John Bogle on Compounding

funds, including both fully disclosed (if often ignored) direct expenses—used for operating, marketing, and investment advisory costs plus generous profits for the managers—together with the hidden costs of fund portfolio transactions, the net rate of return of funds as a group, and, over the long run, of individual funds, has tended to lag the market by about 1-1/2 to 2-1/2 percentage points annually. To save you the trouble of pulling out your calculators (or slide rules!), a long-term return of, say, 10% without costs will provide, over 40 years, a terminal value of twice as much as a return that incurs annual costs of 2% and thus provides a net return of 8%. Costs consume 20% of the return—and that’s expensive. Exhibit I, simply a basic compound interest table, graphically contrasts the relative accumulations over time under these two return assumptions showing that $10,000 at a 10% return grows to $450,000 over 40 years, more than double the $220,000 it reaches at an 8% return. Superficially small differences in annual returns, extended over long periods of time, will make a dramatic difference in the final capital in your retirement fund. 1. RTM in Mutual Fund Returns In periods as short as one year, many mutual funds—especially small, aggressive ones—can and do defy these odds. And in some decade-long periods, perhaps one out of five funds succeeds in doing so by a material amount.

” There was a timely convergence of human and physical capital, supported by a network of modern systems: legal, financial, commercial, educational, governmental, and the like. Result:. Then, two centuries ago, and the modern world was born the world’s standard of living began inexorably to improve. Over the next 200 years, global living standards would rise by about 2 percent per year, increasing our worldly wealth from a mere $700 per capita to $6,000 in real terms, nearly nine times over. (Never underestimate the power of compound interest!) While capitalism has bestowed those economic blessings unevenly, it has bestowed them liberally, as living standards have risen all over the industrialized world. Those blessings are now spreading through the emerging economies of South America and Southeast Asia, including India and China, whose economy will surpass even America’s powerful economic engine within the next two decades.

Our assets, $1 billion at the outset in 1974, now total $530 billion, marking us as the second largest mutual fund firm in the world and the fastest-growing company in the industry, with the highest level of client loyalty; and the lowest costs of any provider—by far—of financial services on the face of the globe. Patterns of Industry Growth Since our inception, we have grown at a 27% annual compound growth rate—and a steady one at that. Charting our mutual fund assets on a semi-logarithmic chart results in something akin to a straight line. Our huge base in recent years has grown at essentially the same rate as our tiny base grew in the early years. Just a decade ago, when our assets totaled $40 billion, I drew a chart that projected what our 1999 assets might be, based on various future rates: 30% (“inconceivable,” I said); 20% (“unlikely”); and 10% (“easy”—our investment returns alone ought to do that job, with new investments from investors adding incremental assets). Well, with $530 billion as 1999 ends, our 27% historic growth rate hasn’t yet gone away (Chart 2). Nonetheless, I was ever fearful of the challenge of unbridled growth both on investment strategy and on organizational effectiveness back in 1989. So I entitled the chart, “The Tyranny of Compounding.”

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

positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one. Although the stock market’s wild and wooly odyssey since I wrote them makes those words seem an eon away, I believe more than ever in that basic principle: Rely heavily on index funds, and begin with the idea of a 50/50 bond/stock ratio, adjusting the ratio in accordance with your own financial profile. In my book, I noted that this approach was consistent with the philosophy of Benjamin Graham, author of The Intelligent Investor1. This simplicity surely has continued to prove itself. During the past decade, the annualized return on a low-cost index fund modeled on the Standard & Poor’s 500 Stock Index has been 14.4%, while the average general equity fund has earned +12.3%. The low-cost bond fund modeled on the Lehman Aggregate Bond Index has earned +8.0% annually, while the average taxable bond fund has earned +6.8%. These solid margins in returns—2.1% per year for the stock index fund and 1.2% per year for the bond index fund—were highly predictable, for they largely reflect the cost advantage index funds hold over actively-managed funds. Once again, the majesty of simplicity—the broadest possible diversification at the lowest possible cost—has proved itself. Pillar 3. Time Marches On. Time dramatically enhances capital accumulation as the magic of compounding accelerates.

in mind that the industry costs reflect fund expense ratios only; they ignore sales charges, paid on the purchase of shares in almost one-half of all mutual funds. Since we offer only no-load funds, Vanguard’s cost advantage is in fact substantially larger than it appears.) The impact of cost is greatest where the time horizon is longest. If a low-cost complex operates at a cost of ¼ of 1% (assuming a market return of 10%) over 25 years, it captures 95% of the market’s return. A high-cost complex (at 2%), would capture but 63%. So here is another form of the tyranny of compounding—cost compounds, too! Since 1980, the expense ratio of the average Vanguard fund has dropped from 59 to 28 basis points, even as the industry’s expense ratio has risen from 99 basis points to 125 (Chart 5). Thus our margin of advantage has risen from 40 basis points to almost 100—by two and one-half times—an 80% competitive advantage in unit costs. This advantage is pervasive—in our U.S. and international stock funds alike; in our balanced funds; in our tax-exempt and taxable bond funds; and in our money market funds. After all, given Vanguard’s unique mutual structure, we have two ways of earning profits for our shareholders: Investing in portfolios of securities that provide generous long-term returns; and minimizing the drag of intermediation costs so as to provide the highest possible portion of those returns.

The magic of compounding accelerates sharply with even modest increases in annual rate of return. While an investment of $10,000 earning an annual return of +10% grows to a value of $108,000 over 25 years, at +12% the final value is $170,000. The difference of $62,000 is more than six times the initial investment itself. Over the past decade, that a two-percentage-point differential I chose in my book characterized almost exactly the spread between a low-cost S&P 500 index fund (+14.4% per year) and the average U.S. stock mutual fund (+12.3%). Final value of an initial investment of $10,000: Index mutual fund $38,400; Managed mutual fund $31,900. And, I should note, that substantial increase in reward came hand-in-hand with no increase whatsoever in risk. In fact, the index fund was some 15% less volatile than the average equity fund.

returns.1 Hence, my projection of 7 percent annual return for stocks (2 percent current dividend yield, 5 percent annual earnings growth, with no significant impact from speculative return). Investment Costs But don’t expect to earn that return, for it represents the gross return on the market before the deduction of investment costs. How much do costs matter? Enormously. If we conservatively assume investment costs of 1 ½ percent per year, and begin with a $1,000 investment when the S&P 500 Index began in 1926 (Chart 2), a cost-free investment would be valued (with reinvested dividends) at $3.5 million today. But after deducting those costs, the remaining value would be about $1 million, some 70 percent less. While investment costs of 1 ½ percent per year may sound inconsequential at first glance, the results are staggering when compounded over an investment lifetime. Note also that the burden of costs accelerates over time, consuming 40 percent of the S&P 500’s return by 1960, 54 percent by 1980, and 65 percent in 2000. As I’ve often observed, the magic of compounding long-term returns is overwhelmed by the tyranny of compounding costs. Investment Returns—Before and After Costs 1,000 10,000 100,000 1,000,000 10,000,000 1926 1940 1960 1980 2000 2012 S&P 500 After 1.5% Investment Costs $3.55 million $1.05 million Annual Returns Gross Return: 9.9% After Costs: 8.

(It is this recent history—covering but 8 of the entire 60 years—that has created the value stock mystique.) Then, growth stocks outperformed through 1980, and value stocks have pretty much dominated since then. Linking all of these cyclical fluctuations, as reflected in Exhibit IV, for the full six decades, the terminal investment in value stocks was equal to about nine-tenths of the growth stock investment. For the full 60-year period, the compound returns were: growth, +11.7%; value +11.5%. I’d call that match a standoff, and a tribute to RTM. My second example of market sector RTM is high-grade versus low-priced stocks. This series— not much considered by investors during the past decade—has been published by Standard & Poor’s Corporation on a consistent basis since 1926. Here, as shown in Exhibit V, the swings in market pre- eminence are much briefer than with growth and value stocks. The most sustained trends have been evident during the past four decades, with low-priced stocks enjoying a six-year feast from 1962 through 1968, followed by a complete reversal in favor of high-grade stocks, a six-year famine that lasted through 1974.

The biggest risk is the long-term risk of not putting your money to work at a generous return, not the short term--but nonetheless real--risk of price volatility. Even though stocks seem very high, consider what I said in my book “never think you know more than the market does.” You’re apt to be wrong. Second, give yourself all the time you can. At the extremes, if you’re in your twenties, begin to invest in stocks even if you only have a small amount to invest; if you’re in your sixties, invest more in bonds and less in stocks. Compound interest is a miracle, and time is your friend.market

benefits at the expense of those they trade with. [But] over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company.” How often investors lose sight of that eternal principle! Yet the record is clear. History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense? Need proof? Just look at the record of stock returns over the past 100 years. The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year, arose from what I call speculative return. Depending on how one looks at it, merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the century than at the beginning. Compounding these returns over the century produced accumulations that are truly staggering. Each dollar initially invested in 1900 at an investment return of 9.5 percent grew by the close of 2005 to $15,062.

Virtually that entire margin was then lost during the next five years, leaving small caps about at par with large caps for nearly the full half-century. The small cap reputation was made during the 1973-1983 decade. Then, seemingly inevitably, RTM struck again for the fifth cycle. Just as the proverb warns us, it was darkest for the large caps before the dawn, and since then the sun has shone brightly upon them. On balance for the full period, the compound annual return on small cap stocks was +12.7% compared with +11.0% for large cap stocks. This difference, to be sure, resulted in a terminal value for small cap stocks that was three times that of large cap stocks. But, given the dominance of small caps in this single decade, I’m not sure I’d rely on it.stock

Sure, few (if any) of us have a century of life in us (yet!), but, like the Gotrocks family over the generations, the miracle of compounding returns is little short of amazing—the ultimate winner’s game. The problem is that this miracle of compounding returns is overwhelmed by the tyranny of compounding costs. If we assume even 2 percent in annual costs, that 9.5 percent nominal return drops to 7.5 percent, and the accumulated capital drops to just $2,100—less than one-seventh as much. In our foolish focus on the short-term stock market distractions of the moment, we, too, often overlook this long history. We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely because of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing. Put another way, while illusion (the momentary prices we pay for stocks) often loses touch with reality (the intrinsic values of our corporations), in the long run it is reality that rules.

Here are the results, based on an initial investment of $10,000 in 1983. Three key conclusions: 1. The managed funds provided an annual return of 13.0%, the Index Fund 15.1%--85% of the market's return for the managers, 99% for, if you will, the non-managers. 2. After 15 years, the investment in the managed fund was worth $62,700, the index fund $81,900 (wow!) The managed balanced fund provided 71% of the market's cumulative return, versus 97% for the index fund. Time and compounding have joined forces to turn a 2.1 point annual advantage into an advantage of $19,000 in accumulated wealth-twice the initial stake! "Little things mean a lot." 3. The superiority of the index fund is accounted for, not by magic, but by costs. The heavy costs of the managed funds were primarily responsible for their shortfall.

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.

Exchange Index. The NASDAQ Index fell a stunning 78% from its high to its low last autumn, while the NYSE index fell 33%, less than half as much. (The principal difference between the two markets is that to be listed on the NYSE a company actually has to have earnings.) In the ensuing recovery, the NASDAQ index is up 73%, and the NYSE up 30%. But, don't forget the surprisingly harsh mathematics of compounding: A 78% loss followed by a 73% gain nets, not to a 5% loss, but a 62% loss! And even a 33% loss balanced by a 30% gain results, not in a 3% loss, but a 14% loss of capital. But we've clearly been told a tale of two markets: Reversion to the mean is alive and well. Chart – A Tale of Two Markets: Growth of $1, 1982-2003 Today, after the fall—and a nice recovery—what does the future hold? Let's look at some numbers that might help us to understand what returns might lie ahead for the stock market, and for the bond market as well. I, for one, place little credence in simply looking at historical experience, for as I've said a thousand times, "financial returns are not actuarial tables." The watchword of investing is uncertainty. To understand why the past cannot foretell the future, we need only heed Lord Keynes' words, written nearly 70 years ago: "It is dangerous . . . to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was."

but also both its management company’s propensity to move managers around, sometimes seemingly at the drop of a hat. Turnover costs can cut your long-term returns by a meaningful amount, so do your best to find funds both with portfolio holdings and portfolio managers that will stay the course. 3. Realize that Taxes are Fund Costs, Too There is yet a third croupier in the fund casino. And in this bull market era, it happens to be the greediest croupier of them all: The Federal Government. Make no mistake about it, Uncle Sam loves the mutual fund industry. For as impatient, aggressive fund managers buy and sell stocks at a furious rate, they pay virtually no attention whatsoever to the taxes such activity will require you to pay. They can ignore taxes, but you can’t. There is awesome value in deferring taxes—and deferring them for as long as you can. When you pay taxes today, that money can’t compound to your benefit tomorrow. Deferring a capital gain for 15 years reduces the present value of each one dollar of taxes to just 41 cents; in 25 years, to 23 cents. Yet fund managers not only require you to pay the 20% tax far too early, realizing long-term capital gains far too prematurely. They also have been realizing some one-third of all capital gains on a short- term basis, thus forcing you to pay taxes at rates up to the 40% maximum on dividend income.

When we apply to the annual data that remarkable magnifying glass called compounding, we can describe the investment returns earned by the fund—on cost and tax assumptions that I think we can all agree are hardly excessive—as shocking. The investor lost 63% of the market’s cumulative return to the intermediaries, 66% of that to taxes, and 85% of that to inflation, ending up with just 2% of the compound market return we calculate from all of those annual return data that the fund industry publishes. 13.3% 11.1% 8.7% STOCK MARKET MUTUAL FUND AFTER EXPS. MUTUAL FUND AFTER EXPS AND TAXES Stock Market Returns, 1950-1999 Annual Returns Final Value of $1,000 $514,000 $193,000 $65,000 STOCK MARKET MUTUAL FUND AFTER EXPS. MUTUAL FUND AFTER EXPS AND TAXES 9.3% 7.1% 4.7% Real Returns, 1950-1999 Annual Returns Final Value of $1,000 $85,000 $31,000 $10,000 STOCK MARKET MUTUAL FUND AFTER EXPS. MUTUAL FUND AFTER EXPS AND TAXES STOCK MARKET MUTUAL FUND AFTER EXPS.TAXES

domination in 1973-1983—but one of seven decades in the period—large caps were actually superior. Annual returns: large cap +11.1%, small cap +10.4%. In any event, the relationship between large caps and small stocks, if not entirely dominated by RTM, is permeated with the force of market gravity. We don’t have an historical chronicle of comparable length to those I’ve used for my first examples of RTM. So, for the evidence in U.S. versus international stocks, I can rely only on data for the past 38 years. Here, as shown in Exhibit VII, we again see profound evidence for my thesis. Here, I’ll compare the returns of the Standard and Poor’s 500 Stock Index and the Morgan Stanley Capital International Europe, Australasia, and Far East (“EAFE”) Index. While there were frequent swings to and fro, our ratio of cumulative value slightly favored the EAFE Index for the first 24 years through 1984. The compound returns were EAFE +9.7%; S&P +8.4%. Then EAFE exploded, outpacing the U.S. by fully two times during the brief 1984-1988 cycle. Since then, the U.S. has fully repaid the compliment, more than redressing that flash of EAFE brilliance during the subsequent nine years. For the full period, the compound returns on U.S. stocks and international stocks were identical at +11.5%. The relative value of each initial $1.00 invested by the investor who stayed in the U.S. was worth precisely the same for the internationalist.

When we put them all together, the comparison of the actual results of the average fund with the results of simply owning a market index is truly a revelation, albeit one that is virtually—if understandably— ignored by the mutual fund industry. So, here are the results: Over the past 15 years, the average pre-tax return of the total U.S. stock market was 16.4% per year. But after the costs of all of the croupiers—fund sellers, fund managers, stock brokers, and the Federal Government—the return for the average fund investor was just 10.2% per year. By way of contrast, a low cost, no-load, low turnover all-market index fund would have provided an annual rate of return of 15.2% to the investor—fully 50% higher. And as both returns and costs compound, the difference widens. The value of an initial $10,000 investment at the end of the period: managed equity fund, $43,000; index fund, $83,300. In short, in search of the perfect plan, the investor in the equity fund relinquished 56% of the market’s gain to the croupiers, with but 46% left for himself. On the other hand, by holding the croupiers’ share to 14% of the market’s cumulative return, the investor who relied on the good plan of a market index fund retained 86%. His $73,000 profit was more than double the $33,000 profit of the regular investor. The point of this chart is not to attempt to persuade you to abandon the active management strategy that you likely follow, much as I might wish to do that.the

Academic studies estimate that over fifteen years, the aggregate returns of mutual funds are overstated by as much as 1%, bringing the 11.8% after-tax return reported above to 10.8%, and raising the Index advantage to +4.3o/o-nearly a 50% increase (before compounding!) Adjusting the average mutual fund returns to correct for this bias, then, leads to even more dramatic fund underperformance than traditional comparisons show. That said, I must in fairness state that the returns of index funds are also lower than the returns of the Index, because they are reduced by portfolio turnover and operating costs. No matter how modest they may be, these costs exist in the real world. During the past 15 years, for example, the Vanguard Index Trust 500 Portfolio had returns of 16.4% before taxes and 14.3% after taxes (compared to 15.1 % for the Index itself), placing it in the 8151 and 86th percentiles, respectively among the surviving mutual funds.

But intermediation costs are paid in current dollars, while the investor’s final capital must be measured in constant dollars. During the past half-century, the inflation rate was 4.2%. Result: Real annual return for the S&P 500, 7.8%; real return for the fund investor, 5.4%. The final purchasing power of each initial dollar falls to $43 in the Index, and to less than $14 in the fund. Since the mutual fund’s annual return before costs was not the 12.0% stated return earned by the S&P Index, but a real return of 7.8%, the 2.4% intermediation cost reduced each year’s real return, not by 20%, but by almost 33%! When we apply to the annual data that remarkable magnifying glass called compounding, we can describe the investment returns earned by the average fund—on cost assumptions that are hardly excessive—as shocking. After intermediation costs and inflation (and ignoring taxes!), the nominal value of $287 had dwindled away to less than $14, just 5%—five percent!—of the compound market return we calculate from the textbook data—say, the Ibbotson tome—that shows the annual returns of the stock market. Yes, Embedded Alpha is a powerful destructive force. Other Destructive Forces But it turns out that there are other forces that are every bit as destructive as costs in undermining the returns earned by mutual fund investors.

respectively. The brute fact: All-in fund costs have consumed about one-third of the annual investment returns earned by their bogeys, even after the benchmarks are adjusted for estimated index fund expenses and taxes. Alas for the fund shareholder, that’s the least of it. Even as we have the famously accretive magic of compounding of investment returns, so we have subtly decretive tyranny of compounding investment costs. Result: the cumulative investment returns earned by mutual funds over the past 15 years have been a pale shadow of the cumulative returns by comparable market indexes: Large-cap funds have provided 51% of the cumulative after-tax profit generated by the S&P 500 Index: Mid-cap funds have provided 37% of the profit generated by the S&P 400 Mid-Cap Index. Small–cap fund have provided 56% of return generated by the Russell 2000 Small Cap Index. That’s just not good enough. Large-cap 15.0% 12.2% $ 81,400 $ 56,200 Pre-tax After-tax S&P 500 17.9 16.7 118,200 101,400 Mid-cap 12.8% 9.8% $ 60,900 $ 40,600 S&P 400 17.5 16.0 112,300 92,700 Small-cap 10.2% 7.5% $ 42,900 $ 29,600 Russell 2000 12.2 10.5 56,200 44,700 Mutual Funds are Meeting the Reasonable Expectations of Investors Fund Type The Cost of Cost* 49% 63% 44% Myth #5: Pre-tax After-tax 15 Year Returns on $10,000 Investment - Blend Funds vs. Index Funds *Appreciation of active fund investment as % of index fund. Fund returns adjusted for survivor bias of 0.3, 1.2 and 2.0 percent, respectively.

 Our original index fund is now the world’s largest mutual fund, and our panoply of stock index funds total $180 billion. Our market share of no-load stock index fund assets is a dominant 82%.  Our original troika of tax-exempt bond funds, and the similarly-structured taxable bond funds that followed—all relying on index-like strategies—total $112 billion in assets, including $24 billion in bond index funds. Market share: Now 45%, vs. 18% in 1980.  Our money market funds, also capitalizing on the low-cost-equals-high- return equation have assets totaling $93 billion. Market share: 33%, vs. 4% two decades earlier.  And the assets of our traditional actively-managed equity funds total $144 billion. Market share: 15% down from 25%, the inevitable result of our focus on indexing. The magnificent returns in the financial markets—stock, bond, money market—through most of our history, really right up to the spring of 2000, have given HMS Vanguard a powerful wind at her back. Our assets have grown at a compound rate of 25% per year, and at a remarkably steady pace, carrying our asset base from $1 billion to $565 billion. But the overwhelming portion of that huge increase has come from our rising share of market. Had our share held steady, our assets today would be $110 billion. The remaining $455 billion is accounted for by the increase of our share of total industry assets from 1.7% in 1981 to 8.3% today—without a single year of decline.

accumulation programs, with a healthy appetite for returns and a strong stomach for risks, and an extended time (15 to 40 years) before retirement. For those making investments that are modest relative to the capital already salted away, with more conservative instincts and shorter time horizons (1 to 15 years), I’d shade equities lower, all the way down to 35/65 at the extreme. For no one knows what future returns the financial markets will provide. Here, I want to emphasize the incredible power of compounding over an extended period of years. Given sufficient time, even a small enhancement to returns is virtually priceless, even if equities fail to provide their historical premium—their excess real return—of 3 1/2% over bonds, as seems highly likely to me. After all, the equity premium has been more than 6% annually during the past decade, and some RTM would hardly be astonishing. But even a 2% risk premium—only about one-half the norm— would make a powerful difference. Exhibit XI shows that a retirement plan program—investing, say, $5,000 regularly, year after year—earning a 5% nominal return would produce $250,000 in 25 years and $634,000 in 40 years, while the same investment at 7% would produce terminal values of $340,000 and $1,068,000, respectively. The modest 2% equity premium adds $90,000 in 25 years, and adds $430,000 in 40 years, itself more than two times the cumulative $200,000 of annual investments. These are hardly trivial differences in capital accumulation.

According to an independent study, the average fund owner earned an annual rate of return of just 2.6% per year, nearly ten full percentage points short of the market's return, and seven percentage points short of the average fund—less return than a savings account would have produced, with no risk at all. Chart: The Stock Market, Funds, & Fund Owners Compounding: The Magic and the Tyranny Now let's compound those returns during the full period: $10,000 in the stock market itself would have produced a profit of $79,000. $10,000 in the average fund would have grown by $44,000—half as much. And the $10,000 invested by the average fund investor would have produced a profit of just $6,000. Just as the growth of $10,000 to $79,000 demonstrates the magic of compounding returns, so that reduction by a full $35,000—to a value of $44,000—demonstrates the tyranny of compounding costs. By the same token, the further $38,000 shortfall—amazing, isn't it!—incurred by the average fund investor demonstrates the woes of timing and selection, brought on as part of our focus on asset gathering at all costs. It is impossible to argue that we have given our shareowners a fair shake.Owners

Indexing wins because it is an exceptionally low cost strategy that is competing, finally, with all stocks as a group, by definition an equally-diversified universe. And the mutual fund portion of that universe—nearly one-quarter of it—is composed of thousands of different individual funds operating at high cost. In such circumstances, an equity index fund cost advantage conservatively estimated at 1.5% annually should provide 1.5% in added return over time. Yes, it is really just that simple. If the stock market’s return is 9% in the future, the typical fund should be expected to deliver 7.5% at best. (If you cannot accept my thesis about RTM in the relative returns of mutual funds, I believe your chances of selecting the future good performers will be highest if you choose from among those with low expense ratios and low portfolio transaction costs.) As shown in Exhibit XII, this difference in compounding causes $10,000 to grow to $61,000 at 7.5% over 25 years, but to $86,200 at 9%. Over 40 years, to $180,000 at 7.5%, but to $314,000 at 9%. It seems almost too easy a way to earn an extra nest-egg of almost $100,000, holding risk constant. But there it is. In short, excessive mutual fund operating costs carry a high penalty in shareholder capital accumulations over the long run. Cost matters.

It was not until the early 1990s that it started to grow, and grow it did. Today, assets of the Vanguard 500 Index funds total $581 billion. With their sister fund, Vanguard Total Stock Market Index (with 83% of its assets in S&P 500 Index stocks), another $662 billion—in all, $1.24 trillion invested in these TIFs (traditional index funds) at Vanguard alone. Today, all told, the assets of all Vanguard index funds total $3.6 trillion, 74% of Vanguard’s present asset base of $4.7 trillion. During the past quarter-century, index funds have come into their own. More broadly, assets of all U.S. index mutual funds have risen from that pathetic $11 million in 1976 to $93 billion in 1996, a 55% compound annual growth rate—to $6.1 trillion in late-2017, still a respectable 22% annual growth rate. In the past decade alone, U.S. investors have added $2.1 trillion of net cash flow to their holdings of U.S. equity index funds and withdrawn more than $900 billion from their holdings of actively managed equity funds. Such a huge $3 trillion swing in investor preferences surely represents no less than an Index Revolution.

We must understand the nature of traditional capitalism; the wisdom of long-term investing and the folly of short-term speculation; the productive power of compound interest to build returns; and the confiscatory power of compound costs to slash those very same returns. In all, the relentless rules of humble arithmetic. We all need to stand back, take a moment for introspection, and finally recognize that these obvious precepts must drive institutional investment management in the years ahead. The arc of investing is bending toward fiduciary duty and the public interest, and its progress is inevitable. 9 Roosevelt’s speech was delivered at the dedication of the John Brown Memorial Park in Osawatomie, Kansas, on August 31, 1910.

5/4/2015 13. Actively Managed Fund Index Fund Expense Ratio 1.12% 0.06% Transaction Costs 0.50 0.00 Cash Drag 0.15 0.00 Sales Charges/Fees 0.50 0.00 All-In Expenses 2.27% 0.06% Tax Inefficiency 0.75 0.30 Total Costs 3.02% 0.36% Gross Return (assumed) 7.00% 7.00% Net Return 3.98% 6.64% Loss in Annual Return -2.66% “The Arithmetic of All-In Investment Expenses” Financial Analysts Journal Note: Counterproductive investor behavior (buying high and selling low) has historically reduced returns to active fund investors by another 1.5-2.0% annually according to Morningstar. 14. $248,890 $70,387 100,000 200,000 300,000 0 10 20 30 40 50 Index Fund (6.64%) Actively Managed Fund (3.98%) Years $ Growth of $10,000 over a 50-year investment lifetime The Miracle of Compounding Long-Term Returns Without the Tyranny of Compounding Long-Term Costs Impact of Compounding Costs on Wealth: Loss in Capital Accumulation: 75% 15. 0.8 1.9 2.5 2.1 1.1 1.8 1.3 0.05 1.0 0.07 1.3 0.09 Active Index Active Index Active Index Expense Ratio Net Yield to Investors U.S. Stock Funds Bond Funds Balanced Funds % 2.2% 1.9% 3.5% 2.1% 2.4% 1.9% Dividend Yields and Expense Ratios Source: Morningstar. Note: Index fund yields and expenses for Vanguard Admiral share classes. Percent of Income Consumed: Active Funds vs. Index Funds 62% 3% 29% 3% 54% 5% 16. Better than the Morningstar Rating System? “Investors should make expense ratios a primary test in fund selection.

followed, Swensen would earn a compound annual return of some 13 percent on the Yale University endowment fund, likely the highest among all of its peer institutions. A truly brilliant choice! Michael Price, for many years the guiding light of Mutual Shares, recommended heavy reliance on equities, focusing on those companies selling at a 30 or 40 percent discount from what other companies would pay to acquire them. “The whole goal is to compound at 15 percent . . . even when the market is up 25 percent (annually).” During the challenging 15 years that followed, neither Mutual Shares (which Mike Price hasn’t managed since 2001) nor the market came anywhere near these returns. But Mutual Shares compounded at 8.1 percent, well ahead of the 6.8 percent annual return for the Total Stock Market Index Fund, a splendid achievement. The recommendations of “Adam Smith” (George J.W. Goodman), trustee, author and publisher, are a bit hard to replicate. He recommended hedge funds and especially “Julian” (presumably Julian Robertson), a good choice for a while. But Robertson’s firm ceased operations in 2000, and we can’t know who came next. “Hire talent whenever you find it,” was “Adam Smith’s” message. Fine! But as we know, talent is hard to identify, and—as in “Julian’s” case—frequently evanescent. John M. Templeton, Dartmouth Professor Peter Williamson, and Charles R. Schwab were all true believers in equities. Templeton was unequivocal: “invest 100 percent in common stocks.” (The 6.

Result: most Janus investors actually experienced dismal returns. To summarize the math: for the decade, these Janus funds reported time-weighted returns averaging 9.3 percent per year, a compound ten-year return of +157 percent. The Janus fund investors, on the other hand, earned dollar-weighted returns averaging but 2.7 percent per year on the money they actually invested, a compound return of only 38 percent. That is, the returns actually earned by Janus shareholders for the decade fell fully 119 percentage points behind the returns that the Janus funds reported. That truly remarkable lag doubtless accounts for the gross disparity between the funds’ high scores in reported performance and their low loyalty scores based on what Janus shareholders actually experienced. Such experience also likely characterizes the lack of shareholder loyalty at Morgan Stanley, AIM, and Columbia (Bank of America). Costs Rear Their (Ugly) Head The data are clear, then, that truly mutual investing has not only reaped rewards for its clients but has also earned their loyalty. Equally clearly, the financial conglomerates have not only failed their investors, but have earned (if that’s the right word) their opprobrium. How do we account for these differences in return?performance

The Triumph of Conglomeration In any event, the mutual model remains stuck, still used by only a single firm, and the conglomerate model has triumphed. Early on, and presciently, Chairman Cohen recognized the serious problems that would be created by this conglomeration. In a 1966 speech, he spoke of the “new and more complex relationships . . . (between) institutional managers and their beneficiaries,” and sought “a more adequate scheme of regulation that ultimately will protect beneficiaries from unwarranted action by their managers, and will realize the fullest benefits of their participation” in their funds. He then noted, prophetically, his concern about “public ownership of investment advisers . . . and the beginning of a trend toward (their) acquisition by industrial companies,” which makes it, “increasingly difficult to define the responsibilities of institutional managers,” who may “be obligated to serve the business interests of the very companies in which they invest.” The snowball that began to roll with the onset of public ownership of management companies in 1958 took a while to gather speed. But during the 1980s and 1990s it came into full flower and, as noted earlier, among the 50 largest firms in the industry only nine remain privately-held. This massive wave of 30 By Peter J. Wallison and Robert E. Litan, 2007.

costs of churning the portfolio, plus at least another ½%-plus annually for investors who pay sales commissions. Now, let’s think long-term instead of short-term. Let’s assume that the long-term market return of 11% per year persists, and conservatively set the total amount gathered by the managers, dealers, and brokers at 2½% per year. That leaves an investor return of 8 ½%. The positive impact of compound interest that magnifies long-term returns, unfortunately, also magnifies the negative impact of costs, so that an assumed 2½% annual cost would consume 31% of the investor’s capital in a decade, 47% in a quarter century, and—believe it or not—68% of the investor’s capital in 50 years, an investment lifetime. The investor, who puts up 100% of the initial capital and assumes 100% of the investment risk, receives but 32% of the long-term pre-tax return. The financial foxes, who put up none of the initial capital and assume none of the risk, receive the remaining 68%. To make matters worse, these foxy strategies provide even worse results for the 30 million fund investors who pay taxes. High portfolio turnover creates enormous tax inefficiencies, exacerbated by the fact that many foxy managers realize capital gains even on a short-term basis, taxable at the full income tax rate. During the bull market, believe it or not, the federal government has confiscated nearly as much of the market’s gains as have the foxy managers.

Alas, however, to the limited extent that these strategies have proven to work effectively—and for a relative handful of funds at that (of course, it would be absurd to imagine they could work for all funds as a group)—the very costs incurred by the fund managers were almost always so high as to consume any value added, even by the most cunning of the portfolio manager-foxes. Fund shareholders were left with annual returns that were generally less than 85% of the returns realized in the stock market. The reason for this shortfall is largely fund costs. The all-in costs of the fund foxes now approach 3% per year on average: 1½% from management fees and expenses, often 1% or more from the costs of churning the portfolio, plus another ½%-plus annually for investors who pay sales commissions. Now, let’s think long-term instead of short-term. Let’s be conservative and set the total croupier’s take— the amount gathered by the managers, dealers, and brokers—at 2½ % per year. The positive impact of compound interest that magnifies long-term returns, unfortunately, also magnifies the negative impact of costs, so that an assumed 2½% annual cost consumes 20% of the investor’s capital in a decade. As time goes on, costs consume 45% of capital in a quarter century, and—believe it or not—and almost 70% of your capital in 50 years. The investor, who puts up 100% of the initial capital, receives but 30% of the long-term pre-tax return.

*Impact of change in price-earnings ratio Sources of Long-Term Stock Market Returns— Dividend Yields and Earnings Growth, 1900 - 2006 1. 4.5% 4.5% 5.0% 1.7% 0.1% 0.1% 0% 2% 4% 6% 8% 10% 12% Nominal Real Speculative Return* Earnings Growth Dividends Total: 9.6% Total: 6.3% Investment Return $1,225,321 $33,094,516 $1,000 $10,000 $100,000 $1,000,000 $10,000,000 $100,000,000 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 The Importance of Dividends Value of Initial Investment of $10,000 in S&P 500, 1926 - 2007 With Reinvested Dividends Price Only 2. But while dividend income has accounted for nearly 50 percent of the long-term nominal annual return on stocks and 75 percent of the real annual return, even these figures dramatically understate the cumulative role played by dividends. Consider this: An investment of $10,000 in the S&P 500 Index3 at its 1926 inception, (Chart 2) with all dividends reinvested, would by the end of September 2007, have grown to $33,100,000 (10.4 percent compounded). If dividends had not been reinvested, the value of that investment would have been $1,200,000 (6.1 percent compounded)—an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95 percent of the compound long-term return earned by the companies in the S&P 500. These stunning figures would seem to demand that mutual funds highlight the importance of dividend income.

The Becker Securities survey, for example, shows that the equity securities managed for pension funds by banks had a compound rate of total return over the past decade of 3.7% (net off estimated expenses); by insurance companies, the figure was 3.6%; by private investment counselors, the figure was 3.3%. One the same basis, the average annual return of common stock mutual funds was 5.4%—or something like half again as good! We at Vanguard will be presenting, in the coming months, a much more comprehensive analysis of mutual fund performance vs. the results of other institutional managers. For the summary figures above can only hint at the magnitude and consistency of mutual fund superiority. The common stock mutual funds also, for example, beat each of the other institutional management groups in the 1973-74 bear market, and beat each one again in the 1975-76 bull market. And the balanced mutual funds—how long has it been since anyone mentioned that group—have shown the same degree of superiority (perhaps to an even greater degree) over the total pension fund returns provided by the banks, and the insurance companies, and the private counseling firms. In each case, I should note, the results were achieved with a surprisingly similar balance between stocks and bonds (about a 70/30 ratio).

year researching the fund industry for my senior thesis in Economics, inspired by an article that I happened upon in Fortune magazine in December 1949. The thesis was entitled “The Economic Role of the Investment Company.” When I wrote my thesis, assets of mutual funds totaled about $2 billion; today assets exceed $10 trillion, a 17 percent annual rate of compound growth that was exceeded by few, if any, other enterprises. (Asset of life insurance companies, by way of contrast, grew from $53 billion to $4.7 trillion—from 25 times fund assets in 1951 to less than one-half today.) The mutual fund industry has become America’s largest financial institution. Yet the record is clear that we have lost our way. Once a profession with elements of a business, we have become a business with elements of a profession—and too few elements at that. Once focused on management and investing, we are now focused on marketing and asset gathering. Once focused on stewardship, we are now focused on salesmanship. We have become an exemplar—alas, even a leader— in the new “bottom line” society that I earlier described. Lest you think that indictment is too strong, let me drive this point home with seven hard examples: 1. In 1951, mutual fund management companies were relatively small organizations, privately- held by their principals, managed by investment professionals who were prudently investing to earn a sound return on the capital invested by their fund shareholders.

Using Justice Brandeis’ formulation, these are “the relentless rules of humble arithmetic.” And cost matters. If the market delivers an annual return of 8 percent, when we deduct costs estimated at 2 ½ percent per year, we together earn 5 ½ percent, less than seventy percent of the total. Compounding the 8 percent return over an investment lifetime (I’m assuming 50 years), $1,000 would grow to $47,000—the magic of compounding returns. But with a net return of 5 ½ percent, the investor who puts up $1,000 sees his capital grow to but $14,000—the tyranny of compounding costs. The investor put up 100 percent of the capital and assumed 100 percent of the risk, but captured only thirty percent of the total market return. That’s simply not good enough. The oppressive impact of investment costs is eternal and meaningful, to be sure. But that impact varies with the level of returns the markets produce. So now let’s think for a bit what returns we might reasonably expect in the years ahead, and the drain that excessive intermediation costs might impose upon them. Of course no one knows what lies ahead, but there are ways to establish reasonable expectations. Before I discuss them, I’d like to present some very subjective comments.

$31,200 $38,700 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Vanguard Total Bond Mkt Avg Taxable Bond Fund Actively Managed Bond Funds Versus Vanguard’s Total Bond Market Index Fund Avg. Annual Return 5.9% 7. 7.0% Fund operates at an effective advisory fee rate of 2 basis points, and our High Yield Bond Fund at less than 4 basis points. That is what negotiating fees for the benefit of the fund investor is all about. It’s unfortunate that such negotiation is conspicuous by its total absence—or at least near- total absence—elsewhere in the mutual fund industry. Owning the Bond Market It is because of low investment expenses, low operating expenses, low marketing expenses, low portfolio turnover costs, and the absence of sales charges that Vanguard Total Bond Market Index Fund most clearly reflects the optimal approach to capturing for investors the maximum possible portion of whatever returns the bond market is generous enough to favor us in the years ahead. At the end of 2006, VTBMF, if you will, celebrated its twentieth anniversary. Given the magic of compounding investment returns—and the tyranny of compounding large costs—the Fund’s record during these two decades speaks for itself. Let’s look at the record. (Chart 7) Based on an initial investment of $10,000 on December 31, 1986, the total value on December 31, 2006, would have come to $38,700, a cumulative rate of return of 7.

-100% -80% -60% -40% -20% 0% 20% The Amazing Gap Between Cumulative Time-Wtd. and Dollar-Wtd. Returns 1996 - 2005 Covers the 200 funds with largest cash flows during 1996-2000. 11. 1996 to 2000 2001 to 2005 1996 to 2005 1996 to 2005 Dollar-wtd minus Time-wtd Q1 149% -8.5% 50.8% 0.03% -50.7% Q2 106% -5.8% 39.3% 0.05% -39.3% Q3 92% 2.5% 40.3% 0.18% -40.1% Q4 70% 2.3% 31.6% 0.13% -31.5% Avg. 103% -2.4% 40.4% 0.10% -40.3% Time-Wtd. Returns $-Wtd High Fund Performance Produces Low Shareholder Returns Cumulative Returns 12. The consistency of this pattern is remarkable. Among those 200 funds, the shareholders of 198 funds actually earned less money than the funds reported. In only two cases did the shareholders do better; in the best case, by just 0.5 percent per year (fifty basis points); in the other case, by a minuscule five basis points per year. When we compound these shortfalls, the results are little short of astounding. (Chart 11) For fully 76 of the 200 funds, that cumulative shortfall ranged from minus 50 to minus 95 percentage points (!) Unsurprisingly, given the marketing ethos of today’s mutual fund business, the funds that reported the highest returns during the bull market experienced the largest gap between fund returns and shareholder returns, and vice versa.

Result: over the past twenty years, the typical mutual fund investor has captured only one- quarter—yes, 27 percent—of the compound real (inflation-adjusted) return on stocks that was there for the taking by simply holding the U.S. stock market portfolio through an index fund. (I’m speaking, of course, of the Vanguard 500 Index Fund.) Facing Up to the Reality It must seem obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism. But despite the contentious nature of the issues I’ve just described— broadly reflecting the triumph of the powerful economic interests of the oligarchs of American business and finance over the interests of our nation’s last line investors—it is remarkable that so little public discourse has been in evidence. In the investment community, I have seen no defense of the inadequate returns delivered by mutual funds to investors, nor of our industry’s truly bizarre, counterproductive ownership structure; no attempt by institutions to explain why the rights of ownership that one would think are implicit in holding shares of stock remain largely unexercised; and no serious criticism of the virtually unrecognized turn away from the once-conventional and pervasive investment strategies that relied on the wisdom of long-term investing, toward strategies that increasingly rely on the folly of short- term speculation.

Underlying Investments Bonds Issued 100% B/C/D? 75% AAA 15% A 5% BBB 5% B The New Alchemy 12. bonds was in “tranches” (series) rated AAA, another 15 percent rated at least A, and 5 percent rated BBB. (Chart 12) Only the remaining 5 percent carried a rating of BB. One might call this the new alchemy— turning lead to gold. But that was an illusion. (I’ve seen a lot of financial legerdemain in my day, but none to equal that.) Early this year, when the first wave of mortgage defaults began to snowball, the financial crisis in mortgages was upon us, at a great and growing cost to our citizens and our society, a classic example of the impact of the financial economy on the real economy. Given the nature of our financial system, few of our giant investment banking firms had the courage to summon the discipline to jump off (or even not to jump on) the mortgage-backed bond bandwagon. The issuance of such bonds in the past five years totaled $2 trillion (including both prime and sub-prime mortgages), likely generating some $80 billion of revenues to “the Street,” its investment bankers, its brokers, its rating agencies, its attorneys, and its securities processors. The only thing the banks could not resist was, of course, temptation, and even the biggest and most savvy firms reveled in the party, its rocking music, and its joyous dancing.

disclose not only the amount of their annual redemptions (as they must today), but their redemption rate as well. Investors would be alerted by high rates—suggesting some combination of shareholder dissatisfaction and excessive market timing—and perhaps encouraged by low rates—suggesting a high level of shareholder satisfaction and a long-term focus among existing fund owners. When I listed Wellington Fund’s modest redemption rates in The Wellington Story all those years ago, that’s precisely what I was trying to accomplish. What’s to be Done? Without full disclosure, it’s hard to imagine that brokers and advisers can measure up to the high standards of commercial honor, equitable principles of trade, and fair dealing with their clients that are demanded by regulatory principles. I’ve already described, in great detail, three of the disclosures that should be mandatory: (1) the amount of investment income consumed by their fees and expenses; (2) the returns actually earned by their shareholders; and (3) the annual rates at which their shareholders are redeeming their shares. But that’s only the beginning: I believe funds should also be required to disclose: (4) Historical returns, not only in nominal terms, but also in real terms, adjusted for rates of inflation. After all, investors saving for retirement ought to be on notice that the kinds of compound returns funds show are not always what they seem.

It may sound simple. But it is true. The mutual fund field is one in which investors, as a group, as a matter of mathematical certainty, not only do not get what they pay for, but get precisely what they do not pay for. Let me put the conclusion in its sharpest formulation: if investors pay nothing, they get everything—that is, 100 percent of the gains that our stock market is generous enough to bestow on us, and for that matter, 100 percent of the losses that our market can be mean enough to inflict on us. Costs Matter! In the short run, investment costs may seem inconsequential. But in the long run, costs can overwhelm stock market returns. As I’ve so often said, “the magic of long-term compounding returns virtually assures investment success for owners of stocks as a group . . . provided that it is not overwhelmed by the tyranny of compounding costs.” Here, let’s look at the facts. Let’s assume a nominal compound annual return on stocks of 7 percent over an investment lifetime—let’s say 60-years—and compare it with an investment system that incurs costs of 2 percent, delivering a net return of 5 percent. The 2 percent cost is a reasonable—maybe even conservative—estimate of equity fund all-in costs, including an expense ratio of 1 to 1 ¼ percent; plus turnover costs of ½ to 1 percent; plus (often) sales loads, when annualized, of ½ percent to 1 ½ percent.

6. Marketing Strategy ∑ Mutual— Demand pull. Minimal effort; low expense commitment. ∑ Manager— Supply push. Spend aggressively to gather assets. 7. Time Horizon Strategy ∑ Mutual—Long-term, value oriented; increase intrinsic values for fund shareholders; free from Wall Street pressures. ∑ Manager—Short-term and focused on price of the manager’s stock; subject to the whims of Wall Street. How Has It All Worked Out? The mutual structure—an experiment in mutual fund governance that has now had those strategies in place for more than 38 years—has yet to be emulated or copied. Vanguard’s structure remains unique in the annals of mutual fund history. How has it all worked out? The numbers tell the story. While I have no intention to “plug” the Vanguard line-up of mutual funds before this audience, I do believe you have a right to know whether our journey, so far, has been a productive one. So, let’s look at three facts: (1) Since our humble beginning with $1.4 billion of assets, today’s assets under management is now approaching $2 trillion—a compound annual growth rate of 21 percent. (Chart 5) As you can see, that growth has been almost a straight line, virtually uninterrupted.

Given the three ingredients of (a) optimistic assumptions as to the rate of earnings growth, (b) a sufficiently long projection of this growth into the future, and (c) the miraculous workings of compound interest—lo! the security analyst is supplied with a new kind of philosopher’s stone which can produce or justify any desired valuation for a really “good stock.” Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom . . . Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment . . . Have not investors and security analysts eaten of the tree of knowledge of good and evil prospects? By so doing have they not permanently expelled themselves from that Eden where promising common stocks at reasonable prices could be plucked off the bushes? This obvious reference to Original Sin reflected Graham’s deep concern about quantifying the unquantifiable (and doing so with false precision). The implications of that bite into the apple of quantitative investing were barely visible when Graham spoke in 1958.this

began to tumble (admittedly, from a highly inflated level of 1,520 on the S & P 500 Index), plummeting to 770 in October 2002, the bottom of a bear market in which fully 50 percent of the values of U.S. stocks had been erased. Five years later, in October 2007, the S&P 500 had recouped all of the lost ground (plus a tiny bit), a 110 percent gain to 1580. (A reminder: down 50 percent and up 100 percent nets out to a return, not of plus 50 percent but of zero. Do the math!) Then, stocks tumbled to below 1300, a 16 percent retreat, still short of the 20 percent dip that Wall Street defines as a “correction,” today recovered to 1354, whatever exactly that means to a long-term investor. What’s more, while during the 1950s and 1960s the daily changes in the level of stock prices typically exceeded two percent only three or four times per year, since last July alone, we’ve witnessed 19 such moves, 10 downward and 7 upward. (Almost another one today – 1.7 percent.)This kind of volatility, to state the obvious, reflects the expectations of speculations, not the real returns of business sought by investors. Of course it’s tempting for investors to think they can take advantage of these extreme fluctuations. But the evidence goes the other way: Staying the course through thick and thin has been the winning strategy. For example, since 1950, the Standard & Poor’s 500 Stock Index has risen from a level of 17 to a recent level of 1,350, a compound (price-only) annual return of 8 percent.

Compounding these returns over 106 years produced accumulations that are truly staggering. (Chart 1) Each dollar initially invested in 1900 at an investment return of 9.5 percent grew by the close of 2005 to $14,808. But let’s be fair. If we compound that initial $1, not at the nominal return of 9.5 percent but at the real (after -inflation) rate of 6.5 percent, the accumulation grows to $793. But increasing real wealth nearly eight times over is not to be sneezed at. Sure, few (if any) of us have 106 years in us, but, like the Gotrocks family over the generations, the miracle of compounding returns is little short of amazing—it is perhaps the ultimate winner’s game. Of course there are bumps along the way in the investment returns earned by our business corporations. Sometimes, as in the Great Depression of the early 1930s, these bumps are large. But we get over them. So, if you stand back from the chart and squint your eyes, the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.

So it is that through the deduction of a “mere” 2.5 percent in annual costs, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs. For in the investment field, time doesn’t heal all wounds. It makes them worse. Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy. The investor in this example, who put up 100 percent of the capital and assumed 100 percent of the risk, earned less than 30 percent of the market return. Our system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 70 percent of that return—surely the lion’s share. An investment in a low-cost index fund, held for the long term, eliminates all of the terribly harmful costs of financial intermediation, and thus guarantees that you’ll earn your fair share of whatever returns our stock market offers. If it sounds like I’m pushing Vanguard’s index funds on you, well, there’s something to that. But only because soundly-operated index funds are the ideal way to invest for the long- term, by reason of their rock-bottom costs and long record of tracking their respective indexes with a remarkable precision. But don’t take my word for it. The index fund has received incredibly strong endorsements from the most respected financial experts in the nation.

Not only are they more likely to be short-term speculators than long-term investors, but because they are managing the pension and thrift plans of the corporations whose stocks they hold, they are faced with a serious conflict of interest where controversial proxy issues are concerned. As one manager has said: “There are only two types of clients we don’t want to offend: actual and potential.” And in mutual fund America, an industry lost its way. Once a profession with elements of a business, mutual funds became a business with elements of a profession—and too few elements at that. Once dominated by small, privately-held organizations run by investment professionals, the mutual fund industry is now dominated by giant, publicly-held financial conglomerates run by businessmen hell-bent on earning a return on the firm’s capital, not the return on the capital invested by the fund shareholders. Result: over the past twenty years, the typical fund investor has captured only about 20 percent of the compound return on stocks there for the taking by holding a simple S&P 500 index fund. (I’m speaking, of course, about the Vanguard 500 Index Fund.)

tax return to 8.2 percent and reducing the compound cumulative profit to $6,170. (Chart 4b) If that sounds like a pretty good profit, just compare it with the after-tax profit with our 500 Index Fund, which has virtually no turnover. Its owners were subjected to income taxes of only 0.6 percent per year (largely on the divided income generated by the fund), with a net after-tax return of 11.7 percent. Result: a net profit of $14,820, or nearly two-and-one-half times the profit on the average managed fund. And now a cold shower of financial reality. Let’s make one final adjustment to our returns. So far, we’ve done all our measurements in nominal dollars, ignoring the fact that it is only real dollars—dollars that are adjusted to take inflation into account—that are available for us to spend. During the past 25 years, inflation averaged 3.3 percent, reducing the real after-tax return of the index fund to 8.4 percent, and the average fund to but 4.9 percent. (Chart 4c) Cumulative real profit after compounding on the original $1,000 investment: just $2,270 for the average actively-managed equity fund; $6,450 for the passively-managed index fund. The average fund produced only about one-third of the profit earned by the market itself through the simple index fund, which was there for the taking. Dare I remind you yet again, fund expenses and taxes matter! Indeed, they make the difference between investment success and investment failure.

Just as the magic of compounding returns over, say, a quarter-century, carries investment values to almost unimaginable heights, so the tyranny of compounding costs results in an almost equally unimaginable deterioration in these returns. If the market return—before costs—averages 7 percent over 50 years but only 5 percent after costs, the final value an initial investment of $10,000 tumbles from $295,000 to $115,000, fully 60 percent less. So, yes, these are tough times for investors who assume that the past is prologue and who ignore the impact of costs, in a shaky financial system in which a short-term speculation has crowded out long- term investment. It is up to professional analysts—exemplified by the CFAs in this audience—to help investors cut through the fog of today’s investment climate, to allocate their assets with care, and to avoid joining the crowd of traders and speculators. Whatever we do, invest we must, however, for not investing is an iron-clad formula for failure.