Vanguard 101

Wherein I describe index investing

Once every couple of decades I have a conversation with a Financial Planner. The last such financial conversation I described here. I have a hard time trusting financial planners, which may be a problem for me. But this means I have to force myself to study harder to learn what the financial planners are likely to tell me.

And as I describe in the link above, I set about to reading about finance and investing. The most bang-for-the-buck came from this book, The Little Book of Common Sense Investing, by John Bogle. John Bogle is the founder of Vanguard.

The biggest financial mistake of my life was seeing Mr. Bogle on Wall Street Week with Louis Rukeyser in the early ‘80s, being enthralled by what he was saying, and then not buying Vanguard. Sadly, I didn’t have enough money for “Admiral shares,” so I didn’t put any money in Vanguard. Then I got distracted and forgot about it.

About a year later I bought shares of some company that’s now bankrupt. That was the story of my financial life through the ‘80s–buying random stuff recommended by brokers that went noplace and lost money. One bright spot was ignoring advice to sell real estate that has done very well.

After I was disappointed with the latest financial planner dude last year, I did some serious reading about investing. Reading a lot of investment experts convinced me that I cannot predict the future. And nobody else can, either. Reading Benjamin Graham convinced me that he was a better securities analyst than I will ever be and that I will certainly be deceived by corporate accounting jiggery-pokery.

I learned something important from John Bogle’s book. Every money manager promises that he will beat the market, but over the time every money manager has underperformed the market. Think of the S&P 500 average. Some mutual funds do better. Others do worse. But they average out: For every fund A that makes one dollar more than the market, there is a fund B that makes one dollar less. With respect to the overall market you are looking at a zero sum game. The winnings of winners summed with the losings of losers equals out. The winner funds get advertised, grow too big to be efficient, then start losing. Loser funds get renamed or rebranded. As a result everything we see is advertised as “beating the market.” It’s like Lake Wobegon where all the children are above average. (But everything I actually bought disappointed me.)

John Bogle’s brilliant insight was that he could create a mutual fund that exactly matches the S&P 500 or any other index. This fund can be managed automatically. No need to hire expensive securities analysts with tassled shoes. No need to pay commissions buying the latest hot stocks Jim Cramer is screaming about today.

All that churning that doesn’t happen. All those capital gains taxes that aren’t owed.

Index funds are passively managed: Just buy every security in an index in proportion to its market capitalization. How is it doing from day to day? Just check the index.

I have never aspired to be average. And losers are passive. This is the one time in life where this doesn’t hold.

But one of the most important lessons for the investor is “don’t screw up.” You’ll lose money by taking the wrong action at the wrong time. Listen to the financial news and everyone is running around with their hair on fire because the market is down. Call my broker. Sell. Sell. Sell. Or everyone is making money as the Dow is hitting record highs. Call my broker! Buy. Buy. Buy.

And the broker makes his commissions and you are broke-er. You missed the run up and caught the fall. Again.

Some companies will drive other companies out of business. You risk losing everything when companies die. If you own both Target and Walmart, then you’re OK even if Target runs Walmart out of business–or vice versa. Buying an index fund you spread your risk across every stock in that index. No need to panic when the news comes out that this company or that is in trouble, because you also own shares in the company that’ll survive to pick up the pieces. The collective productivity and ingenuity of all American businessmen are contributing to your wealth when you own a broad-based equities index fund.

It’s completely passive, but completely safe. If something nukes every publicly traded company in the USA, we’ll have bigger problems than our IRAs.

But this means I’ll never beat the market! My returns will just be average. I’m too smart to settle for average!

Trouble is that whenever I bought funds that “beat the market” the next year they underperformed the market. Past performance is no guarantee of future results. I was so smart I underperformed average. Yeah. Smart.

Look at the year-on-year average performance of the S&P 500 over the last few decades. It has averaged 11% over the long term. That’s a lot better than those mutual funds I bought that were supposed to “beat the market.” Have you seen that kind of return on any of your mutual funds?

Sadly, John Bogle suggests the stock market gains will be more like 4% or 5% in the near term. It’s not great, but it’s enough for me to retire on–provided I can mitigate “sequence of returns risk.” If anyone is interested, I can opine about that.

Bottom line. Unless you’ve got the knack for securities analysis that Benjamin Graham, Warren Buffet, and Charlie Munger have demonstrated, aspire for average! You don’t have to buy Vanguard if you want to do index investing, Fidelity has an index fund with a lower expense ratio. Shop around, but don’t pay a load and pay the lowest expense ratio you can. Be passive!

Steve Poling

Masters degrees in math and computer science. Poet in several computer languages. I write stories about Sherlock Holmes' brother Mycroft, steampunk, and SF.

Grand Rapids, Michigan http://www.catfoodretirement.com