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DIY Investing Resource #2: The Little Book of Common Sense Investing

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The following post was originally published on Eat the Financial Elephant in February 2015, shortly after my wife and I dug out from under our past investing mistakes. I posted it as the second of the four most valuable resources that helped us go from feeling clueless to competent managing our investment portfolio.

If you want to understand stock market investing, especially investing using mutual funds, then John Bogle’s “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns is a must read.

This short, concise book has high information density with valuable insights, explanations, and examples on every one of its 216 pages. The book can be summarized in one of Bogle’s quotes: “The two greatest enemies of the equity fund investor are expenses and emotions.” These points are hammered home again and again throughout the book which outlines the basis behind index fund investing.

Predictable Conclusions

I will acknowledge that the message of this book, touting the virtues of index investing, is of little surprise. The author, John Bogle, founded the Vanguard Mutual Fund Group as well as the first index fund available to retail investors.  

That said, after ten years of investing in actively managed mutual funds sold to us by our investment advisor and pushed through our work retirement plans, we have made most of the mistakes and have fallen prey to almost every single sales tactic and half-truth pushed by the financial industry as presented by Mr. Bogle.

The Parable of Investment Returns

The book starts with a parable about the hypothetical “Gotrocks Family” that owns all of the shares of every stock available in the U.S, representing all investors. This parable demonstrates that all investors get the sum of the earnings of business (all of the dividends + all of the growth in the value of the businesses).  

However, when a few in the family decide they want to get a bigger share, they begin to hire “helpers” (money managers, stock pickers, investment advisors, etc). In the end, the helpers can add nothing of value to the family because the total returns are still the sum of business earnings.  

However the “helpers” do introduce new costs. In the end, a few in the family “win.” Others “lose” by an equal amount because the helpers bring no net value to the equation. 

The family as a whole loses. The costs paid to the “helpers” means they deduct value from the full return the family previously received. The moral of the story: The return for investors = Market Return – Costs.  

Therefore, “if investors pay nothing, they keep everything.” Conversely, the more they pay for this “help”, the less they keep. It is a simple but indisputable idea that forms the basis of index investing.

Four Layers Of Costs

In chapter 11 Mr. Bogle makes the case that the easiest way to choose a winning mutual fund is to focus on low cost, highly diversified index funds that buy and hold their assets forever. In this way you avoid or minimize all four layers of costs outlined in the book: annual expense ratios, sales loads, internal fund expenses incurred through frequent trading, and taxes on capital gains.

Expense ratios are clearly disclosed by funds as a percentage of assets, but few investors understand the impact of these seemingly small numbers. The Vanguard index funds we own have expense ratios averaging .1% compared to an average of about 1.25% for the actively managed funds sold to us when we started out investing with an advisor. This represents 12.5X greater cost EVERY YEAR to hold the active funds.  

The second layer of cost is sales loads. These are commonly 5+% of the amount invested which is paid up front when purchasing mutual funds. This money and all that it would have made over time is gone. Vanguard (and most index) funds have no sales loads.  

The next hidden layer of cost is fund turnover. Bogle estimates that you lose 1%/year in performance for every 100% turnover in assets due to transaction costs. Many actively managed funds turn over their entire portfolio in a year. The average turnover is 60%. Index funds have little to no turnover, eliminating this expense completely.  

The final expense is taxes, averaging 1.8%/year in federal taxes alone for actively managed funds. Index funds incur taxes about 1/3 this size, despite having greater returns. For people investing in actively managed funds in taxable accounts, this creates a huge tax drag. Index funds are taxed more favorably because they avoid capital gains taxes incurred with frequent trading. Instead they buy and hold stocks forever, avoiding this unnecessary taxation. 

Bogle demonstrates that after adding all of these fees together, the average actively managed mutual fund grows to only 1/3 the size of the an index fund over 25 years. You did not misread that statistic. A full 2/3 of your money is gone to fees and taxes after 25 years of investing.

Controlling Behavior

As costly as expenses are, behavioral errors made by chasing past returns are often even more costly to investors. However, most mutual funds market directly to this irrational belief that you can choose a good fund based on past returns.  

Bogle presented fascinating statistics disproving this myth. He showed that of the 335 mutual funds in existence in 1970, only 132 survived the 35 year period through 2005, making the odds of buying and holding a fund forever unlikely, even if you wanted to.  

If you happened to select a fund that survived, 60 of the 132 survivors underperformed the S&P 500 by >1%/year. Another 48 were +/- 1% of the index. This means only 24 of the 335 funds (7%) outpace the market by >1%. Only 9 of 335 (2.5%) outperformed the S&P 500 by >2% annually.  

Choosing actively managed mutual funds over index funds means you pay substantial fees to take on all of the investment risk. In return, you get a 1 in 40 chance of outperforming the market by > 2%.

Wait, It Gets Worse!

Actually, your odds aren’t even that good. Bogle explains that many investors flow into the “winning” funds after they have had their success, so the oversized returns that the funds report are never experienced by most investors holding the funds.  

Bogle also reveals the secret behind how it looks like a much higher percentage of actively managed funds have winning records than actually do. As funds underperform and fall out of favor, they are quietly folded and merged in with successful funds. The returns of the successful funds are what then get reported, even though most investors owning the funds have never received these returns.  

In the first 2 years we managed and closely monitored our own investments, we witnessed this with two funds we bought through our advisor and another fund in my 401(k).  

Unless you closely track each dollar you contribute to a fund and each fund merger carefully, you have no idea what your own personal investment return is. The numbers reported by funds are pure fiction for most investors.

Are You Playing A Winner’s Game?

In this book, John Bogle makes it clear why “investing is simple, but it is not easy.”

He pulls back the curtain on the practices of the financial industry and reveals the many layers of fees that eat away at investor returns.  

He clearly articulates how emotions of greed and fear drive investor behaviors and how Wall Street capitalizes on these emotions.  

This book gives you the tools to invest successfully so you can be guided by the “relentless rules of humble arithmetic” and “don’t allow a winner’s game to become a loser’s game”.

So will you follow Bogle’s warnings? Are you convinced of the idea of index investing? If you don’t fully understand the game you’re playing when investing, you would be wise to read “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns” to learn the rules first.

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Comments

  1. I’m pretty much a Boglehead. But I still have a good chunck of my assets in actively traded funds because of capital gains taxes. Looking at funds I’ve held for a while, gains range from 40% – 190% and as I’m still employed, these gains will be fully taxed at the 15% long-term capital gains rate. Since these funds are roughly 0.5% higher in fees than their comparable EFT counterparts, it will take quite a few years before these fees end up being more than my taxes. So I’m keeping these a bit long but these are some of the first to go once I retire.

    I also have a set of individual stocks. I mostly employ a buy and hold strategy to keep trading costs low and miminize taxable gains. I also found individual stocks allow you to better take advantage of tax loss harvesting without upseting my portfolio balance as much, if needed. My logic is that with this 10% of my portfolio, I’ll accept more risk/beta than the overall market in an effort to try and beat the market. I’ve been doing this lately since the overall market is so high but I think there are a few good companies that have hit temporary hard times. On of my issues is that when these individual companies hit my sell price point, I’m hesitant to sell especially when it’s a short-term holding so I’m falling into one of the many traps of investing in individual stocks.

    • Chris Mamula says:

      Comparing fees vs. taxes is not giving you the full picture. While selling off funds will generate one time cap gains taxes, trading within the actively managed funds which will tend to create unnecessary taxable capital gains every year which a broadly diversified index fund will not. Depending on the amount of turnover of the funds, this may make selling the activley managed funds make more sense. A more accurate comparison would be to compare (annual ER + annual capital gains taxes) times the number of years you would hold the funds. Unfortunately, you don’t know what cap gains taxes will be going forward, you can only get a guestimate by looking back. You also don’t know with certainty what your tax situation will be going forward. Ultimately, you have to give it your best estimate and then not look back. Hopefully that helps and doesn’t further complicate your decision.

      Best,
      Chris

  2. Help me understand how the third layer of cost (transaction costs due to turnover) is not already included in the expense ratio.

    • Chris Mamula says:

      Eric,

      In the post I linked to Investopedia for the definition of expense ratio. Here is the direct quote from their site of what is not included in the ER of a fund.

      “A fund’s trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, are paid directly by fund investors.”

      Every time a fund makes a trade, it generates fees which the fund has to overcome to match or beat an index. You don’t see these fees directly, but they will tend to show up in lower returns (unless you are lucky to pick a “winner”).

      Also, if you hold the fund in a taxable account, this generates capital gains taxes which are passed on to you. These may be long term or short term (which are taxed at your marginal rate). You won’t see this anywhere on your brokerage statements, but you certainly will on your tax bill. When investing in actively managed funds, this generated thousands of dollars annually in unnecessary taxes for my wife and I. Since switching to index funds, we’ve paid exactly $0 in capital gains taxes in 5 years (though you will still pay tax on dividends which is unavoidable).

      Hope that makes sense and clarifies things a bit.

      Chris

      • I had never considered this. I looked at several prospectus samples to understand better. The amounts of trading/transaction costs do not appear to be disclosed explicitly. I suppose these costs simply result in the erosion of the NAV of the fund over time in a manner that is difficult to calculate, but correlated with turnover. I have long since bought into the idea of using low-turnover funds to reduce tax drag, but I have incorrectly thought the trading/transaction costs were captured explicitly somehow. Thanks for the clarification.

  3. Crash Davis says:

    “I mostly employ a buy and hold strategy to keep trading costs low and miminize taxable gains. I also found individual stocks allow you to better take advantage of tax loss harvesting without upseting my portfolio balance as much, if needed.”

    How are you a buy and hold investor if you are buying and selling stocks at a loss to tax harvest? You need to focus on the “hold” a little more seriously. Or better yet, just buy VTI, the best index ETF in existence, and hold forever. Trust me on this one.

  4. Hi Eric,
    Does it ever make sense to tax loss harvest for a short term capital gain?