Historically, most of the returns from the stock market have arisen because of investment returns (primarily earnings growth and dividends), not speculative capital gains, Bogle says. This is a major theme of the book, which is subtitled Investment vs Speculation. Thus, in the past 40 years, the annual investment return was 9%, “almost precisely equal to the stock market’s total return of 9.3%,” Bogle says in Chapter 9, “The speculative return on stocks was just 0.3%.”
But speculation accounts for a huge percentage—99.2%—of the activities of the equity market system, compared to a tiny 0.8% for capital formation. Bogle estimates that annual trading in stocks averaged $33 trillion while capital formation—which he defines as directing fresh investment capital to its highest and best uses—averaged just $250 billion.
Salesmanship vs stewardship
As with his earlier books, Bogle is highly critical of the investment industry and especially the mutual fund industry, for the high costs and conflicts of interest that pervade the system. Too often, the industry has put salesmanship over stewardship. He’s also pessimistic about the American retirement system and 401(k) Defined Contribution plans.
One chapter is devoted to the American retirement system, which he condemns as featuring “too much speculation, too little investment.” Readers and Vanguard fans won’t be surprized to learn that his recipe for fixing the system rests largely on broad-market low-cost index funds. He also comes down hard on exchange-traded funds (ETFs), which he views as exacerbating speculative urges.
In a box entitled Reasonable Investment Expectations for the Coming Decade, Bogle gives readers some idea of what returns might be expected in the decade commencing in early 2012. The dividend yield on the S&P 500 is 2.1% while annual earnings growth of 5 to 6% or a bit less seems “a reasonable likelihood.” The result: a “possible investment return averaging 7 to 8% a year.”
After outstanding earnings in 2011, price/earnings ratios now stand around 16 or the long-term historical average:
“I don’t expect that P/E to be a lot different when 2022 begins. Result: a speculative return of zero, more or less. Combining the two sources, reasonable expectations suggest an annual total stock market return of 6 to 9 per cent during the coming decade.”
Addressing bond returns, assuming a mix of one-third Treasuries and two-thirds corporate bonds, Bogle says investors could expect a fundamental return “near today’s yield of around 3 per cent.” Over 10 years, there should be no significant speculative return, so he pegs the annual total return on bonds at between 2 and 4%.
However, he cautions these numbers reflect nominal returns so if inflation averages 2.5% a year, the return on a balanced 60/40 portfolio would fall from 5.4% to 3% before investment expenses. If those all-in costs come in at the 2% typical for mutual funds, then “only 1% would remain for the investor. That’s largely why index funds (0.1% cost) are such a reasonable option.”
Stocks reasonably valued, bond yields awful
As of mid 2012, Bogle views economic and market conditions as being “as challenging a combination as I have seen at any time during my 61 years in finance.” He views the U.S. stock market currently as being “reasonably valued” while “bonds yields are, well, awful.” The yield on 10-year U.S. treasury notes is just 1.6%, while the yield on the total bond market index is 2.03%: “only slightly above the stock yield of 2.0%.”
Bogle says his “unvarying advice” continues to be to “accept the yield environment as it exists (no matter how painful).” Investors should avoid reaching too far out on the risky limbs of higher-yielding junk bonds and high-dividend stocks, he says. However, he concludes, “Invest you must … for not investing is an iron-clad formula for failure.”
The major ideas in the book are reprised in the 7-minute video clip below. Note in particular Bogle’s call for a “fiduciary society.” It’s well worth watching.