John Bogle on Bubbles & Crashes

The Twelve Pillars of Wisdom Lessons We Should Have Learned before the Bear Market Arrived, but are Only Learning Now Remarks by John C. Bogle The Arizona Republic Investment Strategies Forum Phoenix, AZ April 27, 2001 Despite the 15% stock market rally of the past month, a nice rebound from the early April lows, the bear market in stocks that began nearly 14 months ago may yet have some life remaining. But at that scary low point, even if you were a prudent investor, and even if you had seen the decline coming, you may well have had at least two second thoughts: “Why didn’t I cut back—or even eliminate!—my equity holdings a year ago?” And “What on earth should I do now?” As to the first question, I struggle with that one myself. I have been gradually reducing my equity percentage for years, reflecting first my fight for an uncertain survival from congenital heart disease and my desire to assure my wife’s financial security, and, second, reflecting my increasing age and declining earning power. With some 75% of my retirement plan and personal account in equities throughout most of my career, I had gradually reduced the ratio to below 45% by last summer. Still, deeply concerned about the NASDAQ bubble and cautious about the outlook for future stock returns, I even wondered aloud at the Morningstar Conference last June why I held any equities at all. But—“physician heal thyself,” writ large!—I took no further action. Why? Certainly inertia was part of it.

The collapse of the proud towers; human beings plunging 100 stories to their death, often hand in hand; the poignancy of a husband’s final words to his wife on a cell phone; the threat of terrorism; American troops hunting an elusive foe in deepest Asia; nervousness about our financial system; fear of a change in our way of life. It was a dark moment in U.S. history; indeed, it’s difficult to imagine a more emotion-packed time in American history than the days and weeks following the attack on our nation that took place on September 11, 2001. The Birth—and Burst—of a Bubble When the attack came, a bear market was already underway. At the peak of the technology bubble in March 2000, the total value of all U.S. stocks was $16.2 trillion. As the market prepared to open on September 11, that value had tumbled to $12.of

Today I’d like to examine each of those three key building blocks of investing and consider: 1) the prospects for future returns on stocks and bonds in the aftermath of the burst in the technology bubble; 2) the necessary resolution of the problems borne of financial manipulation that has clearly taken place in America’s corporate community and in the investment community alike; and 3) the extent to which our wealth management institutions have provided their clients with their fair share of financial market returns. In each case, I’ll present some policy recommendations that I believe will help wealth management firms to serve their clients far more effectively in the years ahead. With U.S. households owning some $32 trillion of financial assets—fully one-third of which is held by millionaires—the wealth management industry, as it were, has a huge stake in doing exactly that.

To get some perspective on this remarkable bubble, consider the near 30-year history we have in which we can compare these two different indexes. It begins at the end of 1971 when the NASDAQ Index—then known as the “over-the-counter” index of stocks not listed on a stock exchange—was a motley aggregation of the stocks of small and relatively unknown companies valued at an estimated $60 billion, equal to about 8% of the $750 billion value of the companies listed on the New York Stock Exchange—a pint-sized younger brother to the older and dominant giant.

Today I’m going to present to you graphic evidence of these trends, which, I fear, bode ill for this industry, and for the financial markets as well. While I have been speaking out on these trends for more than a decade now, they’ve only gotten worse. On the other hand, confession being good for the soul, I acknowledge that there is little evidence of their baneful effects on the stock market—so far at least. Protecting the Interests of Those Whose Funds They Command . . . Nonetheless, these trends—the focus on marketing, the soaring levels of fund investment activity, and the huge increase in fund expenses—could combine to engender, a year or two or three down the road, the kind of statement made in 1934 by Justice Harlan Fiske Stone as he reviewed the events that led to the Great Crash of 1929 and the Great Depression that followed. “When the history of the financial era which has just drawn to a close comes to be written, most of the mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . The development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function.

From the start of 1998 through the first quarter of 2000, the NASDAQ Index, home of the New Economy, rose by 200%. During the same period the New York Stock Exchange Index, largely Old Economy issues, rose just 26%. (The difference between the two indexes is not inconsequential: A NYSE listing requires a company to have at least three years of operating earnings; the NASDAQ requires no earnings history.) And then the bubble burst. In fits and starts, the NASDAQ Index plunged. At its low following the terrorist attack, it was down 72% from its earlier peak. The NYSE Index, by contrast, was off just 2% during the same period. From 1998 to date, the net return: NASDAQ +9%, NYSE +8%. In the aftermath of this boom and bust cycle—just one more such cycle in the annals of American finance—this conference presents a wonderful opportunity for this veteran participant in the rapidly-changing world of investing to meet with this group of information technology professionals from all across the nation. I want to discuss the role of technology in changing the financial marketplace, its impact on the mutual fund industry, and how Vanguard has responded. I’ll conclude with some investment advice that I believe will help you become richer rather than poorer as you pursue your personal goal of long-term wealth accumulation. Does Technology Help us to Better Serve Fund Investors?

1. Faith in the Financial Markets I’m confident that few, if any, of you in this sophisticated audience have any doubt that we have moved into a new era for the financial markets. I expect that it will be an era in which the returns of stocks and bonds alike will be substantially lower than the unprecedented double-digit returns we’ve experienced in the past, indeed—unless you’ve put in more than two decades in this wonderful business—the very past that comprises your entire first-hand experience in the markets. And you need three decades to have known first-hand what the 50% market crash in 1973-74 was like. (This one’s now at 40%). Suffice it to say that it was almost exactly twenty-years ago—on August 18, 1982, in the aftermath of a nine-year bear market—that interest rates turned downward and stock prices leaped upward. The T-bill rate, 11% when August began, promptly tumbled to 8%. The Standard & Poor’s 500 Stock Composite Index leaped from 103 to 113 during that single week, and to 120 by month’s end, in the blink of an eye, a gain of 17%. We were on the way. In the great boom, which culminated with a great bubble in March 2000, the Index was to rise to 1527. By then, the annual return on stocks had reached a level unprecedented in any comparable period in history—just short of 20% per year. And the bond market, which earned a return of more than 10% annually over this long period, also performed far better than ever before.

30% in the total stock market index. Most of that drop was represented by the burst in the "new economy" bubble, with the technology-driven NASDAQ Index off 66% and the largely “old economy” New York Stock Exchange Index off but 16% from the high. Yet while a $4 trillion loss in market capitalization is hardly insubstantial, veteran investors recognized that much—perhaps all—of that $16 trillion total never had much substance in the first place. We usually know what is coming, but we never know when. (That’s why we’re not market timers!) After all, the market had also been valued at $12 trillion as recently as early 1999, and most investors were ecstatic with the returns they had earned. The dip simply represented a return to reality, a change in the market’s emotional state from greed to what seemed like caution. The powerful emotions unleashed in the aftermath of the attack quickly soured the mood of investors. Fear was in the saddle, driving the market down another 14% after the market reopened, erasing another $1.4 trillion of value. Only a fool would challenge the notion that some degree of fear was—and still is—warranted. Our world has changed. But wise investors realize that, time and again through stock market history, the emotions reflected in the market pendulum have swung from optimism to pessimism. And then back again. But in the long-run, the perspective is clear. Emotions don’t matter. Economics do.

Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect whose who interests they purport to represent . . . consider only last the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle.”1 In this industry, then as now, small groups “control the resources of great numbers of investors,” and it is fund managers who must accept the lion’s share of the responsibilities for the baneful trends I will discuss today. But fund directors—“those who serve nominally as 1 I last used that quotation in my “State of the Firm” address to the officers of Wellington Management Company in 1971, more than three years before I founded Vanguard. I was reflecting on the harm the fund industry inflicted on investors during the “Go-Go Era” of the 1960s, the precursor of the devastating 50% market crash of 1973-74.

It is hardly necessary to draw a chart showing the parabolic arc that reflected this explosion in the prices of NASDAQ stocks to draw the obvious conclusion: We were experiencing a bubble of historic proportions. 1 The NYSE Index and the NASDAQ Index are mutually exclusive; stocks are either listed or unlisted. It is therefore curious that the comparison of the two is so rarely made. Rather, the customary comparison is NASDAQ vs. the S&P 500, or vs. the Dow Jones Industrial Average, both of which include NASDAQ stocks. For example, at the March 2000 high, NASDAQ stocks represented some 25% of the S&P and 15% of the Dow. Market Capitalization: Nasdaq vs.Year-end

The Boom and the Bust Well, despite the fact that this industry has failed—and failed abysmally, in my view—to measure up to the high ideals I expressed all those years ago, grow it did. And as the great bull market in both stocks and bonds that began in the early 1980s produced the most generous investment returns in all our nation's history, it grew massively. In the greatest bull market in all history, the market capitalization of U.S. stocks grew from less than $1 trillion to $17 trillion. "We never had it so good." But the good times didn't— couldn't—continue to roll by and these recent years have not been very happy ones for idealists. The disgusting recent scandals in some of the fund industry's largest firms are only the small tip of a very large iceberg; soaring fund expenses and moving our focus from prudent management to opportunistic marketing have imposed far larger costs on our investors. Chart – Total Market Capitalization, 1950-2003 Since the great stock market bubble of the late 1990s burst, we have endured the painful experience of the greatest bear market in stocks since 1929–33, with more than $8 trillion erased in the plunge. But most of the air that inflated the bubble was hot air— enormous investor expectations that could never be fulfilled, fed by the aggressive growth projections of corporate managers that were both self-serving and grossly unrealistic. Small wonder that the bubble quickly deflated.

The Birth of a Bubble How did such a bubble ever come to pass? I suppose we’ll never know precisely, but it doesn’t require much analysis to assign the responsibility to a remarkable confluence of events like these: A once-in-a-generation economic boom, with record growth in corporate earnings; the optimism of the new millennium; a time of unity (mostly) in the U.S. and of peace (mostly) around the globe; the ebullience engendered by a quarter-century-long bull market, without a single protracted decline; the intoxicating hype of the financial press and the television networks; and the siren song of a New Era—“the Information Age.” Wired magazine was among the first to trumpet the New Era’s grand promise. In an article entitled, “The Long Boom,” published in mid-1997, the headline read: “We’re Facing Twenty-Five Years of Prosperity, Freedom, and a Better Environment for the Whole World. You Got a Problem with That?” No, “I got no problem with that.” Who among us could possibly have a problem with “watching the beginnings of a global boom on a scale never experienced before. . . entering a period of sustained growth that could eventually double the world’s economy every dozen years and bringing increasing prosperity for--quite literally--billions of people on the planet . . . that will do much to solve seemingly intractable problems like poverty and ease tensions throughout the world, all without blowing the lid off the environment.

Consider some of the extremes. At their peak in 1972, equity-oriented funds comprised 93% of fund industry assets. By 1974, a 50% stock market decline and net liquidations of fund shares had reduced total industry assets from $60 billion to $36 billion, a cool 40% decline. Then came the rise of money market funds, bailing out our shaken industry and producing a remarkable $270 billion of assets by 1982. At that point, money funds constituted an amazing 80% of industry assets, leaving equity funds with a residual share of 14%. Then, as long term interest rates moved well ahead of short-term money market rates, it was the bond fund segment that was the industry’s fastest-growing component. At the close of 1986, Bond fund assets of $240 billion actually exceeded equity fund assets of $180 billion. The 33% stock market crash of September-October 1987 contributed to the dimunition in equity fund share. But despite the fact that the full year 1987 saw the market rise, equity flows were negative in 1988, and didn’t return to 1986 levels until 1991, five years in which stocks were at bargain-basement levels. But with each acceleration in the great bull market, the equity fund share of industry assets increased apace—from 30% in 1991 to 40% in 1993, to 50% in 1995. As the cash began to roll in, the equity fund share leaped to 67% in 1998, and by the time March 2000 rolled around, equity-oriented funds laid claim to 72% of the assets of this then-$7 trillion dollar industry.

” The Wired thesis predicted the triumph of the United States and the end of major wars, a truly global market, corporate restructuring, high economic growth, and waves of new technology. A virtuous circle, the article added, would be driven by an open society in an integrated world, a circle in which the Fed finally lifts its foot off the brake, productivity soars, biotechnology revolutionizes agriculture, alternative sources of energy abound, Europe is $0 $10 $20 $30 $40 $50 1974 1977 1980 1983 1986 1989 1992 1995 1998 Mar-01 NYSE Nasdaq The Bubble Inflates and Bursts: Nasdaq vs. NYSE, 1972 - 2001 $47.11 $34.91 $32.60 $21.$1

“Serious mistakes,” I indicated, included such errors as investing in funds with spectacular records (“no investor ever went broke by failing to invest in a hot new product”), as well as those persistently at the bottom of the deck; excessive reliance on narrowly-based funds (say, emerging market funds); and using mutual funds for short-term trading. As the stock market bubble inflated, some of these dos and don’ts didn’t seem especially necessary. Now, after the fall, their validity has been reaffirmed. Pillar 2. When All Else Fails, Fall Back on Simplicity. There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values.your

The strong recovery from the market lows reached a year ago has carried the market cap back to $12 trillion, and we are "back to (or at least toward) normalcy" in valuations. With this rebound, the annual return on stocks since the bull market that began in 1982, despite the ensuing bear market, now totals 13%, surely an attractive outcome. Through the miracle of compounding, those who owned stocks in 1982 and still hold them today have multiplied their capital more than fourteen times over. So for all of the stock market's wild and wooly extremes, long-term holders of common stocks have been well-compensated for the risks they assumed. For such investors, the coming of the bubble and then its going, simply did not matter. Right here, then, there's an important lesson about deciding to press on, regardless . . . not only regardless of the boom, but regardless of the bust, too. Chart - $10,000 Investment in the stock market 1982-2003 But that doesn't mean there weren't winners and losers during the mania—and lots of both. Simply put, the winners were those who sold their stocks in the throes of the halcyon era that is now history—corporate executives with stock options, technology entrepreneurs with IPOs, and the investment bankers and mutual fund managers who sold the high-flying stocks to their clients, charging hundreds of billions in fees for their services.of

integrated, Russia comes to have a solid foundation, and, down the road, China becomes the world’s largest economy. In all, “a radically optimistic meme.”2 In hindsight, the only meme that seemed to take hold was the contagious idea that only the sky was the limit for the prices of the “New Era” stocks, and investors better jump on the band wagon…before it was too late. There were, to be sure, some respected investors and investment professionals, made wary by their knowledge of the nature of stock market returns and hardened by their experience in previous bear markets, who spoke out with passion and eloquence, calling the market overpriced. But the prophets were few in number, for the most recent prolonged bear market had come a full generation earlier, in 1973-74, when, the NYSE Index tumbled 50%, and the NASDAQ plummeted 60%. Alas, these warnings went unheeded. As Dickens might have said of the stock market last March, “it was the age of not enough wisdom, it was the age of too much foolishness.” Recognizing the Bubble While I’m hardly, in Dickens’ words, one of the profession’s “noisiest authorities,” just over a year ago, right at the market peak, I did prepare a speech on “Risk Control in an Era of Greed.” I pointed out that, “when reward is at its pinnacle, risk is near at hand.

in 1993, a full decade ago. As a group, alas, our corporate directors have failed to measure up to that standard. Two centuries ago, James Madison said, “if men were angels, we wouldn’t need government.” Today, I would echo that idea: If chief executives were angels, we wouldn’t need corporate governance. Extending this analogy of political systems to corporate systems when I recently spoke to the Business Council, I said that we should avoid corporate governance based on the dictatorship of the CEO. While democracy might not be possible, I suggested, at least we should establish a republic, with the elected representatives of the shareholders fully empowered to assure that the corporation held high the interests of the shareholder, above all competing claims. (The assembled group of CEOs, by and large, didn’t seem to care for the analogy, and there was a rather heated response from the floor.) There is powerful evidence that directors failed to do just that. The result: a raft of misleading corporate financial statements and the grotesquely excessive executive compensation that helped create the stock market bubble and—bubbles being bubbles—its subsequent burst. Yet the directors of corporate America couldn’t have been unaware of the management’s aggressive “earnings guidance.” Nor that management’s focus was on raising the price of the stock, never mind at what cost to the value of the corporation.

wealth from public investors to corporate insiders and financial intermediaries. When speculation takes precedence over investment, there is always a day of bounty for the few followed by a day of reckoning for the many. Our late bubble was but the latest "extraordinary popular delusion and the madness of crowds—tulips in Holland, shipping in the South Seas, stocks in 1929, the go-go years of the 1960s. It's all of a piece, with the past, as rational expectations were once again replaced by irrational exuberance. Our, well, flexible financial system cooperated in the madness. Aggressive earnings guidance from corporate executives, realized by fair means or foul; manipulation of revenues and expenses, balance sheets; the debasement of accounting standards; public auditors who became consultants to management, in effect, business partners; the "sell-side" analysts of Wall Street, whose recommendations were often shaped by the desire to attract investment banking clients; and the "buy-side" analysts of the mutual fund industry, who put aside their training, experience, and skepticism and succumbed to the heady spirit of the mania. But if there was a single dominant failing of the recent bubble, it was the market's overbearing focus on the momentary price of a stock rather than on the intrinsic value of a corporation. Yet the price of a stock is perception, and acting on that perception is speculation.

What were those market metrics that so concerned me? Stocks, as measured by the broad-based Standard & Poor’s 500 Stock Index, were selling at 32 times earnings, up from 24 times in 1997 and twice the historic norm of 16 times. The $17 trillion value of the U.S. stock market was nearly 200% of our nation’s $9.4 trillion GDP, up from 107% in 1997 and more than double the 80% relationship that had marked earlier highs. And, drawing on Jeremy Siegel’s Wall Street Journal essay (“Big-Cap Tech Stocks are a Sucker Bet”), nine of the most popular stocks of the day (Cisco, Oracle, Nortel, Yahoo!, etc.), had risen in value from $190 billion in 1997 to $1.6 trillion. At their median price of 153 times earnings, even if the estimates of 30% annual earnings growth projected for them were actually achieved, they would still be selling at 95 times earnings in 2004, and 46 times in 2009. What a pipe dream! The Bubble Bursts We all know that trees don’t grow to the sky. They couldn’t . . . and they didn’t. And many investment veterans had a pretty good idea of what was going to happen in the wildly- inflated stock market. While none of us, I think, had any idea of when, the burst in the bubble began at the very moment I was preparing my remarks. When reward reached its pinnacle, risk was at hand. The ratio of the NASDAQ’s capitalization to that of the NYSE has tumbled from 60% at the high, to just 21% currently.

As the stock market bubble inflated, the mutual fund industry’s well-educated, highly-trained, experienced professional analysts and portfolio managers seemed blissfully unaware of what was going on in the financial statements of the companies into which their funds were pouring literally hundreds of billions of dollars. Somehow our professional investors either didn’t understand, or understood but ignored—I’m not sure which is worse!—the house of cards that the stock market had become. Astonishingly, even after the bear market that has devastated the value of the equity holdings of fund shareholders, the only response we’ve heard from the mutual fund industry is the sound of silence. Why? Because the overwhelming majority of mutual funds continues to engage, not in the process of long-term investing on the basis of intrinsic corporate values, but in the process of short-term speculation based on momentary stock prices. The typical fund manager has lots of interest in a company’s price momentum—its quarterly earnings and whether or not they are meeting the guidance given to Wall Street. But when it comes to what a company is actually worth—its fundamental earning power, its balance sheet, its long-term strategy, its intrinsic value—there seems to be far less interest. Yet focusing on the price of a stock— perception—rather than on the value of a corporation—reality—can hardly be a winning strategy over the long run.of

The Wisdom of Investment In the quest to own the total stock market, the first index mutual fund was designed to replicate the results of the Standard & Poor’s 500 Stock Index. So, shortly afterward, was that original Samsonite pension account. That Index proved to be a marvelous choice. Yes, the S&P 500 is a large-cap index, but the U.S. stock market is a large-cap stock market, and the S&P 500 typically accounts for 70% to 80% of its market capitalization. Yes, the 500 was dangerously exposed to technology (34% of its value) as the great bubble reached its maximum inflation in March 2000, but so was the U.S. stock market. And yes, the S&P committee that adds stocks to and deletes stocks from the Index has often seemed to select the hottest stocks of the day, but the fact is that it is simply keeping the Index in synchronization with the largest stocks of the day. Indeed, it is estimated that a portfolio simply owning the largest 500 stocks in our marketplace would carry a long-term correlation of something like 0.999 with the S&P 500 Index. Two facts may surprise you: First, the long-term correlation of returns between the Standard & Poor’s 500 Stock Index and the total U.S. stock market (measured since 1926 by the University of Chicago’s Center for Research in Security Prices—CRSP—and since 1972 by the Wilshire 5000 Index) is a remarkable 0.98%.

And third, be cautious, and make certain each client understands the role of income as well as the role of capital appreciation, keeping in mind, not only the probabilities of earning high stock returns, but the consequences of assuming excessive risks. 2. Faith in Our Corporate Stewards I would note that caution is the order of the day not only because of the likelihood that we are facing an era of lower returns in the financial markets. We are also facing the huge challenge of helping our clients put their wealth to work productively because, in the aftermath of the bubble, they have likely lost faith in the stewards to whom we have entrusted the management of our corporations. Part of the problem is the mania that resulted in the recent bubble. As Edward Chancellor, author of “Devil Take the Hindmost: A History of Speculation,” reminded us, manias bring out the worst aspects of our system: “Speculative bubbles frequently occur during periods of financial innovation and deregulation . . . lax regulation is another common feature . . . there is a tendency for businesses to be managed for the immediate gratification of speculators rather than the long-term interests of investors.” And surely that’s what we’ve seen. Here’s how The New York Times described the Enron mess: “A catastrophic corporate implosion . . . that encompassed the company’s auditors, lawyers, and directors . . .and

Congress . . . a massive failure in the governance system.” But while Enron may prove to be the worst failure of our corporate stewards, I need not tell you it is hardly alone in its failure to merit the faith of investors. Casino Capitalism Lord Keynes warned us long ago of what happens when speculation achieves predominance over enterprise, and I also quoted some of these words in my ancient university thesis: “In one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . it is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator. But the position is serious when enterprise becomes a mere bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” The analogy of the casino to the recent era in our financial markets is hardly far-fetched. Investors have focused on short-term speculation based on the hope that the price of a stock will rise, rather than long-term investment based on the faith that value of a corporation will grow.

The Tortoise and the Hare If we look at the relationship between the NYSE tortoise and the NASDAQ hare—it may be a trite analogy, but, by God, it’s perfect!—it is the tortoise that has won again, just as Aesop, with his ancient wisdom, described. And the tortoise wins if we start the comparison at the very beginning, with the inauguration of the NASDAQ Index at the start of 1972. Or if we start in 1982. Even if we start in 1992, when the idea of the New Economy was beginning to enter our consciousness, we have a statistical dead heat. And if we start the comparison just as the hare began his explosive dash in 1998—a dash that took him so far ahead of the tortoise that he was almost out of sight—his equally mad reverse dash took him back to the plodding tortoise and then behind, and he even lost that lap of the race too. And so it is that the best of times for the NASDAQ were too good to be true, and that the worst of times has restored us to some semblance of market reality. Mkt Cap of 9 Tech Stocks Mkt Cap/GDP P/E Ratio 107% 180% 124% $191 B $1,600 B $570 B 12/97 3/00 3/01 Metrics of The Stock Market Bubble The Tortoise and the Hare Start Date NYSE Nasdaq NYSE Advantage 1/1972 1/1982 1/1992 1/1998 Annual Returns Through 3/01 12.6% 11.1% +1.8% 15.4% 13.5% +2.2% 13.4% 14.3% -0.3% 6.6% 6.0% +2.1%

Actions and Reactions This reaction to the failed investment ethos of the bubble era is entirely consistent with Sir Isaac Newton's third law of motion—for every action there is an equal and opposite reaction. And that law is also in force in the financial markets themselves. The first reaction to the late bubble is that, like all bubbles, it burst. The bear market was the inevitable reaction to the bull market.Stock

percentage points less, a shortfall that closely parallels our three percentage point estimate for fund costs.1 In other words, the funds earned about 80% of the market’s annual return. But when we compound the annual returns based on an investment of $10,000 at the start of the period, the investor captured only 60% of the market’s cumulative wealth. The market investment would have grown by $120,000, compared to just $71,600 for the average fund. The magic of compounding investment returns; the tyranny of compounding investment costs. What is more, it’s no secret that the fund industry, once an industry that prized investment stewardship as its highest value, has now embraced product marketing as its beacon. In their battle to build assets, and thus advisory fees, mutual fund sponsors are quick to capitalize on the latest fads and fashions of the stock market. During the great NASDAQ bubble, for example, fund sponsors created record numbers of new growth and aggressive growth funds with a heavy tech-stock orientation (340 funds) and pure tech funds (116), with pace-setting budgets advertising their pace-setting short-term returns. These funds rose by an average of 85% during the final upsurge in the market from 1999 through March 2000, and those that were advertised had even higher returns. The result: Great for the marketers, horrendous for the investors. These aggressive funds were the recipients of the largest glut of cash inflow in the industry’s history—$238 billion.

Alas, the slips ‘twixt cup and lip seem as eternal ever, and there’s no evidence that any of these new types of funds have provided better returns than their traditionally managed kinfolk. But for very different reasons, the New Era of technology has given fund owners not only worse returns, but much worse returns. The boom in technology stocks during the late 1990s resulted in the creation of 678(!) risky new funds—Internet funds, telecom funds, technology funds, and technology-oriented growth funds—largely designed to attract fund investors eager to participate in the great NASDAQ boom. The industry’s resultant hyping and promotion of these “New Economy” funds rapidly increased the industry’s risk profile, which reached its most dangerous exposure in mid-March 2000, at the very moment that the bubble, having reached its point of maximum inflation, was about to pop.

Taking The Toll 3: Fund Selection And investors are also hurt in another perverse way. They have a deep-seated tendency to buy on the basis of past performance, pouring their money into exactly the wrong funds at precisely the wrong time. For example, during the twelve months ended March 2000, when the great technology-age market bubble was inflating to its very bursting point, investors poured $240 billion dollars in technology funds and tech-oriented growth funds at their peak levels, funding some of those purchases by actually withdrawing $40 billion from the value funds that had failed to participate in the great boom. In the aftermath, the asset values of the most popular growth funds declined by an average of 63% from high to low, while the most unpopular value funds actually rose in value by 3%. Combined with the toll taken by fund costs and the toll taken by market timing, this penalty for adverse selection is the third leg of the unfortunate triumvirate of tolls that has left mutual fund investors in the backwater of the returns earned by the financial markets. If financial advisors do no more than keep your client from paying these unnecessary tolls, you’ve made a great start on serving them well! Of course, stock market booms and speculative manias are merely a reflection of the public mood. Tuplipmania, the South Seas Bubble, the Crash of 1929, it is often argued “just happen.

On the other hand, investors in value funds, which rose 11% during the same period, actually had a net cash outflow of $29 billion. Then came the burst in the bubble. The growth group fell 51%, while the value group declined just 11%. It is no secret that when a fund rises 85% and then drops 51%, its net return is not 34%. Its net return is minus 10%. ($1.00 rises to $1.85 and then falls to $0.90). And the once-shunned value funds are down 1% on balance—after all was said 1 Source: Lipper. Fund data adjusted for sales charges. 0% 50% 100% Annual Return Profit on $10,000 Investment S&P 500 Avg. Fund Average Equity Mutual Fund vs. The Stock Market Total Returns, 1984 - 2000 16.3% 13.30%

But in the late 1970s, another source of shareholder activity began. As the concept of the fund family took hold, the exchange privilege came into wide use. Investors could redeem shares in, say, the family’s value fund and buy its growth fund or, for that matter, its money market fund—still clearly a redemption, but not “counted,” as it were, in the official data, understating the true redemption rate of fund investors by more than half. From the mid-1980s through 1997, regular redemptions of equity funds averaged some 17% of assets. But exchange redemptions ran at an even higher 19% rate, bringing the typical year’s all-in redemption rate to 36%, a holding period of less than three years for the average shareholder, fully 80% shorter than the 14 year average of the 1950-1975 era. In 1987, with the short-lived market crash and its aftermath, there was a rare departure from this norm. Redemptions jumped to 20% of assets and exchange redemptions (largely into money market funds) leaped to 42%, a combined redemption rate of 62%. In October alone, the annualized rate soared to 120%. (That’s right, a rate that, had it persisted for a year, would have been larger than the entire equity fund asset base!) That rate may well be a harbinger of what lies ahead if stock market conditions move from unsettled, as they are today, to bearish. In any event, the upward trend seems to be accelerating.

Such projections ignored the fact that the remarkably innovative, technology-driven, rapidly changing, dog-eat-dog New Economy would be highly competitive. When you think about it, the Internet was hell-bent on creating the most remarkable medium for unfettered price competition ever designed by the mind of man. Crowning the consumer as king, obviously relegates the producer to the status of the king’s subjects. How could we have ever expected that giving “power to the people” could possibly provide a license for boundless corporate profitability? Old Economy vs. New Economy Meanwhile, back at the Old Economy, the NYSE market seemed virtually immune to the bubble plague that so thoroughly infected the New Economy. Why? Simply because we believed we were in a boom in which the New Economy was in the driver’s seat. And the core of the New Economy was technology, with all of the “come hither” promise of a sultry siren. Only two of the NYSE’s largest 25 stocks are tech stocks, but only two of the 25 largest stocks on NASDAQ are not tech stocks.telecommunication

” And in the recent bubble, the information age, globalization, “the long boom,” and the turn of the millennium simply combined to create an era of unreasonable expectations. Investors, it is said, have no one to blame but themselves. Please don’t believe that. To do so is to ignore the role of the professional investors—and professional marketers—who helped create the aura of omnipotence that enveloped the financial community. Just like those Wall Street security analysts who gave us the “research” that inspired the internet stock craze, as well as Enron, Global Crossing, and scores of other watered stocks—all in the name of capturing more investment banking clients—along with those corporate insiders who purchased stocks through low-cost options and quickly sold them at inflated prices; so too many mutual fund managers accepted uncritically the hyped-up growth projections for technology, medical, and telecommunication stocks, and piled them into the funds they manage. And that’s not all that the mutual fund industry must answer for.and

“When enterprise becomes a mere bubble on a whirlpool of speculation,” as the great British economist John Maynard Keynes warned us 70 years ago, the consequences may be dire. “When the capital development of a country becomes a by-product of the activities of a casino, the job of capitalism is likely to be ill-done.” 5 For the record, the 2006 operating earnings of the S&P 500 totaled $787 billion. The earnings of the major sectors (in billions) were: Financials $215; Energy $121; Health Care $79; Manufacturing and Technology each $81.

punctuate the chart. (blue bars), as price-earnings ratios waxed and waned. (A 100% rise in the P/E, from 10 to 20 times over a decade, for example, would equate to a 7.2% annual speculative return.) Curiously, without exception, every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount—the quiet 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and then the soaring 1980s—RTM writ large. And then, amazingly, we see an unprecedented second consecutive exuberant increase in speculative return in the 1990s—a pattern never seen before. Now look at the 20th century in total: the average annual return on stocks during the century was 10.4% (orange bar). Nearly 10% was represented by investment return; 5% by dividend yields and about another 5% by earnings growth. The remaining 0.6% came from a small net increase in the price-earnings ratio. The message is clear: In the long run, stock returns depend on the reality of the investment returns earned by business. The perception reflected by speculative returns counts for little. Over a long span of years, economics dominate long-term equity returns; emotions, so dominant in the short- term, dissolve. Returns in Retrospect, and in Prospect As 1999 ended, looking at the reasons behind past stock returns would have helped us recognize a bubble that was about to burst.

Pillar 7. The Powerful Magnetism of the Mean In the world of investing, the mean is a powerful magnet that pulls financial market returns toward it, causing returns to deteriorate after they exceed historical norms by substantial margins and to improve after they fall short. Reversion to the mean is a manifestation of the immutable law of averages that prevails, sooner or later, in the financial jungle. In the boom-and-bust bubble we have just witnessed in the NASDAQ Index, we have a wonderful example of reversion to the mean (RTM). After closely tracking the NYSE Index of all listed stocks from the mid-1970s through the end of 1997, the unlisted stocks in the NASDAQ Index took off in 1998, rising 230% (!) though the first quarter of 2000, eleven times the 20% gain in the NYSE Index. Then, reversion to the mean promptly wreaked its havoc, and with a vengeance. Since then, the NASDAQ has tumbled 67%, compared to a loss of but 7% for the NYSE Index. At the high last March, a dollar invested in NASDAQ Index in 1972 had soared to $1.80 for each dollar in the NYSE Index. But it has now fallen to just 58 cents. RTM strikes again, and, I’m confident, not for the last time. $0 $10 $20 $30 $40 $50 $60 $70 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2000 NYSE Nasdaq 7. The Powerful Magnetism of the Mean $58.42 $32.33 $32.60 $18.99 Growth of $1

begun as I began to write this speech ten days ago." And that's exactly what happened as the stock market drop tumbled by precisely 50%. With the market's 41% recovery from the lows (leaving it 31% below its peak) many of the bubble's excesses have been corrected. So now let's set some reasonable expectations for what stocks might do in the next ten years. The dividend yield has nearly doubled, to 1.8%. With the same 6% earnings growth assumption—hardly guaranteed!— the future investment return on stocks could be in the 7% to 8% range. Will speculative return add or detract from that figure? With p/es now around 18 times (based on "normalized" operating earnings, which is a bit of a stretch), I'm dubious that we will get much help—or, for that matter, much harm—from that source. So reasonable expectations—seasoned as always with optimism—suggest a future annual average return on stocks in the range of six to nine percent. But don't agree with me uncritically. Make your own forecast: Just add your own earnings growth estimate to the 1.8% dividend yield, and take a guess at speculative return. Then combine them. But never forget that it's unwise to forecast stock returns without evaluating the broad reasons that will shape them. What About Bonds? Now consider what returns bonds might provide in the coming decade.

during the three-year-bubble surrounding the market’s peak in March 2000. In the great bear market that followed, the NASDAQ (“New Economy”) Index dropped nearly 80 percent, and the NYSE (“Old Economy”) Index fell by 33 percent. Was this innovation good for fund marketers? Clearly yes. Good for fund investors? Categorically no. It remains to be seen whether today’s hottest mutual fund idea, ETFs—index funds that “can be traded all day long, in real time”—will prove to be a blessing to fund investors, or a bane. The Age of Turbulence This “age of turbulence” in which we now live is the product of too many years of cheap credit, and of sharply deteriorating credit standards, as well “new” products like derivatives and product packaging—like securitizing mortgages—in which its lenders off-load their loans to investors. Our highly-leveraged commercial banks and investment banks failed to consider the extraordinary risks of the securities they were creating and marketing, and earned billions in fees and commissions, even as they were left with tens of billions of dollars—even hundreds of billions—on their own balance sheets. The key question today is the extent to which these problems in our financial system will infect our U.S. economic system and our global systems as well.

decline—which was to reach 50%—following the burst of the earlier Go-Go bubble in the market. They banded together to fire me, accomplishing the deed on January 24, 1974. I was devastated. But I promptly set out to recoup my job. In brief, I was able to persuade the directors of the mutual funds that were managed by Wellington to set off on a new course: Establishing a staff dedicated solely to the funds shareholders’ best interest; operating, not for a percentage fee but on an at-cost basis; and giving the funds complete independence from the managers who had fired me. I named the new company after Lord Nelson’s flagship HMS Vanguard—another lucky break—and described our unprecedented foray into running truly mutual mutual funds as The Vanguard Experiment, a test of whether our novel corporate structure and unprecedented form of fund governance that focused on profits to fund shareholders rather than profits to fund managers could succeed. In the words of author-economist Peter L. Bernstein: Jack Bogle’s goal was to build a business whose primary objective was to make money for his customers by minimizing the elements of the inherent conflict of interest (between seller and buyer), but at the same time be so successful that it would be able to grow and sustain itself. It has been no easy task. Strategy Follows Structure We were incorporated in September 1974, almost at the very bottom of the bear market. Our asset base was $1.

them. Price/earnings ratios were replaced by price/sales ratios; volume of goods sold was replaced by visits, impressions, and eyeballs. Rather than analyzing, analysts came to predict the future, without removing the rose-colored glasses that became the analysts’ hallmark. Many analysts came to be paid multi-million dollar salaries, not because they could predict high earnings growth with accuracy (recent events have surely given the lie to that supposition), but because puffing a corporation’s prospects might give their investment banking colleagues a chance to underwrite the client’s next foray into the capital markets, while a negative report might cost them the client. That may explain, according to a recent press report, why, among 8,000 stock recommendations by Wall Street analysts, only 29 recommended “sell.” And fifth, the mutual fund industry. It too poured fuel on the technology fire. Never mind that we were in a NASDAQ bubble, there was money to be made by fund sponsors in selling technology funds to the public. Marketing strategy, of course, aims to sell the public exactly what it wants, and the mutual fund industry was quick to pander to the public’s taste. When tech stocks were ho-hum performers during the first half of the 1990s, only two new tech funds were formed. But when tech stocks approached their peak, the industry hares spawned them like baby rabbits—29 in 1999 and 71 more in the first quarter of 2000.

While it was fear—fear about more terrorism, fear about the economy, fear about the unknown—that clearly took over the marketplace during the first week after the stock market re- opened following the suspension of trading on September 11, we must recognize that we were also in the late phases of the burst in the technology stock bubble that reached its zenith in March 2000. Then, it was not fear that was in the saddle, but greed. Even without the terrorist attack, stock prices were resting on a precarious perch. While now we may well be probing for a sort of “fair value” for stocks, the market pendulum, having swung so far toward greed, rarely stops at fair value as it makes it way to fear. I’ve been in the profession of trusteeship and investing for a half-century now, and I believe the most helpful perspective is to think of stock prices as consisting of two discrete elements—economics and emotions.generated

To state the obvious, investing for income is a long-term strategy and investing for capital gains is a short-term strategy. (The turnover of dividend-paying stocks is one-half the turnover of non-dividend paying stocks.) Investing for growth, as Lord Keynes reminded us, is all about speculation on price, while investing for income is the heart of “enterprise,” the word Keynes chose to describe the long-term yield on any investment. Things haven’t changed much: way back in 1936, he said that “In one of the greatest investment markets in the world, namely, New York, it is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator. But the position is serious when enterprise becomes a mere bubble on a whirlpool of speculation.When

giddy money managers [including, I would add, investors who actively manage their own fund portfolios] are enthralled by the new gadgetry—technology now sits at the center of a speculative frenzy of religious intensity, a financial mania, a bubble.” In the mutual fund arena, turnover of equity fund shares by investors has also soared. In the 1960s and 1970s, liquidations of equity fund shares averaged 9 percent of assets per year; in the late 1990s, the rate has been running at about 36 percent. Put another way, the holding ______________________ 1“Technology, Transactions Costs, and Investor Welfare,” Professor Lynn A. Stout, Washington University Law Review, 1997. period of the average fund shareholder has tumbled from eleven years in the earlier era to slightly more than three years currently. Just three years. Mutual fund shareholders are using the best medium ever designed for long-term investing for the purpose of short-term speculation. And they will be the losers.

Indeed, while investment costs of 3% during 1984-2000 (with average fund costs at higher levels than in the 1950s, ‘60s, and ‘70s) reduced the stock market return of 16% for that period to 13% for the average fund, the average fund investor earned just 5%. How was that shortfall possible? First, because investors were victimized by unfortunate market timing, making modest purchases of equity fund shares when stock prices were cheap during the early years of the period and then making huge purchases when prices were dear as the bubble inflated during the later years. Second, because of adverse fund selection, as investors poured their savings into technology funds and tech-oriented growth funds and pulled them out of value funds at precisely the wrong time, with most of their dollars goings into existing funds with the hottest records of performance and new funds that promised full participation in the “exciting Information Age” that supposedly was before us. To regain the faith of equity investors, the mutual fund industry must face up to the obvious issue of excessive costs.tumble

In his brilliant 2001 memoir, On Money and Markets, the economist/investor Henry Kaufman, one of the wisest of all the wise men in Wall Street’s long history, shared my concerns, expressing his own fears about the globalization of finance, the derivatives revolution, the corporatization of Wall Street, the limits on the power of policy makers, and the transformation of the character of our markets. In his final chapter, he summarizes his concerns: Trust is the cornerstone of most relationships in life. Financial institutions and markets must rest on a foundation of trust as well. . . . Unfettered financial entrepreneurship can become excessive and damaging as well-leading to serious abuses and the trampling of the basic laws and morals of the financial system. Such abuses weaken a nation’s financial structure and undermine public confidence in the financial community. . . . Only by improving the balance between entrepreneurial innovation and more traditional values can we improve the ratio of benefits to costs in our economic system. . . Regulators and leaders of financial institutions must be the most diligent of all. Together, participants in our financial markets must work together to restore that balance, and return financial conservatism to its rightful pre-eminence. For as Lord Keynes wrote all those years ago, “When enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill-done.

The Penalties of Timing and Selection First, consider the timing penalty. With the Standard and Poor's 500 Index languishing under the 300 level during 1984–1992, investors purchased equity funds at a $10 billion annual rate. But with the index over 1100 in 1999, on the way to its 1527 high in 2000, investors poured money in at a $220 billion annual pace. Putting so little of their money into equity funds in the early years when stocks were cheap, and so much of their money when stocks were dear, has cost fund investors plenty, and the fund industry must share the responsibility for that counterproductive pattern. Chart: The Timing Penalty Investors also paid a huge selection penalty, and here the industry's responsibility is far greater. During the bubble, we created and promoted growth funds and sector funds that favored over-priced NASDAQ stocks—the "new economy," technology, and the internet. At precisely the wrong time, investors poured $460 billion into these highly risky funds and withdrew nearly $100 billion from the conservative value funds favoring NYSE stocks—"old economy" stocks which, bless them, both lagged the market as the bubble inflated and held fairly steady as it burst. Chart: The Selection Penalty The net result of cost-induced performance lag of the average fund, leveraged by the timing penalty and the selection penalty paid by the average fund investor, is truly stunning.

It takes only a moment’s contemplation to imagine what might happen in the financial markets if, say, half of that number responded to a major earthshaking (literally or figuratively) news event. The industry’s old gatekeeper—a busy signal on the telephone—is retiring, for better or worse. Perhaps busy Internet service provider numbers, or even an Internet crash, will “protect” us if the dark day comes, but perhaps not. Honestly, it’s sort of scary. The Report Card Let’s grade each aspect of the technologies currently used in mutual fund investing:  Investment technology: Innovative financial instruments, A+; liquidity, A+; cornucopia of funds, A+; soundness of new funds, C; investment behavior of mangers, D.knowledge,

5 billion of their shares are traded each day— an annualized total of nearly $400 billion, for a turnover rate of 1380%. This is hardly your traditional index fund, which (at least in our case) has a total redemption rate of about 20%, about 98% below the turnover of this ETF. Clearly, investors are using Spiders just as the advertisements recommend: “Buy and sell the S&P 500 just as easily as you trade a single stock. . . with real time pricing, you can trade your position throughout the trading day.” To state the obvious, this is a blatant appeal for investors to engage in the folly of speculation, not to the wisdom of investment. Spiders are by no means the least of the ETF problem. The Qubes that replicate the NASDAQ 100 Index win that distinction. In less than two years, the assets of the Qubes have soared from $5 billion to $20 billion. Bear in mind that the technology-stock-driven NASDAQ Index represents a sector of the market so large that at the peak of the bubble its “new economy” market capitalization of $7.2 trillion threatened to exceed the “old economy” market cap of $10.2 trillion of stocks listed on the New York Stock Exchange. (There may be a message in the fact that no ETF invested in the NYSE index has yet been created. But be patient!) On an average day in 2001, $2½ billion of Qubes change hands (much more when markets turn volatile), for an annualized total of nearly $700 billion.behold:

While the methodology is the same—dividend yield plus earnings growth plus change in P/E—the confidence level is minuscule in such an explosive field. While we forgot it during the great tech bubble, the value of a technology stock, like any stock—and any stock market—is simply the discounted value of its future cash flow. No, the market value of a +5.7% +6.3 +12.0% +5.4 +17.4% Components of Stock Market Return Initial Dividend Yield Earnings Growth Investment Return Speculative Return* Calculated Market Return Initial P/E Ratio Final P/E Ratio 1980 - 2000 9.2x 26.4x +1.5% +6.0 +7.5% -2.0 5.5% 2001 - 2011 22.0x 18.Change

Assets of U.S. mutual funds have also soared, from $500 billion in 1985 to $16 trillion currently. (Exhibit 2) But the composition of fund assets has fluctuated widely—in 1970, an equity fund business— 87% equity funds, 8% in balanced funds, only 5% bond funds. (Exhibit 3) Then came the 1973-4 stock market crash. It almost killed the equity fund business. Equity fund assets dropped from $56 billion to $29 billion—a near-50% plunge. Bond funds helped to cushion the blow, and then, miraculously—and not a moment too soon— money market funds were created, bailing out the fund industry. By 1981, money market funds accounted

As I look at these changes, I cannot help but wonder: “Is a position of 18%—or even 26%—in corporate bonds the optimal level for an individual investor? Might not some informed investors prefer a portfolio of, say, 65% in investment-grade corporates and 35% in Treasuries and agencies with a slightly higher yield that would come hand-in-hand with slightly higher volatility and a slight reduction in credit quality?” Much as I believe in the bond index fund (and the index it tracks), it occurs to me that the final form of an index fund tracking the bond market may yet be determined. The Future of Bonds . . . and Bond Funds Most of today’s bond investors have experienced only the sharp and unremitting drop in bond fund yields that has occurred over the past 35-plus years—the yield on the Bloomberg Barclays Aggregate Bond Index has plummeted from 14.6% at the close of 1981 to 2.6% today, a decline of a mere 83%. (Exhibit 12) Today’s low rates have led some experts to say that we’re in a bond fund bubble, one which will soon burst and send yields soaring and prices tumbling. Since anything can happen in a financial crisis, these predictions may prove correct. But I believe bursting bubbles is a concern largely for short-term speculators in bond prices, not long-term investors planning for their financial futures. After all, if an investor purchases a 30-year U.S. Treasury bond paying an annual coupon of 2.

8% for the next three decades, that investor has made a bargain that will be honored—no bubble there!. For the vast majority of investors, bonds should be bought and held for relative price stability and regular income, not traded in a vain attempt to capitalize on momentary fluctuations in market price. Despite the current low interest rate environment, bond mutual funds, driven largely by the total bond market index fund, have flourished in this challenging environment. In 2017, cash flow has totaled some $335 billion. About 50% of that total ($162 billion) has flowed into bond index funds.investment

In fact, the amount of capital formation that Wall Street finances has totaled some $270 billion per year. Today: 99.5% Speculation, 0.5% Investment But capital formation has become, well, the tail of the Wall Street dog. The numbers tell the story. $56 trillion per year in trading volume, as investors buy from and sell to one another, minute after minute, day after day, year after year. That $56 trillion of trading volume dwarfs the capital formation total of $270 billion. Result: short-term trading in the Wall Street Casino represents 99.5 percent of the market’s activity; long-term capital formation 0.5 percent. But it is only capital formation that adds value to our society. Trading, by definition, subtracts value. Indeed, the casino mentality remains in the catbird seat of finance. Is that good or bad for investors and for our society? As Nobel Laureate in Economic Sciences and New York Times columnist Paul Krugman recently put it, “society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return.” I might go even further, and suggest that we are getting less than nothing in return. More broadly, be warned by these words of wisdom from the great British economist John Maynard Keynes in 1936: “When enterprise becomes a mere bubble on a whirlpool of speculation, the position is serious.the

During the 1975-1985 era, following the devastating 50 percent stock market crash of 1973-1974, the prime focus of the industry shifted from stock funds to money market and bond funds. To carve out a competitive niche—with the realization that the “costs matter” principle applies in all asset categories— we established the first municipal bond mutual funds holding portfolios with strictly defined-maturities. Our long-term, intermediate-term, and short-term offerings (unique, but hardly the triumph of amazing brilliance!) quickly changed the structure of the entire bond fund sector. A new framework for bond management had emerged. August 1977. Innovation # 4. One of the crushing failures that preceded Vanguard’s formation was the abject failure of Wellington Fund. New managers had turned this classic conservative balanced fund, founded by Walter L. Morgan, Princeton Class of 1925, into a type of aggressive stock fund. In the1974 market crash— which was wholly predictable—Wellington flamed out, its hard-earned reputation shattered. By 1978, with the substantial demands of implementing those first four innovations behind us, it was time to turn to the task of restoring Wellington Fund to its earlier eminence. Not only returning it to its traditional balanced portfolio (65/35 stocks/bonds), but giving it a new focus—a focus on a specific and clear dividend objective.

history. 4. Our bond fund asset base—some $550 billion—is the industry’s largest. And 5. Wellington Fund’s assets, which had tumbled by some 75 percent—from $2.1 billion to $475 million—in the early 1970’s market crash, have soared to $68 billion. Together, these innovations remain at the heart of Vanguard today. Combining the impact of these five major innovations along with other smaller innovations, Vanguard’s mutual fund assets under management now total $2.1 trillion, the largest fund complex in the world.2 (Please forgive the bragging, but the data are the data.) Our market share has risen to about 17 percent of the assets of all stock and bond funds, a commanding market share, the largest in industry history. The Vanguard Experiment that began in 1974 has become the Vanguard triumph of 2013. Why? Simply because it has served investors well. Interestingly enough, I’ve been preaching that message of reform for mutual funds for my entire 61-year career beginning with the idealistic principles that I articulated in my 1951 Princeton senior thesis on the mutual fund industry, entitled “The Economic Role of the Investment Company.” Here are some brief excerpts: [Mutual funds] should be operated in the most efficient, honest, and economical way possible . . . Future growth can be maximized by reducing sales charges and management fees . . . Funds can make no claim to superiority over the market averages (indexes) . . .

seven months earlier—filed with the State of Delaware the Declaration of Trust for a new mutual fund that promised not to engage in the practice of active management. Originally named “First Index Investment Trust,” it was the world’s first index mutual fund. Its birth was, curiously, the product of a divorce. (Now there’s a paradox!) In 1966, as head of the long-established Wellington Management Company, I bet the firm’s future on a Boston firm—Thorndike, Doran, Paine, and Lewis—run by four aggressive equity managers operating a hot “Go-Go” fund named Ivest, managing a growing pension business, and having investment talent that, I believed, could more effectively manage the portfolio of our faltering Wellington Fund. Yes, I was young and foolish, and (even worse!) I was wrong. But for a time, the merged firm prospered, yet only until the “Go-Go” era came to its inevitable end. As 1973 began, the stock market began its terrible 50 percent crash, even worse for Ivest Fund, which never did recover. (It no longer exists.) Worse, Wellington Fund performance was also a disaster—the worst performing of all balanced funds in 1967-1977. Our new business model faltered, and then failed. In the merger, I had ceded substantial voting power to the new managers, and it was they who fired me as the leader of Wellington Management. On January 24, 1974, I was replaced by their leader, Robert W. Doran. I leave it to wiser heads than mine to explain the perverse logic involved in that outcome.

(In the 20-years ended in 2000, venture capital funds slightly lagged the index despite the substantially higher risks involved.) This experienced expert’s conclusion: “suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns.” It is no secret that in the years before the bull market peaked in 2007, many of the larger endowment funds made substantial advance commitments to private equity deals, and in the ensuing crash were pressed to maintain sufficient liquidity to complete those transactions. In recent years, a market has emerged to relieve the endowments of some of those commitments, but at nothing like 100 cents on the dollar. (Perhaps 50 cents would be more like it.) In any event, the whole issue of market valuations vs. book values (usually the cost basis of the commitments) raises complex questions regarding the precision of reported endowment fund returns. My conclusion: use private equity only if you have the staff, skill, and the skepticism about future projections to do so, and don’t over commit. You may come to find that liquidity can become priceless (no pun intended!) Summing Up Yes, alternatives have provided a solid plus for many endowment funds, especially the largest funds, but remember that the past is not necessarily prologue. Remember reversion to the mean.

General Motors and Ford) to this total, financial earnings now likely exceed 33 percent of the earnings of the S&P 500. While that share may or may not be enough, it seems likely to continue to grow, at least for a while. We’re moving, or so it seems, to a world where we’re no longer making anything in this country; we’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks are being built into our financial system. “When enterprise becomes a mere bubble on a whirlpool of speculation,” as the great British economist John Maynard Keynes warned us 70 years ago, the consequences may be dire. “When the capital development of a country becomes a by-product of the activities of a casino, the job of capitalism is likely to be ill-done.” Once a profession in which business was subservient, the field of money management and Wall Street has become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana was right when he defined the conduct of a true professional with these words: “I will create value for society, rather than extract it.” And yet money management, by definition, extracts value from the returns earned by our business enterprises.

Jack also runs a hot iron over the newest wrinkle in the fabric of our economy: hedge funds. He is disdainful of the “public adulation” being showered over these managers of $1 trillion in assets. “PR” not withstanding, he notes that the aggregate return on hedge funds between 1996 and 2003 was a mere 9.3 percent. He does not foresee a Long-Term-Capital-Management-style flameout, but rather a gradual diminution in hedge fund influence, as their high costs, tax inefficiencies and modest returns show they are but the latest tulip in the garden of finance. Jack is quite right when he attributes capitalism’s travails not to malfeasance but to ignorance. He doesn’t believe necessarily that the Enrons and Worldcoms mask deeper illegalities. “Actual looting,” he writes, “has been limited. Negligence . . . has been rife.” He spares few from this cutting ax: “Corporate directors . . . failed to fulfill their responsibilities,” he says. Accounting gatekeepers were silent partners.” The response? Throughout his book, Bogle returns to the same theme: activism. He approvingly quotes the title of a Bob Monks’ paper, Capitalism Without Owners Will Fail. “Retirement funds and mutual funds,” he says, “must behave like owners . . . We ought to explode a whole barrage of firecrackers under each corporation that places managers’ interest ahead of the owners’ interest.

Innovation in the “Go-Go Era,” circa 1965-1968, saw the proliferation of scores of new “aggressive growth” funds, focusing on stock prices rather than business values; buying “concept” stocks and trading them with rapidity; and often holding “letter stocks” bought from corporate principals at discounted prices, only to immediately mark-up those prices to market value, illicitly inflating fund performance. Of course such an approach was destined to fail. But with the heady returns these funds reported, investors poured billions of dollars into them before it did so. While fund managers prospered, fund investors were ill-served. When the “Go-Go” era, well, “Went-Went,” it was quickly replaced by the “Favorite Fifty” Era, where the idea was to hold established growth stocks which (if one could ignore the certain decay that high growth rates inevitably experience) would provide permanent performance success. But of course by the time that eager fund investors had jumped on that bandwagon, the ride was over. The stock market crashed by 50 percent in 1973-74. While investors were once again impoverished, managers were once again enriched. In the aftermath of the crash, with equity funds in net redemption, the industry came up with still more innovations. They included “Government-Plus Funds,” which provided unrealistically high payouts by claiming that premiums on covered call options were “earnings.

” Grossly over-sold to investors and based on a strategy that could not consistently succeed, these funds raised $30 billion from investors—at one point nearly 10 percent of industry long-term assets—and then quickly collapsed. Within a few years, they had literally vanished from the scene, never to be seen again. Again, investors paid a heavy price. During the next few years, we dreamed up short-term Global Income Funds and Adjustable-Rate Mortgage Funds. (Shades of the recent crisis!) While these funds were hardly identical, they had several common characteristics: they offered income that could not be—and was not—sustained; they jumped on current fads in the marketplace; and they charged premium fees, as well as heavy sales loads. Together they attracted nearly $50 billion of assets, generated huge fees to managers and distributors, and ultimately failed investors. They too soon vanished.Bubble

More recently, in the later 1990s (you must be getting the picture by now), innovation in the mutual fund sector was designed to capitalize on the innovation of the so-called “New Economy” of the Information Age. We created literally hundreds of technology funds, telecommunication funds, internet funds, and, once again, “aggressive growth” funds whose holdings were dominated by stocks in those sectors. Aided by a soaring market, aggressive advertising and promotion, and, yes, investor greed, nearly a half-trillion dollars poured into these funds during the three-year-bubble surrounding the market’s peak in March 2000. And then came the great bear market, another 50 percent decline in which the NASDAQ (“New Economy”) Index dropped nearly 80 percent, and the NYSE (“Old Economy”) Index fell by 33 percent. We actually can measure how costly this short-lived bubble was for fund investors. Let’s compare the returns reported by the funds themselves (“time-weighted” returns) to the returns actually earned by fund investors (“dollar-weighted” returns) during the ten years ended December 31, 2005. The 200 funds that enjoyed the largest cash inflows (about two-thirds of the equity fund total—clearly the better performers in the bull market—reported an annual rate of return of 8.8 percent—slightly below the 9.2 percent return on the S&P 500. But the return actually earned by the investors in these funds was 2.4 percent, a lag of 6.4 full percentage points per year below the 8.

Young and headstrong, with self-confidence that belied my lack of wisdom and experience (I was then but 35 years of age), I put together a merger with a high flying group of four “whiz kids” who had achieved an extraordinary record of investment performance over the preceding six years. (Such an approach— believing that past fund performance has the power to predict future performance—is, of course, antithetical to everything I believe today. It was a great—but expensive—lesson!) Together, we five whiz kids whizzed high for a few years. And then, of course, we whizzed low. The speculative fever in the stock market during the “Go-Go Era” of the mid-1960s “went-went.” Just like the “new economy” bubble of the late 1990s, it burst, and was followed by a 50% market decline in 1973-1974. The once happy band of partners had a falling out, and in January 1974 I was deposed as the head of what I had considered my company. I was heartbroken. What’s in a Name?

the outside looking in, and they are a small minority.) Their shared goal: To increase the price of a firm’s stock, the better to please “the Street,” to raise the value of its currency for acquisitions, to enhance the profits executives realize when they exercise their stock options, to entice employees to own stock in its thrift plan, and to make the shareholders happy. How to accomplish the objective? Aim for high long- term earnings growth, offer regular guidance to the financial community as to your short-term progress, and never fall short of the expectations you’ve established, whether by fair means or foul. What’s wrong with that? What’s wrong, as I said in my 1999 remarks, is that when we “take for granted that fluctuating earnings are steady and ever growing . . . somewhere down the road there lies a day of reckoning that will not be pleasant.” I was warning, of course, about the aftermath of the classic “new economy” bubble that had developed, where stock prices were wildly-inflated by unrealistic expectations and, well, irrational exuberance. Finally, the eternal truth re-emerges: The value of a corporation’s stock is the discounted value of its future cash flow. All over again, we learn that the purpose of the stock market is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realize the present value of a future stream of income at any time. Corporations, we again came to realize, must earn real money.

narrow market sectors and individual foreign countries. (There are also some ETFs that claim to beat the market; I’ll leave to wiser heads to wonder about the validity of such claims, and how on earth they can call themselves index funds.) As mutual fund managers have become primarily mutual fund marketers. ETFs are enriching the coffers of financial entrepreneurs, fund management companies, and stockbrokers; it remains to be seen whether they’ll enrich the investors who trade them. But Some Innovation Has Served Investors To be sure, not all mutual fund innovation has ill-served fund investors. Indeed, among the greatest innovations is our industry’s history was the money market fund. The first one gingerly began in 1971. But—simply by giving investors the true money market rate (less costs), rather than the regulation- limited rates offered on bank savings accounts—assets had burgeoned to $58 billion by 1979, reaching $237 billion at the peak in 1981, and accounting for fully 80 percent of mutual fund assets! It was money funds that gave the industry breathing room after the 1973-74 bear market until stocks began their powerful and sustained recovery after the 1987 market crash. Money fund assets total $2.8 trillion today, accounting for about 24 percent of industry assets. They remain a major factor in the financial markets and a remarkable service to investors. Yes, money funds have also created huge profits for fund managers.

Yet, going back to 1981, consensus estimates for future five-year annual earnings growth projected by corporate managers have averaged 11.6%, nearly twice the 6.3% actual annual growth actually achieved over the two decades. As a result of the happy conspiracy between business executives and financial institutions—relying on market expectations rather than business realities—we witnessed a bubble in stock market prices that inevitably burst, as all bubbles do, sooner or later, Then, the idea of value slowly returns to the stock market. It is truly astonishing how pervasive have been the failures in our capitalistic system. While it’s often alleged that these problems have been limited to just “a few bad apples,” the evidence suggests that the barrel that holds all those apples, good and bad alike, has developed some serious problems. For example:  Yes, there have been “only” a few Enrons, WorldComs, Adelphias, and Tycos. But during the past five years, there have been 5,989 restatements of earnings by publicly-held corporations, with stock market capitalizations aggregating more than $4 trillion, often reflecting overly aggressive accounting procedures.  Yes, the investment banking scandals involved “only” twelve firms, but among them were eight of the nine largest firms in the field. As a result of the investigations by New York attorney general Eliot Spitzer, they ultimately agreed to pay some $1.

Total Returns on Stocks, Past and Future 4.5% 3.4% 2.0% 5.0% 6.4% 6.0% -1.0% 2.7% 0.1% -2% 0% 2% 4% 6% 8% 10% 12% 14% Last 100 Years Last 25 Years Next 10 Years 9.6% 12.5% 7.0% Earnings Growth Dividends P/E Change Investment Return Speculative Return 1. stocks to 9.6 percent per year. In the long run, then, investment returns are driven almost entirely by economics. But in the shorter-run, emotions—reflected in speculative return—can add to, or subtract from those economics that generate long-term returns, often by substantial magnitudes. During the past 25 years, for example, the annual investment return earned in the U.S. stock market was 9.8 percent, relatively close to the historic 9.5 percent historical norm. But speculative return contributed another 2.7 percent, reflected in the willingness of investors to increase the amount they paid for each dollar of corporate earnings from 9 times to 18 times, based on the trailing 12-month reported total earnings of the S&P 500, a 100 percent increase, spread over a quarter century. (Early in 2000, the P/E ratio actually reached an astonishing 32 times, only to plummet to 18 times as the new economy bubble burst.) Net result: during the past 25 years, speculative return enhanced the market’s annual return by nearly 30 percent. Did it matter? You better believe that it did! Compounded over the full quarter-century period, that enhancement was little short of astounding. The annual investment return of 9.

In the late 1990s, fund investors again paid a high price for our focus on the promise of the technology-driven information age, and on the promised land of the great bull market. The price they paid can be measured by the errors that fund investors made in the timing of their fund purchases and the selection of the funds they chose. The next two charts reflect those destructive patterns. The timing penalty (Chart 8) was evidenced by the fact that fund investors placed little money into equity funds during the cheap markets of the late 1980s and early 1990s (less than $10 billion per year), but invested more than $500 billion at the peak market levels of 1998-2000. The selection penalty (Chart 9) made a bad situation worse. Investors poured the lion’s share of that $500 billion into those “New Economy” growth funds, technology funds, telecommunication funds, and even internet funds. It was these funds that led the market upward, and then led the market downward, with late-to-the party fund investors paying an awful price. Ironically, at the height of the bubble, investors were actually liquidating their stodgy old value funds, which would provide excellent downside protection during the bear market that followed.

But we’d best not forget Lord Keynes’s warning of 70 years ago: “When enterprise becomes a mere bubble on a whirlpool of speculation the consequences may be dire. . . When the capital development of a country becomes a by-product of the activities of a casino, the job (of capitalism) is likely to be ill-done.” Whatever the case, some surprising event out there, far beyond our expectations, will surely come to pass, an event that may carry an extreme impact, and one that, once it happens, we’ll quickly concoct an explanation as to why it was so predictable after all. That event, if—perhaps I should say when—it comes, will be just one more Black Swan.

America’s Financial System—Powerful but Flawed A Lecture By John C. Bogle, Vanguard Founder The Phi Beta Kappa National Lecture Series Temple University, Philadelphia, PA November 3, 2010 In all of the talk about the causes of the deep-seated challenges facing our nation— globalization, enormous indebtedness, huge unemployment, the severe recession from which we are now only tentatively emerging, and the stock market crash of 2008-2009—too little attention has been paid to the critical role played by our financial system. Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked. The principal role of our nation’s financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal.

As you may have already figured out, those words (except for the very first sentence) are not mine. Rather they are the words of Harlan Fiske Stone, excerpted from his 1934—yes, 1934—address at the University of Michigan Law School, reprinted in The Harvard Law Review later that year. But his words are equally relevant—perhaps even more relevant—on this very day. For they could hardly present a more appropriate analysis of the causes of the present-day collapse of our financial markets and the economic crisis now facing our nation and our world. You could easily react to Justice Stone’s words by falling back on the ancient aphorism, “the more things change, the more they remain the same,” and move on to a new subject. But I hope you’ll react differently, and share my reaction: In the aftermath of that Great Depression and the stock market crash that accompanied it, we failed to take advantage of the opportunity to demand that our giant businesses and financial organizations—the trustees of so much of our nation’s wealth—measure up to the stern and unyielding principles of fiduciary duty described by Justice Stone. So, 75 years later, for heaven’s sake, let’s not make the same mistake again. The Columbia Connection Given this history and this topic, it seems singularly fitting to present this lecture at Columbia University. For Harlan Fiske Stone (1872-1946) ranks among Columbia’s most distinguished sons.

and elegance”2—the very kind of ingenious simplicity and effectiveness that characterize the index fund. It is the antithesis of the discredited “financial engineering,” the excessive costs, the product complexity, and the rampant speculation that created the global financial crisis that Wall Street has inflicted on Main Street. We created the first index mutual fund in 1975, and today it is the largest mutual fund in the world.3 This afternoon, I’d like to discuss the current state of our economy and financial markets, with the emphasis first on what went wrong, and second on what we might do to assure that our financial system takes on a greater sense of public purpose. I’ll do so by focusing on four quotations from Adam Smith, ranging from the obvious to the prophetic, to the idealistic. I’ll conclude with a few closing words about how all of this fits in with the message of my new book, Enough. True Measures of Money, Business, and Life. Adam Smith I – The Invisible Hand To say that the nation’s financial sector has ignored the principles of efficiency and economy—to say nothing of elegance—would be to put one’s head in the sand. The fact is that the bubble that led to the current financial and economic crisis; the easy credit; the cavalier attitude toward risk taken by our bankers and investment bankers; “securitization,” in which the traditional (and essential!)

Main Street bailing out Wall Street for its disgraceful conduct . . . it doesn’t seem fair, does it? Well, it isn’t! But the rampant greed that has overwhelmed our financial system and corporate world runs deeper than money. Not knowing what enough is subverts our society’s traditional values, as self-interest and greed replace community interest, professions behave as businesses, money vs. service to the community, and service to self takes priority over service to others. This confusion about what is enough leads us astray in our larger lives, as we too often bow down at the altar of the transitory and finally meaningless; and we fail to cherish what is beyond calculation, indeed eternal. Unchecked, our failures ultimately result in the diminution of our national character and values. So in a broader sense, we all bear some of the responsibility for what has gone wrong in America. That message about our society’s worship of wealth and the growing corruption of our ethics, I think, is what Joseph Heller captured when he spoke that powerful single word . . . enough. A Speech at Georgetown I was so inspired by Vonnegut’s poem that, in my commencement address at Georgetown University’s business school two years later, I used it to send a message. It was May of 2007, only a few short months before the great bubble that had enveloped our stock market, our financial system, our real estate holdings, and our economy would begin to burst.

Yet together, we who have been so favored have much to do to help those far less favored, to spread “the blessings of liberty throughout the land.” As our Founding Fathers demanded, we must do our best to “promote the general welfare . . . for ourselves and our posterity.” Despite the recent financial crash and our still-stumbling economy, with unemployment at shocking levels (and showing few signs of improvement), America’s material wealth—our productivity, our technology, and our innovation—remain the envy of the world.of

of all shares. Ownership of U.S. stocks by institutions, on the other hand, has soared more than seven times over—from 8 percent of shares all those years ago to more than 70 percent today. But in our new “agency society,” with financial intermediaries as a group now holding clear voting control of corporate America, our agents have failed to behave as owners. Indeed, in far too many cases, they have placed their own interests ahead of the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. It’s not that we were not warned about the consequences of our failure to honor the fiduciary principle that “no man can serve two masters,” and that fiduciary duty imposes a high standard of morality upon those entrusted with managing the property of others. Indeed, it was way back in 1934—75 years ago—in the aftermath of the Great Crash in the stock market that Supreme Court Justice Harlan Fiske Stone warned: The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to [the] principle [that “no man can serve two masters] if the modern world of business is to perform its proper function.

income tax on big fortunes, and a graduated inheritance tax on big fortunes . . . increasing rapidly in amount with the size of the estate.” Given Theodore Roosevelt’s commitment to progressive taxation, I find myself both amused and disappointed that when President-elect Barack Obama endorsed policies rooted in, yes, the Republican party of Lincoln and Roosevelt, he was described darkly as a “socialist” whose goal was to “spread the wealth,” echoing Roosevelt’s expectation of being called a Communist all those years ago. The Present Financial Crisis The present financial crisis, of course was precipitated importantly by gambling in stocks—to say nothing of the modern-day gambling in bonds and so-called derivatives. This gambling with other people’s money created enormous wealth for the few of Wall Street as, in essence, our nation’s “masters of the universe” served their own parochial interests during the market bubble. But, as we now know, when the bubble burst (as it always does) Wall Street inflicted an incredible disservice to the real people of Main Street, the backbone of our nation. All those years ago, Roosevelt clearly anticipated this outcome: “The absence of effective national restraint upon unfair money-getting has tended to create a small class of enormously wealthy and economically powerful men, whose chief object is to hold and increase their power . . .

(Leave aside that some of those gains reflected, well, irrational exuberance, and represented, well, “phantom returns” destined to vanish.) And our professional money managers, rather than acting as long term investors— serving as vigilant stewards of our assets and acting as prudent trustees for the mutual fund investors and the pension fund beneficiaries they were duty bound to serve—have instead largely become short-term speculators, behaving as stock traders and placing their own interests ahead of the interests of their clients. Fathers of the Crisis There is plenty of responsibility to spread around for what went wrong. So while it is often said that “victory has a thousand fathers, but defeat is an orphan,” the defeat suffered by investors in our devastating financial crisis seems to have, figuratively speaking, a thousand fathers.stock

One result of this crazy speculation—you all must know this by now—has been the unprecedented market turbulence I have described. A simple measure makes the point: During my first few decades in this business, we might have three or four days each year in which stocks rose or fell by two percent or more. Since July 2007, however, stocks have risen or fallen by that amount on 52 days, 21 up and 31 down—volatility without precedent in all history. But does this market craziness reflect reality? No it doesn’t. Since the October 2007 high, the total capitalization of the U.S. stock market has crashed from about $18 trillion to $10 trillion, at the low last Friday, a drop of some $8 trillion. But that’s “the market.” Does anyone here tonight really believe that the value of American corporate business in the aggregate has dropped by $8 trillion—by 40 percent! Well, I for one do not. Over the entire modern era, U.S. business has grown, with remarkably few interruptions, (for example the Great Depression), at about the pace of the real economy. Much of the responsibility for the crash in prices can be laid on Wall Street. Investment bankers, brokers, and money managers shifted their attention away from honoring, first and foremost, the interests of their clients and toward increasing their personal wealth and the earnings of their (largely publicly held) firms.

market crash, and failing to impose discipline on mortgage bankers. Our banks and investment banks, which designed and sold trillions of dollars worth of incredibly complex and risky mortgage-backed bonds and tens of trillions of dollars of derivatives (largely credit default swamps). They were also left holding the bag with many of these toxic derivatives, held in highly leveraged balance sheets—sometimes by as much as 33 to one or more. Just do the math; a mere three percent decline in asset value wipes out 100 percent of shareholder equity. These institutions also brought us “securitization,” selling off loans to untested financial instruments and severing the traditional link between lender and borrower. With that change, the incentive to demand credit-worthiness on the part of those who borrow almost vanished as banks lent the money and then sold the loans to these new bond funds. In banking we’ve come a long, long way from community lending built on the financial probity and the character of the borrower, the kind of thing we saw in “It’s a Wonderful Life.” (Remember Jimmy Stewart as George Bailey and Lionel Barrymore’s crusty Mr. Potter?) Our market regulators, too, have a lot to answer for: The Securities & Exchange Commission was almost apathetic in its failure to recognize what was happening in the capital markets.

But Wall Street marketers and entrepreneurs loved this new system of complex products, quantification, innovation, and unconstrained risk, ignoring its destruction of their clients’ wealth and wallowing in the wealth it generated for themselves. Revenues of our stock brokerage firms, money managers, and the other insiders soared from an estimated $60 billion in 1990 to some $600 billion in 2007. For the outsiders—the market participants as a group, who inevitably feed at the bottom of the food chain of investing—that enormous sum represents a truly staggering hit to their earlier gains in the bull market, and a slap in their face in the bear market that followed. Any confidence in Wall Street that these participants once may have had has largely vanished, just as it should have. Of course, the speculators among us, and those of us who have forgotten the distinction between investment and speculation—two groups that inevitably display a large amount of greed—must share a portion of the responsibility for the financial bubble and the ensuing crash.to

But while the crisis was created largely by Wall Street, it is Main Street that is paying the price. And I’m sure that many of you students have a father or a mother who has been stung by the stock market crash or by the severe recession we are enduring. It won’t be easy, but I hope that they have the strength after Kipling, to “force their heart and nerve and sinew to serve their turn” until the crisis at last abates and our country again moves forward. Which we will. And when in your own lives you “watch the things you gave your life to, broken”—which will surely happen to some of you and your families—remember to “stoop and build ‘em up with worn out tools”. Wrapping Up Let me conclude with a final lesson for you, expressed in the last few lines of Kipling’s poem. Recall them with me: * The motto on Roxbury Latin’s crest is mortui vivos docent.

Isn’t it high time we stand on their shoulders and shape national policy away from the moral relativism of peer conduct and greed and short-term speculation—gambling on expectations about stock prices? Isn’t it high time to return to the moral absolutism of fiduciary duty, to return to our traditional ethic of long-term investment focused on building the intrinsic value of our corporations—prudence, due diligence, and active participation in corporate governance? So, yes, now is time for reform. Today’s agency society has ill-served the public interest. The failure of our money manager agents represents not only a failure of modern-day capitalism, but a failure of modern-day capitalists. As Lord Keynes warned us, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill-done.” That is where we are today, and the consequences have not been pretty. In all, our now-dominant money management sector has turned its focus away from the enduring nature of the intrinsic value of the goods and services created, produced, and distributed by our corporate businesses, and toward the ephemeral price of the corporation’s stock—the triumph of perception over reality.of

As professional institutional investors moved their focus from the wisdom of long- term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill- done.” In the recent era, its job has indeed been ill-done. The triumph of emotions over economics that has been reflected in the casino mentality of so many institutional investors has had harsh consequences. Yet when perception—the precise but momentary price of the stock— vastly departs from reality—the hard-to-measure but enduring intrinsic value of the corporation— the gap can be reconciled only in favor of reality.stock

move the financial sector away from the extraordinary popular delusions of today’s crowds and the madness of today’s speculators, returning to the wisdom of long-term investing. The financial crisis, which took a decade or more to reach full fruition, has now spread into the real economy of business and commerce, of consumers and families. There is little that can be done except to work out the problems over time, and to hope that our Federal government is successful in freeing up the credit markets and relieving—at a staggering cost to taxpayers— the banks of the responsibility for their foray into speculation and their embrace of the toxic securities that now crowd their balance sheets. This economic process will take some years to restore itself. The need to restore confidence in Wall Street goes beyond the financial sector, and indeed beyond the real economy in which each of our citizens has a stake. We need to return capitalism to its traditional roots as a system focused on long-term investing, not short-term speculation. For as the great British economist John Maynard Keynes reminded us more then 70 years ago, words I cited in my Princeton University thesis in 1951, and most recently in my newest book (out in 2 weeks), Enough. The True Measures of Money, Business, and Life. “When investment becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill done.” Especially at this dire time, that is the one thing that our nation cannot afford.

” Indeed, it was way back in 1934—75 years ago—in the aftermath of the Great Crash in the stock market that Supreme Court Justice Harlan Fiske Stone warned: The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to [the] principle [that “no man can serve two masters] if the modern world of business is to perform its proper function. Yet those who serve nominally as trustees, but [are] relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent; corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders; [and] financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those who funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.

known Invisible Hand, we need to call on his almost universally-unknown Impartial Spectator, from Smith’s earlier Theory of Moral Sentiments. Just who is this Impartial Spectator? It is, Smith tells us, “the voice who calls to us . . . capable of astonishing the most presumptuous of our passions, that we are but one of the multitude, in no respect better than any other in it; and that when we prefer ourselves so shamefully and so blindly to others, we become the proper objects of resentment, abhorrence, and execration. It is from him only that we learn the real littleness of ourselves. It is this Impartial Spectator . . . who shows us the propriety of generosity and the deformity of injustice; the propriety of resigning the greatest interests of our own, for the yet greater interests of others . . . in order to obtain the greatest benefit to ourselves. It is not the love of our neighbour, it is not the love of mankind, which upon many occasions prompts us to the practice of those divine virtues. It is a stronger love, a more powerful affection, the love of what is honourable and noble, the grandeur, and dignity, and superiority of our own characters.” Alan Greenspan and the Bubble It is fair to say that the failure to honor those lofty standards played an important role in creating the recent crisis.

Indeed, one Vanguard shareholder described it as “a crisis of ethic proportions” (a nice variation on the standard “epic” proportions), the title that I used for my op- ed essay published in The Wall Street Journal a week ago. For the decline in ethical values played a major role in the failure of managerial capitalism and—managerial capitalists—that led to the financial bubble, and the burst that inevitably followed. While former Federal Reserve Chairman Alan Greenspan believed that competition and free markets would reward trust and integrity, he seemed unmindful of this sea-change in capitalism that was occurring. To his credit, Greenspan admitted his mistake. In his testimony before Congress last October, he acknowledged that the crisis had been prompted by “ . . . the collapse of a whole intellectual edifice . . . Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief,” he said. This failure of self-interest to provide self-regulation was, he added, “a flaw in the model that I perceived as the critical functioning structure that defines how the world works.”

their stipend was skill avoiding obvious fraud and in structuring the package.” Remarkably, Minsky had this insight in 1994, long before the issuance of the complex and highly risky credit default swaps, collateralized debt obligations, and structured investment vehicles that characterized the era that has now come to its crashing conclusion. Business Values and Investment Values Gone Awry Let me now sum up how our business values and investment values have gone awry and the consequences of this failure. I’ll first cite the grave concerns of both Keynes and Minsky, and then add my own perspective. Keynes’ famous paragraph can hardly be more incisive: As the organization of investment markets improves, the risk of the predominance of speculation does however increase. Speculators do no harm as bubbles on a sea of enterprise. But the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job (of capitalism) is likely to be ill done. And Minsky comes out with a similar conclusion: In a capitalist economy, the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations. The key financial relationships link the creation and the ownership of capital assets to the structure of financial relations and changes in this structure.

The task of returning capitalism to its ultimate owners will take time, true enough. But the new reality—increasingly visible with each passing day—is that the concept of fiduciary duty is no longer merely an ideal to be debated. It is a vital necessity to be practiced. What’s at stake here is the very role of capitalism in our society. Should it serve corporate managers and money managers? Or should it serve the citizens who invest their capital? Is speculation to ride in the saddle, or will investment call the tune? Some 70 years ago the eminent British economist John Maynard Keynes warned us: “When enterprise becomes a mere bubble on a whirlpool of speculation, the consequences may be dire . . . when the capital development of a country becomes a by- product of the activities of a casino . . . the job (of capitalism) will be ill-done.”

So while trading back and forth with one another—foolish as it is—is by definition a zero-sum game, once the costs of our Wall Street croupiers are deducted it is a loser’s game. (Think Las Vegas, think the Atlantic City Race Track. Heck, think Governor Rendell’s lottery.) So for investors as a group—who inevitably feed at the bottom of the food chain of investing receiving whatever market returns remain after the croupiers costs—trading is a loser’s game, by the amount of these costs. That $600 billion in 2007 plus many hundreds of billions in earlier years, obviously represent a truly staggering hit to the gains investors earned in the bull market, and a financial slap in their face in the bear market that followed. Any confidence in Wall Street that our investors once may have had has largely vanished, just as it should have. The speculators among us, and those of us who have forgotten the distinction between investment and speculation—two groups that inevitably display a large amount of greed—must share a portion of the responsibility for the financial bubble and the ensuing crash. When an own-a-stock industry becomes a rent-a-stock industry, concern about corporate governance is the first casualty—a harbinger that our capitalistic system is not working properly.

giant manufacturers (think General Electric Capital, for example, or the auto financing arms of General Motors and Ford) to this total, financial earnings now likely exceed 33 percent of the earnings of the S&P 500. While, given the recent collapse of collateralized debt obligations that have already led to the demise of the careers of CEO’s of our nation’s largest bank and largest brokerage firms, that share may decline this year as it remains enormous. We’re moving, or so it seems, to a world where we’re no longer making anything in this country; we’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks—now beginning to emerge—are being built into our financial system. “When enterprise becomes a mere bubble on a whirlpool of speculation,” as the great British economist John Maynard Keynes warned us 70 years ago, the consequences may be dire. “When the capital development of a country becomes a by-product of the activities of a casino, the job of capitalism is likely to be ill-done.” Once a profession in which business was subservient, the field of money management and Wall Street has become a business in which the profession is subservient.

Why? Because our society is paying a high price for the shift that Keynes so accurately predicted. As professional institutional investors moved their focus from the wisdom of long-term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill-done.” And that is one thing that we can’t allow to endure. A Princeton Education I freely confess that I am struck by the confluence of the simple arithmetic of investing and the simplistic virtue of ethical values that have shaped my long career. Both were inspired by my Princeton education and frequent encounters with remarkable Princetonians, beginning with my mentor Walter L. Morgan, ’20, and surely enhanced by my brother-in-law John J.F. (Jay) Sherrerd ’52, the late great Princeton Trustee. In my recent years especially, I’ve reflected on the relationship between these keystones of simple arithmetic and simple values, and how they paralleled my awakened interest in the culture of engineering and my long-standing love for the humanities. In retrospect, I fear that I was too narrow, too cautious in selecting my courses at Princeton.

One example: Collateralized debt obligation (CDOs) have wreaked havoc among our commercial banks and our investment banks, and credit default swaps (CDS) now total an astonishing $600 trillion—speculative derivatives of credit instruments that themselves total less than $20 trillion—an amount of speculation 25 times (!) that modest amount of (risky) underlying investment. We know almost nothing about the counterparties to this boatload of CDS that embody the excesses of our financial system—innovation designed to benefit those who create these instruments rather than those who own them. There’s a wonderful story about an investment banker addressing his colleagues: “the bad news is that we’ve lost an enormous amount of money. The good news is that none of its ours.” The mutual fund industry, of course, is no stranger to financial innovation. Consider the new “products” we created during the recent Information Age bubble. As the stock market soared to new highs—and unprecedented P/E multiples—fund innovation focused on its hottest sectors. During the last three years of the decade alone, we formed nearly 500 new funds investing in technology, telecom, and Internet stocks, compared to only 87 such funds in the decade’s first three years. (Only one pure technology fund during the first three years; 116 in the last three.)aggressive

It is a responsibility to the nation. In these days when we seem to like “stories” to explain complex issues, each of these men exemplify, respectively three short anecdotes centered on individuals whose names will be familiar to you—(1) Alan Greenspan, (2) Bernard Madoff, and (3) Barack Obama, an unlikely triumvirate if ever there were one—and their respective roles in: (1) how this financial crisis began, (2) how we fooled ourselves, and (3) what we must do to work out way through the incredibly intractable economic woes that now plague us. I’ll do this analysis by relating. Alan Greenspan and the Bubble First, former Federal Reserve Chairman Alan Greenspan. More than any other individual, he was central to the development of the financial bubble and the burst that inevitably followed.lenders

When I read Vonnegut’s poem in 2005, I felt like I’d been struck by a bolt of lightning. When I was invited to give the commencement address at Georgetown University’s business school two years later, in May 2007—as it happens, only a few short months before the burst came in the great bubble that had enveloped our stock market, our financial system, our real estate values, and our economy—I decided to use “Enough” as my theme, and began it with Vonnegut’s poem. Here’s what I then said to those newly-minted MBAs: “If you enter the financial field, do so with your eyes wide open, recognizing that any endeavor that extracts value from its clients may, in times more troubled than these, find that it has been hoist by its own petard. It is said on Wall Street, correctly, that ‘money has no conscience’, but don’t allow that truism to let you ignore your own conscience, nor to alter your own conduct and character.” “(But) no matter what career you choose, do your best to hold high its traditional professional values, now swiftly eroding, in which serving the client is always the highest priority. And don’t ignore the greater good of your community, your nation, and your world. As William Penn pointed out all those years ago, ‘We pass through this world but once, so do now any good you can do, and show now any kindness you can show, for we shall not pass this way again.

As you may have suspected, I’ve once again cited a section of Justice Stone’s 1934 speech, and it’s high time we take it seriously. For the fact is that there has been a radical change in our investment system from the ownership society of a half-century ago—which is gone, never to return—to our agency society of today—in which our agents have failed to serve their principals—mutual fund shareholders, pension beneficiaries, and long-term investors. Rather the new system has served the agents themselves—our institutional managers. Further, by their forbearance on governance issues, our money managers have also served the managers of corporate America. To make matters even worse, by turning to short-term speculation at the expense of long-term investment, the industry has also damaged the interests of the greater society. Hear Lord Keynes on this point: When enterprise becomes a mere bubble on a whirlpool of speculation, the consequences may be dire . . . when the capital development of a country becomes a by- product of the activities of a casino . . . the job (of capitalism) will be ill-done. Yet despite these changes in the very nature of corporate ownership we have failed to change the rules if the game. Indeed, in the financial sector we have rolled back most of the historic rules regulating our securities issuers, our exchanges, and our investment advisers.

exchanges. For example, there were 56 stocks in the S&P financial sector in 1989, including 28 banks; today there are 92 stocks, but only 26 banks. The combination of public ownership and earnings growth has been dramatic. For example, earnings of fund manager T. Rowe Price rose from $4 million in 1981 to $582 million in the twelve months ended June 30, 2007. In any event, we’re moving, or so it seems, toward becoming a country where we’re no longer making anything. We’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks are being built into our financial system. “When enterprise becomes the bubble on a whirlpool of speculation,” as the great British economist John Maynard Keynes warned us 70 years ago, the consequences may be dire. “When the capital development of a country becomes a by-product of the activities of a casino, the job (of capitalism) is likely to be ill-done” (1936). 5. Lower Equity Returns in Prospect? The burdensome costs of financial intermediation are all too likely to occur in an era of falling returns on equities, and the arithmetic is not good. Briefly put, the 100-year return of 9 ½ percent annually on stocks included a 4 ½ percent dividend yield. (Chart 8) Today’s 1.8 percent yield represents a dead-weight loss of 2.