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Words From an Investment Sage

As head of the nation’s second-largest mutual fund company, Vanguard Group Chairman John C. Bogle has spent a lifetime championing low-cost investing and the concept of indexing: holding the bulk of your stock assets in a low-expense fund that simply replicates the broad market’s performance.

Since 1994, indexing has exploded in popularity with individual investors, as the blue-chip Standard & Poor’s 500-stock index has racked up stellar gains--a trend that is continuing in 1997. Vanguard’s Index 500 Trust, which replicates the S&P; 500, has soared from $16 billion in assets a year ago to $32 billion now.

Bogle, while still a true believer in the long-term appeal of indexing versus trying to beat the market with actively managed funds, has repeatedly warned that the high-flying S&P; 500 may be a risky bet in the short term.

But his central message is unchanged: Mutual fund investors, he says, should focus on common-sense strategies, invest for the long haul and emphatically reject paying high fund management fees.

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Bogle, 67, had lunch last week with Times Business section editors and reporters. Excerpts from his remarks:

On his periodic warnings, in Vanguard’s investor newsletter, about the short-term risks in buying the S&P; 500 index fund:

I wrote the same thing a year ago. I said: “Don’t expect indexing to be good all the time. A year will come along, probably sooner rather than later . . . where the index doesn’t outperform more than a third of all stock funds.” And here it comes along with another great year, three years in a row, for the index stocks to do well.

I’m not particularly embarrassed about it. I’m glad I warned them a year ago. If it kept anybody out of the fund that was there because they thought they had some new, hot investment, I’m very happy I did that. I think if you’re forewarned along those lines you’re just going to do a lot better.

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On the U.S. stock market’s relative valuation:

I don’t think that there’s any question whatsoever that by any historical or conventional standards, the market is very, very high. A 20%, 30% decline would be, by those measures, not out of the question at all--given that dividend yields are low, P/E [price-to-earnings] ratios are high. . . .

But all of that is historical, and I use this quote in my book [“Bogle on Mutual Funds,” 1993, Irwin Professional Publishing]: “History is a lantern on the stern.” And there’s a lot of truth to that. Even I will acknowledge that there’s some evidence out there that the argument that “this time it’s different” is sustainable. I think it’s wrong, but it can be rationally sustained. [Corporate] earnings growth, under certain economic scenarios--U.S. earnings growth--could well be running in the 10% to 12% range for some years, and that would be good enough to hold this market up. The norm’s about 6%, so we’re talking twice the normal corporate earnings growth.

On whether nervous investors should reduce their stock holdings:

If the reduction were, say, from 75% to 40% [of one’s total assets], that would be too dramatic for me. Even if you’re right. I think old Baron Rothschild said, “Sell to the sleeping point.” But the sleeping point shouldn’t be zero in common stocks, if you’re smart enough to realize that you’re too dumb to know.

But someone could make a moderate reduction in equities, and by moderate I would say, maybe 10 to 15 percentage points [from their normal asset allocation in stocks].

We actually threw this into my book for fun, because it’s a homespun kind of example: Subtract your age from 100 and that’s the percentage you should [normally] have in equities. So if you’re 60, it should be 40%, if you’re 20, it should be 80%. That’s a little too simplistic, but that would be kind of the idea. But that’s so rule-of-thumb and almost inherently wrong, because there are very conservative people that, honest to God, shouldn’t own one share of stock, no matter how much money they have.

But most people should. Although we may end up with a period of relatively low returns or even down returns, it’s hard to believe that the long-term future is that stocks won’t be worth something more than they are today at X date, let’s say 10 years from now.

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So if someone is making their first payment into a 401(k) at age 25, who would really want to say, “You’d really better be careful and balance it; the market’s too high.” If the market is too high, it would be the best thing that would ever happen to them if there’s a big decline, because then they would really be able to accumulate [stocks] when they put significant money in.

On why he disdains market timing:

I’ve got to be right twice, [first to say, “Sell”], then I’ve got to call you up, if I’m thinking of it that day, and say, “Now is the time to get back in.” Since the odds of it being right once are 1 in 10--and I think that’s a very, very generous assessment of my own brilliance--the odds of getting out a second time, you’re at 1 in 10 again or 1 in 100. And please don’t ask me to do it four times, because you can add the same number of zeros I can.

In investing, time is your ally, impulse is your enemy. And the biggest risk is not investing at all.

On why asset allocation--your overall mix of stocks, bonds, cash and other assets--is more important than the individual securities you pick:

All of the studies show that asset allocation determines pretty much all the money you earn [over time]. Professor [William] Sharpe takes it even further, with allocation into international stocks, small-cap, large-cap, etc. And then he can explain even more than 94% of your return. So it’s just the asset classes you pick. I’m a great believer that, in investing, the [main] idea is to set your course along these lines.

On whether many investors will panic when a genuine bear market finally happens, or whether the money invested through long-term retirement accounts will help stabilize the market:

We don’t know nearly as much about the answer to that as we’d like to. And, of course, there aren’t that many periods you can examine to find out how [investors] are going to behave.

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But my own view is that the market-stabilizing attributes of 401(k)s are greatly overrated because my assumption is that if someone is scared to death with money in their right pocket, they will be scared to death with the money in their left pocket too.

On his reasoning behind creating the first stock index mutual fund:

We formed [the fund] and got the underwriting done in 1976. It was a subject of derision and scorn; I won’t tell you some of the things people said about me, but I was called a Communist, a Marxist.

But this is one of the rare cases when theory and practice are the same thing, which is we know the return on [the average actively managed] fund tends to fall 2 percentage points a year behind the index [in the long term] and we know why. And that is because the funds have an expense ratio, the cost of picking the stocks and administering them, administering the accounts, is about 1.5% a year.

And then there’s the cost of portfolio turnover, all that shifting, which accomplishes nothing--well, I mean it can’t accomplish anything because it’s one fund manager selling to another fund manager, and we know that there’s no value there. So there’s the 2%.

On the real importance of indexing’s growing popularity with investors:

This is going to be a big business. I’m sure of it. I’ve been sure of that for a long time. It’s taken a long time for its promise to be realized, everybody knows. But the ultimate implications are that it will set changes into effect in the remainder of the equity fund business. And that means, going right down the list, lower advisory fees, one of the greatest rip-offs in history.

Probably 10% to 15% of all the fees that are paid to mutual fund managers are paid for investment advice. So 85% of what you’re paying your manager for doesn’t have anything to do with picking stocks, and the remainder that goes to picking stocks, as we also know, provides before-expenses average returns, and after-expense below-average returns. So fees should come down, number one. And other fund expenses should come down.

In Einsteinian physics they say E=MC squared, but for us the formula is G-C=N. Gross return minus cost equals net return. People say it can’t be that simple, to which I would respond “Yes, it not only can be that simple, but it is.”

On why shareholders should be angry over expensive fund company TV ad campaigns:

I’m appalled, I’m outraged over fund marketing expenses. This is the shareholders’ money being used in a cause that affords the shareholders not a penny of benefit, but affords the manager who spends the shareholders’ money on marketing a huge increase in benefit to him, i.e. more assets gathered, more fees, more profits. I don’t see how that’s justifiable.

On why fund directors don’t pressure fund management companies to lower fees:

I think that we’d be very well-served if the press would just run a review of fund directors’ [compensation] once a year, just list them from the top down. In some fund complexes, a director could make $250,000 a year, while in the biggest corporations in America the average is probably $75,000. It’s just insane. It’s impossible to escape the conclusion that if you have a [management] contract with the fund and you want directors to keep renewing it and not telling you to cut your fees . . . you pay [your directors] a lot of money so they can’t afford to lose their jobs.

On what the Securities and Exchange Commission should do to push fund fees down:

I think what they should do more than anything else is to get on the old bloody pulpit and yell and say: “Come on directors, do your job. We’re not talking about any specific fund, but fund fees have got out of hand.”

The commission would never dare say profits earned by fund advisors are grossly exorbitant and this is the most profitable business ever designed . . . but there’s no question about it and it’s, it’s just too much. [Fund directors] aren’t looking at their duties properly. So I’d like the commission to step up and reinforce what I think competition will try and do to drive fees down.

On his heart transplant operation a year ago, and his recovery:

It’s some experience, almost mystical. . . . I’m doing wonderfully well. I’m playing squash and climbing mountains and generally being a pain in the neck to everyone in the office. I’ve always been an energetic guy, but I’d gone through a period where, at least in the last four of five years, I’ve kind of had to summon my energy. I could always summon it up. But now I’m back to where I was, where it’s summoning me up.


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