John Bogle Extended Interview - The Clash of Cultures: Investment vs. Speculation

Bogle describes mutual fund industry in 1951: 'Wellington Fund was probably one of the 10 largest funds...was $140 million...probably employed about 40 people...we had one fund.' Culture: 'We had a fiduciary duty to those people, and we honored it very well. Wellington Fund was noted for low cost, noted for balanced investing...very much dedicated to serving the investor. Long-term investment philosophy, very low portfolio turnover.' He joined in 1951 and stayed associated with that fund for 61 years: 'Here it is 2012...I know it like the back of the hand.' The emphasis was on trust: 'We knew what our job was. It was to serve the Wellington shareholders.'

Fundamental conflict in modern mutual fund industry: 'We have management companies that are owned by financial conglomerates...in business to earn the highest possible return on their capital. And what you want as an investor in one of their mutual funds is to earn the highest possible return on your capital.' The problem: 'Because of fees and costs, turnover expenses...are opposed to one another. You can't do both.' Biblical reference: 'As a book we've all read carefully says, No man can serve two masters.' Conclusion: 'The structure of the industry is inherently flawed, and it will have to change.' Industry has grown from small beginnings to $12.5 trillion, fundamentally changing its character.

Adam Smith solution: 'If each investor looks after his own best investment interest and puts the money with the firms that best serve his own interest, then the industry will change.' It's happening: 'In the last six years, the industry has had $200 billion taken out of equity funds. That consists of $600 billion going into index funds and $800 billion going out of actively managed funds. That is...a tsunami.' Fee comparison for income investors: 'Index funds take maybe 3% of your income as a management fee and the actively managed funds...take about 60% on average out of it.' Math: 'Funds yield about 2%...index fund charges maybe five basis points, leaving you with 195 and the active managers are charging 140 basis points...you get 0.7 and the manager gets' 1.4%. Even Morningstar admits: 'If you just look at a fund's cost, you will do a better job in selecting future winners than you will if you follow their somewhat complex recommendations.'

Bogle names rare fiduciary managers: 'I like Longleaf down in the south. They run the funds as fiduciaries. I like Dodge and Cox out in the west coast. They run the funds as fiduciaries.' Key trait: 'They aren't firms that have 200 mutual funds to run. They might have four, five, six.' T. Rowe Price dilemma: 'I certainly think highly of T. Rowe Price...having a very good performance streak' but 'they could so easily reduce their management fees because they...make an awful lot of money.' Personal example: 'About 15 years ago...100 shares of T. Rowe Price for $4,000. Next year I got a dividend from T. Rowe Price of $4,200...capital value of that little investment is probably $350,000 now.' Problem: 'That's great for the shareholders of T. Rowe Price, but if some of that money had gone to the fund shareholders, their performance...would have been even better.' Again: 'No man can serve two masters.'

Wellington turnaround story: 'In '78 it was time to fix the Wellington Fund...I laid out' specific targets including 'bring the income...from approximately 52 cents a share in 1978 to 92 cents a share...give you six years to do it.' Strategy: force income-oriented stocks without increasing bonds. Result: 'The fund, which had gone from $2 billion to $400 billion, is today...as we speak, $64 billion...renaissance is not too strong a word.' Performance: 'We over a long period of time...have beaten the average balance fund by 50 basis points...up 8.2%' annualized vs '7.7' for average. The revelation: 'Ten basis points of that are from active management, and 40 basis points...are from low cost.' Ratio: 'That's four to one.' Conclusion: 'You need both' but cost advantage dominates.

Speculation has exploded: 'Stock market, when I came into Wellington Fund, was probably trading five million shares a day. And today it's trading...six, seven, eight billion shares a day.' Impact: 'Investors' trading costs alone are going to cost probably somewhere between half a percent a year, just the turnover cost' to 'one and a half percent. And then to get these great managers, you're going to be paying them an average probably one and a quarter percent.' Total: 'All of a sudden you've got two percentage points out of your return, just out of cost, many of which are generated by high turnover.' Turnover explosion: 'Mutual fund turnover when I came into this business was about 18 percent a year. Now it's 100 percent.' Zero-sum reality: 'There's no basis for investors to win if I'm trading all the time with you because your fund is going to win or lose or my fund is going to win or lose. But the net value created is what's siphoned out...by Wall Street, the great croupier of the market casino.'

The core dysfunction: 'The principle function of the financial markets...the financial system that provides the oil that greases the wheel of capitalism' is 'directing new capital to its highest and best and most profitable uses.' Wall Street execution: 'Each year about $250 billion, Wall Street raised about $250 billion to direct to the most promising companies, either initial public offerings or secondary public offerings each year...we'll call that investment.' But the speculation overwhelms: Trading volume suggests '$33 trillion' annually. Ratio: '130 to 1...speculation to investment.' The problem: financial system supposed to allocate capital to productive uses, but almost all activity is just trading existing shares back and forth, with Wall Street taking a cut of each transaction.

Bogle's return formula: 'The investment return or fundamental return on stocks...is dividend yield plus corporate earnings growth.' Current outlook: Starting from 'about a 2 percent dividend yield' and 'earnings growth in the range of, let's say, 5 percent per year' gives '7 percent...will double your money every 10 years.' Guidance: 'Don't look for 11%, don't look for 15%...those are all guesses.' Historical context: 'Below the long-term norm of 9% because of that lower dividend.' Speculative return: 'There's always this nasty little element of speculative return...if a multiple of earnings...goes from 10 to 20, say that's a double, and over 10 years that's an addition of 7% return' but 'the price of the market...seems to me, is roughly fairly valued today...around...16 times earnings.' Conclusion: 'I look for speculative return to add nothing or subtract anything' and 'in the long term, say 100 years, speculative return is going to be zero. So don't pay any attention to it.'

Bogle's philosophy: 'Forget the needle, buy the haystack, buy the whole market.' Reasoning: 'Buying a good manager is like looking for a needle in a haystack...it just makes common sense. Own the whole market and not just a few stocks.' Risk management: 'You don't need to take the risk of individual stocks. Take the market risk, which is quite high enough. You don't have to take both.' Method: 'Go for low cost funds and especially index funds...you are guaranteed in a low-cost index fund, you are guaranteed to earn your fair share of whatever the stock market is kind enough to give us, and let's be very clear on this, whatever return, a bad market is mean-spirited enough to take away from us.'

Ancient wisdom applied: 'There's a Greek poet back probably in the third century B.C. named Archilakis...a little fragment...said, The fox knows many things, but the hedgehog knows one great thing.' Modern application: 'In our business, the foxes are all those managers, smarter, they've got all those computers, all those brilliant Harvard Business School graduates, armies of them, and they know everything. They know far more than I could dream of knowing.' The one thing: 'I know one great thing, and that is if you own the market, which they do collectively, if you own the market, you are guaranteed in a low-cost index fund, you are guaranteed to earn your fair share of whatever the stock market is kind enough to give us.' Result: 'It's the hedgehog who wins, and the poor fox with all his wiles and his marketing department...He's yesterday, and he's going as fast as I can get rid of him.'

Behavioral challenge: 'Most investors, many investors, probably the majority, lose because of their own behavior and not because of how stocks and bonds do.' Patterns: 'They buy something that's done well and think it's going to do well in the future and it doesn't...they find a hot manager, they jump on the bandwagon and that doesn't work.' The trap: 'Markets are really...counterintuitive, because when do you feel you're most optimistic and most happy and enthusiastic about buying stocks? At the market peak. When are you scared to death about stocks and really want to get out at the market bottom?' Result: 'You get in at the top and out in the bottom, do you think you're going to do well doing that?' Solution: 'Figure out a sound program...with an appropriate' mix of 'bonds and bond funds...and stock funds, index funds I would say in both cases' and never deviate. This is Bogle's signature advice: 'Stay the course.'