Mutual funds pioneer John C. Bogle shares investing tips for today's economy

Common Sense on Mutual FundsTen years after the success of the book "Common Sense on Mutual Funds," Wall Street legend John C. Bogle revises this classic to address the current financial crisis. The founder of The Vanguard Group and creator of the first index fund takes time out of his busy schedule to talk investment strategy for 2010.

Why did you feel the need to update this book?
I did it for a couple of reasons. One, the first edition was written within a month or two of the market high, after two fantastic decades in which the stocks produced 17% annual returns, totally unprecedented in American's financial history. It's not to a great surprise that the next decade did not do that. The next decade, I think the number is about -1% a year on the SP500 taking into account dividends. So it seemed like it was a good time to do a retrospective.

It also gave me a chance to reaffirm the investment ideas in the original book. As I mentioned in my introduction, I told the reader I had two objectives: 1. to help make him or her a more successful investor, and 2. to chart a course for change in the mutual fund industry. On the first one, just about every word in that book has been borne out by experience over the last decade Yes, stock returns would be much lower. Yes, bonds should play a part in any intelligent investment program. Yes, safety is important and minimizing risk is important. Yes, asset allocation is important. Yes, be sure and keep costs at a minimum, keep tax efficiency at the maximum. Don't chase past returns. And treat mutual funds as long-term investments rather than short-term speculation. Every single word of that has come true and has been validated by the experience of a very difficult decade. So in a funny way, I am awarding myself a batting average of 1000.

John C. BogleIn a tragic way, the industry has not only not followed my ideas for the course for change; it has gone in many ways in the opposite direction. Sometimes very substantially in the opposite direction so I am awarding myself a batting average of 0.000 for charting the course for change. So I have an average batting of .500. Ted Williams only got to .406.

Some of the things that did not change include high cost of funds and high turnover of managers. Why do you think things did not change?
The biggest and most obvious change, which is ironic, is the perils of treating common mutual funds as stocks. Trading them like stocks. Looking at the prices every day. That's not what mutual funds are all about. Stocks are short-term speculations by and large and mutual funds are long-term investments. I am constantly fighting a battle of the folly of short-term speculation against the wisdom of long-term investment.

What's happened in the past decade is mutual funds became formally like stocks in many respects because that's what exchange-traded funds are. They are the driving force of this industry at the moment. They are mutual funds where you can trade your fund shares all day long, day after day in real time. Now, what kind of lunatic would want to do that? Trading is a loser's game by definition. Investing is a winner's game by definition. That is the most flagrant example of things not following my advice but going in the exact opposite direction. The greatest irony of all is they are doing it with my beloved index funds.

You wrote that your principles, including keeping costs down, simplifying your investing, and holding, have not changed despite this tough decade. Why not?

If people followed that advice at the beginning of this difficult decade that just ended, they've done fine. They got a return of 2-3% on an index fund-bond-stock mix. That's not great but it's a long, long way from a disaster. If you compound 3% over a decade, that is probably an increase of 36-37% of your capital. That's not a catastrophe.

People would be surprised at how well it's done. So if you can get through the bad times, just think how good things will be when we have better times ahead. And I think in the next decade, the odds are strong, not overwhelming and it's hard to predict, but it seems to me all the evidence is in favor of stocks again doing better than bonds.

Looking over the past decade, what mistakes are investors making?

Among the biggest mistakes is thinking too short term. You are always looking backwards. We call it the rowboat syndrome, where you've been but have no idea of where you're going. At the beginning of the decade, they poured a future into technology stocks, hundreds of billions of dollars. And when the crash in technology came and value funds had done much better previously, they took the money out of technology funds and put it into value just at the time when growth was going to start to do better again.

Later in the decade, it became putting money in foreign stocks, international stocks and emerging market stocks. Once again, chasing those returns and in 2008, while the US market was down 35%, international market was down 45% and the emerging market was down 55%. Chasing returns cost you a lot of money. Just when you're about to capitulate is the wrong time to capitulate.

If we're getting the timing wrong, do you recommend holding for 20 years and selling if it's not doing well then?

I am not a believer in picking fund management. Let's extend your time period a little bit and let's call it an investment lifetime of 50 years. You're going to have to look somewhere I have never been to find a manager who's going to be running that money for 50 years. The average manager, last time I looked at the data, lasts for about three years.

Half of the money managers in the mutual fund industry own not a single share of the fund that they are managing. And if you go back to about 1970, about two-thirds of the funds that were in existence then are gone now. So how can you be a long-term investor when managers turn over and funds come and go? That's why I like the idea of the index fund. It doesn't matter greatly who is managing the index fund. The trick, which is not the most complicated in the world, is to closely match the index you're watching.

Looking into the future, how can people build up their nest eggs?

First, you have to invest. All investment involves risk. The Treasury bill may be safe at the moment but you have a huge inflation risk. And I would do it through a diversified portfolio of stocks and bonds, with the greater emphasis on stocks in the early years and greater emphasis on bonds in the later years. It's not some magical formula. It's common sense. What do we know about investors at the beginning of their lives and in the end? One, they have more money. If they've been putting money away for 50 years, they're almost certain to have more money than you have or I have on our first week on the job. So you're going to have more money and want to be more careful.

No. 2, as you get older, you start to need income from your investment portfolio. When you're young, you're earning your income. When you're older, the investment portfolio is what provides you with income. And stocks provide much less income than bonds so it's just logical to turn to bonds. Bond yields are not great today, I admit, but they are a lot of higher than 2 ¼ % in stocks.

No. 3, when we get older, we get a little more nervous when these things come along. So the higher bond position takes that behavioral risk out of the equation.

You had an interesting equation about bonds. Can you clarify?

This is just a rule of thumb. A crude rule of thumb. It's the way I want people to start thinking. Have your bond position equal your age. So if you're 65, you'll be 65 in bonds. If you're 80, you'd be 80% in bonds. It's not a hard and fast rule but a pretty good rule. It might cost you return over the long run, probably cost you a return, but it enable you to navigate those stormy waters with a little more equanimity, which is an important part of investing. I wouldn't sit here and say if you're 22, you need to start with 22% in bonds and 78% in stocks. You might want to be 100% for a few years but taper it down as you go on in time and consider the other assets you have as to whether they're fixed income or whether they are variable income.

You wrote a lot about buyer beware about exchange-traded fund and stocks. Is there anything new that's market created that we need to be aware of?

There is always something new under the sun. When you look at the pace of change, when you think about the difficulty of looking ahead, you can think of a number of things that we had never had to deal with before.

No. 1, this financial crisis and it's not over and it suggests we be more conservative.

No. 2, we're looking at the revolution in technology. Perfectly good companies think they are set forever, then someone starts a new company doing a similar thing, and they are out of business 24 hours later. Creative destruction will be more rapid than ever.

No. 3 is international competition. We've had it for a while but this is a more global world than we've had before and the U.S. has to stand up and compete. I would say for me personally, be more a little more conservative, even more conservative than you would otherwise be.

With all the caveats of I don't know what's coming any better than the next guy, I think that is good for every investor to consider. Maybe things aren't going to be as bright as this wonderfully resilient economy has been in the past. Not to the point of abandoning common stocks. Just pushing that balance between stocks and bonds towards the safer side.

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