John C. Bogle, The Clash of the Cultures, Investment vs Speculators. John C. Wiley & Sons, Inc. Hoboken, 2012.
Author John C. Bogle studied finance at Princeton University before he started the first index mutual fund, the Vanguard 500 Index Fund, in 1975. Now Dr. Bogle describes the impact of 2 investment cultures, tradition & speculation, on individual investors.
The structure and culture of capitalism
American capitalism is structured around primary and secondary markets for securities. Both are complex, but in simplified terms, the primary market supplies cash to corporations in exchange for wholesale volumes of securities that certify the beneficial ownership of companies (stocks) or debt (bonds). The primary market’s participants are institutional investors (“Wall Street”). The secondary market supplies cash to the primary market. Institutional investors are rewarded in the secondary market by trading retail volumes of securities for cash with individual investors.
The ever-changing culture of American capitalism is grounded in the fiduciary responsibility of “agents” for their “principals”. The agents are corporate executives and money managers who sell securities and financial services. The principals are investors who buy securities and pay for financial services. The fiduciary responsibility of agents is to look after the best interests of principals by maximizing their investment returns according to regulatory guidelines. The fiduciary behavior of agents is remarkably different between capitalism’s traditional and speculative cultures.
The traditional culture thrives on a mutual reward system between corporations and individual investors. Investors supply the capital and exercise their rights as shareholders. Corporations use the capital to grow the business. Traditional investors patiently hold securities for the long-term and ignore daily fluctuations in share price.
The culture of speculation embraces a mutual reward system between corporations and money managers. Corporate executives seek compensation by generating quarterly reports that fuel speculation. Money managers seek brokerage fees and advisory fees for managing the high turnover rate of securities. Consequently, individual investors pay more fees and earn lower returns.
Speculators are ‘technicians’ who take risks by timing the market for best opportunities to trade shares. The hallmark of speculation is investing for short-term holding periods facilitated by high-speed trading. Speculation began in the 1950’s with a population trend of shifting ownership of U.S. stocks and gradual increase in trading volume of the U.S. stock market. The vast majority of stock owners in 1950 were individual investors who held their investments about 6 ½ years. By 2000, the vast majority of stock owners were institutional investors who held their investments less than 1 year.
Different investment returns
The traditional returns from stocks are dividend yield and earnings growth. The speculative returns are changes in the price paid for a dollar of earnings. In the past 40 years, the stock market’s total return was 9.3% of which the annual investment return was 9% (dividends and earnings growth) and speculative growth was 0.3%. In the past 150 years, the aggregate return from U.S. stock prices was 7% when adjusted for inflation. During that time, U.S. corporations aggregated 4.5% yield and 2.5% real earnings growth. Speculation on earnings was a zero-sum game for all market participants; half won and half lost.
The high trading volume of today’s speculative markets provides two opportunities for individual investors: The first is ‘liquidity’, which is to say that many institutional investors are willing to make cash transactions with individual investors. The second is the remarkably low transaction fees attributable to the competition between brokers for the growing volume of trading.
The big disadvantage of speculation is that individual investors pay higher costs and earn lower returns. At the core of this problem are the self-interests of corporate executives and money managers. Corporate executives are compensated for short-term success in quarterly earnings more than for long-term success in growing the business. The various costs of achieving short-term success reduce the returns of shareholders. Money managers are institutional investors who operate investment funds, hedge funds, pension plans, brokerages, and other financial services. They know a lot about the market and charge high fees for their knowledge. They also use high-speed trading to seek short-term profits. ‘Short-termism’ increases the managers’ expenses, due to portfolio turnover, and raises the shareholders’ tax burden of short-term capital gains. Furthermore, the returns of most professionally operated portfolios eventually revert to or below the performance level of the market (this phenomenon is call “reversion toward the mean”).
Our capitalist society can and should correct for speculation by restoring traditional practices of investment that include exercising shareholders’ rights. Regulators should control speculation by limiting leverage, mandating the public reporting of derivatives trading, and increasing the enforcement of financial crimes (e.g., insider trading, ponzi schemes, conflicts of interest).
Individual investors have little choice but to invest. As “forced capitalists” 1, they must invest for a long time to send children to college and live in retirement. They have no interest in quarterly earnings reports or tricky bursts of cash compared to the traditional investment goal of sustainable growth. They seek investment returns that exceed the economy’s rate of price inflation.
After Bogle explained how multi-layered costs of speculation harm individual investors, he urged individuals to look after their own best interests rather than relying on expensive money managers. One way is to invest in reputable and relatively inexpensive index funds. Here are Bogle’s 10 simple rules for investment success:
- Remember ‘Reversion to Mean (RTM)’– Past performance does not predict a certain future.
- Time is your friend, Impulse your enemy– Aim for compounding returns, not timing the market.
- Buy ‘right’ and ‘hold tight’– Begin with a 50/50 allocation of stocks and bonds, then modify the proportion according to personal need.
- Have realistic expectations– Seek fundamental returns that are adjusted for inflation.
- Forget the needle, buy the haystack– Diversify your investments by buying whole-market index funds.
- Minimize the Croupier’s take– minimize management fees.
- There’s no escaping risk– Even the savings account is eroded by inflation. Use prudent investment to beat inflation and the risks of speculation.
- Beware of fighting the last war– Cyclic trends don’t last. Don’t react to recent trends.
- The hedgehog beats the fox– the “hedgehog” is the traditional strategy of holding diversified assets at minimal cost. The “fox” is speculation.
- Stay the course– Investing is simple, but not easy. It requires discipline, patience, steadfastness, and common sense. The portfolio of an all-stock market and all-bond market fund is not necessarily the best strategy but it is optimal. And there are many worse strategies.
Bogle doesn’t guarantee that his rules will bring success; but neither can more speculative strategies guarantee success.
1. Leo Strine. Toward common sense and common ground. The Journal of Corporation Law 33 (1), 2007.