Common Sense

I finally read "Common Sense on Mutual Funds" by the late, great John ("Jack") Bogle. I feel like I've been reading around this book for a decade, poking away at Bogle's shorter works and various books by other authors that occupy similar spaces and quote from it. I've enjoyed actually going to the source and directly experiencing it.

 

I read the second edition, published in 2009, and really loved how it's structured: it has the exact same text as the original edition from 1999, but with all of the tables and graphs extended to the right to show the next 10 years of data. He also includes periodic boxes labeled "10 Years Later", within which he adds new commentary on how the additional evidence of the last 10 years has affected his earlier analysis. In nearly every case it confirms his earlier assertions: sometimes he regrets being too cautious in his initial pronouncements, but I can't think of a single instance where he was wildly off the mark. It's especially interesting because the 1999-2009 period was basically the reverse of the 1989-1999 period: the 90s were a period of huge and largely uninterrupted growth, while the 2000s were bracketed by two major bear markets and overall resulted in flat or negative returns. And yet, the overall principles Bogle lays down remained as true in the "winter season" of the future as they had in the "summer season" of the past.

I think that this second-edition update is structured basically like how Burton Malkiel's "A Random Walk Down Wall Street" went in the later editions: he updates the relevant figures and charts, but the overall argument has remained identical over the last five decades. And that's really remarkable for both books! As many others have observed, it's easy to sift through past data and invent a model that would have made money in the past. It's significantly harder to work with "real money", anticipating strategies that will work in the future. Both Malkiel and Bogle have the appropriate humility to recognize the limits of what we know, and solid mathematically-backed arguments for their strategies, with a healthy dose of prior data that generally aligns with their recommendations and that continue to mostly hold true into the future.

This is a big book, but well structured and readable. I enjoyed reading it cover-to-cover, but you could probably dip into specific chapters based on your interest. This is one of the more comprehensive financial books I've read, covering the fundamental theory behind investing, where earnings come from, how the industry is structured, and a strong focus on the cultural and ethical principles at play. Much of the material was already familiar to me, but even the "old stuff" was often treated in more depth or with a new perspective that I found helpful.

For example, he spends a fair amount of time writing about the equity risk premium. This is a term I've heard about a lot in my recent financial reading, and I think I'm finally getting it. In The Four Pillars of Investing, William Bernstein illustrates this principle with the example of a falafel vendor raising money for a restaurant, comparing the option of taking a loan from a bank (low risk to the bank, high risk to the entrepreneur) or finding an investor who will buy an equity stake (low risk to the entrepreneur, high risk to the investor). To entice an investor, the business needs to plausibly offer a return on the investment high enough to offset the risk of losing everything. When Bogle introduces the equity risk premium, he goes right to the real-world example of buying a Treasury versus investing in a stock. If two investments offered the same average return, but one is risk-free and the other is risky, investors would always prefer the risk-free one. In order to attract investors, the riskier investment needs to offer a higher expected (not guaranteed!) return. The difference between the risk-free rate (like a Treasury's interest rate) and the expected return on the riskier investment is the equity risk premium. (To these examples, I'm adding my own of choosing to play a game where you can either get $1M outright, or flip a coin to get either $0M or $2M. The average result of these two choices is identical, but pretty much anyone would choose the $1M guaranteed return. In order to accept the coin flip, you'd need an extra incentive.)

As I read more finance stuff, I've gradually come to realize that some things are pure mathematical relationships, like the inverse relationship between current interest rates and the value of existing bonds. Other things describe trends we have observed over time but that aren't bound to natural laws, such as the P/E ratio, the Equity Risk Premium, and so on. Knowing these general trends and relationships is helpful in understanding the range and probabilities of possible outcomes, but they do not offer any guarantees. One of my favorite sayings in investment is "the market can remain irrational for longer than you can remain solvent." We can recognize that something is out of whack and is overdue for a return to the mean, but there's no way to predict when or how that return will occur.

Anyways, Bogle makes an interesting, nuanced point that I don't think I would have followed if I wasn't already primed for following this from other recent readings. Bogle makes the point in the context of his argument that seemingly small fees can make a huge impact; for example, a 0.2% versus a 2.0% expense ratio for a fund. If a fund has gross returns of 10% annually, then netting 9.8% versus 8% doesn't seem like a huge difference until after you've compounded for several years. But if a T-bill returned 6% over the same period, then you're talking about an equity risk premium of 3.8% versus 2%: essentially a doubled premium for the lower-cost fund. Given a certain (reasonable, though definitely not guaranteed) set of assumptions, he shows how an 80/20 stock/bond portfolio using an actively managed fund may have the same expected return as a 20/80 stock/bond portfolio using indexed funds. The difference is that the 20/80 portfolio bears significantly less risk than the 80/20 portfolio. I'm very used to just looking at (average, expected) returns, and it was cool to see a similarly analytical approach to quantifying the impact of costs on risk and not just reward. Anyways, I think that's neat!!

This idea connects well with William Bernstein's argument for purchasing a liability-matching portfolio. If you have a specific goal, and you can achieve that goal with no risk, then boom: you're done, and can spend the rest of your life assured that you'll never run out of money. Alternatively, you can choose to take on more risk to maximize the growth of your portfolio. Over the very long run (which may be longer than your lifetime!), the latter approach will generate more money. So, yeah: once again, risk is an important thing to consider, and fortunately something that we can think discretely about as opposed to just a hand-waving "being able to sleep at night" attitude.

Returning to mathematical certainties versus empirically-derived correlations: I think Bogle does a good job at describing when he's dealing with one type of relationship versus the other, and is especially forceful with the former and appropriately cautionary with the latter. On the mathematical side, he's insistent that, by definition, all investors as a whole must earn the average return of the market: for every manager who manages to beat the market average, there must be another investor who loses to the market average by the same amount. So (comparatively speaking) "beating the market" is a zero-sum game before costs, and once you take costs into account, more expensive actively-managed funds must, by definition, as a group, under-perform the market average.

What the market average does over time, on the other hand, is empirical, not deductive. Going back to 1820, the stock market has consistently trended upward over the long run. There's no guarantee that it will continue to do so, definitely not during a short term and possibly not over a very long term. So there is risk that investing in the market will result in a loss. But it is a certainty that low-cost (generally indexed) funds will perform better than the average actively-managed fund, whether the market is going up or not.

Bogle has a sense of pride, which I think is pretty well-earned, in creating the first commercially-available index fund, and for being generally correct about how the market works, thanks to insights like predicting long-run market returns based on the current dividend yield plus the growth rate. He claims these wins but isn't obnoxious about it.

The biggest outlier between Bogle and the contemporary Boglehead movement is definitely international investments. Pretty much everyone besides him believes in a significant international exposure; the most common belief today is probably reflecting overall global market capitalization, while many (including myself) overweight the US equity markets while still having a significant minority share of international equities. Bogle argues pretty strongly towards having an all-US portfolio, and grudgingly concedes that you might include up to 20% international for diversification purposes. I've read (and heard) his arguments before, though I think this book handles them at more length and in more depth. They include:

• The US has significantly better legal protections, liquidity, transparency, regulations, and other helpful aspects to its financial markets.
• The US has been and remains the global leader in innovation, both creating new successful businesses and growing existing ones.
• Contrarily, given the demographics of the other fully developed markets (Europe and Japan), he doesn't see much opportunity for future growth: they're already built out, and have aging populations and minimal immigration. More growth is possible in emerging markets, but also significant risk, and it's hard to say with certainty that future returns would be worth it.
• The largest US companies already have significant international exposure (earning overseas revenue, using overseas labor, etc.), so you already get some diversification while holding only US stocks.
• Everyone reading this book is a US investor spending US dollars in the US, and international investing exposes you to significant currency risk: a rising dollar will cut into international returns while a weakening dollar will boost them. As with most things in finance, he identifies a long-term reversion to the mean in relative currency strengths. At the time of publication, international stocks had provided great returns; but he notes that this was mostly due to a weakening dollar, and if you correct for the exchange rate, they actually underperformed US markets.

I think it's interesting that the one argument that he seems to (grudgingly) accept as legitimate is diversification, the idea that holding international equities will soften the blow of a broad decline in the US stock market, somewhat like bonds. I think that the diversification hypothesis has been declared dead and buried in the last 15 years: now that we're in a fully globalized world, markets are so interconnected that everything falls when the US does; I'm reminded of the phrase "When America sneezes, the rest of the world catches a cold." We saw this in 2008 (though it may not have been obvious at the time of the second edition) and has continued to hold true since. (Interestingly, the converse has not recently held true, as the US market strongly rebounded from the COVID-19 recession while Europe and Japan continued to languish.)

Pretty much everyone (including modern Bogleheads) disagrees with the rest of his points on international stocks. Taking a crack at summarizing the major counter-arguments I've heard:

• Reversion to the mean applies to the US as well as everyone else. Outperformance can't last forever.
• It's mathematically impossible for US outperformance to continue indefinitely, as it would eventually result in a US capitalization of over 100% of global markets.
• US market strength in the 20th and early 21st century has reflected US dominance (political, military, and economically) over the world. If and when these strengths decline, our market share will as well. In particular, it will be very challenging for the US to remain dominant over countries with significantly larger populations once those countries are fully developed.

It may be worth noting that Bogle wrote this book in the late 90s, and the ~25 years that have passed since then have been pretty friendly to US-only investors; in more recent years, China has emerged as a bigger long-term rival to US supremacy. So Bogle's original advice was very good to people who were reading at the time during their 10-40 year investing journeys, but it's less clear if that will continue for the rest of the century, as he briefly acknowledges in passing.

I also have been enjoying comparing Bogle's arguments with William Bernstein's "Birth of Plenty" thesis. Bernstein identifies a cluster of ingredients (including social norms as well as technology) that create significant and self-sustaining growth. Those are obviously present in the US, were present in Britain before, have been spreading to other advanced economies. But they aren't something you can flip on at will in a developing country: it requires generations of local acceptance and integration. Anyways, if Bernstein is right, then it isn't a slam-dunk that emerging markets will outperform within our lifetimes, or even our children's lifetimes. And, to be a bit more pessimistic, the best we can hope for in the future may be a sustained real growth of ~2% per year in the most advanced countries, including the US, in which case we will be no better but also not significantly worse than anyone else.

I periodically remember how things have changed. At the time that Bogle wrote the first edition of this book, mutual funds (let alone index funds) were still somewhat of an anomaly; most stocks were individually held. By the second edition nearly half of all shares were owned through mutual funds or ETFs; I assume even more are today but am too lazy to look it up. The change is primarily due to higher participation in 401ks, 403bs and IRAs, but I think the diversification and ease of use probably also contribute. I think that the shift towards mutual funds makes his arguments even more relevant, since he's mostly comparing indexed vs. actively managed mutual funds, not so much indexed vs. individual stocks.

The chapter on taxes is really interesting. One thing I hadn't thought of before is how a fund as a whole could have unrealized capital gains thanks to appreciation of its underlying stocks; in his example, if you buy a $100 mutual fund share but there's an unrealized capital gain, then you may only be getting something like $78 worth of stocks for your purchase after accounting for the tax. This tax liability reduces with additional shares, though (since the pre-existing gain is divided among more people), which gives an incentive to grow the fund. He also makes some good points about the value of deferring capital gains; that is not relevant in a tax-advantaged retirement account, but for regular taxable accounts, you can get significant benefits by compounding tax deferrals over a decade or longer. That isn't possible in funds with high turnover, as those gains must be realized when the underlying shares are sold. It seems like tax deferral isn't as relevant for dividend taxes, which must be paid the same year.

Interestingly, both Bogle and Bernstein say it's safest to own the entire market, but Bernstein likes tilting towards value while Bogle seems to slightly prefer tilting towards growth. Over very very very very long periods of time, value stocks have historically returned a bit more than growth; and they don't usually dip as far as growth stocks during downturns, so they're a bit safer to hold in a retirement portfolio. But value stocks tend to return relatively more in dividends, while growth stocks return more in capital appreciation, and Bogle likes how that gives you more control over when and how (or even if) to realize those gains.

Index funds are praised, but are a smaller part of the book than you might think. Bogle would prefer a low-cost managed fund over a high-cost indexed fund, and owning appropriate asset classes is a lot more important than being indexed. He often toys with the idea of directly owning a basket of stocks, and I suspect that he would favor that approach for very wealthy people: mutual and indexed funds are more of a convenience for those of us with extra money to invest but not the deep pockets or professional acumen to assemble our own broadly diversified portfolios. He even supports the idea of very talented managers beating the market; his concern is that you can't identify them in advance, and either they'll close their funds to maintain quality, or expand the fund and practically guarantee future mediocrity.

Early sections of the book cover the same sort of ground as "The Little Book of Common Sense Investing"; the last parts are in the same vein as "The Battle for the Soul of Capitalism", with a little of the autobiographical details of "Enough." So if you're only going to read one Bogle book, this is probably the one that has it all. He writes sternly about the responsibility mutual fund companies hold towards their clients, and how that responsibility is consistently shirked. He eventually names Vanguard and makes a much more direct and impassioned case for why it's special. By this point, hundreds of pages into the book, he's established his intelligence and his values, so it feels deserved.

It's interesting to compare the Bogle-led version of Vanguard as depicted in this book with what exists today. As I've written before, I've been a loyal Vanguard client for decades, but if I were to start investing today I would likely go with Fidelity. Something has changed - no one single decision that made Vanguard lose its way, but a series of decisions over years that he never would have agreed with. One famous one is the introduction of ETFs: Bogle consistently rails against these in the "ten years later" section, and they were brought in essentially over his dead body, after he was forced into retirement. It makes a ton of sense for Vanguard to sell ETFs - investors demand them, and they hew to most of the key Vanguard values like low cost, transparency, and simplicity. But Bogle hated them because they can be (albeit don't have to be) frequently traded like stocks, and so lead people away from the focus on long-term investing that he sees as so critical. More recently, Vanguard has forced all of us legacy users of the mutual fund interface to their new brokerage platform. Again, it makes a lot of sense: it's more economical for them to only support one interface instead of two, and the brokerage site can do almost everything the old mutual fund site could do. But again, being a brokerage is fundamentally about instant gratification, making it easy to buy and sell individual stocks and bonds with the click of a mouse. I can just hear Bogle gnashing his teeth over pushing Vanguard clients away from a long-term-focused platform to the new one.

There's a touching anecdote near the end of the book about how a major institutional investor offered to invest hundreds of millions of dollars into a small-cap short-term bond fund at Vanguard for a few months. It would have been great for the institution since they'd get a major guaranteed return, and it would be great for Vanguard since they'd get the fees and business. But Vanguard rejected it: the existing small investors of the fund would get stuck with the capital gains taxes from that large trade, despite not trading themselves (as good, disciplined long-term investors). The institution was irate, pulled all their business from Vanguard and even wrote a nasty letter in the Wall Street Journal blasting Vanguard. The company lost short-term business, but gained huge respect and loyalty from their existing customers, and attracted many new ones who admired their ethics. I don't see the Vanguard of 2024 making that same decision, and that makes me sad. I'm reminded of Bogle's insistence in Enough. of how crucial it is to focus on the thing you can't count (like reputation) over the things you can count (like quarterly sales).

Anyways! Like I said up top, I really enjoyed this book. Reading it takes a big investment (heh) in time, but it's low-risk and offers significant rewards: practical guidance on personal financial planning, a deep understanding of how markets work, and a wide-ranging, insightful survey of the mutual fund industry and the people it employs and serves. The more I read and hear from Bogle the more I admire him. Even if he's gone, and even if his version of Vanguard is fading, he's left behind an extraordinary legacy in the way individual investors think and behave.

A Little Book

Looking through my post history, it was way back on January 1st 2013 that I wrote that a particular finance book ("A Random Walk Down Wall Street") might be the last financial book I ever read. Why? Because it reinforced the ideas I'd already been following in my personal investing life for the previous decade without adding anything substantially new. By this point I felt confident that I knew everything I needed to know.

Obviously, though, that wasn't the last finance book I read! It's been an interesting topic for me and something I continue to dip into. Some of it has to do with the political, social, legal or broader economic ramifications of finance; but I also sometimes pick up a pure personal finance book, with absolutely zero expectation it will change, let alone improve, my finances.

So why do I keep reading them? I've been mulling it over, and the best analogy I have is that of a religious practice. An observant religious person will regularly attend church or temple services. Why do they do this? Not to be convinced of the rightness of their faith. After a few years, it won't even be to learn more about the faith: sure, there may be some points of theology to discuss, but they've already embraced the core message of their religion. So why do it? Well, for many other reasons, including being part of a faith community, reinforcing their beliefs, coming to deeper and stronger understandings of tenets that they may feel unsure about, being prompted to think about how to apply their specific day-to-day situation to their timeless religious belief.

I don't want to say that personal finance is a religion - it benefits from observable quantifiable data and trends in a way that faith by definition cannot - but adhering to a certain financial practice does involve following a big-picture philosophy as well as applying that philosophy to daily decisions in a way that feels somewhat familiar. Do you follow the Boglehead practice or the Wall Street Bets heresy? Do you adhere to the Total Return creed or are you a Dividend Gang apostate? Has Cryptocurrency entered your pantheon of Acceptable Investment Vehicles? Most importantly of all, when the market inevitably tanks, will your faith be strong enough to stay the course during the storm, or will you flee and be lost?

That's a VERY long intro to say that I recently start, read, and finished "The Little Book of Common Sense Investing" by the late, great John Bogle. I've read multiple books of Bogle's, listened to speeches and interviews from him, and much of my personal finance reading comes from what could be considered the Extended Bogle Universe. I can't say that there's anything "new" in this book, in the sense of additional information or instruction that will cause me to change my behavior. But it was still a really enjoyable read, reinforcing the path I've happily been following, giving encouragement to continue the journey and providing some additional depth and color to familiar topics.

 

This book repeats a lot of little sayings and aphorisms from Bogle. One early one that I really like goes something like "Successful investing is simple, but it isn't easy." He makes a great analogy to dieting. Everyone knows the "secret" to losing weight: eat less and exercise more. If knowing was all that it took, everyone would be at their ideal weight. Knowing what to do is simple, actually following through with it and staying the course is incredibly challenging. So it is too with investing. The basics are very straightforward: live below your means, invest in low-cost equity funds for a very long time, and don't touch your investments until you retire. Actually following that path is a lot harder: it takes discipline, faith, and focus.

The main focus of this book is the advantage of passive index investing over actively managed investments. That's very old news to me at this point, but Bogle gives a detailed and thorough walkthrough of the reasons why indexing has an advantage and just how significant that advantage is. Compounding costs are just as important as compounding returns, and spending an extra 1% or so on expense ratios can have a huge impact on cumulative earnings over long periods of time; in some realistic scenarios over two or three decades, an index fund may realistically end with twice the value as an active fund.

There is some new stuff in this book, one of the most interesting a detailed look at all of the specific actively managed funds over a two-decade period. Many of them didn't even survive the period, shut down and folded into other funds. Bogle finds that, of the 300 that did survive, only 3 had greater returns than the S&P 500 index fund. And of those, two funds' returns were mostly due to extraordinary performance in their first years: most of the money flowed in after those stellar years, and the subsequent performance lagged the S&P 500. So a mere 1 in 300 funds actually managed to beat the index - astonishingly poor odds! Why take that risk?

The end of the book covers some retirement topics, which has been on my mind recently, particularly with reading How To Make Your Money Last. This book is less thorough than that one, but hits some good notes in its briefer duration. There's a particular focus on the utility of Social Security. Bogle has an interesting suggestion of treating social security like a bond: it's a low-risk and low-volatility source of regular income. So, assuming you receive Social Security, you may want to tilt more towards equities than bonds to hit a desired allocation; if you want to be 50/50 equities/bonds, your investment portfolio could be more like 60/40. Bogle gives some math for calculating this, coming up with a capitalized value for the stream of income generated by Social Security; this process has some arbitrary choices but seems well thought-through.

This really is a little book, with small pages and not many pages. The chapters are short and pithy. There's a great focus on memorable quotes, with Warren Buffet prominently featured along with various economists, finance experts, and business leaders.

One thing that was kind of unclear to me early in my investing career was just why I should be investing in stocks: I understand the concept of bonds, getting interest in exchange for loaning money, but just owning a share in stock seems kind of meaningless since no money flows to the company as a result of the security purchase, so why does it increase in value more than a bond? Bogle gives a brief but really excellent explanation of value, dividing it into business fundamentals versus market opinions. This follows the same analysis as A Random Walk Down Wall Street, and I was happy to see Bogle quoting Malkiel. Over the long run, you're an owner of businesses that make money, so you expect to share in their profits. That's the real fundamental return, which will be realized through dividends or reinvestment (and reinvestment resulting in a wealthier company and thus higher share prices). But in the short term the value assigned to those profits may vary widely. The most important thing for you to do as an investor is to tune out the noise. Don't try to predict market swings, which are irrational and emotional, and just stay invested for the long haul. Sooner or later prices will return to reflecting the fundamental value.

For fundamentals, Bogle long posited a simple formula: take the current dividend yield of a stock, and add its projected growth. The sum of these is its future earnings. When you buy a stock, you're essentially buying forward earnings: the profit it will return in the future. You can thus calculate price/earning ratios and determine whether individual stocks and the market as a whole are cheaper than the historical norm, more expensive, or around the same range.

The US stock market's P/E ratio has been really high for quite a while now. Bogle and his successors at Vanguard have always predicted a return to the mean, which is a gentle way of saying either a large and sudden decline in stock prices or a long stagnant period while the economy catches up to the inflated valuation. That hasn't happened yet, even in the seven years since this edition was published. I tend to think that we're overdue for a correction, and I'm instinctively skeptical of any arguments that "the rules have changed"; but over the last years I have started wondering whether external factors like longer life expectancies increase the actual utility of those forward earnings, in such a way that a higher P/E ratio is sustainably justified? And the George W. Bush tax cuts (which I HATE) slashed the long-term capital gains tax, which makes each dollar in profit worth more post-tax, so that may also increase the actual value of a nominal profit. Even if the above suppositions are correct, that doesn't mean that P/E will increase indefinitely, but it's possible (only possible! not probable!) that there's a stable, long-term equilibrium (mean) at a higher level in the 21st century than there was in the mid-20th century.

My fear, though, is that the higher P/E ratio is more a matter of competition and scarcity, a purely demand-driven inflation rather than a supply-driven increase in utility. This could be the case as a result of more direct market participation, particularly as a result of the shift from pensions into 401(k) plans and automatic investing. That feels much less sustainable to me and would point more towards a strong correction.

One benefit of Bogleheading is that all the above doesn't matter - you just want to own the market and get your fair share of whatever it returns. It may be less or more than the historical average, but over the long run (of multiple decades) you'll always be better participating in the market than sitting it out. There have been numerous times in the past when I was confident that a correction was imminent, most recently in 2016 after the Presidential election, and felt tempted to pull all my money out; I'm glad that I opted for laziness, which gave me a much better result! Another Bogle aphorism that I love is "Don't do something, just stand there!"

I really like Bogle's voice, in this book and all of his writing and speaking. He's opinionated and frank with just enough humility. He's been proven right over and over again throughout his career, which understandably lends some confidence to his pronouncements, even if those pronouncements kind of boil down to "We're all just dummies, myself included." I was particularly interested in his discussion of the role of international equities in a portfolio. As he points out, literally everyone other than him (including everyone else at Vanguard) recommends including international exposure, while he's always favored a US-only portfolio. To his credit, in the time since his book was published, you'd still have been better off investing US-only. I feel like that has to change sometime, but again, I've been wrong before!

Reading this book now has felt rather timely, due to some major changes at Vanguard over the last month. They're making a big overhaul to their fee structure, adding new charges for accounts with less than $5 million (!!!) in assets. As a company that has always been defined by rock-bottom expenses, that feels like a huge shift. And just a few days ago, they announced that they're hiring a new CEO, Salim Ramji. Salim was previously at Blackrock, but prior to that he was a consultant at McKinsey, which is very worriesome to me. Salim will be the first Vanguard CEO to not have worked under Bogle, and the first to come from outside the company.

I've been a happy Vanguard customer for (I think) 20 years, but I am keeping an eye on things and seriously considering relocating. These days, most people in my online communities prefer Fidelity, which charges even lower fees, has better customer service and a better app and website. I've been sticking with Vanguard in large part because of their mutual structure: like a mutual insurance company, it's owned by the customers, which aligns the incentives for low costs; but the actual benefits of Fidelity may outweigh the theoretical advantages of Vanguard, and at some point my unhappiness may overcome my inertia and make me switch over.

Anyways! I've enjoyed all of Bogle's books I've read so far. I think "Enough." is still my favorite, as it ventures furthest afield from the technical aspects of investing to share some great life wisdom. I think that by now anyone who's genuinely interested in investing has a solid understanding of index investing, so this book is probably less impactful now than when it first came out, but it could be a helpful resource to people in the earlier stages of their investing journey. For the rest of us, it's like a good Sunday service, refreshing our convictions and keeping us on a good path.

Das Capitalist

I'm in kind of a weird position these days. I'm fortunate enough to have accumulated a bit of a nest egg and have enjoyed learning how to nurture it: practicing frugality, sound investment strategies, simple financial planning. Over the years I have started to dip into some slightly more esoteric topics like tax efficient fund placement and portfolio management. At the same time, I'm increasingly skeptical of our financial system, investment, and, honestly, American capitalism in general.

With this odd confluence of interests, I've found John Bogle a refreshing voice. He has an impeccable background to speak on financial issues: he founded Vanguard, created the world's first index mutual fund, and today is a sort of emeritus godfather to the company overseeing more than five trillion dollars of investors' money. But, as I learned while reading Enough., he is deeply distressed at the state of the financial world, and has been more forceful than almost anyone in calling for its reform. And not just forceful: articulate and detailed, using his insider's knowledge to point out where the bodies are buried.

I'd been meaning to follow up on Enough., and was drawn to the fiery title of one of his earlier books, The Battle for the Soul of Capitalism. I'd picked it up imagining that it might question the roots of capitalism. It doesn't. Bogle is a true believer in free markets and takes the rightness of capitalism for granted. He is a prophet in his own country, speaking to those who share the same fundamental beliefs.

In retrospect this totally makes sense: of course the founder of an investment company would be fervently devoted to capitalism. The title is really about freeing a virtuous soul from the carapace encrusting it, not about redeeming a damned soul.

The book also ended up being more technical than I expected. That was a good thing in some ways: it includes some really clear explanations of concepts that I hadn't fully grasped before, like how to calculate a stock's fundamental expected return (combine its current dividend yield with earnings growth). But, since the book was written more than a decade ago, much of the technical detail is now irrelevant.

The Battle for the Soul of Capitalism was published after the dot-com bust but before the global financial crisis, and for better and worse he proved to be very prescient in many of the alarms he sounded. Several of his specific policy suggestions were eventually addressed by the Obama administration or by shifts in the market. Earnings guidance from management is not as big a factor in 2018 as it was in 2005. Accounting standards seem to have improved, with stronger divisions between traditional accounting and consulting. More corporate boards are independent and it has become rarer for CEOs to also serve as chairmen. But many of the issues Bogle flags have gotten even worse in the past decade. High on this list is short-term trading: we now have high-frequency trading, which is causing unprecedented levels of churn and bizarre volatility.

He ranges over three related topics in the course of the book: corporate America, investment America, and mutual fund America. Each of these has lost its way, each has behaved inappropriately, each is bilking investors out of their money, and each needs to be corrected. (Perhaps surprisingly, he endorses government intervention to put things back on track: he would prefer self-regulation, but reluctantly observes that the industry has demonstrated it cannot police itself.)

The details of each domain are different. Corporate America has been taken captive by managers who behave like owners: instead of acting as stewards for their public investors, they run the companies for their own private benefit, granting themselves obscene compensation and resisting efforts at oversight, using accounting chicanery to defraud pension funds and claim unrealistic but lucrative profits. Investment America charges outrageous fees for abysmal performance, skimming enormous sums from their clients, promoting schemes that maximize their company's take rather than their customers' returns. And mutual fund America is a passive giant, holding a dominant portion of the country's companies but unwilling to use its power to advocate for its investors' interests.

Stepping back from the details, though, I think the core problem Bogle is pointing out is people caring about the company they work for, as opposed to just their own self-interest. Companies that are still run by their original founders or family members tend to behave rather well: they care about what they've created and have an emotional incentive to see it remain strong. In the vast majority of cases, though, a CEO is paid with other peoples' money and is continuing someone else's legacy. In those circumstances, it's understandable that managers will mostly want to enrich themselves, and that's the seed of the problem Bogle identifies in all three of these sections.

But! It isn't at all unique for managers to look after their own interests. Stockholders, after all, are also motivated to enrich themselves. I mean, if I own stock in Caterpillar, I don't really care all that much about what Caterpillar does, I mostly care whether Caterpillar makes me money. Bogle thinks that its acceptable for stockholders to demand profit through the shares they hold, but it isn't acceptable for managers to demand profit through the position they hold. Again, this is something he takes for granted and that's axiomatic for a capitalist, but it struck me many times while reading this.

If greed is the root problem, then apathy is what's preventing a solution. There are too many stockholders, too much intermediation, too little connection between the decisions made in the boardroom and the attention of the real owners. I thought this was very ironic, since Bogle almost single-handledly transitioned the American stock market into the super-diversified form it's in today. When he first started, an individual investor might have bought a number of shares in Coca-Cola, and actually cared about the firm: followed its movements, voted for directors, written letters to shareholder meetings. Now, an investor will own an infinitesimal slice in every company in America. That's largely a good thing for the investor, as it means perfect diversification and broad exposure to the whole market, but it destroys the opportunity for engaged ownership and corporate citizenship that Bogle seems to crave.

I thought Bogle's attack on the mutual fund industry was particularly interesting. He's admittedly biased, but he makes an incontrovertible case that publicly-held mutual funds perform far worse than privately-held ones. But... doesn't that seem like it would apply to other companies as well? Why are we buying stocks at all? Why are we investing in public companies if they do so poorly? He doesn't examine this question - again, it's a core principle that he takes for granted - but two possibilities occur to me.

The first relates to Bogle's belief in professions versus business, an idea he touches on here and deals with at greater length in Enough. In Bogle's view, a profession isn't primarily about making money, it's a prestigious and important element in civil society. He considers professions like law, architecture, and medicine to fit this category. (Think, also, of the old cachet of owning a newspaper: until a few decades ago, it was seen as a mark of prestige and civic engagement, not as an opportunity for creating wealth.) Business is great for making widgets: if you're creating products to sell, or providing a luxury service, then it's right and natural for you to seek high returns and charge what the market will bear. But a profession should remain primarily focused on their calling: they need to make enough money to support themselves and keep their office strong, but profit should not be the primary goal. With this way of thinking, then, publicly traded companies can be a good investment, but not every type of company should be publicly traded. Companies that primarily provide professional services should remain closely held, so they can keep their mission central and not be swayed by the market's demands for higher returns.

The other possibility is that public corporations are just bad investments. The best businesses will be closely held, run by the original founders for their own benefit, or as part of a tight legacy like a family, mutual enthusiasts (e.g. REI), etc. As soon as a business opens up to all investors, the original passion and mission will inevitably fade, second-generation managers will focus on their own interests, and profitability will slide. To adapt a phrase, publicly traded corporations are the worst form of investment, other than all of the other forms we've tried: it's the one form that allows us to easily buy a slice of a company, even if the fact we're allowed to buy into it means it won't be compelling.

Another way to look at it: you would have the most opportunity for upside by personally starting a business, or by directly investing into a private business. But those actions are extremely risky and require a great deal of time and attention from you. We're sacrificing some profit from those and accepting a lower return in exchange for lower risk and more stability. A Fortune 500 company is less likely to fail than your new cafe.

Again, though, all of the above assumes that the primary goal of a business is to maximize profit for the owner. Bogle's main thesis is that "owners capitalism" has been supplanted by "managers capitalism". In the former, a business is run for the benefit of its owners. This doesn't mean accounting shenanigans or short-sighted cost-cutting: it means building a strong, trusted, stable, enduring business that will continue for a century or more, steadily growing and generating profits for its stockholders. In "Managers capitalism", the business is run for the benefit of the CEO and other top officers: they are theoretically stewards who are employees of the stockholders, but instead view the company as their own property to milk, engaging in short-term maneuvers that will boost their personal compensation during their years at the company instead of making decisions that will strengthen it for years to come.

What's missing in the above tension between the owners and the managers? The workers! There are zero words in the book about the value generated by workers and whether they deserve a share, let alone how large that share should be. Bogle is concerned about how profit is distributed, but (in my opinion) it's ultimately the workers who create that value. The owners front the capital that provides opportunity, the managers organize the resources and ensure quality, but it's the workers who actually, uh, work and create economic value.

(The only time Bogle references workers is when discussing pension funds, which, to be fair, he's very passionate about. He seems to care deeply about the social compact pensions represent and is distressed by the likelihood that they will fail to provide their promised benefits. But he's primarily focused on pensions as funds and not as compensation: he mostly treats them as an investment made for a particular purpose instead of as a rightful share of profits earned by workers.)

At the end of the day, Bogle is a true believer in capitalism, but does not believe that capitalism is the answer to every problem. Oddly enough, the more important an enterprise is, the less likely that it should be run as a business. Crucial professions should be run for the sake of their mission and not to maximize profit. Capitalism by itself is not virtuous, just (in his view) a proven effective means of generating wealth and distributing that wealth to a group of people. Managers capitalism is still capitalism: managers are acting rationally to maximize their income. In Bogle's view, though, managers capitalism is a bad, dangerous, and inferior form of capitalism that does not produce broad societal benefits.

Finally! I wanted to jot down a few passages that I thought were especially interesting or well-said. (Transcribed by hand, please excuse typos.)

Page 43:

The truth is that most business measurements are inherently short-term in nature. Far more durable qualities drive a corporation's success over the long term. While they cannot be measured, such traits as character, integrity, enthusiasm, conviction, and passion are every bit as important to a firm's success as precise measurements. Human beings are the prime instruments for implementing a corporation's strategy. Other things being equal (of course, they never are), if those who serve the corporation are inspired, motivated, cooperative, diligent, ethical, and creative, the stockholders will be well served.

I thought this was very well-said. He develops this point further in Enough.: pay attention to the things that count, not the things that can be counted. Also, note that he accurately identifies employees as the primary source of business success. It seems like they should have a seat at the table.


 Page 44:

The companies that will lead the way in their industries over the long term will be those that have made their earnings growth not the objective of their corporate strategy, but the consequence of their corporate performance.

Another keen observation that I first encountered in Enough. Do not focus on improving a business' metrics: focus on improving the business, and the metrics will follow. Metrics should measure success, not drive it.


Page 163:

Looked at from yet another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit. The mutual fund management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return. If this example does not represent the paradigm of the triumph of managers' capitalism over owners' capitalism in mutual fund America, it is hard to imagine what would. Almost half of the fund owners' money was siphoned away by those who quite literally had everything to gain and nothing to lose.

Definitely good for investors to consider. I have to say, though, that I've never been too happy with the (nearly universal) statement that owners assume all the risk. It's only their capital that's at risk. When a company goes under, the owners will lose their capital, but the people who work for that company will be far more devastated: losing their jobs, healthcare, social bonds, professional edge. That isn't especially relevant to the specific case of mutual fund advisors he's discussing here, but it's a formulation that I think bears closer consideration than it receives.


Page 176:

  This devolution is hardly limited to the mutual fund field. It is reflected all across our society, as one profession after another has taken on the defining attributes of a business... I've seen this field move from being primarily a profession of investment management to becoming largely a business of product marketing. The same transition - albeit in a very different way - has taken place in the medical profession, where the human concerns of the caregivers and the human needs of the patient have been overwhelmed by the financial interests of commerce, our giant medical care complex of hospitals, insurance companies, drug manufacturers and marketers, and health maintenance organizations...
  Consider too how the profession of public accounting became dominated by the business of consulting. Think about the increasing dominance of "state" (publishing) over "church" (editorial) in journalism, as well as about the rise of commercialism in law and architecture that has eroded traditional standards of conduct. In all, professional relationships with clients have been increasingly recast as business relationships with customers. In a world where every use of services is seen as a customer, every provider of services becomes a seller. When a provider becomes a hammer, the customer becomes a nail.
  Please don't think me naive. I'm fully aware that every profession has elements of a business. Indeed, if revenues fail to exceed expenses, no organization - even the most noble of faith-based institutions - will long exist. But as so many of our nation's proudest professions - including trusteeship, medicine, accounting, journalism, law, and architecture - gradually shift their traditional balance away from that of trusted profession and toward that of commercial enterprise, the human beings who rely on those services are the losers.
  ... Roger Lowenstein... bemoaning the loss of "Calvinist rectitude" that had its roots in "the very Old World notions of integrity, ethics, and unyielding loyalty to the customer." "America's professions," he wrote," have become crassly commercial... with accounting firms sponsoring golf tournaments." ... And so it is as well in the trusteeship of other people's money.

Terrific explanation of the role of professional services in the landscape of America. I tend to be skeptical when people write about how bad things are today, that stuff was so much better in the good old days. But I do think there has been a sea change in America starting with the greed-driven 1980s, and that force is behind the shifts that distress Bogle here. It feels like we might be on the cusp of a reexamination of the social compact, which might seem like it flies in the face of Bogle's Republican instincts but could restore the more mission-oriented society he longs for.


Page 220:

When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society's abundance is soured... Rather than prizing financial profit above all else, we must work to become a society... once again celebrating achievement over money, character over charisma, substance over form, virtue over prestige.

A nice summation of Bogle's worldview. Capitalism has helped generate our abundance, but isn't inherently virtuous, and must be closely monitored and guided to achieve good ends.


Page 221:

  Numbers are only numbers, quantities on a scoreboard that are only one measure - and, truth be told, hardly the best measure - of an enterprise.
  Put the greater interest of of others and the dignity of our own characters first, and our own self-interest second; put enterprise and animal spirits first, and managing for the bottom line second; put the joy of creating and the will to conquer first, and the mindless conformity of greed last. 

Another good recap of the proper role of measurements. Focus on what counts, not on what can be counted.


Page 232:

Today's reliance on tax-advantaged savings, however valuable to our well-to-do citizens who can afford it, does little but further raise the ever-widening gap between our wealthiest families and our families most in need. This growing division of wealth is not only a destructive force leading toward the creation of a "two nation" society - rich versus poor - but represents an unwelcome departure from the basic principles of our Declaration of Independence and our Constitution.

This was a bit of a tangent from the main thrust of the book, but I found it very interesting. It's super-weird that someone as wealthy and connected as Bogle would sound like Bernie Sanders (way back in 2005!). The point he's getting at here is that our tax code is stacked to favor the already-wealthy. He doesn't proscribe any specific policy recommendations on this particular topic, but judging from his comments elsewhere in the book, it sounds like he favors a strong Social Security system that would provide a secure retirement to all of our citizens.


Anyways! I feel like this write-up has been more scattered than usual, which doesn't reflect the book itself. It's very well-organized and cogent, steadfastly building the thesis and showing how it applies to all of these aspects of our business and financial systems. I don't think I'd necessarily recommend this book; the most interesting aspects of it are more fully developed and better presented in Enough. But I don't regret reading it: despite some of the specific topical references now being outdated, the core problems Bogle identifies sadly still remain, and it's refreshing to see such a detailed condemnation paired with practical suggestions for fixes. To be fair, it sometimes feels like Bogle is writing to an audience of about a dozen people: unless you're the SEC chairman, a senator on the Finance Committee, or the President, you probably won't be in a position to implement the policy changes he wants. But I think all of us who participate in this economy can benefit from a clearer understanding of the systemic problems it faces and the forces that will need to be reconciled, hopefully sooner rather than later.

That Would Be Enough

I recently picked up Enough., a little book written nearly a decade ago by John Bogle. I've distantly admired Bogle for some time now. He's most famous as the founder of Vanguard, the investment company that has grown since its inception to dominate the mutual fund industry. He also created the world's first index fund: a type of mutual fund that seeks to simply match the value of a stock market benchmark, such as the S&P 500, rather than attempting to select stocks that will beat that benchmark. My personal investing has always been through Vanguard funds when possible, and in cases where it hasn't been (such as some 401(k) plans I've participated in), I've tried to follow a similar strategy of simple, low-cost funds.

Some people gain fame and praise for their success: amassing impressive fortunes through the businesses they've founded. Bogle is famous for sort of the opposite reason. While the Vanguard Group today manages about $4 trillion, Bogle himself has lived relatively modestly. In contrast to high-flying managers of hedge funds and major publicly traded corporations, who lose billions of their clients' dollars and walk away with eye-popping payouts, Bogle has fully embraced the principle of keeping costs low, even (especially!) when it means keeping extra money in his investors' pockets instead of his own.

Enough. was a more meandering book than I expected, but a really excellent one. It starts off as a sort of abbreviated memoir, talking through his family's struggles during the Great Depression, early financial lessons he learned, a variety of low-status jobs he held. A recurring metaphor he uses is "looking for diamonds": people who are constantly chasing wealth and pleasure never find it, while those who cultivate their circumstances find unexpected success. His main point is that he did not start out seeking to build an investment giant, and he encountered plenty of obstacles and setbacks along the way; but because he worked through those setbacks, he ended up with greater results than he would have otherwise achieved.

What especially struck me about the book, though, was Bogle's fiery denunciation of the finance industry. It was published in 2008 as the great recession was starting, bringing to unavoidable light many of the problems he has railed against for years. Some of these get at the very heart of what finance is, using stark language that's really eye-opening and kind of calls into question the values that underlie our free-market capitalist system.

So, to start: there are multiple layers of economic activity. There are people who extract value from the Earth and by working with their hands: this is "work", the creation of raw materials and goods. There are people who extract value from people who extract value from the Earth and by working with their hands: this is "trade", the buying and selling of goods and raw materials. And then there are people who extract value from people who extract value from people who extract value from the Earth and by working with their hands: this is "finance", the allocation of funds to facilitate the creation and flow of goods and services.

Finance serves a very important role and is a major component in the success of businesses and nations. However, it does not by itself create anything of value. Ideally, it is just a facilitator, a sort of minimal conduit that collects available money and moves it to where it is needed.

This is the role that finance traditionally played. In the last half-century, to Bogle's immense distress, the order of things has been upended. Finance has become the king rather than the servant. In a sort of perversion of the ideal order, businesses are now changing their actions and strategies in order to appease the artificial numbers demanded by their finance masters, rather than pursuing their core business and simply using finance to reflect their underlying value. Along with this inversion, people working in finance have become the best-paid people on the planet, raking in obscene amounts of money when businesses do well, and paying no price when they do poorly.

One particularly worrisome side-effect of this is that, when the best and the brightest young students are graduating from university and deciding on careers, they are increasingly choosing to chase the most lucrative jobs, which are Wall Street jobs. There's a sort of brain drain in effect: rather than our nation's intellectual capital being put to work on making new discoveries, creating new inventions, they are turning all their mental capacity to an activity that just skims value out of companies and bilks investors, without creating any underlying economic value.

So, yeah! Pretty strong words, especially from such an accomplished and respected figure in the field. I was really struck by how much he sounded like Elizabeth Warren or Bernie Sanders in much of the book, which is not an association I would have expected.

From this broad economic condemnation, he ends the book on a series of reflections related to character in business conduct and as individuals. This is a part that rung particularly strongly to me, as I think about the impact my actions have on the people around me and the longevity of our company. As he points out, these are not at all new ideas: to the contrary, there's a sort of ethical code that's rooted in 18th-century values which historically has produced both virtuous actions and a strong, growing economy. These seem straightforward on their face, but he shares a lot of wisdom in unpacking and explaining them, giving concrete examples of the harm caused when they are not followed. A couple I remember off the top of my mind:

Practicing stewardship. In a business relationship, you have gained the trust of your clients or your customers. It's important that you put their needs before your own and work to ensure their long-term happiness. It can be tempting in the short term to view them as assets to be exploited, but such actions will irrevocably damage your reputation and, incidentally, be much less profitable.

Focusing on the things that count, and not the things that can be counted. People tend to get obsessed with metrics that can be conveniently quantitized and compared: earnings in a quarter, number of customers. But these things are just measures of underlying value, not things of importance in themselves. The most important things are not easily counted: your reputation, how happy your employees are, the quality of the product you provide. Counting is important, but it's wrong to focus on it. Tend to the underlying health of your company and the numbers will follow.

He also makes a surprisingly strong plea for personal character and conduct. He cites his own Christian faith in passing, but focuses more explicitly on the example of people like Benjamin Franklin who were focused on self-improvement. It was cool (but, again, a little surprising coming from a "finance guy") to read such a full-throated endorsement of civic engagement, of giving back to the country that has enabled success, of building ladders that will help others rise. This has been a long tradition in America, but one that has mostly vanished in the self-obsessed "I've got mine" attitude that seemed to ascend in the 80s and has become embedded in the national psyche. He goes back to the original writings of Adam Smith, pointing out the importance of government and civil society, institutions that are increasingly devalued today.

The overall message of "Enough." isn't a surprising one. Don't go chasing after immense wealth. Focus on your circumstances, your character, practice contentment, and you will end up far happier than those who greedily and voraciously pursue ever-increasing money. It's a great message, one given even more weight by the man giving it, who I now respect even more than before.