Don't Count on It!: Reflections on Investment Illusions, Capitalism, "Mutual" Funds, Indexing, Entrepreneurship, Idealism, and Heroes - Hardcover

Bogle, John C.

Hardcover

ISBN 10: 047064396X ISBN 13: 9780470643969

Publisher: Wiley, 2010

Synopsis

Praise for Don't Count On It!

"This collection of Jack Bogle's writings couldn't be more timely. The clarity of his thinking―and his insistence on the relevance of ethical standards―are totally relevant as we strive to rebuild a broken financial system. For too many years, his strong voice has been lost amid the cacophony of competing self-interests, misdirected complexity, and unbounded greed. Read, learn, and support Jack's mission to reform the industry that has been his life's work."
―PAUL VOLCKER, Chairman of the President's Economic Recovery Advisory Board and former Chairman of the Federal Reserve (1979–1987)

"Jack Bogle has given investors throughout the world more wisdom and plain financial 'horse sense' than any person in the history of markets. This compendium of his best writings, particularly his post-crisis guidance, is absolutely essential reading for investors and those who care about the future of our society."
―ARTHUR LEVITT, former Chairman, U.S. Securities and Exchange Commission

"Jack Bogle is one of the most lucid men in finance."
―NASSIM N.TALEB, PhD, author of The Black Swan

"Jack Bogle is one of the financial wise men whose experience spans the post–World War II years. This book, encompassing his insights on financial behavior, pitfalls, and remedies, with a special focus on mutual funds, is an essential read. We can only benefit from his observations."
―HENRY KAUFMAN, President, Henry Kaufman & Company, Inc.

"It was not an easy sell. The joke at first was that only finance professors invested in Vanguard's original index fund. But what a triumph it has been. And what a focused and passionate drive it took: it is a zero-sum game and only costs are certain. Thank you, Jack."
―JEREMY GRANTHAM, Cofounder and Chairman, GMO

"On finance, Jack Bogle thinks unconventionally. So, this sound rebel turns out to be right most of the time. Meanwhile, many of us sometimes engage in self-deception. So, this book will set us straight. And in the last few pages, Jack writes, and I agree, that Peter Bernstein was a giant. So is Jack Bogle."
―JEAN-MARIE EVEILLARD, Senior Adviser, First Eagle Investment Management

Insights into investing and leadership from the founder of The Vanguard Group

Throughout his legendary career, John Bogle-founder of the Vanguard mutual fund group and creator of the first index mutual fund-has helped investors build wealth the right way, while, at the same time, leading a tireless campaign to restore common sense to the investment world.

A collection of essays based on speeches delivered to professional groups and college students in recent years, in Don't Count on It is organized around eight themes

• Illusion versus reality in investing
• Indexing to market returns
• Failures of capitalism
• The flawed structure of the mutual fund industry
• The spirit of entrepreneurship
• What is enough in business, and in life
• Advice to America's future leaders
• The unforgettable characters who have shaped his career

Widely acclaimed for his role as the conscience of the mutual fund industry and a relentless advocate for individual investors, in Don't Count on It, Bogle continues to inspire, while pushing the mutual fund industry to measure up to their promise.

About this title

About the Author

JOHN C. BOGLE is the founder of the Vanguard Group of Mutual Funds and President of its Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as chairman and chief executive officer until 1996 and senior chairman until 2000. In 1999, Fortune magazine named Mr. Bogle as one of the four "Investment Giants" of the twentieth century; in 2004, Time magazine named him one of the world's 100 most powerful and influential people, and Institutional Investor presented him with its Lifetime Achievement Award. In 2010, Forbes magazine described him as the person who "has done more good for investors than any other financier of the past century." Mr. Bogle graduated from Blair Academy cum laude in 1947 and Princeton University in 1951, magna cum laude in economics. In 1999, he received the University's Woodrow Wilson Award for distinguished achievement in the nation's service.

Don't Count on It! is Mr. Bogle's ninth book. His earlier books include Common Sense on Mutual Funds, The Battle for the Soul of Capitalism, The Little Book of Common Sense Investing, and Enough.

From the Back Cover

In his Foreword, former Federal Reserve vice-chairman Alan S. Blinder writes, "America's vaunted financial system let us down big-time during the raucous decade of the 2000s." In Don't Count on It!, John C. Bogle a man Dr. Blinder refers to as "the conscience of Wall Street" identifies modern capitalism's flaws, explains how we arrived at this economic crossroads, and examines how we can begin to repair the damage before it's too late.

Don't Count on It! presents an anthology of Bogle's latest thinking, focused on how numbers deceive us into seeing things as other than they really are. He also presents a cogent analysis of the chinks in the armor of a financial system that has failed to live up to the responsibility owed to its individual and institutional investors.

Read and learn from the wise counsel of Vanguard's founder about how we deceive ourselves into accepting illusory and evanescent numbers rather than focusing on fundamental and intrinsic reality. Bogle argues that we confuse the market of real investing with the market of expectations, disregarding the beauty of simplicity in favor of the wizardry that creates complex "products" that serve Wall Street at the expense of its clients. Specifically, Bogle discusses:

• The unconscionably high costs of financial intermediation
• The disgraceful failure of money managers and agents to abide by what should have been traditional fiduciary standards
• The unfortunate consequences of the dominance of short-term speculation over long-term investment

The subjects of Bogle's anthology go well beyond the investment markets, as indicated by the seven sections of Don't Count on It! Investment Illusions, The Failure of Capitalism, What's Wrong with "Mutual" Funds, What's Right with Indexing, Entrepreneurship and Innovation, Idealism and the New Generation, and Heroes and Mentors.

His book encourages readers to better understand our complex financial system, to examine it, to debate it, to challenge it, and to fulfill our duty to ask simple questions and demand answers that are understandable, intelligent, and, above all, wise.

From the Inside Flap

In his Foreword, former Federal Reserve vice-chairman Alan S. Blinder writes, "America's vaunted financial system let us down big-time during the raucous decade of the 2000s." In Don't Count on It!, John C. Bogle—a man Dr. Blinder refers to as "the conscience of Wall Street"—identifies modern capitalism's flaws, explains how we arrived at this economic crossroads, and examines how we can begin to repair the damage before it's too late.

Don't Count on It! presents an anthology of Bogle's latest thinking, focused on how numbers deceive us into seeing things as other than they really are. He also presents a cogent analysis of the chinks in the armor of a financial system that has failed to live up to the responsibility owed to its individual and institutional investors.

Read and learn from the wise counsel of Vanguard's founder about how we deceive ourselves into accepting illusory and evanescent numbers rather than focusing on fundamental and intrinsic reality. Bogle argues that we confuse the market of real investing with the market of expectations, disregarding the beauty of simplicity in favor of the wizardry that creates complex "products" that serve Wall Street at the expense of its clients. Specifically, Bogle discusses:

• The unconscionably high costs of financial intermediation
• The disgraceful failure of money managers and agents to abide by what should have been traditional fiduciary standards
• The unfortunate consequences of the dominance of short-term speculation over long-term investment

The subjects of Bogle's anthology go well beyond the investment markets, as indicated by the seven sections of Don't Count on It!—Investment Illusions, The Failure of Capitalism, What's Wrong with "Mutual" Funds, What's Right with Indexing, Entrepreneurship and Innovation, Idealism and the New Generation, and Heroes and Mentors.

His book encourages readers to better understand our complex financial system, to examine it, to debate it, to challenge it, and to fulfill our duty to ask simple questions and demand answers that are understandable, intelligent, and, above all, wise.

Excerpt. © Reprinted by permission. All rights reserved.

Don't Count on It!

Reflections on Investment Illusions, Capitalism, "Mutual" Funds, Indexing, Entrepreneurship, Idealism, and HeroesBy John C. Bogle Alan S. Blinder

John Wiley & Sons

Copyright © 2011 John Wiley & Sons, Ltd
All right reserved.
ISBN: 978-0-470-64396-9

Chapter One

Don't Count on It! The Perils of Numeracy

Mysterious, seemingly random, events shape our lives, and it is no exaggeration to say that without Princeton University, Vanguard never would have come into existence. And had it not, it seems altogether possible that no one else would have invented it. I'm not saying that our existence matters, for in the grand scheme of human events Vanguard would not even be a footnote. But our contributions to the world of finance—not only our unique mutual structure, but the index mutual fund, the three-tier bond fund, our simple investment philosophy, and our overweening focus on low costs—have in fact made a difference to investors. And it all began when I took my first nervous steps on the Princeton campus back in September 1947.

My introduction to economics came in my sophomore year when I opened the first edition of Paul Samuelson's Economics: An Introductory Analysis. A year later, as an Economics major, I was considering a topic for my senior thesis, and stumbled upon an article in Fortune magazine on the "tiny but contentious" mutual fund industry. Intrigued, I immediately decided it would be the topic of my thesis. The thesis in turn proved the key to my graduation with high honors, which in turn led to a job offer from Walter L. Morgan, Class of 1920, an industry pioneer and founder of Wellington Fund in 1928. Now one of 100-plus mutual funds under the Vanguard aegis, that classic balanced fund has continued to flourish to this day, the largest balanced fund in the world.

In that ancient era, Economics was heavily conceptual and traditional. Our study included both the elements of economic theory and the worldly philosophers from the 18th century on—Adam Smith, John Stuart Mill, John Maynard Keynes, and the like. Quantitative analysis was, by today's standards, conspicuous by its absence. (My recollection is that Calculus was not even a department prerequisite.) I don't know whether to credit—or blame—the electronic calculator for inaugurating the sea change in the study of how economies and markets work, but with the coming of the personal computer and the onset of the Information Age, today numeracy is in the saddle and rides economics. If you can't count it, it seems, it doesn't matter.

I disagree, and align myself with Albert Einstein's view: "Not everything that counts can be counted, and not everything that can be counted counts." Indeed, as you'll hear again in another quotation I'll cite at the conclusion, "to presume that what cannot be measured is not very important is blindness." But before I get to the pitfalls of measurement, to say nothing of trying to measure the immeasurable—things like human character, ethical values, and the heart and soul that play a profound role in all economic activity—I will address the fallacies of some of the measurements we use, and, in keeping with the theme of this forum, the pitfalls they create for economists, financiers, and investors.

My thesis is that today, in our society, in economics, and in finance, we place too much trust in numbers. Numbers are not reality. At best, they're a pale reflection of reality. At worst, they're a gross distortion of the truths we seek to measure. So first, I'll show that we rely too heavily on historic economic and market data. Second, I'll discuss how our optimistic bias leads us to misinterpret the data and give them credence that they rarely merit. Third, to make matters worse, we worship hard numbers and accept (or did accept!) the momentary precision of stock prices rather than the eternal vagueness of intrinsic corporate value as the talisman of investment reality. Fourth, by failing to avoid these pitfalls of the numeric economy, we have in fact undermined the real economy. Finally, I conclude that our best defenses against numerical illusions of certainty are the immeasurable, but nonetheless invaluable, qualities of perspective, experience, common sense, and judgment.

Peril #1: Attributing Certitude to History

The notion that common stocks were acceptable as investments—rather than merely speculative instruments—can be said to have begun in 1924 with Edgar Lawrence Smith's Common Stocks as Long-Term Investments. Its most recent incarnation came in 1994, in Jeremy Siegel's Stocks for the Long Run. Both books unabashedly state the case for equities and, arguably, both helped fuel the great bull markets that ensued. Both, of course, were then followed by great bear markets. Both books, too, were replete with data, but the seemingly infinite data presented in the Siegel tome, a product of this age of computer-driven numeracy, puts its predecessor to shame.

But it's not the panoply of information imparted in Stocks for the Long Run that troubles me. Who can be against knowledge? After all, "knowledge is power." My concern is too many of us make the implicit assumption that stock market history repeats itself when we know, deep down, that the only certainty about the equity returns that lie ahead is their very uncertainty. We simply do not know what the future holds, and we must accept the self-evident fact that historic stock market returns have absolutely nothing in common with actuarial tables.

John Maynard Keynes identified this pitfall in a way that makes it obvious:* "It is dangerous to apply to the future inductive arguments based on past experience [that's the bad news] unless one can distinguish the broad reasons for what it was" (that's the good news). For there are just two broad reasons that explain equity returns, and it takes only elementary addition and subtraction to see how they shape investment experience. The too-often ignored reality is that stock returns are shaped by (1) economics and (2) emotions.

Economics and Emotions

By economics, I mean investment return (what Keynes called enterprise), the initial dividend yield on stocks plus the subsequent earnings growth. By emotions, I mean speculative return (Keynes's speculation), the return generated by changes in the valuation or discount rate that investors place on that investment return. This valuation is simply measured by the earnings yield on stocks (or its reciprocal, the price-earnings ratio). For example, if stocks begin a decade with a dividend yield of 4 percent and experience earnings growth of 5 percent, the investment return would be 9 percent. If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase would translate into an additional speculative return of about 3 percent per year. Simply add the two returns together: Total return on stocks 12 percent.

So when we analyze the experience of the Great Bull Market of the 1980s and 1990s, we discern that in each of these remarkably similar decades for stock returns, dividend yields contributed about 4 percent to the return, the earnings growth about 6 percent (for a 10 percent investment return), and the average annual increase in the price-earnings ratio was a remarkable and unprecedented 7 percent. Result: Annual stock returns of 17 percent were at the highest levels, for the longest period, in the entire 200-year history of the U.S. stock market.

The Pension "Experts"

Who, you may wonder, would be so foolish as to project future returns at past historical rates? Surely many individuals, even those expert in investing, do exactly that. Even sophisticated corporate financial officers and their pension consultants follow the same course. Indeed, a typical corporate annual report expressly states, "Our asset return assumption is derived from a detailed study conducted by our actuaries and our asset management group, and is based on long-term historical returns." Astonishingly, but naturally, this policy leads corporations to raise their future expectations with each increase in past returns. At the outset of the bull market in the early 1980s, for example, major corporations assumed a future return on pension assets of 7 percent. By the end of 2000, just before the great bear market took hold, most firms had sharply raised their assumptions, some to 10 percent or even more. Since pension portfolios are balanced between equities and bonds, they had implicitly raised the expected annual return on the stocks in the portfolio to as much as 15 percent. Don't count on it!

As the new decade began on January 1, 2000, two things should have been obvious: First, with dividend yields having tumbled to 1 percent, even if that earlier 6 percent earnings growth were to continue (no mean challenge!), the investment return in the subsequent 10 years would be not 10 percent, but 7 percent. Second, speculative returns cannot rise forever. (Now he tells us!) And if price-earnings ratios, then at 31 times, had simply followed their seemingly universal pattern of reversion to the mean of 15 times, the total investment return over the coming decade would be reduced by seven percentage points per year. As the year 2000 began, then, reasonable expectations suggested that annual stock returns might just be zero over the coming decade.

If at the start of 2000 we were persuaded by history that the then-long-term annual return on stocks of 11.3 percent would continue, all would be well in the stock market. But if we listened to Keynes and simply thought about the broad reasons behind those prior returns on stock—investment versus speculation—we pretty much knew what was going to happen: The bubble created by all of those emotions—optimism, exuberance, greed, all wrapped in the excitement of the turn of the millennium, the fantastic promise of the Information Age, and the "New Economy"—had to burst. While rational expectations can tell us what will happen, however, they can never tell us when. The day of reckoning came within three months, and in late March 2000 the bear market began. Clearly, investors would have been wise to set their expectations for future returns on the basis of current conditions, rather than fall into the trap of looking to the history of total stock market returns to set their course. Is it wise, or even reasonable, to rely on the stock market to deliver in the future the returns it has delivered in the past? Don't count on it!

Peril #2: The Bias toward Optimism

The peril of relying on stock market history rather than current circumstances to make investment policy decisions is apt to be costly. But that is hardly the only problem. Equally harmful is our bias toward optimism. The fact is that the stock market returns I've just presented are themselves an illusion. Whether investors are appraising the past or looking to the future, they are wearing rose-colored glasses. For by focusing on theoretical market returns rather than actual investor returns, we grossly overstate the returns that equity investing can provide.

First, of course, we usually do our counting in nominal dollars rather than real dollars—a difference that, compounded over time, creates a staggering dichotomy. Over the past 50 years, the return on stocks has averaged 11.3 percent per year, so $1,000 invested in stocks at the outset would today have a value of $212,000. But the 4.2 percent inflation rate for that era reduced the return to 7.1 percent and the value to just $31,000 in real terms—truly a staggering reduction. Then we compound the problem by in effect assuming that somewhere, somehow, investors as a group actually earn the returns the stock market provides. Nothing could be further from the truth. They don't because they can't. The reality inevitably always falls short of the illusion. Yes, if the stock market annual return is 10 percent, investors as a group obviously enjoy a gross return of 10 percent. But their net return is reduced by the costs of our system of financial intermediation—brokerage commissions, management fees, administrative expenses—and by the taxes on income and capital gains.

A reasonable assumption is that intermediation costs come to at least 2 percent per year, and for taxable investment accounts, taxes could easily take another 2 percent. Result: In a 10 percent market, the net return of investors would be no more than 8 percent before taxes, and 6 percent after taxes. Reality: Such costs would consume 40 percent of the market's nominal return. But there's more. Costs and taxes are taken out each year in nominal dollars, but final values reflect real, spendable dollars. In an environment of 3 percent annual inflation, a nominal stock return of 10 percent would be reduced to a real return of just 7 percent. When intermediation costs and taxes of 4 percent are deducted, the investor's real return tumbles to 3 percent per year. Costs and taxes have consumed, not 40 percent, but 57 percent of the market's real return.

Taken over the long-term, this bias toward optimism—presenting theoretical returns that are far higher than those available in the real world—creates staggering differences. Remember that $31,000 real 50year return on a $1,000 investment? Well, when we take out assumed investment expenses of 2 percent, the final value drops to $11,600. And if we assume as little as 2 percent for taxes for taxable accounts, that initial $1,000 investment is worth, not that illusory nominal $212,000 we saw a few moments ago—the amazing productive power of compounding returns—but just $4,300 in real, after-cost terms—the amazing destructive power of compounding costs. Some 98 percent of what we thought we would have has vanished into thin air. Will you earn the market's return? Don't count on it!

Escaping Costs and Taxes

It goes without saying that few Wall Street stockbrokers, financial advisers, or mutual funds present this kind of real-world comparison. (In fairness, Stocks for the Long Run does show historic returns on both a real and nominal basis, although it ignores costs and taxes.) We not only pander to, but reinforce, the optimistic bias of investors. Yet while there's no escaping inflation, it is easily possible to reduce both investment costs and taxes almost to the vanishing point. With only the will to do so, equity investors can count on (virtually) matching the market's gross return: owning the stock market through a low-cost, low-turnover index fund—the ultimate strategy for earning nearly 100 percent rather than 60 percent of the market's nominal annual return. You can count on it!

The bias toward optimism also permeates the world of commerce. Corporate managers consistently place the most optimistic possible face on their firms' prospects for growth—and are usually proven wrong. With the earnings guidance from the corporations they cover, Wall Street security analysts have, over that past two decades, regularly estimated average future five-year earnings growth. On average, the projections were for growth at an annual rate of 11.5 percent. But as a group, these firms met their earnings targets in only 3 of the 20 five-year periods that followed. And the actual earnings growth of these corporations has averaged only about one-half of the original projection—just 6 percent.

But how could we be surprised by this gap between guidance and delivery? The fact is that the aggregate profits of our corporations are closely linked, indeed almost in lockstep, with the growth of our economy. It's been a rare year when after-tax corporate profits accounted for less than 4 percent of U.S. gross domestic product, and they rarely account for much more than 8 percent. Indeed, since 1929, after-tax profits have grown at 5.6 percent annually, actually lagging the 6.6 percent growth rate of the GDP. In a dog-eat-dog capitalistic economy where the competition is vigorous and largely unfettered and where the consumer is king—more than ever in this Information Age—how could the profits of corporate America possibly grow faster than our GDP? Don't count on it!

(Continues...)

Excerpted from Don't Count on It!by John C. Bogle Alan S. Blinder Copyright © 2011 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Edition details

• Publisher: Wiley
• Publication date: 2010
• Language: English
• ISBN 10: 047064396X
• ISBN 13: 9780470643969
• Binding: Hardcover
• Edition number: 1
• Number of pages: 640