The Little Book of Common Sense Investing: How to Achieve Higher Returns with Lower Risk and Simplicity
The Little Book of Common Sense Investing Bibliography.pdf
If you are looking for a simple and effective way to grow your wealth over time, you should read The Little Book of Common Sense Investing by John C. Bogle. This book is a classic guide on how to invest wisely and successfully using a common sense approach that anyone can follow.
The Little Book of Common Sense Investing Bibliography.pdf
John C. Bogle was the founder of Vanguard Group, one of the largest and most respected mutual fund companies in the world. He was also the creator of the first index fund, a type of fund that tracks a market index such as the S&P 500. He was a pioneer and a champion of low-cost, long-term, diversified investing for individual investors.
In this book, he shares his wisdom and experience on how to achieve financial security and peace of mind by following some simple principles and strategies that he calls common sense investing. He explains why these principles work, how they can benefit you, and how you can apply them in practice.
In this article, we will summarize the main points of his book and show you how you can use it as a blueprint for your own investing journey. Whether you are a beginner or an expert, this book will help you improve your results and avoid costly mistakes.
Why You Should Read This Book
Investing can be confusing and overwhelming for many people. There are so many options, opinions, and advice out there that it can be hard to know what to do and who to trust. Moreover, the financial industry is full of conflicts of interest, hidden fees, and misleading information that can harm your interests and erode your returns.
That's why you need a reliable and unbiased source of guidance that can help you navigate the complex and uncertain world of investing. That's what this book provides. It teaches you the fundamentals of investing that are based on sound logic, empirical evidence, and historical data. It shows you how to avoid the pitfalls and traps that many investors fall into and how to focus on what really matters for your long-term success.
By reading this book, you will learn how to:
Build a diversified portfolio of low-cost index funds that can match or beat the performance of most actively managed funds and individual stocks
Reduce your risk and volatility by spreading your money across different asset classes and sectors
Keep your costs low by minimizing fees, taxes, and other expenses that eat into your returns
Stay the course by avoiding market timing, chasing performance, and emotional investing
Enjoy the simplicity and peace of mind that come from following a proven and easy-to-implement strategy
The Main Principles of Common Sense Investing
The book is divided into 18 chapters, each covering a different aspect of common sense investing. However, the core message of the book can be summarized in four main principles that Bogle advocates throughout the book. These are:
Invest in low-cost index funds
Diversify your portfolio
Keep your costs low
Stay the course
Let's look at each of these principles in more detail.
Invest in Low-Cost Index Funds
The first and most important principle of common sense investing is to invest in low-cost index funds. These are funds that track a market index such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite. They aim to replicate the performance of the index by holding all or most of the stocks or bonds that make up the index.
Bogle argues that index funds are superior to actively managed funds and individual stocks for several reasons:
They have lower costs. Index funds have very low fees compared to actively managed funds, which charge high fees for their management, research, trading, marketing, and distribution. These fees can significantly reduce your returns over time. For example, if you invest $10,000 in a fund that charges 1% per year and earns 10% per year before fees, you will end up with $25,937 after 20 years. However, if you invest in an index fund that charges 0.1% per year and earns the same 10% per year before fees, you will end up with $32,071 after 20 years. That's a difference of $6,134 or 24% more money in your pocket.
They have higher returns. Index funds tend to outperform most actively managed funds and individual stocks over the long term. This is because most active managers fail to beat the market average consistently due to their high costs, their inability to predict the future, their tendency to follow trends or fads, and their exposure to human biases and errors. According to Bogle, only about 15% of active funds beat their benchmark index over a 15-year period. Moreover, those who do beat the index in one period often fail to do so in another period, making it hard to identify them in advance.
They have lower risk. Index funds have lower volatility and lower downside risk than actively managed funds and individual stocks. This is because they are well diversified across hundreds or thousands of securities that represent the entire market or a large segment of it. They are not exposed to the idiosyncratic risk of a single company or sector that can suffer from poor performance, bad news, scandals, or bankruptcy. They also avoid the risk of picking the wrong manager or stock that can underperform or lose money.
Diversify Your Portfolio
The second principle of common sense investing is to diversify your portfolio. This means spreading your money across different asset classes and sectors that have different characteristics and behaviors. By doing so, you can reduce your overall risk and increase your chances of capturing the returns of various markets.
Bogle recommends diversifying your portfolio in two ways:
```html Diversify Your Portfolio
The second principle of common sense investing is to diversify your portfolio. This means spreading your money across different asset classes and sectors that have different characteristics and behaviors. By doing so, you can reduce your overall risk and increase your chances of capturing the returns of various markets.
Bogle recommends diversifying your portfolio in two ways:
Diversify across asset classes. Asset classes are broad categories of investments that have similar features and risks. The main asset classes are stocks (equities), bonds (fixed income), cash (money market), and alternatives (such as real estate, commodities, gold, etc.). Each asset class has its own expected return, volatility, and correlation with other asset classes. Generally, stocks have the highest return and risk, followed by bonds, cash, and alternatives. Stocks and bonds are negatively correlated, meaning they tend to move in opposite directions. Cash and alternatives are usually uncorrelated or weakly correlated with stocks and bonds, meaning they tend to move independently or slightly related to them.
Diversify across sectors. Sectors are subcategories of investments that belong to the same industry or economic activity. For example, some common sectors in the stock market are technology, health care, energy, consumer staples, financials, etc. Each sector has its own growth potential, profitability, valuation, and sensitivity to economic cycles and events. Some sectors are more cyclical, meaning they perform well when the economy is booming and poorly when the economy is slowing down. Some sectors are more defensive, meaning they perform well when the economy is weak and poorly when the economy is strong. Some sectors are more growth-oriented, meaning they have high earnings potential and innovation. Some sectors are more value-oriented, meaning they have low prices relative to their earnings or assets.
By diversifying across asset classes and sectors, you can create a balanced portfolio that can withstand different market conditions and capture the returns of various sources of growth and income. For example, if stocks are doing well, you can benefit from their high returns. If stocks are doing poorly, you can rely on your bonds, cash, or alternatives to cushion your losses. If one sector is underperforming, you can offset it with another sector that is outperforming.
Keep Your Costs Low
The third principle of common sense investing is to keep your costs low. Costs are one of the biggest enemies of investors because they reduce your returns and compound over time. The higher your costs are, the lower your net returns will be.
Bogle identifies four main types of costs that investors face:
Fees. Fees are the charges that you pay to fund managers, brokers, advisors, or other intermediaries for their services. Fees can be expressed as a percentage of your assets (such as expense ratios or management fees) or as a fixed amount (such as commissions or loads). Fees can vary widely depending on the type of fund or service you use. For example, index funds typically charge very low fees (around 0.1% per year or less), while actively managed funds typically charge high fees (around 1% per year or more). Similarly, discount brokers typically charge low commissions (around $5 per trade or less), while full-service brokers typically charge high commissions (around $50 per trade or more).
Taxes. Taxes are the charges that you pay to the government on your investment income or gains. Taxes can vary depending on your tax bracket, the type of investment you hold, the length of time you hold it, and the tax laws in your country or state. Generally, taxes are higher for short-term gains (less than one year) than for long-term gains (more than one year). Taxes are also higher for ordinary income (such as dividends or interest) than for qualified income (such as capital gains or qualified dividends). Taxes can be deferred or avoided by using tax-advantaged accounts (such as IRAs or 401(k)s) or tax-efficient investments (such as municipal bonds or ETFs).
Inflation. Inflation is the decrease in the purchasing power of money over time due to the rise in the general level of prices. Inflation reduces the real value of your investment returns and erodes your savings. Inflation can vary depending on the economic conditions and policies in your country or region. Generally, inflation is higher when the economy is growing fast and lower when the economy is growing slow. Inflation can be hedged or mitigated by using inflation-protected securities (such as TIPS or I-Bonds) or inflation-sensitive investments (such as commodities or real estate).
Behavioral costs. Behavioral costs are the losses that you incur due to your own actions or emotions. Behavioral costs can include market timing, chasing performance, overconfidence, loss aversion, herd mentality, confirmation bias, and other cognitive or emotional biases that affect your decision making. Behavioral costs can be very hard to measure and avoid because they are often subconscious and irrational. Behavioral costs can be reduced or eliminated by following a disciplined and consistent strategy, avoiding emotional reactions, and seeking objective and unbiased advice.
By keeping your costs low, you can increase your net returns and compound your wealth faster. For example, if you invest $10,000 in a fund that earns 10% per year before costs and has a total cost of 2% per year (including fees, taxes, inflation, and behavioral costs), you will end up with $23,674 after 20 years. However, if you invest in a fund that earns the same 10% per year before costs and has a total cost of 0.5% per year, you will end up with $31,409 after 20 years. That's a difference of $7,735 or 33% more money in your pocket.
Stay the Course
The fourth and final principle of common sense investing is to stay the course. This means sticking to your plan and strategy regardless of the market fluctuations and noise. It means resisting the temptation to change your portfolio based on short-term events or emotions. It means having patience and discipline to achieve your long-term goals.
Bogle warns against three common mistakes that investors make that prevent them from staying the course:
Market timing. Market timing is the attempt to predict the future movements of the market and adjust your portfolio accordingly. Market timing can involve buying or selling based on technical indicators, economic forecasts, news events, or gut feelings. Market timing is a futile and costly exercise because it is impossible to consistently predict the market with accuracy and precision. Moreover, market timing involves frequent trading, which increases your costs and taxes and reduces your returns.
Chasing performance. Chasing performance is the tendency to buy or sell based on past results rather than future prospects. Chasing performance can involve buying high or selling low based on recent trends, fads, or popularity. Chasing performance is a dangerous and irrational behavior because it ignores the fundamental value and potential of an investment. Moreover, chasing performance involves following the crowd, which increases your risk and reduces your returns.
Emotional investing. Emotional investing is the influence of emotions such as fear, greed, hope, or regret on your investment decisions. Emotional investing can involve panic selling or euphoric buying based on market swings, news headlines, or personal circumstances. Emotional investing is a harmful and counterproductive behavior because it impairs your judgment and logic. Moreover, emotional investing involves reacting rather than acting, which increases your stress and reduces your returns.
```html Stay the Course
The fourth and final principle of common sense investing is to stay the course. This means sticking to your plan and strategy regardless of the market fluctuations and noise. It means resisting the temptation to change your portfolio based on short-term events or emotions. It means having patience and discipline to achieve your long-term goals.
Bogle warns against three common mistakes that investors make that prevent them from staying the course:
Market timing. Market timing is the attempt to predict the future movements of the market and adjust your portfolio accordingly. Market timing can involve buying or selling based on technical indicators, economic forecasts, news events, or gut feelings. Market timing is a futile and costly exercise because it is impossible to consistently predict the market with accuracy and precision. Moreover, market timing involves frequent trading, which increases your costs and taxes and reduces your returns.
Chasing performance. Chasing performance is the tendency to buy or sell based on past results rather than future prospects. Chasing performance can involve buying high or selling low based on recent trends, fads, or popularity. Chasing performance is a dangerous and irrational behavior because it ignores the fundamental value and potential of an investment. Moreover, chasing performance involves following the crowd, which increases your risk and reduces your returns.
Emotional investing. Emotional investing is the influence of emotions such as fear, greed, hope, or regret on your investment decisions. Emotional investing can involve panic selling or euphoric buying based on market swings, news headlines, or personal circumstances. Emotional investing is a harmful and counterproductive behavior because it impairs your judgment and logic. Moreover, emotional investing involves reacting rather than acting, which increases your stress and reduces your returns.
By staying the course, you can avoid these mistakes and benefit from the power of compounding and the wisdom of the market. For example, if you invest $10,000 in an index fund that tracks the S&P 500 and earn the average annual return of 10% over 20 years, you will end up with $67,275. However, if you miss just the 10 best days in the market over those 20 years due to market timing, chasing performance, or emotional investing, you will end up with only $32,665. That's a difference of $34,610 or 51% less money in your pocket.
The Benefits of Common Sense Investing
The book also highlights the benefits of common sense investing compared to other approaches that are more complex, costly, or risky. Bogle claims that common sense investing can deliver three main benefits:
Higher returns
Lower risk
Simplicity
Let's look at each of these benefits in more detail.
Higher Returns
The first benefit of common sense investing is higher returns. As we have seen, common sense investing can outperform most active funds and beat the market average over the long term by following a low-cost, diversified, and consistent strategy.
Bogle provides several examples and statistics to support this claim in his book. For instance, he shows that from 1976 to 2016, a hypothetical investor who invested $10,000 in Vanguard's S&P 500 Index Fund would have ended up with $1,021,000 (a return of 10.2% per year), while an average investor who invested in an average active fund would have ended up with only $561,000 (a return of 8.4% per year). That's a difference of $460,000 or 82% more money for the index fund investor.
He also shows that from 1984 to 2016, a hypothetical investor who invested $10,000 in Vanguard's Total Stock Market Index Fund would have ended up with $659,000 (a return of 10% per year), while an average investor who invested in an average active fund would have ended up with only $304,000 (a return of 7% per year). That's a difference of $355,000 or 117% more money for the index fund investor.
```html Higher Returns
The first benefit of common sense investing is higher returns. As we have seen, common sense investing can outperform most active funds and beat the market average over the long term by following a low-cost, diversified, and consistent strategy.
Bogle provides several examples and statistics to support this claim in his book. For instance, he shows that from 1976 to 2016, a hypothetical investor who invested $10,000 in Vanguard's S&P 500 Index Fund would have ended up with $1,021,000 (a return of 10.2% per year), while an average investor who invested in an average active fund would have ended up with only $561,000 (a return of 8.4% per year). That's a difference of $460,000 or 82% more money for the index fund investor.
He also shows that from 1984 to 2016, a hypothetical investor who invested $10,000 in Vanguard's Total Stock Market Index Fund would have ended up with $659,000 (a return of 10% per year), while an average investor who invested in an average active fund would have ended up with only $304,000 (a return of 7% per year). That's a difference of $355,000 or 117% more money for the index fund investor.
He further shows that from 2000 to 2016, a hypothetical investor who invested $10,000 in Vanguard's Balanced Index Fund (a mix of 60% stocks and 40% bonds) would have ended up with $25,900 (a return of 5.7% per year), while an average investor who invested in an average balanced fund would have ended up with only $18,800 (a return of 4.1% per year). That's a difference of $7,100 or 38% more money for the index fund investor.
These examples illustrate the power of common sense investing to generate higher returns over time by capturing the market returns and avoiding the costs and risks of active investing.
Lower Risk
The second benefit of common sense investing is lower risk. As we have seen,