Common Sense on Mutual Funds

Even the smallest library of every serious index investor should contain Common Sense on Mutual Funds, the latest book by John Bogle of The Vanguard Group.

As the title promises, this 445-page work is full of common sense and practical advice for the individual investor. But it is by no means simplistic. Rigorous logic and compelling data back up every argument. Bogle hones in early and emphatically on active fund managers who are paid large salaries to churn accounts frenetically and underperform indexes year after year.

With his firm challenging Fidelity for the lead in mutual funds, Bogle could afford to be charitable to the many active fund managers he has left in the dust. Instead he takes the opportunity to call for their sacking. In the preface he refers to no less than Thomas Paine and preaches revolution with near patriotic fervor:

Much of the book contains messages Bogle has always preached: long-term investing, diversification, and low turnover. But the avid Bogle reader will find brand new topics and older arguments are recast in compelling ways, and the writing is carefully crafted and filled with insightful charts and data.

How better to demonstrate the importance of long-term investing than to show that over a longer time horizon the variability (i.e. risk) of stock market returns shrinks to negligible amounts. For instance, an investor with a one-year time horizon faces a standard deviation of 18.1%, whereas an investor placing money in a retirement account at age 40 and pulling it out 25 years later for retirement faces a standard deviation of 2% (Figure 1.3). Time removes much and eventually most risk, a common sense and powerful concept that many overlook.

I had to pull out my 1994 version of Bogle on Mutual Funds to see that he had used a similar chart before (Figures 2-3). It made the point adequately but was crude by comparison with Bogle's new book.

In a time when Internet stocks seem to have dishonored the art of bottom-up valuation, Common Sense is refreshing in its emphasis on the close correlation between stock returns and underlying profits of the companies in question. While today's financial press would have investors believe that stock returns are dreamed up by Wall Street analysts, in fact "fundamental returns" made of dividends and retained corporate earnings created by Main Street are a very strong predictor of the direction stocks will take. In his new book Bogle shows that stock returns have never deviated from fundamental returns more than 4% either positively or negatively.

And Common Sense is good sporting fun if only because of its disdain for Wall Street's whipping boys, highly paid active fund managers. Nearly every chapter has a graph or study on the poor performance of this hapless lot, followed by the inevitable well-deserved barb.

Bogle refrains from tooting his own firm's horn excessively. He cannot be blamed for its being so intertwined with indexing. But the reader should understand that Bogle stands to gain from continued growth in indexing, though much less than its many investors.

In some ways Common Sense reads like a concise, less academic version of A Random Walk Down Wall Street, backed by more powerful graphics. And no wonder, since Burton Malkiel, Random's author, helped edit the first draft. The acknowledgements section lists many impressive contributors.

This book is a must-read for any serious investor today, and it should be kept nearby as a useful reference manual.