Book review: John C. Bogle,The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns

Successful investing is all about common sense.

This quote from the book signifies that if investors follow just common sense, they can become successful in their investment journey. This book emphasizes only one investment philosophy that buying and holding ultra-low-cost broad-based market index funds (such as the S&P 500) for the long term is the most productive investment strategy to create wealth. All 20 chapters of this book converge towards the same investment philosophy. The first edition of the book was published in 2007, and this is the 10th-anniversary edition of the book with revised and updated data. This book is part of the Little Book Big Profits Series of Wiley, where the brightest icons in the financial world write on a range of investment topics in simple and understandable terms.

The author, John C. Bogle, is the founder of The Vanguard Group of mutual funds, and he introduced the first index fund. He is considered a legend in the mutual fund industry. His investment philosophy is well supported by highly regarded financial market wizards such as Warren Buffet, Benjamin Graham, Paul Samuelson, Burton Malkiel, and many others. He has cited Warren Buffett and Benjamin Graham multiple times in various chapters of this book to support his arguments.

The book begins with a parable about the Gotrocks family, a story told by Warren Buffet in Berkshire Hathaway’s 2005 annual report. All members of the Gotrocks family owned 100% of all stocks in the United States. They were not trading the stocks. Hence, all the earnings growth and dividends of all the corporates in the United States belonged to them, and enormous wealth was created for all family members over the decades. After a while, some members started buying and selling shares on the recommendation of some helpers (investment advisors, stock-picking professionals, financial planners, fund managers and consultants) to earn more than other family members. But they were surprised to see that the family wealth grew slower than the overall market after this rearrangement of ownership. It was only because of the helpers as they were consuming some part of the overall wealth generated by the market in the form of fees and other charges. In addition to that, family members were paying transaction costs and brokerage; some were paying taxes on dividends; and some were paying capital gains taxes. Finally, the family sat together, and the wisest old family member suggested getting rid of all these helpers to again reap 100% of earnings growth and dividends. All members followed the advice and adopted their old passive strategy of holding all stocks of the United States, and the Gotrocks family lived happily ever after. The same thing (owning the entire stock market) is done by a broad-based index mutual fund such as the S&P 500. This book presents a comparison of index fund investing with all investment options (individual stocks, active mutual funds, bonds, Exchange-Traded Funds [ETFs] and smart ETFs) with pros and cons.

While analyzing the performance of active mutual funds, the author mentions that actively managed funds come and go, but the index funds stay forever. Out of 355 equity funds in 1970, 281 (almost 80%) had gone out of business by 2016. If a fund does not persist for the long term, how can investors invest in them for the long term? Only 10 mutual funds (out of these 355 funds) outpaced the market returns by more than one percentage point per annum (very poor odds of beating the market). The odds of identifying such long-term winners are like looking for a needle in the haystack. Hence, investing in passive index funds is a simple yet winning strategy. It is like buying the haystack. The cost of financial intermediation (brokerage, transaction charges, asset under management fee, performance fee, sales loads, advertising costs, etc.) is why only a few actively managed mutual funds can beat the index returns after transaction costs. Before costs, beating the market is a zero-sum game, but it becomes a loser’s game after costs. Hence, trying to beat the market is a loser’s game. The power of compounding is affected negatively by the costs incurred by the investors as these costs also compounds in the long term.

The author highlights that many times, mutual funds show good returns, but the mutual fund investors do not earn these returns due to the wrong timing of entry and exit in the fund. Investors invest in mutual funds at the bull market peak due to greed and exit the funds during the bear market in panic due to fear. Past performance of mutual funds cannot guarantee future performance as well. Today’s best-performing funds may not be the best performing funds tomorrow simply because of the reversion to the mean. Hence, trading in individual stocks or holding mutual funds is a costly affair and does not necessarily promise superior performance. Investors should invest in the lowest-cost broad-based index fund that owns the entire stock market. It works irrespective of whether markets are efficient or inefficient.

While comparing index funds with bonds, the author mentions that history tells us that stocks have generally provided more returns than bonds. Therefore, investing in bonds is not a better option. However, investment in bonds is advised to make a balanced portfolio which can be done by investing in the bond market index fund rather than directly investing in bonds. The benefits of the bond index are as good as benefits from stock index funds: broad diversification, ultra-low-costs, disciplined portfolio, tax efficiency and long-term compounding.

In the chapter on ETF, the author outlines that ETF is a sort of wolf in sheep’s clothing. ETF is nothing but an index fund designed to trade in its shares. If you are a long-run investor, stay with traditional index funds and no need to fall into ETFs’ trap. ETFs are passive investments in the index like traditional index funds. However, they can be traded on an exchange like stocks during market hours, making it a vehicle for short-term speculation, which is not the best investment strategy. Because when investors trade ETFs, they pay brokerage, transaction costs, and taxes, which is not a wise idea for wealth creation in the long term. Hence, there is nothing wrong with ETFs if they are held for long-term. They are as good as traditional index funds. However, trading in ETFs is a loser’s game.

While discussing Smart beta ETFs, the author mentions that Smart beta ETFs have become a popular product these days. It is a new breed of passive indexers that wants to beat the market like an active strategy. Smart beta ETF managers select some stocks based on some factors (value, momentum, size, etc.) and make an index by giving weights to the constituent stocks. Smart beta ETFs offer a combination of higher returns and lower risk. The assets of these smart beta ETFs are also growing in recent years, and they have done well in terms of performance. However, the author suggests sticking with investment in traditional index funds to guarantee that you receive your fair share of market returns over the long term. The author is not sure of the long-term success of smart beta ETFs because these are active strategies having more transaction costs than traditional index funds. Here the author quotes the prophetic warning of Carl von Clausewitz, military theorist and Prussian General of the early nineteenth century: ‘The greatest enemy of the good plan is the dream of a perfect plan’. Hence stick to the good plan of investing in the traditional index funds.

Overall, the gist of the book is that the only way to guarantee your fair share of stock market returns is to invest in an ultra-low-cost broad-based index fund that owns the whole stock market. It is the simplest passive, parsimonious, productive and proven investment strategy that ensures long-term wealth creation by the magical power of compounding. This book provides empirical evidence and analysis of the same via historical facts, figures, statistics and simulations. To support the author’s arguments, every chapter contains a ‘Don’t Take my Word for It’ section where well-known financial wizards (investors, fund managers, academicians, market experts, etc.) favour the arguments put by the author. Investors are not supposed to think about beating the market returns. They should instead mimic the market returns. Hence, owning the whole market like the Gotrocks family is the winner’s game. Trading in stocks, bonds, mutual funds assuming to beat the market is a loser’s game.

This book is a must-read for all new investors to avoid turning a winner’s game into a loser’s game. This book is a classic book on teaching how to invest in the stock market, and it is worth a read for all finance students, fund managers and academicians. Warren Buffett also mentions in his 2014 annual shareholder letter that rather than listening to the siren songs of investment managers, investors (large or small) should read this book. This book is quite simple, targeted at common investors. However, this book was repetitive as the same argument (of investing in index funds) was repeated many times in different chapters from different angles. One more thing I want to mention is that this book is not about making you rich overnight. It provides deep insights about investing in individual stocks, mutual funds, index funds, bonds and ETFs.