We Study Billionaires - The Investor’s Podcast Network - TIP743: Should Value Investors Own Index Funds?

Starting point is 00:00:00 You're listening to TIP. For decades, Wall Street has been built on the idea that with enough research, intuition, or market timing, investors can beat the market. But what if the most rational investment strategy wasn't about outsmarting the market at all, but simply owning it? That's the radical simplicity John Bogle introduced when he launched the first index fund available to individual investors in the 1970s. Today, that concept is no longer radical as it's utilized by millions of people. In this episode, we're exploring why index funds work, why Bogle's philosophy continues to resonate with so many people, and how passive investing has reshaped the financial landscape. Bogel argues that trying to beat the market is a loser's game over the long run, largely

Starting point is 00:00:46 because of fees, taxes, and the human behaviors that get in our own way. Instead, he advocates for a low-cost, long-term approach of buying and holding a broad market index fund. This strategy doesn't promise the thrill of chasing high-flying stocks, but it can offer a far more reliable path to building wealth steadily over time. While our show is tailored for value investors who are picking individual stocks and actively managing their portfolios, I've found that index funds are held by many of the listeners of our show to help them gain more peace of mind and provide broader diversification for

Starting point is 00:01:22 their portfolios. So I thought this would be a good opportunity to dive into index funds, such as those that replicate the S&P 500's performance and explore why they continue to perform so well, despite past claims that we were in an index fund bubble or that the U.S. markets could not sustain strong returns due to the high expectations placed on big tech stocks. This episode also served as a good opportunity for me personally to brush up on the power of passive investing. As someone who loves the game of trying to beat the market, it can be easy to overlook the power of such a simple yet effective investment strategy that I believe should be utilized by most investors

Starting point is 00:02:01 wanting to save for their future. Also, before I get into the episode, I wanted to mention that we're quickly approaching our summit event in Big Sky Montana. This September, we'll be gathering in the mountains to connect with kindred spirits, share ideas, have engaging conversations, and enjoy delicious food in a wonderful setting. Our goal is to create an unforgettable experience for you and help you develop friendships that will last a lifetime. To learn more and secure one of the last spots, you can go to theinvestorspodcast.com slash summit or click the link in the description below. You can also shoot me an email at clay at theinvestorspodcast.com.

Starting point is 00:02:39 With that, I hope you enjoyed today's episode on Index Funds. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, PlayFing. How do you cast your lot with businesses? Simply by buying a portfolio that owns shares of every business in the United States and then holding it forever.

Starting point is 00:03:21 This simple concept guarantees you will win the investment game played by most other investors who, as a group, are guaranteed to lose. That's a line from John Bogle's book, The Little Book of Common Sense Investing, which I'll be discussing during today's episode. A few years ago, I had picked up this other book titled The Bogle Effect by Eric Belshunas, and I was just blown away by the impact that John Bogle has had on the investment industry. John Bogle was the founder of Vanguard and the creator of the very first index mutual fund

Starting point is 00:03:53 available to individual investors. He've revolutionized the investment industry by championing low-cost, passive investing as a superior alternative to high-fee actively managed funds. Bogle believed that minimizing costs in holding a diversified portfolio over the long term was the most effective strategy for most investors. His philosophy helped democratize investing, making it more accessible and efficient for millions of people. And today, his legacy lives on through the widespread adoption of index funds,

Starting point is 00:04:25 and the continued growth of Vanguard, which, as at the time of recording, has a whopping $10 trillion in assets under management. In Bogle's book, he actually quotes legendary investors like Warren Buffett, Charlie Munger, and Benjamin Graham, all of whom were active managers themselves. As a matter of fact, Buffett himself recommends that the typical investor simply puts their money in the S&P 500. In his 2013 letter to Berkshire shareholders, he outlined instructions in his will for managing his wife's trust. Rather than selecting an actively managed mutual fund with a superior

Starting point is 00:05:00 track record, or simply putting it in Berkshire Hathaway stock, he directed the trustees to invest 90% of the assets in a very low-cost S&P 500 index fund and the rest in U.S. Treasuries. In 2006, Buffett told John Bogle, a low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of this truth. So if the S&P 500 is good enough for Buffett, I figured that it's good enough for many of our listeners and good enough for us to discuss why it's so powerful here on the show. I've reviewed the track records of countless investors looking to come here on the show, and I continue to be surprised just how a few of them are

Starting point is 00:05:46 able to outperform the S&P 500. And that's one of the reasons that Bogle is such a strong advocate of index funds. Very few active managers are able to outperform the index over long periods of time. It's pretty counterintuitive that closing your eyes and dollar cost averaging into the S&P 500 will have the no-nothing investor actually beating most professionals who have an army of analysts and dedicate their life to the game of investing. You'd think that with the more work that one puts into it, the better their returns will be. But it certainly isn't the case. Before I get into the book here, some might be wondering how they can go about buying an index fund for themselves.

Starting point is 00:06:27 For those who are newer to the show here, this is jargon that they simply might not understand. An index fund is simply a basket or portfolio that holds many stocks, and it's designed to mimic the overall performance of the US stock market or a different market sector. So when I first set up my Roth IRA back when I was in college, I registered an account through Vanguard, set up automatic deposits into my account, and designed it so that when the money was deposited, it would automatically buy Vanguard's S&P 500 ETF, which is listed under the ticker V-OO-O. While most active managers charged fees in excess of 1% per year, the expense ratio on Vue is 0.03%, which is really about as close to 0% as you can get. In addition to the extremely

Starting point is 00:07:14 low fees, past returns have been really good as well. Over the past 10 years, the fund has returned 13.6% per year, which are returns we probably shouldn't expect going forward. If you want to learn more about this fund, you can simply Google V-O-O-V-O-Vanguard, and Vanguard has a page online that outlines everything you need to know about it. Diving into the book here, Bogle argues that the winning strategy for investing in stocks is to own all of the nation's publicly held businesses at a very low cost. And when he refers to the nation here, he's coming from a U.S. investors' perspective. I know that around half of our audience is not based in the U.S., so at this point, I'm just going to take the angle that he does in the book here.

Starting point is 00:07:57 The way Bogle puts it, the index fund eliminates the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains, end quote. Albert Einstein once said that compound interest is the eighth wonder of the world, and I 100% agree with them. I believe that every single person should figure out how to make compound interest work in their favor. One of the simplest ways to do it is to just buy an index fund. Bogel writes, the magic of compounding is little short of a miracle. Simply put, thanks to the growth, productivity, resourcefulness, and innovation of our corporations, capitalism creates wealth, a positive sum, game for its owners. Investing at equities has been a winner's game, end quote. It never ceases to

Starting point is 00:08:44 amaze me how with simply a click of a button, I can purchase partial ownership of the greatest businesses in the United States and benefit from the growth and innovations those businesses bring for the rest of my life. And I can do this without having to put any of the work in myself. These businesses are filled with people working endlessly to expand and serve their customers. Many are led by people who are smarter and more hardworking than anyone you'll ever meet in your life. And they're competing in a competitive market that rewards those who can create value and discards those who can't. It's this intense competitive environment that makes stocks in the companies they represent the most powerful and successful investment class in history. Unfortunately, all of this wealth that the stock market generates has led to a swath of people trying to profit from it for themselves.

Starting point is 00:09:36 like how a bee is attracted to honey. Vogel opens up this book with a parable about the Got Rocks family to illustrate the foolishness and counter-productivity of our vast and complex financial market system. So a wealthy family named the Got Rocks grown over generations to include thousands of brothers, sisters, aunts, uncles, and cousins owned 100% of every stock in the United States. Each year, they reap the rewards of investing,

Starting point is 00:10:03 all of the earnings growth that these thousands of corporations generated and all the dividends they distributed. Each family member grew wealthier at the same pace and all harmonious. Their investment compounded over decades, creating enormous wealth because the Gotrock's family was playing a winner's game. But after a while, a few fast-talking helpers arrived on the scene, and they persuade some smart Got Rock's cousins that they can earn a larger share than their relatives. These helpers convinced their cousins to sell their shares in some companies to other family members and to buy shares of other companies from them in return. The helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members,

Starting point is 00:10:51 and to their surprise, however, the family wealth begins to grow at a slower pace. The simple reason is that some of the return is now consumed by the helpers, and the family share of the generous pie that the U.S. industry bakes each year starts to decline. To make matters worse, while the family had always paid taxes on their dividends, some of the members are also paying taxes on the capital gains they realize from their stock swapping back and forth, further diminishing the family's total wealth. The quote-unquote, smart cousins quickly realized that their plan has actually diminished the rate of growth in the family's wealth. They recognize that their foray into stock picking has been a failure and conclude that they need professional assistance to pick

Starting point is 00:11:35 the right stocks for themselves. So they go out and hire stock picking experts, more helpers, to gain an advantage. These money managers charge a fee for their services, so when the family appraises its wealth a year later, it finds that its share of the pie has diminished even further. After failing to pick good stocks for themselves and failing to pick good managers, the smart cousins decide to hire more helpers, finding the best investment consultants and financial planners available to advise them on how to select the right managers who will then surely pick the right stocks. Alarmed at last, the family sits down together and take stock of the events that have

Starting point is 00:12:15 transpired since some of them began to try to outsmart the others. How is it that our original 100% share of the pie made up each year of all those dividends and earnings has dwindled to just 60%. Their wisest member, a sage old uncle, softly responds, all that money you've paid to those helpers, and all those unnecessary extra taxes you're paying come directly out of our family's total earnings and dividends. Go back to square one and do so immediately. Get rid of all your brokers, get rid of all your money managers, get rid of all your consultants. Then our family will again reap 100% of however large a pie corporate America bakes for us year after year." So they follow the old uncle's wise advice, returning to their original passive but productive

Starting point is 00:13:04 strategy holding all the stocks of corporate America and standing still. This is exactly what an index fund does. As I alluded to earlier, the story illustrates how inaction can be rewarded in the investment industry. Vogel writes, the way to wealth for those in the business is to persuade clients. Don't just stand there, do something. But the way to wealth for their clients in aggregate is to follow the opposite maxim. Don't do something, stand there. The moral of the Got Rock story is that successful investing is about

Starting point is 00:13:36 owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's corporations. The higher levels of investment activity that takes place, the greater the costs of financial intermediation in taxes, ultimately bringing less returns to the investors. Therefore, the lower one can keep investment costs, the greater the rewards they will reap. This is really the central message of the book. In the second chapter of his book here, Bogle explains how the gains for the shareholder must match the gains for the underlying business itself. This is a concept I touched on with Francois Voshaun back on episode 709.

Starting point is 00:14:15 Each year in his annual letter, Rochon estimates his portfolio's increase in intrinsic value during the year by looking at the increase in the portfolio's earning power. When looking back over the past 30 years, his returns as a shareholder have essentially matched that of the increase in the value of the underlying businesses themselves. To outline a very simple example here, let's say that we have a company that earns $1 per share and it trades at 20 times earnings. If the company increased its earnings by $10 to $1.10 and $0.10, then the P.E. multiple remain constant, then the share price would also increase by 10%. In reality, things can get a bit more complicated,

Starting point is 00:14:56 but that's the general idea. Warren Buffett once stated, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. History has proven that this is a fundamental truth in investing. Like gravity, there's a strong link between the cumulative long-term returns earned by U.S. businesses, which is the annual dividend yield plus the annual rate of earnings growth, and the cumulative returns earned by the stock market. Bogle shares a chart that shows the returns of the stock market from 1900 to 2016, and over that time, stocks returned 9.5 percent, and the estimated business returns were around 9%.

Starting point is 00:15:39 The 0.5% difference between the two is what Bogle refers to as the speculative return, which is essentially an investor's willingness to pay more or less for each dollar of earnings. What's sort of funny about this idea shared by Bogle is just how little it's discussed. When you're sitting at a dinner table, most people want to discuss the change in the share prices, while pretty much ignoring how the actual businesses are performing. It ties in well with the quote here he shares. The stock market is a giant distraction to the business of investing. If you owned a local business on Main Street and you were a true long-term owner of that business,

Starting point is 00:16:17 you would not be concerned about what your neighbor wanted to pay for that business. You would worry about how much revenue the business generated this year and what your profit margins are. Your neighbor's opinion on your business would be of little concern, which highlights how short-term movements and stock prices can include just a lot of noise. vocal rights, too often the market causes investors to focus on transitory and volatile short-term earnings expectations rather than on what is really important, the gradual accumulation of the returns earned by corporate businesses." Now, what's interesting about the S&P 500 today is that we're seeing valuation levels at very historic highs. The Schiller PE on the S&P 500, as of

Starting point is 00:17:02 the time of recording is 38, and over the past 150 years, there have only been two times that it has reached these levels. That includes the 1999 tech bubble and the 2021 speculative mania post-COVID. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you, you're going to you have is with people who are actually shaping the future. That's what the Oslo Freedom Form is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them

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Starting point is 00:21:28 Now, what happens to the Schiller PE from here? Nobody can really say for certain, it's possible that earnings continue to rise and the multiple starts to normalize, leading to lower than average returns for investors, or earnings could continue to rise, and the multiple might remain relatively constant. One thing is for certain, though. In the long run, reality prevails. Stock market returns will eventually closely coincide with the returns of the underlying businesses. I don't think we should immediately jump to the conclusion that because the Schiller

Starting point is 00:21:59 PE is elevated, then we should assume that the market is overvalued and future returns will be lower than average. In fact, I think looking at the S&P 500's overall PE ratio in isolation, tells you very little about what's really going on and where we might be heading. Big Tech obviously plays a key role in the performance of the index, and these companies tend to command above average earnings multiples, which is likely for a good reason. Companies that are growing, earn high returns on capital, and have the potential to grow for a really long time, should be valued more than a company that's capital intensive, earns lower returns on capital, and doesn't grow that much. Thus, when an index includes many great companies, then it should

Starting point is 00:22:44 command a higher multiple to its earnings. I think another consideration that many investors look at is currency debasement. If the currency is being debased, on average at 6% per year, the money tends to naturally flow towards companies that can grow their earnings at a nominal rate greater than 6%, which benefits big tech stocks that dominate the index. As long as that currency debasement continues, then I think it's reasonable to expect that investors will be willing to pay up for companies that can outpace that debasement. So when we look at some of the holdings within the S&B 500, Nvidia is the number one holding.

Starting point is 00:23:21 It's a 7.1% weighting. Invidia has a PE ratio of 52, and in fiscal year 2025, they increased their operating income by an astounding 147%. This is quite different than the tech stocks we saw in the 1999 tech bubble. We saw stocks doubling overnight that were generating practically zero or even negative earnings. Now if we look at Apple, on the other hand, it's the third largest allocation in the S&P 500. It's a 5.6% weighting. Apple's PE ratio is 33, while their operating income increased by just 7% in the most recent

Starting point is 00:24:00 fiscal year. So I think that the underlying stock and business returns for even the companies within the S&B 500 are going to be a mixed bag. And this can really make it difficult to judge the future returns going forward because you know, some companies will be doing really well, some maybe not so much. But without a doubt, I would say that there are just so many exceptions. businesses in the index, and this leads me to believe that investors are in good hands investing in these top companies in America if they have a long-term time horizon.

Starting point is 00:24:31 Some who are bullish on America and the S&P 500 are pointing to the future that artificial intelligence will bring. A tsunami of capital is pouring into AI infrastructure and development, and big tech especially is preparing for an AI-centric future. Continued breakthroughs in the AI models, coupled with the massive increases in the and computing power thanks to companies like NVIDIA are set to create a productivity boom. Who stands to benefit from this AI revolution? I think it's logical to assume that Big Tech will be a massive beneficiary with all of their investments, data, talent, platforms, and capital at their disposal. With this in mind, PE ratios of 20 for alphabet, 27 for meta,

Starting point is 00:25:14 and 36 for Amazon may prove to be quite cheap in hindsight, but time will tell. Although the historical long-term return of the S&P 500 has been around 9%. Bogle suggests lowering your expectations for future returns because multiples are elevated today. To look at returns going forward, we want to consider the dividend yield, the EPS growth, and the change in the multiple. As of the time of recording, the S&P 500's dividend yield is around 1.2%. Part of this is because the market overall is elevated, but the other part is that many

Starting point is 00:25:47 of the top holdings do not pay dividends such as NVIDIA, Amazon. Tesla, these companies are heavily reinvesting for future growth. If we assume that corporate earnings grow at the rate of its historical growth in nominal GDP, this would translate to earnings growth of around 6% on average per year. So if we add the dividend yield in the growth in earnings, that gives us about a 7% expected return. However, this ignores the potential for a multiple re-rating in the future. A modest re-rating in the S&P 500's earnings multiple over the next decade could add a 1 to 2%

Starting point is 00:26:23 headwind to the annual returns, bringing the returns to investors to around 5% to 6%. But just because a multiple re-rating can happen does not mean it will, so each investor can come to their own conclusion on what they deem to be a reasonable expectation going forward. So-called financial experts have called for normalized returns for U.S. stocks for close to a decade, yet U.S. markets have continued to roar and deliver strong earnings growth and multiple expansion. Of course, the multiple expansion cannot go forever, but the U.S. has defied gravity to some extent when it comes to the earnings growth side of the equation for quite some time with the continued rise of big tech stocks. I think that many equity investors, myself included, have become a bit

Starting point is 00:27:07 complacent with just how good returns have been in the U.S. over the past 15 years. It can be helpful to study history just to put things into perspective and see what types of things are possible, especially after markets have done so well for so long. I'm sure that many investors in Japan felt similar at the end of 1989. So during the 1980s, the Japanese stock market increased by 19% per year and proceeded to fall in the 15 years that followed from 1989. From 1990 to 2004, the Japanese market fell by 80% and would not reach its prior highs until 2024.

Starting point is 00:27:46 That's 35 years later. I think that just because U.S. markets have done so well in recent history, it can be good to sort of keep in mind that broader perspective of the realm of possibilities going forward. Valuations, economic conditions, and investor sentiment can all shift dramatically over time, and markets don't move in straight lines forever. History teaches us that periods of extraordinary returns are oftentimes followed by extended stretches of stagnation or even decline.

Starting point is 00:28:15 Investors who ignore that possibility can end up taking on more risk than they realize, and this doesn't mean that we should expect a repeat of Japan's experience, but it does highlight that markets can behave in ways that seem unthinkable during the boom times. Having humility and acknowledging uncertainty can help us build more resilient portfolios. In the end, studying history is not about predicting the future, it's about preparing for a range of outcomes, both good and bad. One of the mental models that Bogle shares in this book is Occam's Razor. Occam's Razor suggests that when there are multiple solutions to a problem, you should

Starting point is 00:28:53 choose the simplest one. Of course, he uses this mental model when it comes to investing, as he suggests to simply invest in all of the U.S. businesses in the stock market, or its equivalent like the S&P 500. To help make his case, he compares the performance of the S&P against active mutual fund managers. Data from the SPIVA report showed that from 2001 to 2016, 90% of actively managed mutual funds underperform their benchmarks, and additionally, the S&P 500 outpaced 97% of actively managed large-cap funds. Bogle writes here, in 1951, I wrote in my senior thesis at Princeton University that mutual

Starting point is 00:29:34 funds can make no claim to superiority over the market averages. Sixty-six years later, that has proven to be a huge understatement." The other drawback of actively managed funds is that they come and go. Of the 355 equity funds that existed in 1970, almost 80% of them have gone out of business and shut down. If the fund you're investing in does not endure over the long term, how can you invest for the long term? You can safely assume that it was not the best performing funds that have fallen to the demise. It was the laggards that disappeared.

Starting point is 00:30:12 Sometimes giant conglomerates acquired their management companies and shut down underperforming funds, or asset shrinkage led to a cutback on the number of funds managed. There are many reasons as to why these funds disappeared, few of which are good for investors. Two funds that did manage to outperform the market over long time periods were the Fidelity Magellan Fund and the Fidelity Contra Fund, both of which outpaced the S&P 500 by more than 2%. However, these funds did not always outperform, despite the track record overall being quite good. For example, the Magellan Fund's best years were early on when the asset base was low. In those early days, it outperformed by more than 10% per year.

Starting point is 00:30:54 Once the AUM hit more than $30 billion in 1993, the funds returns swiftly decelerated and underperformed the market from 94 to 99. As Buffett reminds us, a fat wallet is the enemy of superior returns as a similar story played out for the Contra Fund, which was managed by Will Danoff. The returns were the highest in the earlier years when the AUM was low, and as the AUM ballooned, the fund eventually started to underperform. This is something to keep in mind when you consider investing in an active manager that's raising capital. A hot start may have been a byproduct of the flexibility that they had when they had that low-starting AUM. History suggests that the odds of outperformance over multiple decades are quite low. Bogal equates trying to select a mutual fund

Starting point is 00:31:42 that will outpace the market over the long term to looking for a needle in the haystack. He proposes that instead of looking for the needle, instead just by the haystack. Since few mutual fund managers even last over the long term, you have the peace of mind knowing that an index fund with Vanguard is a permanent vehicle should you need it to be. It's built to last at the foundational level. I'm sure that many of our listeners are familiar of the impact that fees can have on your investment returns, but since it's so important to understand, I wanted to be sure to highlight it here as well.

Starting point is 00:32:16 As I mentioned earlier, the fees on Vanguard's S&P 500 index fund VOO is practically zero, and fees that are charged by investment managers can really vary widely. you typically see anywhere from 0.5% to 2%, which also might vary from year to year based on their performance. And we even shouldn't take for granted the S&P 500 index funds that are out there. You know, the fees within these ETFs can vary widely. Some may have expense ratios of 0.5% or 1%, you know, and even have sales loads of 1%. As Bogle puts it, your index fund should not be your manager's cash cow. It should be your own cash cow. So let's look at a few examples of how fees impact the end result for someone saving for retirement.

Starting point is 00:33:03 Here in the U.S., individuals can save an a tax advantage account referred to as in the Roth IRA, which has a contribution limit in 2025 of $7,000. I myself invest in a Roth IRA account. If someone saves $7,000 per year in the S&P 500 from age 30 to age 65, and they managed to get a 10% annual return, they would end up with $2.2 million at retirement. That return might be a bit high, but it's just for illustrative purposes. Now let's use the same returns but apply a 1% fee bringing our net return down to 9% per year.

Starting point is 00:33:39 This would bring the ending amount down to $1.7 million. So just a 1% fee compounded over that 35 year time period would cost that investor $500,000 or over 20% of his ending capital. Now, if we were to apply a 2% fee, the ending amount would be just $1.33 million, costing the investor nearly $900,000. It's no wonder that these financial companies and Wall Street firms have such nice furniture and nice suits to welcome you in. Wall Street makes a killing in taking their share of the market's gains year after year.

Starting point is 00:34:18 To put this another way, the investor puts up 100% of the capital, took 100% percent of the investment risk, yet they received around 60% of the returns. So this is the risk you face when investing with an actively managed fund. You need the manager to not only outperform the market, but also overcome the fees that they're charging to fully justify the service they're offering, assuming that your goal is to achieve at least a market return. Bogle argues that investors pay far too little attention to the costs of investing, especially for three distinct reasons. First, when the overall stock market returns have been high, it's easy to become complacent and believe that your returns are quote-unquote good enough.

Starting point is 00:35:03 Second, when investors tend to focus on short-term returns, they can easily overlook the impact of costs over an investment lifetime. And third, so many of the costs are hidden from plain view, such as portfolio transaction costs, the unrecognized impact of front-end sales charges and taxes incurred on fund distributions. I think that there can also be this sense that you aren't really paying for a manager's services when you really are. If someone has a million dollars and they're paying a 1% fee, that fee might be incurred monthly within your investment account with the manager to where it's almost invisible.

Starting point is 00:35:40 If the fees were actually taken out of your bank account, then I'd imagine that many people would think harder about the fees they're paying to their managers. The other deceiving thing about fees is that since they're oftentimes based off a percentage of assets, they compound drastically. What might look like a tiny fee in the first few years ends up being pretty enormous when you look out 20, 30, 40 years down the line. So the main takeaway with regards to fees is that they matter a lot to investors. There are several parts in the book where Bogle has a don't take my word for it section. He has one where he references Peter Lynch, who himself is an active manager, of course, he managed the Magellan Fund.

Starting point is 00:36:20 Lynch is well known for well outperforming the market from 1977 to 1990, and upon his retirement, he noted that the S&P 500 outperformed most of his peers in the industry and that the public would be much better off in an index fund. Now, of course, our show does discuss stock picking and interviews many active managers, which is why we primarily focus on those managers who actually do have a track record of outperforming the market. A few that we've interviewed over the past year or so include four. Branch Ravre Shah, Joseph Sheposhenk, Dev Kontasaria, Guy Speer, Monish Pabry, Chris Blumstrand,

Starting point is 00:36:58 and Andrew Brinton. It's hard to find some new names that have outperformed the market for more than 10 years, but from time to time, we do find them. Another interesting reality when it comes to mutual funds and active managers is that the returns that the investors actually receive tends to be less than the fund's actual returns since inception. It's not that the managers are being dishonest, but the core issue is that investors tend to put money in with an active manager after they've achieved good performance and take money out once the performance has faltered. Boe will share some statistics with regards to this. While the S&P 500 delivered returns of 9.1% over a 25-year time period, the average equity

Starting point is 00:37:39 fund earned 7.8% and the average investor was earning only 6.3% per year. This isn't necessarily an issue with the active managers, but with how humans are hardwired. I'd imagine that more investors were piling money into the stock market overall in 2006 when the rising tide was lifting all boats. When the market fell, I'm sure many people were either forced to sell because they lost their job during the crisis, or they sold out of fear believing that it wouldn't recover and they couldn't bear losing any more money. So this probably applies to both the active managers and the index investors, where they're

Starting point is 00:38:16 buying high and selling low. The difference with active managers, though, is that they will be out promoting their products and their funds when they're getting those high returns. Or some firms might have eight different strategies, shut down six that haven't done well, and go out and market the two that have the performance to show for. Thus, leading investors onto believe that the superior performance will continue. I once heard Monish Pabrai once joke that you could be an active manager with outperformance out on a boat in the middle of the ocean, and money would still find a way to get to you. For example, when we look back at the year 1990, investors put a net total of $18 billion into equity funds. This was a time when stocks were cheap

Starting point is 00:39:01 and bargains were plentiful. If we fast forward to 1999 and 2000, we all know that the market was substantially overvalued, yet investor flows were $420,000. billion. Investors also overwhelmingly tend to choose the new economy funds, technology funds, and the hottest performing growth funds, and ignore the more conservative value-oriented funds. One other drawback of mutual funds is that they're incredibly tax-inefficient, whereas their index fund counterparts offer excellent protection against the ravages of taxation. Since we're discussing taxes here, I'll mention that I'm not a CPA, and none of this is intended to be tax advice, so The portfolio turnover of the average actively managed equity fund is a whopping 78%.

Starting point is 00:39:48 This means that the average holding period of a stock in a mutual fund is less than one and a half years. This constant buying and selling means that investors are typically incurring a taxable event if a stock is being sold at a gain, which adds an additional drag to the mutual fund's performance. Not only do ETFs protect investors from this taxable event from taking place, there's There's also substantially less turnover. The turnover on the S&B 500, for example, is between 2% and 5%. Ironically, it's the active managers themselves who are getting in their own way to delivering

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Starting point is 00:43:51 fundrise.com slash income. This is a paid advertisement. All right, back to the show. I think one of the less discussed benefits of indexing over selecting individual stocks is that you really don't have to question yourself too much. When you invest in something like the S&P 500, you're not betting on one CEO, one business model, or one industry. You're betting on the adaptive capacity of the American economy. So whenever there's a severe broader market drawdown, you can be nearly certain that the index will eventually rebound to hit new highs yet again. This can be a more robust bet, and one that history has shown, pays off over time, even after the devastating shocks like the Great Depression, World War II, the dot-com crash in COVID-19.

Starting point is 00:44:36 However, with a fund manager or with an individual stock, you don't always have that level of certainty. Once Kodak or Blockbuster fell by 50%, they had another 90 to 100% to fall from there. This dynamic can make index funds easier to hold during those severe market drawdowns, where many businesses are significantly impaired. An index fund also avoids some of the damage from the catastrophic situations by getting rid of the market's losers. When Kodak was removed from the S&P 500, it was replaced by a better performing company. So as an index investor, you're not only avoiding the risk of a catastrophic loss, you're

Starting point is 00:45:14 automatically reallocating capital to the future winners without lifting a finger. So the no-nothing investor can be watering the flowers and pulling the weeds without even necessarily knowing that they're doing that within a portfolio that holds index funds. The S&P 500 was first established back in 1957, and it included 500 companies from various industries. Of those original 500 companies, only 53 of them remain today, just over 10% of the original counterparts. So it's constantly turning over a small portion of the portfolio, ringing out the bad, and bringing in the good. Historically, the S&P 500 turns over about 20% of its constituents each decade. When we look at the top 10 holdings from the year 2000, for example,

Starting point is 00:46:00 only one of them remains in the top 10 today, which is Microsoft. I thought it was interesting that Bogle included a chapter here on what he thinks Benjamin Graham would have thought about indexing. Ben Graham is of course known as the father of value investing as he wrote the book, The Intelligent Investor, which was published in 1949, but the first index mutual fund was not formed until 1974, so Graham was pretty limited to selecting individual securities when investing in public markets. Graham categorized two types of investing styles he referred to as the aggressive investor and the defensive investor. And he shared that most investors should be satisfied with the reasonably good return

Starting point is 00:46:40 obtainable from a defensive portfolio. The defensive portfolio would comprise of about a 50-50 split of stocks and bonds with the goal of having a balanced portfolio that helped provide psychological, comfort during both the bull and the bear markets. For the stock portion of the portfolio, he recommended only investing in large, conservatively finance, and established companies. This sounds eerily similar to investing in something like the S&P 500. By the time mutual funds had become popular, Graham became skeptical of their ability

Starting point is 00:47:11 to beat the market over long periods after accounting for the fees that they charged. Graham's timeless lessons for the intelligent investor are as valid today as when he prescribed him in the first edition of his book. He wrote, The real money and investment will have to be made not out of buying and selling, but of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value, end quote. So odds are that Graham would have been a strong proponent of investing in low-cost index funds, just as Warren Buffett is today. In fact, in a 1976 In the 26th interview, Graham was asked about whether investors should be content with earning the

Starting point is 00:47:52 market's return to which he said yes, and he also expressed his skepticism about an active manager's ability to beat the market after fees. I love this quote that Bogle shares here from Graham. To achieve satisfactory investment results is easier than most people realize to achieve superior results is harder than it looks. So if you're someone who's actively managed your own portfolio for more than, say, 5 to 10 years, or you've used an active manager and found yourself underperforming the market by more than a percent or two, then perhaps you would be better suited to a more passive

Starting point is 00:48:25 strategy that follows the principles that Graham and Bogle outline. Although Bogle's approach to investing in stocks is quite simple, it can still be very difficult to actually execute. Stocks tend to decline by 50 percent a couple of times a century. They experience a 30 percent decline about once every four to five years, and a 10 percent decline at least to every other year. This high volatility makes them difficult to hold onto during the turbulent times, and for most people, seeing a decade's worth of growth disappear in less than a year is a gut-wrenching experience. Charlie Munger stated, if you're not willing to react with equanimity to a market price decline of 50% two or three times a century, you're not fit to be a common shareholder

Starting point is 00:49:09 and you deserve the mediocre result you're going to get, end quote. So volatility is not a flaw of the system. It's the price of admission for the superior returns that equities offer over the long run. If you want the reward, you have to accept the ride that comes with it. The most effective way to manage the emotional roller coaster of the stock market is to keep your focus on the long term. While there are no sure things in investing, history tells us that given enough time, stocks will eventually recover from their occasional downturns. And this is referring to, you know, these broader market indexes and not necessarily individual companies. So because of this intense volatility, some investors might opt to invest in other asset classes

Starting point is 00:49:51 that are either less volatile or not correlated to the market movements, such as bonds, real estate, reits, their own business, gold, art, etc. In addition to volatility being the price paid for good returns, it can also serve as an opportunity to buy when there's blood in the streets. History suggests that even if you find yourself with investable cash during a market correction, It might be one of the best investment opportunities you'll ever get. Because it's during these market crashes that market prices are discounted at their cheapest levels relative to the underlying value. This of course assumes that you're investing in a market that will eventually recover

Starting point is 00:50:29 to new highs and not some of these outlier scenarios like we've seen in the past in say Argentina, Russia, Greece, etc. One reason that market crashes can be an excellent time to buy is that the percentage gain to get back to even is larger than every percentage loss. For example, a 20% loss requires a 25% gain to recover, and a 50% loss requires a 100% gain to recover, and so on. During the March 2020 correction, when the market was down 33%, it would have taken a 50% gain to get back to even.

Starting point is 00:51:02 Assuming that you believe that it was reasonable that the market would get back to its prior highs, then it would have been highly advantageous to continue investing during that time period. The tricky thing is that it's during these drawdowns is when it's most emotionally difficult to invest. Our gut instinct will likely tell us to be conservative or stack cash when we see red across our entire portfolio. But that's usually when the best opportunities are going to present themselves. Historically, some of the strongest forward returns come right after periods of extreme fear and pessimism. That's why having a plan in place before volatility strikes can make all the difference in how we've respond.

Starting point is 00:51:42 Napoleon once said that a genius is the man who can do that average thing when everyone else around him is losing his mind. That's not to say that we should try in time when these economic shocks are going to occur, because historically it's been significantly profitable to just dollar cost average into the market rather than trying to wait for these major declines to take place. Now, some of you might be listening to this and hear just how positively I've spoken about index fund investing, but wonder why I myself do not own any index funds. There are four points that I'd like to share with regards to this.

Starting point is 00:52:16 The first point relates to just my love for the game of investing. For me, investing isn't just a means to an end. It's something I genuinely enjoy. I love diving into company filings, understanding business models, and trying to piece together where the market may be mispricing certain opportunities. It's intellectually stimulating and I find the process itself rewarding. Managing my own portfolio also gives me a sense of control and involvement that a passive investing approach simply doesn't offer. It allows me to align my capital with the businesses and ideas

Starting point is 00:52:50 I believe in the most over the long term. During episode 734, I shared my investment philosophy and highlighted how it's been such a privilege to have the opportunity to partner with some of the best business managers in the world. The stock market allows us to really get to know a company in its management's long-term vision, and we don't have to pay a management fee for the privilege of partnering with them. Of course, an index can also give you access to those same people, but it just isn't the same when you're actually buying directly those shares and controlling the entry price and position sizing. The second point here relates to the inefficiencies of the market, breeding opportunities for value investors. While markets are broad,

Starting point is 00:53:31 Efficient over the long term, they can be quite irrational in the short and medium term. Investor sentiment, macro uncertainty, and herd behavior often push certain stocks well above or below their intrinsic value. Ben Graham eloquently shared his idea of Mr. Market and how Mr. Market goes through moot swings based on sentiment, which leads to stock prices moving much more than the underlying business value. Just looking at some of the Magnificent 7 over the past year, from high to low, companies like Alphabet, Amazon, and Meta have all deviated by over 40%.

Starting point is 00:54:06 I'm fairly certain that their underlying value did not change by more than 40% over the past 12 months. The third reason I decided not to index is that the future expectations of returns for the S&P 500 just simply are not as attractive as they once were. As I mentioned earlier, the Schiller PE of the S&P is 38, which is far above the historical norm. Just to get a ballpark figure of the expected future returns, if we assume that the show that we assume no change in the multiple, a 1% dividend yield, and earnings growth of 6 to 8% nominal terms, we're looking at around a 7 to 9% expected return.

Starting point is 00:54:41 So while I don't expect the stock market to crash by 70% or anything like that, I feel that I can just find better opportunities with higher expected returns. As I mentioned in the episode on my investment philosophy, I'm also considering the growth in the US dollar money supply or the currency debasement. and over the past decade, this is averaged around 6% per year. If the currency I'm using is being diluted by 6% and my returns are expected to be 7% to 9%, then I don't feel I'm being adequately compensated for the risk I'm taking. Ideally, I'm getting a 15% return or higher at this point in my investment journey,

Starting point is 00:55:19 where I'm focused more on capital appreciation rather than capital preservation. And that's not to say that achieving a 15% return is by any means easy to do, but it is the goal over the long run. Now, the final reason why I've decided not to index is because my returns in recent years have exceeded that of the index. And I hope for that to hopefully continue. I don't have my exact returns calculated to the nearest decimal point since I don't have all my data for my previous broker.

Starting point is 00:55:46 But the other day, I was preparing for a presentation I'm doing for our TIP Mastermind community about how value investing has changed my life. And I ran the numbers on how much my net worth has increased since January of 2022, just after I joined TIP, and simply calculated that my net worth has compounded at 30% over that roughly three-and-a-half-year time period, which of course includes investment contributions and doesn't directly translate to the exact returns that I'm getting. Now, that's not to say that I won't ever own an index funds. I wouldn't be surprised if later in life I start allocating more of my portfolio to index funds to diversify my asset base and provide more peace of mind in the midst of an ever-changing

Starting point is 00:56:28 and uncertain world. In doing so, it could also help make my overall portfolio more anti-fragile as the chance of having a significant capital impairment is very low when you have a long-time horizon holding an index fund. Broad market exposure through index funds can also act as a stabilizing force, especially when paired with more concentrated or higher-risk positions. Morgan Housel wrote in his book, The Psychology of Money, If I had to summarize money success in a single word, it would be survival.

Starting point is 00:56:57 With that said, if I ever had a friend or family member ask me where they should park their long-term savings, I think almost always I would answer an index fund if I had to give an answer. For most people, especially those who don't want to spend their weekends, reading 10Ks, or dissecting earnings calls, is the smartest, most reliable way to build wealth over time. It removes the pressure of picking individual stocks, it keeps costs low, and it ensures broad market exposure to the growth of the economy, and most importantly, to a large extent, it ensures survival. So while I've taken a different route personally, I still have a deep respect for indexing

Starting point is 00:57:34 and believe it's the right choice for the vast majority of investors for those reasons. In Nick Majuli's book, Just Keep Buying, he also makes some great points with regards to stock picking. Even if one does beat the market over, say, five years, it's just so difficult to know whether you're truly good at it, meaning that you actually have the skills to beat the market over long periods of time, rather than just getting lucky. In most domains, the amount of time it takes to judge whether someone has skill in that domain is relatively short. For example, any competent basketball coach could tell whether someone was skilled at shooting a ball within just 10 minutes. Similarly, a professional chef can often judge from one meal whether a cook knows how to get

Starting point is 00:58:17 the seasoning and the balance of flavors right. Now for stock picking, it takes multiple years just to get a good idea of whether one is skilled or not. The reason is that the feedback loop can take years. And even if an investment makes money in absolute terms, it can still lose money in relative terms if you're comparing it to an index. More importantly, though, the result that you get from that decision may have nothing to do with why you made it in the first place.

Starting point is 00:58:44 So maybe, you know, a stock you owned jumped because a competitor stumbled or interest rates fell, and not because the business performed how you expected it to. Conversely, a rock-solid thesis can look like a loser for years if sentiment or market liquidity flows are a big driver of the share price movements. When outcomes are decoupled from your original reasoning, you risk drawing the wrong lesson. confusing luck for skill and reinforcing behaviors that won't work over the long run. Another point shared by Majuli is that even if you're a skilled stock picker, you're almost certain to go through some periods of underperformance.

Starting point is 00:59:21 There are periods of up to three years where certain investment styles are just simply out of favor. And it's up to these great investors to stick to a process that works and not deviate from it. It's often said that the great investors are going to underperform the market about one-third of the time. So if you're picking stocks, it's really key to not let the market's short-term movements change your process. Letting the markets' movements sway your decision-making might help you in the short term by chasing trends or whatnot, but be detrimental to your

Starting point is 00:59:51 returns over the long term. Sticking to a process can be challenging because the world is constantly changing. Technologies change, consumer preferences change, and economic regime cycle in and out. What worked yesterday might be outdated tomorrow, making it take. attempting to abandon a proven process for whatever seems to be working now. But the irony is that those who stay disciplined amidst this uncertainty are often the ones who achieved lasting success. And just to add to my point earlier about survival, capitalism's brutal, and just maintaining one's business over a decade can be even a tough task, nonetheless trying to deliver value

Starting point is 01:00:30 in excess of the broader market. Over half of stocks end up underperforming the market, and around 40% of public companies end up losing all their value. Getting money and growing money are two entirely different skill sets, and as Morgan Hausel puts it, getting money requires taking risk, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility and fear that what you've made can be taken away from you just as fast. It requires frugality and an excessive that at least some of what you've made is attributable to luck, so past success cannot be relied upon to repeat indefinitely."

Starting point is 01:01:11 So to ensure survival, sometimes you might need to do things that just don't make sense when you plug it into a spreadsheet. Perhaps for some, that means holding most, if not all of your portfolio and index funds. Perhaps for others, it might mean holding one to two years worth of cash because it gives you the peace of mind to not worry about the day-to-day market movements. Or maybe it means avoiding individual stocks that aggressively use debt, since excessive leverage can make a company vulnerable to creditors in financial distress. Having some sort of financial plan in place is essential, but recognize that it's oftentimes the norm for things to not go according to plan.

Starting point is 01:01:52 A good plan leaves some route for error, and for things you can never foresee happening, such as the housing crisis or COVID, or God forbid, losing your job or having trouble paying your bills. I'll close out the episode the way John Vogel closes out his book. I quote, the simple ideas in this book really work. I believe the classic index fund must be the core of such a winning strategy. But even I would not have had the temerity to say what the late Dr. Paul Samuelson of MIT said in a speech in the autumn of 2005. The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel, the alphabet, and wine and cheese. Those essentials of our existence that we have come to take for granted have stood the test of time, and so will the traditional index fund, end quote.

Starting point is 01:02:43 With that, I think we'll close out the episode there. Thank you for your time and attention today, and I hope to see you again next week. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP743: Should Value Investors Own Index Funds?

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