John Bogle on Earnings Growth

topic for my senior thesis, then as now, a requirement for the Bachelor of Arts degree at Princeton. Chart – Total Mutual Fund Assets, 1952-2003 Over the next 18 months, I spent countless hours researching and writing my thesis. Remarkably little public information was available about this field, then consisting of some 130 mutual funds with assets aggregating just $2½ billion. Harvard strategy guru Michael Porter advises people considering their careers to "pick a good industry," and I certainly did that when I chose my thesis topic. With an annual growth rate of almost 16% since then, the fund industry just may have been the fastest growing business in America, and today there are 9,000 funds, with total assets that approach $7 trillion! An Idealistic Senior Thesis Read today, my thesis would probably impress you as no more than workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. (And you can read it, for two years ago it was published by McGraw-Hill, part of John Bogle on Investing: The First 50 Years; my "Press On Regardless" speech appears as Chapter 25. If you wait a half- century, perhaps anything can be published!) On page after page, my youthful idealism speaks out, calling again and again for the primacy of the interests of the mutual fund shareholder. At the very opening of my thesis, I get right to the point: Mutual funds must not "in any way subordinate the interests of their shareholders to other economic roles.

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.”

We measure the economics of equity ownership by what I call investment return, the dividend yield on stocks plus the annual rate of earnings growth that stocks achieve. We measure the emotions of equity ownership by the change in the price that investors are willing to pay for each dollar of earnings (the P/E ratio)—what I call speculative return. Added together, these two returns produce the total market return. In 1983, for example, the starting dividend yield on the Standard & Poor’s 500 Stock Index was 5% and its earnings growth was 11%, an investment $53.07 $0 $10 $20 $30 $40 $50 $60 1975 1979 1983 1987 1991 1995 1999 '11/01 Nasdaq NYSE Growth of $1: Nasdaq vs. NYSE 3/00 $34.74 $31.07 $21.11/01

In December 1949, I happened upon an article in Fortune magazine (“Big Money in Boston”) on the then tiny mutual fund industry, and decided on the spot to write my Princeton senior thesis on mutual funds. Walter L. Morgan, founder of Wellington Fund, read it, and gave me the first break of my incipient business career: he hired me. That’s where it all began. So, let’s mark luck—which I’ll dignify by calling opportunity—as an unrecognized attribute of leadership. But it is critical to be ready when opportunity knocks. And, when it did, we had a plan. As a result, today we are the second largest mutual fund firm in the world, and first both in long- term growth rate and in current inflow of investor dollars. How? Because when opportunity knocked at the outset, we posited, accurately as it turned out, a coming age of rising family incomes, financial savvy, and investor education. And so we set out to provide investors with the very best value that we could. Such a strategy would require exceptionally low operating costs and the elimination of sales commissions.lowest

In short, speculation (betting on higher valuations) is the drivers seat. Investment (betting on the fundamentals of dividend yields and earnings growth) is in the back seat—perhaps even in the rumbleseat. But while speculation drives stock returns in the short run, it is the crystal clear lesson of history—at least of the past 200 years—that in the long-run fundamentals drive returns. And so the tension must be resolved. Two extreme possibilities: One: a market drop of, say, 35%. This would lower price-earnings ratios to a more normal level of 13 times. And, at 5200 on the Dow, we would still repose--I might add, “fat, dumb, and happy”-- where we sat in January 1996, but a year and one half ago. This would hardly be a doomsday scenario. Two: a New Era, in which stock returns average 15% (14% earnings growth plus a 1% dividend yield), rather than the long-term historic norm of about 10.5% (6.5% earnings growth plus a 4% dividend yield). In short, a new era of boom times and high valuations that would justify today’s price levels. Indeed, Barton Biggs, the eminent if volatile guru at Morgan Stanley, bearish as he has been for so long (“Famine will follow feast, as it always has.”) entertained this idea a few months ago in a paper entitled “A New Higher Mean to Revert to?” (He did at least include the question mark.) He tranced on a new real mean of 10% (after inflation), but finally fell back on a 7%-8% range, not nearly enough, I think, to justify today’s price levels.

Investment Return and Speculative Return This dual nature of investment returns is clearly reflected in the stock market history, and remains basic in appraising the state of the stock market today. I continue to use the term speculative return to refer to the portion of the stock market’s total return that is derived from “changes in the public valuation”—that is, the changes in the price that investors are willing to pay for each dollar of earnings per share. But rather than using Keynes’ term enterprise to describe the yield of an investment over the years, I use the term investment return—the sum of the initial dividend yield plus the annual growth rate of earnings; that is, the return that corporations actually deliver to investors. Added together, investment return plus speculative return represent the total stock market return we experience. History illuminates this division of stock market returns with great clarity. The reason that stocks returned nearly 20% per year during the great bull market are clear: The dividend yield on the S&P 500 Index averaged almost 5%, the subsequent annual earnings growth was just short of 7%; the combined investment return, then, was almost 12%. But as the fear of investors at the outset changed to hope and finally to greed, the price-to-earnings ratio quadrupled—from nine to 36—adding more than eight percentage points of speculative return. The math is not very complicated: An average annual return on stocks of almost 20%.

return of 16%. The price-earnings ratio rose from 11.1 times, to 11.8 times, for a 6% speculative return. Result: Market return for the year, 22%. Long Term Investing is about Economics Now let’s examine these two sources of return over the long run. Over the past 130 years, the market return of U.S. stocks has averaged 9.0% per year. The annual investment return from earnings and dividends has averaged 8.8%; the speculative return just 0.2%. Were this a football score, it would read: Economics 88, Emotions 2. Long-term investing is all about economics. That virtual one-for-one parity between economic return and market return, however, is something we rarely see. Pendulum-like, the cumulative investment return swings way above the market return, and then way below. When emotions turn negative, and P/E ratios fall, the speculative return sharply diminishes the investment return. From 1961 through 1981, for example, a fall in the P/E from 23 times to 8 times—from optimism at the beginning of the period to pessimism at the end—resulted in a negative speculative return of minus 4.6% annually, slashing the 12.1% annual investment return by almost 40% to a market return of just 7.5% $0 $1 $10 $100 $1,000 $10,000 $100,000 1872 1882 1892 1902 1912 1922 1932 1942 1952 1962 1972 1982 1992 Investment Return 8.8 % (earnings growth plus yield) Market Return 9.0 % (includes speculative return*) Annual Growth Rate Stock Market Total Return vs.

Driven by the long bull markets in both stocks and bonds, the ever-market-sensitive mutual fund industry too has burgeoned, growing at a 17% annual rate since 1986 and increasing assets eight times over. Vanguard’s 26% growth rate since then has multiplied 19-fold. To be sure, we found ourselves in the most rapidly growing segment of the fund industry—the direct marketing (largely no-load) sector— which became the industry’s largest distribution channel in 1996. This growth reflects an increasingly cost-conscious breed of self-motivated investor. Happily, we had sensed this trend years earlier, and were well prepared. For in 1977 the Vanguard funds abandoned their 50-year dependence on stock brokers and made an unprecedented leap forward to no-load distribution. Direct marketing has grown at a 21% annual rate, resulting in an 11-fold asset growth. The runners-up in the growth sweepstakes, growing at a 16% rate, were independent firms offering load funds, largely sold by stock brokers. Their assets grew seven-fold. In a poor third place, growing at just 12%, with but a four-fold asset increase, were the proprietary load funds, managed and distributed by the brokers. Despite the obvious and innate competitive advantage held by broker-sold funds, their notably high costs and notably low returns (not entirely unrelated!) were too much for even their dedicated distribution systems to overcome.

Putting Numbers on Keynes’s Distinction While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, decades later it occurred to me to do exactly that. By the late 1980s, based my own first-hand experience and my research on the financial markets, I realized that equity returns were a combination of these two essential sources: enterprise and speculation. I defined enterprise as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. I defined speculative return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation that investors place on future corporate earnings).

While, yes, interest rates have tumbled from 13% to 5%, the earnings yield-about equal to the 13% bond yield at the outset-is now only 3.6%-about two-thirds as high as the interest rate (i.e., the ratio has dropped from 0.96 to 0.70). In this context, then, let's examine the source of the market's astonishing near 21 % annual total return during the great, long bull market. Well, 6.0% came from the very high initial yield, some 7% came from earnings growth, and 8% per year came from the increase in the price-earnings ratio alone. How much does this change impact the total? Let's just say that if the price-earnings ratio--a measure, not of reason, but simply of emotion-had remained unchanged, the Standard & Poor's 500 Index would today be reposing at a level, not of 1239, but of ... 345. Almost 1,000 points lower! As we look ahead for, say, a decade, we know-we know-that the future contribution of dividend yield will begin at, not 6%, but 1.3%.better

Simply adding speculative return to (or subtracting it from) investment return produces the total return generated by the stock market. For example, with the current dividend yield of 2 percent, if stocks experience earnings growth at the long-term average of 5 percent over the coming decade, the investment return would total 7 percent in nominal terms. During the coming decade, I actually expect the P/E ratio to change little on balance from the present level of about 16 times. So my expectation for total stock returns over the next decade is about 7 percent per year before inflation. Let’s see how this methodology worked in the past. (Chart 1) By relying on it, decade after decade, over the past century, we can account, with remarkable precision, for the total returns actually earned by U.S. stocks. The investment return on stocks (top line of figures) proves to be remarkably susceptible to reasonable expectations. The initial dividend yield (red bar)—a crucial, but wholly underrated, factor in shaping stock returns—is a known number. The steady contribution of dividend yields to investment return during each decade has always been a positive, only once outside the range of 3 percent to 5 percent. Speculative Return: Impact of P/E Change 0.8% -3.4% 3.3% 0.3% -6.3% 9.3% -1.0% -7.5% 7.7% 7.2% -3.2% 0.2% -10% -5% 0% 5% 10% 15% ? 4.7% 2.0% 5.6% -5.6% 9.9% 3.9% 5.5% 9.9% 4.4% 7.4% 0.8% 4.8% 4.8% 3.5% 4.3% 5.9% 4.5% 5.0% 6.9% 3.1% 3.5% 5.2% 3.2% 1.2% 4.5% 2.

Make no mistake about it, then: It was speculative return that drove the Great Bull Market. The fact is that, based solely on investment return, $1 invested in the S&P 500 at the outset would have grown to $7—a handsome seven-fold enhancement. But the leap in the P/E multiple alone increased that investment return to a market return of $24—nearly twenty-four times over, 3½ times (!) the hardly inconsequential investment gain. Yes, we had literally never had it so good. Can it happen again? I can’t imagine how. To understand why, let’s take Lord Keynes’ advice and look at the sources of the past returns on stocks and then apply them to the decade ahead. Today, the S&P 500 Index yields not 5% but 1½%, reducing this key contributor to stock returns by fully 3½ percentage points. When we add an assumed 6% earnings growth (corporate earnings, truth told, grow at about the same pace as our economy), the investment return on stocks would be just 7½% per year. Will speculative return add to or detract from this figure?earnings

2% -10% -5% 0% 5% 10% 15% 20% 8.2% 6.3% 11.5% -1.1% 14.9% 10.8% 8.6% 13.4% 9.6% 10.6% 2.0% 9.3% 7.0% Dividend Yields Have Accounted for Half of the Long-Term Returns on Stocks Market Return (S&P 500) 9.0% 2.9% 14.8% -0.8% 8.6% 20.1% 7.6% 5.9% 17.3% 17.8% -1.2% 9.5% 7.0% -5% 0% 5% 10% 15% 20% 25% 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 1900 – 2010 Avg Investment Return: Dividend Yield and Earnings Growth Oct.1

The Gotrocks Family Even before you think about index funds, however, think about the eerie nature of our financial system. Using my version of a parable from Warren Buffett’s letter in the Berkshire Hathaway 2005 Annual Report (it’s in the Little Book), here’s how investing actually works: Once upon a Time . . . a wealthy family named the Gotrocks, grown over the generations to include thousands of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game. But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other “dumb” relatives. These Helpers convince the cousins to sell their shares in overvalued companies to other family members and to buy shares of undervalued companies from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members. To their surprise, however, the family’s share of the generous pie that U.S.

It took nearly three long years for us to develop into a full-fledged fund complex, providing not only administrative services to the funds, but distribution and investment services as well. And two more years were to pass before the new enterprise began to grow. But ever since 1981, our path has been one of unremitting growth—indeed the highest growth rate in the mutual fund industry. Mutuality—The Rock Foundation Suffice it to say that mutuality is Vanguard’s most distinctive characteristic, the rock foundation upon which all that we have accomplished depends. But without Dr. Franklin’s angels—energy and persistence—sitting on our shoulders, we never would have been able to form the new enterprise, nor to establish its character, nor to build it to its present substantial size. With assets of the Vanguard funds now exceeding $575 billion, we have become the second largest fund complex in the world.

The second component, earnings growth, has little short-term visibility as we work our way through a serious recession in an uncertain economic environment. Corporate profits are tumbling in 2001, and forecasting 2002 is an exercise in guesswork. But the earnings of American corporations are likely to be somewhat higher in 2005 than in 2000, and almost certain to be much higher in 2010. Agree or disagree with my conclusion, that’s what the serious investor should be thinking about. We also know that over the long term, the after-tax earnings of U.S. corporations have grown apace with our population and our productivity, and at a remarkably similar rate. Since the end of World War II, for example, our gross domestic product has grown at a rate of about 7%; so have corporate profits. Looking ahead to the coming decade, a continued—if optimistic— earnings growth rate of 7% plus a dividend yield of 1½% would bring the investment return on stocks to 8½%. It is these economics that will drive the market.

Investors put up 100 percent of the capital and consume 100 percent of the risk; aren’t we entitled to more than 20 percent of the return? Investment vs. Speculation With that background, let me turn to some of the issues of the day in our financial markets, including the triumph of short-term speculation over long term investment, the roots of the crisis in the debt markets, and the role of financial innovation. It is buying and holding businesses that meets my definition of investment, an idea—believe it or not—that I pursued in my Princeton University thesis on the mutual fund industry way back in 1951. There, inspired by the wisdom of John Maynard Keynes, I drew a clear distinction between investment and speculation. Keynes defined “enterprise” as “the activity of forecasting the prospective yield of assets over their entire life.” He defined “speculation” as “the activity of forecasting the psychology of the market. Keynes used no numbers to make that distinction. But in the late 1980s, I did exactly that. I defined enterprise as investment return, the sum of the current dividend yield on stocks plus their subsequent rate of earnings growth.change

The secular rate of earnings growth, on the other hand, while hardly certain, is also relatively stable, usually paralleling the growth in our gross domestic product (GDP). Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth (blue bar) was positive in every decade, usually running between 4 percent and 7 percent per year. Total investment returns, then, have been less than 6 percent annually only twice (in the 1930s and in the 2000s), and only twice much more than 11 percent. Speculative return, however, (green bar) is, well, speculative. It has alternated widely, from positive to negative and back again from one decade to the next. But over the long-run, speculation has neither added to nor subtracted from investment return. In fact, when P/E ratios were historically low (say, below 12 times) they have been highly likely (84 percent probability) to rise over the subsequent decade. And when they were historically high (say, above 20 times) they have been highly likely to decline (87 percent probability), though in neither case do we know when that change is coming. Of course, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has been a sensible and effective approach to projecting the total return on stocks (orange bar) over the decades.

The fact is that it is the fUndamentals of dividends and earnings growth, not speculative changes in the price-earnings ratio, that create market returns in the long run. Never forget that essential fact! Nothing could be clearer from this chart comparing fundamental returns with market returns for the past 40 years. Over this long period, dividends and earnings growth averaged 11% per year, and the market return averaged 12%. If you are a long-term investor-and if you are a short-term investor, I have no wisdom to offer you-you should expect far lower returns in the years to come. However, no matter what the markets give us, my conviction remains steadfast that common stocks should remain the principal asset class in a long-run investment program. If your own program was soundly balanced before the bear market-as it should have been-and you were strong enough to resist the temptation to sell stocks at the bottom of the bear market, there should be no need to change the balance now. Fourth simple principle: Stay the Course.

The value of a corporation is reality, and acting on that reality is investment. When executives are paid for raising the price of their company's stock rather than for increasing the value of their company's business, they don't need to be told what to do: Achieve strong, steady earnings growth and tell Wall Street about it. Set "guidance" targets with public pronouncements of your expectations, and then meet your targets— and do it consistently. First, do it the old-fashioned way, by increasing volumes, cutting costs, raising productivity, developing new products and services. But in a competitive economy, these targets are not easy to meet. So when you can't meet them by making, you meet them by counting. Push the accounting numbers to the edge—and sometimes beyond. Undertake mergers, not for business reasons but because of loopholes in accounting rules that allow such transactions to provide a short-term boost to earnings. And when all of that isn't enough, cheat. And, as we now know, a number of large firms did exactly that. Owners Capitalism Becomes Managers Capitalism What we've witnessed is a profound shift from traditional owners capitalism—in which the goal is to provide those who invest their capital with a fair return—to managers capitalism—in which major portions of that return are diverted to corporate executives.

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

The point is this: Over the very long run, it is the economics of investing—enterprise— that has been virtually entirely responsible for the total return on stocks. The evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, the 9.5 percent average nominal annual return on U.S. stocks (second column from right) has been composed of 9.3 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.8 percent), and only 0.2 percent of speculative return. But don’t expect history to repeat itself. When we look to the future, we should largely ignore historical returns.investment

international stocks. The net result of all four examples, to tip my hand, is that, among each of these key market sectors, RTM is alive and well. Let’s begin with growth stocks (generally, those with above-average earnings growth, price- earnings ratios, and market-to-book ratios) and value stocks (lower in each case, and offering above- average yields). For this study, I’ve done a 60-year examination of growth mutual funds—those with stated growth objectives and demonstrated above-average volatility—and value mutual funds—equity funds stating that they seek both growth and income and demonstrating average volatility. (Before published industry norms became available in 1968, I’ve relied upon a sample of funds whose portfolios and annual returns made this distinction clear.) The conventional wisdom today is to give the value philosophy the accolades as superior to the growth philosophy. Perhaps this is so because so few have examined the full historical record. Nonetheless, over the long run, as shown in Exhibit IV, RTM proves powerful and profound. In the early years, growth funds controlled the game, and were clearly the winners from 1937 through 1968. At the end of that era, the investment in value stocks was worth just 62% of the investment in growth stocks. Then, value stocks enjoyed a huge resurgence through 1976, redressing almost precisely the entire earlier deficit.

in the number of dollars that investors are willing to pay for each dollar of corporate earnings; that is, the annualized percentage change in the P/E multiple. Simply add the two categories of return together and, viola! we have the total returns generated in the stock market. (It works!) Over the very long run, it is the economics of investing—enterprise—that has determined the total return on stocks. The momentary emotions that surround investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. For example, the 10.0 percent average annual return on U.S. stocks during the past century was almost identical to the 9.9 percentage points of investment return, an average dividend yield of 4.6 percent, plus average annual earnings growth of 5.3 percent. Speculative return added only one-tenth of one percent to that total. Despite the transient booms and busts of stock market history, for the investors who have stayed the course, buying and holding a portfolio invested across all of American business, has been an extraordinarily successful strategy. The Triumph of Speculation Keynes had predicted that otherwise sensible professional investors would gradually abandon their focus on enterprise and follow the ignorant crowd of uninformed individuals in betting on the psychology of the market, attaching their hopes to a favorable change in the conventional basis of valuation, i.e., that they are speculators.

Emotions seem more likely to reduce that investment return than to increase it. With a price-earnings ratio of about 22 times based on normalized earnings (far higher relative to actual earnings during the present recession), some retreat toward the long-term norm of 16 times seems more than likely, producing a negative speculative return of 1% to 3%. The result, if all goes well: A stock market return in the range of 6% to 9% per year over the next decade. That may not sound like much. But don’t forget that the long-term norm is 9%, and that in one decade out of every three stocks have produced less than 6% annually. And before you write-off stocks, don’t forget that prospective bond returns are also low. The U.S. Treasury 10- year bond, for example, yields just 4¼% today, and money market fund yields will soon be below 2%. Wise investors will scale down their expectations to reflect these new realities. My advice to long-term investors: Stick to prudent investment principles; hold a stock/bond allocation consistent with your own risk tolerance; and make sure your portfolio is broadly diversified. Let economics rule your decisions, keep your emotions out of play. And then follow the wisest of all investment rules: Stay the course. Market Returns in the Coming Decade? (2001 - 2011) 20x 22x Dividend Yield 1.5% 1.5% Earnings Growth 7.0 7.0 Investment Return 8.5% 8.5% Speculative Return* -1.0 Market Return 7.5% 8.5% 30x 1.5% 7.0 8.5% +3.1 11.

In the money market fund segment, of course, current yields have no necessary relationship to past or future yields—don’t forget that it is impossible to have both a fixed income payment and a fixed principal value—the capital flows (at least ever since this segment reached maturity in the mid-1980s) seem to represent a residual figure, with money coming into the funds because it is coming out of stock and bond funds, and vice versa. The Tragic Flaw But the tragic flaw of this industry is that mutual funds have failed to give our investors an adequate share of the returns actually generated in the stock market, the bond market, and the money market. During the two decades ending December 31, 1999, these returns were at the highest levels in U.S. history: 18% per year for stocks, 10% for bonds, 7% for the money markets. As a result, despite relative returns that significantly lagged those of the markets in which they invested, fund investors enjoyed good absolute returns. In buoyant markets, that lag may—MAY!— have been a tolerable flaw. After all, in that 18% stock market, the average equity fund did provide a 15% return. But when the financial markets generate significantly lower returns, such a lag will become intolerable. And, in my judgment, it’s precisely such an era that we have entered. The mathematics of the stock market— today’s low dividend yield plus nominal earnings growth—suggests an investment return averaging about 6½% over the coming decade.

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.

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.

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.

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.

Think about it: while the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market before those costs—for all of us as a group—is a zero-sum game. And after intermediation costs are deducted, beating the market becomes a loser’s game. The rise of the financial sector is one of the little-told tales of the recent era.giant

It’s only a small step from the workings of the financial markets to the consideration of what returns we might expect from stocks in the years ahead. (Our host has asked me to discuss this question.) While only a fool tries to predict what the stock market will do in the short term—there are, alas, lots of fools who do exactly that—predicting long-term returns is largely a product of another set of those simple “relentless rules of humble arithmetic,” similar in concept to the causal linkage between maintaining low investment costs and capturing your fair share of stock market returns. Why so? While in the short-run stock returns are largely shaped by emotions—such as optimism, pessimism, hope, greed, and fear—in the long run they are shaped almost entirely by economics. For example, over the past century, of the 9.6 percent average annual nominal (before inflation) Total Return generated by common stocks, fully 9.5 percent was accounted for by the average dividend yield of 4.5 percent and average earnings growth of 5.0 percent—the Investment Return on capital earned by America’s businesses, The remaining 0.1 percent came from Speculative Return, the willingness of investors to pay a slightly higher price for each dollar of corporate earnings at the end of the period than at the beginning. Since a majority of you here today are not investment professionals, let me put this concept in the homey terms I used in this very hall just a few years ago.

The Rise of Quantitative Investing And the bad news for traditional managers continues. Another form of index-like competition is emerging, and I’m confident it too will take its place in the field. I refer to what are called “quantitative” investment strategies, which I define to be computer-driven strategies that rely rigidly and exclusively on mathematical formulas to manage investment portfolios. I differentiate the use of quantitative techniques as the foundation of portfolio strategy and selection from the clearly pervasive use of computers to screen and value individual stocks and stock groups as part of the traditional security-analyst-based management process. (“We’re all quants now.”) Today, industry estimates place the assets managed by quants at $100 billion, and the growth rate is strong. Some of these quantitative strategies might fairly be described as the ultimate form of investment relativism. But they must not be confused with closet indexing. With fully disclosed policies and strategies, they are hardly hidden in the closet; their strategies are rigorous and controlled, not random and intuitive; and their costs are often well below conventional norms. (It’s far less costly to run a computer program than to employ a large portfolio research and management staff.) Typically known as enhanced index funds, these funds seek to outpace a market index.

But if we can distinguish the reasons why the past was what it was, we set some reasonable expectations about the future. Keynes helped us make this distinction by pointing out that the state of long-term expectation is a combination of enterprise ("forecasting the prospective yield of assets over their whole life") and speculation ("forecasting the psychology of the market"). I'm well familiar with those words, for 52 years ago I also incorporated them in that thesis at Princeton. Investment Return and Speculative Returns This dual nature of returns is clearly reflected in stock market history. Using Keynes' idea, I divide stock market returns into: a) Investment Return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth; and b) Speculative Return, the impact of charging price/earnings multiple on stock prices. Consider the record of stocks during the twentieth century: Note first the steady contribution of dividend yields (the yellow bars) to total return during each decade; always positive, only once outside the range of 3% to 5%. Note too that, with the exception of the depression-ridden 1930s, the contribution of earnings growth (the green bars) was positive in every decade, usually running between 4% and 7% per year. Result: Total investment returns (the line at the top) that were negative in only a single decade (again, the 1930s), and generally ran in the 8% to 13% annual range.return

In that January 5, 2000 speech, I considered the outlook for the stock market during the first decade of the new millennium. I asked just two questions: (1) Will the bagel of investment fundamentals give us its usual sustenance? And (2) Will the doughnut of speculation get even sweeter than it was when I spoke, or will it finally sour again? Here’s how I answered the first question about investment return: Since the dividend yield on stocks was then at an all-time low of just over 1 percent, it was sure to contribute little to future investment returns. (Remember that the long-term norm was 4 ½ percent.) As to earnings growth, ever the optimist, I guessed that 8 percent growth might be possible. Thus, the economics of investing suggested an investment return of 9.2 percent—the 1.2 percent yield, plus 8 percent earnings growth. My answer to question (2) about speculative return: The bullish emotions that had driven stock returns skyward during the 1990’s, could not recur. After all, stocks were then selling at 30 times earnings; almost double the long-term norm of 16 times. (What was the market thinking?!) I suggested that P/E ratio would drop to perhaps 20 times, slashing 4 percentage points per year from the projected investment return of 9.2 percent, thereby reducing the total return on stocks to about 5 percent during the first decade of the 21st century, only about one-half of the long-term norm of 9.6 percent.

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

Earnings Management and Executive Compensation Second, as the market’s focus moved from earnings to earnings growth, corporations began to report earnings that lost touch with reality. In what I have called a “happy conspiracy” among corporate managers, public accountants, Wall Street analysts, investment bankers, and Old Economy vs.24%

Total Returns on Stocks, Past and Future 4.5% 3.4% 2.0% 5.0% 6.4% 6.0% -1.0% 2.7% 0.1% -2% 0% 2% 4% 6% 8% 10% 12% 14% Last 100 Years Last 25 Years Next 10 Years 9.6% 12.5% 7.0% Earnings Growth Dividends P/E Change Investment Return Speculative Return 4. Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana was right when he defined the standard of conduct for a true professional with these words: “I will create value for society, rather than extract it.” And yet money management, by definition, extracts value from the returns earned by our business enterprises. Warren Buffett’s wise partner Charlie Munger lays it on the line: “Most money-making activity contains profoundly antisocial effects . . . As high- cost modalities become ever more popular . . . the activity exacerbates the current harmful trend in which ever more of the nation’s ethical young brainpower is attracted into lucrative money-management and its attendant modern frictions, as distinguished from work providing much more value to others.” Yet even as I write these remarks, I read that this brainpower is pouring into financial services at the most breath-taking rate in history.

First, the dividend yield was a known quantity. It had fallen to an all-time low of 1.1%, eliminating it as a major driver of future investment return, and leaving the heavy lifting to earnings growth. I picked 6% as a reasonable expectation for the coming decade, a bit above the trend line. If so, investment return in the decade ahead would have come to 7.1%. Chart – Past Stock Returns, and a Look to the Future What about speculative return? Over the previous two decades, the market's p/e ratio soared from seven times to 30.5 times, producing a 7.5% annual rate. With a p/e more than double the century-long norm, even if one naively believed that "this time is different," and that such a stratospheric ratio wouldn't decline, even if it held, the future speculative return would be zero. But my guess was that the p/e ratio might drop to the neighborhood of 18 times, providing a negative speculative return of about 5% per year. Result: An expected average return on stocks in 1999–2009 of less than just 2% per year—and not ten individual years at 2%; stock markets just don't behave that way. More likely, I said, was a 40% or 50% drop over a few years, followed by a return to more normal returns, say in the range of 9% annually. I've often said, "while we may know what will happen in the market, we never know when." But in an April 6, 2000 speech, I threw caution to the winds: "So let me be clear.have

While my projection was then seen as absurdly pessimistic, in fact it proved to be a bit too optimistic. Earnings growth was virtually identical to my 8 percent guess-timate, but the price/earnings multiple tumbled to 17 times, somewhat below my projection of 20 times. But in terms of Total Return, the forecast looks pretty good, with the market on track to produce about a total return of 4 percent per year during the decade ending in 2009—remarkably close to the 5 percent figure that I forecast seven years ago. So, emboldened by a combination of wisdom, common sense, luck, and yes, the relentless rules of humble arithmetic, let’s look ahead to the next ten years. I expect the bagel of investment return to be nicely positive, most likely in the range of eight percent per year; i.e., adding today’s dividend yield of a higher but still stingy two percent to what I’ll guess is earnings growth in the six percent range. (After all, corporate earnings grow at about the same nominal rate as our economy. What else is new?) As to speculative return, I think investors are a bit too optimistic, and therefore I look to slightly lower valuations—a doughnut not quite so sweet—perhaps lowering the Total Return on stocks to 7 percent per year. Will that forecast be as accurate as my previous guess? Only time will tell, but I am hardly alone among experienced investors who believe we are facing an era of subdued returns in the stock market.

Consider Morningstar Mutual Funds, which provides “everything you ever wanted to know about your fund, but were afraid to ask,” and on a single page at that: Historical asset values and dividends; total returns on a quarterly basis, absolute and relative to market indexes and peers; fund expense ratios and sales charges; tax efficiency; risk analysis; the 25 largest stock holdings; the average price-earnings ratio, earnings growth rate, and market capitalization; industry weightings; and, if you’re into Modern Portfolio Theory, alphas, betas, and R-squareds. And there’s still room left on the page for a two-paragraph editorial comment! All topped-off by the fund’s rating: one-star, worst; five-star, best. I fear, however, that fund investors pay little attention to this plethora of information on fund risks, costs, and portfolio construction. Rather, they select funds that have had hot past performance and five-star ratings. But since past performance has rarely proven prologue to the future, “stars” cannot—and do not—give investors the power to select future winners.A

” You now know enough about Vanguard, I hope, to decide for yourselves whether that’s accurate, and indeed to decide whether or not I am truly an entrepreneur as you understand the term. Given the writer’s challenge, let me conclude by putting this saga of my slice of the world in some sort of context. Times have changed since Vanguard began in 1974. A fairly consistent 30% annual growth rate has turned a tiny firm into a giant corporation. The original crew of 28 now totals 5800. The dream has become the reality. Clearly, if an entrepreneur is defined as a leader who turns an idea into an enterprise, the day of the entrepreneur at Vanguard has passed. The skills of the manager, not the leader, are—must be—in the driver’s seat. The creator, however, remains the spirit and the missionary, and the mission remains unchanged: a fair shake for fund shareholders. And that’s, I suppose, my story—so far.

Equity Returns Over the Coming Decade 2.0% 2.2% 2.5% 6.0% 2.3% -1.0% -2% 0% 2% 4% 6% 8% Earnings Growth Dividends P/E Impact Inflation Expenses Net Real Return Sources Uses 5. 7% 7% What’s more, those rising costs are all too likely to occur in an era of falling returns on equities. Briefly put, the 100-year return of 9 ½ percent annually on stocks included a 4 ½ percent dividend yield. (Chart 4) Today’s 1.8 percent yield represents a dead-weight loss of 2.7 percentage points in future investment returns. By the same token, the glorious 12 ½ percent return of the past 25 years included not only a 3.4 percent dividend yield, but an 1.7 percent annual speculative return, borne of a price-earnings return that rose from 9 times to 18 times—a double! The drop in yields, and the likelihood (in my view) that today’s price-earnings ratio of 18 will not only not redouble, but is apt to decline by a few points in the coming decade, means that we are likely to experience a future return on stocks of about 7 percent. Shamelessly, I persist in reducing that nominal annual return of 7 percent by the estimated 2.3 percent expected rate of inflation, slashing it to a real return of just 4.7 percent. (Chart 5) Annual mutual fund costs—sales loads, expense ratios, and hidden turnover costs— are now running at about 2.5 percent, reducing the humble real return of the average fund by more than half, to just 2.2 percent. 2.2 percent! (That may be a best-case scenario.

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

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

Even over periods as long as a quarter century, however, there have been variations in returns based on the esoteric force of speculation, rather than on the rock foundation of investment. But they have been reasonably subdued. The combination of dividend yields and earnings growth have remained the predominant driver of return. Exhibit IX presents the differences between the two. Actual returns fall within a range of plus or minus some two percentage points of fundamental returns in 88 of the 102 25-year periods since 1871. I was struck by the fact that there seem to be six waves—each of plus or minus 15 years duration—from the peak-to-valley role of speculation versus investment. Just for fun, I’ve delineated these six waves, arguably three grand RTM cycles, on the Exhibit. To illustrate just how these differences between fundamental and actual returns have worked in the past, I turn to Exhibit X, which compares the role of investment and speculation in two very different climates. When we moved from pessimism to optimism, as in 1937-1962, the fundamental return of 6.3% was supplemented by a speculative return of 3.1%. This additional return resulted from the upward reevaluation in the price of $1 of earnings, from $9.30 to $17.20, bringing total return to 9.4%. On the other hand, when optimism moved to pessimism, as in 1953-1978, the revaluation of $1 earnings from $9.90 to $7.90, resulted in a negative impact of -2.8%, reducing the fundamental return of 8.3% to 5.5%.

In short, it is by no means obvious that this combined blast from our monetary masters and our fiscal authorities will make a positive difference either to our markets or our economy. Maybe, just maybe, we should not intervene and just let the markets clear. Not only are our markets driven by the confidence of investors putting their dollars on the line, but our economy is driven by the confidence of consumers spending on their needs and wants, and corporations, spending to enhance the returns on their capital. That confidence has been shaken. The inherent risk in our financial markets—enhanced in the recent present era by truncated time horizons, the dominance of speculation over investment, excessive financial innovation, easy credit, a seeming unawareness of burgeoning credit risk, and a concentration of assets in banking conglomerates—has markedly increased during the recent era. I share the concern of many economists that these problems in our financial system may well carry over to the performance of our economy, now approaching—if not already in—recession. If that is the case, we will see the leveling off of corporate earnings growth, perhaps followed by significant earnings declines. Thus, the probabilities favor continued market turbulence—and some economic turbulence as well. So the risks are high; the uncertainties rife. Yet perhaps we’ll muddle through. After all, throughout our 230-year history, America has always done exactly that.

My point in discussing the overpowering force of fundamental factors in driving stock returns is to emphasize that the economics of capitalism and competition seem somehow to have established an historic limit of 4% real (6% nominal) on long-term earnings growth. What is happening in the U.S. stock market today—and what has driven the stock market during its past three glorious years—is the notion that earnings growth has moved to a new, distinctly higher, plateau. Indeed, during the past 15 years, real returns have averaged fully 12.6%—a return significantly exceeded only five of the 181 15- year periods since 1816—and not by very much. (The record of 14.2% was set way back in 1865-1880.) Even if the coming decade produces but a 3% real return, the quarter century return would be 8.6%, far above the long-term norm of 6.7%. But the remarkable returns earned on stocks since 1982 have raised serious questions about whether the old shackles on fundamental returns have been ripped away, freeing America to enter a new era of corporate profitability. For equity investors, it is the central question of the day. A year ago, one respected firm headlined its investment strategy bulletin, “A New, Higher Mean to Revert To?”4 The report began by saying, “as the fat returns from U.S. equities keep piling up, you have to wonder if in this brave new world, the historical returns of 6%-7% real are obsolete, and have to be revised upward.” Then it took the middle ground.

by American business, the annual investment return achieved simply by adding the initial dividend yield to any increase in earnings per share. Today, the dividend yield is a bit over 1%, and corporate earnings in the U.S. have grown over the long-term at a 6% to 7% annual rate— about the same rate as our economy, measured in nominal terms by our gross domestic product. Adding the two together, the obvious result: An investment return of 7% to 8%. But it is not only these economics that drive the market. We have to concern ourselves with emotions, measured by the change in the amount investors will pay for each dollar of earnings—the p/e ratio. If it goes from 20 to 24 times in a year, add a mere 20%(!) to the market return. From the start of the great bull market in 1982 to its high last March, the market’s p/e rose from 8 to 32, a cool 300% gain, equal to 7% per year. The great bull market, then, was a not product of the (in fact) normal earnings growth during the period, but a product of our emotional exuberance. It is inconceivable to me that that scenario will repeat itself. Indeed, today the p/e ratio is about 30 times based on this year’s estimated sharply lower earnings, and a still high 22 times relative to what are probably normalized earnings. In any event, we are likely to be facing an extended period with an economic return of no more than 7% or 8%.

And so it was that after the spring of hope a year ago, we have now completed a summer, a fall, and a winter of, if not despair, surely disappointment. We await the next season. What does it hold for investors? The Sources of Stock Market Returns With apologies to Dickens, I turn again to a tale of two markets . . . but a tale of two other markets: Stock markets past, and stock markets yet-to-come. Do we have everything before us, or nothing before us? To answer that question, we must look at the U.S. stock market in total, well-represented by the Standard & Poor’s 500 Stock Index, which includes both listed stocks (now 85% of its value) and Nasdaq stocks (15%). Let’s begin with the eternal mathematics of the stock market, in which returns are derived from two distinct elements: Investment, and speculation. Investment return is represented by the sum of a stock’s dividend yield plus the rate of its earnings growth: It tends to be steady, recurrent, and almost always positive. Speculative return is measured by the willingness of investors to pay more—or less—for each dollar of earnings: It is intermittent, spasmodic, and may as easily be negative (a falling price-earnings ratio) as positive (a rising price/earning ratio). Simply adding the two elements together gives us the total market return. But over the long run, it is investment return—earnings and dividends—that calls the market’s tune.

Consider the past 40 years: Dividend yield plus earnings growth came to a total of 11.2% per year. The actual return of the stock market came to an identical 11.2%. 0.1 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 Investment Return vs. Market Return: 1961 - 2001 Investment Return 11.2%/year Market Return 11.2%/year

If speculative return came, as it did, to zero over the full period, in the short-term, and even over extended periods, it plays a crucial role, beautifully exemplified by dividing that 40- year period into two equal 20-year segments. Both periods saw excellent annual investment returns: 12% during 1961-1981; 10% during 1981-2001. But speculative return subtracted 4½% in the first period and added 5% during the second. Result: a market return of 7½% in the first 20 years, and 15% in the second. Curiously, despite a lower rate of corporate earnings growth and dividends during the second period, the annual return on stocks doubled. Why? Because the price/earnings ratio, which had tumbled from 22 times in 1961 to 8 times in 1981, had returned to 20 times in April 2001 (after reaching an astonishing 32 times at the market high last March). The point is that the economics of market returns—the earnings and dividends of America’s corporations over two centuries—are almost always both predictable and productive. The emotions of market returns, on the other hand—the change in the price that investors are willing to pay for each dollar of earnings—are unpredictable, at times remarkably productive; at other times, remarkably counterproductive. This dramatic example of the two forces that determine stock returns—investment and speculation—helps us look ahead and consider what returns we might expect over the coming decade.

We begin with a dividend yield that is only 1%, a fraction of the historical norm of 4%. That, to put it bluntly, is not a lot of gas in the market’s tank. But if we assume that corporate earnings growth will continue at its 7% annual rate of the past 40 years, stocks would enjoy a total investment return of 8% annually during the coming decade. 0.1 Investment Returns and Market Returns Two Contrasting 20-year Periods Investment Return 12.1% Market Return 7.5% 0.1 1961 - 1981 1981 - 2001 1961 1981 1981 2001 Investment Return 10.3% Market Return 15.2%

Truth told, I look with some bemusement about how far one can take an enterprise with common sense, a few simple ideas, a heavy dose of idealism, a focus on serving human beings, a fantastic crew, and a determination to press on regardless. It’s been a thrill to see a company that offers little more than simple investment philosophy and simple human values become a commercial success, but even more, an artistic $1 $10 $100 $1,000 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Vanguard Assets, 1974 - 2001 (millions) Annual Growth Rate: 24.9% Year-end Assets 25% Trendline $1.4 b $565 b 4.2% 7.9% 8.3% 6.1% 1.2001

Still assuming an investment return of 8%, we’d require a speculative return of 7%, which would require a final p/e ratio of nearly 40 times. Wow! I simply don’t believe that number is in the cards. In any event, the point is that when you consider most market forecasts, realize that they are largely guesses, not about earnings and dividends, but about market sentiment—in other words, about investor confidence. In that sense, simply predicting, in the abstract, the future level of the stock market is one giant confidence game. (I didn’t say con game, but I could have.) And who among us can do that with any claim to prescience? Market Returns in the Coming Decade? (April 2001 - April 2011) Negative- P/E 16x Positive- P/E 24x Dividend Yield 1% 1% Earnings Growth 7 7 Investment Return 8% 8% Speculative Return* -2 +2 Market Return 6% 10% Neutral- P/E 20x 1% 8% 8% Wow!ratio

7%, and 13%, respectively.) But today money market instruments yield about 2½%—not 6%— and bonds less than 6%—not 9%—so the handwriting is on the wall. In stocks, of course, the handwriting on the wall is harder to read, but the math is less than mysterious. Stocks are likely to provide earnings growth that will parallel the growth of our economy, most likely—but never certainly—6% in nominal terms. Add to that figure the current dividend yield—a measly 1½%—and the future investment return on stocks would average 7½% per year. Speculative return—whether investors will pay more or less for $1 of earnings (i.e., the price-earnings ratio)—may increase or reduce that total. But with stocks selling at a (normalized) 22 times earnings today, I believe the P/E is more likely to go down than up. A drop to 18 to 20 times, for example, would reduce the investment return over the next decade by one or two percentage points, taking the market return to 6½% or even 5½%. (If the P/E rises—unlikely in my view—the return could be 8½% or 9½%). If that tentative range seems wrong to you, you can use my simple methodology to calculate future stock returns for yourself. Just insert your own idea of earnings growth, and of the P/E ratio in 2011. But don’t get carried away! And always hold some stocks, for no one, least of all I, can predict future returns with accuracy. And now to the don’ts. First, don’t use those mathematics to predict the future of technology stocks.

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

stock is not about concepts; not revenue growth, nor price-to-sales, nor site visits, nor eyeballs, nor the growth rate in the exciting early years of a new venture. Whether we’re talking about the New Economy or the Old Economy, the market value of a stock is about money—tomorrow’s earnings capitalized in today’s dollars. Second, don’t make an excessive commitment to any individual stock (especially employer stock) or to technology stocks as a group. If the past year and a half haven’t taught you that lesson, then you either aren’t paying attention, or you are truly brilliant (or lucky!) Technology is a competitive business, changing at exponential speed, and rapid future growth is hardly assured for any company. You should be aware that the technology sector of the market has provided a steady 12% to 16% of the market’s earnings during recent years, meaning that earnings growth has been no more than average. But the tech sector began the decade at 8% of the market’s value, rose to 35% (!) at the market high in March 2000, before tumbling to 15% currently, a figure more in keeping with its earning potential. Even though that relationship looks a lot more like fair value, the tech share of earnings this year is crumbling and its earnings visibility is close to zero. That means very high risk, as well as high return potential. That stock index fund I recommended to you earlier, obviously, also has 15% in technology stocks today.

The S&P 500 Index Fund earned an annual return of 12% per year, a 51-times increase; the annual return of the average large-cap blend fund was 10% per year, an increase of “only” 30 times. But investors in mutual funds looked at their wonderful absolute returns, and disregarded (or were not even aware of) their terrible relative returns. Indeed, they likely applauded their money managers. There is little, if any, chance that 12% annual return on stocks during the era that we have witnessed (or at least heard about) is going to recur during the coming decade. Why? Because as John Maynard Keynes warned us long 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.” So let’s look to the sources of stock returns to create rational expectations for the coming decade. What were those sources of that 12% annual return of the S&P 500 on stocks since 1982? A 3.3% dividend yield and 5.4% annual earnings growth, for an Investment Return of 8.7%.that

rose from 7.8 times to 26.5 times (Wow!), an annual Speculative Return of 3.4%. Total Return on stocks 12.1%. (Chart 3) That was yesterday. Tomorrow is a different matter. Today, the dividend yield is 2.0%. Guessing at earnings growth, I use a lower figure, 4.0%. Investment return, 6.0%. Were the P/E declined to 19 times (just a guess, but a reasonable one), the annual speculative return would be -2%. Total stock market return 4%.1 Investment Costs Become Even More Important It must be obvious that if future returns on stocks fall well below the extraordinary returns of the Great Bull Market, fund expenses will take an even larger chunk out of returns. In that 12% stock market era, 2% expenses consumed “only” one-sixth of the annual return, although the net cumulative return would have dropped from 5180% to 2710%. In a 4% annual stock market, 2% expenses would consume fully one-half of the annual return, reducing the cumulative return from 295% to 100%. As expenses take on such a dominant role in shaping returns, the index fund cost advantage will become even more obvious. Individual investors who look to the past to tell them about the future are foolish at best. They are courting disappointment, and, given the likelihood of lower returns on stocks, will likely be ill-served if they haven’t revised upwards the amounts they are saving each month. (If returns are higher than I suspect, they’ll simply have built a larger nest-egg.) 1 Feel free to disagree.

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.

management company was the party that should manage the shareholders’ money in the future . . . sadly, “boardroom atmosphere” almost invariably sedates their fiduciary genes.” My own concern about this issue goes back even further than Mr. Buffett’s. In 1971, as CEO of Wellington Management Company, then a publicly-held manager, I addressed our executives with these words: “It is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization.” That proposition has been proven over and over again. The necessary resolution of this issue would be to roll back conglomerate ownership, came to grips with the public shareholder issue, and at last make it clear that the interests of mutual fund investors must come first. It will not be an easy battle. IX. What Would a Fiduciary Strategy Mean? So yes, the fiduciary duty of fund directors and fund managers must take precedence over the business strategy of fund managers. The Investment Company Act of 1940 clearly demands this fiduciary strategy. Section 1 declares that is in “the national public interest and the interest of investors,” in the words of the SEC, that “funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers, underwriters, or others.” This industry has largely ignored that fundamental principle.

5/4/2015 The Mutual Fund Industry Today: “Conflicts, Conflicts Everywhere”* John C. Bogle United States Securities And Exchange Commission Asset Management Unit April 28, 2015 *Title of a speech by Julie Riewe, Co-Chief of Asset Management Unit, Division of Enforcement NOTE: The views I express in this speech and the visuals that follow are my own and do not necessarily reflect the views of Vanguard’s present management. 2. 740B 1,000 10,000 1951 1960 1970 1980 1990 2000 2015 Equity Bond Money Market Balanced $ A Tiny Industry Grows into a Behemoth TOTAL ASSETS March 2015 $9.9T 3.7T 2.5T $16.9T TOTAL TOTAL ASSETS December 1951 Equity $2.45B Balanced 680M TOTAL $3.13B Annual Growth Rate 1951-2015: 15% 3. Mutual Fund Industry Leaders: Then and Now Rank 1951 Fund Name Total Assets* (Millions) 2015 Manage r Name Total Assets (Billions) 1 M.I.T. $472 Vanguard $2,988 2 Inve stors Mutual 365 Fide lity 1,615 3 Keystone Funds 213 BlackRock 1,230 4 Tri-Continental 209 American Funds 1,216 5 Affiliate d Funds 209 JPMorgan Funds 519 6 Wellington Fund 194 State Stree t 497 7 Dividend Shares 186 T Rowe Price 493 8 Fundamental Investors 179 Franklin Templeton 480 9 State Street Investment 106 PIMCO 375 10 Boston Fund 106 Fede rated 272 Total $2,239 Total $9,686 Percentage of Industry 72% Percentage of Industry 57% Total industry assets: $3.1 billion. Total industry assets: $16.9 trillion *Includes associated funds. 4.

1,000 10,000 100,000 Cumulative Investment Return Cumulative Speculative Return Cumulative Total Returns Investment and Speculative Returns, 1900-2015 $ Value of Initial $1 9.2% Annual Real Return 0.4% Initial Dividend Yield + 10-Year Earnings Growth Annualized Impact of P/E Change From JPM Fall 2015 17 DON’T FORGET REVERSION TO THE MEAN (RTM) . . .

5/4/2015 37. Costs and Indexing— More Important than Ever -3% 4.5% 5% 4.5% 2% -4% -2% 0% 2% 4% 6% 8% 10% Historical Next 10 Years Dividend Yield Earnings Growth Speculative Return ? Gross Return 9% Gross Return 4% Historical Returns 9% -1 8% Active 4% -2 2% Index 4% -0.05 3.95% Prospective Gross Return Costs Net Return 38. What’s a Competitor to Vanguard to Do? What’s a race car driver to do when he’s in last position? • Increase speed—i.e., improve performance, more aggressive marketing, more money to distributors (a la life insurance) • Reduce friction—i.e., cut fees, cut staff, cut research • Copy the car in front—i.e., more indexing, less innovation • Get a new car—i.e., focus on other lines of business, recordkeeping, benefit plans, venture capital, limousine services, etc. 39. The “Golden Rule” of the ‘40 Act Put the Shareholder First! “… the national public interest and the interest of investors are adversely affected … when investment companies are organized, operated [and] managed … in the interest of directors, officers, investment advisers … [or] underwriters … rather than in the interest of … such companies’ security holders …” Investment Company Act of 1940, Section 1.B.2. 40.

” *In 1982, the private owners of State Street Management sold their company to the (ironically then-mutual) Metropolitan Life Insurance for a profit of $100 million. 43. Ownership of 50 Largest Mutual Fund Management Companies—2015 Privately Owned (10) Plus Mutual (1) Publicly Owned Conglomerate Total Firms with Public Ownership: 39 (Includes 3 largest firms) 44. Public Ownership and Professional Organizations From my 1971 speech to the partners of Wellington Management Company: I reveal an ancient prejudice of mine: All things considered ... it is undesirable for professional enterprises to have public stockholders ... The pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Note: Wellington, now private, was then publicly-owned.

4.7% 5% 4% 2% 0.4% -1% -2% 0% 2% 4% 6% 8% 10% Historical Next 10 Years Earnings Growth* Dividend Yield Speculative Return* Looking Ahead 1.—No Great Alternatives Reasonable Expectations for Stocks—Below Long-Term Norms 9.1% 6% Historical Returns 9% -2 7% Active 6% -2 4% Index 6% -0.05 5.95% Prospective Gross Return Costs Net Return *Assumed decline in P/E from 20x to 17x Sources of Annual Returns on Stocks WHAT ABOUT BONDS? . . .

Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Honestly, I could hardly say it better today. In his foreword to the first edition of my book Common Sense on Mutual Funds (1999), now 15 years ago, legendary financial economist Peter L. Bernstein shared my concern: 1 When I was running Vanguard, I banned the use of the word “product.” In my view, it is businesses such as toothpaste, beer, and cars that are in business to sell their products. 2 Wellington Management had itself “gone public” in 1960.

capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” First Principles So let me sum up my first point: Eroded by the dominance of short-term speculation, our Investment Standards are deteriorating. Part of the reason is that investors focus far too much attention on the momentary rises and falls of the stock market, which are in so many respects just noise—in Shakespearian terms, “a tale told by an idiot, full of sound and fury, signifying nothing.” The stock market is in fact a derivative, a collection of the current market prices of some 3,500 publicly-held corporations. Those stock prices derive their value from the dividend yields and earnings growth that these corporations collectively generate. Intrinsic value (investment return) is one phrase we use to describe this phenomenon. Intrinsic value is reflected in the real market—essentially, what U.S. businesses actually accomplish. Real companies, with real strategies, managed and operated by real people, producing real products and real services ever more efficiently, with real returns earned for real owners, and real dividends distributed to those owners. The intrinsic value reflected in the real market is the expected future cash flows generated by all of those corporations, discounted over time. For any individual corporation, those future flows are uncertain. But the cash flows for all corporations in aggregate generally track the growth of our U.S.

averaged 9%—4 ½% from dividend yields, and 4 ½ % from earnings growth.2 Speculative return, over the long term, has accounted for zero—nothing. That’s why I describe the stock market as “a giant distraction from the business of investing.” Ethical Values The great Bull Market of the 1980s and 1990s led to a focus on stock prices over intrinsic values. Paraphrasing Oscar Wilde’s definition of the cynic, the “security analyst became one who knows the price of everything, but the value of nothing.” We reveled in our greed when markets were good. We suffered in our fear when they were bad. And during the two 50% Bear Market declines we’ve experienced since 1980, we relied on the hope that things would get better. (They did!) During two consecutive decades of strong returns for stocks, Wall Street was all too likely to overreach, and investors seem to accept with equanimity the idea that the costs of all those croupiers didn’t matter much. After 20 years of earning above-average returns of, say, 9% each year, most investors wouldn’t pay much attention to the fact that the market itself earned 11% per year. During the rising stock market, it shouldn’t be surprising that the field of finance has flourished.

speculation. (3) The rise of “product proliferation” with thousands of new funds formed each year, embracing aggressive share distribution as integral to the manager’s interest in gathering assets and increasing fee revenues. (4) The conglomeratization of the mutual fund industry, a change that served the monetary interests of mutual fund managers and a disservice to the interests of mutual fund shareholders, and finally, (5) the triumph of the index fund, which did precisely the opposite; shareholders first, managers second. Let’s take a look at each of these changes. 1. The Stunning Growth of Mutual Fund Assets When I joined the industry in 1951, fund assets totaled just $3 billion7. Today, assets total $13 trillion, a remarkable 15 percent annual growth rate. When a small industry—dare I say a cottage industry?—becomes something like a behemoth, almost everything changes. “Big business,” as hard experience teaches us, represents not just a difference in degree from small business—simply more numbers to the left of the decimal point—but a difference in kind: More process, less human judgment. For the first half-century of industry history, equity funds were our backbone. Equity fund assets topped $56 billion in 1972, and then, after a great bear market, tumbled to $31 billion in 1974. Recovering with the long bull market that followed, equity assets soared to $4 trillion.

But that high return came at the expense of the return on the capital entrusted to them by the mutual fund investors that they were duty bound to serve. The dimension of that change has been extraordinary. Exhibit 10. Among today’s 50 largest mutual fund complexes, only nine remain private. 40 are publicly held, including 30 owned by financial conglomerates. The only different ownership model is the single mutual mutual fund structure—Vanguard’s— in which the fund management company is owned by the fund shareholders. All of the public fund management companies have external owners, and obviously face a potential conflict of interest. As I spoke to Wellington’s officers in 1971 (when our firm had public shareholders): I reveal an ancient prejudice of mine: All things considered . . . it is undesirable for professional enterprises to have public stockholders . . . The pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization.

12. To make matters worse, during the index fund’s early years it appeared to lag the returns of the average fund manager (largely because of flaws in the data). The fund attracted few additional assets. Even with the acquisition of a $40 million actively-managed Vanguard fund, First Index didn’t cross the $100 million mark until 1982.12 Indeed, it wasn’t until 1984 that a second index mutual fund joined the industry. By 1990, total assets of, by then, five index funds reached $4.5 billion, only about 2 percent of equity fund assets. Exhibit 13. The experiment in indexing was stumbling. Growth in Assets of Equity Funds— Active vs. Index 13. 1,000 10,000 100,000 1,000,000 10,000,000 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Active Index $39 billion $14 million $1.9 trillion $167 billion $590 million $1.5 trillion $84 billion $4.8 trillion $900 billion $ millions $5.1 trillion Annual Growth Rate Active Funds: 14.4% Index Funds: 38.4% Net Cash Flow, 2008-April 2013 Active Funds: -$386 billion Index Funds: +$667 billion 12 In 1980, the Trust’s name was changed to Vanguard 500 Index Fund.

Past returns tell us absolutely nothing about the return that a Treasury note purchased at the end of any period would earn during the subsequent decade. For example, the returns on the 10-year Treasury note. During 1926-1981, its return averaged 3.8 percent. But with the entry yield in 1981 at 13.7 percent (!), the return over the 1981-1991 decade turned out to be 13.1 percent. So both our arithmetic and our logic confirm that the current yield of a bond has been—and should almost certainly continue to be—a highly reliable guide to its future return. (The correlation between year-end yield and subsequent ten-year return for Vanguard Total Bond Market Index Fund is a still impressive 0.80.) Stock Returns The methodology for stock returns is similar but more complex. Keynes focused on the two broad sources that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.”3 The second was speculation—“forecasting the psychology of the market.” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that. What Keynes had described as “enterprise,” I defined as investment return—the initial dividend yield on stocks plus the subsequent annual rate of earnings growth.

What Keynes termed “speculation,” I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings). Simply adding speculative return to—or subtracting it from—investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 3 Keynes, John Maynard. The General Theory of Employment, Interest, and Money, 1936.

percent.4 If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple metric of separating enterprise and speculation (i.e., investment return and speculative return) has been borne out in practice. Indeed I have the temerity to suggest that Lord Keynes would respect this mathematical extension of his concept. Decade after decade over the past century-plus, we can account, with remarkable precision, for the total returns actually earned by U.S. stocks. The investment return on stocks proves to be remarkably susceptible to reasonable expectations. The initial dividend yield (RED)—which remains a crucial but underrated factor in shaping stock returns—is a known factor. The steady contribution of dividend yields to investment return during each decade has always been a positive, only once outside the range of 3 percent to 5 percent. (That horrific 1.2 percent yield in 1999 augured ill for future stock returns!) Earnings growth (BLUE), while hardly certain, has proved to be relatively stable. With the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year.

(ORANGE) The point is this: Over the very long run, it is the durable economics of investing—enterprise—that has determined total return; the evanescent emotions of investing— speculation—so important over the short run, has ultimately proven to be virtually meaningless. In the eleven decades shown in the chart, for example, the 9.1 percent average total annual return on U.S. stocks has been dominated by those 8.8 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.3 percent), and only 0.3 percentage points of speculative return, borne of an inevitably period-dependent increase in the price- earnings ratio from 12.5 times to 22 times, amortized over the decades.college

and university endowment managers 15 years ago. First, times have changed, so relying on past returns in the bond and stock markets to be prologue would, as always, be unwise to a fault. This time is different, but not in a positive way. This difference is most obvious in the case of bonds. On June 30, 1996, the yield on the U.S. bond market index was 7 percent; today it is only about one-third of that level—2.3 percent. (RIGHT) Yes, that index is heavily weighted (70 percent) by those now-extremely-low-yielding U.S. Treasurys and mortgage-backed obligations, with but a 30 percent allocation to corporate and other investment grade bonds, the total portfolio provides a short-to-intermediate-term duration (5 years). But a portfolio that is more heavily weighted with longer-dated investment-grade corporates could produce a yield of something in the 3 ½ percent range, suggesting a return of about that level in the coming decade. The stock arithmetic is also sobering. (LEFT) First, investment return: the yield on common stocks today is 2.3 percent, about the same as in 1996. Corporate earnings grew at a 6 percent rate during the previous 15 years (about the same, as we might have expected, as the 5.5 percent growth in nominal GDP); perhaps 6 percent is a reasonable, if perhaps a tad optimistic, expectation for earnings growth in the coming decade (barring Armageddon!)

Adding to that earnings growth the current yield of a bit more than 2 percent would provide a total investment return in the 8 percent range for stocks. Speculative return is tougher to ascertain, depending (as it does) on investor psychology and future expectations. But with stocks now at 20 times earnings, they currently appear more expensive than the long-term norm of 17 times, (using the Schiller 10-year average P/E ratio in both cases).is

Speaking at the annual meeting of my Wellington partners, I began my remarks with a 1934 quotation from Justice Harlan Fiske Stone: “Most of the mistakes and major faults of the financial era that has just drawn to a close will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . Those who serve nominally as trustees but consider only last the interests of those who funds they command suggest how far we have ignored the necessary implications of that principle.” I endorsed that point of view. Then I revealed “an ancient prejudice of mine: All things considered, it is undesirable for professional enterprises to have public shareholders. Indeed it is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Although the field of money management has elements of both a business and a profession, any conflicts between the two must, finally, be reconciled in favor of the client.” It is a matter of fiduciary principle. I then explored some ideas about how such a reconciliation might be achieved, including, “a mutualization, whereby the funds acquire the management company . . .with

Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to a predominantly financial economy. But our financial economy, by definition, subtracts from the value created by our productive businesses. Think about it: while the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market before those costs is a zero-sum game. But after intermediation costs are deducted, beating the market—for all of us as a group—becomes a loser’s game. Yes, the more that our financial system takes, the less our investors make. Yet the financial field is where the money is made in modern-day America, the breeding ground for the wealthiest of our citizens. (If you made less than $140 million dollars last year, you didn’t make enough to rank among the 25 highest-paid hedge fund managers.)

that something called "the mutual fund industry" existed. When I saw the industry described in the article as "tiny but contentious," I knew immediately that I had found the topic for my senior thesis, then as now, a requirement for the Bachelor of Arts degree at Princeton. Over the 15 months that followed, I spent countless hours researching the industry and writing my thesis. Then, remarkably little public information was available about this field, which consisted of only some 130 mutual funds with assets aggregating just $2½ billion. Harvard strategy guru Michael Porter advises students considering their future careers to "pick a good industry," and, as luck would have it, I did exactly that when I chose my thesis topic. With an annual growth rate of almost 16 percent since then, the fund industry may well have enjoyed the fastest growth rate of any business in America. Today, there are more than 8,000 funds, with total assets that exceed $10 trillion. Read today, my thesis would probably impress you as no more than workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. On page after page, my youthful idealism speaks out, calling again and again for the primacy of the interests of the mutual fund shareholder. At the very opening of my thesis, I get right to the point: Mutual funds must not "in any way subordinate the interests of their shareholders to other economic roles. Their prime responsibility must always be to their shareholders."

In fact, the dividend yield on stocks has accounted for almost one-half of their total long-term return. Of the 9.6 percent nominal total return earned by stocks over the past century, fully 9½ percent has been contributed by investment return—4 ½ percent by dividend yields and 5 percent from earnings growth. (The remaining 0.1 percent resulted from an 80 percent increase in the price-earnings ratio, from 10 at the start of the century to 18 at the end, amortized over the long period. I describe changes in the P-E ratio as speculative return.) When we take inflation into account, the importance of dividend income is magnified even further. (Chart 1) During the past century, the average rate of inflation was 3.3 percent per year reducing the nominal 5 percent earnings growth rate to a real growth rate of just 1.7 percent.2 Thus, the inflation-adjusted return on stocks was not 9.6 percent, but 6.3 percent. In real terms, then, dividend income has accounted for almost 75 percent of the annual investment return on stocks. 2 Some analysts believe that the real earnings rate is even less, about 1 percent per year. “Earnings Growth: The Two Percent Dilution,” William J. Bernstein and Robert D. Arnott, Financial Analysts Journal, September/October 2003.

*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.

Putting Numbers on Keynes’s Distinction By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings. (Essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings.) Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 percent.5 If the price-earnings ratio rises from fifteen times to twenty times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple numeric approach of separating enterprise and speculation—i.e.

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

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

Investment Return: Dividends and Earnings Growth -5 0.8 -3.4 3.3 0.3 -6.3 9.3 -1.0 -7.5 7.7 7.2 0.1 -10 -5 2.9 14.8 -0.8 8.6 20.1 7.6 5.9 17.3 17.8 9.6 9.0 -10 -5 20th Century Stock Returns - by the Decade (%/year) Market Return (S&P 500) 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s Speculative Return: Impact of P/E Change 8.2 6.3 11.5 -1.1 14.9 10.8 8.6 13.4 9.6 10.6 4.7 3.5 4.3 5.9 4.5 5.0 6.9 3.1 3.5 5.2 3.2 2.0 5.6 -5.6 9.9 3.9 5.5 9.9 4.4 7.4 4.5 5.0 9.5 1900 – 2006 5. The investment return on stocks (top line) proves to be remarkably susceptible to reasonable expectations. The initial dividend yield—a crucial—but underrated—factor in shaping stock returns—is a known factor. And the steady contribution of dividend yields to investment return during each decade has always been a positive, only once outside the range of 3 percent to 5 percent. The secular rate of earnings growth on the other hand, while hardly certain, is relatively stable. There were no long-term Black Swans in investment returns, and even the sharp earnings drop in the Great Depression was but a 2-Sigma event (meaning within the 95 percent probability range). Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year. Total investment returns were only once (again, the 1930s) less than 6 percent annually, and only twice more than 11 percent.

But if we recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the U.S. Gross Domestic Product, this relative consistency is hardly surprising. Speculative return is, well, speculative, and has alternated from positive to negative over the decade. But over the long-run speculation hasn’t produced any Black Swans either. In fact, if P/E ratios are historically low (say, below 10 times) they have been likely to rise over the subsequent decade. And if they are historically high (say, above 20 times) they have been likely to decline (though in neither case do we know when the change is coming). Nonetheless, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has been a sensible and effective approach to projecting the total return on stocks over the decades. The point is this: Over the very long run, it is the economics if investing—enterprise—that has determined total return; the evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, the 9.6 percent average annual return on U.S. stocks has been composed of 9.5 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 5 percent), and only 0.

That we’ll somehow “muddle through” challenges like these—now on a global scale in our “the earth is flat” modern world— seems to be the prevailing expectation of our money managers. While risk abounds, however, stocks are selling at valuations that are in fact somewhat higher than long-term norms, implying optimism on the part of investors. Over the past century, stocks have sold at about 14 times corporate earnings; today they’re selling at about 18 times, reflecting a more confident outlook about what lies ahead. What’s more, as we’ll soon see, stocks currently offer a risk premium over bonds that is extremely low by historical standards. And as former Federal Reserve chairman Alan Greenspan has said, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” But whatever may come to pass in the world, in America, and in our robust economy, please don’t forget this unfailing principle: in the long run it is the reality of business—the investment return on stocks, consisting of the dividend yields and earnings growth generated by our corporations—that drives the returns generated by the stock market itself. Over the past century-plus, for example, the nominal investment return earned by stocks was 9.5 percent, consisting of an average dividend yield of 4.5 percent and average annual earnings growth of 5.0 percent. (Chart 1) Speculative return, which added a mere 0.on

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

Total Returns on Bonds * , Past and Future 11.9% 4.6% 6.3% 7.8% 10.4% 4.6% 6.1% 7.2% 0% 2% 4% 6% 8% 10% 12% 14% 1980s 1990s 2000 - 06 Next 10 Years 2. Initial yield Return over following period *Intermediate-term U.S. Government Bonds. Est. loss of 2.5 percentage points per year in the contribution that dividend income makes to investment return. Next, let’s assume that corporate earnings will continue to grow (as, over time, they usually have) at about the pace of our economy’s nominal growth rate, say 6 percent per year over the coming decade. (That may be a bit optimistic.) If these assumptions are correct, then the most likely investment return on stocks would be in the range of 8 percent. Now let’s consider speculative return in the coming decade. The present price/earnings multiple on stocks now looks to be about 18 times. If the P/E ratio remains at the present level a decade hence, speculative return would neither add to nor detract from that possible 8 percent investment return. My guess (it is little more than that) is that the P/E might ease down to about 16 times, reducing the market’s return by about 1 percentage point a year to an annual rate of 7 percent. (You don’t have to agree with me. If you think the P/E will leap to 25 times, add 3 percentage points to the investment return of 8 percent, bringing the total return on stocks to 11 percent.

0% 5% 10% 15% 20% 25% 30% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Financial Sector’s Share of S&P 500 Earnings, 1980 – 2007 7. Source: Standard & Poor’s Corporation Was Minsky right? Has a new element of uncertainty been introduced into our economy? I’m inclined to agree. Indeed, I express the secular changes in the economy in a way quite similar to Minsky. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and to what is now predominantly a financial economy, and a global one at that. But the costs that we incur in our financial economy, by definition, subtract from the value created by our productive businesses. Think about it. When investors—individual and institutional alike—engage in far more trading— inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. While the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market—for all of us as a group—is a zero-sum game before those costs are deducted. After intermediation costs are deducted, beating the market becomes, by definition, a loser’s game.

Charles Prince, chairman of the giant Citigroup, said it as well as any friend—or foe—of the situation could have: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Epilogue: just last week, Citigroup slashed the value of its mortgage-backed portfolio by more than $3 billion. Not to be outdone, Merrill Lynch followed suit with a $5 billion writedown; UBS wrote down $3.4 billion, and Deutsche Bank has written down a mere $3.1 billion. Following a long age of rife credit availability, and borrowers with high confidence and low collateral, then, we are beginning to pay the price, even as we face a whole plethora of other risks created by our financial system. Stay tuned. Looking Ahead But if systemic risks are increasing, how can it be that risk premiums on stocks are at less than one-half the historic average? Today’s projected equity premium, for one example, is just 2 percent, some 60 percent below the century-long average of 5.2 percent. (Chart 13) Bonds, based on the current yield on investment-grade issues, should return about 5 percent over this period. The stock return over the coming decade is projected at 7 percent, based on today’s dividend yield of about 2 percent and prospective nominal earnings growth of about 6 percent, with a shading for the slightly lower price- earning ratio that I expect a decade hence. And while the spread of high-yield bonds relative to U.S.

Investing in Times of Market Turbulence Remarks by John C. Bogle Founder and former chief executive, The Vanguard Group The Millennium Lecture Series The Princeton Club of New York New York, NY January 28, 2008 These are turbulent days in the financial markets, and market participants are looking for answers about what they should do. But my answers depend on just who it is that is asking the questions. This distinction is as unique as it is self-evident. If the questioner is a speculator, buying and selling stocks with the focus on their momentary prices, inevitably acting on emotions, and guessing (usually fruitlessly) about how other investors here in the U.S. and around the globe will respond to unpredictable volatility in the world’s stock markets, I’m not sure I have the credentials to advise him. But if I did, I’d say— as I’ve been saying since early August when the U.S. market reached its high—“Get out. And stay out.” At least until the markets settle down a bit. (Of course, I have no ideas when that might be.) If, on the other hand, the questioner is an investor, holding a highly-diversified balanced portfolio that includes bonds and both U.S. and global stocks, with the equities focused on the economics of investing—the dividend yields and potential earnings growth of our corporations— not the emotions reflected in the actions of speculators, I’d say, as I also did last summer: “Don’t do something, just stand there.” Or, perhaps more graciously, “Stay the Course.

1. A Parable The first of the two relentless rules of humble arithmetic I’ll mention is a simple one: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return that we investors share. To understand that is how our financial system really works. Consider my version of this parable told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 annual report. It clarifies the foolishness and counterproductivity of our vast and complex financial market system. Here goes: Once upon a time . . . a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game. But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members, and to buy some shares of others from them in return.

thesis topic I certainly did just that. With an annual growth rate of almost 16 percent since then, the fund industry just may have been the fastest growing business in America. Today, there are 9,000 funds, with total assets that approach $12 trillion! Read today, my thesis would probably impress you as no more than workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. And you can read it, for six years ago it was published by McGraw-Hill as part of John Bogle on Investing: the First 50 Years. (If you wait a half-century, perhaps anything can be published!) On page after page of the thesis, my youthful idealism speaks out, calling again and again for the primacy of the interests of the mutual fund shareholder. At the very opening of my thesis, I get right to the point: Mutual funds must not “in any way subordinate the interests of their shareholders to other economic roles. Their prime responsibility must always be to their shareholders.” (Important advice that the industry seems to have ignored; witness the disgusting market-timing scandals uncovered by New York Attorney General Eliot Spitzer four years ago.) Shortly thereafter, “there is some indication that costs are too high,” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” (My advice fell upon deaf ears there as well!)

$1 $10 $100 $1,000 $10,000 $100,000 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 Investment Return 9.5 % (earnings growth plus yield) Annual Growth Rate Investment Return Growth of $1 from 1900 1. accretion of dividend yields and earnings growth—resembles a gently upward-slopping line with, at least during the past 75 years, precious few significant aberrations. (Chart 1) Speculation is just the opposite. It represents the short-term—not long-term—holding of financial instruments—not business—focused (usually) on the belief that their prices—as distinct from their intrinsic values—will rise; indeed, the expectation that the prices of the stocks that are selected will rise more than other stocks, as the expectations of other investors come to match one’s own. The line that we draw representing the path of stock prices over the same period is significantly more jagged and spasmodic than the line showing investment returns. (Chart 2) In the short run, speculative returns are only tenuously linked with investment returns. But in the long-run, both returns must be—and will be—identical. Don’t take my word for it. Listen to Warren Buffett: “the most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns.” Illustrating the point with Berkshire Hathaway, the publicly-owned

For investing is all about buying businesses—real operating companies, making real goods and providing real services for real consumers who use the goods and services in their daily lives; real companies that are operated by real managers and staffed by real workers, with real strategies; earning real net income and plowing some of it back into real capital goods and distributing what remains to the owners in the form of, yes, real dividends. Let’s call this the real capitalism. In the long run, it is the returns earned by businesses that create value for investors. For example, over the past 100-years, the return on stocks has averaged 9 ½ percent per year—4 ½ percent from dividend yields and 5 percent from earnings growth. Speculation can—and does!—raise or lower this total investment return during interim periods. For example, the price that investors paid for each dollar of earnings on stocks in 1980 soared from $8 (a p/e ratio of 8 times) and to $32 (32 times earnings) in early 2000—adding, on average, an amazing total of some 7 percentage points per year to investment return in the greatest bull market of all time.

on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about nearly a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard but in my Battle book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in our financial system. 2. A Parable So what’s gone wrong? Let’s begin with a parable that describes how the system really works. It’s my version of a story told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 annual report, and it clarifies the foolishness and counterproductivity of our vast and complex financial market system. Here goes: Once upon a time . . . a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game.

as in ours, it is hard to see what unique contribution public investors being to the enterprise. They do not, as a rule, add capital; they do not add expertise; they do not contribute to the well-being of our clients. Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Although the field of money management has elements of both, differences between a business and a profession must, finally, be reconciled in favor of the client. . . . If it is a burden to our fund and counsel clients to be served by a public enterprise [which Wellington Management Company then was], should this burden exist in perpetuity? And if we believe that it is in the interest of our fund and counsel clients that our firm should be owned by its active executives and not by the public, shouldn’t we work to solve this problem in a way that is equitable to all? What a great objective to be accomplished by 1976!” Mutualization? I then turned to the options available for a publicly-held fund manager which sought to free itself of those burdens: “I wish there were a simple way to accomplish what I am talking about, let alone to describe it. But, let me say that a variety of options may open up as the legal atmosphere clears. For example, there may be ‘mutualization’ whereby the funds acquire the management company.

what has gone wrong in our nation’s corporate, financial, and mutual fund sectors, while The Little Book offers common sense advice on how to invest intelligently for the long term. (Hint: It recommends index funds as the core investment in individual & institutional portfolios.) Investment and Speculation Now, before I turn to the recent turbulence in the markets that I’m sure is on many of your minds this evening, I want to focus on the fundamental distinction between investment and speculation that I first touched on in that ancient thesis. Echoing the inspired wisdom of Lord Keynes, I defined investment as “forecasting the prospective yield on an asset” over its entire life. (Keynes used the term enterprise to describe this practice; today finance teachers describe it as discounted future cash flow.) Speculation, on the other hand, is “the activity of forecasting the psychology of the market.” When I speak of investment return, I speak of the current dividend yield on stocks plus their subsequent rate of earnings growth, together representing the real return on corporate capital. When I speak of speculative return, I speak of the impact of the change in the number of dollars that investors are willing to pay for each dollar of corporate earnings. Simply add the two together and, viola!

But in the very long run, speculative returns account for nothing—zero. Speculation simply reflects the optimism or pessimism—the hopes and fears—of the mass of investors, reflected in the “expectations market” rather than garnered through the stern arithmetic of the “real market” of investment returns—authentic earnings growth and dividend yields. In this sense, as I wrote in my 2007 book The Little Book of Common Sense Investing, “the stock market is a giant distraction to the business of investing.” Of course it is! But the market is more than a mere distraction. It is an expensive distraction. For it must be obvious that all investors as a group exactly capture the market’s return. If stocks return 8 percent, we earn a gross return of 8 percent. But only before the costs of our investment system are deducted, say about 2 percent per year. After these costs, our net return drops to 6 percent. “Gross return minus cost equals net return.” What else is new? So, those who invest in business—buying and holding a diversified list of stocks that may encompass the entire U.S. stock market (yes, I’m speaking of the index fund)—capture virtually the entire return of the market. Those who speculate on stock prices, on the other hand, lose to the market by the amount of “croupier costs” they incur. (My choice of this gambling term is deliberate; speculating on whether the momentary price of a stock will rise or fall is, simply put, gambling.)

we have the total returns generated in the stock market Here’s the point: Over the very long run, it is the economics of investment—enterprise— that has determined the total return on stocks. The momentary emotions that surround investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. Example: The 9.6 percent average annual return on U.S. stocks during the past century, has been composed of 9.5 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 5 percent), and only one tenth of one percent of speculative return, borne of an inevitably period-dependent increase in the price- earnings ratio. Despite the transient booms and busts of stock market history, for investors who have stayed the course, buying and holding a portfolio across all of American business, has been an extraordinarily successful strategy. What’s more, the investment return on stocks has proven to be remarkably susceptible to reasonable expectations. The dividend yield on the date of investment—a crucial but underrated factor in shaping stock returns—is a known factor.while

record financial wealth was in fact “phantom wealth”—borne not of the cumulative earnings and dividends generated by American business, but of extraordinarily high—indeed, speculative— valuations that were accorded by the marketplace to those fundamental investment returns.1 Whatever the case, sooner or later, valuations will reflect reasonable expectations for dividend yields and earnings growth, and the wealth created by business will determine the future level of stock prices. Put another way, let’s not forget Benjamin Graham’s observation that while in the short run the market is a voting machine, in the long run it is a weighing machine. Put yet another way, “the fundamental things apply as time goes by.” Now a caveat: Corporations generate earnings for the owners of their stocks, pay dividends, and reinvest what’s left in the business. In the aggregate, over the past century, the nominal returns generated by our businesses have grown at an annual rate of about 9 ½ percent per year, including about 4 ½ percent from dividend yields and 5 percent from earnings growth. But these are the gross returns generated by the corporations that dominate our system of competitive capitalism. Investors who hold stocks, either directly or through the collective investment programs provided by mutual funds and defined benefit pension plans, receive their returns only after the cost of acquiring them and then trading them back and forth among one another.

One good example— which is already sowing the seeds of yet another financial crisis that is now emerging—is hyping the assumed future returns earned by pension plans, even as rational expectations for future returns deteriorated. Other examples of financial engineering include post-merger accounting that allows the creation of a veritable “cookie jar” of reserves to be drawn on to create illusory earnings growth later on, even as we learn that some 61 percent of corporate mergers actually destroy shareholder value; failing to include the cost of stock options as a compensation expense (a practice now, happily, prohibited); the concealment of debt by forming special-purpose entities, abused most notably by Enron; and the unwillingness of financial institutions to “mark-to-market” the toxic mortgage-backed bonds that have destroyed their balance sheets. Banks, of course, hate the idea; let’s call their preference “mark to management.” Under GAAP, these practices are all, well, legal. Surely it can be said, then, that the problem in such creative financial engineering isn’t what’s illegal. It’s what’s legal.managers—when

Loose accounting standards made it possible to create, often out of thin air, what passes for earnings, even under GAAP standards. My favorites, as it were, include hyping the assumed future returns earned by the pension plan, even as rational expectations for future returns deteriorated; post-merger accounting that creates a veritable “cookie jar” of reserves to be drawn on to create illusory earnings growth later on, even as we learn that some 61 percent of corporate mergers actually destroy shareholder value; failing to include the cost of stock options as a compensation expense (a practice now, happily, prohibited); and the concealment of debt by forming special-purpose entities, abused most notably by Enron. Under GAAP, these practices are all, well, legal. Surely it can be said, then, that the problem in such creative financial engineering isn’t what’s illegal. It’s what’s legal. (Indeed, even the back-dating of options—the most recent example of the malfeasance of corporate managers— when accounted for properly—is legal.) And so the management consultant’s bromide—“If you can measure it, you can manage it”—became the mantra of the chief executive.

So to realize the winning returns generated by businesses over the long term, the intelligent investor will minimize to the bare bones the costs of our financial system. That’s what common sense tells us, and it’s the truth. 2. Business Reality Trumps Market Expectations That brings us to my second relentless rule of humble arithmetic. Successful investing is not about the stock market, but about owning all of America’s businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s—and, for that matter, our world’s—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital. Dividend yields, plus earnings growth, account for substantially 100 percent of the return on stocks. Put another way, that wonderful parable about the Gotrocks family brings home the central reality of investing: “The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns,” in the words of Warren Buffett.the

Putting Numbers on Keynes’s Distinction By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings. (Essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings.) Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 ½ percent and experience subsequent earnings growth of 4 ½ percent, the investment return would be 9 percent.a

publicly-owned investment company he has run for 40 years, Buffett says, “When the stock temporarily over-performs or under-performs the business, a limited number of shareholders— either sellers or buyers—receive out-sized 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 since the twentieth century began. 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. Perhaps it is 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 period than at the beginning.

quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that by putting numbers on Keynes’s distinction. By the late 1980s, based on my own first-hand experience and my research on the financial markets, I concluded that, consistent with what Keynes had written, the two essential sources of equity returns were: (1) investment (Keynes’ “enterprise”), and (2) speculation (the word Keynes used). I defined Investment Return as the initial dividend yield on stocks plus their subsequent annual rate of earnings growth over a decade. I defined Speculative Return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the rate of return on stocks that is generated by changes in the valuation that investors place on future corporate earnings). Simply adding speculative return to investment return, I concluded, produces the Total Return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and generate subsequent earnings growth of 5 percent, their investment return would be 9 percent. If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated!

decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple numeric approach of separating enterprise and speculation—i.e., investment return and speculative return—has been borne out in practice. Indeed, I have the temerity (again!) to suggest that Lord Keynes would respect this mathematical extension of his concept. Decade after decade over the past century, we can account, with remarkable precision, for the total returns actually earned by U.S. stocks. Investment Return and Speculative Return The investment return on stocks has proven to be remarkably susceptible to reasonable expectations. The initial dividend yield—a crucial (but today underrated) factor in shaping stock returns—is a known factor at the moment one invests. The steady contribution of dividend yields to investment return during each decade over the past century has always been a positive, only once outside the range of 3 percent to 5 percent. (The yield was only 1 percent when the year 2000 began, a red flag that investors should have heeded.) The long-term rate of earnings growth, on the other hand, while hardly as given to precision as the current dividend yield, is relatively stable.

The Commodity Futures Trading Commission allowed the trading and valuation of derivatives to proceed opaquely, without transparency, without demanding the sunlight of full disclosure, and without concern for the ability of the counterparties to meet their financial obligations if their bets went sour. And let’s not forget Congress, which passed responsibility for regulation of the derivatives market to the CFTC almost as an afterthought. Congress allowed—indeed encouraged—risk-taking by our government-sponsored (now essentially government-owned) enterprises—Fannie Mae and Freddie Mac—allowing them to expand far beyond the capacity of their capital, and pushing them to lower their lending standards. Congress also gutted the Glass- Steagall Act of 1933, which had separated traditional banking and investment banking, a separation that for more than 60 years well-served our national interest. Our professional security analysts also have much to answer for, especially in their almost universal failure to recognize the huge credit risks assumed by the new breed of bankers and investment bankers who were far more interested in earnings growth for their institutions than in the sanctity of their balance sheets.AAA

$1 $10 $100 $1,000 $10,000 $100,000 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 Investment Return 9.5 % (earnings growth plus yield) Market Return 9.6 % (includes speculative return*) Annual Growth Rate *Impact of change in price-earnings ratio Investment Return Versus Market Return Growth of $1 from 1900 5. But is this speculation by mutual fund managers and by other market participants healthy for investors? For financial planners? For our financial markets? Of course not. For when we put investment return and speculative return together and look at the past century, we see that the average annual total return on stocks over that long period was 9.6 percent (Chart 5). Of this total, fully 9.5 percent represented investment return, roughly 5 percent from the initial dividend yield and 4.5 percent from earnings growth. (Dare I remind you, however, that these totals do not reflect any deduction for the croupier costs of investing, such as advisory fees and transaction costs? We’ll talk about that later on.) What I call the speculative return—the annualized impact of any increase or decrease of the price-earnings multiple—came to but 0.1 percent, borne of a period-dependent increase in the P/E ratio from 10 to 18. The message is clear: In the long run, stock returns have depended almost entirely on the reality of the relatively predictable investment returns earned by business.

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.

The fact is that (after-tax) corporate earnings have historically grown at about 5 percent (in nominal terms), roughly the same rate as the growth of our economy. Earnings have rarely represented less than 4 percent of our annual Gross Domestic Product, nor more than 8 percent. With the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually composing between 4 percent and 7 percent per year of total stock returns. If we can but recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the GDP, we can understand that the fundamentals of our economy drive long-term stock returns. But in the short-term, it is speculative return that calls the tune. Speculative return is, well, speculative, and has alternated from positive to negative over the decades, as price-earnings multiples are highly volatile. Over history, P/Es have generally ranged from 10 times to about 25 times (although as high as 40 times a decade ago!) When P/E ratios are historically low (say, below 10 times) they have been highly likely to rise over the subsequent decade.have

The moral of the story, then, is that successful investing is about owning all of America’s businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s—and, for that matter, our world’s—corporations. The higher the level of our own activity by investors, the greater the costs of financial intermediation and taxes, the smaller the net returns that our business owners as a group receive. The lower the costs that investors as a group incur, the higher rewards that they reap. So to realize the winning returns generated by businesses over the long term, the intelligent investor will minimize to the bare bones the costs of our financial system. That’s what common sense tells us, and it’s the truth. 3. The Index Fund While on first impression it might seem intimidating to own a share in all of America’s businesses and thereby capture whatever returns our stock market is generous enough to deliver, in fact it is amazingly simple. It is, of course, by investing in an index mutual fund, that fund I mentioned early in these remarks, hinted at in my senior thesis and realized by Vanguard’s creation of the first index fund in 1975.

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

Costs Matter! 10,000 100,000 1,000,000 1 10 20 30 40 50 60 Market Return: 7% Growth Rate Less 2% in Fees: 5% Growth Rate $579,000 $177,000 $ In year 1, costs consume 30% of return After 30 Years: Costs consume 50% of return By year 60, costs consume 69% of return As investors focus on the long term, and recognize the ever more powerful role of costs, there will be an awakening. “Knowledge is power.” Note now the role of costs in the allocation of market returns between investors and service providers. After year one, costs have consumed only 30 percent of the return; at year 10, it grows to 35 percent; after 25 years, to 46 percent; it crosses 50 percent in year 30, rises to 63 percent after 50 years and to 69 percent after 60 years. To borrow a phrase first coined by Justice Brandeis almost 100 years ago—there is simply no denying the Relentless Rules of Humble Arithmetic. How Is The Fund Industry Responding To The Cost Challenge? Yet, as I look around the competitive landscape, I see the apparent denial of this obvious tautology. While I have the greatest personal respect for BlackRock chief Lawrence Fink, his firm’s dominant position in exchange traded funds (ETFs) is threatened—caught on the horns of a nasty dilemma: On the one hand, he has a fiduciary duty to the shareholders of the BlackRock, Inc. to maximize assets under management, to maximize advisory fees, and to maximize profits.

Stock market returns sometimes get well ahead of business fundamentals (as in the late 1920s, the early 1970s, the late 1990s). But it has been only a matter of time until, as if drawn by a magnet, they soon return, although often only after falling well behind for a time (as in the mid- 1940s, the late 1970s, the 2003 market lows). 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. We can measure these emotions by the price/earnings (P/E) ratio, which measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall. When greed holds sway, we see very high P/Es. When hope prevails, P/Es are moderate. When fear is in the saddle, P/Es are very low. Back and forth, over and over again, swings in the emotions of investors momentarily derail the long-range upward trend in the economics of investing. While the prices we pay for stocks often lose touch with the reality of corporate values, in the long run, reality rules.

$1 $10 $100 $1,000 $10,000 $100,000 Investment Return Versus Market Return Growth of $1: 1900-2012 Investment Return Market Return Annual Growth Rate 9.3% 9.5% 1900 2012 1930 1960 1990 Chart 1 Note in Chart 1 that as cumulative investment return (blue line) has marched ever onward, ever upward, it is closely shadowed by the cumulative return produced in the stock market itself (red line). When the market return gets ahead of investment return, either it comes back down or the investment return comes up. When the market return falls behind the investment return, it catches up, a reasonably predictable pattern that reflects the omnipresent rule of the stock market, reversion to the mean (RTM). From 1900 to date, the nominal annual returns were: investment return, 9.3 percent; market return, 9.5 percent. Over shorter-term periods, however, the differences can be—and often are—substantial. For example, it’s illuminating to track the sources of these differences over the past decades since the 1900s.

What rate of future earnings growth do you expect? Your Expectations for the Coming Decade, Part One a) 4 percent or less b) 5 or 6 percent (the long term norm) c) 7 or 8 percent d) 9 percent or more 6. even more obvious if we asked the relevance of, say, an historical bond yield of 6 percent when the present yield is 4 ¾ percent.) So I urge those of you who rely on Monte Carlo simulations that rely only on historical stock returns either to exchange them for the kind of source-based analysis we’ve just gone through; or, alternatively, to calculate those Monte Carlo simulations using market returns excluding dividend yields, and then add back today’s far lower dividend yield. Relying on these unarguable sources of return, let’s now consider what returns we might expect for stocks in the coming decade, starting from this very day. Just for fun (so we can see not what I expect, but what you expect), we’ll now do a quick poll to determine your own expectations on each of the sources of stock market returns. We’ll begin with investment return. We know that today’s dividend yield on stocks is about 2.3 percent, less than one-half of the historic norm of 5 percent. What should we add in the way of potential earnings growth for our publicly-held corporations? For reference, the long-term norm has been about 4.5 percent, though in the past 25 years it’s been more than 6 percent. Let’s have a show of hands on some reasonable choices.

been historically high (say, above 20 times) they have been highly likely to decline. But in neither case is it given to us to know when the change is coming. So, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has proved to be a sensible and effective approach to projecting the total return on stocks over the decades. The point is this: Over the very long run, it is the economics of investing—enterprise— that has determined total return. The evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, investment return accounted for fully 9 percent of the 9.5 percent annual return on U.S. stocks (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.5 percent). Speculative return—the result of an inevitably period-dependent increase in the price-earnings ratio from 13 times to 21 times—accounted for only 0.5 percent of the total. Long-term ownership of American business, then, has been a winner’s game. Hyman Minsky Adds the Crucial Ingredient These simple insights based on the sources of stock market returns provides a solid framework for understanding how markets work.

The investment return on stocks proves to be remarkably susceptible to reasonable expectations. The initial dividend yield (red)—a crucial but generally underrated factor in shaping stock returns—is a known factor, and the steady contribution of dividend yields to investment return during each decade has always been a positive, only once—in the decade of the 2000s—outside the range of 3 percent to 7 percent. The secular rate of earnings growth, (blue) on the other hand, while hardly certain, is relatively stable. There were few surprises in long-term investment returns, and even the sharp earnings drop in the Great Depression was within the 95 percent probability range. Chart 3 2% 3% 4% 5% 6% 7% 8% 9% 10% 1929 1938 1947 1956 1965 1974 1983 1992 2001 Corporate Profits as a Percentage of GDP 2011 Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year. (During the past decade however, thanks to the near-collapse of our financial system, earnings growth was only barely positive.) Only twice (in the 1930s and in the 2000s to date) were total investment returns (top line) less than 6 percent annually, and only twice more than 12 percent. But if we recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the U.S. gross domestic product, this relative consistency is hardly surprising (Chart 3).

(Chart 6) While just one of you expects that 9 percent-plus earnings growth, the clear majority expects earnings growth of 5 to 6 percent. So let’s add 5 ½ percent earnings growth rate to the divided yield of 2.3 percent. Result: your rational expectations are for an investment return on stocks of about 7.8 percent, more or less, in the coming decade.

What P/E do you expect to prevail in June of 2018? Your Expectations for the Coming Decade, Part Two a) Much higher—21 times or more b) Somewhat higher—19 or 20 times c) About the same—18 times d) Somewhat lower—15 to 17 times e) Much lower—14 times or less. 7. Investment Advisor Consensus 8. Initial dividend yield: 2.3% Earnings growth: +5.5 Investment return: 7.8% Speculative return: -0.6% Total return: 7.2% Now let’s find out the impact you believe speculative return will have on that investment return. The P/E that I’ll use for today is 18 times, based on the reported earnings of the S&P 500 over the past twelve months. (I should note that the P/E would be 16 times if we use projected operating earnings, but we’ll work with the 18 number.) So question two is: (Chart 7) What P/E ratio do you expect to prevail in June 2018? While you’re a little divided here, and I see some hands voting for much higher PEs, it looks like you’ve clustered between “about the same” and “somewhat lower” valuations. If we use a central number of 17 times for the 2018 P/E, speculative return would subtract almost a percentage point from your, 7.8 percent investment return. Result: the clear consensus of you professional financial planners is that stock returns will likely average about 7.2 percent in the decade ahead. (Chart 8) According to a recent survey in Business Week, your clients happen to be more optimistic— expecting a return of 11.8 percent per year!

For long-term investors as a group, owning businesses is a winner’s game. After all, businesses earn a return on their capital, and they pay dividends, and they grow with our economy. Trading stocks with other investors, on the other hand, is inevitably, a zero-sum game—Peter’s gain is Paul’s loss. But only before costs. After the huge costs paid to the croupiers of Wall Street day after day—hundreds of billions of dollars each year—on all that frenetic activity that we read about as billions of shares of stock change hands day after day, that zero-sum game of beating the market is converted—magically, but mathematically—into a loser’s game. The minute by minute fluctuations of the market, using Shakespeare’s metaphor, are truth told “a tale told by an idiot, full of sound and fury, signifying nothing.” (You’ll know that’s Macbeth, Act V.) Even as the media covers this sound and fury if it were of surpassing importance, financial journalists ignore the fact that essentially 100 percent of the long-term return on stocks is based on the profitability of our corporate businesses. Short-term speculation does little to enhance or diminish that return. (The stock market’s long-term nominal annual return of about 9 ½ percent, for example, was produced almost entirely by dividend yields averaging 4 ½ percent and annual earnings growth averaging 5 percent.)

career that followed) on the mutual fund industry. It was entitled, “The Economic Role of the Investment Company.” This dual nature of returns is reflected when we look at stock market returns over the decades. Using Keynes’s idea, I divide stock market returns into two parts: (1) Investment Return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth, which together form the essence of what we call “intrinsic value”; and (2) Speculative Return, the impact of changing price/earnings multiples on stock prices. Let’s begin with investment returns on the average annual investment return on stocks over the decades since 1900. (Chart 2a) Note first the steady contribution of dividend yields to total return during each decade; always positive, only once outside the range of 3 percent to 7 percent, and averaging 4.5 percent. Then note that the contribution of earnings growth to investment return, with the exception of the depression-ridden 1930s, was positive in every decade, usually running between 4 percent and 7 percent, and averaging 5 percent per year. Result: Total investment returns (the top line, combining dividend yield and earnings growth) were negative in only a single decade (again, in the 1930s). These total investment returns—the gains made by business—were remarkably steady, generally running in the range of 8 percent to 13 percent each year, and averaging 9.5 percent. Enter speculative return.

Speculative return is, well, speculative (shown in green in Chart 2). It has alternated from positive to negative over the decades. But note that every decade of significant negative speculative return has been followed by a decade of positive speculative return—the terrible 1910s, then the booming 1920s; the awful 1940s, then the great 1950s; the nasty 1970s, then the booming 1980s and 1990s—an unprecedented double decade of large speculative returns. But over the full century, speculative return had virtually no influence on the general level of stock returns, contributing only 0.2 percent to the 9.5 percent total investment return (shown in orange in Chart 2). The point is this: Over the very long run, it is the economics of investing—enterprise—that has determined total return; the evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. As we show, in the past eleven decades, the 9.5 percent average annual return on U.S. stocks has been composed of 9.3 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.8 percent), and only 0.2 percent of speculative return, borne likely of an inevitably period-dependent increase in the price-earnings ratio during this long period. Over the long term, ownership of American business has been a winner’s game. III.

(Chart 2b) Compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart as price/earnings ratios (P/Es) wax and wane. A 100 percent rise in the P/E, from 10 to 20 times over a decade, would equate to a 7.2 percent annual speculative return. Curiously, without exception, every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount—the quiet 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and then the soaring 1980s—reversion to the mean (RTM) writ large. Then, amazingly, there is an unprecedented second consecutive exuberant increase in speculative return in the 1990s, a pattern never before in evidence. By the close of 1999, the P/E ratio had risen to an unprecedented level of 32 times, setting the stage for the return to sanity in valuations that soon followed.stock

Jack Bogle’s Stock Market Expectations 9. Initial dividend yield: 2.3% Earnings growth: +6.0 Investment return: 8.3% Speculative return: -1.2% Total return: 7.1% Indeed my own expectations are for earnings growth of about 6 percent, bringing investment return to about 8.3 percent. I believe that 16 times is a reasonable expectation for the P/E a decade hence, resulting in a speculative return of more than -1 percent. Result: total return of 7.1 percent. (Chart 9) So, for the sake of simplicity, let’s agree on a compromise figure of 7 percent per year as the most likely return on stocks over the coming decade. A return of 7 percent per year on U.S. stocks is well below the historical norm of 9.6 percent. But that shouldn’t be surprising. After all, the current dividend yield of 2.3 percent is more than three full percentage points less than the long-term norm of 5 percent—a dead-weight drag on the future investment returns that stocks can generate, and the P/E today is well above the long term norm of 15 times. Our rational, and mutual, expectations simply reflect that change in the simple realities of investing. Of course each of you has the right to disagree with these estimates, and with me. So make your own individual forecast: Just add your own earnings growth estimate to today’s 2.3 percent dividend yield, and calculate the investment return. Then calculate the speculative return by taking a guess at the prevailing P/E multiple ten years hence.

game spreads). Today, stock option compensation, even in its present form, creates huge distortions in our financial system. These problems require a whole new way of thinking about investing. We need more investors and fewer speculators, and we need investors—institutional and individual alike—to understand three simple facts: (1) Investing for the long term—buying and holding all of the publicly-held corporations in America, for example—is a winner’s game. In the long run—since 1900—the 9.6 percent nominal annual return on stocks was created almost entirely from the real returns earned by business. Dividend yields averaging 4.5 percent and earnings growth averaging 5 percent gave us 9.5 percentage points of that total. Only 1/10 of 1 percent came from the expectations market. But if long term investing is a winner’s game, as it is, consider the next fact: (2) Trading stocks with one another—as we now do to the tune of 4 billion shares—say, $100 billion!—every business day makes beating the market a zero sum game, but only before the deduction of the money we spend on all of that busy trading. And so, Q.E.D., Fact (3): After those costs, the lavish rewards we bestow on our financial croupiers—our stock brokers, our investment bankers, our money managers—beating the market (essentially what all those short-term speculators are trying to do) becomes a loser’s game.

Equity Fund Returns Over the Coming Decade 2.0% 4.5% 6.0% (2.5%) (-1.0%) -2% 0% 2% 4% 6% 8% Earnings Growth Dividends P/E Impac t Inflation Real Return Sources Uses 10a. 7% 7% Equity Fund Returns Over the Coming Decade 2.0% 2.5% (2.0%) 6.0% (2.5% ) (-1.0%) -2% 0% 2% 4% 6% 8% E arnings Gr owth Dividends P/E Impact Inflation Net Real Fund Return Sources Uses 7% 7% Expenses 10b. Equity Fund Returns Over the Coming Decade 0.50% 2.0% (2.0% ) 6.0% (2.0%) (-1.0%) (2.5% ) -2% 0% 2% 4% 6% 8% E arnings Gr owth Dividends P/E Impact Inflation Net Real Investor Return Sources Uses 7% 7% Expenses Timing/Selection Penalty 10c. far lower. To explain why this is the case, we need only to understand these simple mathematics of investing: 1. Inflation will almost certainly erode the nominal returns we’ve just calculated. Assuming that inflation averages 2 ½ percent per year (as expected today), the nominal return on stocks of 7 percent over the coming decade would be reduced to 4 ½ percent. (Chart 10A) 2. All investors as a group must necessarily earn precisely the market’s real return, but only before the costs of investing are deducted. So if equity funds, on average, incur costs of only 2 percent per year, a conservative figure in the light of combined fund costs—fund expense ratios, sales loads, and turnover costs—their average annual net real return would be just 2 ½ percent. (Chart 10B) 3.

I expressed these principles when doing so was distinctly counter to my own self-interest. Speaking to my partners at Wellington in September 1971—1971!—I cited the very same words of Justice Stone with which I opened my remarks this evening. I then added: I endorse that view, and at the same time reveal an ancient prejudice of mine: All things considered, absent a demonstration that the enterprise has substantial capital requirements that cannot be otherwise fulfilled, it is undesirable for professional enterprises to have public stockholders. This constraint is as applicable to money managers as it is to doctors, or lawyers, or accountants, or architects. In their cases, as in ours, it is hard to see what unique contribution public investors bring to the enterprise. They do not, as a rule, add capital; they do not add expertise; they do not contribute to the well-being of our clients. Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Even though the field of money management has elements of both, there are, after all, differences between a business and a profession . . (So we must ask ourselves this question): if it is a burden to our fund and counsel clients to be served by a public enterprise, should this burden exist in perpetuity?

IV. Reasonable Investment Expectations for the Coming Decade Now let’s review and look ahead. Relying on the sources of market returns has proved in the past to be an exceptional way to establish reasonable expectations for the future returns on stocks. We know more than we think. The initial dividend yield at the start of the decade is already a known factor, and corporate earnings are likely to continue to grow at a rate closely related to the growth of our nation’s GDP. While the level of the P/E ratio a decade hence can hardly be known in advance, we do know that RTM comes heavily into play. If the P/E ratio was below 12 at the start of a past decade, it was highly likely (90 percent probability) to rise by its conclusion. If the P/E ratio was above 18, it was highly likely (80 percent probability) to decline over the decade. So let’s look at what we might expect in the decade beginning in mid-2012 (Chart 5). Today’s dividend yield on the S&P 500 is 2.0 percent. Annual earnings growth in the range of 5 percent seems a reasonable possibility. Result: an investment return in the range of 7 percent per year. With outstanding earnings in 2011, the P/E now stands at around 16, close to the long-term historical average, so I don’t expect that P/E to be a lot different when 2022 begins. Result: a speculative return of zero, more or less.

In their cases, as in ours, it is hard to see what unique contribution public investors bring to the enterprise. They do not, as a rule, add capital; they do not add expertise; they do not contribute to the well-being of our clients. Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Even though the field of money management has elements of both, there are, after all, differences between a business and a profession. My candor—Wellington Management was then owned largely by public investors—may well have played a supporting role in my dismissal as chief executive of Wellington Management Company in January 1974.gave

2% 0.2% -10% -5% 0% 5% 10% 15% ? 4.7% 2.0% 5.6% -5.6% 9.9% 3.9% 5.5% 9.9% 4.4% 7.4% 0.8% 4.8% 4.8% 3.5% 4.3% 5.9% 4.5% 5.0% 6.9% 3.1% 3.5% 5.2% 3.2% 1.2% 4.5% 2.2% -10% -5% 0% 5% 10% 15% 20% 8.2% 6.3% 11.5% -1.1% 14.9% 10.8% 8.6% 13.4% 9.6% 10.6% 2.0% 9.3% 7.0% Dividend Yields Have Accounted for Half of the Long-Term Returns on Stocks Market Return (S&P 500) 9.0% 2.9% 14.8% -0.8% 8.6% 20.1% 7.6% 5.9% 17.3% 17.8% -1.2% 9.5% 7.0% -5% 0% 5% 10% 15% 20% 25% 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 1900 – 2011 Avg Investment Return: Dividend Yield and Earnings Growth Oct.decade

Investment returns (top line of figures) are generated by the initial (known) dividend yield on stocks (red bar), about 2 percent today, plus subsequent earnings growth (blue bar), averaging about 5 percent. A reasonable expectation for investment return in the coming decade is therefore around 7 percent, measured in today’s dollars. Such a return would be well below the historical norm of 9 percent (second column from the right)—creating a huge gap in appreciation of cumulative equity wealth during the coming decade. (Reminder: These are the market returns, before investment costs. Investors as a group do not—indeed cannot—earn these returns.) The second element, speculative return (green bar), depends entirely on investor expectations and investor behavior. Unlike investment return, speculative return is enormously variable. We can easily measure it by the number of dollars that investors are willing to pay for each dollar of future earnings on stocks. If valuations a decade hence prove to be materially higher or lower than today’s price-earnings multiple of about 16 times, speculative return would be an important factor in the stock market’s performance. For example, a valuation of 20 times could add about 2 percentage points per year, to returns raising that 7 percent investment return to a 9 percent total return. A drop to 12 times, on the other hand, would cost about 3 percentage points, dropping the 7 percent return to just 4 percent.

of corporate earnings growth, followed by actual earnings declines. Thus the probabilities favor continued market turbulence—and some economic turbulence as well. These risks of investing in business and in the economy are well known. But there are other huge, seemingly unacknowledged risks out there in our society. The risks presented by the Social Security and Medicare payments committed to by our national government. For that matter, the staggering string of huge (and in fact understated) deficits in our Federal budget. Our enormous expenditures (soon to reach $1 trillion) on the wars in Iraq and Afghanistan, bleeding the resources of our empire. Terrorism; the threat of global warming and the cost of dealing with it. Unfettered global competition, our trade deficit, and the decline in the value of the U.S. dollar. There are other risks, too, more subtle in nature. Forgive me here for going where angels fear to tread but, a political system dominated by money and vested interests; a Congress and an administration seemingly focused entirely on the short-term, the long-term consequences be damned. The vast chasm between the very wealthiest among us (the top 1 percent of our citizenry holds more than a third of our total wealth) and those at the bottom of the economic ladder (some 20 percent of New York City residents earn less than $8,300 per year).

1. 2. 3. 4. 5. 6. (2+3) (2 + 3 – 5) Asset Class Allocation Projected Annual Return Value Added by Managers Adjusted Annual Return Less Investment Costs Net Return Traditional Policy Portfolio Equities 60% 7.0% 0.0% 7.0% -0.06% 6.9% Bonds 40 3.0 0.0 3.0 -0.10 2.9 Total 100% 5.4% 0.0% 5.4% -0.08% 5.3% Policy Portfolio with 30% Allocated to Alternatives Equities 40% 7.0% +2.5% 9.5% -1.0% 8.5% Bonds 30 3.0 +1.0 4.0 -0.5 3.5 Venture Capital 10 12.0 +3.0 15.0 -3.0 12.0 Hedge Funds 20 12.0 +3.0 15.0 -3.0 12.0 Total 100% 7.3% +2.2% 9.5% -1.5% 8.0% The Elusive 8% A Template for DB Plan Returns Over the Coming Decade Chart 6 So is 5.3 percent the nominal return that our DB plans—corporate and government alike—are projecting? No, it is not. The typical return projection is 8 percent, with precious few plans much lower or higher. Where does this estimate come from? Well, here is what one large corporation tells us: “We consider current and expected asset allocations, as well as historical and expected returns on various categories of plan assets . . . evaluating general market trends as well as key elements of asset class returns such as expected earnings growth, yields and spreads. Based on our analysis of future expectations of asset performance, past return results, and our current and expected asset allocations, we have assumed an 8.0 percent long-term expected return on those assets.” (Note the reliance on historical returns.)

capital proxies, etc. My advice: look before you leap, and don’t leap until the fund has a ten-year track record. And above all, remember (courtesy of Warren Buffett), “What the wise man does in the beginning, the fool does in the end.” Commodity Funds. First principles: the prices of stocks and bonds are ultimately supported by their internal rate of return—respectively, dividends and earnings growth, and interest coupons. That is why stocks and bonds are considered investments. Commodities have no internal rate of return; their prices are based entirely on supply and demand. That is why they are considered speculations. I freely concede that the huge rise in the prices of most commodities in recent years doesn’t guarantee that speculation on future price increases will not be rewarded. But that may well be the odds-on bet. Managed Payout Funds. The fund industry apparently only recently discovered that growing millions of investors are moving from the accumulation phase of investing to the distribution phase. (Although, that demographic handwriting has been on the wall for decades). So we have new funds that, in effect, guarantee the exhaustion of your assets in whatever time period you choose (something that has always been all too easy to accomplish!) We also have funds designed to distribute 3 percent, 5 percent, or 7 percent of your assets without necessarily invading principal. Only time will tell if that will happen.

Investing Today In a New York Times piece in August, I was quoted (correctly) as saying “this is the worst time for investing that I’ve ever seen.” It is. Because while the prospects for future returns on stocks are highly likely to be positive, albeit below long-term norms, based on the methodology I developed for realistic return expectations a quarter century ago that has met the test of time. In it, I separate stock returns into two components: investment return, and speculative return. (This is the math part of the talk!) I show that future investment returns—the current dividend yield (about 2 percent today) plus subsequent earnings growth (probably about 5 percent) would likely be around 7 percent, measured in nominal dollars, well below the historical norm of 9 percent—a huge gap over the long-term. Consider that each dollar invested at 7 percent over a quarter century would grow by 5.4 times; at 9 percent, by 8.6 times. The second element, speculative return, depends entirely on investor opinion and investor behavior, and we can easily measure it by the number of dollars that investors are willing to pay for future earnings on stocks. If valuations a decade hence were materially higher or lower than today’s price-earnings multiple of about 16 times, speculative return could be an important factor in the stock market’s performance. For example, a valuation of 20 times could add almost 2 percentage points per year, raising that 7 percent to 9 percent.

Whatever the benefits, the tremendous drain on investment returns represented by the costs of our investment system raises serious questions about the efficient functioning not only of that investment system, but of our entire society. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to what is predominantly a financial economy. But the costs that we incur in our financial economy, by definition, subtract from the value created by our productive businesses. Think about it. When investors—individual and institutional alike—engage in far more trading—inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. To reiterate: while the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market before those costs—for all of us as a group—is a zero-sum game. And after intermediation costs are deducted, beating the market becomes a loser’s game. The rise of the financial sector is one of the seldom-told tales of the recent era.

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