Common Sense on Mutual Funds
By John C. Bogle David F. SwensenJohn Wiley & Sons
Copyright © 2010 John Wiley & Sons, Ltd
All right reserved.
ISBN: 978-0-470-13813-7
Chapter One
On Long-Term InvestingChance and the Garden
Investing is an act of faith. We entrust our capital to corporate stewards in the faith-at least with the hope-that their efforts will generate high rates of return on our investments. When we purchase corporate America's stocks and bonds, we are professing our faith that the long-term success of the U.S. economy and the nation's financial markets will continue in the future.
When we invest in a mutual fund, we are expressing our faith that the professional managers of the fund will be vigilant stewards of the assets we entrust to them. We are also recognizing the value of diversification by spreading our investments over a large number of stocks and bonds. A diversified portfolio minimizes the risk inherent in owning any individual security by shifting that risk to the level of the stock and bond markets.
Americans' faith in investing has waxed and waned, kindled by bull markets and chilled by bear markets, but it has remained intact. It has survived the Great Depression, two world wars, the rise and fall of communism, and a barrage of unnerving changes: booms and bankruptcies, inflation and deflation, shocks in commodity prices, the revolution in information technology, and the globalization of financial markets. In recent years, our faith has been enhanced-perhaps excessively so-by the bull market in stocks that began in 1982 and has accelerated, without significant interruption, toward the century's end. As we approach the millennium, confidence in equities is at an all-time high.
Chance, the Garden, and Long-Term Investing
Might some unforeseeable economic shock trigger another depression so severe that it would destroy our faith in the promise of investing? Perhaps. Excessive confidence in smooth seas can blind us to the risk of storms. History is replete with episodes in which the enthusiasm of investors has driven equity prices to-and even beyond-the point at which they are swept into a whirlwind of speculation, leading to unexpected losses. There is little certainty in investing. As long-term investors, however, we cannot afford to let the apocalyptic possibilities frighten us away from the markets. For without risk there is no return.
Another word for "risk" is "chance." And in today's high-f lying, fast-changing, complex world, the story of Chance the gardener contains an inspirational message for long-term investors. The seasons of his garden find a parallel in the cycles of the economy and the financial markets, and we can emulate his faith that their patterns of the past will define their course in the future.
Chance is a man who has grown to middle age living in a solitary room in a rich man's mansion, bereft of contact with other human beings. He has two all-consuming interests: watching television and tending the garden outside his room. When the mansion's owner dies, Chance wanders out on his first foray into the world. He is hit by the limousine of a powerful industrialist who is an adviser to the President. When he is rushed to the industrialist's estate for medical care, he identifies himself only as "Chance the gardener." In the confusion, his name quickly becomes "Chauncey Gardiner."
When the President visits the industrialist, the recuperating Chance sits in on the meeting. The economy is slumping; America's blue-chip corporations are under stress; the stock market is crashing. Unexpectedly, Chance is asked for his advice:
Chance shrank. He felt the roots of his thoughts had been suddenly yanked out of their wet earth and thrust, tangled, into the unfriendly air. He stared at the carpet. Finally, he spoke: "In a garden," he said, "growth has its season. There are spring and summer, but there are also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well."
He slowly raises his eyes, and sees that the President seems quietly pleased-indeed, delighted-by his response.
"I must admit, Mr. Gardiner, that is one of the most refreshing and optimistic statements I've heard in a very, very long time. Many of us forget that nature and society are one. Like nature, our economic system remains, in the long run, stable and rational, and that's why we must not fear to be at its mercy.... We welcome the inevitable seasons of nature, yet we are upset by the seasons of our economy! How foolish of us."
This story is not of my making. It is a brief summary of the early chapters of Jerzy Kosinski's novel Being There, which was made into a memorable film starring the late Peter Sellers. Like Chance, I am basically an optimist. I see our economy as healthy and stable. It is still marked by seasons of growth and seasons of decline, but its roots have remained strong. Despite the changing seasons, our economy has persisted in an upward course, rebounding from the blackest calamities.
Figure 1.1 chronicles our economy's growth in the twentieth century. Even in the darkest days of the Great Depression, faith in the future has been rewarded. From 1929 to 1933, the nation's economic output declined by a cumulative 27 percent. Recovery followed, however, and our economy expanded by a cumulative 50 percent through the rest of the 1930s. From 1944 to 1947, when the economic infrastructure designed for the Second World War had to be adapted to the peace-time production of goods and services, the U.S. economy tumbled into a short but sharp period of contraction, with output shrinking by 13 percent. But we then entered a season of growth, and within four years had recovered all of the lost output. In the next five decades, our economy evolved from a capital-intensive industrial economy, keenly sensitive to the rhythms of the business cycle, to an enormous service economy, less susceptible to extremes of boom and bust.
Long-term growth, at least in the United States, seems to have defined the course of economic events. Our real gross national product (GNP) has risen, on average, 3 percent annually during the twentieth century, and 2.9 percent annually in the half-century following the end of World War II-what might be called the modern economic era. We will inevitably continue to experience seasons of decline, but we can be confident that they will be succeeded by the reappearance of the long-term pattern of growth.
Within the repeated cycle of colorful autumns, barren winters, verdant springs, and warm summers, the stock market has also traced a rising secular trajectory. In this chapter, I review the long-term returns and risks of the most important investment assets: stocks and bonds. The historical record contains lessons that form the basis of successful investment strategy. I hope to show that the historical data support one conclusion with unusual force: To invest with success, you must be a long-term investor. The stock and bond markets are unpredictable on a short-term basis, but their long-term patterns of risk and return have proved durable enough to serve as the basis for a long-term strategy that leads to investment success. Although there is no guarantee that these patterns of the past, no matter how deeply ingrained in the historical record, will prevail in the future, a study of the past, accompanied by a self-administered dose of common sense, is the intelligent investor's best recourse.
The alternative to long-term investing is a short-term approach to the stock and bond markets. Countless examples from the financial media and the actual practices of professional and individual investors demonstrate that short-term investment strategies are inherently dangerous. In these current ebullient times, large numbers of investors are subordinating the principles of sound long-term investing to the frenetic short-term action that pervades our financial markets. Their counterproductive attempts to trade stocks and funds for short-term advantage, and to time the market (jumping aboard when the market is expected to rise, bailing out in anticipation of a decline), are resulting in the rapid turnover of investment portfolios that ought to be designed to seek long-term goals. We are not able to control our investment returns, but a long-term investment program, fortified by faith in the future, benefits from careful attention to those elements of investing that are within our power to control: risk, cost, and time.
How Has Our Garden Grown?
In reviewing the long-term history of stock and bond returns, I rely heavily on the work of Professor Jeremy J. Siegel, of the Wharton School of the University of Pennsylvania. This material is somewhat detailed, but it deserves careful study, for it provides a powerful case for long-term investing. As Chance might say, the garden represented by our financial markets offers many opportunities for investments to flower. Figure 1.2, based on a chart created by Professor Siegel for his fine book Stocks for the Long Run, demonstrates that stocks have provided the highest rate of return among the major categories of financial assets: stocks, bonds, U.S. Treasury bills, and gold. This graph covers the entire history of the American stock market, from 1802 to 2008. An initial investment of $10,000 in stocks, from 1802 on, with all dividends reinvested (and ignoring taxes) would have resulted in a terminal value of $5.6 billion in real dollars (after adjustment for inflation). The same initial investment in long-term U.S. government bonds, again reinvesting all interest income, would have yielded a little more than $8 million. Stocks grew at a real rate of 7 percent annually; bonds, at a rate of 3.5 percent. The significant advantage in annual return (compounded over the entire period) exhibited by stocks results in an extraordinary difference in terminal value, at least for an investor with a time horizon of 196 years-long-term investing approaching Methuselan proportions.
Since the early days of our securities markets, returns on stocks have proved to be consistent in each of three extended periods studied by Professor Siegel. The first period was from 1802 to 1870 when, Siegel notes, "the U.S. made a transition from an agrarian to an industrialized economy." In the second period, from 1871 to 1925, the United States became an important global economic and political power. And the third period, from 1926 to the present, is generally regarded as the history of the modern stock market.
These long-term data cover solely the financial markets of the United States. (Most studies show that stocks in other nations have provided lower returns and far higher risks.) In the early years, the data are based on fragmentary evidence of returns, subject to considerable bias through their focus on large corporations that survived, and derived from equity markets that were far different from today's in character and size (with, for example, no solid evidence of corporate earnings comparable to those reported under today's rigorous and transparent accounting standards). The returns reported for the early 1800s were based largely on bank stocks; for the post-Civil War era, on railroad stocks; and, as recently as the beginning of the twentieth century, on commodity stocks, including several major firms in the rope, twine, and leather businesses. Of the 12 stocks originally listed in the Dow Jones Industrial Average, General Electric alone has survived. But equity markets do have certain persistent characteristics. In each of the three periods examined by Professor Siegel, the U.S. stock market demonstrated a tendency to provide real (after-inflation) returns that surrounded a norm of about 7 percent, somewhat lower from 1871 to 1925, and somewhat higher in the modern era.
In the bond market, Professor Siegel examined the returns of long-term U.S. government bonds, which still serve as a benchmark for the performance of fixed-income investments. The long-term real return on bonds averaged 3.5 percent. But, in contrast with the remarkably stable long-term real returns provided by the stock market, bond market real returns were quite variable from period to period, averaging 4.8 percent during the first two periods, but falling to 2.0 percent during the third. Bond returns were especially volatile and unpredictable during the latter half of the twentieth century.
Stock Market Returns
Let's look first at the stock market. Table 1.1 contains two columns of stock market returns: nominal returns and real returns. The higher figures are nominal returns. Nominal returns are unadjusted for inflation. Real returns are corrected for inflation and are thus a more accurate reflection of the growth in an investor's purchasing power. Because the goal of investing is to accumulate real wealth-an enhanced ability to pay for goods and services-the ultimate focus of the long-term investor must be on real, not nominal, returns.
In the stock market's early years, there was little difference between nominal returns and real returns. In the first period (with its more dubious provenance), from 1802 to 1870, inflation appears to have been 0.1 percent annually, so the real return was only one-tenth of a percentage point lower than the nominal stock market return of 7.1 percent.
Inflation remained at an extremely low level through most of the nineteenth century. In the stock market's second major period, 1871 to 1925, returns were almost identical to those in the first period, although the rate of inflation accelerated sharply in the later years. Nominal stock market returns compounded at an annual rate of 7.2 percent, while the real rate of return was 6.6 percent. The difference was accounted for by annual inflation averaging 0.6 percent.
In the modern era, the rate of inflation has accelerated dramatically, averaging 3.1 percent annually, and the gap between real and nominal returns has widened accordingly. Since 1926, the stock market has provided a nominal annual return of 10.6 percent and an inflation-adjusted return of 7.2 percent. Since the Second World War, inflation has been especially high. From 1966 to 1981, for example, inflation surged to an annual rate of 7.0 percent. Nominal stock market returns of 6.6 percent annually were in fact negative real returns of -0.4 percent. More recently, inflation has subsided. From 1982 to 1997, during substantially all of the long-running bull market, real returns averaged 12.8 percent, approaching the highest return for any period of comparable length in U.S. history (14.2 percent in 1865-1880).
The high rate of inflation in our modern era is in large part the result of our nation's switch from a gold-based monetary system to a paper-based system. Under the gold standard, each dollar in circulation was convertible into a fixed amount of gold. Under our modern paper-based system, in which the dollar is backed by nothing more (or less) than the public's collective confidence in its value, there are far fewer constraints on the U.S. government's ability to create new dollars. On occasion, rapid growth in the money supply has unleashed bouts of rapid price inflation. The effect on real long-term stock returns has nonetheless proved neutral. Even as nominal returns have risen in line with inflation, the rate of real return has remained steady at about 7.0 percent, much as it did through the nineteenth century.
(Continues...)
Excerpted from Common Sense on Mutual Fundsby John C. Bogle David F. Swensen Copyright © 2010 by John Wiley & Sons, Ltd. Excerpted by permission.
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