Chapter 1: A Parable
You can read this first chapter in its entirety on John Bogle’s personal site, but suffice it to say that much of the chapter focuses on a retelling of Warren Buffett’s classic tale of the Gotrocks and the Helpers. In a nutshell, the point of the tale is that individuals that you have to pay to help you make wise investment choices are actually taking money away from you instead of helping you make more money. The moral is, in Buffett’s words, that for investors as a whole, returns decrease as motion increases. An effective individual investor should thus look for steady investments with few middlemen – and middlemen that charge minimally for their services.
Chapter 2: Rational Exuberance
From the Gotrocks parable of the first chapter, Bogle attempts to apply the lesson of the story to stocks. He compares, over the long term, the return on investment for businesses versus the return on investment for stocks and finds that their correlation is very tight. What does that mean? Over the long haul, an investment in the stock of a business will match the success of the business itself. There may be short term twists in investor emotions, but when you buy a stock for a long haul, you’re buying into the underlying business. Thus, short term stock market investing is a completely different game than long term investing, and Bogle admits to not having an understanding of investor emotion which is required to play the short term game. I guess if you’re interested in short term individual stock picking, turn to someone like Jim Cramer.
Chapter 3: Cast Your Lot With Business
Here, Bogle pulls out Ockham’s razor, which basically states that all things being equal, the simplest solution tends to be the best one. From there, he talks about the general investing strategy of investing in a very wide array of stocks (he uses the S&P 500 as an example) matches the overall success of the stock market over a long term. Then he compares the S&P 500 to large cap funds from other companies and finds that in 26 of the last 35 years, the S&P 500 outpaces the average large cap fund from other companies. Why is this?
Chapter 4: How Most Investors Turn a Winner’s Game into a Loser’s Game
Bogle effectively answers this question in the following chapter by stating that the stock market is a zero-sum game. For every stock that beats the market, there is a stock that doesn’t beat the market. Adding them together matches the market. Common sense, right? For the truly average investor, half of the stocks he or she picks will beat the market, and half will not beat the market, averaging out to the value of the market. However, this is before fees. If you add in fees, the average investor will not beat the market; their return on investment will be less than the market, and substantially less if the fees are high. If the market returns 8% and you’re paying 2.5% in fees, your return is only actually 5.5% – you might as well have your money in a savings account. Thus, this average investor should focus on minimizing fees before anything else.
Chapter 5: The Grand Illusion
This chapter goes in a new direction, demonstrating that emotion is often the cause of additional weakness in investor returns. Investors tend to buy into the stock market as it races upward, but by doing that, they forego a large portion of the gains. Here’s an example. Let’s say that the stock market is at 10,000 at the beginning of 2010. At the beginning of 2011, the stock market is up to 11,000, a gain of 10%. People decide to buy in after seeing the stock market go up, so it continues to go up and attract new investors. At 2013, the market peaks at 13,000, then begins to go back down, bottoming out at the 11,500 mark at the start of 2014. The people in at the beginning, sitting there quietly and calmly, earned an annual average of about 4%, while the people who bought in only when it was going up a year later only earned 2% annually. In other words, calm and steady investing wins the race through market fluctuations.
Chapter 6: Taxes Are Costs, Too
Yet another challenge to the equity investor is that of taxes, which are addressed in Chapter 6. In a nutshell, actively managed mutual funds are terrible from a tax perspective because they regularly must pay distributions – by law, a fund must distribute at least 90% of its realized capital gains and dividend income each year. This means an actively managed fund, which has sold a bunch of stocks throughout the year and made a real gain on them, must pay out 90% of that gain to the holders of the fund. Most people just roll that back into the fund, making their investment value the same, but they must pay capital gains taxes on the amount of the distribution. In other words, the less active management a fund does, the better for the shareholders because there’s a much smaller chance for a distribution at the end of the year. An index fund has only a tiny amount of active management (just to match the index), so they rarely pay out a distribution and thus rarely incur taxes. So, compared to an actively managed mutual fund, an index fund is far better for tax purposes.
Chapter 7: When the Good Times No Longer Roll
Here, the book looks at periods of lower returns, mostly because, as noted at the beginning of the chapter, it is widely believed that we are heading into such an era. In such a period, the real returns of a managed mutual fund will reach 0% far quicker than an index fund will, meaning that you’re much more likely to have periods over the long haul where you lose money in a managed fund than you will with an index fund. It’s easy to find periods where index funds lost money and a particular managed fund had a gain, but those are huge anomalies because of the factors riding against it.
Chapter 8: Selecting Long-Term Winners
This chapter mostly lays out the performance of managed mutual funds over a 35 year period. Over those thirty five years, less than one percent of the funds actually beat the market by more than 2% per year and survived the investor growth that went along with it, and likely over the next thirty five years, none of those funds will be able to repeat the feat due to turnover in fund manager and changing market dynamics. In other words, managed funds over the long haul almost always fail to beat the overall stock market.
Chapter 9: Yesterday’s Winners, Tomorrow’s Losers
What about the short term? Obviously, some funds are better poised to take advantage of boom times in certain areas than others. For example, some funds did a fantastic job of capitalizing on the dot-com boom in the late 1990s, dominating the market in 1998 and 1999. What happened to those funds? Almost universally, they saw incredibly huge collapses in 2000-2002, far exceeding the downturn in the overall market. Even averaging them out results in a return much worse than the market itself. If you are interested in doing a short-term dance, you could make money this way, but investing in specific sectors isn’t a healthy long-term situation.
Chapter 10: Seeking Advice to Select Funds?
So, should you spend money on an investment advisor? This chapter gives a resounding “no.” In fact, most advisors do far, far worse than the market once their fees are calculated in. Instead, just take your cash and invest directly into index funds yourself, and then don’t worry about it. As for me, this is already what I’m doing, and I couldn’t be happier about it.
Chapter 11: Focus on the Lowest-Cost Funds
Starting here, the book talks about how you can select a fund of your own, which is a pretty sizable task given the enormous number of funds available out there. How do you start eliminating funds? The first thing you should do is eliminate all funds with high fees. Ignore performance for now because it comes and goes (the lesson of chapters eight through ten), but costs go on forever. To demonstrate how important this is, Bogle takes a huge selection of funds of all types and groups them into four groups based on their fees, and over the long haul the lowest fee group does the best. Why? The performance of all four groups roughly averages out, so the fees make up the difference.
Chapter 12: Profit from the Majesty of Simplicity
Now that you’ve focused in on funds with low fees, the next step that Bogle recommends is to invest in a fund that covers the whole market, like something that indexes with the S&P 500 or the Wilshire 2000. Why? These funds have their feet in every sector, so when a particular sector goes up, you get a boost, but you don’t die when a particular sector goes down, either. The conclusion that comes about here is that your first mutual fund investment, especially one you’re in for the long haul, should be in an index fund that represents the broad market.
Chapter 13: Bond FUnds and Money Market Funds
The premise of this chapter is simple: money market funds and bond funds follow the same trends that stock funds follow. In other words, if you’re going to buy a mutual fund that invests in equities other than stocks, you should also buy a broad-based index fund with low fees. The chapter gives several examples of how this is true.
Chapter 14: Index Funds That Promise to Beat the Market
What about an index fund that’s advertised to beat the market? These funds use some statistical method to select some portion of the market and simply sit on the results of that statistical method. What this really comes down to, though, is the trust you put in this statistical method, and the trust shouldn’t be strong. Why? These methods are based on historical data, and over and over again it is demonstrated that past performance does not indicate future results. Similarly, by using a “filtering” method, this isn’t really an index fund at all, but an actively managed fund using a very simplistic strategy. Bogle advises using the basic investment ideas from chapters 11 and 12 – often, you’ll discover the fees are high or that they don’t broadly cover the market.
Chapter 15: The Exchange Traded Fund
Here, the book talks about exchange traded funds, or mutual funds that are traded on the stock market like normal stocks. Bogle believes that over a long period, these ETFs do match the mutual fund that they’re intended to represent, but that the same rules apply: look for ones that represent the broad market and that you can own for a very low cost. Then hold them. Active trading of these is no different than active trading of ordinary stocks – the fees and taxes will eat you alive.
Chapter 16: What Would Benjamin Graham Have Thought about Indexing?
In this chapter the book begins to wind down. Bogle uses various quotes from Benjamin Graham (the father of value investing) and Warren Buffett to support the idea of investing in index funds – interesting, but not as meaty as the previous chapters.
Chapter 17: “The Relentless Rules of Humble Arithmetic”
This chapter is basically a continuation of the previous one. Bogle cites tons of investors who completely agree with the investment philosophy expressed in the book. Again, little meat, but it does summarize the main points of the book quite well.
Chapter 18: What Should I Do Now?
The book ends with a bang, however, as Bogle lays out what an individual investor should do with the information contained within the book. Obviously, he’s a fan of investing in broad-based index funds with tiny fees, but he also suggests having a small amount of your portfolio (5% or so) in funny money that you can play with. That money should go into things like individual stocks, actively managed funds, ETFs, and commodities like gold. This way, most of your portfolio can float with the market, but you do have the ability to speculate a bit.
Buy or Don’t Buy?
This book does a fantastic job of laying out the reasoning behind a seemingly very simple investing strategy, one that demonstrably works. If you’re interested in learning the basics of a real-world investment philosophy spelled out smoothly enough for the average person to really understand it, buy this book. I must admit that I am also partial to the book because Bogle is describing the investment philosophy that I subscribe to, but I am recommending this book because of the clarity and focus of the writing.
Be warned, however, that this is not a get-rich-quick investment philosophy. This book does not tell you how to beat the stock market, but it does tell you how to match the market over and over again with minimal effort. Because of that, this philosophy is as low-risk as can be for investing in stocks, and thus I would really recommend this book to someone who is just getting their toes wet in investing. More experienced investors may not get nearly as much out of this book because they either already subscribe to this philosophy (or another one) or are seeking a complex investment strategy.
The Little Book of Common Sense Investing is the twenty-sixth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.