John Bogle on Diversification

“A Question So Important that It Should Be Hard to Think about Anything Else” Remarks by John C. Bogle, Founder, The Vanguard Group Before the CFA Society of Philadelphia On CFA Day, the 60th Anniversary of the CFA Institute June 12, 2007 I’m honored (and humbled) to be on the same program as two of Philadelphia’s finest money managers, John Neff and Ted Aronson. Not only are they both professional investors, a somewhat exceptional title in this age of the professional speculator, but they are also men of extraordinary career accomplishment and high personal integrity. With their long experience, they are far more able than I to comment on the financial markets. I will focus on the evolution of the investment profession and on what lies ahead.1 “It is my basic thesis—for the future as for the past—that an intelligent and well-trained financial analyst can do a useful job as portfolio adviser for many different kinds of people, and thus amply justify his existence. Also I claim he can do this by adhering to relatively simple principles of sound investment; e.g., a proper balance between bonds and stocks; proper diversification; selection of a representative list; discouragement of speculative operations not suited for the client’s financial position or temperament—and for this he does not need to be a wizard in picking winners from the stock list or in foretelling market movements.

diversification, and focus on the long term—to say nothing of being skeptical of stock-picking and market-forecasting wizards—would be an understatement. (Indeed, it’s pretty much what I wrote in my Princeton senior thesis in 1951.) What’s more, an entire chapter of my latest book2 is devoted to showing that, given the radical change in our investment environment during the past three decades, Ben Graham would have gone even further, and endorsed the stock market index fund as the core strategy for the vast majority of investors. (Warren Buffett, who worked closely with Ben Graham, not only personally assured me of Graham’s endorsement, but put it in writing in his endorsement of my new Little Book.) The fact is that, even when I entered the mutual fund industry 56 long years ago—hired by fund pioneer Walter Morgan, whose Wellington Fund was, and remains today, the paradigm of these sound principles—this industry invested pretty much in the way Graham prescribed. The portfolios of the major equity funds consisted largely of a diversified list of blue-chip stocks; and managers invested for the long-term, eschewed speculative operations, managed their funds at costs that were (by today’s standards) tiny, and delivered market-like returns to their investors. (As the record clearly shows, those fund managers were hardly “wizards in picking winners.”) What a difference a half-century makes! How different?

markets come and bull markets go, inevitably followed by bear markets, which too come and go. But these pillars of wisdom are timeless, and should serve us well in all seasons. I’d like to review them with you today. Pillar 1. Investing Is Not Nearly as Difficult as It Looks. The intelligent investor in mutual funds, using common sense and without extraordinary financial acumen, can perform with the pros. In a world where financial markets are highly efficient, there is absolutely no reason that careful and disciplined novices—those who know the rudiments but lack the experience—cannot hold their own or even surpass the long-term returns earned by professional investors as a group. Successful investing involves doing just a few things right and avoiding serious mistakes. “Doing a few things right,” as I stressed in my book, included focusing on broad-based mainstream equity funds with wide diversification; evaluating funds relative to peers with similar objectives; ignoring short-term performance in favor of performance over at least a decade; carefully considering the drag of high expense ratios and sales charges; paying careful attention to portfolio quality, in stock funds, bond funds, and money market funds alike; and focusing on an asset allocation that is consistent with your own risk tolerance.

—in the fund arena is “performance chasing,” looking backward instead of forward in deciding where to invest. Investors who didn’t care for non-U.S. stocks when they seemed cheap seemed to develop a perhaps fatal attraction for them when they got, if not expensive as such, surely far more expensive. In my view, trying to pick winning market sectors,—whether sectors in the U.S. market such as real estate, gold, energy, technology, or sectors in the international market such as emerging markets, China, or Latin America—is a loser’s game. I remain a believer in the broadest possible diversification and intelligent asset allocation between stocks and bonds (depending largely upon one’s age, wealth, income needs, and risk tolerance) and then doing nothing. It’s not the typical case of “Don’t just stand there. Do something!,” but rather, “Don’t do something. Just stand there!”

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 the early years, pension funds accounted for by far the largest portion of indexed portfolios. But during the 1990s and through 2001, index mutual funds have been the driving force. While the rising market has carried pension fund index assets up eight times, since 1990, from $172 billion to $830 billion, the percentage of pension equity assets invested under index strategies has risen only slightly from 20% in 1990 to 23% today. During the same period, assets of index mutual funds have risen eighty fold, from $5 billion to $400 billion, from 2% of equity mutual fund assets to 12%. Truly, we are witnessing the triumph of indexing. Disquieting Cross-Currents But beneath the surface of this triumph lie disquieting cross-currents. In its original incarnation, indexing was a way to bring the wisdom of investment to those who could grasp the merit of complete diversification, buying essentially all of the stocks in the U.S. market, operating without advisory fees and at rock-bottom operating costs, minimizing turnover costs and extra taxes, and hanging on to each stock for Warren Buffett’s favorite holding period—forever. All that was required was that investors accept the self-evident fact that capturing nearly 100% of the 1% 8% 10% 5% 0.1% 0% 2% 4% 6% 8% 10% 12% 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Domestic Equity Indexed Assets as a Percentage of U.S.Assets

 For bonds, there is no viable substitute for the bond fund. A choice of taxable or tax-exempt funds; a quality level to suit every taste (U.S. Treasury, investment-grade, high-yield); a maturity level to fit every risk profile; and the ability to acquire extraordinary diversification without being nickled and dimed (and dollared) to death in buying and selling small lots of individual bonds.  And for stocks, it’s hard to imagine a better concept than a broadly diversified equity fund, holding one hundred or more stocks in every imaginable industry; minimizing individual stock risk; and either retaining experienced professional managers to select and supervise the portfolio or, maybe even better, just owning the entire stock market in a single fund; and operating with remarkable efficiency. Truth told, the only other choices are to pick stocks yourself, or, if you’re in the six-figure or seven-figure or eight-figure wealth category, to hire such managers to pick stocks for you. So there are solid conceptual reasons why American families continue to pour half of their hard-earned dollars into mutual funds. And yet a moment’s reflection on the industry trends that I’ve shown you presents a perverse riddle that, for whatever reason, has made mutual fund investing far less productive than it ought to have been. The obvious “market sensitivity” exhibited by fund investors has not helped them. It has hurt them.

interest rates (i.e., not at all). In the 1970s and 1980s, a weak dollar increased strong foreign returns by 20%. So far, in the 1990s, a strong dollar has reduced weak foreign returns by a further 30%. In the long run, my best guess is that the dollar will be a neutral factor. The returns will depend on how foreign corporations perform, and whatever else may be said, I’m dubious that those in France, England, Germany and Japan will outpace those in the U.S. (I may be exhibiting a bit of Jingoism here.) The emerging markets? Perhaps, but risks there clearly abound and are notoriously unpredictable. Skeptical as I am, however, I will concede there is a place for international investing from a diversification standpoint. Indeed, I have no hesitancy recommending an international position-- say, from 5% of equities to no more than 20%, given the extra economic and financial risks and the ever-elusive ability to forecast the strength of the dollar. In all, we have been favored with the fruition of the ancient Chinese curse: “May you live in interesting times.” But especially interesting they are, with stocks soaring to unprecedented heights as new forces of technology and globalization permeate our world. We can’t walk away from this moment, so let’s deal with it. To this end, let me close with five simple principles of investing which may help you: First, invest you must.

It is hardly farfetched, then, to expect future bond returns that are likely to parallel those of stocks. If so, the traditional 3% equity risk premium—the amount by which stock returns have exceeded bond returns over the past century—may be far smaller, perhaps even non-existent. There are, of course, those who say that there is some God-given mandate that an equity premium must exist. Yet history tells us that bond returns have exceeded stock returns in one out of every five decades. The reality is that restoring an equity premium to stocks will require either (a) lower interest rates, or (b) some combination of higher earnings growth, higher dividend yields, and lower P/E ratios, which is likely only if there is another downward leg in the stock market. In any event, my view is that we are entering an era of lower returns on financial assets. After a golden era of truly extraordinary returns, investors have to realize that reality is now the rule of the day. But the faith of investors in our financial markets will be restored far more quickly if we do three things: First, encourage our clients to develop realistic expectations about future market returns. Second, help them to invest carefully, to increase their savings, and to observe the time- honored principles of diversification and asset allocation.

fund. While this period was an especially fine one for the large cap stocks in the S&P, even a total stock market index fund—the Wilshire 5000 Equity Index, adjusted to account for estimated costs—would have returned 17.7%, only 0.5 percentage points shy of the 500 and still an advantage of two full percentage points in annual return. (And that’s even before fund sales charges are taken into account!) The fact is that, at least in my judgment, the index fund should be the investment of choice. It is the odds-on (pardon another expression from the world of gambling) favorite to win the race (another!) against three of every four managers. We know that, for the market as a totality, low-cost investing—which is really all that an index fund is about—ineluctably beats high-cost investing over the long run. And while I happen to prefer the all-market index because of its complete diversification and nominal portfolio turnover, I can’t imagine that the long-term return of the S&P 500 Index, comprising as it does 70% of the market, will vary significantly from the return of the total market. In any event, the marketplace, now dominated by S&P 500 indexing, is increasingly moving in the direction of all-market indexing. I fully expect that over the next few years this broader strategy will become the principal choice for institutional indexers and fund indexers alike.

The computer and the Internet have also given us nonstop access to data that allow us to analyze and evaluate mutual funds beyond our wildest dreams, and to make fund selections with unimaginably vast information literally at our fingertips. Never again will mutual fund investors lack the ability to make fully informed investment decisions. From that standpoint, mutual fund investors are among the greatest beneficiaries of the computer revolution. But they are also among its greatest victims. With each passing day, mutual fund investors are proving—as we must have known all along—that in investing, information is all too often mistaken for knowledge; and knowledge is all too seldom translated into wisdom. But, wisdom—far more than mountains of detailed data—and common sense—far more than opportunism—are ever destined to be the prime ingredients of long-term investment success. Communications technology has given us immediate access to abundant information when we are considering our fund decisions—to buy, to hold, to add or subtract, to withdraw entirely. How much information? Consider Morningstar’s Principia database, in which it provides for each of the 3000 stock funds in its database:  For the stock portfolio: price-earnings ratios, growth rates, market capitalization, industry diversification, rate of turnover.  Risk Characteristics: R-squares, Betas, Alphas, standard deviations, Sharpe Ratios.

sectors of the market offers less diversification and commensurately more risk. Third, if the original paradigm was minimal cost, it’s clear that holding market sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully. And as to the fourth and final, quintessential aspect of the original paradigm—assuring, indeed guaranteeing, that you will earn your fair share of the stock market’s return—the fact is that an investor who trades ETFs—and especially sector ETFs—has nothing even resembling such a guarantee. The typical ETF investor has absolutely no idea of what relationship his or her investment return will bear to the return earned by the stock market itself. But, after all of the selection challenges, the timing risks, the extra costs, and the added taxes, I’d bet on a substantial shortfall. (Think Gotrocks here.) But the fact is that, despite the demonstrated success of the classic indexing strategy over three decades now, the growth in market share of traditional index funds stopped dead in 1999, at 10 percent of equity fund assets. All of the increase since then—the remaining 6 percentage points of that 16 percent total has come in ETFs. This stampede into exchange traded funds (ETFs) has been dominated overwhelmingly by highly specialized funds that, in the words of an ETF advertisement, “can be traded in real time, all day long.

In the fund arena then, just as costs matter, so taxes matter. A Good Solution: The Index Fund At this point, you are probably thinking either (a) that you should just forget about mutual funds for taxable accounts, or (b) that there must be a better way for them to achieve the valuable diversification that mutual funds clearly provide. Well, there is a better way, through which you can avoid suffering the negative consequences of both high costs and excessive taxes, and come as close as the law of the financial markets allows to achieving a positive Alpha. For there are a relative handful of funds that operate at a minimal cost and with a minimal tax burden. Most are market index funds, usually owning all of the stocks in a given arena (i.e., the Standard & Poor's 500 Stock Index, composed of large cap stocks that represent 70% of the value of the total market) or in a few cases the entire stock market (the Wilshire 5000 Equity Index). And they are working well, especially the latter, since significant changes to its composition simply do not take place. Let's begin with a baseline: the after-tax return of the Standard & Poor's 500 Stock Index. We'll deduct income tax from the dividends, and assume no capital gain realization, deferring all capital gains taxes. With a pre-tax return of 16.7% over the past 15 years and an estimated tax impact of -1.6% (largely because of income taxes), it produces an after-tax return of 15.1 %.

Samuelson himself. Writing in his Newsweek column in August 1976, he expressed delight that there had finally been a response to his earlier challenge. Now such an index fund lay in prospect. “Sooner than I dared expect,” he wrote, “my explicit prayer has been answered. There is coming to market, I see from a crisp new prospectus, something called the First Index Investment Trust” (the original name of what is now Vanguard 500 Index Fund). He noted that the fund met five of his goals: (1) availability for investors of modest means; (2) proposing to match the broad-based S&P 500 Index; (3) carrying an extremely small annual expense charge, (4) offering extremely low portfolio turnover; and (5) “best of all, giving the broadest diversification needed to maximize mean return with minimum portfolio variance and volatility.” While our IPO almost failed (the goal was $150 million; the capital finally raised came to but $11 million), we began operating our tiny index fund in August 1976. Mutual Admiration Paul Samuelson and I met face-to-face only perhaps a half-dozen times during our (arguably) 61-year relationship. But he often sent me notes, and must have made at least a score of telephone calls to me in my office. But as time went on, I appreciated not only his brilliance,

The counterproductive leap in fund portfolio turnover—which rose six-fold (from 14% annually to an incredible 117%) from 1960 to 2001—must be reversed, as we return at long last to our original focus on middle-of-the-road funds, and on long-term investing that emphasizes, not the price of the stock, but the value of the corporation. And all of this foolishness about earnings “guidance,” these forecasts of unsustainable growth rates for American corporations, and the managed earnings that haunt our capitalistic system must be replaced with realistic expectations and principled accounting standards. And fees will have to come down.diversification)

earlier chart on style diversification showed, that was exactly the period when investors should have been moving out of growth and technology funds and into value funds. What folly! When it jumps on the bandwagon of past performance, the crowd is always wrong. Pillar 9. You May Have a Stable Principal Value or a Stable Income Stream, But You May Not Have Both. Contrast a money market fund—with its volatile income stream and fixed value— and a long-term government bond fund—with its relatively fixed income stream and extraordinarily volatile market value. Intelligent investing involves choices, compromises, and trade-offs, and your own financial position should determine the most suitable combination for your portfolio.2 As 1991 began, the yield of the average money market mutual fund was just under 6%, and the yield on a long-term U.S. Treasury bond fund was just over 7½%. During the ensuing decade, the value of a $1,000 investment in the money market fund never varied, while $100 invested the bond fund fell to as low as $93 (in 1992) and rose to as high as $123 in 1998. Stable principal vs. variable principal. But the annual income on the $100 money market fund investment was not to approach $6 again until 2000. Indeed, with declining interest rates, annual income is now on the way to the $4 level. The annual income stream on the $100 initial investment in the long-term bond fund, on 2 In my book, I compared a 90-day U.S. Treasury bill with a 30-year Treasury bond. $1.

3) The strongest (meaning lowest cost, highest quality) bond and money market line-up 4) The greatest reluctance to pander to the public taste in their new fund offerings 5) The lowest portfolio turnover 6) The greatest tax-efficiency 7) The longest holding periods by their own shareholders. And most firms that have one of those high SQ characteristics, have all of them. (Just check the record.) But there aren’t nearly enough high SQ firms, and even those that do possess high SQs have room for improvement. That improvement will come, day by day, week by week, year by year, as investors turn to high SQ firms. And as they do, other firms will be compelled to raise their own SQs, placing the mutual fund industry’s dominance on a far firmer foundation. Back to Basic Principles To make this transition requires only that investors speak and managers listen. In order to solidify mutual fund dominance, we need to develop the will to go back to basics like these:  We must honor fundamental investment principles such as asset allocation and diversification.  We must recognize that intelligent long-term investing means a focus on the value of the corporation rather than the price of its stock.  We must remind ourselves that the returns that investors as a group receive are, by definition, the returns earned by the financial markets, minus the costs of the intermediaries.

folly of short-term speculation—are obliged to own (surprise!) stock and bond market index funds. As evidenced from the substantial shortfall in returns experienced by mutual fund investors in the example that I cited earlier, the investment merits of indexing—the broadest possible diversification, at the lowest reasonable cost, without sales loads or marketing fees, and with maximum tax efficiency—have proven themselves over and over again. Yes, I concede that owning such funds is as interesting as watching the grass grow, or perhaps as interesting as watching paint dry. But since less than 10 percent of investors or investment managers are apt to beat the market over the long-term, buying and holding a low-cost index fund and capturing nearly 100 percent of whatever annual returns the financial markets are generous enough to deliver to us seems a far better option than plunging headlong into a game rigged with such overpowering odds against success. Of course, since I started the first index mutual fund a little over three decades ago— Vanguard Index 500 is now the largest fund in the world—you would be wise to discount my passionate advocacy of indexing. So ignore me! But listen to Warren Buffett. Listen to Yale’s David Swensen. They both say exactly the same thing. Listen to Jack Meyer, the former—but equally sensational—manager of Harvard’s endowment fund. Listen to any Nobel Laureate in Economics, beginning with Paul Samuelson.

Just one more example. In 1980, with the quantum surge in oil prices and high expectations for the petroleum industry, the energy sector’s weight rose to an all-time high of 32%. It would have seemed, I suppose, foolish to own such a single-industry-dependent index fund back then, and in fact during 1976-1985, the index didn’t, well, fly very impressively. Nonetheless, the long-term record of the S&P 500 over the past half-century, as we have seen, brooks no apologies. Like the bumble bee, the index can fly. And on long trips, it can soar. Today, of course, the index has an equally heavy weighting in the “New Economy,” including an important dependence on technology stocks (32% as year 2000 began, now 27%). I admit that concentration unnerves me a bit. But I’m such a believer in the magic of indexing that I remain unshaken in my conviction that, no matter what the short-term holds, indexing continues to represent the best way to invest for the long-term. Finally, broad diversification, low cost, minimal portfolio turnover, and tax-efficiency conquer all. Is the S&P Really “The Market”? For all of its well-known idiosyncrasies, the S&P 500 has proven it can be an excellent representation of the stock market itself. Composed solely of large-cap stocks, it represents about three-quarters of the market’s total capitalization; its returns have maintained a fairly stationary correlation (R2) of 0.

97 with the total market; and its performance has been virtually identical to that of the Wilshire 5000 Total Equity Market Index over the nearly three full decades in which both indexes have been available. That is not to say the S&P is an easy target for an investor—or even an average index fund manager—to track. Change it does! Indeed in the past 20 years there have been an astonishing 489 changes in the 500 Stock Index. These are not trivial changes; on average during that period, each year has resulted in the addition of stocks accounting for 2.8% of the index’s capitalization—an aggregate two-decade replacement equal to 58% of its value. Typically, these changes are represented by mergers; the few stocks deleted from the index for other reasons typically have very small market caps. In essence, we have a process in which old stocks are deleted from the Index at a rate of about three percent per year, meaning that the weightings of each of the other holdings is reduced by about three percent per year.the

realistic about what fund managers might accomplish. Even excluding the oppressive impact of sales loads, Graham’s view was that fund returns “were not very impressive . . . on the whole, the managerial ability of invested funds has been just about able to absorb the expense burden and the drag of uninvested cash.” Graham’s timeless lesson for the intelligent investor, as valid today as when he described it in his book, is clear: “the real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and increases in value,” again exemplified in the distinction between the business market and the expectations market that I mentioned earlier. Owning and holding a diversified list of securities? Wouldn’t Graham recommend a fund that essentially buys the entire stock market and holds it forever, patiently receiving interest and dividends and increases in value? Doesn’t his admonition to “strictly adhere to standard, conservative, and even unimaginative forms of investment,” eerily echo the concept of market indexing? When he advises the defensive investor “to emphasize diversification more than individual selection,” hasn’t Benjamin Graham come within inches of describing the modern-day stock index fund?

The powerful forces of efficient financial markets would likely repel any such challenge, and such a defeat for our hypothetical fund could be accomplished, over the long tenn, only against all odds. The surprising, if simple, fact is that broad diversification makes it just as difficult to achieve significant underperformance relative to the market as to achieve significant overperformance. In short, the risk-return equation appears highly favorable, thanks simply to the minimization of the fiscal drag of operating and tax costs. (That's the three dimensional view once again, as seen from this pair of eyes.) Perhaps a look at history might help to evaluate the risk that growth stocks, purchased at notably high valuations, might under perform the market over the long-run. Jeremy 1. Siegel, professor of finance at The Wharton School, has helped answer the question. He studied the performance of the famous Nifty 50 growth stocks of the halcyon Go-Go era of 1965-1972. In an article in The Journal of Portfolio Management [Summer 1995], Siegel shows that a frozen portfolio of these fifty high-priced stocks purchased at the start of 1971 in fact nicely outperformed the stock market over the next twenty-five years. Some of the fifty did well-Philip Morris was the champion, up 21%. With McDonald's (+18%), Coca-Cola, and Disney (each +16%) in close pursuit. Some did ill-MGlC Investment finished fiftieth, losing 4.3% per year, with Emery Air Freight (-0.

participation, not only in the giant cap stocks of the S&P 500, but also in the small-cap and mid-cap segments of the market. (While I see no compelling reason to include international equities in your program, I would note that they can be successfully indexed too.) The index fund is the ultimate response to the power of RTM in the selection of mutual funds. It avoids “the loser’s game” of selecting individual funds based on past performance that overpoweringly reverts to a mean that persistently falls short of the market return. Rare indeed is the serious study that suggests that it is possible to select significant winners in advance. Indeed, I accept the general notion of RTM among market segments such as growth stocks versus value stocks and U.S. stocks versus international stocks. But even if you believe that the clear lessons of history are pointing us in the wrong direction—always a risky bet—there would remain the equally risky bet of determining just which of the countervailing segments will in fact prove to be superior. If, for example, large cap and small cap stocks do not each revert to the market mean over the next 10 to 20 years, which of the two is the more likely to provide the superior return? Indeed, it is the extraordinarily broad diversification—the total, absolutely complete, diversity—of the total stock market index fund that commends it to investors. But only if that diversity comes with minimal cost.

counsel for the fund’s underwriters reported that he had purchased 1000 shares at the original offering price of $15.00 per share—a $15,000 investment. The value of his holding that evening (including dividend reinvestment), he proudly announced, was $461,771. Now there’s a number that requires no comment. (Well, maybe one comment. Of the 360 equity mutual funds then in existence, only 211 remain today.) I hope that my bluntness today about the merits of classic all-market index funds has not pushed you beyond your tolerance. But if you aren’t persuaded by what such index funds have accomplished during their 30-year history, at least reflect on the underlying reasons for their success; no more than common sense, simplicity, and the relentless rules of humble arithmetic, broad diversification, low expense ratios, no sales loads (and no aggressive marketing), and minimal portfolio turnover, held by investors for the long-term and guaranteed to give them their full share of whatever returns the financial markets are generous enough to provide.

The record is clear that, for the overwhelming majority of funds, their best years came when they were small. "Small was beautiful" ... but "nothing fails like success." When funds catch the public fancy-and are vigorously hawked to a public unsuspecting of their potential exposure to the problems of size-their best years are behind them. Unbridled growth should be a warning to any intelligent investor. How many funds should you own? If a single ready-made 65%/stock-35%/bond index fund can meet the needs of many investors and if a pair of stock and bond index funds with a custom-made balance can meet the needs of many more, what is the optimal number of funds for investors who elect to use actively-managed funds? Probably no more than four or five equity funds. Owning too many funds can easily result in a dangerous combination of over-diversification and excessive cost.

These rules are for selecting stock funds. Rules for Bond Funds. They are similar but easier. First, it's up to you to decide on how to balance your income needs against your risk tolerance. Short term bond funds provide stable returns but varying income; in long-term bond funds, variable returns but higher income; intermediate term bonds are in-between. But whatever profile fits your needs, place special emphasis on two things: Low Cost and High Quality. Cost is the single-most important determinant of a bond fund's future standing relative to its peers. What is more, in their struggle to earn competitive returns, high cost funds tend to hold lower quality bonds. For high consistency in returns and low risk, stick to low-cost funds investing in Treasury bonds or high-grade corporate bonds. Take your risks in the stock market, not the bond market. And when you look for this delectable combination of low costs, high quality, and superior performance, there's a good place to begin. Bond Index Funds. They can operate at a minuscule cost of as little as 0.20% annually (compared to all-in costs of 1.25% for the average managed fund), all the while bringing you the benefits of maximum diversification and low risk. Once you decide on your long-term objectives, define your tolerance for risk, and carefully select an index fund or small number of actively managed funds that meet these first seven Rules. Then follow the final rule. Rule 8: Hold Tight. Stay the course.

In an uncertain world, that’s enough concentration for any investor, especially for you who earn your living there. Finally, if you are concentrated in technology stocks today, don’t stay the course. The broadest possible diversification is the best possible diversification, and you’d best get on with an all-market index strategy right away.Cap

investors choose whichever meets their needs) reflect not only Thrift, but Simplicity. We built into our structure the priceless value of Thoreau-like simplicity: the broadest possible diversification, the lowest possible portfolio turnover, and (of course) a minimum of financial complexity. We recognized even then, well before its time, the reality that in the mutual fund industry, investors as a group do not get what they pay for; they get precisely what they don’t pay for. Therefore, if they pay (almost) nothing, they get (almost) everything. Despite that obvious (and winning) strategy, it took a decade of disappointments, setbacks, and failures to fully engage the trust—and attract the assets—of investors. Not until the late 1980s did the turn finally come. The increasing momentum that followed would, by 2009, make Vanguard the largest firm in our field. (That is hardly bragging on my part. I remain nervous about our giant size and the challenges of managing $2 ½ trillion of Other People’s Money.) Driven largely by our index funds and funds with index-like investment strategies, our growth still leads the field. While about 20 percent of mutual fund investors hold Vanguard fund shares, in recent years we have accounted for some 40 percent of the total net cash flows into the entire mutual fund industry.

9 percent annual return on his Templeton Growth Fund for the period, in fact, would barely outpace the bond market return of 6.2 percent, despite assuming twice the risk.) Nor did Williamson accept any need for “an anchor to windward” (in bonds or cash) to modify volatility. Schwab described equities as “the investment of choice,” and—surprising as it may seem for this marketer focused on managed funds with good past performance—favored the use of index funds. Finally, both George Putnam and yours truly recommended a balanced approach. With bonds then yielding 7 percent and stocks but 2 percent, we both liked the concept of earning more income for endowments that must pay out returns to their universities, as well as the likelihood of substantially reduced volatility. I also urged endowment managers not to rely on “history and computers” to forecast stock and bond returns. My major recommendation couldn’t have been more specific: a 50/50 portfolio using U.S. stock and bond index funds, a balanced portfolio with extraordinary diversification and remarkably low costs—“on automatic pilot,” if you will.1 Simplicity writ large. 1 I also mentioned a 60/40 stock/bond portfolio and a 55/40/5 portfolio (the 5 in emerging markets), but all three portfolios provided similar returns and carried roughly comparable risks.

While the most vigorous industry advocates find “evidence of price competition clear,”28 the data presented by these advocates show that while there were 1,240 fee decreases during 1998-2004, there were even more fee increases—1480 in all. Even these advocates do not dispute “the empirical fact that mutual fund boards of directors rarely ‘fire’ advisers and do not put advisory contracts up for bids among advisers.” Without such competition, mutual fund managers are hardly likely to reduce their fees, and hence their own profitability. Recap of the Issues Let me summarize here the arguments I’ve made so far: In its early years, the investment company industry had many characteristics that well-served fund investors. The focus was largely on private trusteeship; prudence and diversification were the watchwords of investment policy; fund trustees often were a step removed from fund distribution; expense ratios were moderate, and far below today’s levels. Today public ownership—largely by giant conglomerates—overwhelmingly dominates the fund industry, and it has ill-served fund investors. By way of contrast, the results of that “Vanguard Experiment” in mutual fund governance are now clear. It has been both a remarkable commercial success for the firm itself, and an artistic success for its shareholder/owners. Our central idea was to create a firm honoring the industry’s original values.

Stewardship vs. Salesmanship— Bond Mutual Funds Gone Awry Remarks by John C. Bogle Founder and Former Chief Executive, The Vanguard Group FIASI Hall of Fame Speaker Series Fixed Income Analysts Society New York, NY April 17, 2007 I’m delighted and honored to be with you this evening, the third time I’ve addressed FIASI in the past decade. The first occasion was on March 18, 1998, when my theme was “Bond Funds: Treadmill to Oblivion.” In my remarks, I made the point that “fixed income funds simply cannot provide adequate returns to investors when their sound principles of management and diversification are offset by more than compensatory cost encumbrances.” (Today, it seems so obvious!) * I have no idea whether or not that speech lit the spark that led to my induction into the FIASI Hall of Fame a year and one-half later on November 10, 1999. But that surprising and wonderful event led to my second speech for FIASI. Its simple title clearly echoed the message of its progenitor: “Giving the Bond Fund Investor a Fair Shake.” Yet today, that fair shake is the rare exception to the costly penalties that the mutual fund industry imposes on its clients, in bond funds and stock funds alike. The problem, simply put, is that in the famously efficient U.S. bond markets, bond fund managers as a group are average. That is, they produce average returns. (No Lake Wobegon * The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

The on-going crisis we are now facing in two relatively recent innovations— collateralized debt obligations (CDOs, backed by pools of mortgages) and specialized investment vehicles (SIVs, essentially money market funds that borrow short and lend long)—are examples of the complex—and costly— vehicles created by our financial sector. Banks like getting paid large fees for lending money, and when they can quickly get the loans off their own books and into public hands (so-called “securitization”), it can hardly be surprising that they aren’t much concerned about the credit-worthiness of those families for whose homes they have provided mortgages. With the endorsement—and, I would argue, the complicity—of our rating agencies, this financial legerdemain created a modern version of alchemy. The lead, as it were, was a package of say, 5,000— let’s call them B-rated—mortgages, miraculously turned into the gold, as it were, of a $100-million CDO with (in one typical case) 75 percent of its bonds rated triple-A, 10 percent rated double-A, 5 percent rated A, and only 10 percent rated double-B. (Hint: we now know that, despite the risk-reducing character of such broad diversification, lead is still lead.) Derivatives Innovation in the financial sector, of course, has included the development of an enormous market of financial derivatives.description:

” Meanwhile, the fund itself is incurring heavy trading costs and charging heady advisory fees, to the point where an electronics fund, for example, cannot conceivably match the return of electronics stocks as a group. (At least an “industry index fund” could do that.) If I am correct in this analysis, today’s specialty stock funds, having come and gone once in the 1940s, will come and go again in the 1980s. When the speculator sours on mutual funds—an eventuality that will accelerate when we get the next sharp market correction—what then do we have to offer the investor and the saver? The obvious and, I think, correct response is “back to basics”—back to broadly-diversified, economically-managed funds with sensible objectives. Indeed, I expect that the pendulum will swing even further away from today’s speculation. If the investor wants (and needs) broad diversification among equities, and if the saver wants (and needs) broad diversification among bonds, perhaps unmanaged stock index funds and bond index funds will become important factors in this industry in the decade ahead. There is not much evidence to support this view. Our stock index fund—Vanguard Index Trust— during its first decade has been, as they say, an artistic but not a commercial success.

dollars per year to our fund investors. That’s enough savings to keep our money market and bond funds consistently in the 95 th (or higher) percentile among their peers, and to place our equity funds fairly consistently in at least the 75th percentile in terms of the returns we generate for our shareholder/owners. It is that innovation—based on the common sense observation that costs matter, and that funds should be, well, “of the shareholder, by the shareholder, and for the shareholder”—that has engendered the other major innovations that we have been responsible for over the years. By far the most important of these was our second strategic innovation. Immediately after Vanguard began operations in May 1975, we created the world’s first market index mutual fund, simply tracking the returns of the S&P 500 Stock Index. To do its job, the basic index fund takes diversification to the nth degree. It owns the lion’s share of the entire U.S. market, and thus assures that its investors are guaranteed to capture the gross return of the stock market (or the bond market, or any discrete segment of each). But if this diversification assures that the index fund earns the market’s return, it is rock-bottom costs that assure that it delivers to its investors nearly 100 percent of whatever returns the market may provide. (With its passive strategy, it also virtually eliminates portfolio trading costs, and also provides commensurate tax efficiency.)

Vanguard LT Municipal Fund Average LT Municipal Fund Volatility (vs index) 91% 82% Quality (A or above) 100% 86% Turnover (5 yr avg) 12% 41% Expense Ratio 0.15% 1.0% 5.66% 4.72% 10-yr Annual Return $7,340 $5,860 Profit on $10,000 Vanguard Ins LT Muni Fund 88% 100% 18% 0.16% 5.71% $7,420 4B. Duration 5.6 6.1 5.7 3.0 3.5 4.0 4.5 5.0 5.5 6.0 0 0.5 1 1.5 2 Vanguard ST Fed: 5.07% Lehman 1-5 Treas, less 0.20 bps: 4.8% Vanguard ST Treas: 4.95% Avg ST Gov’t Fund: 4.43% Slope: -0.67 Number of funds: 90 Expense Ratio Return Short-term Government Bond Funds 10-Year Returns versus Expenses 5A. Over the past decade, $10,000 initially invested in the Vanguard Long-Term Municipal Bond Fund provided a profit of $7,340, 25 percent larger than the $5,860 earned by its average rival, achieving that extra gain with a higher quality portfolio. With low costs, broad diversification, and no serious attempt to outguess the market in long-term tax-exempt bonds, once again the index-like strategy wins. Both Vanguard Long-Term Tax-Exempt Bond Fund and its close counterpart, Vanguard Insured Long-Term Tax-Exempt Bond, ranked in the top decile of the 143 funds in the category. Once again, load funds were conspicuous by their paucity among the top 20 funds (only 4 with loads) and dominated the bottom-20 fund group (18 with loads). Short-Term U.S. Treasury Bond Funds Our sweep of the bond fund arena concludes with an examination of short-term funds investing in U.S. Government obligations.

provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds’ weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some “subsectors”—in contrast to historical experience— diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies. In recognition of the radical change in the market’s reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. Do those comments suggest that active management, reduced diversification, and investing for higher yield had found their way into indexing? I’ll let you make the call. I’m confident that the Vanguard Fixed-Income Group has learned much from the cascade of ill-tidings that led to such a shocking 200 basis point shortfall in the return of VTBMF to its target index, an assumption borne out by the fact that our annual tracking error has returned to its earlier excellence, and in fact looks even better.

When we invest in a mutual fund, we are expressing our faith that the professional managers of the fund will be vigilant stewards of the assets we entrust to them. We are also recognizing the value of diversification by spreading our investments over a large number of stocks and bonds. A diversified portfolio minimizes the risk inherent in owning any individual security by shifting that risk to the level of the stock and bond markets. Kindled by bull markets and chilled by bear markets, Americans’ faith in investing has waxed and waned, but it has remained intact.a

That promise depends on the broadest possible diversification and on minimizing the costs of investing, the principal characteristics that drive our enterprise. I also resonated to Commander Watson’s goal, “Act with Audacity.” (We even have a building on our campus named “Audacious,” one of Lord Nelson’s ships-of-the-line in his brilliant victory aboard HMS Vanguard at the historic Battle of the Nile in 1798.) Of course it was audacious to create this new mutual structure, to eliminate so many of the conflicts of interest that plague our industry, to start the world’s first index mutual fund, and to create an innovative bond strategy that was almost immediately copied by our peers.

But I see little in it that persuades me that the complexity that is being offered will serve the interests of fund investors—as distinct from the interests of fund marketers—nearly as effectively as the simplicity that combines sensible asset allocation, broad diversification, and low costs, a strategy that has demonstrably served investors so effectively in the past. Let me be clear: I favor innovation when it serves fund investors. And I’m pleased that I’ve been lucky enough to have played a key role in such innovations in the past: the stock index fund; the bond index fund; the defined-maturity bond fund; the tax-managed fund; even the first fund-of-funds, absent an additional level of expense ratios. (I’ve also been involved in some innovations that haven’t worked for investors as I’ve hoped. We’ll save them for the question and answer period!)