Review: Common Sense on Mutual Funds

Each Friday, The Simple Dollar reviews a personal finance book.

BogleOver the last couple of years, I’ve become quite familiar with John Bogle’s investing philosophy of low-cost broad-based index fund investing. Because this philosophy made so much sense to me, especially after reading Bogle’s short book The Little Book of Common Sense Investing, that I actually took the leap and made my first investments with Vanguard, Bogle’s investing house based on his philosophy – and I couldn’t be happier.

Unsurprisingly, several people recommended Bogle’s first book, Common Sense on Mutual Funds, to me. It’s a much weightier book than The Little Book of Common Sense Investing, but I desired reading it so that I could understand the philosophy in more depth. Let’s dig in and see what I learned.

Digging Through Common Sense on Mutual Funds

Part I – On Investment Strategy

1. On Long-Term Investing The book opens by discussing the fact that in any given year, the stock market might be way up or way down (or somewhere in the middle). The volatility is far, far worse than that when looking at individual stocks – look at Enron and Google, for example. The only way to minimize this volatility is to buy everything and stay in for a long period of time so that the peaks and valleys can average out. Over the long-term history of the stock market (since 1800, adjusted for inflation), this comes out to about an 8% return per year, but the return has been much higher than that over the last thirty years or so. Your best bet is to invest now (to maximize your timeframe), invest in a broad investment with low costs (like an index fund), and just sit on it, contributing more over time, until your personal needs encourage you to withdraw it.

2. On the Nature of Returns So what about that volatility? What causes it? Bogle spends this chapter arguing that it’s speculation, and that over a long period of time, some of the time people will speculate in stocks and other times people will speculate in something else. When the speculators are putting their money in, the stock market will go up faster than expected. When the speculators are pulling their cash out, the stock market will go down far below what is expected. In fact, over the long term, the stock market grows almost perfectly in accordance with company earnings – the only time that’s not true is when speculators interfere with it.

3. On Asset Allocation Bogle makes an interesting argument here, stating basically that minimizing costs is more important than worrying about your asset allocation. Figuring out that perfect balance of domestic and international stocks, small-cap and large-cap stocks, bonds, real estate, and whatever else you might want to invest in is worthwhile, but it’s far more important to make sure that your costs are low, because even 2% costs (pretty typical for a managed and advertised fund) can pretty much undo any benefit you get from perfect asset allocation. As for the actual allocation, Bogle is a big advocate of simplicity – broad based index funds, somewhere between 50% and 70% in stocks, and the rest in bonds.

4. On Simplicity Here, Bogle argues that many people vastly overthink their investment choices. In fact, he argues that just investing in one very broad-based index fund and just dumping your money into it does better than a person who micromanages their portfolio. If you feel you must do something more complex than just a small number of index funds, Bogle offers quite a bit of advice, but most of it boils down to just emulating simplicity through complexity – so why not just keep it simple?

Part II – On Investment Choices

5. On Indexing Bogle lays out very carefully here how an index fund works: basically, an index fund is a mutual fund that just follows a very simple rule or two and buys everything that matches that rule. That way, there’s very little cost to manage it. For example, the Vanguard 500 has a very simple rule: “match the S&P 500.” That’s it – Vanguard pays very little to manage that fund because it just matches the S&P 500. I explained this strategy with much more clarity for beginners a while back – Bogle just covers the same material here.

6. On Equity Styles Does indexing work if you want to focus on a specific sector of stocks, like large-cap value stocks, for example? Bogle argues quite persuasively here that it does. An investing house could easily create an index based on a statement like “all stocks in the Wilshire 5000 with a P/E ratio under 10 and a company valuation of more than a billion,” for example, which would produce an index of large-cap growth stocks. Bogle then looks at such funds that do exist in various forms and compares indexed funds to managed funds in each grouping – and in almost every grouping, the indexed funds win.

7. On Bonds Bonds are perfect for indexing strategies because it’s very easy to identify and buy specific classes of bonds. Thus, no one should ever have to pay significant management fees for a bond fund. Bogle states that one should have a fraction of their portfolio devoted to bonds, either directly in bonds (via something like Treasury Direct) or via a bond index fund.

8. On Global Investing The risk-reward factor for international stocks is much different than that for domestic stocks. Generally, they tend to offer much greater risk in exchange for somewhat greater reward. For some investors, this might be a worthwhile tradeoff, but Bogle argues that investing in international stocks is not a necessary move for most individual investors.

9. On Selecting Superior Funds Lots of people out there desperately want to “beat the market” via a normal mutual fund, and it just doesn’t happen consistently. Other than Peter Lynch’s run with the Fidelity Magellan fund in the 1980s, no fund has consistently beaten the stock market over a multi-year period. The idea that one will find a “superior fund” is a mirage – it just doesn’t happen. Instead, you should seek a fund that consistently matches the market with low costs.

Part III – On Investment Performance

10. On Revision to the Mean “Revision to the mean” is a statistical phenomenon that happens over and over again in all sorts of fields. Basically, it means that you might be able to select a small set of stocks that does better than the market over some period of time, but over a long period any set of stocks will eventually move towards the market average. This means you might be able to find a fund that beats the market for a year or two, but over the long haul, it will eventually match the market. When you add in the costs to this picture, it becomes clear what the benefit of a low-cost fund is.

11. On Investment Relativism If you want to compare two funds, you should compare them using as many different periods as possible: one year, three years, five years, and ten years. If you can’t find that information about a fund, something is suspicious and it should be avoided. Advertisements for funds, of course, will cherry-pick from among those numbers to talk highly about a fund, but just selecting one or two of those numbers gives a very unclear picture.

12. On Asset Size An actively managed fund that sees some success will eventually see a lot of investors wanting to get in – and thus a lot of assets to manage. The more assets an active fund manager has to use, the harder it is to find the great bargains out there. Eventually, that manager will have so much cash that he or she will be forced to compromise their investment philosophy – and revision to the mean begins.

13. On Taxes Another concern with actively-managed fund is taxes. If the fund manager does a significant amount of buying and selling within a fund, the fund may end up requiring you to pay taxes on it at the end of the year, whether you actually sold any of your fund holdings or not. Indexing largely avoids this, because within the index a firm “buy and hold” mentality exists – rarely are items sold within a fund.

14. On Time In the end, though, time is the most important factor of all, and that’s where costs will eat you alive. Let’s say you can choose between funds that have a 2% cost and another that has a 0.2% cost. Over a long period of time, you might jump around between the 2% funds or you might buy and hold the 0.2% fund. Over that same period, both investments will eventually revert to the mean – in other words, both investments will match the market. The only difference is that the index fund will match the market with only a 0.2% reduction in your investment, while the others will match the market while peeling 2% off the top. Let’s say the market raises at 10% over 30 years. The 0.2% fund actually returns you 9.8%, while the 2% one returns you only 8%. If you put in $1,000 and wait 30 years, the 2% cost fund will be worth $10,062.66, while the 0.2% fund will be worth $16,522.29, a difference of $6,459.63. That’s a pretty important difference and an excellent argument for finding minimal costs.

Part IV – On Fund Management

15. On Principles Bogle argues that the entire concept of a mutual fund should be based on the principles of trusteeship, professional competence and discipline, and focus on the long term (remember, this is how Bogle sees the industry). He believes that if a fund manager ever abandons his or her basic principles, they let down all of their clients, something I do agree with even if I don’t believe that the principles he states are absolutes – mostly because I see a role for short-term funds.

16. On Marketing Bogle is really harsh here on funds that are heavily advertised, arguing that this advertising not only creates a false picture of the actual status of the fund, but also takes money out of the pocket of the investor. In other words, he basically advises people to avoid heavily advertised funds, because he believes a great fund should be able to stand on its own two legs.

17. On Technology The internet provides some amazing benefits to mutual fund investors. The amount of information available at one’s fingertips is amazing. It’s also incredibly easy to start investing, with online accounts incredibly easy to sign up for and manage. Yet there is a dark side, and that is the ease with which one can change investment direction with just a click or two of the mouse. Because of that, people tend to invest for the very short term, which can be disastrous.

18. On Directors Bogle argues that most directors of mutual fund companies are draining a company dry. These individuals collect fat paychecks without doing much at all because the real work of the company is handled by the fund managers and the personnel that support and directly manage those fund managers. Bogle argues that a company should spend far less on directors and return far more to their investors.

19. On Structure So how should a mutual fund company be organized? Bogle says that a mutual fund house should have as few middlemen as possible between the stocks owned in the fund and the individual fund investor, and most of those middlemen are focused entirely on service. Bogle believes that most funds are best served by just having the fund managers managing the money and service workers providing services to the investor and that’s it. No big management structure, no marketing department, and so on.

Part V – On Spirit

20. On Entrepreneurship This final section focuses on a few interesting issues not directly related to mutual fund investing. Here, Bogle tells his story of entrepreneurship, relating how and why he started Vanguard. It’s an interesting and inspirational short tale here, one that would perhaps be interesting fleshed out as an entirely separate book as it seemed to end just as I was getting interested – I definitely wanted more detail.

21. On Leadership Here, Bogle talks about leadership, compressing most of the material from books on leadership down to just a handful of pages. I generally avoid such books, as I’ve often found that a good leader comes from within, not from the pages of a book, but this was interesting reading. Bogle seems to generally feel that a good leader leads by example and by principle.

22. On Human Beings This final chapter is basically a “thank you” to all of the people at Vanguard, both the staff and the investors. Bogle seems to really get that any success he has is largely due to these people, which is really refreshing to see.

Buy or Don’t Buy?

Common Sense on Mutual Funds seemed to me to be a much meatier version of The Little Book of Common Sense Investing – or, since Common Sense came first, the other book is a bare-bones version of this one.

If you really want to understand Bogle’s (and by association, Vanguard’s) investment philosophy in great detail, Common Sense on Mutual Funds is well worth reading. It makes a strong, detailed, compelling case for investing in low-cost broad-based index funds, written by the man who really brought this investment strategy into the mainstream. In fact, I’d go so far as to say that if you’re interested in investing as an individual investor, this one’s worth reading.

On the other hand, if 400+ pages on these topics sounds like pulling nails, then Common Sense on Mutual Funds is probably not for you. It’s fairly long, somewhat dry in places (but quite entertaining in others), and doesn’t apply much at all to people who aren’t looking at investment options. If you’re mostly worrying about getting rid of debt or don’t have the cash to spare to invest, you’re quite fine leaving this book (and other investment books) on the shelf.

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  1. Tom says:

    Hello. I’ve been reading your blog for a few weeks and thoroughly enjoying it–really good stuff. I’m glad to see you’ve reviewed and enjoyed “Commonsense on Mutual Funds”. I’ve got it on the bookshelf beside me here at work and I *love* this book. Everyone should read it. Very thorough and makes a great case for the indexing way of investing. Keep up the great work and thanks for all of the great articles!

  2. Philip says:

    Post messed up I guess:

    P/E less than 10 is a value stock, not growth if I’m not mistaken.

    This was a great review about a great man and a great book. I too invest with Vanguard.

    I would guess this book is older so it doesn’t mention the Target Retirement Funds. These are perfect for 90% of the population and would make a great blog entry.

  3. Thanks for the very thorough review Trent. Congratulations on summarizing 400+ pages of reading! Thanks.

    Peter

  4. Peggy says:

    Nitpicking — it’s REVERSION to the mean, not REVISION to the mean.

    The hubby and I are about to sit down for our annual financial review and strategy session, and I’ll be sure to suggest this as one of the books we read as we refine our plans and such. Thanks!

  5. Fuji says:

    Trent, is all your money with Vanguard? I recently read advice not to invest all your money with one firm – all your eggs in one basket so to speak. What is your opinion on that?
    Thanks. :)

  6. Michael says:

    I’ve been reading-up on expense ratios recently, and it appears that you cannot simply subtract the expense ratio from the annual return as shown under Chapter 14 above. Basically, the formula used above is

    end value = initial*(1+ROR-er)^years

    but I believe that it should be

    end value = initial*((1+ROR)*(1-er))^years

    where er is the expense ratio.

    On the page http://www.oreilly.com/pub/h/1889 , Example 3 and the accompanying text explain (briefly) why to use the second formula (which is also what the SEC’s expense calculator seems to use). The difference between the two calculations can be significant, particularly for higher expense ratios.

    I’m curious if the book says (or folks have seen) differently.

  7. Red says:

    Very interesting looking book, I’ll have to add this to my library queue.

  8. Michael says:

    @Fuji

    Here is a list of “baskets” for your “eggs.” Each fund met these requirements:
    1. Minimum initial investment under $5,000.
    2. Open to new retail investors.
    3. “Audited net expense ratio” under .40%

    Note: the UA fund charges $10/year and 0.05% redemption fees for accounts under $10,000. I have not investigated the other funds.

    DWS Eq 500 Index S $2500 0.30%
    Legg Mason P S&P 500 D $0 0.39%
    RiverSource 500 Index E $2000 0.38%
    Schwab S&P 500 In Inv $100 0.36%
    T. Rowe Price Eq Idx 500 $2500 0.35%
    United Assoc S&P500 II $1000 0.16%
    Vanguard 500 Index $3000 0.18%

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