The Little Book of Common Sense Investing
Since this Little Book’s first publication in 2007, John C. Bogle’s investment principles have endured and served investors very well. When Bogle speaks (or writes) – people listen. Bogle knows a thing or two about investing. He is the founder and former chairman of the Vanguard Group. After creating Vanguard in 1974, he served as chairman and chief executive officer until 1996, and senior chairman until 2000. At the time of this post, Vanguard Group manages an astounding $4 trillion+ in assets. It is unequivocally one of the world’s largest investment companies, offering a large selection of low-cost mutual funds, Exchange Traded Funds (ETFs), portfolio advice, and related services.
The premise of Bogle’s common sense investing book is simple: a portfolio constructed of index funds is the only investment that effectively guarantees an investor of their fair share of stock market returns. This strategy is so beloved by investing oracle Warren Buffett he said this of Bogle inside the book’s jacket:
“If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.”
Bogle believes common sense investing, via The Index Revolution as he calls it, will help investors collectively build a new and more efficient investment system, one that serves investors at its highest priority.
Strong and powerful words…about an investing strategy that is not yet dominant.
I finally got around to re-reading The Little Book of Common Sense Investing this fall. Here’s what I liked about it and what you, the investor, the reader of this site, should consider taking away from it.
On rational exuberance
“In our foolish focus on the short-term stock market distractions of the moment, we investors often overlook this long history.” Meaning, staying invested in the stock market (less minuscule money management fees) has delivered staggering growth. “Each dollar initially invested in stocks in 1900 at a return of 9.5 percent grew by the close of 2015 to $43,650.” While none of us expect to live 116 years, Bogle claims the descendants that follow us will enjoy the miracle that is compounding returns.
On the premise of indexing
“Returns earned in the stock market must equal the gross returns earned by all investors in the market.” Bogle therefore argues owning the stock market over the long-term is a winner’s game. Attempting to beat the stock market via individual stock selection is a loser’s game. This is because no matter how long (or short) the timeframe: the gross return in the stock market, minus intermediation costs, equals the net return by all investors as a group. So, whether markets are totally efficient, or not, indexing works.
On costs when it comes to investing
There are “relentless rules of humble arithmetic.” We investors as a group get precisely what we don’t pay for! Meaning if we pay next to nothing for our money management fees, via indexing, we get everything (in terms of stock market returns).
“Our system of financial intermediation has created enormous fortunes for those who manage other people’s money. Their self-interest will not soon change. But as an investor, you must look after your self-interest. Only by facing the obvious realities of investing can an intelligent investor succeed.”
Bogle reminds readers when it comes to investing, time doesn’t heal all wounds: “When returns are concerned, time is your friend. But where costs are concerned, time is your enemy.” With all things being equal, higher money management costs therefore make the difference between investment success and investment failure.
Bogle is a fan of the Dividend Growth Investor blog; he does not dismiss dividends as an important part of investor gross returns:
On the grand illusion
Surprise, surprise! The grand illusion is this: there are dual penalties associated with money management costs and investor behaviour – it’s a double-whammy for investors fraught with money inflows into most funds after good performance and money outflows from most funds after poor performance. This means “investor emotions plus fund industry promotions” signalling trouble for the retail investor.
On five ways to avoid financial devastation? (only two work)
- Select a very low-cost index fund that simply holds the stock market portfolio.
- Select funds with rock-bottom costs, minimal portfolio turnover, and no sales loads.
To paraphrase, don’t look for individual (stock) needles, buy the haystack (of stocks) and hold them for good. “Your index fund should not be your manager’s cash cow. It should be your own cash cow.”
Bogle: “Not a terrible idea, but not a world-changing one, either.” Smart-beta ETFs weight their portfolios by factors, not by the market capitalizations of its components like traditional index funds do. Bogle is skeptical of this approach since the goal is to create more profits for the money manager by gathering the assets of investors seeking a performance edge. He believes short-term investing strategies are rarely – if ever – optimal long-term strategies.
On what you and I should know:
- We must start to invest at the earliest possible moment, to gain the greatest long-term returns.
- That investing entails risks.
- Investing costs really matter.
- Taxes matter, and they too like investing costs, must be minimized.
- Beating the market may only work for the few.
As with all things related to the Vanguard Group, and their indexing mantra, Bogle beat the passive investing drum in consistent fashion throughout The Little Book of Common Sense Investing.
While I’m not ready to change my investing ways entirely (moving fully away from owning any dividend paying stocks) I have embraced the virtues of low-cost ETF investing more over time – and will continue to do so. I may or may not eventually become a completely indexed investor.
Investors who want to take more control over their portfolios would be well-served to read this book. Indexing is not the only way to invest but few books claim the virtues of this approach any better, with simple messages, stock market history, and tales of poor investor behaviour.
Have you read Bogle’s Little Book of Common Sense Investing? What’s your take on indexing using low-cost ETFs or mutual funds?
I’ll jump in late to the discussion, but I’m surprised that Bogle concludes that only by Indexing one will achieve good returns. Throughout the book he stresses the importance of Dividends and Earning Growth (which to me provides Dividend Growth).
Look at Exhibit 2.2 and what has been the positive throughout every 10 year period? Dividends have provided positive returns during every period. And those are All dividend stocks, not just the Dividend Growth stocks. Separate the DG stocks from the total and one’s return would have been much better.
See the following comment by Bogle:
“Compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart as price/earnings ratios (P/Es) wax and wane (Exhibit 2.3).”
Others can try to find those Super Performers and Losers, I’ll stick with a select group (less than 20 stocks) of companies with a long history of paying and growing their dividends.
Well, as you know from my posts, I remain a fan of 30+ CDN stocks – all of them pay dividends and most of them have done so for the last 40+ years. Unless one or many of them stop paying a dividend then I won’t be selling them.
I’m a dividend stock investor first and a passive index ETF investor second. I still think managed mutual funds have a place in my portfolio even though I don’t like the higher fees.
One question that I ponder from time to time…..I know we are not there yet, but if indexing becomes a larger piece of the pie, who will determine stock prices? We need active investors to set the price, indexing only follows. My view is that if indexing becomes too big a piece of the pie, price inefficiencies will start to form in the market. Active managers will see this and figure out how to earn excess returns and the tide will shift back to active management until we find a point of equilibrium between active and passive. Thoughts????? Tom
I agree Tom. If everyone indexed then the market might become more inefficient since the herd mentality will prevail. This means the market can/could be exploited more easily. Time will tell…but I think I’ll always own a few dividend paying stocks.
re: if indexing becomes a larger piece of the pie, who will determine stock prices? We need active investors to set the price, indexing only follows.
An index investor might be popularly classified as a “passive” investor, but both the index fund and the actual index itself are wholly active entities. There may be some mirroring going on but there is by no means mere blind aping. The index funds, along with all the other market makers of the pie, will still determine stock prices.
who will determine stock prices? Stocks themselves – will also have a hand in the stock’s price. If a stocks earnings per share rises – its share price should go up. I agree supply and demand will play a part.
While true that if the market becomes 100% indexed, there would be no one for price discovery, that is only a theoretical consideration, as there will always be some who think they can beat the market. Most authorities think that even at 90% passive, the market will function normally.
Indexing is good for those that do not like as much “RISK” or swings!. (or are lazy and don’t want to learn). But, I have found that taking on a little more risk can pay off with triple digit returns. How boring would it be if we ALL just bought the index? I am never happy with those returns! But, for some that lack time to do it themselves – it suits them fine! The book is a good read 🙂
Thanks for the comment Mike! I don’t think we’ll ever see everyone index. There has to be some ways to exploit the market, somewhere, somehow!
I’m going to disagree with you on a few points, Mike.
(I’m going to summon a lot of Cullen Roche here, so bear with me)
re: I have found that taking on a little more risk can pay off with triple digit returns.
Yup it can, I’ve also experienced this first hand. But it can also lead to triple digit losses (100%), something I’ve also experienced first hand (the best lessons are always the most expensive!). I’m not so sure most people should be plying their (low-risk earned) savings to higher risk endeavours. As I’ve said, if you don’t get things right from the beginning, then you do have to assume additional risk (above that of indexing). If you do actually get things right from the start, there is absolutely no need to assume that addition risk because you’ll be in fine shape to achieve your financial goals.
re: How boring would it be if we ALL just bought the index?
I think it would be just the opposite of boring. A LOT fewer people would lose their shirts, there would be a lot less inequality, a lot more people would be in better financial shape, and perhaps most importantly, people would have much more time and capital to apply to other areas of their life, which just might lead to a greater standard of living across the board. Boring, perhaps; better, probably.
re: But, for some that lack time to do it themselves – it suits them fine!
It’s not always about lacking time or being lazy or not wanting to learn etc. As per Cullen Roche, he is a self-made millionaire who indexes his personal money (and REALLY understands this stuff). He works to specialize and create value in his professional life in order to maximize his income, this is where he plys “risk”. Doesn’t always make sense to have a risk-based income and then turn around and expose that income to even more risk. He has zero control over market returns, but he does have control over his ability to create income.
Some very good points SST. I think TIME is the most important thing we have. How we use it and how we waste it. If someone is very good at his/her profession and takes risks there – that pay off – that requires their TIME to do this – than great – they are using their TIME in their profession to make good $$$ – and because they do not have the time for investing – they buy the index! Great! Others may treat investing as their profession and allocate most of their TIME to this. Perhaps even enjoy it. So they take more risks there. I guess – my point is that taking a little risk in anything we do – can really pay off. I would also like to add – that when I talk about risk – I am not saying 100% of ones portfolio should be at a higher risk. But 10% – 20% – might be worth it if it wasn’t your hard earned money (but are some of your gains in play). I actually think too many people think some investments are very risky – while I see them as little to no risk at all. Example: Pot stocks to me are not risky at all. Yes, they have daily swings – but there is little risk IMO. It will be legal July 1st (just like alcohol) and has huge upside and growth. In fact there will not be enough ready in time to meet the demand. Have a look at the last 4 months of EMH, ACB, APH, WEED, etc. So while some buy the index – others look for more growth. I hold onto my Divs for income – but go for huge growth as well. I guess, if I did not have the time to invest myself – then I could see buying the index could work for me. But, I love growing my $$$ faster than what the index would provide. As for double digit losses – they are hard to take – but Nortel, Enron, BreX and others all went to zero and were top stocks in many mutual funds at that time. Who ever thought they were risky?
Mike, I’m not sure that investing is supposed to be a source of entertainment. As Larry Swedroe says, “if you are investing for excitement, you’d be better off finding a less expensive form of entertainment”.
Funny, I just read this book last week, great read. I also recently finished “A wealth of common sense” by Ben Carlson, that was even better in my opinion than Bogle’s version ( not implying that the the former was written to compete with the latter). I think Carlson’s book is technically sound but still very relatable so I’m recommending it to a friend who’s completely new to investing and looking to learn more. I think Bogle’s book is an easy read for people with a certain level of investing knowledge but complete newbies might get bogged down by the way charts and the historical information are presented. Either way, both good books. The goal is to have more people increase their level of financial knowledge, happy to do my part by providing good book recommendations.
Thanks for the comments Alana.
No doubt Bogle’s writing style is appealing – it’s an easy read on purpose!
Kudos to Ben for a great book as well. I enjoy his site and visit it often.
I like index investing, I have a few index funds. I also have individual stocks that are almost all in the top holdings in the very funds I hold. I could just invest it all in the funds but I keep coming back to the issue that if a fund is charging .25% (as an example) I’d be “paying” almost two grand in fees PER YEAR whereas holding the stocks costs me nothing after the initial purchase ($9.99).
Fair point about fees and stocks to buy and hold. This is where I’ve focused some time as well – own the same stocks the big funds own. I feel on the Canadian-side it’s not too hard to find the stocks that consistently reward investors. U.S. and internationally seems far more difficult; to me at least. Although not an indexed product, I’m happy to own VYM for growth and yield and likely always will.
When you hold a healthy portfolio, say $500k, even low fees matter. That’s $500 per year, every year, for 0.10% invested. Still a small sum of money in the grand scheme of things but something to be mindful of. Indexing works for the masses but it’s not for everyone.
In a perfect scenario, yes, indexing broadly — “owning the market” — works wonders. However, barely any investor is perfect. If one doesn’t start saving early enough, or doesn’t save enough, or has to liquidate due to life events, or spends a decade naively investing in high-fee products, etc., then the power of indexing is greatly reduced. The risk dispersement profile will still exist, but the power of the long-term returns is also greatly dispersed.
What one has to realize is that if you index broadly for the long-term, fundamentally what you are actually investing in is the long-term global production and innovation of the human race. Thus, if you only have say 10 or 15 years to index, your risk profile will increase (e.g. you could be investing at a time of lowered production). Longer investment lengths will smooth out the business/political/war/et al cycles as human production continues its slow but steady chug ahead.
re: “Each dollar initially invested in stocks in 1900 at a return of 9.5 percent grew by the close of 2015 to $43,650.”
We should all know by now that this stat and its brethren are used exclusively to hype certain products (aka a push for profit). It’s been proven to be a completely faulty calculation. A correct answer regarding very long-term returns can only be achieved via the life-time returns of Bogle’s/Vanguard’s flagship index fund. It’s highly strange that he would use a fake stat to push his product instead of the power of his very own product.
Good point about smoothing out the business/political/war/et al cycles….this is where short-term equity investing certainly has risks.
Slow and steady. That’s how I invest. I’m downright boring.
I’m not sure that’s a fake stat but rather one where there is a bias to picking a particular time horizon to make a point/his point.
The reality is, for me, I don’t care what stocks returned 100 years ago. It’s largely irrelevant to me. I do care now and for the next 30 or so what equity returns might be.
re: I’m not sure that’s a fake stat [Each dollar initially invested in stocks in 1900 at a return of 9.5 percent grew by the close of 2015 to $43,650].
It is, for many reasons: no one could invest in ALL stocks; the “index” was ever revolving and growing; an investor would have to keep buying more and more stocks from 1900 to 1976 (the year Vanguard achieved a full index fund); there is zero calculation of fees and/or tax considering all the buying and selling an investor would have to do, etc.
It’s not even real on a purely theoretical level., let alone in practice.
Even Ben Carson agrees it’s bogus, and he’s an actual financial professional (with a good reputation to uphold!).
edit: Ben Carlson (of Wealth of Common Sense).
OK, there is zero calculation of fees and/or tax but you could say that for many stats – no? No disagreement but rather more details into every stat are required since you can endlessly play with numbers to suit your needs. Such is a nature of statistics.
From what I’ve read, in the US, at least, Vanguard’s ownership structure is unique in that it is a mutual, mutual fund, meaning the company is owned by its unit holders. That is what has enabled Vanguard to continually lower fees as assets grew.
I agree with Buffett – Jack Bogle is an icon for the investing community for having the vision and commitment to create index funds despite facing an avalanche of opposition from self-interested investment firms. Even if you aren’t a fan of indexing, for those who lack the skill, time or desire to do stock picking, indexing with low cost ETFs following a Couch Potato strategy makes a great deal of sense comparedb. In his book he outlines the case for why he expects the next 10-year period to be one of muted returns (I don’t have my notes in front of me but I believe it was a maximum of 6.9% and possibly lower) as PE ratios eventually will need to revert back towards longer-term trends.
Correct Bart. The unitholders basically own the company. The more AUM (assets under management) the lower the company can drive costs down. Very interesting model for 1974 when you think about it!
There will be reversion to the mean eventually and with demographic shifts, I can see equity returns going down over time – in the future. Not 9.5% but closer to 4%.
“Just for mathematical reasons, the dividend yield is 2 percent, a little under 2 percent in fact, and the long-term dividend yield on stocks is pretty close to 4 … the earnings growth on stocks has been a little over 5, that’s going to be a very tough target in the future so let’s call it 4 … 4 and 2 percent give you a 6 percent investment return, but then you have to take … the valuations in the market. …You take that 6 percent return and maybe knock it off a couple of points perhaps for a lower valuation, slightly lower valuation over a decade and you’re talking about a 4 percent nominal return on stocks. And that’s low, lower than history. History is around 6 and a half.”
Much of his advice would apply to individual stocks as well.
Vanguard is #2 of ETF providers by assets under management with $681 Billion. With and average MER of only 1/2 of 1% they will still bring in $3.4 Billion. Buy a group of etf’s, hold and over their value will grow as will Vanguards income, not yours.
Vanguard is certainly very wealthy. They have more assets under management than that 🙂
“About $4.5 trillion in global assets under management, as of September 30, 2017.”
Jack Bogle, who has done more for investors than anyone else, recommends buying low cost index funds, not individual stocks, which he specifically says is a loser’s game. The largest and most well known personal finance web site in the world, Bogleheads.org, following his advice, recommends that, too. The mutually owned structure of Vanguard has led the way for low cost index funds and ETFs, such that the broad market cap weighted ones that Bogle recommends are more like 0.05%, nowhere near 0.5%. Investors net worth certainly does grow a lot over time.
I’ve always found the structure of Vanguard very appealing and interesting – quite novel for 1974! I’m not against low-cost ETFs for indexed products at all, I just happen to believe in an income model via dividend stocks more; at this time anyhow. Cheers!
re: Jack Bogle…recommends buying low cost index funds, not individual stocks, which he specifically says is a loser’s game.
But he also utilizes statements such as the following: “Each dollar initially invested in stocks in 1900 at a return of 9.5 percent grew by the close of 2015 to $43,650”, which innately required buying individual stocks for 66% of that time period. So he’s saying buying individual stocks was a winners game until his product came on the market, now buying individual stocks is a losers game.
Does he say anything about ETFs and index funds now outnumbering individual stocks? Is buying individual index funds the new “losers game”? Is there an index fund index fund I can buy?
I’m not saying index funds are terrible by any means, but lets try and present truthfully, Mr. Bogle.
I struggle with the indexing approach only because by buying the index you get all the stocks, sure, but those stocks are both good and bad though. Why buy bad stocks purposely and why pay a money management fee to do that? Indexers will say you cannot possibly know what stocks in the future will go from bad to good or good to bad. True. But if you own a basket of stocks, then your chances of having a “few winners” and a “few losers” increases and your returns should even out – without paying a fee for it to someone else. Furthermore, indexing focuses on total return. That’s great, but I prefer the dividends in hand portion of that total return since I can do what I want with that portion of equity returns.
Mark, a recent paper showed that only 4% of stocks provided all the gains above t-bills since 1926, so if you didn’t pick those stocks you underperformed the index. This is why indexing works. It doesn’t matter if you own all the bad stocks, you just need to own the 4% of super performers (like Google etc,) that make up for all the others. That’s why it is so difficult to even match the market, let alone beat it. By picking a basket of stocks, it is less diversified than the market, so it doesn’t even out as you are highly likely not to own the 4% of super winners. It’s total return that matters. You can also do what you want with the capitals gains (using your bonds or cash reserve as a buffer during a downturn) as well as the dividends.
Yes, indexing works but so does dividend investing so maybe I have been lucky with my portfolio in the last 5-7 years. My CDN portfolio is up about 10% over that period – the same return as ETF XIU.
It is difficult to match the market, but maybe I have luck going with me?
Mark, I agree several strategies work in the sense that they all get you where you want to go. We can debate which one is the best, but at the end of the day the one you are most comfortable with is the one you should go with as that’s the one you are most likely to stick with when the going gets tough.
Very true Grant, although I am buying more VYM over time. Not a true-indexed product as you know but still a good low-cost one!
@Grant: nice to see another SSRN reader!
re: only 4% of stocks provided all the gains above t-bills since 1926, so if you didn’t pick those stocks you underperformed the index. This is why indexing works.
This has been known for a long time — that only a small fraction of the index components provide the greater bulk of the total return. However, with a weighted index, as the paper stated, all you have to do is own the top 4% of the holdings, e.g. the top 20 stocks in the S&P 500. It’s easy enough to rebalance and buy-and-sell as the index does. You don’t need to own the components with a weighting of 0.05% because even if it gains 1,000%, it will barely move your portfolio.
re: By picking a basket of stocks, it is less diversified than the market…
But that’s exactly what indexes are — picked baskets of stocks! An index is NOT “The Market”. There might be 50,000+ publicly traded stocks globally, if you don’t own ALL of them (aka “The Market”), then you own a picked basket of stocks and are less diversified.
Indexing (aka diversification) works to preserve capital; concentration (aka the 4%) works to build capital. Within and index, “all the others” do two things, i) lower the losses and ii) lower the returns. The chaff keeps you from both sinking and soaring.
SST, market index data is available since 1900. That is what Bogle is talking about, not individual stocks. That Bogle didn’t develop a product to invest in the market index, the index fund until 1975, is irrelevant to what is saying. Bogle advises investing in cap weighted broad market index funds. The proliferation of different sub market ETFs has nothing to do with his advice.
re: market index data is available since 1900.
Yup it is, except the data is super sketchy esp. in the first third of that century. Not only that but as I’ve stated (and other actual financial pros are in agreement), the pre-1976 data works neither in theory nor in practice. It’s simply financial sector marketing.
SST, I think the point you are missing is that you need to own the super performers BEFORE they become super performers, so you get the big gains. You do that by owning the index. If you wait to own them until they are in the top 4%, as you suggest, you miss out on all the big gains. Do you think that the FANG stocks will have enormous gains going forward? You want to own them when they are small stocks so you get the big gains.
Of course the index is a basket of stocks, but it’s a much more diversified basket of stocks than someone who picks a portfolio of stocks. Financial theory tells us that a less diversified portfolio has a wider dispersion of expected returns, which, on average, will be lower than a more diversified portfolio.
re: you are missing is that you need to own the super performers BEFORE they become super performers, so you get the big gains.
You are misunderstanding the factual math.
In an index, future “super performers” are still weighted very lightly so even their “big gains” won’t amount to much. Doesn’t matter how much a component ‘super performs’ if you only receive a fraction of that performance. To truly benefit from “the big gains” you must hold the “super performers” outside of an index, at full weight. That’s math, not opinion.
The best performing stock in the S&P for 2017 (I think) is Vertex (VRTX) up ~80%. Weighted at 0.15 it provides 0.12% of the total index return.
Apple (APPL), weighted heaviest at 3.8, only has to rise 3% to provide an equivalent return (I think it’s up ~45% YTD).
With the top 4% providing most of the index return, yes, it absolutely pays to own them, and only them.
SST, the problem with your approach is you have to know, in advance, which of the stocks in the index to pick that are going to be the next super performers. Today’s top 4% in the index will amost certainly not be tomorrow’s super performers. They’ve already had their super run. How do you know which ones will be tomorrow’s super performers? You are confusing the top 4% today, and what will turn out to be, looking back over a investing lifetime, the top 4% of all stocks over that time period. That is why indexing works. You don’t have to pick those future super winners. You own them all in the index fund.
Yes, you do own them all, but math and I will try and explain one last time.
The index committee will inherently apply a very light weighting to all future super performers. They will also inherently apply a heavy weighting to those current and proven super performers. Meaning, the future SP has to grow into its heavy weight status, all the while possessing an ‘under-weight’ ranking.
If you buy a SP within and index, you will NEVER access a super performers full return and will always be subject to collecting fractions of the super performance. The only way to reap the full return of a SP (at any stage of its life) is to own it outside of an index.
The huge downside to this is, as you said, trying to pick a future SP. You will almost always fail in this endeavour. That’s why it’s much more palatable to buy the top 4% index holdings — those proven SP which are still churning out very strong returns, and providing almost all of the index return — outside of an index.
Index weighting will ALWAYS negate “future super performer” returns.
Index weighting will ALWAYS support current/proven super performer returns.
Diversification (index) is for preserving capital.
Concentration (4%) is for growing capital.
I agree with that: “Index weighting will ALWAYS negate “future super performer” returns.” You can only get the returns of the collective index; and those stocks weightings within it, and nothing more.
SST, I think the problem with your thinking is that if you buy the top 4% of the stocks of the index, those stocks have already generated their super performance. It’s too late. The FANG stocks will not be the super performers of the future. You need to own the future performers before they become so. As you don’t know which ones they will be, the only way to do that is to own the index. It doesn’t matter that they will initially be a small percentage of today’s index. They are the future superperformers that will rapidly grow and become a very large percentage by cap weight. Perhaps you are confusing the 4% number of stocks with percentage of cap weight of the index?
re: I think the problem with your thinking…
It’s not “my thinking”, it’s math.
I recommend doing less thinking on the matter and more math.
re: The FANG stocks will not be the super performers of the future.
There is also more to a SP than mere total return. FANG stocks have the ability to churn out quality returns year after year; future SP might pull out a couple double baggers and then fade or even be bought up.
It’s this ability to produce the bulk of the index returns on a continual basis which makes a company a SP, even if their current return is no where near that of some marginally weighted future SP.
SST, Btw, if you do buy just the top 4% of the S&P, you will have a much less diversified portfolio than the S&P, which, as financial theory tells us will give you a wider dispersion of returns than a more diversified portfolio, which on average will be lower.
re: if you do buy just the top 4% of the S&P [incl FANG stocks*], you will have a much less diversified portfolio than the S&P
The top 4% of the S&P is the top 20 stocks. FANG/hi tech stocks make up a minority 30% of the top 20 stocks (but with a 50% weighting within that 20). Other “physical goods” stocks like Home Depot, Johnson & Johnson, Pfizer, Procter & Gamble, Exxon, and Berkshire provide adequate diversification.
For the entire index, Consumer (All) 21%, IT 22%, Financials 15%, and Healthcare 15% carry almost all of the total index weight.
Compared to the mix of the top 20: Consumer 17%, IT 12%, Financials 17%, Healthcare 10%.
If anything, owning just the top 4%/top 20 stocks is LESS risky and MORE diversified than holding the entire index.
Math is your friend, not the enemy.
*Note: the ‘N’ in FANG is for Nexflix, which holds a 0.35 weighting, is not even close to being in the Top 4%/20, so to use it in the acronym does nothing more than further demonstrate misunderstanding.
SST, You think that owning 20 stocks is more diversified than owning 500 stocks?…..seriously? There can’t be than total return….by definition total return is the total of all sources of return.
Yup, 505 stocks will obviously give a total return, but 20 of those stocks will provide the bulk of that return.
The other 485 stocks don’t provide you with much of anything.
Maybe it’ll take 50 light weight ‘Materials’ or ‘Utility’ stocks to off-set any “risk” a heavily weighted Facebook or Amazon stock drags into the index. Not a great utilization of my money, that’s for sure.
Why stop at 505 stocks? Why not 5,005? Maybe 10,005 or 100,005 stocks.
What degree of diversification (aka risk mitigation) does each extra stock provide?
Once again, as has been shown, diversification is for preservation of capital, concentration is for accumulation of capital. Those extraneous stocks will both anchor and buoy you; they will hold your returns in a defined corral.
If I hold only those top 20 stocks, am I guaranteed to underperform the total return of the entire index? Doubtful, seeing as how all 20 of those stocks will be held at full weighting outside of index parameters.
Take the N in FANG, for example. Held outside of an index, Netflix is a super performer; held inside of an index, its super performance is castrated.
Anyway…there’s enough risk adverse people for whom indexing will work just fine.
They will probably also enjoy Bogle’s book.
SST, here’s a great article that explains much better than I can, that if you don’t try to pick the winners, you will win.