Don't Count on It!

Reflections on Investment Illusions, Capitalism, "Mutual" Funds, Indexing, Entrepreneurship, Idealism, and Heroes

John C. Bogle

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470949023
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

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.

Part One

INVESTMENT ILLUSIONS

Many of the themes in this book are captured in Chapter 1, one of my favorite efforts, and broad enough to provide the book’s title: Don’t Count on It! In this opening chapter, subtitled “The Perils of Numeracy,” my keynote speech delivered at the Princeton Center for Economic Policy Studies in 2002, I challenge the growing trend in our society to give numbers a credence that they simply don’t deserve, all the while assigning far less importance to the things that can’t be expressed with numbers—qualities such as wisdom, integrity, ethics, and commitment.

The consequences of this misperception are damaging. They lead to expectations that past financial market returns are prologue to the future (they most certainly are not!); to our bias toward optimism, evidenced in the failure of investors to consider real (after-inflation) returns in their retirement planning; to creative accounting (or is it “financial engineering”?) that produces corporate earnings numbers that we accept as reality when they are often far closer to illusion; and to the damaging toll it inflicts upon the real world of real human beings, who ultimately produce the real goods and services that our society relies upon.

In Chapter 2, I explore another of my favorite themes, “The Relentless Rules of Humble Arithmetic,” an essay published in the Financial Analysts Journal in 2005. In the long-run, the reality of the inescapable mathematics of investing trumps the illusion reflected in the performance numbers provided by fund managers. For example, during the two-decade period 1983-2003, a fund emulating the S&P 500 index earned a cumulative return of 1,052 percent, and its investors earned a return of 1,012 percent. In remarkable contrast, the average equity fund reported a cumulative return of just 573 percent, and the investors in those very same funds averaged a gain of less than one-half that amount, only 239 percent. Surely using stock market returns as a proxy for equity fund returns—to say nothing of the returns actually earned by fund investors—ignores those relentless rules. The idea that fund investors in the aggregate can capture the stock market’s return has proven to be yet another investment illusion.

In Chapter 3, I combat the investment illusion that the past is prologue, pointing out that the reality is far different. In “The Telltale Chart” (actually a series of 11 charts), I focus on the pervasive power of “reversion to the mean” in the financial markets—the strong tendency of both superior investment returns and inferior returns to revert to long-term norms. This pattern is documented over long historic periods among: (1) conventional sectors of the stock market, such as large versus small stocks and value versus growth stocks; (2) both past winners and past losers in the equity fund performance derby; and (3) stock market returns in general. I also show a powerful—and, I would argue, inevitable—tendency of the stock market’s total return to revert to the mean of its investment return (dividend yields and earnings growth). Speculative return—generated by increases and decreases in price-to-earnings valuations—follows the same type of pattern. But since speculative return is bereft of any underlying fundamental value, it reverts to zero over the long term. Yes, the investment returns earned by our corporations over time represent reality; speculative booms and busts, however powerful in the short run, prove in the long run to be mere illusion.

Another investment illusion is that costs don’t matter. The money managers who dominate our nation’s investment system seem to ignore the reality that costs do indeed matter. That self-interested choice is smart, for those management fees and trading costs have resulted in soaring profitability for America’s financial sector. Financial profits leaped from 8 percent of the total earnings of the firms in the S&P 500 index in 1980 to 27 percent in 2007—33 or more percent if the earnings from the financial activities of industrial companies (i.e., GE and GMAC) are included.

The enormous costs of our financial sectors represent, as the title of Chapter 4 puts it, “A Question So Important That It Should Be Hard to Think about Anything Else.” Why? Because the field of money management subtracts value from investors in the amount of the costs incurred. Ironically, the financial sector seems to prosper in direct proportion to the volume of the devilishly convoluted instruments that it creates—immensely profitable to their creators, but destructive to the wealth of those who purchase them. This complexity is also destructive to the social fabric of our society, for in order to avoid financial panic, we taxpayers (a.k.a. “government”) are then required to bail them out.

Finally comes the most devious investment illusion of all: confusing the creation of real corporate intrinsic value with the ephemeral illusion of value represented by stock prices. Chapter 5—“The Uncanny Ability to Recognize the Obvious”—focuses on how important it is to recognize the obvious, especially in this difficult-to-discern difference between illusion and reality. Part of that difference is the difference between the real market of business operations and the creation of value (essentially long-term cash flows) and the expectations market of trying to anticipate the future preferences of investors. Since they simply track the stock market, even index funds face the same challenges that all investment strategies face when stock prices lose touch with reality. In the recent era, it has been speculation on stock price movements that has dominated our markets, not the reality of intrinsic value. So I reiterate my long-standing conviction: When there is a gap between illusion and reality, it is only a matter of time until reality prevails.

Chapter 1

Don’t Count on It! The Perils of Numeracy⁸

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:⁹ “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 re...