The Little Book of Common Sense Investing

My reading highlights and comments on this book.

The road to riches for those “in the business is to persuade their clients: ‘Don’t stand there. Do something.’ But the road to riches for their clients as a whole is to follow the opposite maxim: ‘Don’t do something. Stand there.’ For that is the only way to avoid playing the loser’s game of trying to beat the market.”

For investors as a whole, returns diminish as movement increases. The lower the costs incurred by investors as a group, the greater the benefits they reap.

The price-to-earnings (P/E) ratio measures the number of dollars investors are willing to pay for each dollar of earnings.

“John Maynard Keynes. Here’s what he wrote 81 years ago: It is dangerous . . . to apply to the future inductive arguments based on past experience, unless one can distinguish the general reasons why the past experience was what it was. But if we can distinguish the reasons why the past was what it was, then we can establish reasonable expectations about the future. Keynes helped us make that distinction by pointing out that the state of long-term expectation for stocks is a combination of enterprise (“forecasting the prospective yield of assets over their whole life”) and speculation (“forecasting the psychology of the mark¹et”).”

Stock market returns can be divided into two parts: (1) investment return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth (together, they form the essence of what we call “intrinsic value”), and (2) speculative return, the impact of the change in the price-to-earnings multiples on stock prices.

Beware of costs: Before costs, beating the market is a zero-sum game. After costs, it is a loser’s game. Fund performance comes and goes. Costs go on forever.

What are those costs? The first and best known is the fund’s expense ratio, and it tends to change little over time.

The second large cost of stock fund ownership is the sales commission paid on each share purchase.

The third major cost incurred by fund investors is the cost of buying and selling the securities in the portfolio.

If you are investing for a lifetime, you have two basic options. You can (as is customary) select three or four actively managed funds and hope that you have picked good ones, knowing that their portfolio managers, on average, are likely to last only about nine years and that the funds themselves are likely to have a life expectancy of little more than a decade. Result: you own perhaps 30 or 40 funds over your lifetime, each one carrying that burden of fees and turnover costs. Or (no surprise here) you can invest in a low-cost, minimal transaction cost, broad-market index fund, with the certainty that the same non-manager will still be tracking its index closely for the rest of your life. There is really no viable way that a portfolio of actively managed funds will serve you more effectively and consistently than the index fund. Simplicity, cost-efficiency, and staying the course ought to win the race.

The Return to the Mean (RTM)—the tendency of funds whose records substantially exceed industry norms to revert back toward or below the average—is alive and well in the mutual fund industry.

(2013) Thinking, Fast and Slow, Nobel Laureate Daniel Kahneman: “[Our] mind is strongly biased toward causal explanations and does not deal well with ‘mere statistics.’ When our attention is drawn to an event, associative memory will search for its cause. . . but they [causal explanations] will be wrong because the truth is that regression to the mean has an explanation but not a cause.”

Under normal circumstances, it takes between 20 and 800 years [of performance tracking] to statistically prove that a money manager is skillful, not lucky. To be 95% confident that a manager is not merely lucky, it can easily take almost a millennium—which is far longer than most people have in mind when they say “long term.” Even to be only 75% confident that he is skillful, you would typically need to track a manager’s performance for a period of between 16 and 115 years. . . . Investors need to know how the money management business really works. It is a stacked deck. The game is unfair.

Conventional wisdom holds that indexing may make sense in highly efficient market corners, such as the S&P 500 for U.S. large-cap stocks, but that active management may have an advantage in other market corners, such as small-cap stocks or non-U.S. markets. That assertion proves to be false. Whether markets are efficient or inefficient, all investors as a group in that segment earn the return of that segment. In inefficient markets, the most successful managers may achieve unusually large returns, but that means that some other manager suffered unusually large losses.

As a group, all investors in any discrete segment of the stock market must be, and are, average.

As a group, bond fund managers will almost inevitably deliver a gross return parallel to the baseline established by the current interest rate environment.

“Try to beat the market, in any way, and you will likely be beaten . . . by the cost of doing so.”

Carl von Clausewitz, the Prussian military theorist and general of the early 1800s: “The greatest enemy of a good plan is the dream of a perfect plan.”

Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, the use of only two asset classes was my starting point. My advice for investors in the accumulation phase of their lives, working to build their wealth, focused on an 80/20 stock/bond mix for younger investors and 70/30 for older investors. For investors beginning the post-retirement distribution phase, 60/40 for younger investors, 50/50 for older investors.

Two fundamental factors determine how you should allocate your portfolio between stocks and bonds (and your risk tolerance generally): (1) your capacity to take risks, and (2) your willingness to take risks.

Your capacity to take risks depends on a combination of factors, including your financial position; your future liabilities (e.g., retirement income, college tuition for your children and/or grandchildren, a down payment on a house); and how many years you have available to fund those liabilities. In general, you can accept more risk if those liabilities are relatively far in the future. Similarly, as you accumulate more assets relative to your liabilities, your capacity to take risks increases.

Your willingness to take risks, on the other hand, is purely a matter of preference. Some investors can handle the market’s ups and downs without worry. But if you cannot sleep at night because you fear your portfolio’s volatility, you are probably taking more risk than you can handle. Taken together, your capacity to accept risk and your willingness to accept risk constitute your risk tolerance.

Let’s begin with a basic asset-accumulation model for the wealth-building investor. The key points to consider are simply common sense. (1) Investors who seek to accumulate assets by investing regularly can afford to take a bit more risk—that is, to be more aggressive—than investors who have a relatively fixed pool of capital and depend on income and even distributions of their principal to meet their daily expenses. (2) Younger investors, with more time to let the magic of compounding work for them, can also afford to be more aggressive, while older investors will likely want to pursue a more conservative course.

My highest general recommended target allocation to stocks would be 80% (equity) for younger asset-accumulating investors for a long period of time.

My lowest target stock allocation, 25 percent, would apply to older investors in the late years of retirement.

As an intelligent investor, you must make four decisions about your asset allocation program:

First, and most important, you must make a strategic choice in allocating your assets between stocks and bonds. Investors in different positions with unique needs and circumstances will obviously make different decisions.

The decision to maintain a fixed ratio or a ratio that varies with market returns cannot be avoided. The fixed ratio (periodic rebalancing to the original asset allocation) is a prudent choice that limits risk and may be the best choice for most investors. The portfolio that is never rebalanced, however, is likely to deliver higher returns in the long run.

Third is the decision whether to introduce an element of tactical allocation, varying the stock/bond ratio as market conditions change. Tactical allocation carries its own risks. Changes in the stock/bond ratio may add value, but (more likely, I think) they may not. In our uncertain world, tactical changes should be made sparingly, for they imply a certa2in foresight that few, if any, of us possess. In general, investors should not engage in tactical allocation.

Fourth, and perhaps most important, is the decision whether to focus on actively managed mutual funds or traditional index funds. Clear and convincing evidence points to the index fund strategy.

Low costs enable low-risk portfolios to deliver higher returns than high-risk portfolios.

“I have often been quoted as an advocate of a simple and seemingly rigid similar asset allocation: your bond position should equal your age, with the remainder in stocks. This asset allocation strategy can meet the needs of many, if not most, investors quite well, but it was never intended to be more than a rule of thumb, a starting point for your thought process. It is (or was!) based on the idea that when we are younger, we have limited resources to invest, do not need investment income, have a greater tolerance for risk, and believe that stocks will provide higher returns than bonds over the long term, we should own more stocks than bonds. But as we age and eventually retire, most of us will have accumulated a significant investment portfolio. Then, we are more inclined to be more risk-averse, more willing to sacrifice maximum capital appreciation, and to rely more on the higher income returns that bonds have provided over the past 60 years. In these circumstances, we should own more bonds than stocks.”

A rule of thumb suggests that an annual withdrawal rate of 4% (including both income and principal) of the year-end value of the initial retirement capital, adjusted annually for inflation, is likely, but not guaranteed, to be sustainable throughout the retirement years.

Investing involves risks. But we also know that not investing condemns us to financial failure.

The risk of selecting individual stocks, as well as the risk of selecting both fund managers and investment styles, can be eliminated by the total diversification offered by the traditional index fund. Only market risk remains.

Costs count, in a commanding way over the long run, and we know that we must minimize them. → (Franklin) “Beware of little expenses; a small leak will sink a great ship.”

Taxes count, and that they, too, must be minimized.

(Franklin) “One man may be more cunning than another, but not more cunning than everybody else.” → (Bogle) “Don’t think you know more than the market; no one does. And don’t act on hunches that you think are your own but are usually shared by millions of others.”