In the book ‘The Little Book of Common Sense Investing’, John Bogle, Founder and former CEO of Vanguard has shared his decades of experience on how investors can win in the markets. Simply put, he makes a persuasive case for how it is difficult to outperform markets and the best way for most investors to gain from stock markets is through passive funds.
Bogle has backed his recommendation for passive funds with valid facts. For instance, we all know that costs are a major drag for returns. Also, choosing an active equity winning fund based on past performance is not always feasible. While Bogle’s book mainly extols the benefits of investing in index funds it has lot more to offer.
He presents some interesting data on the survivorship of active equity funds in US. For instance, Bogle observes that while the fund industry advises investors to hold for the long term, the funds themselves may not exist for the long term because the worst performing funds are either merged, go out of business or acquired by other fund houses. He presents this data to back his argument – of the around 355 equity funds existed in US in 1970, 223 funds had vanished and only 132 survived till 2005. His analysis shows that only nine were very successful and investors poured money in these funds thinking that these funds will sustain the performance. As the fund size grew, their performance suffered. Bogle discovered that only three out of the 355 equity funds that started in 1970 – only 8/10 of 1% - have both survived and mounted a record of sustained excellence. These were Davis New York Venture, Fidelity Contrafund and Franklin Mutual Share. However, there is no certainty that even these funds would do well, he argues.
One of the fallacies of investors is to choose funds based on past performance or star ratings. Bogle rightly points out that the star ratings are based on a composite of 3, 5, 10-year periods. He says that the previous two years performance alone accounts for 35% percent of the rating of a fund with 10 years of history and 66% for a fund with a track record of up to five years. This shows that there is heavy bias in favor of short term returns. According to him, even the number of stars assigned to a fund are not of much significance.
Bogle also shows how mutual fund investors make a big mistake by investing in funds when markets peak. For instance, US investors invested only $ 18 billion in 1990 when stocks were cheap. In 1999 and 2000, they invested $ 420 billion in equity funds when the stocks were overvalued. What followed in 2001 through 2005 was that these funds tumbled into negative territory. Thus, he shows that investor returns often turn out to be less as compared to fund returns due to market timing.
So how do you choose a fund? His simple advice is to buy index funds or ETFs and stay the course. He also advises investors to stay away from fad NFOs.
If you’re still not convinced by Bogle’s advice, he asks you to put 5% of your investible assets in Funny Money Account (FMA) and 95% in Serious Money Account (SMA). Invest 95% in in an equity index fund and a bond index fund and gamble with the remaining 5%. His advises you to measure the performance of both portfolios (FMA & SMA) and decide where you wish to invest.
The book is divided into 18 chapters covering the benefits of index funds, bond funds & money market funds, ETFs and how active funds operate. Bogle also offers a ring side view of how the invest management industry functions.
While Bogle’s arguments hold true for the US market, the situation is entirely different in Indian markets, where most active funds outperform passive funds by a healthy margin. Nevertheless, the book offers great insights into the working of mutual fund industry and the common fallacies of investors.