The Little Book of Common Sense Investing

1. The Relentless Rules of Humble Arithmetic: Why Costs Matter

"The miracle of compounding returns is overwhelmed by the tyranny of compounding costs."

Costs erode returns. In the world of investing, the seemingly small differences in costs can lead to enormous differences in long-term results. This is due to the compounding effect over time. For example, if the stock market generates a 7% annual return, and a typical actively managed fund charges 2% in fees, investors are left with only 5% - nearly 30% of their potential return is lost to costs.

The math is unforgiving. Consider two scenarios over 50 years:

• Investing $10,000 at 7% annually (market return) grows to $294,570
• The same investment at 5% (after fund costs) grows to only $114,674

The difference - $179,896 - is the cost of investing in high-fee funds. This stark reality underscores why low-cost index funds, which typically charge less than 0.1% in fees, are so compelling for long-term investors.

2. Indexing: The Simple Path to Owning the Entire Stock Market

"Don't look for the needle in the haystack. Just buy the haystack!"

Simplicity wins. An index fund is a mutual fund that aims to track the performance of a specific market index, such as the S&P 500. By owning a small piece of every company in the index, investors can capture the overall return of the entire market. This approach eliminates the risk of picking individual stocks or timing the market.

Broad diversification, low costs. Index funds offer two key advantages:

1. Diversification: By owning the entire market, you spread your risk across hundreds or thousands of companies
2. Low costs: Because index funds don't require teams of analysts or frequent trading, they have much lower expenses than actively managed funds

Historical data consistently shows that the majority of actively managed funds fail to outperform their benchmark indexes over long periods, especially after accounting for fees and taxes. This reality makes indexing a compelling strategy for most investors.

3. The Grand Illusion: Fund Returns vs. Investor Returns

"Surprise! The Returns Reported by Mutual Funds Aren't Actually Earned by Mutual Fund Investors."

Timing is everything. There's often a significant gap between the returns that mutual funds report and the actual returns earned by investors in those funds. This discrepancy arises because investors tend to buy funds after they've performed well and sell after they've declined.

The data tells the story:

• From 1980-2005, the average equity fund reported a 10% annual return
• However, the average fund investor earned only 7.3% annually
• This 2.7% annual gap compounds to an enormous difference over time

The reasons for this "behavior gap" include:

• Chasing performance: Investing in funds that have recently done well
• Market timing: Trying to buy low and sell high, but often getting it wrong
• Lack of patience: Not staying invested through market cycles

This illusion highlights the importance of a buy-and-hold strategy with low-cost index funds, which helps investors avoid the pitfalls of performance chasing and market timing.

4. The Futility of Chasing Past Performance

"Yesterday's Winners, Tomorrow's Losers"

Past performance does not predict future results. Despite the ubiquity of this disclaimer, investors consistently fall into the trap of selecting funds based on their recent outperformance. The data overwhelmingly shows that top-performing funds rarely maintain their edge.

The numbers are stark:

• Of 355 equity funds existing in 1970, only 9 outperformed the S&P 500 by more than 2% annually over the next 35 years
• Of those 9, only 3 maintained their edge through 2005
• Studies show that 95% of investor dollars flow to funds rated 4 or 5 stars by Morningstar, based largely on past performance

The reasons for this lack of persistence include:

• Reversion to the mean: Periods of outperformance are often followed by underperformance
• Asset bloat: As successful funds attract more money, it becomes harder to maintain their edge
• Manager turnover: Star managers often leave or lose their touch

Instead of chasing past performance, investors are better served by focusing on low costs and broad diversification through index funds.

5. The Tyranny of Compounding Costs Over Time

"Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy."

Small fees, big impact. The long-term effect of investment costs is often underestimated. Due to the power of compounding, even seemingly small differences in annual fees can lead to dramatic differences in wealth accumulation over an investing lifetime.

Consider the impact over 50 years:

• A 1% annual fee reduces a 7% return to 6%
• $10,000 invested at 7% grows to $294,570
• The same investment at 6% grows to only $184,202
• The 1% fee costs the investor $110,368, or 37% of their potential wealth

This tyranny of compounding costs applies to all types of investment expenses:

• Management fees
• Trading costs
• Taxes from frequent trading
• Sales loads and marketing fees

The relentless math of compounding costs makes a compelling case for low-cost index funds, which typically have expense ratios below 0.1%, compared to 1% or more for many actively managed funds.

6. Emotions and Expenses: The Twin Enemies of Investors

"The two greatest enemies of the equity fund investor are expenses and emotions."

Behavioral biases hurt returns. Investors often make poor decisions based on emotions like fear and greed. These behavioral biases lead to buying high and selling low, significantly undermining long-term returns.

Common emotional pitfalls include:

• Overconfidence: Believing you can outsmart the market
• Loss aversion: Holding onto losing investments too long
• Recency bias: Giving too much weight to recent events
• Herd mentality: Following the crowd into popular investments

Expenses compound the problem. While emotions lead to poor timing decisions, high expenses consistently erode returns year after year. The combination of these two factors explains why the average investor significantly underperforms the market over time.

The solution is twofold:

1. Use low-cost index funds to minimize expenses
2. Adopt a buy-and-hold strategy to avoid emotional decision-making

By focusing on what you can control (costs) and removing emotion from the equation, investors can dramatically improve their long-term results.

7. Bond and Money Market Funds: Where the Rules Are Even More Powerful

"In the bond market, you get what you don't pay for."

Costs matter even more for bonds. The impact of expenses is even more pronounced in bond and money market funds because:

1. Bond returns are generally lower than stock returns, so fees eat up a larger percentage
2. The bond market is more efficient, making it harder for active managers to add value

The data is clear:

• Over 10 years (1996-2006), the average intermediate-term bond fund returned 5.5% annually
• A low-cost bond index fund returned 6.8% annually
• This 1.3% annual difference compounds to a 24% higher return over a decade

For money market funds, where yields are typically very low, the impact of fees is even more dramatic. A fund with a 0.5% expense ratio might yield 3%, while one with a 0.05% ratio yields 3.45% - a 15% difference in annual return.

The lesson: In fixed-income investing, controlling costs through low-fee index funds is paramount to maximizing returns.

8. ETFs: A Wolf in Sheep's Clothing

"The ETF is a trader to the cause of classic indexing."

Not all index funds are created equal. Exchange-Traded Funds (ETFs) have exploded in popularity, often marketed as a superior alternative to traditional index mutual funds. While some broad-market ETFs can be excellent low-cost options, many specialized ETFs encourage harmful investor behavior.

The potential pitfalls of ETFs include:

• Encouraging frequent trading: The ability to buy and sell throughout the day often leads to overtrading
• Narrow focus: Many ETFs track very specific sectors or strategies, reducing diversification
• Higher costs: While some ETFs have very low fees, many specialized ETFs have much higher expense ratios
• Tax inefficiency: Frequent trading of ETFs can lead to unexpected capital gains taxes

Investor returns lag fund returns. Studies show that investors in specialized ETFs often significantly underperform the ETFs themselves due to poor timing decisions. The ease of trading and the proliferation of niche strategies can turn index investing into a form of speculation.

For most investors, broad-market, low-cost ETFs or traditional index mutual funds remain the best options for capturing market returns with minimal costs and complexity.

9. The Fundamental Truth: Owning Businesses, Not Trading Stocks

"The stock market is a giant distraction to the business of investing."

Focus on the real market. Successful investing is about owning businesses, not trading pieces of paper. The stock market is simply a mechanism for buying and selling shares in real companies. Over the long term, stock returns are driven by the fundamental performance of businesses - their earnings growth and dividend payments.

Key principles to remember:

• Stocks represent ownership in real businesses
• Long-term returns come from business growth and dividends
• Short-term price fluctuations are often driven by emotions and speculation

The index fund advantage. By owning a broad-market index fund, investors can participate in the long-term growth of the entire economy without getting caught up in the noise and emotion of short-term market movements. This approach aligns with Benjamin Graham's concept of being a business owner rather than a stock trader.

By focusing on owning businesses through low-cost, broadly diversified index funds, investors can capture their fair share of market returns while avoiding the pitfalls of speculation and excessive trading.

10. The Future of Investing: Indexing's Inevitable Ascendancy

"No business can forever ignore the interest of its clients."

The tide is turning. As investors become more educated about the impact of costs and the difficulty of outperforming the market, indexing is gaining widespread acceptance. This trend is likely to accelerate in the coming years for several reasons:

1. Lower market returns: In an era of potentially lower stock and bond returns, cost control becomes even more critical
2. Increased transparency: Better reporting of fees and investor returns is highlighting the shortcomings of many active strategies
3. Regulatory pressure: Governments are pushing for greater fee disclosure and fiduciary standards
4. Technological advances: Automated investing platforms are making low-cost indexing more accessible

The industry must adapt. Traditional active management firms will face increasing pressure to lower fees and improve transparency. Those that fail to adapt may see significant outflows as investors shift to lower-cost alternatives.

The future of investing is likely to see:

• A continued shift towards low-cost index funds and ETFs
• Greater emphasis on holistic financial planning rather than product sales
• Increased use of technology to reduce costs and improve investor outcomes

While active management will always have a place, the relentless math of indexing suggests it will play an increasingly dominant role in the investment landscape. Investors who embrace this reality early stand to benefit from lower costs and potentially superior long-term returns.

Last updated: August 9, 2024