John Bogle is the founder and former CEO of Vanguard...he is perhaps the strongest proponent of indexing & he launched the first index mutual fund way back in 1976. His creation Vanguard is currently the world’s largest mutual fund company.
John Bogle’s book Enough begins with a wonderful epigram-a short witty poem depicting the reality of the modern financial system. It goes on to read something like this,
Some men wrest a living from nature and with their hands; this is called work.
Some men wrest a living from those who wrest a living from nature and with their hands; this is called trade.
Some men wrest a living from those who wrest a living from those who wrest a living from nature and with their hands; this is called finance.
The epigram is used by the author to describe the correlation between financial system and the economy of a country!
He then goes on to describe the ironclad equation under which the system works, what he terms as The Relentless Rules of Humble Arithmetic.
They are and I am quoting them from his book,
The gross return generated in the financial markets, minus the costs of the financial system, equals the net return actually delivered to investors.
Thus, as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted (i.e., forever), the ability of our citizens to accumulate savings for retirement will continue to be seriously undermined by the enormous costs of the system itself.
The more the financial system takes, the less the investor makes.
The investor feeds at the bottom of what is today the tremendously costly food chain of investing.
John Bogle sums up the above reality in these words, On balance, the financial system subtracts value from our society.
The author laments that we live in a world where we are merely trading pieces of paper, swapping stocks and bonds back and forth with one another...!
The author correctly asserts that all such activities obviously increase the costs and has led to the creation of complex financial derivatives which add to the mayhem due to immeasurable risks.
If I were an investor (or an investment advisor) the following is what I would interpret from the wisdom contained in Enough,
· The financial system is an additional layer to the real economy that produces goods and services which all of us consume. When I say this, I would exclude plain vanilla commercial banking which facilitates economic activities.
· As investors, we primarily plough our savings into companies that comprise the real economy...i.e. either as stakeholders in ownership (equities) or as lenders of capital (debt)....and we do this in order to meet our financial goals and objectives. Period!
· It implies, therefore, as an investor I should try and be closest to the returns generated by the system itself i.e. the market rate of return delivered to investors in the aggregate or as a group. The portfolio that mimics the market average return is obviously a broad market cap-weighted index (fund / ETF)
· As elsewhere (and also in India) the ‘market rate of return’ includes the performance of various professionals such as MF managers, PMS Managers, Insurance managers, stock pickers, FIIs, hedge funds and so on and so forth.
· To expand upon the ‘relentless rules of humble arithmetic’...some of these active investors (at random) will outperform the market average in some time periods-such that their (equally brilliant and motivated) counterparts will underperform (at random) by an equivalent amount. Both i.e. the alpha and anti-alpha are usually known in hindsight. The market is not a fairy tale mythical land where everyone can extract excess returns 'above the average' at the expense of other active investors (also trying to outperform.)
· To conclude: As investors it makes logical sense to reap the benefits of capitalism and enterprise by buying ‘capitalism in the aggregate’ via the market (broad index) portfolio...rather than indulge in (active) guesswork about individual pieces (stocks, companies, sectors and managers)....the individual pieces will exhibit random outcomes-both desirable and undesirable! The individual pieces will have additional (concentrated) risks over and above the market risk.
