LittleBookBigProfitsSeries

IntheLittleBookBigProfitsseries,thebrightesticonsinthefinancialworldwriteontopicsthatrangefromtried-and-trueinvestmentstrategiestotomorrow’snewtrends.Eachbookoffersauniqueperspectiveoninvesting,allowingthereadertopickandchoosefromtheverybestininvestmentadvicetoday.

BooksintheLittleBookBigProfitsseriesinclude:

TheLittleBookThatStillBeatstheMarket byJoelGreenblatt

TheLittleBookofValueInvesting byChristopherBrowne

TheLittleBookofCommonSenseInvesting byJohnC.Bogle

TheLittleBookThatMakesYouRich byLouisNavellier

TheLittleBookThatBuildsWealth byPatDorsey

TheLittleBookThatSavesYourAssets byDavidM.Darst

TheLittleBookofBullMoves byPeterD.Schiff

TheLittleBookofMainStreetMoney byJonathanClements

TheLittleBookofSafeMoney byJasonZweig

TheLittleBookofBehavioralInvesting byJamesMontier

TheLittleBookofBigDividends byCharlesB.Carlson

TheLittleBookofBulletproofInvesting byBenSteinandPhilDeMuth

TheLittleBookofCommodityInvesting byJohnR.Stephenson

TheLittleBookofEconomics byGregIp

TheLittleBookofSidewaysMarkets byVitaliyN.Katsenelson

TheLittleBookofCurrencyTrading byKathyLien

TheLittleBookofMarketMyths byKenFisherandLaraW.Hoffmans

TheLittleBookofVentureCapitalInvesting byLouGerken

TheLittleBookofStockMarketCycles byJeffreyA.HirschandDouglasA.Kass

TheLittleBookofStockMarketProfits byMitchZacks

TheLittleBookofBigProfitsfromSmallStocks byHilaryKramer

TheLittleBookofTrading byMichaelW.Covel

TheLittleBookofAlternativeInvestments byBenSteinandPhilDeMuth

TheLittleBookofValuation byAswathDamodaran

TheLittleBookofBull’sEyeInvesting byJohnMauldin

TheLittleBookofEmergingMarkets byMarkMobius

TheLittleBookofHedgeFunds byAnthonyScaramucci

TheLittleBookoftheShrinkingDollar byAddisonWiggin

BooksbyJohnC.Bogle1994 BogleonMutualFunds:NewPerspectivesfortheIntelligentInvestor

—ForewordbyPaulA.Samuelson1999 CommonSenseonMutualFunds:NewImperativesfortheIntelligent

Investor—ForewordbyPeterL.Bernstein

2001 JohnBogleonInvesting:TheFirst50Years—ForewordbyPaulA.Volcker,IntroductionbyChancellorWilliamT.Allen

2002 CharacterCounts:TheCreationandBuildingoftheVanguardGroup2005 TheBattlefortheSoulofCapitalism

—ForewordbyPeterG.Peterson2007 TheLittleBookofCommonSenseInvesting:TheOnlyWayto

GuaranteeYourFairShareofStockMarketReturns2008 Enough.TrueMeasuresofMoney,Business,andLife

—ForewordbyWilliamJeffersonClinton,ProloguebyTomPeters2010 CommonSenseonMutualFunds:FullyUpdated10thAnniversary

Edition—ForewordbyDavidF.Swensen

2011 Don’tCountonIt!ReflectionsonInvestmentIllusions,Capitalism,“Mutual”Funds,Indexing,Entrepreneurship,Idealism,andHeroes—ForewordbyAlanS.Blinder

2012 TheClashoftheCultures:Investmentvs.Speculation—ForewordbyArthurLevitt

2017 TheLittleBookofCommonSenseInvesting:10thAnniversaryEdition|Updated&Revised

THELITTLEBOOKOFCOMMONSENSEINVESTING

TheOnlyWaytoGuaranteeYourFairShareofStockMarketReturns

10thAnniversaryEdition|Updated&Revised

JOHNC.BOGLE

Coverdesign:Wiley

Copyright©2017byJohnC.Bogle.Allrightsreserved.

PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.

Firsteditionpublished2007byJohnWiley&Sons,Inc.

PublishedsimultaneouslyinCanada.

Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyrightAct,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,(978)750-8400,fax(978)646-8600,orontheWebatwww.copyright.com.RequeststothePublisherforpermissionshouldbeaddressedtothePermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201)748-6008,oronlineatwww.wiley.com/go/permissions.

LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttotheaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimpliedwarrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreatedorextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescontainedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitoranyothercommercialdamages,includingbutnotlimitedtospecial,incidental,consequential,orotherdamages.

Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidetheUnitedStatesat(317)572-3993,orfax(317)572-4002.

Wileypublishesinavarietyofprintandelectronicformatsandbyprint-on-demand.Somematerialincludedwithstandardprintversionsofthisbookmaynotbeincludedine-booksorinprint-on-demand.IfthisbookreferstomediasuchasaCDorDVDthatisnotincludedintheversionyoupurchased,youmaydownloadthismaterialathttp://booksupport.wiley.com.FormoreinformationaboutWileyproducts,visitwww.wiley.com.

ISBN978-1-119-40450-7(Hardcover)

ISBN978-1-119-40452-1(ePDF)

ISBN978-1-119-40451-4(ePub)

http://www.copyright.comhttp://www.wiley.com/go/permissionshttp://booksupport.wiley.comhttp://www.wiley.com

TothememoryofthelatePaulA.Samuelson,professorofeconomicsatMassachusettsInstituteofTechnology,NobelLaureate,investmentsage.

In1948whenIwasastudentatPrincetonUniversity,hisclassictextbookintroducedmetoeconomics.In1974,hiswritingsreignitedmyinterestinmarketindexingasaninvestmentstrategy.In1976,hisNewsweekcolumnapplaudedmycreationoftheworld’sfirstindexmutualfund.In1993,hewrotetheforewordtomyfirstbook,andin1999heprovidedapowerful

endorsementformysecond.Whilehedepartedthislifein2009,heremainsmymentor,myinspiration,myshininglight.

ContentsIntroductiontothe10thAnniversaryEdition

NotesChapterOneAParable

NoteChapterTwoRationalExuberance

NotesChapterThreeCastYourLotwithBusiness

NotesChapterFourHowMostInvestorsTurnaWinner’sGameintoaLoser’sGame

NoteChapterFiveFocusontheLowest-CostFunds

NoteChapterSixDividendsAretheInvestor’s(Best?)FriendChapterSevenTheGrandIllusion

NotesChapterEightTaxesAreCosts,Too

NotesChapterNineWhentheGoodTimesNoLongerRollChapterTenSelectingLong-TermWinners

NoteChapterEleven“ReversiontotheMean”

NoteChapterTwelveSeekingAdvicetoSelectFunds?ChapterThirteenProfitfromtheMajestyofSimplicityandParsimony

NoteChapterFourteenBondFundsChapterFifteenTheExchange-TradedFund(ETF)

NotesChapterSixteenIndexFundsThatPromisetoBeattheMarket

Note

ChapterSeventeenWhatWouldBenjaminGrahamHaveThoughtaboutIndexing?

NoteChapterEighteenAssetAllocationI:StocksandBonds

NotesChapterNineteenAssetAllocationII

NoteChapterTwentyInvestmentAdviceThatMeetstheTestofTimeAcknowledgmentsEULA

ListofIllustrationsChapter2

EXHIBIT2.1InvestmentReturnversusMarketReturn.Growthof$1,1900–2016

EXHIBIT2.2TotalStockReturnsbytheDecade,1900–2016(PercentAnnually)

Chapter3

EXHIBIT3.1S&P500versusTotalStockMarketIndex:PortfolioComparison,December2016

EXHIBIT3.2S&P500andTotalStockMarketIndex,1926–2016

EXHIBIT3.3PercentagesofActivelyManagedMutualFundsOutperformedbyComparableS&PIndexes,2001–2016

Chapter4

EXHIBIT4.1TheMagicofCompoundingReturns,theTyrannyofCompoundingCosts:Growthof$10,000over50Years

EXHIBIT4.2TheTyrannyofCompounding:Long-TermImpactofLaggingtheMarketby2Percent

Chapter5

EXHIBIT5.1EquityMutualFunds:ReturnsversusCosts,1991–2016

Chapter6

EXHIBIT6.1S&PPriceReturnversusTotalReturn

EXHIBIT6.2S&P500—DividendsperShare

EXHIBIT6.3DividendYieldsandFundExpenses,2016

Chapter7

EXHIBIT7.1S&PIndexFundversusAverageLarge-CapFund:ProfitonInitialInvestmentof$10,000,1991–2016

EXHIBIT7.2TheTimingandSelectionPenalties:NetFlowintoU.S.EquityFunds

Chapter9

EXHIBIT9.1CumulativeInvestmentReturnandSpeculativeReturn,1900–2016

EXHIBIT9.2TotalReturnonStocks,PastandFuture

EXHIBIT9.3InitialBondYieldsandSubsequentReturns

EXHIBIT9.4TotalReturnonBonds,PastandFuture

EXHIBIT9.5TotalReturnon60/40Stock/BondBalancedPortfolio,PastandFuture

Chapter10

EXHIBIT10.1Winners,Losers,andFailures:Long-TermReturnsofMutualFunds,1970–2016

EXHIBIT10.2FidelityMagellan:Long-TermRecordversusS&P500,1970–2016

EXHIBIT10.3FidelityContrafund:Long-TermRecordversusS&P500,1970–2016

Chapter11

EXHIBIT11.1ReversiontotheMean,FirstFiveYears2006–2011versusSubsequentFiveYears2011–2016

EXHIBIT11.2ReversiontotheMean,FirstFiveYears2001–2006versusSubsequentFiveYears2006–2011

Chapter13

EXHIBIT13.1OddsofanActivelyManagedPortfolioOutperformingPassiveIndexFund

EXHIBIT13.2CostsofSelectedS&P500IndexFunds

Chapter14

EXHIBIT14.1PercentageofActivelyManagedBondFundsOutperformedbyS&PIndexes,2001–2016

Chapter15

EXHIBIT15.1TraditionalIndexFundsversusExchange-TradedIndexFunds

EXHIBIT15.2CompositionofTIFAssetsandETFAssets,December2016

Chapter16

EXHIBIT16.1“SmartBeta”Returns:10-YearPeriodEndedDecember31,2016

Chapter18

EXHIBIT18.1ByReducingCosts,YouCanEarnHigherReturnwithLowerRisk

Chapter19

EXHIBIT19.1TheLow-CostBalancedIndexPortfolioversusItsHigh-CostPeers,1992–2016

EXHIBIT19.2AssetAllocationsofVariousBalancedFunds

Introductiontothe10thAnniversaryEdition

Don’tAllowaWinner’sGametoBecomeaLoser’sGame.SUCCESSFULINVESTINGISALLaboutcommonsense.AsWarrenBuffett,theOracleofOmaha,hassaid,itissimple,butitisnoteasy.Simplearithmeticsuggests,andhistoryconfirms,thatthewinningstrategyforinvestinginstocksistoownallofthenation’spubliclyheldbusinessesatverylowcost.Bydoingsoyouareguaranteedtocapturealmosttheentirereturnthatthesebusinessesgenerateintheformofdividendsandearningsgrowth.

Thebestwaytoimplementthisstrategyisindeedsimple:Buyafundthatholdsthisall-marketportfolio,andholditforever.Suchafundiscalledanindexfund.Theindexfundissimplyabasket(portfolio)thatholdsmany,manyeggs(stocks)designedtomimictheoverallperformanceoftheU.S.stockmarket(oranyfinancialmarketormarketsector).1Thetraditionalindexfund(TIF),bydefinition,basicallyrepresentstheentirestockmarketbasket,notjustafewscatteredeggs.Iteliminatestheriskofpickingindividualstocks,theriskofemphasizingcertainmarketsectors,andtheriskofmanagerselection.Onlystockmarketriskremains.(Thatriskisquitelargeenough,thankyou!)Indexfundsmakeupfortheirlackofshort-termexcitementbytheirtrulyexcitinglong-termproductivity.TheTIFisdesignedtobeheldforalifetime.

Theindexfundeliminatestherisksofindividualstocks,marketsectors,andmanagerselection.Onlystockmarketriskremains.

Thisismuchmorethanabookaboutindexfunds.Itisabookthatisdeterminedtochangetheverywaythatyouthinkaboutinvesting.Itisabookaboutwhylong-terminvestingservesyoufarbetterthanshort-termspeculation;aboutthevalueofdiversification;aboutthepowerfulroleofinvestmentcosts;abouttheperilsofrelyingonafund’spastperformanceandignoringtheprincipleofreversion(orregression)tothemean(RTM)ininvesting;andabouthowfinancialmarketswork.

Whenyouunderstandhowourfinancialmarketsactuallywork,youwillseethattheindexfundisindeedtheonlyinvestmentthatessentiallyguarantees

thatyouwillcaptureyourfairshareofthereturnsthatbusinessearns.Thankstothemiracleofcompounding,theaccumulationsofwealththataregeneratedbythosereturnsovertheyearshavebeenlittleshortoffantastic.

Thetraditionalindexfund(TIF).

I’mspeakinghereaboutthetraditionalindexfund.TheTIFisbroadlydiversified,holdingall(oralmostall)ofitsshareofthe$26trillioncapitalizationoftheU.S.stockmarketinearly2017.Itoperateswithminimalexpensesandwithnoadvisoryfees,withtinyportfolioturnover,andwithhightaxefficiency.Thattraditionalindexfund—thefirstonetrackedthereturnsoftheStandard&Poor’s500Index—simplyownssharesofthedominantfirmsincorporateAmerica,buyinganinterestineachstockinthestockmarketinproportiontoitsmarketcapitalization,andthenholdingitforever.

Themagicofcompoundinginvestmentreturns.Thetyrannyofcompoundinginvestmentcosts.

Pleasedon’tunderestimatethepowerofcompoundingthegenerousreturnsearnedbyourbusinesses.Let’sassumethatthestocksofourcorporationsearnareturnof7percentperyear.Compoundedatthatrateoveradecade,each$1.00initiallyinvestedgrowsto$2.00;overtwodecades,to$4.00;overthreedecades,to$7.50;overfourdecades,to$15.00,andoverfivedecades,to$30.00.2

Themagicofcompoundingislittleshortofamiracle.Simplyput,thankstothegrowth,productivity,resourcefulness,andinnovationofourcorporations,capitalismcreateswealth,apositive-sumgameforitsowners.Investinginequitiesforthelongtermhasbeenawinner’sgame.

Thereturnsearnedbybusinessareultimatelytranslatedintothereturnsearnedbythestockmarket.Ihavenowayofknowingwhatshareofthesemarketreturnsyouhaveearnedinthepast.Butacademicstudiessuggestthatifyouareatypicalinvestorinindividualstocks,yourreturnshaveprobablylaggedthemarketbyaroundtwopercentagepointsperyear.

Applyingthatfiguretotheannualreturnof9.1percentearnedoverthepast25yearsbytheStandard&Poor’s500StockIndex,yourannualreturnhaslikelybeenintherangeof7percent.Result:investorsasagrouphavebeen

servedonlyaboutthree-quartersofthemarketpie.Inaddition,asexplainedinChapter7,ifyouareatypicalinvestorinmutualfunds,you’vedoneevenworse.

Azero-sumgame?

Ifyoudon’tbelievethatreturnrepresentswhatmostinvestorsexperience,pleasethinkforamomentabout“therelentlessrulesofhumblearithmetic”(Chapter4).Theseironrulesdefinethegame.Asinvestors,allofusasagroupearnthestockmarket’sreturn.

Asagroup—Ihopeyou’resittingdownforthisastonishingrevelation—weinvestorsareaverage.Foreachpercentagepointofextrareturnabovethemarketthatoneofusearns,anotherofourfellowinvestorssuffersareturnshortfallofpreciselythesamedimension.Beforethedeductionofthecostsofinvesting,beatingthestockmarketisazero-sumgame.

Aloser’sgame.

Asinvestorsseektooutpacetheirpeers,winners’gainsinevitablyequallosers’losses.Withallthatfeverishtradingactivity,theonlysurewinnerinthecostlycompetitionforoutperformanceisthepersonwhositsinthemiddleofourfinancialsystem.AsWarrenBuffettrecentlywrote,“WhentrillionsofdollarsaremanagedbyWallStreeterscharginghighfees,itwillusuallybethemanagerswhoreapoutsizeprofits,nottheclients.”

Inthecasino,thehousealwayswins.Inhorseracing,thetrackalwayswins.InthePowerballlottery,thestatealwayswins.Investingisnodifferent.Inthegameofinvesting,thefinancialcroupiersalwayswin,andinvestorsasagrouplose.Afterthedeductionofthecostsofinvesting,beatingthestockmarketisaloser’sgame.

LesstoWallStreetcroupiersmeansmoretoMainStreetinvestors.

Successfulinvesting,then,isaboutminimizingtheshareofthereturnsearnedbyourcorporationsthatisconsumedbyWallStreet,andmaximizingtheshareofreturnsthatisdeliveredtoMainStreet.(That’syou,dearreader.)

Yourchancesofearningyourfairshareofthemarket’sreturnsaregreatly

enhancedifyouminimizeyourtradinginstocks.Oneacademicstudyshowedthatduringthestrongbullmarketof1990–1996themostactiveone-fifthofallstocktradersturnedtheirportfoliosoverattherateofmorethan21percentpermonth.Whiletheyearnedtheannualmarketreturnof17.9percentduringthatbullmarketperiod,theyincurredtradingcostsofabout6.5percent,leavingthemwithanannualreturnofbut11.4percent,onlytwo-thirdsofthemarketreturn.

Mutualfundinvestors,too,haveinflatedideasoftheirownomniscience.Theypickfundsbasedontherecentperformancesuperiority—oreventhelong-termsuperiority—ofafundmanager,andoftenhireadviserstohelpthemachievethesamegoal(WarrenBuffett’s“Helpers,”describedinthenextchapter).ButasIexplaininChapter12,theadvisersdoitwithevenlesssuccess.

Obliviousofthetolltakenbycosts,toomanyfundinvestorswillinglypayheavysalesloadsandincurexcessivefundfeesandexpenses,andareunknowinglysubjectedtothesubstantialbutundisclosedtransactioncostsincurredbyfundsasaresultoftheirhyperactiveportfolioturnover.Fundinvestorsareconfidentthattheycanconsistentlyselectsuperiorfundmanagers.Theyarewrong.

Mutualfundinvestorsareconfidentthattheycaneasilyselectsuperiorfundmanagers.Theyarewrong.

Contrarily,forthosewhoinvestandthendropoutofthegameandneverpayasingleunnecessarycost,theoddsinfavorofsuccessareawesome.Why?Simplybecausetheyownsharesofbusinesses,andbusinessesasagroupearnsubstantialreturnsontheircapital,payoutdividendstotheirowners,andreinvestwhat’sleftfortheirfuturegrowth.

Yes,manyindividualcompaniesfail.Firmswithflawedideasandrigidstrategiesandweakmanagementsultimatelyfallvictimtothecreativedestructionthatisthehallmarkofcompetitivecapitalism,onlytobesucceededbyotherfirms.3Butintheaggregate,businesseshavegrownwiththelong-termgrowthofourvibranteconomy.Since1929,forexample,ournation’sgrossdomesticproduct(GDP)hasgrownatanominalannualrateof6.2percent;annualpretaxprofitsofournation’scorporationshavegrownatarateof6.3percent.ThecorrelationbetweenthegrowthofGDPandthegrowthofcorporateprofitsis0.98.(1.0isperfect.)Iassumethatthislong-termrelationshipwillprevailintheyearsahead.

Getoutofthecasinoandstayout!

Thisbookintendstoshowyouwhyyoushouldstopcontributingtothecroupiersofthefinancialmarkets.Why?Becauseduringthepastdecadetheyhaverakedinsomethinglike$565billioneachyearfromyouandyourfellowinvestors.Itwillalsotellyouhoweasyitistoavoidthosecroupiers:SimplybuyaStandard&Poor’s500Indexfundoratotalstockmarketindexfund.Then,onceyouhaveboughtyourstocks,getoutofthecasino—andstayout.Justholdthemarketportfolioforever.Andthat’swhatthetraditionalindexfunddoes.

Simplebutnoteasy.

Thisinvestmentphilosophyisnotonlysimpleandelegant.Thearithmeticonwhichitisbasedisirrefutable.Butitisnoteasytofollowitsdiscipline.Solongasweinvestorsacceptthestatusquooftoday’scrazy-quiltfinancialmarketsystem,solongasweenjoytheexcitement(howevercostly)ofbuyingandsellingstocks,andsolongaswefailtorealizethatthereisabetterway,suchaphilosophywillseemcounterintuitive.ButIaskyoutocarefullyconsidertheimpassionedmessageofthisLittleBook.Whenyoudo,youtoowillwanttojointheindexrevolutionandinvestinanew,“moreeconomical,moreefficient,evenmorehonestway,”4amoreproductivewaythatwillputyourowninterestsfirst.

ThomasPaineandCommonSense.

Itmayseemfarfetchedformetohopethatanysinglebookcouldignitethesparkofarevolutionininvesting.Newideasthatflyinthefaceoftheconventionalwisdomofthedayarealwaysgreetedwithdoubtandscorn,evenfear.Indeed,240yearsago,thesamechallengewasfacedbyThomasPaine,whose1776tractCommonSensehelpedsparktheAmericanRevolution.HereiswhatTomPainewrote:

Perhapsthesentimentscontainedinthefollowingpagesarenotyetsufficientlyfashionabletoprocurethemgeneralfavor;alonghabitofnotthinkingathingwrong,givesitasuperficialappearanceofbeingright,andraisesatfirstaformidableoutcryindefenseofcustom.Butthetumultsoonsubsides.Timemakesmoreconvertsthanreason....Ioffernothing

morethansimplefacts,plainarguments,andcommonsense.

Aswenowknow,ThomasPaine’spowerfulandarticulateargumentscarriedtheday.TheAmericanRevolutionledtoourConstitution,whichtothisdaydefinestheresponsibilitiesofourgovernmentandourcitizens,theveryfabricofoursociety.

Similarly,Ibelievethatinthecomingera,myownsimplefacts,plainarguments,andcommonsensewillcarrythedayforinvestors.TheIndexRevolutionwillhelpusbuildanewandmoreefficientinvestmentsystemforournation,asysteminwhichservinginvestorsisitshighestpriority.

Structureandstrategy.

Somemaysuggestthat,asthecreatorbothofVanguardin1974andoftheworld’sfirstindexmutualfundin1975,Ihaveavestedinterestinpersuadingyouofmyviews.OfcourseIdo!Butnotbecauseitenrichesme.Itdoesn’tearnmeapenny.Rather,IwanttopersuadeyoubecausethosetworocksonwhichVanguardwasfoundedallthoseyearsago—ourtrulymutual,fund-shareholder-ownedstructureandourindexfundstrategy—willenrichyouoverthelongterm.

Don’ttakemywordforit!

Intheearlyyearsofindexing,myvoicewasalonelyone.Buttherewereafewotherthoughtfulandrespectedbelieverswhoseideasinspiredmetocarryonmymission.Today,manyofourwisestandmostsuccessfulinvestorsendorsetheindexfundconcept;amongacademics,theacceptanceisclosetouniversal.Butdon’ttakemywordforit.Listentotheseindependentexpertswhohavenoaxtogrindexceptforthetruthaboutinvesting.You’llhearfromsomeofthemattheendofeachchapter.

Listen,forexample,tothisendorsementbythelatePaulA.Samuelson,NobellaureateineconomicsciencesandprofessorofeconomicsattheMassachusettsInstituteofTechnology,towhosememorythisbookisdedicated:“Bogle’sreasonedpreceptscanenableafewmillionofussaverstobecomeintwentyyearstheenvyofoursuburbanneighbors—whileatthesametimewehavesleptwellintheseeventfultimes.”

Itwilltakealongtimetofixourfinancialsystem.Buttheglacialpaceofthatchangeshouldnotpreventyoufromlookingafteryourownself-interest.You

don’tneedtoparticipateinitsexpensivefoolishness.Ifyouchoosetoplaythewinner’sgameofowningsharesofbusinesses,andtorefrainfromplayingtheloser’sgameoftryingtobeatthemarket,youcanbeginthetasksimplybyusingyourowncommonsense,understandingthesystem,andeliminatingsubstantiallyallofitsexcessivecosts.Then,atlast,youwillbeguaranteedtoearnyourfairshareofwhateverreturnsourbusinessesmaybegenerousenoughtodeliverintheyearsahead,reflectedastheywillbeinourstockandbondmarkets.(Caution:You’llalsoearnyourfairshareofanyinterimnegativereturns.)Whenyouunderstandtheserealities,you’llseethatit’sallaboutcommonsense.

The10thAnniversaryEditionofTheLittleBookofCommonSenseInvesting.

WhenthefirsteditionofTheLittleBookofCommonSenseInvestingwaspublished10yearsago,myhopewasthatinvestorswouldfinditusefulinhelpingthemtoearntheirfairshareofwhateverreturns—positiveornegative—ourfinancialmarketsdeliver.

ThatoriginalLittleBookof2007wasadirectsuccessortomyfirstbook,BogleonMutualFunds:NewPerspectivesfortheIntelligentInvestor,publishedin1994.Bothbookssetforththecaseforindexinvesting,andbothbecamethebest-sellingmutualfundbooksever,withinvestorspurchasingacombinedtotalofmorethan500,000copies.

Duringthenearquarter-centurysincethepublicationofmyfirstbook,indexfundshavecomeintotheirown.Assetsofequityindexfundshaverisen168-fold,from$28billionto$4.6trillioninmid-2017.Inthepastdecadealone,U.S.investorshaveadded$2.1trilliontotheirholdingsofequityindexfundsandwithdrawnmorethan$900billionfromtheirholdingsofactivelymanagedequityfunds.Suchahuge$3trillionswingininvestorpreferencessurelyrepresentsnolessthananinvestmentrevolution.

Inretrospect,itseemsclearthatmypioneeringcreationofthefirstindexmutualfundin1975providedthesparkthatignitedtheindexrevolution.Anditalsoseemsreasonabletoconcludethatmybooks,readbyanestimated1.5millionreaders,playedamajorroleinfuelingtheextraordinarypoweroftherevolutionthatfollowed.

Thecreativedestructionreapedbyindexfundshas,byandlarge,servedinvestorswell.Asyoureadthis10thAnniversaryEditionofTheLittleBookofCommonSenseInvesting,you’llseethatitstandsfirmlybehindthesound

principlesofitspredecessors,withnewchaptersondividends,assetallocation,andretirementplanningfocusedontheimplementationofthoseprinciples.

 Learn!Enjoy!Act!

JOHNC.BOGLE

ValleyForge,Pennsylvania

September1,2017

Don’tTakeMyWordforItCharlesT.Munger,WarrenBuffett’sbusinesspartneratBerkshireHathaway,putsitthisway:“Thegeneralsystemsofmoneymanagement[today]requirepeopletopretendtodosomethingtheycan’tdoandlikesomethingtheydon’t.[It’s]afunnybusinessbecauseonanetbasis,thewholeinvestmentmanagementbusinesstogethergivesnovalueaddedtoallbuyerscombined.That’sthewayithastowork.Mutualfundscharge2percentperyearandthenbrokersswitchpeoplebetweenfunds,costinganotherthreetofourpercentagepoints.Thepoorguyinthegeneralpublicisgettingaterribleproductfromtheprofessionals.Ithinkit’sdisgusting.It’smuchbettertobepartofasystemthatdeliversvaluetothepeoplewhobuytheproduct.”

***

WilliamBernstein,investmentadviser(andneurologist),andauthorofTheFourPillarsofInvesting,says:“It’sbadenoughthatyouhavetotakemarketrisk.Onlyafooltakesontheadditionalriskofdoingyetmoredamagebyfailingtodiversifyproperlywithhisorhernestegg.Avoidtheproblem—buyawell-runindexfundandownthewholemarket.”

***

Here’showtheEconomistofLondonputsit:“Thetruthisthat,forthemostpart,fundmanagershaveofferedextremelypoorvalueformoney.Theirrecordsofoutperformancearealmostalwaysfollowedbystretchesofunderperformance.Overlongperiodsoftime,hardlyanyfundmanagershavebeatenthemarketaverages....Andallthewhiletheychargetheirclientsbigfeesfortheprivilegeoflosingtheirmoney....[One]specificlesson...isthemeritsofindexedinvesting...youwillalmostneverfindafundmanagerwhocanrepeatedlybeatthemarket.Itisbettertoinvestinanindexedfundthatpromisesamarketreturnbut

withsignificantlylowerfees.”

***

It’sreallyamazingthatsomanygiantsofacademia,andmanyoftheworld’sgreatestinvestors,knownforbeatingthemarket,confirmandapplaudthevirtuesofindexinvesting.Maytheircommonsense,perhapsevenmorethanmyown,makeyouallwiserinvestors.

NOTE:LittleBookreadersinterestedinreviewingthesourcesforthe“Don’tTakeMyWordforIt”quotesfoundattheendofeachchapter,otherquotesinthemaintext,andthesourcesoftheextensivedatathatIpresentcanfindthemonmywebsite:www.johncbogle.com.Iwouldn’tdreamofconsumingvaluablepagesinthissmallbookwithaweightybibliography,sopleasedon’thesitatetovisitmywebsite.

Notes1Keepinmindthatanindexmayalsobeconstructedaroundthebond

market,oreven“roadlesstraveled”assetclassessuchascommoditiesorrealestate.Today,ifyouwish,youcouldliterallyholdallyourwealthinadiversifiedportfoliooflow-costtraditionalindexfundsrepresentingeveryassetclassandeverymarketsectorwithintheUnitedStatesoraroundtheglobe.

2Overthepastcentury,theaveragenominalreturnonU.S.stockswas10.1percentperyear.Inrealterms(after3.4percentinflation)therealannualreturnwas6.7percent.Duringthenextdecade,bothreturnsarelikelytobesignificantlylower.(SeeChapter9.)

3“Creativedestruction”istheformulationofJosephE.Schumpeterinhis1942bookCapitalism,Socialism,andDemocracy.

4“Economical,”“efficient,”and“honest”arethewordsIusedinmy1951PrincetonUniversitythesis,“TheEconomicRoleoftheInvestmentCompany.”Someprinciplesareeternal.

http://www.johncbogle.com

ChapterOneAParable

TheGotrocksFamilyEVENBEFOREYOUTHINKabout“indexfunds”—intheirmostbasicform,mutualfundsthatsimplybuysharesofsubstantiallyallofthestocksintheU.S.stockmarketandholdthemforever—youmustunderstandhowthestockmarketactuallyworks.Perhapsthisfolksyparable—myversionofastorytoldbyWarrenBuffett,chairmanofBerkshireHathaway,Inc.,inthefirm’s2005AnnualReport—willclarifythefoolishnessandcounterproductivityofourvastandcomplexfinancialmarketsystem.

OnceuponaTime...AwealthyfamilynamedtheGotrocks,grownoverthegenerationstoincludethousandsofbrothers,sisters,aunts,uncles,andcousins,owned100percentofeverystockintheUnitedStates.Eachyear,theyreapedtherewardsofinvesting:alloftheearningsgrowththatthosethousandsofcorporationsgeneratedandallofthedividendsthattheydistributed.1Eachfamilymembergrewwealthieratthesamepace,andallwasharmonious.Theirinvestmentcompoundedoverthedecades,creatingenormouswealth.TheGotrocksfamilywasplayingawinner’sgame.

Butafterawhile,afewfast-talkingHelpersarriveonthescene,andtheypersuadesome“smart”Gotrockscousinsthattheycanearnalargersharethantheirrelatives.TheseHelpersconvincethecousinstoselltheirsharesinsomeofthecompaniestootherfamilymembers,andtobuysharesofothercompaniesfromtheminreturn.TheHelpershandlethetransactionsand,asbrokers,theyreceivecommissionsfortheirservices.Theownershipisthusrearrangedamongthefamilymembers.Totheirsurprise,however,thefamilywealthbeginstogrowataslowerpace.Why?BecausesomeoftheinvestmentreturnisnowconsumedbytheHelpers,andthefamily’sshareofthegenerouspiethatU.S.industrybakeseachyear—allofthosedividendspaid,allthoseearningsreinvestedinthebusinesses—100percentattheoutset,startstodecline,simplybecausesomeofthereturnisnowconsumedbytheHelpers.

Tomakemattersworse,inadditiontothetaxesthefamilyhasalwayspaidontheirdividends,someofthemembersarenowalsopayingcapitalgainstaxes.

Theirstock-swappingbackandforthgeneratescapitalgainstaxes,furtherdiminishingthefamily’stotalwealth.

Thesmartcousinsquicklyrealizethattheirplanhasactuallydiminishedtherateofgrowthinthefamily’swealth.Theyrecognizethattheirforayintostock-pickinghasbeenafailure,andconcludethattheyneedprofessionalassistance,thebettertopicktherightstocksforthemselves.Sotheyhirestock-pickingexperts—moreHelpers!—togainanadvantage.Thesemoneymanagerschargefeesfortheirservices.Sowhenthefamilyappraisesitswealthayearlater,itfindsthatitsshareofthepiehasdiminishedevenfurther.

Tomakemattersstillworse,thenewmanagersfeelcompelledtoearntheirkeepbytradingthefamily’sstocksatfeverishlevelsofactivity,notonlyincreasingthebrokeragecommissionspaidtothefirstsetofHelpers,butrunningupthetaxbillaswell.Nowthefamily’searlier100percentshareofthedividendsandearningspieisfurtherdiminished.

“Well,wefailedtopickgoodstocksforourselves,andwhenthatdidn’twork,wealsofailedtopickmanagerswhocoulddoso,”thesmartcousinssay.“Whatshallwedo?”Undeterredbytheirtwopreviousfailures,theydecidetohirestillmoreHelpers.Theyretainthebestinvestmentconsultantsandfinancialplannersthattheycanfindtoadvisethemonhowtoselecttherightmanagers,whowillthensurelypicktherightstocks.Theconsultants,ofcourse,tellthemthattheycandothejob.“Justpayusafeeforourservices,”thenewHelpersassurethecousins,“andallwillbewell.”Alas,withthoseaddedcosts,thefamily’sshareofthepietumblesonceagain.

GetridofallyourHelpers.Thenyourfamilywillagainreap100percentofthepiethatcorporateAmericabakesforyou.

Alarmedatlast,thefamilysitsdowntogetherandtakesstockoftheeventsthathavetranspiredsincesomeofthembegantotrytooutsmarttheothers.“Howisit,”theyask,“thatouroriginal100percentshareofthepie—madeupeachyearofallthosedividendsandearnings—hasdwindledtojust60percent?”Theirwisestmember,asageolduncle,softlyresponds:“Allthatmoneyyou’vepaidtothoseHelpersandallthoseunnecessaryextrataxesyou’repayingcomedirectlyoutofourfamily’stotalearningsanddividends.Gobacktosquareone,anddosoimmediately.Getridofallyourbrokers.Getridofallyourmoneymanagers.Getridofallyourconsultants.Thenourfamilywillagainreap100percentofhoweverlargeapiecorporateAmericabakesforus,yearafteryear.”

Theyfollowedtheolduncle’swiseadvice,returningtotheiroriginalpassivebutproductivestrategy,holdingallthestocksofcorporateAmerica,andstandingpat.

Thatisexactlywhatanindexfunddoes.

...andtheGotrocksFamilyLivedHappilyEverAfterAddingafourthlawtoSirIsaacNewton’sthreelawsofmotion,theinimitableWarrenBuffettputsthemoralofhisstorythisway:Forinvestorsasawhole,returnsdecreaseasmotionincreases.

Accurateasthatcrypticstatementis,Iwouldaddthattheparablereflectstheprofoundconflictofinterestbetweenthosewhoworkintheinvestmentbusinessandthosewhoinvestinstocksandbonds.Thewaytowealthforthoseinthebusinessistopersuadetheirclients,“Don’tjuststandthere.Dosomething.”Butthewaytowealthfortheirclientsintheaggregateistofollowtheoppositemaxim:“Don’tdosomething.Juststandthere.”Forthatistheonlywaytoavoidplayingtheloser’sgameoftryingtobeatthemarket.

Whenabusinessisconductedinawaythatdirectlydefiestheinterestsofitsclientsintheaggregate,itisonlyamatteroftimeuntiltheclientsawakentoreality.Then,thechangecomes—andthatchangeisdrivingtherevolutioninourfinancialsystemtoday.

ThemoraloftheGotrocksstory:Successfulinvestingisaboutowningbusinessesandreapingthehugerewardsprovidedbythedividendsandearningsgrowthofournation’s—and,forthatmatter,theworld’s—corporations.Thehighertheleveloftheirinvestmentactivity,thegreaterthecostoffinancialintermediationandtaxes,thelessthenetreturnthatshareholders—asagroup,theownersofourbusinesses—receive.Thelowerthecoststhatinvestorsasagroupincur,thehighertherewardsthattheyreap.Sotoenjoythewinningreturnsgeneratedbybusinessesoverthelongterm,theintelligentinvestorwillreducetothebare-bonesminimumthecostsoffinancialintermediation.That’swhatcommonsensetellsus.That’swhatindexingisallabout.Andthat’sthecentralmessageofthisbook.

Don’tTakeMyWordforItListentoJackR.Meyer,formerpresidentofHarvardManagementCompany,theremarkablysuccessfulwizardwhotripledtheHarvardUniversityendowmentfundfrom$8billionto$27billion.Here’swhathehadtosayina2004BusinessWeekinterview:“Theinvestmentbusinessisagiantscam.Mostpeoplethinktheycanfindmanagerswhocan

outperform,butmostpeoplearewrong.Iwillsaythat85to90percentofmanagersfailtomatchtheirbenchmarks.Becausemanagershavefeesandincurtransactioncosts,youknowthatintheaggregatetheyaredeletingvalue.”

WhenaskedifprivateinvestorscandrawanylessonsfromwhatHarvarddoes,Mr.Meyerresponded,“Yes.First,getdiversified.Comeupwithaportfoliothatcoversalotofassetclasses.Second,youwanttokeepyourfeeslow.Thatmeansavoidingthemosthypedbutexpensivefunds,infavoroflow-costindexfunds.Andfinally,investforthelongterm.[Investors]shouldsimplyhaveindexfundstokeeptheirfeeslowandtheirtaxesdown.Nodoubtaboutit.”

***

Intermsthatareabitlesscontentious,PrincetonUniversityprofessorBurtonG.Malkiel,authorofARandomWalkDownWallStreet,expressestheseviews:“Indexfundshaveregularlyproduced[annual]ratesofreturnexceedingthoseofactivemanagersbycloseto2percentagepoints.Activemanagementasawholecannotachievegrossreturnsexceedingthemarketasawhole,andthereforetheymust,onaverage,underperformtheindexesbytheamountoftheseexpenseandtransactioncosts.

“Experienceconclusivelyshowsthatindex-fundbuyersarelikelytoobtainresultsexceedingthoseofthetypicalfundmanager,whoselargeadvisoryfeesandsubstantialportfolioturnovertendtoreduceinvestmentyields....Theindexfundisasensible,serviceablemethodforobtainingthemarket’srateofreturnwithabsolutelynoeffortandminimalexpense.”

Note1Tocomplicatemattersjustabit,theGotrocksfamilyalsopurchasedthenew

publicofferingsofsecuritiesthatwereissuedeachyear.

ChapterTwoRationalExuberance

ShareholderGainsMustMatchBusinessGains.THATWONDERFULPARABLEABOUTtheGotrocksfamilyinChapter1bringshomethecentralrealityofinvesting:“ThemostthatownersinaggregatecanearnbetweennowandJudgmentDayiswhattheirbusinessesinaggregateearn,”inthewordsofWarrenBuffett.IllustratingthepointwithBerkshireHathaway,thepubliclyownedcorporationthathehasrunfor46years,pleaseheedcarefullyMr.Buffett’sstatement:

Whenthestocktemporarilyoverperformsorunderperformsthebusiness,alimitednumberofshareholders—eithersellersorbuyers—receiveoutsizedbenefitsattheexpenseofthosetheytradewith....Overtime,theaggregategainsmadebyBerkshireshareholdersmustofnecessitymatchthebusinessgainsofthecompany.

“Overtime,theaggregategainsmadeby...shareholdersmustofnecessitymatchthebusinessgainsofthecompany.”

Howofteninvestorslosesightofthateternalprinciple!Yettherecordisclear.History,ifonlywewouldtakethetroubletoexamineit,revealstheremarkable,ifessential,linkagebetweenthecumulativelong-termreturnsearnedbyU.S.business—theannualdividendyieldplustheannualrateofearningsgrowth—andthecumulativereturnsearnedbythestockmarket.Thinkaboutthatcertaintyforamoment.Canyouseethatitissimplecommonsense?

Needproof?Justlookattherecordsincethebeginningofthetwentiethcentury(Exhibit2.1).Theaverageannualtotalreturnonstockswas9.5percent.Theinvestmentreturnalonewas9.0percent—4.4percentfromdividendyieldand4.6percentfromearningsgrowth.

EXHIBIT2.1InvestmentReturnversusMarketReturn.Growthof$1,1900–2016

Thatdifferenceof0.5percentagepointsperyeararosefromwhatIcallspeculativereturn.Speculativereturnmaybeaplusoraminus,dependingonthewillingnessofinvestorstopayeitherhigherorlowerpricesforeachdollarofearningsattheendofagivenperiodthanatthebeginning.

Theprice/earnings(P/E)ratiomeasuresthenumberofdollarsinvestorsarewillingtopayforeachdollarofearnings.Asinvestorconfidencewaxesandwanes,P/Emultiplesriseandfall.1Whengreedholdssway,veryhighP/Esarelikely.Whenhopeprevails,P/Esaremoderate.Whenfearisinthesaddle,P/Esaretypicallyverylow.Backandforth,overandoveragain,swingsintheemotionsofinvestorsarereflectedinspeculativereturn.Theymomentarilyderailthesteadylong-rangeupwardtrendintheeconomicsofinvesting.

AsreflectedinExhibit2.1,theinvestmentreturnonstocks—dividendyieldplusearningsgrowth—trackscloselywiththetotalmarketreturn(includingtheimpactofspeculativereturn)overthelongterm.Anysignificantdivergencesbetweenthetwoareshort-lived.

Compoundingthesereturnsover116yearsproducesaccumulationsthataretrulystaggering.Eachdollarinitiallyinvestedinstocksin1900atareturnof9.5percentgrewbythecloseof2015to$43,650.2Sure,few(ifany)ofushave116yearsinus!Butourdescendantsfollowus,and,liketheGotrocksfamily,enjoythemiracleofcompoundingreturns.Thesereturnshavebeen

littleshortofamazing—theultimatewinner’sgame.

AsExhibit2.1makesclear,therearebumpsalongthewayintheinvestmentreturnsearnedbyourbusinesscorporations.Sometimes,asintheGreatDepressionoftheearly1930s,thesebumpswerelarge.Butwegotoverthem.So,ifyoustandbackfromthechartandsquintyoureyes,thetrendofbusinessfundamentalslooksalmostlikeastraightlineslopinggentlyupward,andthoseperiodicbumpsarebarelyvisible.

Reversiontothemean.

Tobesure,stockmarketreturnssometimesgetwellaheadofbusinessfundamentals(asinthelate1920s,theearly1970s,andthelate1990s,perhapseventoday).Butithasbeenonlyamatteroftimeuntil,asifdrawnbyamagnet,theyultimatelyreturntothelong-termnorm,althoughoftenonlyafterfallingwellbehindforatime,asinthemid-1940s,thelate1970s,andthe2003marketlows.It’scalledreversion(orregression)tothemean(RTM),whichwe’lldiscussindepthinChapter11.

Inourfoolishfocusontheshort-termstockmarketdistractionsofthemoment,weinvestorsoftenoverlookthislonghistory.Whenthereturnsonstocksdepartmateriallyfromthelong-termnorm,weignoretherealitythatitisrarelybecauseoftheeconomicsofinvesting—theearningsgrowthanddividendyieldsofourcorporations.Rather,thereasonthatannualstockreturnsaresovolatileislargelybecauseoftheemotionsofinvesting,reflectedinthosechangingP/Eratios.

“Itisdangerous...toapplytothefutureinductiveargumentsbasedonpastexperience.”

WhatExhibit2.1showsisthatwhilethepriceswepayforstocksoftenlosetouchwiththerealityofcorporatevalues,inthelongrunrealityrules.So,whileinvestorsseemtointuitivelyacceptthatthepastisinevitablyprologuetothefuture,anypaststockmarketreturnsthathaveincludedahighspeculativestockreturncomponentaredeeplyflawedguidestowhatliesahead.Tounderstandwhypastreturnsdonotforetellthefuture,weneedonlyheedthewordsofthegreatBritisheconomistJohnMaynardKeynes.Here’swhathewrote81yearsago:

Itisdangerous...toapplytothefutureinductiveargumentsbasedonpast

experience,unlessonecandistinguishthebroadreasonswhypastexperiencewaswhatitwas.

Butifwecandistinguishthereasonsthepastwaswhatitwas,thenwecanestablishreasonableexpectationsaboutthefuture.Keyneshelpedusmakethisdistinctionbypointingoutthatthestateoflong-termexpectationforstocksisacombinationofenterprise(“forecastingtheprospectiveyieldofassetsovertheirwholelife”)andspeculation(“forecastingthepsychologyofthemarket”).

I’mwellfamiliarwiththosewords,for66yearsagoIincorporatedthemintomyseniorthesisatPrincetonUniversity.Itwasentitled,“TheEconomicRoleoftheInvestmentCompany.”Itled,providentially,tomylifetimecareerinthemutualfundindustry.

Thedualnatureofstockmarketreturns.

Thisdualnatureofreturnsisclearlyreflectedwhenwelookatstockmarketreturnsoverthedecades(Exhibit2.2).PuttingmyownnumberstoKeynes’sidea,Idividestockmarketreturnsintotwoparts:(1)investmentreturn(enterprise),consistingoftheinitialdividendyieldonstocksplustheirsubsequentearningsgrowth(together,theyformtheessenceofwhatwecall“intrinsicvalue”),and(2)speculativereturn,theimpactofchangingprice/earningsmultiplesonstockprices.Let’sbeginwithinvestmentreturns.

EXHIBIT2.2TotalStockReturnsbytheDecade,1900–2016(PercentAnnually)

ThetopsectionofExhibit2.2showstheaverageannualinvestmentreturnonstocksovereachofthedecadessince1900.Notefirstthesteadycontributionofdividendyieldstototalreturnduringeachdecade:alwayspositive,onlytwiceoutsidetherangeof3percentto7percent,andaveraging4percent.

Thennotethatthecontributionofearningsgrowthtoinvestmentreturn,withtheexceptionofthedepression-ridden1930s,waspositiveineverydecadeandabove9percentinseveraldecades,butusuallyranbetween4percentand7percent,andaveraged4.6percentperyear.

Result:Totalinvestmentreturns(thetopsection,combiningdividendyieldandearningsgrowth)werenegativeinonlyasingledecade(again,inthe1930s).Whilethesedecade-longtotalinvestmentreturns—thegainsmadebybusiness—varied,Iconsiderthemremarkablysteady.Theygenerallyranintherangeof8percentto13percentannually,andaveraged9percent.

Enterspeculativereturn.

Enterspeculativereturn,showninthemiddlesectionofExhibit2.2.Comparedwiththerelativeconsistencyofdividendsandearningsgrowthoverthedecades,trulywildvariationsinspeculativereturnpunctuatethechart.P/Eswaxandwane,oftenwitharemarkableimpactonreturns.Forexample,a100percentriseintheP/E,from10to20timesoveradecade,wouldequatetoa7.2percentannualspeculativereturn.

Asyoucansee,withoutexceptioneverydecadeofsignificantlynegativespeculativereturnwasimmediatelyfollowedbyadecadeinwhichitturnedpositivebyacorrelativeamount:thenegative1910sandthentheroaring1920s;thedispiriting1940sandthenthebooming1950s;thediscouraging1970sandthenthesoaring1980s.

Thispatternisreversiontothemeanwritlarge.RTMcanbethoughtofasthetendencyforthoseP/Estoreturntotheirlong-termnormsovertime.Periodsofsubparperformancetendtobefollowedbyperiodsofrecovery,andviceversa.Then,amazingly,duringthe1990s,therewasanunprecedentedsecondconsecutiveexuberantincrease,apatternneverbeforeinevidence.

Areturntosanity.

InApril1999,theP/Eratiohadrisentoanunprecedentedlevelof34times,settingthestageforthereturntosanityinvaluationsthatsoonfollowed.Thetumbleinstockmarketpricesgaveusourcomeuppance.Withearningscontinuingtorise,theP/Ecurrentlystandsat23.7times,comparedwiththe15timeslevelthatprevailedatthestartofthetwentiethcentury.Asaresult,speculativereturnhasaddedjust0.5percentagepointstotheannualinvestmentreturnearnedbyourbusinessesoverthelongterm.3

Combininginvestmentreturnandspeculativereturn:totalstockmarketreturns.

Whenwecombinethesetwosourcesofstockreturns,wegetthetotalreturnproducedbythestockmarket.(ThelowersectionofExhibit2.2.)Despitethehugeimpactofspeculativereturn—upanddown—duringmostoftheindividualdecades,thereisvirtuallynoimpactoverthelongterm.Theaverageannualtotalreturnonstocksof9.5percent,then,hasbeencreated

almostentirelybyenterprise,withonly0.5percentagepointcreatedbyspeculation.

Themessageisclear:Inthelongrun,stockreturnsdependalmostentirelyontherealityoftheinvestmentreturnsearnedbyourcorporations.Theperceptionofinvestors,reflectedbythespeculativereturns,countsforlittle.Itiseconomicsthatcontrolslong-termequityreturns;theimpactofemotions,sodominantintheshortterm,dissolves.

Accuratelyforecastingshort-termswingsininvestoremotionsisnotpossible.Butforecastingthelong-termeconomicsofinvestinghas

carriedremarkablyhighoddsofsuccess.

Evenaftermorethan66yearsinthisbusiness,Ihavealmostnoideahowtoforecasttheseshort-termswingsininvestoremotions.4But,largelybecausethearithmeticofinvestingissobasic,Ihavebeenabletoforecastthelong-termeconomicsofinvestingwithremarkablyhighoddsofsuccess.

Why?Simplybecauseitisinvestmentreturns—theearningsanddividendsgeneratedbyAmericanbusinesses—thatarealmostentirelyresponsibleforthereturnsdeliveredinourstockmarketoverthelongterm.Whileillusion(themomentarypriceswepayforstocks)oftenlosestouchwithreality(theintrinsicvaluesofourcorporations),itisrealitythatrulesinthelongrun.

Therealmarketandtheexpectationsmarket.

Todrivethispointhome,thinkofinvestingasconsistingoftwodifferentgames.Here’showRogerMartin,deanoftheRotmanSchoolofManagementoftheUniversityofToronto,describesthem.Onegameis“therealmarket,wheregiantpubliclyheldcompaniescompete.Whererealcompaniesspendrealmoneytomakeandsellrealproductsandservices,and,iftheyplaywithskill,earnrealprofitsandpayrealdividends.Thisgamealsorequiresrealstrategy,determination,andexpertise;realinnovationandrealforesight.”Looselylinkedtothisgameisanothergame,theexpectationsmarket.Here,“pricesarenotsetbyrealthingslikesalesmarginsorprofits.Intheshortterm,stockpricesgouponlywhentheexpectationsofinvestorsrise,notnecessarilywhensales,margins,orprofitsrise.”

Thestockmarketisagiantdistractiontothebusinessofinvesting.

Tothiscrucialdistinction,Iwouldaddthattheexpectationsmarketislargelyaproductoftheexpectationsofspeculators,tryingtoguesswhatotherinvestorswillexpectandhowtheywillactaseachnewbitofinformationfindsitswayintothemarketplace.Theexpectationsmarketisaboutspeculation.Therealmarketisaboutinvesting.Thestockmarket,then,isagiantdistractiontothebusinessofinvesting.

Toooften,themarketcausesinvestorstofocusontransitoryandvolatileshort-termexpectations,ratherthanonwhatisreallyimportant—thegradualaccumulationofthereturnsearnedbycorporatebusinesses.

WhenShakespearewrotethat“itisataletoldbyanidiot,fullofsoundandfury,signifyingnothing,”hecouldhavebeendescribingtheinexplicabledaily,month-by-month,orevenannualswingsinstockprices.Myadvicetoinvestors:ignoretheshort-termsoundandfuryoftheemotionsreflectedinourfinancialmarkets,andfocusontheproductivelong-termeconomicsofourcorporatebusinesses.Thewaytoinvestmentsuccessistogetoutoftheexpectationsmarketofstockpricesandcastyourlotwiththerealmarketofbusiness.

Don’tTakeMyWordforItSimplyheedthetimelessdistinctionmadebyBenjaminGraham,legendaryinvestor,authorofTheIntelligentInvestor,andmentortoWarrenBuffett.Hewasrightonthemoneywhenheputhisfingerontheessentialrealityofinvesting:“Intheshortrunthestockmarketisavotingmachine...inthelongrunitisaweighingmachine.”

Usinghiswonderfulmetaphorof“Mr.Market,”BenGrahamsays,“Imaginethatinsomeprivatebusinessyouownasmallsharewhichcostyou$1,000.Oneofyourpartners,namedMr.Market,isveryobligingindeed.Everydayhetellsyouwhathethinksyourinterestisworthandfurthermoreofferseithertobuyyououtortosellyouanadditionalinterestonthatbasis.Sometimeshisideaofvalueappearsplausibleandjustifiedbybusinessdevelopmentsandprospectsasyouknowthem.Often,ontheotherhand,Mr.Marketletshisenthusiasmorhisfearsrunawaywithhim,andthevalueheproposesseemslittleshortofsilly.

“Ifyouareaprudentinvestor...willyouletMr.Market’sdailycommunicationdetermineyourviewasthevalueofyour$1,000interestintheenterprise?Onlyincaseyouagreewithhim,orincaseyouwanttotradewithhim....Buttherestofthetimeyouwillbewisertoformyour

ownideasofthevalueofyourholdings....Thetrueinvestor...willdobetterifheforgetsaboutthestockmarketandpaysattentiontohisdividendreturnsandtotheoperatingresultsofhiscompanies.(Italicsadded.)...

“Theinvestorwithaportfolioofsoundstocksshouldexpecttheirpricestofluctuateandshouldneitherbeconcernedbysizabledeclinesnorbecomeexcitedbysizableadvances.Heshouldalwaysrememberthatmarketquotationsarethereforhisconvenience,eithertobetakenadvantageofortobeignored.”

Notes1Changesininterestratesalsohaveanimpact,uneventhoughitmaybe,on

theP/Emultiple.So,I’moversimplifyingabithere.

2Butlet’sbefair.Ifwecompoundthatinitial$1,notatthenominalreturnof9.5percentbutattherealrateof6.3percent(after3.2percentinflationduringtheperiod),$1growsto$1,339,butafractionoftheaccumulationinnominalterms.Butincreasingrealwealthmorethan1,300timesoverisnottobesneezedat.

3OurmeasureoftheP/Eratioatthecloseof2016isbasedontheyear-endpriceof2247fortheS&P500relativetoreportedearningsfor2016of$95pershare—aP/Eof23.7.WallStreetanalyststendtorelyonoperatingearnings(beforewrite-offsandothernegatives)thatareforecastforthecomingyear($118pershare).ResultingP/E:17.4times.

4I’mnotalone.Idon’tknowanyonewhohasdonesoconsistently,norevenanyonewhoknowsanyonewhohasdoneso.Infact,70yearsoffinancialresearchfindsnoonewhohasdoneso.

ChapterThreeCastYourLotwithBusiness

WinbyKeepingItSimple—RelyonOccam’sRazor.HOWDOYOUCASTyourlotwithbusiness?SimplybybuyingaportfoliothatownssharesofeverybusinessintheUnitedStatesandthenholdingitforever.Thissimpleconceptguaranteesyouwillwintheinvestmentgameplayedbymostotherinvestorswho—asagroup—areguaranteedtolose.

Pleasedon’tequatesimplicitywithstupidity.Waybackin1320,WilliamofOccamnicelyexpressedthevirtueofsimplicity,essentiallysettingforththisprecept:Whentherearemultiplesolutionstoaproblem,choosethesimplestone.1AndsoOccam’srazorcametorepresentamajorprincipleofscientificinquiry.ByfarthesimplestwaytoownallofU.S.businessesistoholdthetotalstockmarketportfoliooritsequivalent.

Occam’srazor:Whentherearemultiplesolutionstoaproblem,choosethesimplestone.

Forthepast90years,theacceptedstockmarketportfoliohasbeenrepresentedbytheStandard&Poor’s500Index(theS&P500).Itwascreatedin1926astheCompositeIndex,andnowlists500stocks.2Itisessentiallycomposedofthe500largestU.S.corporations,weightedbythevalueoftheirmarketcapitalizations.Inrecentyears,these500stockshaverepresentedabout85percentofthemarketvalueofallU.S.stocks.Thebeautyofsuchamarket-cap-weightedindexisthatitneverneedstoberebalancedbybuyingandsellingsharesduetochangingstockprices.

Withtheenormousgrowthofcorporatepensionfundsbetween1950and1990,theS&P500wasanidealmeasurementstandard,thebenchmark(orhurdlerate)thatwouldbethecomparativestandardforhowtheprofessionalmanagersofpensionfundswereperforming.Today,theS&P500remainsavalidstandardagainstwhichtocomparethereturnsearnedbytheprofessionalmanagersofpensionfundsandmutualfunds.

TheTotalStockMarketIndex

In1970,anevenmorecomprehensivemeasureoftheU.S.stockmarketwasdeveloped.OriginallycalledtheWilshire5000,itisnownamedtheDowJonesWilshireTotalStockMarketIndex.3Itnowincludessome3,599stocks,includingthe500stocksintheS&P500.Becauseitscomponentstocksalsoareweightedbytheirmarketcapitalization,thoseremaining3,099stockswithsmallercapitalizationsaccountforonlyabout15percentofitsvalue.

ThisbroadestofallU.S.stockindexesisthebestmeasureoftheaggregatevalueofstocks,andthereforeasuperbmeasureofthereturnsearnedinU.S.stocksbyallinvestorsasagroup.Asjustindicated,bothindexesholdtheverysamelargestocks.Exhibit3.1showsthe10largeststocksineach,andtheirweightsintheconstructionofeachindex.

EXHIBIT3.1S&P500versusTotalStockMarketIndex:PortfolioComparison,December2016

S&P500 TotalStockMarketIndexRank Weighting Rank WeightingAppleInc. 3.2% AppleInc. 2.5%MicrosoftCorp. 2.5 MicrosoftCorp. 2.0AlphabetInc. 2.4 AlphabetInc. 2.0ExxonMobilCorp. 1.9 ExxonMobilCorp. 1.6Johnson&Johnson 1.6 Johnson&Johnson 1.3BerkshireHathawayInc.

1.6 BerkshireHathawayInc.

1.3

JPMorganChase&Co. 1.6 JPMorganChase&Co. 1.3Amazon.comInc. 1.5 Amazon.comInc. 1.3GeneralElectricCo. 1.4 GeneralElectricCo. 1.2FacebookInc. 1.4 FacebookInc. 1.1Top10 19.1% Top10 15.6%Top25 33.3 Top25 27.3Top100 63.9 Top100 52.9Top500 100.0 Top500 84.1Totalmarketcap $19.3

trillion$22.7trillion

http://Amazon.comhttp://Amazon.com

Giventhesimilarityofthesetwoportfolios,itishardlysurprisingthatthetwoindexeshaveearnedreturnsthatareinlockstepwithoneanother.TheCenterforResearchinSecurityPricesattheUniversityofChicagohasgonebackto1926andcalculatedthereturnsearnedbyallU.S.stocks.ThereturnsoftheS&P500IndexandtheDowJonesWilshireTotalStockMarketIndexparalleloneanotherwithnearprecision.From1926,thebeginningofthemeasurementperiod,through2016,youcanhardlytellthemapart(Exhibit3.2).

EXHIBIT3.2S&P500andTotalStockMarketIndex,1926–2016

Forthefullperiod,theaverageannualreturnontheS&P500was10.0percent;thereturnontheTotalStockMarketIndexwas9.8percent.Thiscomparisoniswhatwecallperioddependent—everythingdependsonthestartingdateandtheendingdate.Ifweweretobeginthecomparisonatthebeginningof1930insteadof1926,thereturnsofthetwowouldbeidentical:9.6percentperyear.

Yes,therearevariationsovertheinterimperiods:theS&P500wasmuchthestrongerfrom1982to1990,whenitsannualreturnof15.6percentoutpacedtheTotalStockMarketIndexreturnof14.0percent.Butsincethen,small-andmid-capstockshavedoneabitbetter,andtheTotalStockMarketIndexreturnof10.2percentperyearnarrowlyexceededthe9.9percentreturnoftheS&P500.Butwithalong-termcorrelationof0.99betweenthereturnsofthetwoindexes(1.00isperfectcorrelation),thereislittletochoosebetweenthetwo.4

Returnsearnedinthestockmarketmustequalthegrossreturnsearnedbyallinvestorsinthemarket.

Whichevermeasureweuse,itshouldnowbeobviousthatthereturnsearnedbythepubliclyheldcorporationsthatcomposethestockmarketmustofnecessityequaltheaggregategrossreturnsearnedbyallinvestorsinthatmarketasagroup.Equallyobvious,aswillbediscussedinChapter4,thenetreturnsearnedbytheseinvestorsmustofnecessityfallshortofthoseaggregategrossreturnsbytheamountofintermediationcoststheyincur.Ourcommonsensetellsustheobvious,justwhatwelearnedinChapter1:Owningthestockmarketoverthelongtermisawinner’sgame,butattemptingtobeatthestockmarketisaloser’sgame.

Alow-costall-marketfund,then,isguaranteedtooutpaceovertimethereturnsearnedbyequityinvestorsasagroup.Onceyourecognizethisfact,youcanseethattheindexfundisguaranteedtowinnotonlyovertime,buteveryyear,andeverymonthandweek,eveneveryminuteoftheday.Nomatterhowlongorshortthetimeframe,thegrossreturninthestockmarket,minusintermediationcosts,equalsthenetreturnearnedbyinvestorsasagroup.Ifthedatadonotprovethatindexingwins,well,thedataarewrong.

Ifthedatadonotprovethatindexingwins,well,thedataarewrong.

Overtheshortterm,however,itdoesn’talwayslookasiftheS&P500(stillthemostcommonbasisofcomparisonformutualfundsandpensionplans)ortheTotalStockMarketIndexiswinning.Thatisbecausethereisnopossiblewaytocalculatepreciselythereturnsearnedbythemillionsofdiverseparticipants,amateurandprofessionalalike,Americansandforeigninvestors,intheU.S.stockmarket.

Inthemutualfundfield,wecalculatethereturnsofthevariousfunds,countingeachfund—regardlessoftheamountofitsassets—asasingleentry.Sincetherearemanysmall-capandmid-capfunds,usuallywithrelativelymodestassetbases,attimestheymayhaveadisproportionateimpactonthedata.Whensmall-andmid-capfundsareleadingthetotalmarket,theall-marketindexfundseemstolag.Whensmall-andmid-capstocksarelaggingthemarket,theindexfundlooksformidableindeed.

Activefundsversusbenchmarkindexes.

TheobvioussolutiontothechallengeofcomparingactiveequityfundsofalltypeswiththeS&P500Indexistomeasurefundsagainstotherindexesthatmorecloselyreflecttheirowninvestmentstrategies.Someyearsago,theS&PIndicesversusActive(SPIVA)reportbegantodoexactlythat.Thereportprovidescomprehensivedatacomparingactivemutualfundsgroupedbyvariousstrategieswithrelevantmarketindexes.Inits2016year-endreport,SPIVAextendedthelongesttimehorizonevaluatedinthereportto15years(2001–2016)andreportedthepercentageofactivelymanagedfundsthatwereoutperformedbytheirrelevantbenchmarkindexes.Theresultswereimpressive(Exhibit3.3).Onaverage,anastonishing90percentofactivelymanagedmutualfundsunderperformedtheirbenchmarkindexesoverthepreceding15years.Theindexsuperioritywasconsistentandoverwhelming.

EXHIBIT3.3PercentagesofActivelyManagedMutualFundsOutperformedbyComparableS&PIndexes,2001–2016

FundCategory Growth Core ValueLarge-Cap 95% 97% 79%Mid-Cap 97 99 90Small-Cap 99 95 81

TheS&P500outpaced97percentofactivelymanagedlarge-capcorefunds.TheS&P500GrowthandValueindexesareusedascomparisonsforfundsinthoselarge-capcategories,andsoonforthethreemid-capcategoriesandthethreesmall-capcategories.Thesweepingacross-the-boardsuperiorityoftheindexescanleavelittledoubtthatindexfundsareheretostay.

In1951,IwroteinmyseniorthesisatPrincetonUniversitythatmutualfunds“canmakenoclaimtosuperiorityoverthemarketaverages.”Sixty-sixyearslater,thathasproventobeahugeunderstatement.

Therecordofaninvestorinthefirstindexmutualfund:$15,000investedin1976;valuein2016,$913,340.

Therecenteranotonlyhasfailedtoerode,buthasnicelyenhancedthelifetimerecordoftheworld’sfirstindexfund—nowknownastheVanguard500IndexFund.ItbeganoperationsbackonAugust31,1976.Letmebespecific:ataluncheononSeptember20,2016,celebratingthe40thanniversaryofthefund’sinitialpublicoffering,thecounselforthefund’sunderwritersreportedthathehadpurchased1,000sharesattheoriginalofferingpriceof$15pershare—a$15,000investment.Heproudly

announcedthevalueofhisholdingthatday(includingsharesacquiredthroughreinvestingthefund’sdividendsanddistributionsovertheyearsinadditionalshares):$913,340.5Now,there’sanumberthatrequiresnoembellishment.Butitdoesdemandonecaveatandonecaution.

Acaveatandacaution.

Thecaveat:Ofthe360equitymutualfundsinexistencewhenthefirstindexfundwasformedin1976,only74remain.Activelymanagedfundscomeandgo,buttheindexfundgoesonforever.Thecaution:Duringthatfour-decadeperiod,theS&P500Indexgrewatanannualrateof10.9percent.Withtoday’slowerdividendyields,theprospectoflowerearningsgrowth,andaggressivemarketvaluations,itwouldbefoolishintheextremetoassumethatsuchareturnwouldrecuroverthenextfourdecades.SeeChapter9,“WhentheGoodTimesNoLongerRoll.”

ThepastrecordconfirmsthatowningAmericanbusinessthroughabroadlydiversifiedindexfundisnotonlylogicalbut,tosaytheleast,incrediblyproductive.Equallyimportant,itisconsistentwiththeage-oldprincipleofsimplicityexpressedbySirWilliamofOccam:Insteadofjoiningthecrowdofinvestorswhodabbleincomplexalgorithmsorothermachinationstopickstocks,orwholooktopastperformancetoselectmutualfunds,orwhotrytooutguessthestockmarket(forinvestorsintheaggregate,threeinevitablyfruitlesstasks),choosethesimplestofallsolutions—buyandholdadiversified,low-costportfoliothattracksthestockmarket.

Don’tTakeMyWordforItHearDavidSwensen,thewidelyrespectedchiefinvestmentofficeroftheYaleUniversityEndowmentFund.“[Overthefifteenyearsending1998,a]minuscule4percentof[mutual]fundsproducedmarket-beatingafter-taxresultswithascant0.6percent[annual]marginofgain.The96percentoffundsthatfailtomeetorbeattheVanguard500IndexFundlosebyawealth-destroyingmarginof4.8percentperannum.”

***

Thesimpleindexfundsolutionisusednotonlybyinvestorsofaveragemeans.Ithasbeenadoptedasacornerstoneofinvestmentstrategyformanyofthenation’spensionplansoperatedbyourgiantcorporationsandstateandlocalgovernments.Indexingisalsothepredominantstrategyfor

thelargestplanofthemall,theretirementplanforfederalgovernmentemployees,thefederalThriftSavingsPlan(TSP).Theplannowholdssome$460billionofassetsforthebenefitofourpublicservantsandmembersofourarmedservices.Allcontributionsandearningsaretax-deferreduntilwithdrawal,muchlikethecorporate401(k)thriftplan.6

***

IndexingisalsopraisedacrosstheAtlantic“pond.”ListentothesewordsfromJonathanDavis,columnistforLondon’sTheSpectator:“NothinghighlightsbetterthecontinuinggapbetweenrhetoricandsubstanceinBritishfinancialservicesthanthefailureofprovidersheretoemulateJackBogle’sindexfundsuccessintheUnitedStates.EveryprofessionalintheCityknowsthatindexfundsshouldbecorebuildingblocksinanylong-terminvestor’sportfolio.Since1976,theVanguardindexfundhasproducedacompoundannualreturnof12percent,betterthanthree-quartersofitspeergroup.Yeteven30yearson,ignoranceandprofessionalomertastillstandinthewayofmoreinvestorsenjoyingthefruitsofthisunsungherooftheinvestmentworld.”

Notes1WilliamofOccamexpresseditmoreelegantly:“Entitiesshouldnotbe

multipliedunnecessarily.”Butthepointisunmistakable.

2Until1957,theS&PIndexincludedjust90companies.

3Fulldisclosure:Vanguardcreatedthefirstindexmutualfund,trackingtheStandard&Poor’s500Index,in1975.ThefirmalsocreatedthefirstTotalStockMarketIndexFundin1992.

4Youshouldknowthat,inestablishingatrustforhiswife’sestate,WarrenBuffettdirectedthat90percentofitsassetsbeinvestedinalow-costS&P500Indexfund.

5Thisinvestorpaidseparatelythetaxesdueondividendsandcapitalgainsdistributions.

6TheTSPalsooffersRothcontributions,whicharetreatedsimilarlytoRothIRAsfortaxpurposes.Rothcontributionsaremadewithafter-taxincome,butallsubsequentgrowthiscompletelytaxfree.I’llexpandonthesubjectofsavingforretirementinChapter19.

ChapterFourHowMostInvestorsTurnaWinner’sGameintoaLoser’sGame

“TheRelentlessRulesofHumbleArithmetic”BEFOREWETURNTOthesuccessofindexingasaninvestmentstrategy,let’sexploreinabitmoredepthjustwhyitisthatinvestorsasagroupfailtoearnthereturnsthatourcorporationsgeneratethroughtheirdividendsandearningsgrowth,whichareultimatelyreflectedinthepricesoftheirstocks.Why?Becauseinvestorsasagroupmustnecessarilyearnpreciselythemarketreturn,beforethecostsofinvestingarededucted.

Whenwesubtractthosecostsoffinancialintermediation—allthosemanagementfees,allofthatportfolioturnover,allofthosebrokeragecommissions,allofthosesalesloads,allofthoseadvertisingcosts,allofthoseoperatingcosts,allofthoselegalfees—thereturnsofinvestorsasagroupmust,andwill,anddofallshortofthemarketreturnbyanamountpreciselyequaltotheaggregateamountofthosecosts.Thatisthesimple,undeniablerealityofinvesting.

Inamarketthatreturns7percentinagivenyear,weinvestorstogetherearnagrossreturnof7percent.(Duh!)Butafterwepayourfinancialintermediaries,wepocketonlywhatremains.(Andwepaythemwhetherourreturnsarepositiveornegative!)

Beforecosts,beatingthemarketisazero-sumgame.Aftercosts,itisaloser’sgame.

Thereare,then,thesetwocertainties:(1)Beatingthemarketbeforecostsisazero-sumgame.(2)Beatingthemarketaftercostsisaloser’sgame.Thereturnsearnedbyinvestorsintheaggregateinevitablyfallwellshortofthereturnsthatarerealizedinourfinancialmarkets.Howmuchdothosecostscometo?Forindividualinvestorsholdingstocksdirectly,tradingcostsmayaverage1.5percentormoreperyear.Thatcostislower(maybe1percent)forthosewhotradeinfrequently,andmuchhigherforinvestorswhotradefrequently(forexample,3percentforinvestorswhoturntheirportfoliosoveratarateabove200percentperyear).

Inactivelymanagedequitymutualfunds,managementfeesandoperatingexpenses—combinedinwhatwecallafund’sexpenseratio—averageabout1.3percentperyear,andabout0.8percentwhenweightedbyfundassets.Thenadd,say,another0.5percentinsalescharges,assumingthata5percentinitialsaleschargewerespreadovera10-yearholdingperiod.Iftheshareswereheldforfiveyears,thesaleschargecostwouldbetwicethat0.5percentfigure—1percentperyear.(Manyfundscarrysalesloads,nowoftenspreadoveradecadeormore.About60percentoffundsare“no-load”funds.)

Butthenaddagiantadditionalcost,allthemoreperniciousbybeinginvisible.Iamreferringtothehiddencostsofportfolioturnover,whichIestimateaverageafull1percentperyear.Activelymanagedmutualfundsaresaidtoturntheirportfoliosoveratarateofabout80percentperyear,meaning,forexample,thata$5billionfundbuys$2billionofstockseachyearandsellsanother$2billion,atotalof$4billion.Atthatvolume,brokeragecommissions,bid-askspreads,andmarketimpactcostsaddamajorlayerofadditionalcoststhatarebornebyfundinvestors,perhaps0.5to1.0percent.

Weinvestorsasagroupgetpreciselywhatwedon’tpayfor.Ifwepaynothing,wegeteverything.

Result:the“all-in”costofequityfundownershipcancometoasmuchas2percentto3percentperyear.1Soyes,costsmatter.Thegrimironyofinvesting,then,isthatweinvestorsasagroupnotonlydon’tgetwhatwepayfor.Wegetpreciselywhatwedon’tpayfor.Soifwepaynothing,wegeteverything.It’sonlycommonsense.

AfewyearsagowhenIwasrereadingOtherPeople’sMoney,byLouisD.Brandeis(firstpublishedin1914),Icameacrossawonderfulpassagethatillustratesthissimplelesson.Brandeis,latertobecomeoneofthemostinfluentialjuristsinthehistoryoftheU.S.SupremeCourt,railedagainsttheoligarchswhoacenturyagocontrolledinvestmentAmericaandcorporateAmericaalike.

“Therelentlessrulesofhumblearithmetic.”

Brandeisdescribedtheirself-servingfinancialmanagementandtheirinterlockinginterestsas“tramplingwithimpunityonlawshumananddivine,obsessedwiththedelusionthattwoplustwomakefive.”Hepredicted

(accurately,asitturnedout)thatthewidespreadspeculationofthaterawouldcollapse,“avictimoftherelentlessrulesofhumblearithmetic.”Hethenaddedthisunattributedwarning(I’mguessingit’sfromSophocles):“Remember,OStranger,arithmeticisthefirstofthesciences,andthemotherofsafety.”

Brandeis’swordshitmeliketheproverbialtonofbricks.Why?Becausetherelentlessrulesofthearithmeticofinvestingaresoobvious.(It’sbeensaidbymydetractorsthatallIhavegoingformeis“theuncannyabilitytorecognizetheobvious.”)

Thecuriousfactisthatmostinvestorsseemtohavedifficultyrecognizingwhatliesinplainsight,rightbeforetheireyes.Or,perhapsevenmorepervasively,theyrefusetorecognizetherealitybecauseitfliesinthefaceoftheirdeep-seatedbeliefs,biases,overconfidence,anduncriticalacceptanceofthewaythatfinancialmarketshaveworked,seeminglyforever.

It’samazinghowdifficultitisforamantounderstandsomethingifhe’spaidasmallfortunenottounderstandit.

What’smore,itishardlyintheinterestofourfinancialintermediariestoencouragetheirinvestor/clientstorecognizetheobviousreality.Indeed,theself-interestoftheleadersofourfinancialsystemalmostcompelsthemtoignoretheserelentlessrules.ParaphrasingUptonSinclair:It’samazinghowdifficultitisforamantounderstandsomethingifhe’spaidasmallfortunenottounderstandit.

Oursystemoffinancialintermediationhascreatedenormousfortunesforthosewhomanageotherpeople’smoney.Theirself-interestwillnotsoonchange.Butasaninvestor,youmustlookafteryourself-interest.Onlybyfacingtheobviousrealitiesofinvestingcananintelligentinvestorsucceed.

Howmuchdothecostsoffinancialintermediationmatter?Hugely!Infact,thehighcostsofequityfundshaveplayedadeterminativeroleinexplainingwhyfundmanagershavelaggedthereturnsofthestockmarketsoconsistently,forsolong.Whenyouthinkaboutit,howcoulditbeotherwise?

Byandlarge,thesemanagersaresmart,well-educated,experienced,knowledgeable,andhonest.Buttheyarecompetingwithoneanother.Whenonebuysastock,anothersellsit.Thereisnonetgaintofundshareholdersasagroup.Infact,theyincuralossequaltothetransactioncoststheypaytothose“Helpers”thatWarrenBuffettwarnedusaboutinChapter1.

Investorspayfartoolittleattentiontothecostsofinvesting.It’sespecially

easytounderratetheirimportanceundertoday’sthreeconditions:(1)whenstockmarketreturnshavebeenhigh(since1980,stockreturnshaveaveraged11.5percentperyear,andtheaveragefundhasprovidedanontrivial—butclearlyinadequate—returnof10.1percent);(2)wheninvestorsfocusonshort-termreturns,ignoringthetrulyconfiscatoryimpactofcostsoveraninvestmentlifetime;and(3)whensomanycostsarehiddenfromview(portfoliotransactioncosts,thelargelyunrecognizedimpactoffront-endsaleschanges,andtaxesincurredonfunddistributionsfromcapitalgains,oftenrealizedunnecessarily).

Perhapsanexamplewillhelp.Let’sassumethatthestockmarketgeneratesatotalreturnaveraging7percentperyearoverahalfcentury.Yes,thatmayseemalongtime.Butaninvestmentlifetimeisnowactuallyevenlongerthanthat—65or70yearsforaninvestorwhogoestoworkatage22;beginstoinvestimmediatelyandworksuntil,say,age65;andthencontinuestoinvestoveranactuariallifeexpectancyof20ormoreyearsthereafter.Nowlet’sassumethattheaveragemutualfundoperatedatacostofatleastanassumed2percentperyear.Result:anetannualreturnofjust5percentfortheaveragefund.

$10,000growsto$294,600...orto$114,700.Wheredidthat$179,900go?

Basedontheseassumptions,let’slookatthereturnsearnedon$10,000over50years(Exhibit4.1).Assuminganominalannualreturnof7percent,thesimpleinvestmentinthestockmarketgrowsto$294,600.Why?Themagicofcompoundingreturnsoveraninvestmentlifetime.Intheearlyyears,thelineshowingthegrowthata5percentannualratedoesn’tlookallthatdifferentfromthegrowthinthestockmarketitself.

EXHIBIT4.1TheMagicofCompoundingReturns,theTyrannyofCompoundingCosts:Growthof$10,000over50Years

But,eversoslowly,thelinesbegintodiverge,finallyresultinginatrulydramaticgap.Bytheendofthe50-yearperiod,thevalueaccumulatedinthefundtotalsjust$114,700,anastoundingshortfallof$179,900tothecumulativereturnearnedinthemarketitself.Why?Thetyrannyofcompoundingcostsoverthatlifetime.

Intheinvestmentfield,timedoesn’thealallwounds.Itmakesthemworse.Wherereturnsareconcerned,timeisyourfriend.Butwherecostsareconcerned,timeisyourenemy.Thispointispowerfullyillustratedwhenweconsiderhowmuchofthevalueofthe$10,000investmentiserodedwitheachpassingyear(Exhibit4.2).

EXHIBIT4.2TheTyrannyofCompounding:Long-TermImpactofLaggingtheMarketby2Percent

Bytheendofthefirstyear,onlyabout2percentofthepotentialvalueofyourcapitalhasvanished($10,700vs.$10,500).Bythe10thyear,17percenthasvanished($19,700vs.$16,300).Bythe30thyear,43percenthasvanished($76,100vs.$43,200).Andbytheendofthe50-yearinvestmentperiod,costshaveconsumed61percentofthepotentialaccumulationavailablesimplybyholdingthemarketportfolio,leavingonly39%fortheinvestor.

Youputup100percentofthecapitalandyouassume100percentoftherisk.Butyouearnlessthan40percentofthepotentialreturn.

Inthisexample,theinvestor,whoputup100percentofthecapitalandassumed100percentoftherisk,earnedlessthan40percentofthepotentialmarketreturn.Oursystemoffinancialintermediation,whichputupzeropercentofthecapitalandassumedzeropercentoftherisk,essentiallyconfiscated60percentofthatreturn.

Irepeat:Whatyouseeinthisexample—andpleasedon’teverforgetit!—isthatoverthelongterm,themiracleofcompoundingreturnshasbeenoverwhelmedbythetyrannyofcompoundingcosts.Addthatmathematicalcertaintytotherelentlessrulesofhumblearithmeticdescribedearlier.

Simplyput,ourfundmanagers,sittingatthetopoftheinvestmentfoodchain,haveconfiscatedanexcessiveshareofthereturnsdeliveredbyourfinancialmarkets.Fundinvestors,inevitablyatthebottomofthefoodchain,havebeen

leftwithashockinglysmallshare.Investorsneednothaveincurredthatloss,fortheycouldhaveeasilyinvestedinasimple,verylow-costindexfundtrackingtheS&P500.

Costsmakethedifferencebetweeninvestmentsuccessandinvestmentfailure.

Inshort,thehumblearithmeticofinvesting—thelogical,inevitable,andunyieldingpenaltyassessedbyinvestmentcosts—hasdevastatedthereturnsearnedbymutualfundinvestors.UsingJusticeBrandeis’sformulation,ourmutualfundmarketersseem“obsessedwiththedelusion”thatinvestorscapture100percentofthestockmarket’sreturn—andarefoistingthatdelusiononinvestors.

Whenourfundmarketerscitethestockmarket’shistoricalannualreturnof9.5percentsince1900andignorefundexpensesof2percentandinflationof3percent,theysuggestthatinvestorscanexpectareal,after-costreturnof9.5percent.Well,tostatetheobvious,theyshouldn’t.Youneedonlyaddandsubtractforyourself.Thetruthisthattherealreturntoinvestorsequals(youguessedit!)only4.5percent.

Fundinvestorsdeserveafairshake.

Unlessthefundindustrygivesitsinvestorsafairshakeandimprovesthenetreturnthatitdeliverstofundshareholders,itwillfalterandfinallyfail—avictim,yes,oftherelentlessrulesofhumblearithmetic.Werehelookingoveryourshoulderasyoureadthisbook,JusticeBrandeissurelywouldbewarningyou,“Remember,Oreader,thatarithmeticisthefirstofthesciencesandthemotherofsafety.”

Costsmakethedifferencebetweeninvestmentsuccessandinvestmentfailure.So,sharpenyourpencils.Doyourownarithmetic.Realizethatyouarenotconsignedtoplayingthehyperactivemanagementgamethatisplayedbytheoverwhelmingmajorityofindividualinvestorsandmutualfundownersalike.Thelow-costindexfundistheretoguaranteethatyouwillearnyourfairshareofwhateverreturns—positiveornegative—ourbusinessesearnandtheirstockpricesanddividendsdeliver.

Don’tTakeMyWordforItTheinnatesuperiorityoftheindexfundhasbeenendorsed(perhapsgrudgingly)byawiderangeofmutualfundindustryinsiders.Whenheretired,here’swhatPeterLynch,thelegendarymanagerwhosteeredFidelityMagellanFundtosuchgreatsuccessduringhis1977to1990tenure,hadtosayinBarron’s:“TheS&Pisup343.8percentfor10years.Thatisafour-bagger.Thegeneralequityfundsareup283percent.Soit’sgettingworse,thedeteriorationbyprofessionalsisgettingworse.Thepublicwouldbebetteroffinanindexfund.”

***

NowhearindustryleaderJonFossel,formerchairmanoftheInvestmentCompanyInstituteandoftheOppenheimerFunds,intheWallStreetJournal:“Peopleoughttorecognizethattheaveragefundcanneveroutperformthemarketintotal.”(Italicsadded.)

***

Evenhyperactiveinvestorsseemtobelieveinindexingstrategies.Here’swhatJamesJ.Cramer,moneymanagerandhostofCNBC’sMadMoney,says:“Afteralifetimeofpickingstocks,IhavetoadmitthatBogle’sargumentsinfavoroftheindexfundhavemethinkingofjoininghimratherthantryingtobeathim.Bogle’swisdomandcommonsense[are]indispensable...foranyonetryingtofigureouthowtoinvestinthiscrazystockmarket.”(Sofar,Mr.Cramerdoesn’tseemtohavetakenhisownadvice.)

***

Andevenmanagersofalternativeinvestmentsjointhechorus.Oneofmoneymanagement’sgiants,CliffordS.Asness,managingandfoundingprincipalofAQRCapitalManagement,addshisownwisdom,expertise,andintegrity:“Market-capbasedindexingwillneverbedrivenfromitsdeservedperchascoreanddeservedkingoftheinvestmentworld.Itiswhatweshouldallownintheoryandithasdeliveredlow-costequityreturnstoagreatmassofinvestors...thenowandforeverking-of-the-hill.”

Note1I’veignoredthehiddenopportunitycostthatfundinvestorspay.Most

equityfundsholdabout5percentincashreserves.Ifstocksearnareturnof7percentandthesereservesearn2percent,thatcostwouldaddanother0.25percentagepointstotheannualcost(5percentofassetsmultipliedbythe5percentdifferentialinearnings).

ChapterFiveFocusontheLowest-CostFunds

TheMoretheManagersTake,theLesstheInvestorsMake.NEARLYALLFUNDEXPERTS,adviserstoinvestors,thefinancialmedia,andinvestorsthemselvesrelyheavily—indeedalmosttotheexclusionofotherinformation—onselectingfundsbasedontheirpastperformance.Butwhilepastperformancetellsuswhathappened,itcannottelluswhatwillhappen.Indeed,asyouwilllaterlearn,emphasisonfundperformanceisnotonlynotproductive;itiscounterproductive.Ourowncommonsense,deepdown,tellsus:Performancecomesandgoes.

Butthereisonepowerfulfactorinshapingfundreturns,oftenignored,thatisessentialtoknow:Youcanbemoresuccessfulinselectingwinningfundsbyfocusing,notontheinevitableevanescenceofpastperformance,butonsomethingthatseemstogoonforeveror,morefairly,afactorthathaspersistedinshapingfundreturnsthroughoutthefundindustry’slonghistory.Thatfactoristhecostofowningmutualfunds.Costsgoonforever.

Fundperformancecomesandgoes.Costsgoonforever.

Whatarethesecosts?Thefirstandbestknownisthefund’sexpenseratio,andittendstochangelittleovertime.Althoughsomefundsscaledowntheirfeeratesasassetsgrow,thereductionsareusuallysufficientlymodestthathigh-costfunds(averageexpenseratioofthehighest-costdecilefunds,2.40percent)tendtoremainhigh-cost;lower-costfundstendtoremainlower-cost(fourthdecileaverageexpenseratio,0.98percent),andthefewverylow-costfundstendtoremainverylow-cost(lowest-costdecileaverageexpenseratio,0.32percent).Theaverage-costfundsinthefifthandsixthdeciles(1.10percentand1.24percent)alsotendtopersistinthatcategory.

Thesecondlargecostofequityfundownershipisthesaleschargepaidoneachpurchaseofshares.Thedragofsalesloadsisalmostinvariablyignoredinthepublisheddata,althoughit,too,tendstopersist.Loadfundsrarelybecomeno-loadfunds,andviceversa.1(Icanrecallnolargefundorganizationmakingtheimmediateconversionfromaloadtoano-load

distributionsystemsinceVanguardtookthatunprecedentedstepwaybackin1977.)

Thethirdmajorcostincurredbyfundinvestorsisthecostofthepurchaseandsaleofportfoliosecurities.Thesetransactionscostmoney.Weestimatethatturnovercostsareroughly0.5percentoneachpurchaseandeachsale,meaningthatafundwith100percentportfolioturnoverwouldcarryacosttoshareholdersofabout1percentofassets,yearafteryear.Similarly,50percentturnoverwouldcostabout0.50percentperyearofafund’sreturns.A10percentturnoverwouldslashthecostto0.10percent,andsoon.

Ruleofthumb:assumethatafund’sturnovercostsequal1percentoftheturnoverrate.In2016,purchasesandsalesofportfoliosecuritiesinequitymutualfundstotaled$6.6trillion,equalto78percentofaverageequityfundassetsof$8.4trillion.Thecostofallthattrading,oftenamongcompetitors,cametosomethinglike$66billion,anannualcostequalto0.8percentoffundassets.

Costsarelarge,andtoooftenignored.

Mostcomparisonsoffundcostsfocussolelyonreportedexpenseratios,anduniformlyfindthathighercostsareassociatedwithlowerreturns.Thispatternholdsnotonlyforequityfundsasagroup,butineachofthenineMorningstarstyleboxes(large-,mid-,andsmall-capfunds,eachsortedintothreefundgroupswitheithergrowth,value,orblendedobjectives).

Whilefewindependentcomparisonstakeintoaccounttheadditionalcostoffundportfolioturnover,asimilarrelationshipexists.Fundsinthelowest-turnoverquartilehaveconsistentlyoutperformedthoseinthehighest-turnoverquartileforallequityfundsasagroup,andineachoftheninestyleboxes.

Addingtheseestimatedturnovercoststoeachfund’sexpenseratiomakestherelationshipbetweenfundcostsandfundreturnssheerdynamite.Takingintoaccountbothcosts,wefindthatall-inannualcostsofactivelymanagedequityfundsrangefrom0.9percentofassetsinthelowest-costquartileto2.3percentinthehighest-costquartile,asshowninExhibit5.1.(Thisexerciseignoressaleschargesandthereforeoverstatesthenetreturnsearnedbythefundsineachquartile.)

Costsmatter.Alot.

EXHIBIT5.1EquityMutualFunds:ReturnsversusCosts,1991–2016

AnnualRateCosts

CostQuartile

GrossReturn

ExpenseRatio

Turnover(est.)

TotalCosts

NetReturn*

CumulativeReturn

Risk**

One(lowestcost)

10.3% 0.71% 0.21% 0.91% 9.4% 855% 16.2%

Two 10.6 0.99 0.31 1.30 9.3 818 17.0Three 10.5 1.01 0.61 1.62 8.9 740 17.5Four(highestcost)

10.6 1.44 0.90 2.34 8.3 632 17.4

500IndexFund

9.2% 0.04% 0.04% 0.08% 9.1% 783% 15.3%

*Thisanalysisincludesonlyfundsthatsurvivedthefull25-yearperiod.Thus,thesedatasignificantlyoverstatetheresultsachievedbyequityfundsduetosurvivorshipbias.

**Annualstandarddeviationofreturns.

Costsmatter!Exhibit5.1showsa1.4percentdifferencebetweentheaverageexpenseratiooffundsinthehighest-costquartileandthelowest-costfunds.Thiscostdifferentiallargelyexplainstheadvantageinreturnsamongthelowest-costfundsoverthehighest-costfunds.Duringthepast25years:averagenetannualreturnoflowest-costfunds,9.4percent;netannualreturnofhighest-costfunds,just8.3percent,anenhancementinreturnachievedsimplybyminimizingcosts.

Note,too,thatineachofthefundquartiles,whenweaddbackfundcoststothefunds’reportednetreturns,thegrossannualreturnsearnedineachcategoryarevirtuallyidentical.Thosegrossreturns(beforecosts)fallintoanarrowrange:10.6percentforthehighest-costquartileand10.3percentforthelowest-costquartile,justwhatwemightexpect.Ineachquartilecostsaccountforessentiallyallofthedifferencesintheannualnetreturnsearnedbythefunds.

Thereisyetanothersignificantdifference.Ascostsincrease,sodoesrisk.Usingthevolatilityofannualreturnsasthemeasureofrisk,thelowest-costfundscarriedsignificantlylessrisk(averagevolatilityof16.2percent)than

theirhighest-costpeers(17.4percent).Whenwetakethatreductioninriskintoaccount,therisk-adjustedannualreturnforthelowest-costquartilecomesto8.9percent,fully1.5percentagepointshigherthanthe7.4percentrisk-adjustedreturnofthehighest-costquartile.

Themagicofcompounding,again.

That1.5percentannualadvantageinrisk-adjustedreturnmaynotseemlikemuch.Butwhenwecompoundthoseannualreturnsovertime,thecumulativedifferencereachesstaggeringproportions.Thecompoundreturnfortheperiodis855percentforthelowest-costfundsand632percentforthehighest-costfunds,anincreaseofmorethan35percent,asuperiorityarisingalmostentirelyfromthecostdifferential.Talkabouttherelentlessrulesofhumblearithmetic!

Inotherwords,thefinalvalueofthelowest-costfundsmultipliedtheoriginalinvestmentmorethaneightfold,whilethehighest-costquartilereturnsweremultipliedaboutsixfold.Surely“fishinginthelow-costpond”shouldenhanceyourreturns,andbyawidemarginatthat.Again,yes,costsmatter!

Areweoverstatingtheimportanceoffundcosts?Ithinknot.ThesenextfewparagraphsfromarespectedanalystatMorningstarconfirmmyconclusions,andthensome:

Ifthere’sanythinginthewholeworldofmutualfundsthatyoucantaketothebank,it’sthatexpenseratioshelpyoumakeabetterdecision.Ineverysingletimeperiodanddatapointtested,low-costfundsbeathigh-costfunds.

Expenseratiosarestrongpredictorsofperformance.Ineveryassetclassovereverytimeperiod,thecheapestquintileproducedhighertotalreturnsthanthemostexpensivequintile.

Investorsshouldmakeexpenseratiosaprimarytestinfundselection.Theyarestillthemostdependablepredictorofperformance.Startbyfocusingonfundsinthecheapestortwocheapestquintiles,andyou’llbeonthepathtosuccess.

Lowcostsandindexfunds.

Butifyouarepersuadedbythispowerfulaffirmationthat,yes,costsmatter,

anddecidetofocusonthelowest-costgroupoffunds,whylimitthesearchtoactivelymanagedfunds?Traditionalindexfunds(TIFs)hadthelowestcostsofall:expensesaveragingjust0.1percentduringthisperiod.Withnomeasurableturnovercosts,itstotalall-incostswerebut0.1percent.ThegrossreturnoftheS&P500Indexfundwas9.2percentperyear;thenetreturn,9.1percent.Carryingalowerriskthananyofthefourcostquartiles(volatility15.3percent),itsrisk-adjustedannualreturnwasalso9.1percent,acumulativegainthatrankedtheindexfundaheadofeventhelowest-costquartilefundsby0.2percentperyear.

Ifthemanagerstakenothing,theinvestorsreceiveeverything:themarket’sreturn.

Caution:Theindexfund’sannualrisk-adjustedreturnof9.1percentoverthepast25yearsisallthemoreimpressivesincethereturnsoftheactiveequityfundsareoverstated(asalways)bythefactthatonlythefundsthatweregoodenoughtosurvivethedecadeareincludedinthedata.Adjustedforthis“survivorshipbias,”thereturnoftheaverageequityfundwouldfallfrom9.0percenttoanestimated7.5percent.

What’smore,selectingtheindexfundeliminatedtheneedtosearchforthoserareneedlesinthemarkethaystackrepresentedbytheveryfewactivefundsthathaveperformedbetterthanthathaystack,intheoften-vainhopethattheirwinningwayswillcontinueoverdecadesyettocome.

AsMorningstarsuggests,ifinvestorscouldrelyononlyasinglefactortoselectfuturesuperiorperformersandtoavoidfutureinferiorperformers,thatfactorwouldbefundcosts.Therecordcouldhardlybeclearer:Themorethemanagersandbrokerstake,thelesstheinvestorsmake.Again,ifthemanagersandbrokerstakenothing,theinvestorsreceiveeverything(i.e.,thetotalreturnofthestockmarket).

Don’tTakeMyWordforItAsfarbackas1995,TylerMathisen,nowManagingEditorofCNBCBusinessNews,deservescreditforbeingamongthefirstjournalists—ifnotthefirst—torecognizetheimportantrolethatmutualfundcosts(expenseratios,turnovercosts,andunnecessarytaxes)playinerodingthereturnsdeliveredtomutualfundshareholders.Mathisen,thenexecutiveeditorofMoney,concededthesuperiorityofthelow-cost,low-turnover,

tax-efficientindexfund:

“Fornearlytwodecades,JohnBogle,thetart-tonguedchairmanoftheVanguardGroup,haspreachedthevirtuesofindexfunds—thoseboringportfoliosthataimtomatchtheperformanceofamarketbarometer.Andformuchofthattime,millionsoffundinvestors(nottomentiondozensoffinancialjournalistsincludingthisone)basicallyignoredhim.

“Sure,werecognizedtheintrinsicmeritsofindexfundssuchaslowannualexpensesandbecausethefundskeepturnovertoaminimum,tinytransactioncosts.Moreover,becauseindexfundmanagersconvertpaperprofitsintorealizedgainslessfrequentlythandotheskippersofactivelymanagedfunds,shareholderspaylesstaxeachyeartoUncleSam.Tobesure,thosethreeadvantagesformatrioasimpressiveasDomingo,Pavarotti,andCarreras.

“Well,Jack,wewerewrong.Youwin.Settlingforaverageisgoodenough,atleastforasubstantialportionofmostinvestors’stockandbondportfolios.Infact,moreoftenthannot,aimingforbenchmark-matchingreturnsthroughindexfundsassuresshareholdersofabetter-than-averagechanceofoutperformingthetypicalmanagedstockorbondportfolio.It’stheparadoxoffundinvestingtoday:Gunningforaverageisyourbestshotatfinishingaboveaverage.

“We’vecomearoundtoagreeingwiththesometimesprickly,alwaysprovocative,fundexecknowntoadmirersanddetractorsalikeasSaintJack:Indexingshouldformthecoreofmostinvestors’fundportfolios.Sohere’stoyou,Jack.Youhavearighttocallit,asyourecentlydidinabookletyouwrote,TheTriumphofIndexing.”

(Thanks,Tyler!)

Note1Theuseoffront-endloadshasdiminishedinrecentyears,oftenreplacedby

“spreadloads”thatsharplyincreasefundexpenseratios.Forexample,theAshareclassofferedbyoneofthelargestmutualfunddistributorscarriedafront-endloadof5.75percentin2016,andanexpenseratioof0.58percent.ThedistributornowoffersanewT-shareclassofitsfunds,carryingafront-endloadof2.5percentplusanannualmarketingcostofanadditional0.25percentperyearthatmustbepaidforaslongastheinvestorownstheshares.Thisannualfeewillraisethefund’sexpenseratiostoanestimated0.83percent.

ChapterSixDividendsAretheInvestor’s(Best?)Friend

ButMutualFundsConfiscateTooMuchofThem.DIVIDENDYIELDSAREAvitalpartofthelong-termreturngeneratedbythestockmarket.Infact,since1926(thefirstyearforwhichwehavecomprehensivedataontheS&P500Index),dividendshavecontributedanaverageannualreturnof4.2percent,accountingforfully42percentofthestockmarket’sannualreturnof10.0percentfortheperiod.

Anastonishingrevelation.

Compoundedoverthatlongspan,dividendsmadeacontributiontothemarket’sappreciationthatisalmostbeyondbelief.Excludingdividendincome,aninitialinvestmentof$10,000intheS&P500onJanuary1,1926,wouldhavegrowntomorethan$1.7millionas2017began.Butwithdividendsreinvested,thatinvestmentwouldhavegrowntosome$59.1million!Thisastonishinggapof$57.4millionbetween(1)marketpriceappreciationaloneand(2)totalreturnwhendividendsarereinvestedsimplyreflects(onceagain)“themagicofcost-freecompounding”(Exhibit6.1).

EXHIBIT6.1S&PPriceReturnversusTotalReturn

ThestabilityoftheannualdividendspershareoftheS&P500istrulyremarkable(Exhibit6.2).Overthe90-yearspanbeginningin1926,therewereonlythreesignificantdrops:(1)a55percentdeclineduringthefirstyearsoftheGreatDepression(1929–1933);(2)a36percentdeclineintheDepression’saftermathin1938;and(3)a21percentdeclineduringtheglobalfinancialcrisisof2008–2009.Thismostrecentdeclineoccurredlargelybecausebankswereforcedtoeliminatetheirdividends.Dividendspershareonthe500Indexfellfrom$28.39in2008to$22.41in2009,butreachedanewhighof$45.70in2016,60percentabovetheearlierpeakin2008.

Mutualfundmanagersgivedividendincomealowpriority.

EXHIBIT6.2S&P500—DividendsperShare

Giventheobviouspowerofcompoundingdividendsoverthelongtermandtherelativestabilityofcorporatedividendpayouts,activelymanagedmutualfundsmustgivedividendincomeahighpriority.Right?

Wrong!Becausemutualfundmanagementcontractsconsistentlycallforadvisoryfeesthatarebasedonafund’snetassets—notonitsdividendincome.Whenstockmarketdividendyieldsarelow(asinrecentyears),fundexpensesconsumeahugeshareofthetotaldividendincomeearnedbyfunds.

Theresult:astaggeringproportionofequityfunddividendincomeisconsumedbyexpenses.“Staggering”isnooverstatement.Inactivelymanagedgrowthfunds,expensesactuallyconsume100percent(!)offund

income.Inactivelymanagedvaluefunds,expensesconsume58percentofdividendincome.

Thecontrastbetweenactivelymanagedfundsandcomparableindexfundsisstark.Thecomparablevalueindexfundexpensesconsumed2percentoffundincomein2016;theexpensesonalow-costgrowthindexfundconsumedjust4percent(Exhibit6.3).

Activelymanagedequityfundsconfiscateyourdividendincome.

EXHIBIT6.3DividendYieldsandFundExpenses,2016

ActivelyManagedFunds

GrossYield

ExpenseRatio

NetYield

ShareofGrossYieldConsumedbyExpenses

Growthfunds 1.3% 1.3% 0.0% 100%Valuefunds 2.1 1.2 0.9 58Low-CostIndexFundsGrowthfunds 1.4% 0.1% 1.3% 4%Valuefunds 2.5 0.1 2.4 2

Source:Morningstar.

Despitethepowerfulimpactofdividendsonlong-termreturns,you,likenearlyallinvestors,arelikelyunawareofthisastonishingconfiscationofdividendincome.Howcouldyouknow?Whileitmaybepossibletocalculatethesedatafromafund’sfinancialstatements,thosestatementsarehardlybeaconsoffull,clear,andforthrightdisclosure.

Sowhynotconsideralow-costindexfund,whichhasnoactiveportfoliomanager;hasanannualexpenseratioaslowas0.04percent;whichdeliversyourfairshareofthefund’sdividendincome;anddoesvirtuallynotradingofstocksthroughthoseHelpersmentionedattheoutset?Whynot,indeed?Chapter13exploresthisideafurther.

Don’tTakeMyWordforItAbloggerwhogoesbythename“DividendGrowthInvestor”pickeduponmymessageabouttheimportanceofdividendsandwroteanarticlethatechoesmydividendphilosophy.

“JohnBogleisaninvestinglegend....Ihavereadseveralofhisbooks,andreallyenjoyedhissimplemessages.IreallylikedBogle’smessageonkeepingcostslow,keepingturnoverlow,stayingthec