I wanted to dig deeper into personal finance after the last read. In particular, I wanted to know more about index funds and why despite their simplicity, they’re so popular. So, I turned to none other than the creator of the first index fund and founder of The Vanguard Group, John C. Bogle in his book The Little Book of Common Sense Investing Using “the relentless rules of humble arithmetic” as well as countless opinions from his financial peers (including Warren Buffett), Bogle provides a convincing case for picking index funds based on the following observations:
- The returns of the stock market correspond to the performance of the businesses represented by the stocks.
- The stock market is a zero-sum game. For every gain you make, someone else loses an equal amount.
- You are probably not a skilled investor, and even if you think you are, there’s no way to distinguish it from luck unless you have >90 years of investing data (which is unlikely for any individual).
Therefore, any sort of “betting” on individual stocks or funds goes from a zero-sum game to a loser’s game. It’s just like poker: the house always wins. So if you can’t win by picking a handful of stocks, what do you do? You pick all of them to maximize diversification and minimize risk. This is what an index fund does–it passively tracks a pre-set collection of stocks called an index (e.g., S&P 500) weighted by market capitalization that is representative of the market at large.
The book mainly compares the performance of index funds with actively-managed mutual funds. Through various astonishing and sometimes counter-intuitive examples, the most boring and simplest index fund will outperform trusted individual advisers and mutual funds managed by armies of financial advisers in the long run. This is not only because the returns of index funds are higher, but the associated costs are dramatically lower. A startling statistic I saw: only 3 out of 355 mutual funds outperformed the Vanguard 500 index between 1980 and 2005! And even those returns were only marginally better. A big lesson I learned is that returns come and go, but costs are forever.
The book also talks about other securities like bonds, which are lower in risk than stocks and thus produce lower and more predictable returns. Even here, an index fund performs well although marginally so. However, a big caution point of the book was the rise of ETFs, which are a trading equivalent of index funds. The thing to look out for is the associated costs; it’s much better in the long term to buy and hold than to actively trade.
Bogle concludes the book with a nice summary of the lessons learned as well as some practical advice you can immediately apply to your investments. If nothing else, I would highly recommend reading this last chapter!
This book presents many other miscellaneous lessons, and while it does sometimes alternate between an idealistic manifesto and a gory number-packed treatise, it has definitely solidified the index fund as a cornerstone in my investing strategy. I would highly recommend this to someone looking to understand different investment options!