John Bogle on Volatility vs Risk

Investing with Simplicity Speech by John C. Bogle Senior Chairman and Founder, The Vanguard Group ~ ~ ~ The Personal Finance Conference The Washington Post Washington, D.C. January 30, 1999 Many of you have heard the ancient Chinese curse---<:urse, mind you-that says, "may you live in interesting times." Curse or not, surely this is as interesting a time as it is possible to imagine. The extraordinary volatility in the financial markets is just one example of the stepped-up pace of our lives in an era-·a new era, to be sure-in which the technology revolution, the information explosion, and the rise of global interdependence have altered almost every activity in our daily lives. In important measure, it is these developments that have brought most investors unprecedented prosperity and wealth accumulation, and helped make mutual funds the investment of choice among American families. You now have all the information you could possibly need---except, of course, information about the future course of events and markets-to make investment decisions. But you should not mistake information for knowledge ... nor should you ever, ever mistake knowledge for wisdom, the ultimate weapon of the intelligent investor. During this "Personal Finance" conference, you'll hear a lot of good common sense. Pay attention to it. But you'll also hear a considerable amount of investment wizardry, financial legerdemain, and tempting solutions, often from the apparently omniscient. Disregard it.

” The oddly and narrowly constructed Dow Jones Industrial Average, of course, remains our basic measure of daily market swings, though the market-value-weighted S&P 500 is equally invariably used when the time comes to make relative return comparisons over longer periods. Today, just as institutional pension officers scowl over their bifocals as they review the quarterly performance comparisons in regular meetings with their investment advisers, so individual investors receive the data each quarter, either in real time on their computers, or as late (shocking!) as the next morning’s newspaper. It seems dubious in the extreme that such short-term focus can be other than counterproductive. I should point out that these rat-a-tat volleys of comparative information are of relatively recent vintage. Indeed, mutual fund sponsors were prohibited by the Statement of Policy of the NASD from publishing “total returns”—even without making comparisons—from 1950 through 1 In fact, I must confess to being amused by the irony that the “bogle” is in fact the earliest-known goblin, already part of Scottish literature in 1500. (Some years ago, I was called “Beta Bogle, the data devil.”) Given my role in forming the first index mutual fund in 1975, it is not without possibility that active managers place me in the goblin category.

operating costs. Today, such “large cap blend funds”4 account for only 11 percent of all stock funds. These 500 “market beta” funds are now overwhelmed by 3,100 U.S. equity funds diversified in other styles; 400 funds narrowly-diversified in various market sectors; and 700 funds investing in international equities—some broadly diversified, some investing in specific countries. The challenge in picking funds, dare I say, has become roughly like the challenge in picking individual stocks. I don’t consider that progress. 3. Investor Behavior. But fund investors no longer just pick funds and hold them. They trade them. In 1951, the average fund investor held his or her shares for about 16 years; today that holding period averages about four years. To make matters worse, fund investors don’t trade very well. Because they usually chase good performance, and then leap out after bad performance, the asset-weighted returns—those actually earned by fund investors—have trailed the time-weighted returns reported by the funds themselves by an astonishing amount—more than 6 percentage points per year over the past decade. (Cumulative 10-year return reported by the funds: 133 percent; return earned by their investors, 27 percent.) Astonishing! And depressing. 4. Investment Process. In 1951, funds were typically managed by investment committees. Today I can’t identify a single fund run by a committee.

Even though I have chosen the mutual fund categories dominated by large cap funds with similar volatility characteristics to those of the Index, the capitalizations of the stocks in their portfolios are inevitably somewhat smaller. Nonetheless, during the two decades—which obviously includes considerable “survivorship bias” in favor of the funds—the comparative differences were not large. During the first decade, the survivors actually outpaced the Index by 16 basis points, a somewhat uncharacteristically favorable outcome, only to fall 152 basis points behind during the second decade, a more normal result.1 1 If we compare the decade 1987-1997 with 1977-1987, the top quartile reversion to the market was a slightly larger 6.9 percentage points, with all 44 funds reverting toward the mean, including 35 that fell below it, an even more imposing outcome. The past decade was one in which the average fund fell 2.2% behind the Index.

represents 40% of the value of the $20 trillion world stock market, a fully diversified portfolio, invested 40% in the U.S. and 60% in Europe, Pacific and Emerging Markets, should provide the highest future “risk adjusted” returns. (Risks should be lower because global markets tend to fluctuate in different magnitudes, at different times, than U.S. markets.) But here history cannot help us very much. In the 1970s and the 1980s, for example, U.S. investors in foreign stocks earned returns of 17% per year versus 11% in the U.S.--without much difference in volatility risk. Precedent? Hardly. Precursor? No. So far in the 1990s, U.S. stocks are up 17% per year, foreign stocks up just 5%, and no one can predict which pattern, if either, faces us in the years ahead. To buttress the skeptical case, foreign returns earned by U.S. investors are heavily influenced by changes in the value of the U.S.and

managers sowing the seeds of their own performance inferiority today? Stranger things have happened. Well, these trends suggest why I describe the present era as the Age of Investment Relativism, in which the overarching goal is to avoid inferior short-term returns relative to the S&P 500, rather than to achieve superior absolute long-term returns. Since quantitative science entered the business of mutual fund performance in the mid-1980s, relativism has become the basis of a comprehensive performance measurement system. Beta (risk, measured by the fund’s price volatility relative to the 500 Index), and Alpha (the fund’s rate of relative return adjusted for risk) have entered our lexicon. We also have the Sharpe Ratio, measuring a fund’s excess return over the Treasury bill relative to its risk (standard deviation), not to be confused with the information ratio (Selection Sharpe Ratio), which measures excess return over a benchmark standard—usually, of course, our devilish friend, the S&P 500. I do not believe that this focus on simplistic mathematical precision is an entirely healthy state of being for managers or for their clients, nor for the market itself. Yet there is, as yet, no end in sight—no Omega on the horizon. The Real Villain: The Index Fund Surely the most important reason by far for the defensive reaction of managers to index comparisons is the index fund itself. The index is a mean adversary, but the index fund is the real villain of the piece.

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.

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

Fund turnover has risen from about 15 percent during my first 15 years in this business to 100 percent in recent years, reflecting a trend toward speculation that has been growing since the mid-1960s. Total turnover on the New York Stock Exchange was also less than 20 percent through the mid-1960s. Even by the mid-1990s, it rarely exceeded 50 percent. But in 2007, stock turnover exceeded 200 percent per year. If we include the trading in exchange traded funds (ETFs), that number has now soared to 280 percent, double the 1929 level. Clearly, the nature and character of our equity markets have changed. We are in a new era, one with the highest speculation component in history. How Did We Get Here? This soaring volatility in our financial markets—what I’ve described as “an orgy of speculation”—is a product of many forces. Surprisingly enough, one is the institutionalization of the stock market. The change is dramatic: Over the past half-century, individual ownership of stocks by individual investors has dropped from 92 percent of the total to 26 percent. Institutional ownership—largely by mutual funds and corporate and government pension funds— has soared from 8 percent to 74 percent—quite literally, a revolution in stock ownership that has changed the nature and structure of our financial markets.

This risk is reflected in the volatility of your portfolio and should take care of itself over time as returns are compounded. 3. Time Marches On $0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Avg. Eq. Fund S&P 500 Fund Money Mkt. 4. Nothing Ventured, Nothing Gained $15,500 $31,900 $38,400 Note: Return required on S&P 500 to reach $108,000 in 2016 is 7.March)

the fund’s volatility during those inevitable times when stock prices tumble. But “slightly lower” must be what the client is given to expect. In any event, it is important that the client understand that it is next to impossible to “market-time” a changing cash position. And most important of all, the client must understand that, in a positive stock market over time, he will pay a commensurate price in relative rate of return. Put simply, he should understand that, over the long-run, a percentage point increase in volatility is meaningless; a percentage point increase in return is priceless. That powerful, and, I think virtually unarguable syllogism, should give both adviser and client ample food for thought. Confronting the Index Challenge In this age of investment relativism, I’m convinced that—faced with the competition of index investing and quantitative investing—too many managers today are responding in the most ineffective manner possible, by “closet indexing.” But shaping an inchoate and undisclosed policy around the structure of an index is, finally, managerial suicide. It is the ultimate concession to the unarguable economic value of the low-cost, passively managed index fund over the high-cost, actively managed traditional fund.

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

Nonetheless, I can accept, if a bit grudgingly, the current fashion of “benchmarking”— comparing the return of a small-cap growth fund, for example, with the return of an index of small-cap growth stocks. As a short-term tool for ascertaining whether or not the manager is investing in accordance with his own proscriptions (and, assumedly, those of his clients), benchmarking seems reasonable enough. But over the long-run, it seems to me obvious that the fairest comparison of return is with the all-market index, not the style index. It is difficult to imagine that a client seeking a particular style—and a manager offering that style as representative of his or her particular area of expertise and comparative advantage—does not make that selection because it is expected to enhance long-term returns. “What gaineth the client,” one might say, “if he wineth the style derby, but loseth to the whole stock market.” For all of the scientific computerized data we see presented with grand precision— comparative returns, risk-adjusted returns, Alpha and Beta (with Omega not yet on our horizon), measured over short periods and long, and taken out to two decimal points and sometimes more—I think we in the profession have the duty, simply as a matter of fair and complete disclosure, to present both sets of comparisons—the style benchmark and the all-market benchmark—to our clients.

are almost always terrible times to change investment strategies. The market, however fickle, has usually taken into account almost every eventuality. Pillar 12. Think Long-Term. Do not let transitory changes in stock prices alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is “a tale told by an idiot, full of sound and fury, signifying nothing.” Stocks may remain overvalued, or undervalued, for years. Patience and consistency are valuable assets for the intelligent investor. The best rule: Stay the Course. During the past two years, the stock market’s noise has been the loudest in history as volatility has reached record highs. Millions of speculators are scared half to death, as they should be. But long-term investors must realize that, as greed turns to fear, much of the worry is already reflected in the lower level of stock prices. And even if it turns out we should be reducing our stock position until the decline is over, where on earth would we ever get the insight that tells us the right time to get back in? One correct decision is tough enough. Two sequential correct decisions—both made at the right moment—are nigh on impossible. Impulse is your enemy, and patience and consistency are your friends. Of my twelfth pillar of wisdom—Think Long-Term—I can only say, “Amen!” Please keep these Twelve Pillars of Wisdom in mind.

stocks moved in and out of the 500, creating portfolio turnover and potential tax-inefficiencies. So, in 1992 we created the all-in-one Total (U.S.) Stock Market Index Fund. That same year, when Standard & Poor’s/BARRA answered my public prayer and developed a growth index and a value index—each regularly adjusted to represent one-half of the weight of the 500—we started our Growth Index and Value Index Funds. I stated then—and reiterate now—my expectation that the long-term total returns were unlikely to differ significantly. The idea was to allow more aggressive long-term investors to hold the growth index fund for lower taxable income, higher tax-efficiency, and higher likely volatility. More conservative investors could hold the value index fund (for higher retirement income and lower volatility, at the cost of some tax-efficiency). Still earlier, in 1989, we converted a tiny actively-managed Vanguard small-cap fund into a passive Russell 2000 Index fund, creating the industry’s first small-cap index fund. And a few years ago, my successors at Vanguard added three more index funds—mid-cap (S&P 400), small- cap growth (half of the Standard & Poor’s 600), and a small-cap value fund (the other half). Over their histories, the segment funds formed before 1992 have done quite respectably—if largely unspectacularly. The newer funds, in even narrower market segments, have not been around long enough to fairly evaluate.

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

, popular fads are driving “product” creation in the fund industry—great for fund sponsors, awful for fund investors. Let me remind you of this time-honored principle: successful short-term marketing strategies are rarely—if ever—optimal long-term investment strategies. Recent experience with “Smart Beta” funds provides a classic example of the pitfalls faced by investors who create strategies through data mining. Renamed “Strategic Beta” by Morningstar, this category has boomed, even though the pioneering RAFI 1000 fund—formed a decade ago—has demonstrated only that its risk-adjusted return and its Sharpe Ratio both lag the S&P 500. Otherwise, it looks more like a closet index fund, with an R2 of 0.97 relative to the S&P 500. Yet the assets of these strategic beta funds have ballooned—from $100 billion in 2006 to $810 billion currently.despite

who were seeking a higher yield and were willing to assume the higher price volatility that inevitably accompanies it, the long portfolio, and so on. Changing the Standard for Bond Funds This solution gave Vanguard a large competitive edge. For sorting the funds into three maturities muted much of the “noise” in the performance of “managed” municipal bonds. With comparative performance of the funds sorted by maturities, the lowest-cost funds would be almost sure to win, and Vanguard was already the fund industry’s lowest-cost provider of bond funds. Over time, investors’ perceptions of bond funds changed. The three-tier (or more!) approach became the industry standard—not only in municipal bond funds, but in taxable bond funds as well. Today, with $150 billion of assets, Vanguard’s tax-exempt and taxable bond funds are the collection of bond funds largest in the industry. (Exhibit 6) Six Vanguard muni funds are ranked among the industry’s ten largest. Our taxable bond funds also adopted a similar defined maturity strategy, with assets that now total $836 billion. Three Vanguard funds made the list of the top ten taxable bond funds. Our Total Bond Market Index Fund, with assets of $328 billion, is a mere $229 billion larger than the #2 fund with assets of $99 billion. In all, bond investments under the Vanguard mantle now total just short of $1.1 trillion (See Appendix I), including some $260 billion our balanced funds, LifeStrategy Funds, and Target Retirement Funds.

Opportunistic marketers might develop a niche strategy, inducing narrowly focused ETFs (think lithium ion battery producers, or Israeli tech firms) and hope that they attracts assets. Another strategy might be to translate a quantitative, rules-based active strategy into a proprietary index and sell an ETF that tracks it. This sort of strategy is often referred to as “Smart Beta,” really an actively managed wolf in an index fund sheep’s clothing. Mark me down as dubious as to their long-term staying power. Offering narrow, even speculative ETFs could well be the optimal short-term marketing strategy for attracting cash inflows and generating trading commissions. But it is unlikely to be the optimal long-term investing strategy. For the fund managers owned and controlled by financial conglomerates (including banks), I believe a totally different strategy will emerge. Using the terminology of The Boston Consulting Group, maintain your fund business as the “cash cow” that it is today—delivering high margins and generous profits, albeit likely at a declining rate. Don’t invest more capital. Don’t cut management fees. Nominal cuts won’t help, and severe cuts would eliminate those cash flows. While fund cash outflows are highly likely to continue, a sharply rising stock market, however unlikely, would help offset the outflows, slowing the declines in assets under management, fee revenues, and profits.strategy,

As I look at these changes, I cannot help but wonder: “Is a position of 18%—or even 26%—in corporate bonds the optimal level for an individual investor? Might not some informed investors prefer a portfolio of, say, 65% in investment-grade corporates and 35% in Treasuries and agencies with a slightly higher yield that would come hand-in-hand with slightly higher volatility and a slight reduction in credit quality?” Much as I believe in the bond index fund (and the index it tracks), it occurs to me that the final form of an index fund tracking the bond market may yet be determined. The Future of Bonds . . . and Bond Funds Most of today’s bond investors have experienced only the sharp and unremitting drop in bond fund yields that has occurred over the past 35-plus years—the yield on the Bloomberg Barclays Aggregate Bond Index has plummeted from 14.6% at the close of 1981 to 2.6% today, a decline of a mere 83%. (Exhibit 12) Today’s low rates have led some experts to say that we’re in a bond fund bubble, one which will soon burst and send yields soaring and prices tumbling. Since anything can happen in a financial crisis, these predictions may prove correct. But I believe bursting bubbles is a concern largely for short-term speculators in bond prices, not long-term investors planning for their financial futures. After all, if an investor purchases a 30-year U.S. Treasury bond paying an annual coupon of 2.

rate of the 1950s and early 1960s to the 140 percent rate of the past three decades.8 While most fund managers were once investors, they now seem to be speculators. The new financial culture of ever-higher trading activity in stocks was embraced by investors of all types. Then institutional traders, of course, were simply swapping shares with one another, with no net gain for their clients. What’s more, the old equity fund model of blue-chip stocks in market-like portfolios— and commensurately market-like performance (before costs, of course!)—evolved into a new, more aggressive model. The relative volatility of individual funds increased, measured in the modern era by “Beta,” the volatility of a fund’s asset value relative to the stock market as a whole. This increase in riskiness is easily measured. Exhibit 7. The volatility of equity fund returns increased sharply, from an average of 0.84 (16 percent less volatile than the market) in the 1950s to 1.11 during recent years (11 percent more volatile). That’s a 30 percent increase in the relative volatility of the average fund. In the earlier era, no equity fund had volatility above 1.11; during recent years, 38 percent of equity funds exceeded that level. Relative Volatility of Equity Mutual Funds Relative Volatility 1950-1956 2008-2011* Difference Over 1.11 0 % 38 % +38 % 0.95-1.11 34 38 +4 0.85-0.94 30 10 -20 0.70-0.84 36 6 -30 Below 0.70 0 9 +9 7. * *S&P 500 = 1.

That shift toward higher volatility began during the “Go-Go Years” of the late 1960s, when “hot” managers were treated like Hollywood stars and marketed in the same fashion. It has largely continued ever since. (The creation of index funds was a rare and notable exception. An all-market index fund has Beta of 1.00.) But as the inevitable “reversion to the mean” in fund performance came into play, these aggressive manager stars proved more akin to comets— speculators who too often seem to soar into the sky and then flame out—focused on changes in short-term corporate earnings expectations, stock price momentum, and other quantitative measures. Too often, they forgot about prudence, due diligence, research, balance sheet analysis, and other old-fashioned notions of intrinsic value and long-term investing. With all the publicity focused on the success of these momentary stars, and the accompanying publicity about “the best” funds for the year or even the quarter, along with the huge fees and compensation paid to fund management companies and the huge compensation paid to fund portfolio managers of the “hot” funds, of course the manager culture changed. But even a short-term failing in performance became a career risk, so it became best to be agile and flexible, and watch over the portfolio in, as they say, “real time.” As equity fund assets soared, more aggressive funds proliferated, and steady and deliberate decision making was no longer the watchword.

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

performance—even superior. For, looking solely at total returns always conceals more than it reveals. Consider, for example, the substantial downside protection offered by the index portfolio in fiscal years 2001, 2002, 2003, and especially 2009, when the average endowment portfolio tumbled 19 percent, nearly double the 10 percent drop for the balanced portfolio Given those differences, we cannot and should not ignore risk. The indexed portfolio had a standard deviation of annual returns of 8.9 percent, exposed to some 20 percent less risk than the 11.3 percent volatility of the average endowment. As a result, the risk-adjusted return of the 50-50 portfolio, measured by the Sharpe Ratio was 0.45, well above the 0.38 Sharpe Ratio for the average endowment. Another risk, of course, is the risk of differing from the average, and the dispersion of returns among the endowment funds is significant. Today’s 990 endowment funds in the sample are not “a group.” Performance among individual endowment funds has diverged widely. While we don’t have nearly enough data on this point, one study limited to just 28 endowment funds for the period 1999-2009 showed that, with average annual return for the decade of 6.3 percent, their standard deviation of returns was 1.7 percentage points. One-sixth of the funds earned returns of 8.0 percent or more, and one-sixth earned returns of less than 4.7 percent. (The absolute range, even for this limited sample, ranged from 10.5 percent to 4.3 percent.)

We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation” that has ill-served our investors. Once an industry that “sold what we made,” our new motto has become “if we can sell it, we will make it.” For example, right at the peak of the late, great bull market, we created 494 new “aggressive growth” funds, investing largely in technology and telecommunication stocks. The consequences for our investors were devastating.  Our funds, once broadly diversified, became largely specialized. In 1951, almost 80 percent of all stock funds (60 of 75) were broadly diversified among investment-grade “blue-chip” stocks, pretty much tracking the movements of the stock market itself, and lagging its returns only by the amount of their then-modest operating costs. Today, our total of 512 “large-cap blend funds” account for only 11 percent of all stock funds. These “market beta” funds are now vastly outnumbered by 4200 more specialized funds—3,100 U.S. equity funds diversified in other styles; 400 funds narrowly-diversified in various market sectors; and 700 funds investing in international equities, some broadly diversified, some investing in specific countries. The challenge in picking funds, dare I say, has become roughly akin to the challenge in picking individual stocks. I don’t regard that change as progress  The wisdom of long-term investing has given way to the folly of short-term speculation.

0.0 0.5 1.0 1.5 2.0 2.5 Vanguard IT Index Fund: 6.65% Leh 5-10 Credit, less 0.20 bps: 6.72 Vanguard Tot Bond Mkt Inst: 6.20% Vanguard Tot Bond Mkt Inv: 6.07% Vanguard IT Inv Grade: 6.43% Avg IT Corp Fund: 5.52% Slope: -1.09 Number of funds: 313 Intermediate-term Corporate Bond Funds 10-Year Returns versus Expenses 3A. Vanguard IT Inv Grade Fund Average IT Inv Grade Fund Volatility (vs index) 85% 75% Quality (A or above) 98% 81% Turnover (5 yr avg) 55% 213% Expense Ratio 0.21% 0.93% 6.44% 5.52% 10-yr Annual Return $8,670 $7,110 Profit on $10,000 Vanguard IT Bond Index Fund 100% 100% 97% 0.17% 6.65% $9,040 3B. Duration 5.2 4.6 5.9 The adjusted annual return of 6.7 percent for the index was more than 20 percent higher than the 5.5 percent return of its average peer. Since the slope of the cost/return line is -1.09 (meaning that each percentage point reduction in cost increases return by 1.09 percentage points), actively managed bond funds as a group in fact earned a lower gross return than either the index fund or the adjusted index. Clearly, relative cost proved to be the principal differentiator in net return. (Chart 3B) Vanguard Intermediate-Term Investment Grade Bond Fund, for example, has an expense ratio of 0.21 percent, less than a quarter of the 0.93 percent expense ratio of its average peer. Similarly, the slightly-longer-duration Vanguard Intermediate-Term Bond Index Fund carries an

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

Vanguard ST Treasury Fund Average ST Gov’t Fund Volatility (vs index) 93% 100% Quality (A or above) 100% 99% Turnover (5 yr avg) 119% 155% Expense Ratio 0.26% 0.88% 4.95% 4.43% 10-yr Annual Return $6,200 $5,400 Profit on $10,000 Vanguard ST Federal Fund 90% 100% 81% 0.20% 5.07% $6,400 5B. Duration 2.2 2.4 2.2 While the Vanguard Short-Term Federal and Treasury funds are not, technically speaking, index funds, they track the index return with remarkable precision, turning in net average annual returns of 4.95 percent and 5.07 percent over the past decade, slightly higher than the index net return of 4.8 percent and outpacing 71 of the 90 short-term government funds. The low-cost, no-load option wins again. Treasurys being Treasurys, investment quality is virtually uniform. (Chart 5B) Both the Vanguard funds and the index itself hold 100 percent of their portfolios in short-term U.S. Government notes, and the actively managed funds hold 99 percent. With its towering 0.88 percent average expense ratio, however, the average short-term bond fund has a lot to overcome. It doesn’t succeed—it can’t succeed—in overcoming that handicap, even by assuming somewhat more volatility risk than the index and the Vanguard funds. The other outliers earning above- market returns did so simply by holding longer maturities, with the highest-returning funds carrying 3.3- to 3.9-year durations, compared to the duration of 2.2 years for the Vanguard funds.

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.

America’s Financial System—Powerful but Flawed A Lecture By John C. Bogle, Vanguard Founder The Phi Beta Kappa National Lecture Series Temple University, Philadelphia, PA November 3, 2010 In all of the talk about the causes of the deep-seated challenges facing our nation— globalization, enormous indebtedness, huge unemployment, the severe recession from which we are now only tentatively emerging, and the stock market crash of 2008-2009—too little attention has been paid to the critical role played by our financial system. Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked. The principal role of our nation’s financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal.

118% 19% 48% 111% 74% 16 % 41% 79% 0% 20% 40% 60% 80% 100% 120% 140% 1946 1949 1952 1955 1958 1961 1964 1967 1 970 1973 1976 1979 19 82 1985 1988 1991 1994 1997 2000 2003 2006 Equity Fund Portfolio Turnover 3. But it is not mutual fund managers alone who are engaging in this inevitably counterproductive trading behavior for investors as a group. They are reflecting a trend toward speculation that has been growing since the mid-1960s. Total turnover of U.S. publicly-traded equities was also less than 20 percent through the mid-1960s. Even by the mid-1990s, it rarely exceeded 50 percent. But in 2007, stock turnover exceeded 215 percent per year. (Chart 4) That number soars to 280 percent if we include the breath-taking level of trading in exchange traded funds (ETFs). Clearly, the nature and character of our equity markets have changed. We are in a new era, one that is importantly defined by this orgy of speculation, by far the highest in history. When our market participants are largely investors, focused on the economics of business, the underlying power of our corporations to earn a solid return on the capital invested by their owners is what drives the stock market, and volatility is low.

One result of this crazy speculation—you all must know this by now—has been the unprecedented market turbulence I have described. A simple measure makes the point: During my first few decades in this business, we might have three or four days each year in which stocks rose or fell by two percent or more. Since July 2007, however, stocks have risen or fallen by that amount on 52 days, 21 up and 31 down—volatility without precedent in all history. But does this market craziness reflect reality? No it doesn’t. Since the October 2007 high, the total capitalization of the U.S. stock market has crashed from about $18 trillion to $10 trillion, at the low last Friday, a drop of some $8 trillion. But that’s “the market.” Does anyone here tonight really believe that the value of American corporate business in the aggregate has dropped by $8 trillion—by 40 percent! Well, I for one do not. Over the entire modern era, U.S. business has grown, with remarkably few interruptions, (for example the Great Depression), at about the pace of the real economy. Much of the responsibility for the crash in prices can be laid on Wall Street. Investment bankers, brokers, and money managers shifted their attention away from honoring, first and foremost, the interests of their clients and toward increasing their personal wealth and the earnings of their (largely publicly held) firms.

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

But if you missed the returns achieved on the 40 market days in which it had its highest percentage gains—only 40 out of 14,588 days!—the Index would be at just to 280, an annual return of just 5 percent. There is a lesson to be learned here about the impossibility of successfully jumping into and out of the market, rather than simply staying the course. How Did We Get Here? The soaring volatility in the financial markets is a product of many forces. Surprisingly enough one is the institutionalization of the stock market. The change is dramatic: Over the past half-century, individual ownership of stocks by individual investors has dropped from 92 percent of the total to 26 percent. Institutional ownership—largely by mutual funds and corporate and government pension funds—has soared from 8 percent to 74 percent—quite literally, a revolution in stock ownership that has changed the nature and structure of our financial markets.

But those are fairly big moves for valuations, and I don’t personally see significant reasons either for multiples to rise much (and thus produce positive speculative returns) or to fall much (and thus produce negative speculative returns). So I expect that our possible 7 percent investment return (far right bar) will be neither materially enhanced nor materially depleted by speculative return during the coming decade. But even if stocks seem likely to provide adequate returns, nearly all prudent investors still need a balanced portfolio, including bonds, to reduce risk and contain volatility. The basic rule of asset allocation is age-based; less bonds when you are young, and more bonds as you age. Yet bonds today offer investors the lowest yields since I came into this field in 1951.Alas,

amounts of your capital—but an investor can’t do that forever; (4) Reach for higher yields by using junk bonds—with their far higher credit risk—or shift some of the bond portion into high dividend stocks—with much more volatility risk. But in general, make only moderate changes in your asset allocations; avoid box-car changes in favor of marginal changes. For in the real world, as you see above, 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 clients’ income returns while leaving risk absolutely unchanged. And this brings me full circle in my discussion. The simple mathematical fact is that, because of high mutual fund expenses, the passively- managed all-stock-market index fund typically holds the same composite portfolio as the average actively-managed fund, and generates about the same gross dividend yield, say, 2.1 percent for stocks and 2.9 percent for taxable bonds. (Chart 6) But active stock funds (the managed funds are in red) subtract expenses averaging about 1.2 percent, leaving less than 90 basis points for the investor. Active taxable bond funds generate gross income of about 3 percent, but subtract about 0.9 percent in expenses on average, consuming more than 30 percent of the yield and leaving just 2.0 percent to distribute.

But even if stocks seem apt to provide adequate returns, nearly all prudent investors still need a balanced portfolio, including bonds to reduce risk and contain volatility. The basic rule of asset allocation is age-based; less bonds when you are young, and more bonds as you age. Yet bonds today offer the lowest yields since I came into this field in 1951. Alas, today’s yields are excellent predictors of the total returns you’ll earn on bonds over the coming decade. Worst case: the (so-called) risk-free rate—based on the 10-year Treasury bond—is now 1.6 percent, down from a high of 11.6 percent in 1980. Two more mathematical facts: a 1.6 percent return would increase your capital by just 17 percent during the next 10 years; in the same length of time with an 11.6 percent return would multiply capital three times over. So, yes, holding a balanced stock-and-bond allocation is essential, but it will not likely provide the kinds of handsome returns we were lucky enough to experience during the 1980s and 1990s, albeit better than we have seen thus far during the 21st century. (During the past 12 years, bonds were the driver. In the coming decade; it is stocks that will have to do the heavy lifting.) Of course, investors are not limited to U.S. Treasury 10-year bonds. Owning an investment grade corporate bond with a somewhat longer maturity should produce a yield of perhaps 3 percent. So it seems it is reasonable to own a mix of Treasurys and corporates, and earn about 2 ½ percent.

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.