John Bogle on Market Psychology

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

But Wellington's success-and his long life-serve as a testament to the durability of his investment principles. The bear market of last summer---one of only three 20+ percent drops in the past 20 years-has been reversed with a 25 percent gain that has now taken the market to newall-time highs. Surely we've never had it so good! But these spasms themselves remind us of something vital to recognize. The second principle: Markets Fluctuate. Many mutual fund investors seem to forget that fundamental reality. When stocks tumble, they push the proverbial panic button. Net cash flow into equity mutual funds, previously running at $18 billion a month, turned negative in August, with outflows of $11 billion, the first month of outflow since 1990. Those billions missed the recovery-and even at the lower stock prices of August and September, fund investors continued to pull money out of stock funds, albeit in smaller amounts.began

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.

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.

Then, I explained stock market returns with a, well, crusty speech entitled “The Bagel and the Doughnut.” The date was January 5, 2000, almost precisely at the stock market’s peak; the occasion, a meeting of Philadelphia’s Sunday Breakfast Club. In my remarks, I relied on an analogy inspired by William Safire in his essay, “Bagels vs. Doughnuts.” These baked goods, Safire tells us, are similar in shape but different in character: Bagels are “serious, ethnic, and hard to digest. Doughnuts are fun, crumbly, sweet, and fattening.” Investment return, I argued, is the bagel of the stock market, reflecting the reality of intrinsic business values. Its underlying character is nutritious, crusty and hard-boiled. Speculative return is the spongy, tempting, and sweet doughnut of the market itself, reflecting investment expectations and driven by the illusion of momentary stock prices, however precise. The bagel-like economics of investing are almost inevitably productive in the long run; the doughnut-like emotions of investing are fickle and largely unpredictable—witness the Great Bull Market of the 1980s and 1990s, and its collapse in 2000-2002, almost entirely the result of a change in the doughnut of investing from the soft sweetness of unbridled optimism on the part of investors to the acid sourness of pessimism.

7% on stocks during this one-and-one quarter century period, a remarkable tribute to the long run rationality of the financial markets. In the shorter run, to be sure, there is a lot of irrationality. (In particular, it seems apparent today.) Stock market irrationality can be measured by the ephemeral—but critical—factor of the price that investors are willing to pay for $1 of corporate earnings, the widely known price-to-earnings ratio. If, following Lord Keynes, we use the term investment to describe the fundamental return based on earnings and dividends, we use the term speculation to describe this second determinant of stock prices: the price that investors will pay for each dollar of earnings. If the power of fundamentals dominates market returns in the very long run—as it clearly does—the power of speculation dominates market returns in the shorter run. (Speculation, indeed, may be the only reason for the sometimes astonishing daily, weekly, or even monthly swings we witness.) Over time, investors have been willing to pay an average of about $14 for each $1 of earnings. But if, in their optimism, they are willing to pay $21, stock prices will leap by 50% for that reason alone. If, in their pessimism, they are willing to pay only $7, stock prices will fall by 50%. The changing price of $1 of earnings creates powerful leverage indeed— but it doesn’t last forever. 3 I am indebted to Jeremy J.

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%.

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.

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

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

simply for not being a fox. That is the American financial system today, and that is how capital formation works in the mutual fund industry. To the extent that another investment approach can avoid, or at least minimize, the inherent pitfalls that are built into the traditional mutual fund system, that approach will hold the winning hand. When Mr. Market Speaks, Funds Listen Where might that approach begin? By investing for the long term. The ultimate example of long-term investing is simply buying and holding the stocks of America’s businesses. Short-term speculation, its polar opposite, is buying shares—pieces of paper if you will—of hundreds of stocks listed on the nation’s stock exchanges, and then feverishly trading them in the market casino. The strategy of America’s most successful investor is the paradigm of long-term investing. Warren Buffett purchases the shares of a few businesses and holds them, ignoring the noise created by a man he calls “Mr. Market,” who comes by and offers him a different price for the businesses in his portfolio each day. The foxy managers of the fund industry however, do precisely the opposite, trading the pieces of paper in their portfolios at turnover rates of 50% to 200% annually. Responding at each moment to the prices set by Mr. Market’s madness, they pay little attention to the value of a corporation. As Columbia Law School Professor Louis Lowenstein has observed: Fund managers “exhibit a persistent emphasis on momentary stock prices.

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.)

But when our markets are driven, as they are today, largely by speculators, by expectations, and by hope, greed, and fear, the inevitably counterproductive swings in the emotions of market participants—from the ebullience of optimism to the blackness of pessimism—the resultant turbulence that we are now witnessing was almost inevitable.

But I’m guessing that earnings multiples are likely to be lower a decade hence, with the speculative return reducing that figure by about a percentage point. In sum the economics of investing are unlikely to be as good as in the past. Here’s the point: When our markets are driven by economics, the underlying power of our corporations to earn a solid return of the capital invested by their owners drives the long-term returns that are earned by equity investors. But in the interim, when our markets are driven, as they are today, by emotions—hope, greed, and fear; the speculative, counterproductive swings from the ebullience of optimism to the blackness of pessimism—be ready for turbulence. The Age of Turbulence To be sure, every era has its times of turbulence and its times of stability and growth. But surely the 21st century, the new and present millennium, has begun with turbulence riding in the saddle of the stock market.stocks

But the news media, competing to attract public attention and readership, needs news that is interesting, exciting, dramatic, and—of course—frequent. And financial markets provide just that, with their constant price changes in real-time. While these changes ultimately must reflect the reality of those glacial changes in corporate cash flow, the stock market is primarily an expectations market, a market that reflects human emotions, surges of optimism and pessimism based on hope, greed and fear. Business on the other hand, is about the real market, a market that reflects on the delivery of real goods and services, produced, Manufactured, and delivered by real people, using real strategies, that result in real earnings and real dividends. In short, those that invest (as a group) win: those that speculate (as a group) loose. This is the central message of “The Evolution of an Investor” from Conde Nast’s Portfolio, included in your materials. It is the story of a successful stockbroker who comes to understand the system and the damage it does to investors, turns his back on speculation, and adopts instead a new approach that focuses on long-term investment.which

Even more important, never forget Calvin Coolidge’s reminder that character counts. As the president told the National Council of Boy Scouts in 1926, “Character is what a person is; it represents the aggregate of distinctive mental and moral qualities belonging to an individual . . . good character means a mental and moral fiber of a high order, one which may be woven into the fabric of the community and state, going to make a great nation.” What’s more, especially in these days in which pessimism abounds, he’d likely advise us to hold on to our idealism. President Coolidge said, “We make no concealment of the fact that we want wealth, but there are many other things we want very much more. We want peace and honor, and that charity which is so strong an element of all civilization. The chief ideal of the American people is idealism. I cannot repeat too often that America is a nation of idealists.” (One of his predecessors, Woodrow Wilson, said, “Of course I’m an idealist. I am an American, and America is the most idealistic nation on earth.” Some ideas transcend politics!) We must also pay homage to our great American past, and resolve to honor more fully our nation’s founding principles. The Declaration of Independence assures us “that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.” I share those values, and indeed wrote about them in my recent book, Enough.

Our political leaders, too, seem to have pressed some sort of panic button, enough (apparently) to unite a Democratic congress and a Republican administration in an election year. But I’m also concerned that the $150 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, giving money to “the people” has a cost, even though I’ve yet to see an acknowledgement of that yet. It must be paid for, either by taxation or by borrowing, and ultimately with devalued dollars.) In short, it is by no means clear that this combined blast from our monetary masters and our fiscal authorities will make a large difference. 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. The inherent risk in the stock prices—in the first instance based on speculation, emotions, and investor psychology—may well carry over to the performance of our economy, now approaching—if not already in—recession.off