- Before costs, investors as a group earn the market return; trading among them moves money around but adds nothing.
- After costs, the group must earn less, by exactly what it pays to brokers, managers, advisers and the tax collector.
- Costs come every year and compound, like interest in reverse.
- Judge a cost by what it takes over the whole time you hold something.
- market return
- the return of the whole market
- zero-sum
- one side's gain is another side's loss
- index fund
- a fund that simply holds all the shares in a market (or an index), in proportion, and keeps them
- expense ratio
- a fund's yearly running costs, as a % of what you hold
- commission
- a fee paid to a broker for each trade
- Helpers
- Bogle's name for brokers, managers and advisers paid by investors
Watch out: Thinking that because some investors beat others, investors as a group can beat the market. Every gain from a trade is another investor's loss. Only the Helpers are sure to come out ahead.
- Market return ≈ dividend yield + earnings growth + speculative return.
- Speculative return per year = (P/E end ÷ P/E start)^(1/years) − 1.
- Long run: the businesses dominate. Short run: P/E swings dominate.
- Returns boosted by a rising P/E are a weak guide to the future.
- dividend yield
- yearly dividends as a % of the share price
- earnings growth
- how fast company profits grow each year
- P/E ratio
- share price ÷ earnings per share: what investors pay for each 1 of earnings
- investment return
- dividend yield + earnings growth
- speculative return
- the yearly effect of a change in the P/E ratio
- reversion to the mean
- the tendency of unusual results to move back toward the long-run average
Watch out: Treating a rising P/E as a lasting source of return. A P/E can't rise forever: if it went from 15 to 30 in one decade, that decade gained about 7% a year from mood alone, and a later fall back to 15 would take it away again. Bogle, like many others, calls this tendency to swing back reversion to the mean.
- An index fund holds all the shares of an index, in proportion, and keeps them.
- Cap-weighted: weight = company value ÷ total value.
- Price changes don't force trades; the fund stays in step automatically.
- Bogle: the simplest way to own all of business (Occam's razor).
- index
- a list of shares with a rule for weighting them
- index fund
- a fund that holds the shares of an index in the same proportions
- market capitalisation
- share price × number of shares: a company's total market value
- cap-weighted
- each company counts in proportion to its market value
- S&P 500
- an index of about 500 large U.S. companies
- Occam's razor
- when several solutions work, choose the simplest
Watch out: Thinking an index fund must constantly rebalance as prices move. A cap-weighted fund rebalances itself; it trades mainly when companies join or leave the index, or when money comes in or goes out.
- Funds report time-weighted returns; investors earn dollar-weighted returns.
- Money arriving after good years and leaving after bad ones makes investor returns lag.
- Bogle's 1980–2005 estimate: about 2.7 points a year.
- Recent estimates are smaller (Morningstar: about 1.2), and some researchers argue the true timing cost is much smaller still.
- time-weighted return
- the fund's return per share, as if no money came in or went out
- dollar-weighted return
- the return on the money investors actually had in, given when they added and withdrew it
- investor return
- another name for the dollar-weighted return of a fund's investors as a group
- performance chasing
- buying what has recently done well
Watch out: Assuming you earned the return in a fund's advert or fact sheet. That figure is for money that stayed put the whole time. If you added or withdrew money along the way, your own return can be quite different. Some brokers and fund companies show a personal (dollar-weighted) return on statements.
- Selling at a profit realises gains, which may be taxed that year.
- High turnover → more realised gains → bigger yearly tax bills.
- Paying tax later lets the money keep compounding.
- Rules depend on the country and account: this lesson teaches the idea, not any country's law.
- capital gain
- the profit when something is sold for more than it cost
- realised gain
- a gain that has been locked in by selling (often taxable)
- turnover
- how much of a fund's portfolio is traded in a year
- tax-efficient
- arranged so that as little tax as possible is due before you sell
- taxable account
- an account where gains and income are taxed as they arise
Watch out: Comparing funds only on their pre-tax returns when the money is in a taxable account. A fund that trades heavily can hand you a tax bill each year that its advertised return doesn't show. (Bogle also notes a twist: an index fund pays out more of its dividends, because its low costs eat less of them, so it can look less tax-efficient on dividends while being more tax-efficient overall.)
- Rough expected return ≈ dividend yield + earnings growth + P/E change per year.
- Bogle's 2007 estimate: about 7%. The actual 2007–2016 return: about 6.9%, through a severe crash.
- The same costs take a larger share of a lower return.
- A forecast states assumptions; it is not a promise.
- expected return
- a reasoned estimate of a future average return, never a promise
- assumption
- an input you choose, such as the future P/E
- sensitivity
- how much the answer changes when an assumption changes
- sequence
- the order of good and bad years along the way
Watch out: Treating the past few decades' return as the expected future return. If part of a past return came from a rising P/E, it can't simply be repeated: the P/E would have to keep rising forever.
- Records that leave out closed funds look better than reality (survivorship bias).
- Unusual results tend to fade (reversion to the mean).
- A big gain followed by a big loss can leave almost nothing: 1.55 × 0.66 ≈ 1.02.
- Current SPIVA data: most active funds trail their index over long periods, and top performers rarely stay on top.
- survivorship bias
- the distortion when failed funds drop out of the record
- reversion to the mean
- the tendency of unusual results to move back toward the average
- persistence
- whether a fund's good performance continues
- star rating
- a score based on a fund's past risk-adjusted returns
Watch out: Choosing a fund because it has the best record of the last few years. Bogle reports that a portfolio switching into Morningstar's 5-star funds earned 6.9% a year over 1994–2004, against 11.0% for the total stock market (a study by Mark Hulbert). Ratings describe what has happened; Bogle reports they were poor predictors over 1994–2004.
- Advisers can help with planning, taxes and behaviour; neither Bogle nor Graham expects them to beat the market reliably.
- Commission and fee-only pay create different conflicts; both are costs.
- A 1% yearly fee can take around 30% of 30 years' gains.
- Help is most worth having after big losses, budget trouble, chaotic portfolios or big life changes. Trust, then verify.
- commission
- pay an adviser receives from a product provider for a sale
- fee-only adviser
- an adviser paid only by the client, not by product providers
- conflict of interest
- when an adviser's pay depends on what they recommend
- advice fee
- a yearly charge, often a % of the money advised on
- investment counsel
- a professional adviser paid a fee to manage or advise on investments
- due diligence
- checking someone's background before trusting them
Watch out: Treating a recommendation as free. If an adviser is paid by commission, the product price includes their pay; if fee-only, it's on your statement. Either way, ask how much it is in money per year, and what you get for it.
- Costs = expense ratio + trading costs, plus any sales charges.
- Bogle's rule of thumb: trading costs ≈ 1% of the turnover rate.
- Before costs, funds earn similar returns; after costs, cheap funds tend to come out ahead.
- Costs are the one thing you can know in advance.
- expense ratio
- yearly running costs as a % of your money
- sales charge (load)
- a one-off charge on buying or selling
- trading costs
- costs of the fund's own buying and selling, not in the expense ratio
- turnover
- how much of the portfolio is traded in a year
- all-in cost
- Bogle's term: expense ratio + trading costs (sales charges come on top)
Watch out: Looking only at the expense ratio. A fund with a low expense ratio but very high turnover, or a big sales charge, may not be cheap at all. Add up all three.
- Bond and money-market returns come mainly from interest, set by the market.
- Similar funds earn similar returns before costs; costs decide most of the difference after.
- A fee takes a bigger share of a small yield: 1% of a 4% yield is a quarter of it.
- Higher yield usually means more risk: longer maturities or weaker borrowers.
- bond
- a loan that pays interest and is repaid at maturity
- maturity
- the date a bond is repaid
- yield
- the yearly income from a bond or fund, as a % of its price
- credit quality
- how likely the borrower is to pay; lower quality pays more but risks default
- money-market fund
- a fund of very short-term, high-quality loans
Watch out: Choosing a bond fund for its higher yield without asking why it's higher. A higher yield often means longer bonds or weaker borrowers: more risk, not a better manager. Bogle also warns against sales charges on bond funds: a 5% charge can wipe out a whole year's interest.
- New "smart" indexes depart from the market portfolio, so Bogle treats them as active strategies.
- Back-tests are chosen with hindsight and can mislead.
- ETFs are a vehicle: broad and held can match a classic index fund; narrow and traded can't.
- Researchers still debate whether factor tilts will keep paying.
- ETF
- exchange-traded fund: a fund whose shares trade on an exchange during the day
- fundamental index
- an index weighted by measures like sales or dividends, not market value
- factor ("smart beta")
- a trait such as value, size or momentum that a strategy tilts toward
- back-test
- applying a rule to past data to see how it would have done
- data mining
- searching past data until something looks good, which may not last
Watch out: Assuming "index" means "low cost and the whole market". An index can be narrow, frequently changed, or built to follow an active strategy. Check what it holds, how often it trades, and what it costs.
- Graham: most investors should be defensive, simple and diversified.
- Bogle's arithmetic: returns come from businesses; costs and behaviour decide what investors keep.
- His plan: broad low-cost index funds, stay the course, at most a small "funny money" account.
- The arithmetic applies to everyone; the plan is one investor's reasoned choice.
- defensive investor
- Graham's term for someone who invests simply and avoids speculation
- the relentless rules of humble arithmetic
- Bogle's phrase for: returns minus costs equals what investors keep
- serious money / funny money
- Bogle's split between long-term savings and a small amount for speculation
- stay the course
- keep to a sensible plan through good and bad markets
- asset allocation
- how money is divided between stocks, bonds and cash
Watch out: Treating any one investor's rule of thumb as a rule for you. "Bonds equal to your age" or "5% for fun" are Bogle's personal guides, offered with his own caveats. The arithmetic is general; the plan is personal.