Thursday, January 30, 2014

John Bogle's "Relentless Rules of Humble Arithmetic"

From some remarks by John Bogle at NYU back in 2007:

"...it's been said (by my detractors) that all I have going for me is 'the uncanny ability to recognize the obvious.' The curious irony, however, is that most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.' But only by facing the obvious realities of investing will the intelligent investor succeed."

Later in those same remarks Bogle added the following:

"The first of the two relentless rules of humble arithmetic I'll mention is a simple one: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return that we investors share."

He goes on to explain "the foolishness and counterproductivity of our vast and complex financial market system."

He does this by using his own version of a parable by Warren Buffett.*
(The original version was covered in a post last year.)

Bogle's version of the parable:

"Once upon a time...a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner's game.

But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some 'smart' Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members, and to buy some shares of others from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members.

To their surprise, however, the family wealth begins to grow at a slower pace. Why? Because some of the return is now consumed by the Helpers, and the family's share of the generous pie that U.S. industry bakes each year—all those dividends paid, all those earnings reinvested in the business—100 percent at the outset, starts to decline, simply because some of the return is now consumed by the Helpers.

To make matters worse, while the family had always paid taxes on their dividends, some of the members are now also paying taxes on the capital gains they realize from their stock-swapping back and forth, further diminishing the family's total wealth.

The smart cousins quickly realize that their plan has actually diminished the rate of growth in the family's wealth. They recognize that their foray into stock-picking has been a failure and conclude that they need professional assistance, the better to pick the right stocks for themselves. So they hire stock-picking experts—more Helpers!—to gain an advantage. These money managers charge a fee for their services. So when the family appraises its wealth a year later, it finds that its share of the pie has diminished even further.

To make matters still worse, the new managers feel compelled to earn their keep by trading the family's stocks at frantic levels of activity, not only increasing the brokerage commissions paid to the first set of Helpers, but running up the tax bill as well. Now the family's earlier 100 percent share of the dividend and earnings pie is further diminished.

'Well, we failed to pick good stocks for ourselves, and when that didn't work, we also failed to pick managers who could do so,' the smart cousins say. 'What shall we do?' Undeterred by their two previous failures, they decide to hire still more Helpers. They retain the best investment consultants and financial planners they can find to advise them on how to select the right managers, who will then surely pick the right stocks. The consultants, of course, tell them they can do exactly that. 'Just pay us a fee for our services,' the new Helpers assure the cousins, 'and all will be well.'

Alarmed at last, the family sits down together and takes stock of the events that have transpired since some of them began to try to outsmart the others. 'How is it,' they ask, 'that our original 100 percent share of the pie—made up each year of all those dividends and earnings—has dwindled to just 60 percent?' Their wisest member, a sage old uncle, softly responds: 'All that money you've paid to those Helpers and all those unnecessary extra taxes you’re paying come directly out of our family's total earnings and dividends. Go back to square one and do so immediately. Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultants. Then our family will again reap 100 percent of however large a pie that corporate America bakes for us, year after year."

Market participants have a better alternative even if too many choose to ignore it. The emphasis should be on generating returns via increases to the intrinsic value of business instead of more cleverly trading price action than the next guy.

More from Bogle:

"That brings us to my second relentless rule of humble arithmetic. Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital."

This can be accomplished by owning an index fund bought well. It can also be accomplished, at least for those inclined and able to do so effectively, by owning a shares of good businesses, also understood and bought well.

In any case, it's buying only what one truly understands (an easy mistake to make is overestimating how well understood an investment truly is), knowing one's own limits, minimizing frictional costs, then allowing -- instead of clever trading -- the per share increase to intrinsic value to be the primary driver of future long run returns.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKaShareholder Letter

In both cases the emphasis is on not making the mistake that was made by the Gotrocks family.

This plainly makes a huge amount of sense but I suspect, since not many seem to have taken the advice of Buffett or Bogle before, they aren't likely to be inclined to do so now.

One of the reasons?

It's just too simple.

"...our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

"Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever." - Warren Buffett

"The business schools reward difficult complex behaviour more than simple behavior, but simple behavior is more effective." - Warren Buffett

Warren Buffett: What He Does Is "Simple But Not Easy"

And, as Bogle points out above, too obvious. Well, sometimes what's simple and obvious also happens to be wise.

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

Some will continue to think they can pick the winning funds beforehand. Some actually will. Others will pay excessive fees thinking that the skill involved will more than offset it.

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former President and CEO of the Harvard Management Company from 1990 to 2005, commenting on investment managers

An investment plan based upon picking the exception seems not a realistic plan at all.

The same is true for stocks. Many shouldn't be trying to pick individual stocks -- especially if their particular approach involves excessive amounts of trading -- but will continue to do it anyway despite the evidence that they're likely to underperform.

Investor overconfidence is a big part of the problem.

Bogle rightly emphasizes humble arithmetic. Yet, in what may seem but is not at all contradictory, Buffett and Munger say, when it comes to investing well, the numbers themselves matter less than some think.**

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

They're hardly implying that the numbers aren't relevant, it's just that there's no place for false precision in the investment process.

Too much of what matters isn't quantifiable.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* The parable can be found in the 2005 letter
on pages 18-19. Buffett's version of this parable is also covered in the prior post. For those familiar with it, there'll be not much new here in Bogle's version. Still, I do happen to think it's the kind of thing worth revisiting from time to time. Others will likely see it, much like Bogle's detractors, as just more recognition of what is obvious. Well, considering the large proportion of participants who underperform the market as a whole, it sure seems that, too often, the obvious gets ignored by some otherwise very smart people. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
** Charlie Munger in this speech at UC Santa Barbara: "You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
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