(Image, John Bogle on the Rise of Index Funds, accessed 16 July 2016, http://www.barrons.com/)
Have you ever looked at the statement you receive from your investment manager and wondered, what the heck are they talking about!
You think you’re getting good returns but it turns out you’re underperforming. The question is, WHY?
One reason that investors continue to underperform is provided by a simple illustration from John Bogle in his book, The Little Book of Common Sense Investing.
John Bogle is the founder and retired CEO of The Vanguard Group. He was also named one of the “world’s 100 most powerful and influential people”, by Time magazine in 2004.
Bogle’s innovative idea was creating the world’s first index mutual fund in 1975. Bogle’s idea was that instead of beating the index and charging high costs, the index fund would mimic the index performance over the long run. Thus, achieving higher returns with lower costs than actively managed funds.
Let’s see what he has to say.
One of my favorite chapters in Bogle’s book is Chapter 4 titled, How Most Investors Turn a Winner’s Game into a Loser’s Game.
“Before we turn to the success of indexing as an investment strategy, let’s explore in a bit more depth just why it is that investors as a group fail to earn the returns that our corporations generate through their dividends and earnings growth, ultimately reflected in the prices of their stocks.”
“To understand why they do not, we need only to recognize the simple mathematics of investing:”
“All investors as a group must necessarily earn precisely the market return, but only before the costs of investing are deducted.”
“Investors pay far too little attention to the costs of investing. It’s especially easy to underrate their importance under today’s three conditions:
(1) when so many costs are hidden from view (portfolio transaction costs, the unrecognized impact of front-end sales cha[n]ges, taxes incurred on realized gains);
(2) when stock market returns have been high (during the 1980s and 1990s, stock returns averaged 17.5 percent per year, and the average fund provided a nontrivial—but clearly inadequate—return of 15 percent); and especially;
(3) when investors focus on short-term returns, ignoring the truly confiscatory impact of cost over an investment lifetime.”
“Based on these assumptions, let’s look at the returns earned on $10,000 over 50 years (Exhibit 4.1 below). The simple investment in the stock market grows to $469,000, a remarkable illustration of the magic of compounding returns over an investment lifetime.”
“In the early years, the line showing the growth at a 5.5 percent annual rate doesn’t look all that different from the growth in the stock market itself. But ever so slowly, the lines begin to diverge, finally at a truly dramatic rate. By the end of the long period, the value accumulated in the fund totals just $145,400, an astounding shortfall of $323,600 to the cumulative return earned in the market itself.”
“In the investment field, time doesn’t heal all wounds.”
“In the investment field, time doesn’t heal all wounds. It makes them worse. Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy. This point is powerfully illustrated when we consider how much of the value of the $10,000 investment is eroded with each passing year (Exhibit 4.2 below).”
“By the end of the first year, only about 2 percent of the value of your capital has vanished ($10,800 vs. $10,550). By the 10th year, 21 percent has vanished ($21,600 vs. $17,100). By the 30th year, 50 percent has vanished ($100,600 vs. $49,800). And by the end of the investment period, costs have consumed nearly 70 percent of the potential accumulation available simply by holding the market portfolio.”
“The investor, who put up 100 percent of the capital and assumed 100 percent of the risk, earned only 31 percent of the market return. The system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 70 percent of that return—surely the lion’s share. What you see here—and please don’t ever forget it!—is that over the long term, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
“The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
Don’t you love it when really smart people, like Bogle, provide such simple illustrations on what happens when you decide to leave you money with some investment managers. He of course recommends an index fund, while I personally prefer the screens here at The Acquirer’s Multiple.
Concentrated investing using value stocks like the ones provided here, have historically proven to be one of the most successful methods of achieving long term out-performance in the stock market.
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