John Bogle on Inflation

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.

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.

Now let’s assume that we’re fortunate enough to enjoy future nominal returns in the stock market averaging 7 percent per year, roughly what reasonable expectations suggest for the coming decade. (We can talk about that later.) Let’s also assume that the inflation rate will be about 2 ½ percent, leaving a 4 ½ percent real stock market return. If equity fund costs continue at today’s 2 ½ percent rate (and there’s no evidence that they are declining), they would confiscate about 60 percent of that annual real return. But don’t stop there. Compounded over an investment lifetime—say, 50 years—$10,000 invested at 4 ½ percent (let’s make it 4.4 percent to take into account the minimal costs of an index fund) would produce a real profit of $76,100. On the other hand, $10,000 invested at a return of 2 percent (net of that 2 ½ percent cost) would grow by just $16,900 in real terms. Rather than taking the road less traveled by—passively owning the entire market—the investor who travels the traditional road of active management would earn less than 25 percent of a stock market profit that is there for the taking. (The exact figure is 22 percent.)

and foremost, their principals—pension beneficiaries and owners of mutual fund shares. These intermediaries consume far too large a portion of whatever returns our corporations and our financial markets are generous enough to provide, with far too small a portion of these returns delivered to the last-line investors who have put up all of the capital and assumed all of the risks. Curiously enough, what has happened to our system of capitalism is precisely what this university’s great founder warned us about two centuries ago. Hear Thomas Jefferson: “I hope we shall crush in its birth the aristocracy of our moneyed corporations which dare already to challenge our government in a trail of strength, and bid defiance to our laws.” We didn’t do that, and here are nine quick examples—three each from corporate America, investment America, and mutual fund America—that reflect the negative consequences of this change. In Corporate America:  One, the staggering increase in managers’ compensation. CEO pay has risen from 42 times the compensation of the average worker in 1980 to 340 times currently, a 756 percent rise after inflation, while the real income of the average worker has barely kept pace with the cost of living. Long ago, Herbert Hoover, one of our few businessmen to serve as president, put it well: “The only trouble with capitalism is capitalists. They’re too darn greedy.” Imagine what he’d say today.  Two, the rise of financial engineering.

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

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

220 basis point cost have taken on the 13.3% return earned on the Standard & Poor’s 500 Stock Index over the past 50 years? The fund would earn 11.1%, or 2.2% less. When compounded, $1,000 in the S&P Index itself would grow to $514,000; the fund, after costs, would grow to $193,000—a $321,000 loss to the financial intermediaries. When we include taxes in the equation—given the high market returns of the past 50 years, I’ll use 240 basis points, a conservative tax rate—the mutual fund annual pre-tax return of 11.1% drops to 8.7% after taxes, and the compounded value falls another $128,000 to $65,000. But there’s more trouble ahead. Each year, intermediation costs and taxes are paid in current dollars, while the investor’s final capital must be measured in constant dollars. During the past half-century, the inflation rate was 4.0%. Result: Real annual return for the investor, 4.7%. The final purchasing power was reduced another $55,000 to $10,000. Wow! Put another way, the mutual fund’s real annual return before costs was not the 13.3% earned by the S&P Index, but 9.3%, so the 2.2% intermediation cost reduced each year’s real return, not by 16%, but by 24%. And that 2.4% annual tax cost further reduced the fund’s net return, not by 22%, but by 34%.

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

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.

When compounded over this grand 20-year era for investing, and adjusted for inflation, the average investor has captured but 16 percent of the market’s compounded real profit. (I’m not kidding! $1,000 invested in a simple index fund mimicking the Standard & Poor’s 500 Stock Index in 1984 and held today produced a profit of $5,490 after inflation; for the average fund investor, the real profit came to just $910.) No wonder that David Swensen, the integrity-laden and remarkably successful manager of the Yale endowment fund, characterizes such a shortfall as “the colossal failure of the mutual fund industry.” Where is the Public Discourse? It ought to be obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism.“the

In fairness, an index fund modeled on the Standard & Poor’s 500 Index would also have fallen well short of the index itself, but still performed quite remarkably relative to the mutual fund. Assuming costs of 20 basis points, its 13.1% return would have compounded to $471,000 vs. $193,000 for the fund; after a 120 basis point charge for taxes (index funds are typically about twice as tax-efficient as ordinary funds), its net total value would be $276,000 vs. $65,000. And the Index fund total would have been cut to $45,000 after inflation, vs. $10,000. That too may seem like a far cry from $514,000, but it’s hardly realistic to eliminate taxes from the real world of investing. The important reality is that the Index fund would have provided 2.4 times the after- cost value of the mutual fund, 4.2 times the fund’s after-tax value, and 4.5 times the fund’s real terminal value. Yes, Embedded Alpha is a powerful destructive force. What Active Managers Can Learn From Indexing Paraphrasing the Greek philosopher Horace, I fear that, like the mountains, the financial giants and fund managers who developed the ML/BARRA study have “labored and brought forth a mouse.” Had they made their own calculations of annual Embedded Alpha, then compounded the resultant return over the long-term, and then considered the reality that costs and taxes are paid in current dollars but long-term returns are received in real dollars, they would have realized the enormity of the issue.

absolute, returns. The fact is that for more than two centuries the U.S. stock market has demonstrated a profound tendency to provide real (after-inflation) returns that surround a norm of about 6.7%. As shown in Exhibit VIII,3 the swings around this norm over moving 25-year periods are reasonably narrow, with returns much above ten percent in only 7 of the 172 periods and returns much below four percent in another 5 periods. In short, real returns have ranged between roughly 4% and 10% in 93% of the 25-year periods, a remarkable record of consistency. Surely RTM is alive and well in the stock market. The standard deviation of returns in 25-year periods—about one-half of an investing lifetime for most investors today—is 2.0%. In fairness, in a shorter time frame of ten years, the standard deviation is 4.0%; in an investment lifetime of 50 years, it is a minuscule 1%. So time horizon makes a meaningful difference. The root cause of these long-term returns is fundamental: corporate dividends plus the growth of corporate earnings. And, using data we have available from 1871 forward, we can measure the extent to which these two financial fundamentals have dictated the returns earned on equities. Real corporate earnings have grown at an annual rate of 3.9% since 1871; real dividend yields have averaged 2.8%. So, the total fundamental return on stocks has been 6.7%. This figure precisely matches the actual real return of 6.

to enhance their knowledge. Rather, they rely on a fund’s past performance and star rating. Our trust is placed “in our stars, not in ourselves,” precisely the opposite of what Cassius told Brutus. But the “stars” do not give investors the power to select future winners. While Morningstar’s information is priceless in understanding a fund’s investment style, past returns, and present portfolio, the evidence strongly suggests that it is virtually worthless in enabling investors to enhance their returns. Technology has made information accessible without providing knowledge and without engendering wisdom. Perhaps a rereading of the Book of Proverbs would remind us of what is really important: “Get wisdom, get insight.” The Quality of Advice With all the information and commentary that is available on Internet websites, I find myself particularly troubled by the offering of investment and financial planning advice. This advice is voluminous and comprehensive, giving investors the ability to plan their financial futures with decimal point precision, and to manipulate the data to their hearts’ content, raising and lowering their expected retirement plan contributions, their allocations to stocks and bonds, and their assumptions about future returns in the financial markets, about tax rates and inflation rates, and about retirement age. But, at bottom, the data that is provided tacitly ignores the most fundamental characteristic of investing: Uncertainty.

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.

The long boom in the real estate market has now turned down, with home prices in retreat, so similar to what happened in the “new era” stock market early in 2000, and stock prices remain below the levels they reached eight long years ago. As I see it, our policy makers are running scared, with the Federal Reserve making credit available to banks (likely a necessary step) and driving short-term interest rates down (great for borrowers but terrible for lenders and savers, and probably terrible for the dollar). I’m not at all sure that this is sound policy-making, for it increases the likelihood that inflation will rear its ugly head later on. Our political leaders, too, seem to have pressed some sort of panic button, enough to unite a Democratic congress and a Republican administration in an election year. But I’m also concerned that the $160 billion fiscal stimulus plan—right out of Keynesianism—will not provide much in the way of stimulating the economy, even as it adds to an already staggering deficit in the Federal budget. Yes, it’s easy for our politicians to give money to “the people,” for of course it’s these self-same people who are in fact doing the giving. When they pay for the “gift,” either through higher taxes or through devalued dollars, that truism will become clear.

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

the other hand, began at $7.91 in 1991, and has remained above $7.10 each year. It should be about $7.20 in 2001. Variable income vs. stable income. Is stable income or stable principal the higher priority for you? Or some of each? Be clear on what you plan to achieve in your defensive holdings, and invest accordingly. Pillar 10. Beware of “Fighting the Last War.” Too many investors—individuals and institutions alike—are constantly making investment decisions based on the lessons of the recent, or even the extended, past. They seek stocks after stocks have emerged victorious from the last war, bonds after bonds have won. They worry about the impact of inflation after inflation, having turned high real returns into so-so nominal returns, has become the accepted bogeyman. You should not ignore the past, but neither should you assume that a particular cyclical trend will last forever. None does. When I wrote my book, inflation was at the forefront of investors’ minds. But, ever the contrarian, I raised a caveat emptor suggesting that “it would be foolish to assume that inflation would be an eternal fact of life.” Sure enough, inflation, having averaged 5.7% during the fifteen previous years, has run at less than one-half that rate (2.6%) since then. “The last war,” it turned out, was over. Similarly, stocks in high-tech companies soared during the late 1990s, and large-cap tech stocks came to dominate the portfolios of growth funds.

our hearts’ content, raising and lowering our expected retirement plan contributions, our allocations to stocks and bonds, and our assumptions about tax rates and inflation rates, retirement age, and future returns in the financial markets. But, at bottom, the data that is provided tacitly ignores the most fundamental single characteristic of investing: Uncertainty. I go quickly to first principles: The stock market is not an actuarial table. Yet the projections provided by financial advice websites seem to me to cast an aura of predictability—if not certainty, surely high relative assurance—on the numbers that pop up on our computer screens. But, as ever, the output is highly sensitive to the input. Consider, for example, a retirement plan for a 30-year old investor, investing 6% of a $50,000 income—with a 3% company match—in a 401(k) plan, salary growing at 5% per year until planned retirement at age 65, when he began to draw upon his nest-egg to meet expenses. If he believes that the stock market’s annual return will be 12%, at his actuarial life expectancy of 90 years the accumulated capital would be $2,827,101. (Note the precision!) If, on the other hand, the market return turns out to be 9%, he runs out of money at age 81—a zero balance, and nine years too soon at that. But believe me, no one in the world knows whether the future return on stocks will be 12%, 9%, 5%, or anything else. So, pauperhood at that age is just as likely as a $2.8 million nest-egg.

Corporate Managers—Serving Themselves In all those years since Berle/Means, the self-indulgence of our corporate manager/agents has increased sharply, particularly since 1980. The most obvious manifestation of this trend is executive compensation. In 1980, the ratio of the average compensation of CEOs was 42 times that of the average worker. By 2016, the compensation ratio had soared to 335 times. I can find no business rationale for that shocking increase, other than that corporate managers have almost unfettered power, and can use it with abandon to their own advantage. Measured in real (inflation-adjusted) 1980 dollars, CEO compensation has risen at a rate of 6.5% annually, increasing by more than 560% in real terms during the period. In comparison, the compensation of the average worker increased by less than 1% per year, an insignificant cumulative increase of just 14% over 36 years.are

especially true today. The prospects for returns on financial assets in the coming years are unlikely to reach historical norms, and the temptation is to do whatever it takes to earn yesterday’s return. In stocks, reasonable expectations during the coming decade strongly suggest a return no more than 6% to 7% annually in nominal terms, before adjusting for inflation, investment fees and expenses, taxes on income and capital gains, and counterproductive investment behavior. Together, these costs could easily total 1% to 7% per year. Real, after-cost annual returns for stock investors, could range from 1% to 3% over the next ten years. (The arithmetic is an eye-opener!) Inflation is beyond our control, but investment expenses, taxes, and our behavior are, to a large extent, well within our ability to control. The arithmetic for bonds is even worse. The benchmark 10-year U.S. Treasury note has a current yield of 2.2%, which is almost certain to result in a decade-long return of 2% to 3% per year. With a larger weighting of investment-grade corporates and a modest extension of maturities, a high-grade bond portfolio might allow a 3% gross yield. But after inflation, investment fees and expenses, taxes, and misbehavior (yes, it’s a concern among bond investors too), negative real returns over the coming decade seem a certainty.

Warning to trustees and managers of corporate and state and local pensions: the 7 ½% future return your pension funds are assuming is simply not going to be there—not with a 50/50 stock/bond portfolio unlikely to earn a gross annual return of much more than 4%, maybe a net return of 3% after investment costs and 1% or less after inflation. Exceeding the market’s return—net of investment costs—may be possible for a single fund or manager. But it is impossible for all funds and managers as a group. Seeking out higher-than-market returns and accepting higher-than-market risks is rarely advisable. Going further out on the long limb of risk is a dangerous choice. (Limbs have been known to break.) Even in today’s environment of low expectations for future returns on financial assets, the most reliable strategy is to accept the markets’ returns, get your clients’ asset allocations right, hold investment costs to a minimum, and of course, keep your fingers crossed. That simple formula may not be the most brilliant investment strategy ever designed—especially to you who have done the challenging work of earning your CFA charters. But the number of strategies that are worse is infinite. We cannot know the future, but we should expect surprises and challenges. No matter what happens, there is one simple strategy that will never steer us wrong: put our clients’ interests first. At last, our investor/clients are poised to take their position at the forefront of our industry.

Balanced Portfolio Returns Also Below Norm of 7% Reasonable Expectations: Nominal Gross Return (50/50 Stock/Bond): 4.5% Don’t Forget These Deductions -1.5% Active Fund Costs or -0.05% Index Fund Costs * * * -2% Inflation -0.5% Taxes -1.5% Investor Behavior Looking Ahead 3.—No Great Alternatives 50 YET MUTUAL FUNDS WILL CONTINUE TO DOMINATE INVESTOR SAVINGS. WHY? . . .

economy, which has moved forward, despite interruptions, at a steady pace of about 2 ½% per year (in inflation adjusted dollars) over the past century. When the stock market leaps up and plunges down— second-by-second, day-by-day, year-by-year—it reflects nothing more than those transitory emotions— hope, and greed, and fear—that have affected investors (or, I should say, speculators) forever. These emotions represent investors’ reactions to momentary events, or their expectations of future events, or their expectations of how other investors might perceive these events. That’s why we call it the expectations market, with speculative sentiment often raising or lowering stock prices far above or below their intrinsic value. In other words, speculative return reflects the change in price investors are willing to pay for each dollar of earnings. Over the long run, however, speculative return has played no role whatsoever in shaping the market’s total returns. Rather, it is investment return that has accounted for virtually all of the long-run returns generated by stocks. Over the entire history of the U.S.has

CEO pay has risen from 42 times the compensation of the average worker in 1980 to 340 times currently, a 756 percent rise after inflation, while the real income of the average worker has barely kept pace with the cost of living. Long ago, Herbert Hoover, one of our few businessmen to serve as president, put it well: “The only trouble with capitalism is capitalists. They’re too darn greedy.” Imagine what he’d say today.  Two, the rise of financial engineering. In a remarkable manipulation of financial statements, corporate earnings are managed to meet the “guidance” that these executives give to Wall Street, quarter by quarter. Two of the prize tools for earnings shenanigans: (1) mergers that are made, not with a sound business rationale, but because of the consequent opportunity to manage “pro forma” earnings by creating a veritable “cookie jar” of reserves, to be drawn on at will in order to present a rosy, but false, picture of corporate growth; and (2) arbitrarily raising the assumptions for future returns on corporate pension plans, even as prospective returns eroded. Just think of it: In 1981, when the long-term U.S. Treasury bond yielded 13.9 percent, corporations projected pension plan returns at 7 percent per year—only half as much. Currently, with bond yields at 4.7 percent—65 percent lower—the projected return averages about 8.5 percent—20 percent higher.

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.

 Three, mutual fund returns fall drastically short of market returns. And they fall short by almost exactly the amount of the costs they incurred—all those management fees, operating expenses, sales charges, and hidden portfolio transaction costs. How could it be otherwise? Over the past two decades, for example, the annual return of the average equity fund (10 percent) has lagged the return of the S&P 500 Index (13 percent) by three percentage points per year, largely because of those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection, the return actually earned by the average fund investor has lagged the return of the average fund by another 3 percentage points, reducing it to just 7 percent per year—roughly 50% of the market’s annual return. Warren Buffett accurately describes the problem: “the principal enemies of the equity investor are expenses and emotions.” The fund industry has failed investors on both counts. A return of 7% in a 13% market is a shocking gap, but the reality is far worse. When compounded over this grand 20-year era for investing, and adjusted for inflation, the average investor has captured but 16 percent of the market’s compounded real profit. (I’m not kidding! $1,000 invested in a simple index fund mimicking the Standard & Poor’s 500 Stock Index in 1984 and held today produced a profit of $5,490 after inflation; for the average fund investor, the real profit came to just $910.)

Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest when controversial proxy issues are concerned. This conflict is pervasive, for it is said that money managers have only two types of client they don’t want to offend: actual, and potential. And so in corporate America we have witnessed staggering increases in executive compensation not only unjustified by corporate performance but also grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity; and the failure of the traditional gatekeepers we rely on to oversee corporate management—our regulators, our legislators, our auditors, our attorneys, our directors. And so developed what I described, way back in 1999, as “the happy conspiracy” between our business sector and our investment sector, mutually reinforcing one another, in which traditional values and long standing virtues were undermined. The web is wide, and includes corporate managers, CEOs and CFOs, directors, auditors, lawyers, Wall Street investment bankers, sell-side analysts, buy-side portfolio managers, and indeed institutional and individual investors as well.on

2.2% 2.5% 2.3% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% The Impact of Expenses and Inflation on 7% Equity Return 7.0% Nominal Return Inflation Expenses Net Real Return 3. Yes, under these (likely) circumstances, the risk premium for holding stocks vs. Treasuries would be just 2.4 percent annually, only about one-half of the long-term annualized risk premium of 4.6 percent (9.6 percent for stocks; 5.0 percent for bonds). But when rational expectations belie historical experience, it is current reality that must lead the way. (As Lord Keynes wrote: “when the facts change, I change my mind. What do you do?”) Now, let’s assume that 7 percent is a rational expectation for future nominal returns in the stock market, and 4.6 percent in the bond market. While the marketers whose job it is to gather assets for their financial services firms can afford—in their own self-interest—to ignore the reality of inflation and do their sales presentations using nominal dollars, investors have no such luxury. Unless we focus on real, inflation-adjusted returns, we will seriously jeopardize our future financial security. The financial markets are telling us that inflation is expected to be about 2.3 percent over the coming decade. Thus, the real return on stocks would average 4.7 percent.

It’s all too easy for sellers of financial products to focus on historical stock market returns rather than looking ahead, to disregard the impact of inflation, and to ignore the impact of investment costs, pretending that those relentless rules of humble arithmetic that I earlier discussed do not exist. But when we think in terms of prospective returns, and then real returns, mutual fund costs take on a whole new level of significance. At their present estimated annual level of 2.5 percent—including expense ratios, sales loads, and the hidden costs of that huge annual portfolio turnover—fund costs would consume more than 50 percent of that projected real return of 4.7 percent for the stock market, leaving a net real return of just 2.2 percent a year during the coming decade. (Chart 3) (I haven’t even dared to mention the cost of taxes, in an industry where tax-inefficiency is rife.)

0.8% 1.5% 2.3% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% The Impact of Expenses and Inflation on 4.6% Bond Return Nominal Return Inflation Expenses Net Real Return 4.6% 4. Similar arithmetic, of course, prevails in the bond market. Prospective returns will be lower than in the past, inflation will take its toll, and costs will overpower the return that remains. At 2.3 percent per year, inflation would confiscate exactly 50 percent of the bond market’s nominal return of 4.6 percent, leaving a real bond market return of 2.3 percent. And estimated annual costs of at least 1.5 percent for the average bond mutual fund (expenses plus sales loads) would, in turn, confiscate nearly 70 percent (!) of that real return, reducing it to barely 0.8 percent per year. (Chart 4) It’s at this point that the role of the financial professionals and investment fiduciaries intersects with these investment realities. To what extent is it appropriate for investment professionals—including estate planning professionals—to offer high cost “products” to their clients? To what extent are the trustees of our institutionally-managed pension plans and the directors and managers of our mutual funds focused on providing their plan beneficiaries and fund shareholders with their fair share of the future returns—future real returns—earned in our financial markets?

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

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

declines of 20 percent or more). The current bear market is the worst of the bunch—off by almost 55 percent, even worse than 1973-74 and 2000-2001, when the drops reached 50 percent. What’s more, this decline is the first that I can recall in which the distress in the financial economy has so profoundly impacted the real economy of goods and services, harming a large mass of our citizenry, even those who had no meaningful participation in the boom that led to the bust, but who are now paying the penalty for the market’s excesses. It is not Wall Street, but the ordinary citizens of the United States who will foot the bill for the gross financial excesses of the recent era. “The government,” as always, has no money of its own. So it is paying the financial sector with our money. We may pay for part of this bailout with higher taxes; but given our flawed political system, the cost is more likely to be extracted from future generations with dollars that buy less. Inflation is just another form of taxation, albeit one that is sharply regressive. What we are witnessing is the verification of “the financial instability hypothesis” put forth by the economist Hyman P. Minsky (1919-1996). In 1992, Minsky warned that, “capitalist economies exhibit . . . debt deflations that . . . spin out of control (as) the economic system’s reactions to the movement of the economy amplify the movement.” Sad to say, Minsky adds, “. . .

barrage of unnerving changes: booms and bankruptcies, inflation and deflation, shocks in commodity prices, the revolution in information technology, and the globalization of financial markets. In recent years, our faith has been enhanced— perhaps excessively so—by the bull market in stocks that began in 1982 and has accelerated, without significant interruption, toward the 20th century’s end. As we approach the millennium, confidence in equities is at an all-time high. Might some unforeseeable economic shock trigger another depression so severe that it would destroy our faith in the promise of investing? Perhaps. Excessive confidence in smooth seas can blind us to the risk of storms. History is replete with episodes in which the enthusiasm of investors has driven equity prices to— and even beyond—the point at which they are swept into a whirlwind of speculation, leading to unexpected loses. There is little certainty in investing. As long-term investors, however, we cannot afford to let the apocalyptic possibilities frighten us away from the markets. For without risk, there is no return. As you might suspect, then, even these ten years later, I wouldn’t change a word that I then wrote.

federal government in today’s national affairs can offer much guidance that will help us through the financial mess in which our nation finds itself, so unlike the role of government in the era of remarkable prosperity over which President Coolidge presided. Under Coolidge, our economy flourished, growing by 22 percent (in real terms) from 1923 to 1929. There was, literally, zero inflation; federal government expenditures held flat (really!); the U.S. debt was slashed; the top marginal income tax rate was cut from 43% to 24%; unemployment fell to 3.2 percent. In short, in the president’s words, our citizens “reached a state of contentment seldom before seen.” Given that level of growth and prosperity, it is hardly surprising that Coolidge believed that government should try to get out of the way and leave it to the private sector—to rely on our citizens—to keep the momentum going. “I want the people of America to be able to work less for the government and more for themselves,” Coolidge said. “I want them to have the rewards of their own industry. This is the chief meaning of freedom.” But in this recent winter of our discontent, it is only to state the obvious that America’s growth has been hobbled and our prosperity limited. Our national product is no higher than it was three years ago, and unemployment, at 9.5 percent, is running at the highest levels of the past quarter century.

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

When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should? And so in corporate America we have the staggering increases in executive compensation, unjustified by corporate performance and grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity, and the failure of the traditional gatekeepers we rely on to oversee corporate management—our auditors, our regulators, our legislators, our directors. In investment America, control has devolved to a new class of institutional owners. The 25 largest institutional investors alone hold nearly 40 percent of all stocks, yet all we hear from these agent-owners on corporate malfeasance is the sound of silence.

If the market’s annual return proves to be 7 percent over the coming decade, and if the costs of investing are 2 ½ percent (as in mutual funds), these investors as a group will earn 4 ½ percent. Gross return, minus cost, equals net return. What I call (after Brandeis), “the relentless rules of humble arithmetic.” ( If we adjust for 2 ½ percent inflation, that nominal return would be only 2 percent per year. (Leave out taxes which cost investors in active funds another 1 percent per year) And to make matters worse, precisely the opposite of what I predicted in my thesis has happened. Money managers have largely failed to supply the stock market with demand that is (as I said earlier) “steady, sophisticated, enlightened and analytic . . . focused on corporate performance rather than share prices.” In fact, our money managers have done precisely the reverse. I would argue, then, that our now-dominant institutional agents have not only failed to honor the interest of their shareholders/beneficiary principals, but they have also abandoned the time-honored investment principles that focused on the wisdom of prudent long-term investment, and turned instead to an excessive focus on short-term speculation.

Annualize the change, and then combine the two. But never forget that it's unwise in the extreme to forecast stock returns based on historical norms rather than on evaluating the broad forces that have shaped them in the past and will continue to shape them in the future. But whatever returns the stock market is generous enough to deliver in the years ahead, please don't make the mistake of thinking that those pre-inflation, pre-investment-cost figures have anything to do with reality.are

continues to provide news stories at lightening speed under deadlines that demand news every moment, appealing, of course, to the short-term concerns of their readership. Executive Compensation Let me close with a few comments about how the business world and the media handle executive compensation. I hold, deeply, the conviction that the vast majority of our corporate CEOs are substantially overpaid, many grossly overpaid. As is well-known, while the real (inflation adjusted) compensation of the average employee has remained pretty much flat during the past 25 years (now at $35,000), the real compensation of the average CEO (now about $10,000,000) has risen eight-fold. Yet, there’s no evidence that CEOs as a group have created much extra value. Indeed, during that quarter-century, they’ve projected that the earnings of their companies would grow at 11 percent (in nominal dollars), but delivered growth of 6 percent, only half as much even as our economy has grown at a 6.2 percent rate. But CEO pay is not based on corporate performance. It is based on the pay of corporate peers. And since each corporate board seems to believe that its own CEO is well above average, whenever the CEOs pay ranks in the bottom quartile among his peers, he gets moved up a few quartiles. Of course, some other CEO is thus inevitably cast into the bottom quartile, and so on.

It’s worth dwelling on that phrase: “the critical functioning structure that defines how the world works.” As the New Yorker writer John Lanchester observed: “That’s a hell of a big thing to find a flaw in.” Lanchester continued: “the people in power thought they knew more than they did. The bankers evidently knew too much math and not enough history—or maybe they didn’t know enough of either.” Think about it: In our financial system, we have ignored both math and history, and largely focus our expectations on the returns that the financial markets may deliver. We’ve also ignored the exorbitant costs extracted from our returns by Wall Street traders and money managers, costs that substantially diminish—indeed often overwhelm—our participation in the returns that our corporations earn and the excessive taxes that we incur in this era of record levels of speculative trading. Together, these costs have devastated the real (inflation-adjusted) returns that remain for investors. In all, our now-dominant money management sector has turned its focus away from the enduring nature of the intrinsic value of the goods and services created, produced, and distributed by our corporate businesses, and toward the ephemeral price of the corporation’s stock—the triumph of perception over reality. We live in a world in which it is far easier to hype the price of a company’s stock than it is to build the intrinsic value of the corporation itself.

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.

at about 4 ¾ percent, or about 2 ¼ percent after inflation—but before all-in bond fund costs of 1½ to 2 percent.) III. Innovation, Simplicity and Complexity To be sure, while all of us collectively are bound by the returns that are generated by the stock and bond markets, some of us will do better, some worse. Financial innovations designed to help us do better have been created all through history. But during the last decade, innovation has burgeoned to levels that are truly remarkable. Part of the reason is the expectation that stock and bond returns will lag behind historic norms—and far behind the halcyon norms of the 1980s and 1990s, when stock returns averaged 17 percent (!) and bond returns averaged 9 percent (!) (“We never had it so good.” Literally!) But if we know (within a fairly narrow tolerance) what returns to expect from broadly-diversified portfolios of stocks and bonds, what explains our expectations (or our hopes) that we can out-guess the markets and add additional returns by selecting strategies or managers that hold optimal subsets of the market portfolio? I fear that it is the triumph of hope over experience. The incredible rise—and fall—of so many derivative instruments in the present era should raise a red flag of caution regarding the value of financial innovation to investors. The flood of complexity—and its attendant high costs—seems to have overwhelmed simplicity—with its attendant low costs.

dancing.” (Rubin never heard of the “liquidity put.” Yet, as 2007 ended, Citigroup would write- down an astonishing $22 billion for expected future losses on CDOs and consumer loans). For Merrill Lynch, the write-down was $22 billion. Following a long age of cheap credit and rife credit availability and borrowers with high confidence and low collateral, we are beginning to pay the price, even as our economy itself faces a whole plethora of other risks created by our financial system. The key question is the extent to which these problems in our financial system will infect our economic system. The long boom in the real estate market has now turned down, with home prices in retreat, even as the same thing happened in the stock market early in 2000, and stock prices are now below the levels they reached eight long years ago. As I see it, our policy makers are running scared, with the Federal Reserve making credit available to banks (a good, and necessary step) and driving short-term interest rates down (great for borrowers but terrible for lenders and savers, and probably terrible for the dollar). I’m not at all sure that this is sound policy-making, for it increases the likelihood that inflation will rear its ugly head later on. Maybe, just maybe, we should not intervene and just let the markets clear.

The Elusive 8 Percent With reasonable expectations for a nominal annual return of roughly 7 percent on stocks over the coming decade, and, with somewhat more assurance, a return of roughly 3 percent on bonds, a traditional 60/40 stock/bond policy portfolio of a defined benefit pension plan might reasonably expect to earn a gross annual return averaging about 5.4 percent (Chart 6). Given the cost efficiencies in managing and administering portfolios with substantial assets, I might have assumed an annual cost of 0.5 percent, bringing the return to 4.9 percent. But if the pension fund adopts an index strategy, the cost could easily be as low as 10 basis points or less, bringing the net annual return to 5.3 percent, within one-tenth percent of the market return.2 (Note: Even an inflation rate as low as 2 percent would result in a real return of only about 3 percent per year.) 2 This example is a clear affirmation that investors as a group not only don’t get what they pay for, they get precisely what they don’t pay for. Therefore, if they pay nothing, they get everything (i.e., the markets’ gross returns).

AIG; and there are scores of others, companies that had the world at their fingertips, yet have fallen on hard times. But owning all of our nation’s corporations—including big winners like Apple as well as those losers like Eastman Kodak (unbelievable!)—carries only a fraction of the risk of owning individual companies. Such a totally diversified portfolio is an odds-on bet (but not a guarantee!) to grow over the long-term, simply because of its internal dynamics; putting vast sums of capital to work productively, earning a return on that capital, distributing part of that return to their owner/shareholders, and reinvesting the remainder of the cash flow in the business for future growth. But understand that the way the stock market values the shares of companies is very risky in the short-term; recessions subject our corporations to lower earnings; high—even speculative—valuations ebb and flow. But, bonds—the major alternative to stocks—despite their well-protected interest coupons and generally low default rates are, arguably, even riskier. Why? Because while the dollar value of our savings is fairly secure, the value of the dollar itself tends to shrink over time, as inflation takes its toll. Even at 3 percent per year, inflation would cut the purchasing power value (vs. nominal value) of today’s $1.00 to 74 cents over a decade and to 22 cents over a half-century. Many of you here tonight have witnessed just that in the past 50 years.

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

This conflict is pervasive, for it is said that money managers have only two types of client they don’t want to offend: actual, and potential. And so in corporate America we have witnessed staggering increases in executive compensation not only unjustified by corporate performance, but also grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity; and the failure of the traditional gatekeepers we rely on to oversee corporate management—our regulators, our legislators, our auditors, our attorneys, our directors. It’s high time for our now- empowered institutional agents to fight for the rights of their investor principals, honoring their agency responsibilities of corporate ownership and exercising their rights in overseeing governance. Building A Fiduciary Society So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society, one that guarantees that our last-line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—have their rights as investment principals protected. These rights must include: 1. The right to have money manager/agents act solely on their principals’ behalf. The client, in short, must be king. 2.

So, let’s put these projections together. If it’s reasonable to expect stocks to return around 7 percent annually during the coming decade, and bonds to return as much as 3 percent (before costs), a traditional balanced index portfolio with 60 percent stocks and 40 percent bonds should provide a return of about 5 percent, not so different from the past twelve years (although, as I noted earlier, it was bonds, not stocks that led the way). This return is far below the 7 percent historical return on such a portfolio. And those are nominal dollars, not real dollars. If we are lucky enough to hold the inflation rate to 2 ½ percent, that 5 percent market portfolio return drops to a real return of 2 ½ percent. That figure, of course, is before the costs of investing—say, very conservatively, at least 1 ½ percent—and perhaps another 1 percent in taxes for taxable investors—a real, after-cost, after-tax return of, well, zero. (It’s frightening to do the math!) As we meet today, however, that is the investment reality. Seeking Income that Is “Enough” Considering income generation alone, such a portfolio could yield up to 2 ½ percent, before costs, in nominal dollars.moderate

In investing, then the relentless rules of humble arithmetic—the subtraction of the logical, inevitable, and unyielding penalty assessed by investment costs, excessive taxes, and rising living costs—devastates the returns that investors in mutual funds earn over time. Using Justice Brandeis’s formulation, the mutual fund industry is obsessed with the delusion—and is foisting that delusion on investors—that a nominal gross return of 12 ½ percent per year in the stock market, minus fund expenses of 2.5 percent, minus taxes of 1.8 percent, and minus inflation of 3.3 percent, still equals a real net return of 12 ½ percent. Well, to state the obvious, it doesn’t! And unless the fund industry changes, it will falter and finally fail, a victim, yes, of the relentless rules of humble arithmetic. Were he here in your class this evening, Justice Brandeis surely would have warned, “Remember, NYU students, that arithmetic is the first of the sciences and the mother of safety.” 4.Economy

By then, I hope, our corporations will be required to report the actual returns of their DB plans over the prior ten years, disclosure that, absurdly, has never been mandated. VI. The Challenges We Face To sum up, in mid-2012, economic and market conditions together constitute as challenging a combination as I have seen at any time during my 61 years in finance (a milestone I will reach on July 5). Economic conditions in the U.S. and around the globe are, bluntly put, threatening. The battle has been joined between Keynesians demanding that governments borrow and spend to increase aggregate demand for goods and services, and Hayek-ites (disciples of the Austrian School of Economics) calling for fiscal austerity. It’s premature to guess how a compromise might be reached. For the political will to save both the Euro from fragmentating and the dollar from inflation by taking strong action to reduce our nation’s massive overlay of debt seems stymied by partisan interests. Our economic future depends on resolving these seemingly intractable issues—and there are many others!

traditional balanced portfolio with 60 percent stocks and 40 percent bonds should provide a return of 5 ½ percent, not so different from the past decade. (Although, as I noted earlier, it was bonds, not stocks that led the way.) This return is far below the 7 ½ percent historical return on such a portfolio. And those are nominal dollars, not real dollars. If we have inflation of 2 ½ percent, that 5 ½ percent return drops to 3 percent. As we meet tonight, that’s the investment reality. Seeking Returns that are “Enough” If that’s not, in some sense, “enough” of a return for you, the options to earn income that will cover your living costs are simple, but not easy: reduce your household expenses (no matter how painful); leverage your portfolio by borrowing at today’s low interest rates (a very risky strategy); spend moderate amounts of your capital (but you can’t do that forever); reach for higher yields by owning junk bonds (with their far higher credit risk); or increase your position in high dividend stocks (which have considerable volatility risk). But in general, make only moderate changes in your asset allocations; avoid box-car changes in favor of marginal changes. In the real world, as you see, for every pro, there’s a con. As it is said, there’s no such thing as a free lunch. Or is there? In fact, there is one remarkably easy way to increase your income return and leave risk absolutely unchanged. And this brings me full circle in my discussion this evening.

Who Actually Earns the Market’s Returns? In my view, then, we are looking ahead to a decade of returns in the financial markets that are well below historical norms (9 percent for stocks, 5 percent for bonds), albeit a decade in which equities seem highly likely to provide a significant return premium over bonds. But please remember this: the returns I have projected are not of the real world. They are the theoretical returns delivered by the stock and bond markets, before the deduction of investment costs. That raises this crucial question: Just who is it that earns the returns generated in our financial markets? Answer: Very few investors. So whatever returns the financial markets are generous enough—or stingy enough—to deliver, please don’t make the mistake of thinking you will actually earn those returns. Of course all investors as a group must necessarily earn precisely the market return. But they do so only before the costs of investing are deducted. After these costs are taken into account—all of the advisory 3 My own 5.4 percent expectation for nominal returns entails an assumed 2.5 percent inflation rate for a real return of 2.9 percent, virtually identical with Cliff’s figure.

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 a speculative return averaging 1.7 percent per year, borne of a price-earnings ratio that doubled on balance, from 9 times to 18 times. The sharp drop in yields, and the likelihood (in my view) that today’s price-earnings ratio of 18 will not only not redouble, but, in my judgment, is likely 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 9) If annual mutual fund costs—sales loads, expense ratios, and hidden turnover costs— continue to run at about 2.5 percent, those costs will reduce the real return of the average fund by more than half, to a humble 2.2 percent. (And I have even deducted those excessive taxes.) Clearly, reducing investment costs is at the crux of the ability of our nation’s families—the very backbone of our savings base—to earn the wealth to which they aspire.