Wednesday, January 09, 2008

Book reflections on "The little book of Common Sense Investing" by John C. Bogle

Just finished reading “The little book of Common Sense Investing” by John C. Bogle, founder of Vanguard Mutual fund group. I think this book should be read together with Dr. William Bernstein’s The four pillars of Investing and Nassim Taleb’s Fooled by Randomness.

I really recommend the little book series for everyone – it’s so much stuffed condensed into a 8 cm by 10cm by 2 cm book. Almost every sentence makes me think hard. A couple of points kept me thinking:

1. A few risks to be aware of when one is doing individual fund selection.

a. Market risk – the risk that the overall market sinks, so your returns will also drop

b. Individual stocks risk – if one does individual stock selection, there is a risk that the few stocks chosen might do very badly.

c. Market sector risk – This one is similar to individual stock risk, except that it applies to a broader market segment. If say, during the subprime, financials didn’t do too well, and you invested in financial stocks that didn’t have anything to do with subprime, the stock will still undergo a selldown because of market sector. I think can be equally applied to regional funds. Think Japan funds.

d. Manager risk – bad managers, bad selection, bad fund returns.

2. The point that they keep drumming over cover to cover is to buy index funds and hold for long. By doing that, we eliminate individual stock risk, market sector risk (not regional market risk though) and manager risk – leaving essentially market risk. But holding long term sort of reduces market risk too. While historical results doesn’t mean future results, what we can gather from the past is that stocks had always been rising up, so it’s a good bet that I’ll rise up. Keyword: Good bet. Nothing is for sure (except death).

3. Overall market returns is essentially annual dividend yield PLUS annual rate of earnings growth PLUS speculative returns.

a. Dividend yield is more or less stable throughout the years, forming a core

b. Earnings growth increases or decreases according to good times and bad

c. Speculative returns also changes according to sentiment of overall market

4. The author’s point is that on average, speculative returns do not form a good part of market returns. Investment returns – dividend yield plus earning growth – are the ones that drive stock market returns over the long term.

5. Fund return is not investor’s return. Another equation to introduce: Investor’s return is Market return MINUS cost. Costs include expense, sales load, operating costs of the funds. The author is recommending low cost, low expense ratio, no sales load, passively managed (is there such a word?) index funds. He raised a good point that returns can be compounded…so do costs. So as investors, we must really go and hunt for a low cost funds (think fundsupermart instead of from banks). Oh, watch out for high turnover % in funds too, as all these would add in to higher frictional cost, increasing the costs further.

6. If one is hunting for funds, be aware of buying funds in the top few rankings. A few things to consider:

a. Once in the top tier rankings, it means that the funds had already achieved high returns. If you buy into the funds now, then there is a possibility of regression to the mean – meaning you’ll be buying at a high price. Risky business. First guy this year statistically finishes bottom next year.

b. Smaller funds have higher returns than bigger funds. That is the killer for large asset funds. Once they grow big to a certain size, their returns will drop. Why? 1000 to 2000 is a 1000 pt increase or 100% returns. 1,000,000 to 1,001,000 is also 1000 pt increase, but it’s only 0.1% returns. Think about that.

7. Buying index funds with low cost means that you’ll be getting very close to the market’s return. While you’re getting average returns, this beats a lot of actively managed funds hands down in terms of long term returns. Gunning for average turns out to be not so average.

8. Again, magic of compounding comes in. 8% long term returns for market means you’ll double your money in 9 years. So start now, start early.

I've never really mentioned this, but let me say it here. This review reflects my views only, I won't even pretend to say that it's John C. Bogle's view point. I read the book, tried to recall the main ideas of what he's trying to say in the book, and write this review based on my impression on those ideas. In other words, I could be way off the mark.