A Review of John Bogle’s “Common Sense on Mutual Funds” – Chapter 2

This is a chapter-by-chapter review of John Bogle’s Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*. As the series progresses, I’ll create an index of each chapter.

Chapter 2 – On the Nature of Returns

Chapter 2—if you can’t already tell from the title—looks at where market returns come from. We’ll start with stock market returns.

On page 51 of the book, Bogle lists three variables that determine long-term (a decade or so) stock market returns:

1. The dividend yield at the time of initial investment.

2. The subsequent rate of growth in earnings.

3. The change in the price-earnings ratio during the perioid of investment.

This makes a lot of sense when you think about it. The higher the initial dividend yield, usually the lower initial purchase price. The lower the initial purchase price, the greater the potential for future gains.

For example, if current dividend yields are 2%, earnings growth is expected to be 4%, and the P/E ratio is projected to go from 13 to 20 over the next ten years (4.4% per year), the expected return would be around 10.4% over the next ten years. Of course, that’s not what we’re looking at these days.

According to this week’s Barron’s, the S&P 500 has a current dividend yield of 1.98% and a P/E ratio of a whopping 86.2! Keep in mind that the P/E ratio is price divided by earnings. The earnings for the S&P 500 index have plummeted 46.10 to 12.83, while the index value has gone from 876.07 to 1105.98. That’s the reason for today’s massive market P/E. The only way for the market P/E to get back down to a more reasonable level (of say 15 to 18), two or three things have to happen:

Investment Return consisting of…

1. Earnings must increase

2. The index price level must decrease

and Speculative Return…

3. A combination of the two.

At the current level of 1105.98, earnings would have to increase to $61.44 to $73.73 in order to bring the P/E ratio back to a normal level.

Were the adjustment to come from the price level of the index, the value of the index would have to drop to between 189.45 to 227.34. Ouch!

There’s no doubt that with earnings as low as they are, that they are bound to recover somewhat. We just don’t know how much and how long it will take for them to turn around.

Anyway, back to the main point. If the dividend yield is currently 1.98%, corporate earnings are expected to grow at 6% (a number I got from the book), and the P/E ratio for the index is expected to drop to 25 (-22% per year…a guesstimate) over the next 5 years. The average rate of return for the index over the next 5 years would be -14%. Not very encouraging.

As far as bonds are concerned, the metric Bogle uses to predict future long-term (10 years) bond returns is simply the current yield at time of purchase. According to his research, the initial yield had a correlation of +.93 (+1.0 is perfect correlation) with the returns earned on bonds following the intial purchase.

Bogle goes into more detail than I can give you here. I gave you the basic points of the chapter.

Next, we’ll look at Bogle’s thoughts on asset allocation.

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A Review of John Bogle’s “Common Sense on Mutual Funds” – Chapter 1

This is a chapter-by-chapter review of John Bogle’s Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*. As the series progresses, I’ll create an index of each chapter.

Chapter 1 – On Long-Term Investing

Summary: To invest with success, you must be a long-term investor.

Bogle opens the chapter with a discussion of long-term growth rates for various asset classes (mainly stocks). Remember, that this version of the book is the old book with inserted or updated thoughts. In his discussion of long-term returns, Bogle added this, which I found interesting:

Despite the woes encountered by the stock market over the past decade, our economy continued to grow solidly, at a real (inflation-adjusted) rate of 1.7 percent, exactly half the 3.4 percent growth rate of the modern economic era. Despite the onset of recession in 2008, the gross national product (GNP) actually rose by [a] skinny 1.3 percent for the full year, although a decline (the first since 1991) of about 4 percent is projected for 2009.

But after this winder or our disciontent—from mid-2008, through the winter of 2009—we have enjoyed a spring and summer of recovery. for what it’s worth, the stock market provides far more value relative to our economy than was the case a decade ago. Then, the aggregate market value of U.S. stocks was 1.8 times the nation’s GNP, an all-time high; by mid-2009, with the value of the market at $10 trillion and hte GNP at $14 trillion, the ratio has tumbled to 0.7 times, 60 percent below the earlier peak, and roughly the same ratio as the historical average.

Not sure why he chose to use Gross National Product rather than Gross Domestic Product but I guess it doesn’t make much difference. The point to take from the quote is that the stock market isn’t as fully valued as it was ten years ago.

One thing that bugs me about chapter 1 is that Bogle relies heavily on Jeremy Siegel’s book, Stocks for the Long Run. The bulk of Siegel’s book is accurate but his data for index returns from 1802 to 1926 is unreliable because it was based on an index that was cherry-picked and consisted of very few stocks (more on this later).

Bogle then goes on to talk about the risk characteristics of both the stock and bond markets and shows how the wide swings (volatility) in market returns tend to dissapate the longer one stays in the market. Read this post to see what I mean. Bogle mentions that one way to fight the volatility of the stock market is to include bonds in your portfolio. This is pretty standard stuff.

The chapter then moves on to discuss costs. Basically, Bogle believes that when it comes to investing, you get what you don’t pay for. It’s very hard to beat the market so the only thing that keeps you performing as well as the market is costs. He breaks it down like so:

1. All investors own the entire stock market, so both active investors (as a group) and passive investors—holding all stocks at all times—must match the gross return of the stock market.

2. The manage fees and transaction costs incurred by the active investors in the aggregate are substantially higher than those incurred by passive investors.

3. Therefore, because active and passive investments together must, by definition, earn equal gross returns, passive investors must earn the higher net return.

It’s important to note that Bogle is not saying that some active managers can’t outperform the market but that on the whole, they can’t because of expenses. Interesting thought.

He closes out the chapter with a list of six simple principals for long-term success (along with my thoughts):

1. Invest you must. For most people, there’s no other way to build wealth.

2. Time is your friend. Start as EARLY as you can and put the magic of compounding to work.

3. Impulse is your enemy. Don’t allow your emotions to take control.

4. Basic arithmetic works. Watch your investment expenses and keep them under control.

5. Stick to simplicity. Keep it simple by sticking with a simple asset allocation.

6. Stay the course. Through thick and thin, stay the course. Reread the other five principals when you feel yourself wavering.

Okay, there’s your review of Chapter 1 – On Long-Term Investing. Tomorrow we’ll look at Chapter 2 – On the Nature of Returns.

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A Review of John Bogle’s “Common Sense on Mutual Funds” – Introduction

As I mentioned yesterday, I received a copy of John Bogle’s Common Sense on Mutual Funds*. It’s a fully updated 10th anniversary edition. I remember reading the bulk of the first edition when it first cam out. I enjoyed the first edition so I’m looking forward to do doing an in depth review of this updated version.

The book contains 22 chapters divided into 5 parts:

Part I: On Investment Strategy

Part II: On Investment Choices

Part III: On Investment Performance

Part IV: On Fund Management

Part V: On Spirit

What’s different about the updated version of the book is that in addition to the old text, it has inserts where Bogle felt it was necessary to expand and update on the old material. The one flaw is that the updating without taking out old material makes the book rather large. The new book comes in at over 600 pages.

Anyway, starting tomorrow, I’m going to be reviewing one chapter per day each week. Tomorrow’s chapter will be Chapter 1 – On Long-Term Investing. I’ve already read it. It’s interesting. Come back tomorrow. Read along with me if you so desire*.

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John Bogle’s Six Lessons for Investors

John Bogle had an excellent opinion piece in today’s Wall Street Journal titled Six Lessons for Investors. His lessons (along with my commentary):

1. Beware of market forecasts, even by experts. – His point being that forecasts are nearly always optimistic and although sometimes they may be right, they are more often wrong.

2. Never underrate the importance of asset allocation.

3. Mutual funds with superior performance records often falter. – The S&P 500 was down 37% in 2008 while Bill Miller’s Value Trust was down 55%—and that was the second year in a row his fund had underperformed the S&P 500 after fifteen straight years of beating the average.

4. Owning the market remains the strategy of choice. – If you own the market, you don’t have to worry as much about problems with one particular company. Yes, if the economy tanks, you’re still going to lose money.

5. Look before you leap into alternative asset classes. – It hurts to be a bandwagon investor!

6. Beware of financial innovation. – Lumping together crappy mortgages and selling them off as “safe” securities was a financial innovation—a really stupid one!

Read Mr. Bogle’s piece here.

Of course the question is: will we learn from these lessons?

Related: Jonathan Clements on the Credit Crisis and Current Economy