The Little Book of Common Sense Investing - critical summary review

In their most basic form, “index funds” are “mutual funds that simply buy shares of substantially all of the stocks in the U.S. stock market and hold them forever.” “The Little Book of Common Sense Investing” by John C. Bogle – the creator of the first index fund – is not just a book about index funds. It is a book, in his explanation, about how financial markets work, about the value of diversification, and about why long-term investing serves far better than short-term speculation. It is, in a sentence, a book “determined to change the very way you think about investing.” Well, get ready for such a change!

The Gotrocks family

Before you can understand how index funds work, you must understand how the stock market works. And there’s no better way to do that than a “folksy parable,” first told by Warren Buffett in the Berkshire Hathaway’s 2005 Annual Report, and adapted by Bogle for his own purposes. The moral, however, remains unchanged.

Once upon a time, there lived a wealthy family named the Gotrocks and they owned 100% of every stock in the United States. The value of some stocks fell, the value of others rose, but all in all, in the long run, they were always on the plus side as a family. After all, they earned on every stock in the country and, historically, the stock market has returned an average of 10% annually. The Gotrocks family was playing a winner’s game.

Unfortunately, after a while, “a few fast-talking Helpers” persuaded some smart Gotrocks cousins to sell some of their shares to other family members and buy theirs. That way, the Helpers told them, the cousins could earn a larger share than any of their other relatives. Even so, with the ownership of the stocks merely rearranged in the family, the Gotrocks’ wealth should have grown at the same pace. It didn’t. That’s because some of the investment return was now consumed by the Helpers and some by the state, because stock-swapping back and forth generates capital gains taxes.

In search of a solution, the cousins only made matters worse by hiring stock-picking experts. The commissions the family had to pay them further diminished the family’s original 100% share of the dividends and earnings pie. Alarmed, the Gotrocks asked for advice. An old uncle gave them the best one: “Get rid of all your brokers, money managers and consultants. Go back to square one, and do so immediately. Go back to your original passive but productive strategy: holding all the stocks of corporate America, and standing pat.” Well, this is precisely what an index fund does.

The difficulty of selecting long-term winners

Summed up by Buffett, the moral of the Gotrocks story sounds like a fourth Newton’s law: “for investors as a whole, returns decrease as motion increases.” Bogle makes it plainer by subverting a common belief into an investor’s dictum: “Don’t do something. Just stand there.”

Unfortunately, most investors don’t. They believe that actively managed funds will get them more money than any passive strategy. Unlike the Gotrocks, they don’t have to think in terms of large families, and unlike the cousins, they believe they are smart enough to pick the winners, the good performers. After all, there are many mutual funds whose annual return far surpasses the market’s. Are there, though?

If you consider the 46-year records of the 355 equity funds that existed in 1970, you’re in for a big surprise: 281 of those funds (almost 80%) have gone out of business! In other words, there are 8 in 10 chances that you’ll invest in a fund that is bound to cease trading in the next half a century. And if your fund doesn’t endure for the long term, Bogle justly asks, how can you invest for the long term?

That’s not the worst part. Out of the remaining 74 funds, 29 were outperformed by the market (11 solidly, trailing by 2% or more), and 35 did neither better nor worse than the market. That leaves only 10 winning funds, and only two of those were solid winners: Peter Lynch’s Fidelity Magellan Fund and Will Danoff’s Fidelity Contrafund. Even if we take into calculation the marginal winners – which outpaced the market by one percentage point per year – you’re still left with terrible odds: only one fund out of every 35 beats the market. Still interested in finding it?

How most investors turn a winner’s game into a loser’s game

Nobel Prize-winning economist Paul Samuelson summed up the difficulty of selecting a superior manager perfectly in the following thought experiment. “Suppose it was demonstrated that one out of twenty alcoholics could learn to become a moderate social drinker,” he wrote. “The experienced clinician would answer, ‘Even if true, act as if it were false, for you will never identify that one in twenty, and, in the attempt, five in twenty will be ruined.’” 

However, the difficulty of choosing the right fund is not the only problem with actively managed funds. The other – as the Gotrocks found to their dismay – are the costs. Even if your manager is somehow capable of selecting long-term winners, you will have to pay them for their money-making abilities. Deduct that from your winnings and you’re a loser again! Here’s why.

Let’s assume that at 25 years of age you make an initial investment of $10,000, and that the stock market averages 7% return per year over 50 years. Taking into account “the magic of compounding returns,” you will have earned almost $300,000 by the time you’re 75 years old.. 

Now, let’s assume that instead of investing the money to buy all the stocks in the U.S. stock market, you invest them in an actively managed fund that performs a bit better than the market. If the fund operates at a cost of 2% or 3% per year, even in the best possible scenario, your net annual return will dwindle to 5%. By the end of the 50-year period, that amounts to about $115,000 in fund totals, or about $180,000 less than what you would have earned in the market itself! How is that possible? Easy: blame it on “the tyranny of compounding costs.” Over the long term, it inevitably overwhelms the magic of compounding returns.

“The grim irony of investing, then,” writes Bogle, “is that we investors as a group not only don’t get what we pay for: we get precisely what we don’t pay for. So, if we pay nothing, we get everything. It’s only common sense.” As the example shows, commonsensical are the following two ideas as well: 1) Beating the market before costs is a zero-sum game; and 2) Beating the market after costs is a loser’s game.

Knowledge vs. luck

There’s another, final problem with actively managed funds, and this one involves overperforming managers. To understand it better, we’ll use another thought experiment, this one by former trader and mathematical statistician Nassim Nicholas Taleb.

Let’s imagine a group of 10,000 investment managers trying to guess whether a stock will go up for a single year. If they guess right, they make $10,000 over the year. Let’s also imagine that at the end of every year, the losers are tossed out of the game. By the end of the first year, due to random chance only, we could expect 5,000 of the managers to be out, and 5,000 to be up $10,000 each. If we continue running the contest, there would be 313 managers $50,000 richer in five years. Stranger still, in a decade, there would be 10 people with $100,000 on their accounts – all out of sheer luck. “The number of managers with great track records in a given market,” concludes Taleb, “depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits.”

The odds are discouraging. According to Ted Aronson, an investor, you would have to monitor the performance of an actively managed fund for 20 years to know, with about 75% statistical certainty, if the money manager is skillful and not lucky. To be 95% percent certain, it would take you nearly a millennium! That, of course, is not a stat that will ever be available, because most successful money managers only play the game for a few decades. So, we’ll never know if even the best among them were merely lucky.

Intelligent investing and index funds

In the long run, the market evens out. Even though there have always been decades of abundant stock market returns – the late 1920s, the early 1970s, the late 1990s – it’s only a matter of time before the market lows neutralize the winnings: the Great Depression, the late 1970s, the dot-com bubble and the financial crisis of 2007/08. This is called reversion (or regression) to the mean (RTM) and it’s a statistical phenomenon confirmed by numerous comprehensive analyses. What they unambiguously demonstrate is that fund performance always reverts toward the mean, or even below.

In other words, if you are a serious investor who, instead of looking for a get-rich-quick-or-die scheme, is interested in a guaranteed stock market return, then speculating on the market through actively managed funds is not for you (if it is for anybody). Much like picking the stocks yourself, statistically it boils down to nothing short of looking for the proverbial needle in the haystack. Moreover, it costs. As Bogle writes, when you use a money manager, even though you put up 100% of the capital and assume 100% of the risk, you earn less than 40% of the potential return.

Speculation is, by definition, irrational; intelligent investing is not. Promoted by Benjamin Graham in his 1949 influential book of the same title, intelligent investing has little to do with adrenaline, trading, and imagination, but a lot to do with safety, conservatism, and limited ambitions. It advises strict adherence to “standard, conservative, and even unimaginative forms of investment” and puts an emphasis on diversification. The more eggs in your basket, the more chances you’ll replicate the market’s return. The less you pay people while doing this, the more of the earned money is yours. “To achieve satisfactory investment results is easier than most people realize,” wrote Graham in 1949; “to achieve superior results is harder than it looks.”

In its absolute form, Graham’s strategy could really only be put into practice after Bogle created the first stock market index fund in 1976, an event described by Paul Samuelson as “the equivalent of the invention of the wheel, the alphabet, and wine and cheese.” An index fund is essentially an all-market portfolio, that is a basket that holds many, many eggs (stocks), specifically designed to “mimic the overall performance of the U.S. stock market (or any financial market or market sector).” That’s why, by definition, it eliminates the three greatest risks of investing: the risk of picking the wrong individual stocks, the risk of picking the wrong manager, and the risk of emphasizing certain market sectors that might underperform. That leaves you only with the stock market risk. In the long run – and traditional index funds (TIFs) are designed to be held for a lifetime – that also guarantees a fair share of stock market returns.

Final notes

“The Little Book of Common Sense Investing” couldn’t have been more aptly titled. The great thing is that it justifies its subtitle as well. Read it. Even Warren Buffett says it’s the best thing you can do if you’re serious about investing.

12min tip

Don’t try to beat the market – bet on it. Invest in low-cost index funds.