Six Lessons for Investors Be diversified and don't assume past performance
will continue
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By JOHN C. BOGLE<http://online.wsj.com/search/search_center.html?KEYWORDS=JOHN+C.+BOGL...>
There is almost no limit to the ability of investors to ignore the lessons
of the past. This cost them dearly last year. Here are six of the most
important of these lessons:
1) *Beware of market forecasts, even by experts.* As 2008 began, strategists from Wall Street's 12 major firms forecast the end-of-the-year closing level and earnings of the Standard and Poor's 500 Stock Index. On average, the forecast was for a year-end price of 1,640 and earnings of $97. There was remarkably little disparity of opinion among these sages.
Reality: the S&P closed the year at 903, with reported earnings estimated at $50.
Strategists aren't always wrong. But they have been consistent, betting year after year that the market will rise, usually by about 10%. Thus, they got it about right in 2004, 2006 and 2007, but also totally missed the market declines in 2000, 2001 and 2002, and vastly underestimated the resurgence in 2003.
Ignore the forecasts of inevitably bullish strategists. Bearish strategists
on Wall Street's payroll don't survive for long.
2) *Never underrate the importance of asset allocation. *Investing is not
about owning only common stocks. Nor are historical stock returns a sound
guide to future returns. Virtually all investors should keep some "dry
powder" in their portfolios in the form of high-grade short- and
intermediate-term bonds. Investors who failed to learn that lesson fell on
especially hard times in 2008.
How much in bonds? A good place to start is a bond percentage that equals
your age. Although I don't slavishly adhere to that rule, my bond position
accounted for about 65% of my personal portfolio in early 2000. Because
returns on my bond funds since then have totaled 50% and returns on my stock
funds were negative 25%, bonds are now about 75% of my portfolio, still
close to my advancing age.
With all the focus on historical returns that greatly favor stocks, don't
ignore bonds. Consider not only the probabilities of future returns on
stocks, but the consequences if you are wrong.
3) *Mutual funds with superior performance records often falter.* Last year
was an extreme example. With the S&P 500 off 37% for the year, Legg Mason
Value Trust fell by 55%. Fidelity Magellan Fund, after a good 2007, was off
49%. Funds managed by proven long-term pros felt the pain -- Dodge and Cox
Stock down 43%; Third Avenue Value down 46%; CGM Focus down 48%; Clipper
down 50%; Longleaf Partners down 51%. (Full disclosure: Four of Vanguard's
actively-managed equity funds also lagged the market by wide margins.)
Only time will tell whether the disappointing shortfalls experienced by
these and other funds will be recovered in the future, whether the skills of
their managers have atrophied, or whether their luck has run out. Whatever
the case, chasing past performance is all too often a loser's game. Managers
of funds seeking market-beating returns should make it clear to investors
that they must be prepared to trail the market -- perhaps substantially --
in at least one year of every three.
4) *Owning the market remains the strategy of choice.* Such a strategy
guarantees a return that lags the market return by a minuscule amount, and
exceeds the return captured by active equity-fund managers as a group by a
substantial amount. Why? Because the heavy costs incurred by investors in
actively managed equity funds can easily amount to 2% to 3% annually.
Typical expense ratios run from 1% to 1.5%; the hidden costs of portfolio
turnover often come to 0.5% to 1.0%; a 5% front-end sales load, amortized
over a holding period of five to 10 years, adds another 0.5% to 1.0% per
year in costs.
As a group, investors are by definition indexers. (That is, they own the
entire market.) So indexing wins, not because markets are efficient
(sometimes they are, sometimes they are not), but because its all-in annual
costs amount to as little as 0.1% to 0.2%.
Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover,
no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and
(admittedly a fairer comparison) more than 60% of all funds focused on
large-cap U.S. stocks. This continues the pattern -- with some variations --
that goes back to the start of the first index fund 33 years ago. The bond
index fund did even better. Its return of 5% for 2008 outpaced more than 80%
of all taxable bond funds.
In sum, active management strategies as a group lose because they are
expensive. Passive indexing strategies win because they are cheap.
5) *Look before you leap into alternative asset classes.* During 2006-07,
equity mutual funds focused on developed international markets and emerging
markets provided strong relative returns to U.S. stocks. During that period,
U.S. investors made net purchases of $285 billion in mutual funds investing
in non-U.S. stocks, and liquidated on balance some $35 billion from funds
focused on U.S. stocks.
This extreme example of "performance chasing" at its worst is hardly
defensible. But, disingenuously, it was touted by fund marketers as adding
"non-correlated assets," or "reducing volatility risk." In 2008 -- with
non-U.S. developed market funds falling by 45% and emerging market funds
tumbling by 55%, we learned once again that, just when we need it the most,
international diversification lets us down.
Commodities were no different. As the global recession developed, commodity
funds sank, the largest such fund tumbled 50%. Always keep in mind: When the
investment grass looks greener on the other side of the fence, look twice
before you leap.
6) *Beware of financial innovation. *Why? Because most of it is designed to
enrich the innovators, not investors. Just think of the multiple layers of
fees to the salespersons, servicers, banks, underwriters and brokers selling mortgage-backed debt obligations. These new products (credit default swaps are another example) enriched their marketers during 2005-07, only to impoverish the clients who held them in 2008.
Our financial system is driven by a giant marketing machine in which the
interests of sellers directly conflict with the interests of buyers. The
sellers, having (as ever) the information advantage, nearly always win.
We can't say that we haven't been warned about the perils of ignoring the
past. More than 2,000 years ago, the Roman orator Cato noted that, "there
must be a vast fund of stupidity in human nature, or else men would not be
caught as they are, a thousand times over, by the same snares . . . while
they yet remember their past misfortunes, they go on to court and encourage
the causes to what they were owing, and which will again produce them."
While the events of 2008 reinforced that message, perhaps these stern and
oft-repeated lessons of experience will help investors avoid similar
mistakes in 2009 and beyond.
of Mutual Funds. His newest book, "Enough. True Measures of Money, Business, and Life," was published by Wiley in November.*
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