The man who inventing indexing

I couldn’t agree more with the first line of John Bogle’s new book: “Investing is all about common sense.” Right on! If more people used the brains they were given, we’d have much less financial trauma in the world.

However, in Bogle’s mind common sense pretty much comes down to one thing: index investing. It’s the only way to keep your costs to a minimum while benefiting from the efficiencies of the stock market, he contends. As soon as you get into picking your own stocks or buying mutual funds, you’re a goner, he says.

“Our financial croupiers always win,” he writes in The Little Book of Common Sense Investing. “After the deduction of the costs of investing, beating the stock market is a loser’s game.”

Bogle is quick to acknowledge that he has a vested interest in the indexing concept. An almost legendary figure in the US, he’s the founder of the Vanguard Funds and in 1974 created the world’s first index mutual fund. Think of him as the Billy Graham of the indexing world, seeking to convert naysayers at every opportunity – and this is a man who will turn 78 in May and who has had a heart transplant!

His proselytizing has been successful. Indexing has become an incredibly popular way to invest and exchange-traded funds (ETFs), indexed securities that trade on stock markets, are growing at a prodigious rate.

Bogle sprinkles his book with charts and statistics to prove the point that simply putting your money into an index fund that tracks the broad US market is all you need to do to get rich. The market’s average annual investment return over the period from 1900 to the end of 2005 was 9.5 per cent, he writes. That means every dollar invested in 1900 was worth slightly more than $15,000 on Dec. 31/05 (or $793 after discounting for inflation). Impressive – although as he notes, we aren’t likely to live for 106 years!

He doesn’t take kindly to dissenters. “If the data do not prove that indexing wins, well, the data are wrong,” he writes. However, he stresses that his deep belief in the value of indexing only extends to funds that own the entire market. He is disdainfully dismissive of the new breed of index fund that focuses on specific sectors and which are sometimes based on “indexes” the promoters have created themselves.

That even extends to the much-praised new WisdomTree funds, created by renowned professor Jeremy Siegel of the University of Pennsylvania’s Wharton School. Siegel’s funds focus on dividend-paying stocks rather than the broad market. In a recent debate between the two men published by USA Today, Bogle described the approach as an “oversold panacea” and warned of the danger of investors jumping in and out of specialized funds depending on market conditions.

“Investors are going to jump on these bandwagons after superior performance has been achieved and in this case (they) are their own worst enemy,” he said “It’s a dangerous weapon. I’ve compared it to a Purdy shotgun…It’s great for big-game hunting but, alas, great for suicide.” Clearly, Bogle is a purist when it comes to indexing.

I have my own reservations when it comes to indexing. One dovetails well with Bogle’s own views, although to my knowledge he has not discussed it. That’s my view that the TSX is too small for indexing to work effectively, as was demonstrated in the late 1990s when Nortel accounted for a third of the Index’s total capitalization. Even using a capped index, as is done routinely today, the TSX is too heavily weighted towards two sectors, resources and financials, for indexing to be effective. My second concern is with the psychology of indexing. It’s easy to stick with a long-term plan when markets are bullish or even flat. It becomes very difficult with stocks go into a prolonged dive as they did from 2000 to 2002. Finally, age must be a consideration. Bogle takes the long view but many investors don’t have that luxury. It’s hard to think in terms of 10- or 20-year horizons when you’re 70.

That said, there is a role for indexing in a portfolio when it is done properly. If you’re interested in the concept, this book is the place to go to understand the theory and practice behind it – this is the man who created the idea of the index fund, after all. There’s a lot of material about US taxes and mutual funds that won’t mean boo to Canadian readers but skip over that stuff and concentrate on the meat. And pay special attention to Bogle’s comments about how all index funds are not created equal and his rules for choosing the best ones. They’ll help to keep you on track and to avoid the tide of new speculative ETFs.