantee future mediocrity.

Early sections of the book cover the same sort of ground as "The Little Book of Common Sense Investing"; the last parts are in the same vein as "The Battle for the Soul of Capitalism", with a little of the autobiographical details of "Enough." So if you're only going to read one Bogle book, this is probably the one that has it all. He writes sternly about the responsibility mutual fund companies hold towards their clients, and how that responsibility is consistently shirked. He eventually names Vanguard and makes a much more direct and impassioned case for why it's special. By this point, hundreds of pages into the book, he's established his intelligence and his values, so it feels deserved.

It's interesting to compare the Bogle-led version of Vanguard as depicted in this book with what exists today. As I've written before, I've been a loyal Vanguard client for decades, but if I were to start investing today I would likely go with Fidelity. Something has changed - no one single decision that made Vanguard lose its way, but a series of decisions over years that he never would have agreed with. One famous one is the introduction of ETFs: Bogle consistently rails against these in the "ten years later" section, and they were brought in essentially over his dead body, after he was forced into retirement. It makes a ton of sense for Vanguard to sell ETFs - investors demand them, and they hew to most of the key Vanguard values like low cost, transparency, and simplicity. But Bogle hated them because they can be (albeit don't have to be) frequently traded like stocks, and so lead people away from the focus on long-term investing that he sees as so critical. More recently, Vanguard has forced all of us legacy users of the mutual fund interface to their new brokerage platform. Again, it makes a lot of sense: it's more economical for them to only support one interface instead of two, and the brokerage site can do almost everything the old mutual fund site could do. But again, being a brokerage is fundamentally about instant gratification, making it easy to buy and sell individual stocks and bonds with the click of a mouse. I can just hear Bogle gnashing his teeth over pushing Vanguard clients away from a long-term-focused platform to the new one.

There's a touching anecdote near the end of the book about how a major institutional investor offered to invest hundreds of millions of dollars into a small-cap short-term bond fund at Vanguard for a few months. It would have been great for the institution since they'd get a major guaranteed return, and it would be great for Vanguard since they'd get the fees and business. But Vanguard rejected it: the existing small investors of the fund would get stuck with the capital gains taxes from that large trade, despite not trading themselves (as good, disciplined long-term investors). The institution was irate, pulled all their business from Vanguard and even wrote a nasty letter in the Wall Street Journal blasting Vanguard. The company lost short-term business, but gained huge respect and loyalty from their existing customers, and attracted many new ones who admired their ethics. I don't see the Vanguard of 2024 making that same decision, and that makes me sad. I'm reminded of Bogle's insistence in Enough. of how crucial it is to focus on the thing you can't count (like reputation) over the things you can count (like quarterly sales).

Anyways! Like I said up top, I really enjoyed this book. Reading it takes a big investment (heh) in time, but it's low-risk and offers significant rewards: practical guidance on personal financial planning, a deep understanding of how markets work, and a wide-ranging, insightful survey of the mutual fund industry and the people it employs and serves. The more I read and hear from Bogle the more I admire him. Even if he's gone, and even if his version of Vanguard is fading, he's left behind an extraordinary legacy in the way individual investors think and behave.