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The value of index funds

Marketplace Staff Apr 27, 2007

The value of index funds

Marketplace Staff Apr 27, 2007

TESS VIGELAND: You hear it all the time: Put your money in index funds. Index funds, index funds, index funds. Well there are thousands of mutual funds that let you tie your money to, say, the S& P 500 or the Russell 2000.
Thirty years ago, it wasn’t that easy to do – until John Bogle created the first indexed mutual fund. He’s the founder of the Vanguard Group.
And that fund was called the Vanguard First Investment Trust.

Well, Mr. Bogle has written a new book called, appropriately enough, “The Little Book of Common Sense Investing.”
Welcome to Marketplace Money and tell me: What makes index funds such a great long-term investment?

JOHN BOGLE: Indexing has to be, if you think about the mathematics for a minute, the gold standard as a way to invest. If the stock market produces, let’s say, an 8 percent annual return, investors will . . . clearly, the average, all investors together, will earn 8 percent. But they won’t receive 8 percent. They’ll earn net about 5.5 percent, because the costs of investing come out of that market return. And investors pay those costs. They run, believe it or not Tess, about $400 billion a year. So that, we can say with some high mathematical accuracy, is the amount by which we investors lose to the stock market.

VIGELAND: We had quite a lesson, just a few weeks ago, when the Asian markets took a dive. And of course, that had a ripple effect throughout the world. And we’ve had all these problems with subprime mortgages and that’s affecting the markets as well. And I think it’s times like those where investors say, “Oh my goodness, I can’t possibly subject myself to the entire market.” But I guess the lesson is, here we are a few weeks later, and I think if most people looked at their mutual funds and their index funds, they’re pretty much back to where they were.

BOGLE: They’re back to where they were, and actually a little bit ahead compared to the beginning of the year. I’ve been asked about, you know, what in a sense investors make out of these almost insane fluctuations in the market. And I say they are really very important if you’re a speculator. But if you’re a long-term investor, these events you’ve just talked about will not even be footnotes to history. We let ourselves get transfixed by momentary changes in stock prices, and at the same time forget that what investing is about is the accumulation. Not of prices, but the accumulation of values, intrinsic value.

VIGELAND: What got us to the point where long-term investing is now, you know, three days? I mean, I exaggerate of course, but you have written about this real change where we used to hold onto our portfolios so much longer than we do now. And I think . . . I think I saw that the holding period is now about one year for an average stock.

BOGLE: You’re right. And yet, when I came into this business all those years ago, it was six years. Holding a stock for six years has something to do with the wisdom of long-term investing. And holding a stock for one year is the foley of short-term speculation. And I think what we’ve had, we’ve got hip kinda on the idea that action creates value. But action can’t create value, because your action is offset by somebody else’s action. This giant institutional money-management field in the United States controls 70 percent of all the stock in America. So when Manager A is selling, he’s selling to another member of the system, let’s call him Manager B. And no value is created, net-net. The only thing you can be sure of in that equation, is the croupe – the man in the middle – is making money. So all this trading, by absolute definition, enriches the . . . Wall Street, the financial community, the mutual fund managers . . . and is costly to mutual fund investors. It can’t be any other way.

VIGELAND: You’ve also written about what you call the amazing disappearance of the individual stockholder. And of course, the vast majority of us holds stocks through mutual funds. What’s the downside of that?

BOGLE: Firstly, by mutual funds almost on whim, we look at past performance. We think that managers will be good eternally – not the case. You know, we have portfolio managers who emerge kind of as stars, they can’t come into the office on January 1 saying, “I love my portfolio and I’ll see you December 31.” They’d get fired. They feel like they’ve gotta act all the time, and action is by definition expensive. Buy an index fund and hold it forever, and when you get back to the emotions of the moment, one of my other rules is, “Don’t peek.” Investors who look at their portfolios, trade them all day long in real time are very, very unwise. I happen to look at my portfolio, just for estate planning purposes, once a year. January 1. And that’s it.

VIGELAND: Once a year, really?

BOGLE: The last time I made any investment decision – all my money is in Vanguard, of course, in our stock and bond funds. Both the stock and bond, about 60 percent bonds, 40 percent stocks – I haven’t made a change in the portfolio, I think, in three years.

VIGELAND: Well, so, if we know that we’re supposed to diversify and we’re supposed to hold onto our stocks for a long time, is there any other piece of advice that you can give us that would help us all perhaps retire sooner, or send our kids to college with more back up, or . . . ?

BOGLE: Yeah. Get your asset allocation right. More bonds as you’re older, less bonds when you’re . . . much less bonds when you’re younger and accumulating money. Get cost out of the system. Diversify as broadly as you can.

VIGELAND: And again, the best way to get the cost out of the system is simply to hold on.

BOGLE: Hold on, and in a very diversified index fund, simply an index fund that owns all of American business. Think about owning businesses, and not trading stocks, and that’s a . . . that will save you an awful lot of money in the long run. Even in the short run, for that matter.

VIGELAND: Thank you so much. John Bogle is the author of “The Little Book of Common Sense Investing,” and he’s also the founder of the Vanguard Group. Thanks so much for coming in.

BOGLE: Thank you Tess, very much. A treat to be with you.

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