Advice for Today's Market? Diversify Wisely

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Sean McCabe

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Compound 8% and 6% over 50 years. Or use returns adjusted for possible inflation, so call it 5% and 3%. Take a dollar, and at 5% over 50 years it grows to $11.50. But at 3% it grows to just $4.40. Most people would not want to give that $7 difference to Wall Street, and they're right. Investors earned it, why give it all away? I've been working on this idea of low-cost indexing for a long time, and my record of failure in persuading active managers of its self-evident validity is just about 100%.

Bodie: But that's not true, Jack. Passive indexing is huge today.

Bogle: Vanguard's total assets are $1.2 trillion, and clearly indexing has been the driving force in our growth. But there are two things that are sad about that. One is that many index funds are just ripping off customers. They have 50 to 100 basis points of expenses, and it's ethically outrageous that people can sell these things.

Indexing is now about 14% of equity fund assets, and that's O.K. as far as it goes. I'd have thought it would get to 20% to 25%. It's proven to work and only works in low-cost mode. But the underlying tragedy is that indexing leveled off at around 9% of fund assets in 1999 or 2000, and the growth to 14% is in exchange-traded funds [ETFs]. And those are index funds you can buy and sell in real time all day long. What kind of a nut would want to do that?

The other thing that really troubles me is commodities. People need to understand this infinitely important principle of investing, which is that stocks and bonds have an internal rate of return. For a bond, it's the interest rate compounded over the years. For stocks, it's today's dividend yield of 2.5% or so and implied 6% earnings growth. With commodities, you're betting solely on the expectation that you'll sell at a higher price than you bought. It will give you diversification, but I can't believe the rate of return on gold is going to be 7% to 8% a year, like the long-term return on stocks.

Christopher Farrell: On Wall Street the talk is about return, but both of you emphasize risk.

Bogle: You can control risk. You can't control return. That's up to the beneficence that stock and bond markets are generous enough to bestow on us. That's why we talk about diversification.

We can, however, look ahead and make reasonable predictions. In the bond market, we know with 90% probability that return in the next 10 years will be 4.5% to 5%. That's the historical number. If we have huge inflation and a Great Depression, and lots of bonds default—this is why I like Treasuries—then that's something else again. In stocks, we know the sources of stock returns. Dividend yield is almost 2.5%, and earnings growth from these levels ought to be 6% over the next decade. That's an 8.5% return.

Market volatility is to be ignored, up to a point. I said in my last book [The Little Book of Common Sense Investing; his new book is Enough: True Measures of Money, Business and Life] that it turns out the stock market is a giant distraction to the business of investing. Think about now, in this orgy of speculation. In 1929 there was 140% turnover in the U.S. market [meaning the entire market of stocks was bought and sold almost one and a half times]. When I came into the business in 1951 it was 25% to 30% a year. Last year it was 280%. It will probably be 300% to 320% this year.

The volatility of the market doesn't really hurt the average retired investor because dividends keep coming in. But some of these dividends are gone. Companies that were paying them have gone out of business, almost entirely, actually, in the financial sector. So dividends are somewhat jeopardized, which I find broadly speaking one of the more challenging things. On the other hand, a lot is behind us.

Bodie: I'd supplement what we've been talking about by saying that everyone should think of his total capital as composed of a financial part and a human-capital part. If your human capital is safe, your nonhuman capital can be very tilted toward equities at a young age and tilted toward bonds at an older age. Let's take my son-in-law who works on Wall Street. His human capital is effectively a risky stock, since his industry is volatile. So I say to him over and over: "You want to be all in fixed income."

Bogle: Did you persuade him?

Bodie: Yes.

Bogle: I'm amazed, because if you're in that business you think trees grow to the sky.

Bodie: I was very forceful because he is in charge of my three-year-old granddaughter, who is the most precious thing in my life right now.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.