Remarks by John C. Bogle
Founder, The Vanguard Group and
President, Bogle Financial Markets Research Center
at the National Press Club
March 21, 2001
Wow! Late last December, when I accepted the
National Press Club's invitation to speak today, I selected a theme
that would reflect my expectation that the stock market would continue
to fall. But I surely didn't expect it to fall this far, this fast!
Since December, however, U.S. stocks have moved
into the worst "bear market"a decline of at least 20% from
high to lowsince 1987. It has now lasted fully twelve months,
the second longest bear market since the 21-month, 50% drop from
the January 1973 high to the October 1974 low. In all, the aggregate
value of U.S. equities has tumbled by nearly $5 trillion,
from $17 trillion a year ago to just over $12 trillion currently.
The brunt of the decline has been borne by technology
stocks, the mainstay of the NASDAQ Index. That volatile index has
tumbled from 5048 a year ago to 1857 at yesterday's low, a 63% drop
that clearly confirms that the bubble in New Economy stocks has
burst. The large-stock-dominated Standard & Poor's 500 Stock Index,
a much broader representation of the total market, is now
off 24% from its high. You can get a pretty good idea of the nature
of the decline by observing that technology stocks, representing
34% of the value of the S&P 500 a year ago, constitute just 19%
A Bubble About to Burst
How did the huge technology-led bubble come
to pass? A once-in-a-generation combination of a booming economy
and the optimism of the new millennium; the ebullience engendered
by a quarter-century without a single protracted market decline;
a time of unity (mostly) in the U.S. and peace (mostly) around the
globe; robust growth in "operating" corporate earnings (but not
without some aggressive earnings management); and the siren song
of a New Era"the Information Age"with growth projections
for high tech companies that lost all touch with reality.
The fact of the matter is that it was not difficult
to know we were in a speculative bubble. Indeed, right at the high
of the market a year ago, I prepared a speech on "Risk Control in
an Era of Greed," pointing out that, "when reward is at its pinnacle,
risk is near at hand," and reminding my audience that speculation
has been around for at least 2,200 years. I quoted the Roman orator
Cato: "There must certainly
be a vast Fund of Stupidity in Human Nature,
else Men would not be caught as they are, a thousand times
over, by the same Snare, and while they yet remember their
past Misfortunes, go on to court and encourage the Causes to which
they were owing, and which will again produce them."
After examining the stock market metrics in
March of 2000, I concluded: "So, let me be clear: You can place
me firmly in the camp of those who are deeply concerned that the
stock market is all too likely to be riding for a painful fallindeed
a fall that may well have begun as I began to write this speech
ten days ago. Viewed a decade hence, today's stock market may just
be one more chapter in "Extraordinary Popular Delusions and the
Madness of Crowds."
It was just dumb luck that the timing of my
prescient forecast hit the nail on the head. Indeed, I am hardly
alone among investment professionals who often have a good idea
of what is going to happen in the financial markets, but
very little, if any, idea of when it's going to happen. Still,
today I'd like to look ahead at what returns we might expect in
the U.S. stock market during the coming decade.
Investment Return Calls
First, it is absolutely critical to recognize that
the mathematics of the market are eternal. Complex and mysterious
as the stock market may seem, its returns are determined by the
elementary interaction of just two simple elements, albeit
two elements whose qualities are as different as the night from
the day. The first is investment return, determined by dividend
yields and earnings growth. Investment return tends to be recurrent
and steady. The second is speculative return, reflected in
any change in the price that investors are willing to pay for each
dollar of earnings. Speculative return, however, is intermittent
and spasmodic. Add them together and you have market return.
It's that simple. It really is! Over time, it is earnings and dividendsinvestment
returnthat determine the total return achieved by the
stock market. Consider the past 40 years. Dividend yield plus earnings
growth came to a total of 11.2% per year. The actual return of the
stock market came to an identical 11.2%. In the long run,
it turns out, earnings and dividends call the market's tune.
But speculative return can be the driving
force over the short-term, and even over extended periods. For example,
during 1961-1981, the p/e ratio tumbled from 22 to 8 times, resulting
in speculative return of minus 4 ½% annually, reducing the
investment return of 12% to a market return
of 7 ½%. During 1981-2001, howeverthe period in which
most American families have acquired their investment experiencethe
p/e ratio soared as high as 33 before retreating to the present
level of 24, still enough to add 5% per year in speculative
return, raising the annual investment return of 10%
to a market return of 15%.
Speculative Return Giveth . . . and Taketh
Curiously, despite the all-time high market returns
we've reveled in during 1981-2001, the fundamentals of earnings
and dividends were actually a bit lower than in 1961-1981
(10% vs. 12%). But, the annual market return more than doubled,
from 7% to 15%. Why? Simply because the pendulum of market speculation,
which pulled returns down as it swung from the grand ebullience
of 1961 to the deep pessimism of 1981, sent returns soaring
as it swung back to the roaring optimism that culminated as we celebrated
the new millennium.
And what a difference it made! Consider the magic
of compounding returns on an investment of $10,000 at the start
of each period. The 1961 investor, earning a 7 ½% compound
market return, enjoyed a $32,000 profit at the end of 1981.
The 1981 investor, on the other hand, earned a 15% return,
producing a $140,000 profit by March 2001. That remarkable
near-five-fold increase came, not from corporate profits or dividends,
but solely because of a change in the attitude of investors.
The point is that the economics of market returnsthe
earnings and dividends of America's corporations over two centuriesare
almost always both predictable and productive. The
emotions of market returns, on the other handthe price
that investors will be willing to pay for each dollar of earningsare
unpredictable, at times remarkably productive; at
other times, remarkably counterproductive.
We can use this dramatic example of the two forces
that determine stock returnsthe oasis of investment vs.
the mirage of speculationto look ahead and consider what
returns we might expect over the coming decade. We begin with a
dividend yield that is only 1%, a fraction of the historical norm
of 4%. That, to put it bluntly, is not a lot of gas in the market's
tank. But if we assume that corporate earnings growth will continue
at its 7% annual rate of the past 40 years, stocks would enjoy a
total investment return of 8% annually during the coming
Will speculative return enhance or reduce that
figure? If, ten years hence, investors continue to pay the same
$24 for each $1 of earnings as they pay today (a price-earnings
ratio of 24), then the market return will be that same 8%. If the
p/e ratio were to fall by one-fourth, to 18, that would result in
a negative speculative return of minus 3% per year, bringing
the 8% investment return down to 5%. If, on the other hand, the
p/e were to rise by one-fourth to 30, we'd have a positive
speculative return of 2%, bringing the market return to 10%. Since
the current (and still-relatively-high) p/e of 24 seems much more
likely to decline than to rise, I believe that 5% is a better guess
than 10%. (Warren Buffett, using a different but equally disciplined
methodology, comes up with an estimated return similar to mine.
You'll have to decide how much comfort to take from that!)
What would it take to again enjoy a 15% return on
stocks during the coming decade? Again, assuming an investment
return of 8%, it would require a speculative return of 7%.
That, in turn, would require a final p/e ratio of 47 times. To be
clear, I simply don't believe that number is in the cards.
Market Returns in the Coming
(March 2001-March 2011)
Impact of Speculative Return
The point I'm trying to make is that future market
predictions are largely guesses, not about earnings and dividends,
but about market sentimentinvestor confidence. In that sense,
the market is one big confidence game. (I didn't say "con
game," but I could have.)
I think we would all be well served if the popular
seers of the day would articulate their forecasts in the same two
segments of return that I havehow much is investment, and
how much is speculation. For example, when one of today's most respected
seers predicts, as she does, a level of 1650 in the Standard & Poor's
500 Index at year-end (50% above yesterday's level of 1110), she's
actually forecasting a p/e ratio of 32 times. I share her hope,
but not her conviction.
The Party's Over
In short, we have departed a two-decade-long golden
era for equity investors in which, "we never had it so good," and
are entering an era in which "the party's over." I do not believe
we have yet seen the stock market's lows. Although we are approaching
prices that represent fair value, don't forget that the market overdoes
everything. Having swing so far above fair value, the market
pendulum is unlikely to come to rest there, but to over-swing on
the downside as well.
A new environment for investing which is more likely
to be bland than spicy would hardly be without precedent. The Dow-Jones
Industrial Average, for example, first hit 1000 in 1966; it got
there again (or close) in 1968, again in 1972, again in 1976, again
in 1981, and once again in 1982a 17year plateaubefore
permanently moving into the ever higher ground on which we seemed
so firmly planted just one year ago. Despite the promise of James
Glassman's Dow 36,000, it is at least possible that we'll
find the market in a trading rangeplus or minus 25% from today's
level of 10,000-plusif not for 17 years, for an extended period
But whatever returns the stock market may earn,
please don't make the mistake of thinking that investors will actually
earn those returns. The fact is that few investors ever
capture 100% of the market's long-run rate of return. Why? Because
investing costs money. The fact is that a huge proportion of
long-term investment success is represented by the allocation of
financial market returns between investors on the one hand and financial
intermediaries and tax collectors on the other. For investors as
a group, market return, minus intermediation costs and taxes, equals
investor return. It is as simple as that.
Costs matter! They matter most where they are
at once very large, easily measurable relative to
the value of the services provided, and compounded over timethree
of the defining characteristics of the mutual fund industry. Fund
costs are numerous and substantial. Let me add them up: Management
fees and operating expenses now average 1.6% per year; sales
charges, at least 0.5% annualized; hidden portfolio transaction
costs, with funds now turning their portfolios over at an average
of more than 100% per year, 0.7%; opportunity cost (funds
are rarely fully invested in stocks) perhaps 0.3%. Aggregate
That may not seem like much, but such costs would
consume fully 31% of a 10% market return. The extra taxes investors
are socked with as a result of that hyperactive portfolio trading
could easily consume another 1.5%, leaving only half of the
market's annual return for the fund investor. Simply put, there
are too many croupiers in the mutual fund casino, and their rakes
sweep too wide a swath from financial market returns.
Fund investors have not yet focused on the confiscatory
power of costs. Why? Simply because the stock market's return has
been so generous. In the 15% market return environment of
the past two decades, the average mutual fund provided a gross
return of about 15% (just about what you would rationally
expect). But after costs and taxes, it delivered an estimated net
return of 9%. Result: $10,000 invested in the average mutual
fund produced a profit of $46,000, less than one-third of
the profit on the same investment in the stock market itself, which,
without costs or taxes, grew by $154,000. Despite this abysmal
shortfall, however, fund investors felt pretty comfortable simply
because they had made a lot of dollars in mutual funds, albeit
had hardly received a fair share of the market's beneficence.
But what if a future environment provides a 5% annual
market return? Assuming that fund costs do not decline, but that
tax costs (in a lower return environment) do, the average
fund investor could receive but a 1% return, with many shareholders
garnering negative returns. While $10,000 invested in the stock
market today would earn $6,000 in a decade, the average fund investor
would earn but $1,000! "Disappointment" would be far too mild a
characterization of the shareholder's reaction. So, in a future
market environment of much lower returns, the confiscatory power
of excessive mutual fund costs and unnecessary taxes will severely
challenge the mutual fund industry.
Mutual Funds in the New Environment
In many respects, this industry is a child of the
great bull market of the past two decades. Soaring stock prices
not only raised portfolio values, but enticed millions of investors
into the fold, lifting equity fund assets from $41 billion in 1981
to $3.7 trillion today. But in a bland market environment,
will simply have to get its act together. Significant reductions
in management fees are long overdue, and even if fund directors
lack the willpower and knowledge to demand them, I expect investors
will finally vote with their feet and abandon funds with excessive
costs, finally forcing down fund fees and operating costs.
Transaction costs also must decline, as the counterproductive
short-term speculation that is the focus of so many fund portfolio
managers today finally abates. (Even the average fund now
holds an average equity position for but eleven months.) A return
to the industry's once-traditional long-term orientation (then the
average holding period for a stock was six years) is long
overdue, and would reduce not only fund transaction costs, but the
heavy tax burden that such turnover foists on often unsuspecting
shareholders. It is by no means coincidental that this gradual shift
from investment to speculation has come hand-in-hand with the shift
in portfolio supervision from investment committees to portfolio
managers, and the development of a "star system." Alas, however,
the fund industry has produced infinitely fewer stars than comets.
Totaling up the Tolls
The devastating toll this extraordinary level of portfolio
turnover has taken on fund shareholders can hardly be underestimated.
The direct turnover costs themselves (estimated at $28 billion
last year) paid to brokers, market makers, and investment bankers
are the least of it. Despite the fact that fund investors suffered
capital losses estimated at $240 billion last year, equity
fund shareholders received $345 billion in taxable capital gains
distributions. When these unnecessary distributions are paid to
investors in tax-deferred 401(k) plans and IRAs, there is little
harm done. But the unnecessary realization of gains through excessive
portfolio turnover, borne of speculative investment strategiesand
the fact that nearly one-third of all gains are realized on a short-term
basis and taxed at ordinary income ratesconstitutes a heavy
and unrecoverable burden on the funds' taxable shareholders.
Industry sales charges could also stand reduction.
But the trend today is in the opposite direction. Not so much because
funds which carry sales charges are raising them, but because one
no-load fund group after another is starting a new series of load
funds, often foreclosing purchases of the original no-load
shares to all but existing fund shareholders. Quite clearly, sales
charges represent one more dead weight to the returns delivered
by mutual funds to their investors in the aggregate.
Central to the fund industry's problems is that
the accumulation of assets under management has become the name
of the game; the magnetic attraction of distribution seems irresistible.
And so it is that aggressive marketing has long since superceded
prudent management as the fund industry's central ethic.
Marketing Supercedes Management
We all know what is the best marketing strategy: Offering
the public exactly what it wants. And in its ability to follow
the crowd, the mutual fund industry has few peers. If the investing
public demands cake, well, let them eat cake. The problem is that
the most desirable "cake" is inevitably the cake that has been sweetest
in the recent past, never mind that exceptional past returns achieved
by individual funds or by investment styles is all too rarely prologue
to exceptional future returns. Indeed, quite the reverse is true.
St. Matthew had it right two long millennia ago: Many that are
first shall be last; and the last shall be first.
Taken to its logical conclusion, such a marketing
strategy inevitably places mutual fund managers in the wrong place
at the wrong time. Consider the past decade: It began in 1990 with
the stocks on the bargain counter, yet the smallest component
of the industry's $1.1 trillion asset base was its equity funds,
comprising just 25% of the total. At 30% of assets, bond funds were
considerably larger, and money market funds, at 45%, comprised nearly
one-half of the industry total. Caution, clearly, was the order
of the day, for investors and for the industry.
Now advance the calendar to the first quarter of 2000.
Since 1990, the stock market had risen by nearly 500%(!) and was,
at least in retrospect, richly valued. But the equity fund share
of fund assets had more than doubled to 62% of the industry's then
$6.6 trillion of assets. Conversely, the bond fund share had tumbled
by more than half, to just 13%, and the conservative money market
share had fallen by nearly half, to just 25%. Taking into account
the relative price volatility of the various types of funds and
investment styles, the mutual fund industry's exposure to market
risk had risen nearly 2½ times over. When stocks were near the
cheapest levels in modern history, fund investors had a 33% exposure
to stock market risk; when prices reached the dearest levels ever
recorded, they had a 74% risk exposure.
Money Follows Returns
For that counterproductive increase in risk, we can
give much of the credit to the fund industry itself. To understand
what a marketing industry we have become, just consider the shift
in equity fund capital flows during the years leading up to the
stock market peak last March. From 1989 through 1998, net investor
purchases were fairly evenly divided between relatively conservative
middle-of-the road value-oriented funds (37% of cash flows), and
riskier, more aggressive growth-oriented funds (37% of flows). (The
remainder went to international funds and balanced funds.) But in
1999, the growth fund share leaped to 92%, and then to 113%(!) during
the first quarter of 2000. On the other side of the coin, the share
of cash flow into value funds dropped to 8% in 1999 and to minus
37% during the first quarter of 2000. (That is, investors purchased
$127 billion of growth funds and liquidated $42 billion of
value funds.) At the very moment when they should have been minimizing
it, fund investors were maximizing their speculative risk.
Clearly, it was relative fund performance that clearly
drove this shift in investor preferences. While growth funds and
value funds provided comparable returns from 1990 through 1997,
growth funds soared into the lead through early 2000, providing
annualized returns averaging 42%, compared to just 8% for value
funds. But reversion to the meanthat seeminglyuniversal
rule that "the last shall be first and the first shall be last,"
over and over againpromptly took over. Since last March, growth
fund prices have declined nearly 40% on average, while value
fund prices have seen a slight rise.
Pandering to the Public Taste
It would be easy, far too easy, to argue that the
investorever following past performance, ever following the
crowdis his own worst enemy. But the fund industry must bear
a large share of the blame. First, it pandered to the public taste
by creating 494 new growth funds during that 2 ¼ year period, compared
to just 110 value funds. Second, not only did funds vastly step
up their advertising budgets to encourage investors to jump on the
stock market bandwagon, but advertised the heady past performance
of some of the industry's "hottest" funds, many with annual returns
What's wrong with that? At least these two things:
First, winners rarely, if ever, repeat. And those
who produce advertisements hyping past performance are as aware
of that inevitable fact as the countless academics whose studies
attest to it. Second, advertising is expensive. Directly
or indirectly, it is the mutual fund shareholder who foots the bill.
In 1999-2000 the industry's seemingly unbridled marketing budget
likely included some $1 billion for media advertising alone (not
including $120 million that one fund group recently spent to have
a football stadium carry its name!). To put it bluntly, fund shareholders
had $1 billion of their money spent on advertising. How this
expenditure advanced their interestsor their returnsis
not at all clear.
This marketing opportunism found its finestif
most perversefocus in the fund industry's response to the
Information Revolution or, more accurately, to the soaring returns
generated by information technology stocksinternet companies,
cell phone makers, computer manufacturers, etc. In 1989-1995 an
average of but one new technology fund was formed each year.
In 1999, the number leaped to 29, and in the ebullient first quarter
of 2000 another 71 new tech funds joined the fray. Investors
took the bait, and in the first-quarter of 2000 technology funds
alone gathered 30% of the industry's all-time record equity
fund cash inflow of $113 billion. Up to then, returns on technology
funds had averaged 92%, annualized(!)more than double
the return of even the soaring growth funds. But in the aftermath
of the tech stock boom, tech funds have tumbled by 63%, half-again
the 42% tumble in the weak growth fund group. Sweet marketing,
it turns out, is usually sour investing.
Last March, two funds were formed that will go down
in history as paradigms of the paradox that the time to sell funds
is not the time to buy them. A giant brokerage firm organized two
highly concentrated and aggressive "New Era Funds"an Internet
Strategies Fund and a Focus 20 Fund. Right at the market's high,
in an initial public offering, the firm sold $2 billion of their
shares to clients. The base offering price was $10.55 per
share. Apre moi le deluge! During the ensuing year, the net
asset value of the Internet fund tumbled to $2.44 per share,
trailed only slightly by the Focus 20 fund at $3.24, together
obliterating $1.4 billion of investor assets into thin air. Viewed
at the time as a marketing triumph, this offering, has become,
at least for the moment, an investment disaster.
So the chickens have come home to roost in the mutual
fund industry, and much change is required. I hope it is not ungracious
to my hosts in the press if I point out that both the media's embrace
of the New Economy and its focus on short-term investment thinking
and past performance have helped lead mutual fund investors astray.
Now that the party's over, I hope you will help to refocus the attention
of serious investors on long-term investing, reasonable expectations,
diversification and asset allocation, and cost- and tax- efficiency.
Standing up for those eternal principles of investment success would
be an invaluable public service.
Did He Say Bond Funds?
The equity fund deck of the huge mutual fund battleshipwith
its high expenses, excessive tax costs, short-term investment orientation
and marketing-driven focus that have together so substantially impaired
the returns earned by fund ownersis by no means the only deck
in need of repairs. The bond fund deck is another. One failing is
the industry's near-shunning of bond funds just when investors needed
them most. Another is offering bond funds with such high costs that
they deserve to be shunned. In a New Environment in which
bond returns are apt to be more competitive with stock returnsall
the while carrying far lower riskthe industry will be forced
to rectify those failings.
It's hard to overstate how much refurbishing the bond
fund deck of the industry ship requires. Excessive management fees
and operating expenses and excessive sales charges wreak even greater
hardships on bond fund investors than on stock fund investors. Consider
the simple mathematics. Today, the yield on the Lehman Bros. Aggregate
Bond Index (government and investment-grade corporate) is 6.6%.
If an investor pays a 4½% initial sales charge and a 1% annual expense
ratio and holds the fund for five years, his average yield would
be just 4.6%! Two-thirds of the return to the shareholder, one-third
to the croupiers. (For a tax-exempt bond fund the penalty is even
greater!) Clearly, that is a far cry from a fair shake.
And yet, nearly half of the industry's bond funds926
of 1,874 fundscarry a sales charge. The average expense ratio
is 1.1%, and only 75 fundsone out of 25 (!)have
expense ratios below 0.3%, my idea of a fair shake.
Yet when investors will to bond funds in the New Environment that
will emerge once the fall in the stock market is over, they will
have few choices that make even the most tenuous economic sense.
Here again, the fund industry has much to do to earn the loyalty
and trust of fund investors.
Too Broad a Brush?
Lest I paint the industry with too broad a brush,
let me say that there are some firms who have resisted the temptations
that I have catalogued today. It is a curious fact that those firms
have generally avoided, not some, but all of those
baneful practices. These firms have: 1) Minimized costly and aggressive
marketing (though no firm can totally eliminate it). 2) Shared at
least some significant portion of their staggering economies of
scale with investors by holding the line on costs. 3) Maintained
investment discipline in portfolio management and focused on the
long term; and 4) Avoided the fads and fashions of the day, introducing
new funds not just because they make dollars for the manager
but because they make sense for the shareholder. While no firmno
firmhas had the discipline to bat 1.000 in this tough league,
there are at least a few that are batting upwards of .750. But painfully
few. Out of the 400 fund complexes in this business today, I don't
think that I could name more than a dozen that meet my high, but
I think reasonable, standards.
Confession, it is said, is good for the soul.
So I confess that I make my candid remarks today from a singular
vantage point. When I founded the Vanguard Group more than 26 years
ago, it was deliberately structured as a mutual mutual fund
organization, controlled, not by an outside corporation, but by
the fund shareholders themselves. Since cost so obviously matters
(I guess that I've made that clear!), we operate on an at-cost
basis, hold expenses to the bare bones minimum, and do not squander
shareholder resources on marketing.
This focus quickly led me to the founding of
the industry's first stock and bond market index funds (which do
provide substantially 100% of those markets' annual returns), and
to the elimination of all sales charges. It is putting the shareholder
first in everything we do that has been the foundation of whatever
success Vanguard may have enjoyed.
If the criticisms of the fund industry I've
expressed today sound tough, it is not because of my pugnacity,
but because of my perspective. While few firms willindeed,
realistically, few firms canfollow Vanguard's example, any
firm that wants to be as successful in the New Environment after
the fall as it has been in the Old Environment before the
fall will have little choice but to move in our direction. .
It's high time we get back to the business of prudent, long-term
investing. And it's best, I think, to place stewardshipserving
clients in the most honest, efficient, and economical way possible-at
the top of the agenda. It is that single valuethe stewardship
of other people's moneythat will place the mutual fund industry
on the right side of history.
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.