Table of Contents
Little Book Big Profits Series
In the Little Book Big Profits series, the brightest icons in the financial world write on topics that range from tried-and-true investment strategies weve come to appreciate to tomorrows new trends.
Books in the Little Book Big Profits series include:
The Little Book That Beats the Market, where Joel Greenblatt, founder and managing partner at Gotham Capital, reveals a magic formula that is easy to use and makes buying good companies at bargain prices automatic, giving you the opportunity to beat the market and professional managers by a wide margin.
The Little Book of Value Investing, where Christopher Browne, managing director of Tweedy, Browne Company, LLC, the oldest value investing firm on Wall Street, simply and succinctly explains how value investing, one of the most effective investment strategies ever created, works, and shows you how it can be applied globally.
The Little Book of Common Sense Investing, where Vanguard Group founder John C. Bogle shares his own time-tested philosophies, lessons, and personal anecdotes to explain why outperforming the market is an investor illusion, and how the simplest of investment strategiesindexingcan deliver the greatest return to the greatest number of investors.
To Paul A. Samuelson, professor of economics at Massachusetts Institute of Technology, Nobel Laureate, investment sage. In 1948 when I was a student at Princeton University, his classic textbook introduced me to economics. In 1974, his writings reignited my interest in market indexing as an investment strategy. In 1976, his Newsweek column applauded my creation of the worlds first index mutual fund. In 1993, he wrote the foreword to my first book, and in 1999 he provided a powerful endorsement for my second. Now in his ninety-second year, he remains my mentor, my inspiration, my shining light.
Introduction
Dont Allow a Winners Game to Become a Losers Game.
SUCCESSFUL INVESTING IS ALL about common sense. As the Oracle has said, it is simple, but it is not easy. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nations publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return that they generate in the form of dividends and earnings growth.
The best way to implement this strategy is indeed simple: Buying a fund that holds this market portfolio, and holding it forever. Such a fund is called an index fund. The index fund is simply a basket (portfolio) that holds many, many eggs (stocks) designed to mimic the overall performance of any financial market or market sector. Classic index funds, by definition, basically represent the entire stock market basket, not just a few scattered eggs. Such funds eliminate the risk of individual stocks, the risk of market sectors, and the risk of manager selection, with only stock market risk remaining (which is quite large enough, thank you). Index funds make up for their short-term lack of excitement by their truly exciting long-term productivity.
Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.
This is much more than a book about index funds. It is a book that is determined to change the very way that you think about investing. For when you understand how our financial markets actually work, you will see that the index fund is indeed the only investment that guarantees you will capture your fair share of the returns that business earns. Thanks to the miracle of compounding, the accumulations of wealth over the years generated by those returns have been little short of fantastic.
Im speaking here about the classic index fund, one that is broadly diversified, holding all (or almost all) of its share of the $15 trillion capitalization of the U.S. stock market, operating with minimal expenses and without advisory fees, with tiny portfolio turnover, and with high tax efficiency. The index fund simply owns corporate America, buying an interest in each stock in the stock market in proportion to its market capitalization and then holding it forever.
Please dont underestimate the power of compounding the generous returns earned by our businesses. Over the past century, our corporations have earned a return on their capital of 9.5 percent per year. Compounded at that rate over a decade, each $1 initially invested grows to $2.48; over two decades, $6.14; over three decades, $15.22; over four decades, $37.72, and over five decades, $93.48. 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 in equities is a winners game.
The returns earned by business are ultimately translated into the returns earned by the stock market. I have no way of knowing what share of these returns you have earned in the past. But academic studies suggest that if you are a typical investor in individual stocks, your returns have probably lagged the market by about 2.5 percentage points per year. Applying that figure to the annual return of 12 percent earned over the past 25 years by the Standard & Poors 500 Stock Index, your annual return has been less than 10 percent. Result: your slice of the market pie, as it were, has been less than 80 percent. In addition, as explained in Chapter 5, if you are a typical investor in mutual funds, youve done even worse.
If you dont believe that is what most investors experience, please think for a moment, about the relentless rules of humble arithmetic. These iron rules define the game. As investors, all of us as a group earn the stock markets return. As a groupI hope youre sitting down for this astonishing revelationwe are average. Each extra return that one of us earns means that another of our fellow investors suffers a return shortfall of precisely the same dimension. Before the deduction of the costs of investing, beating the stock market is a zero-sum game.
But the costs of playing the investment game both reduce the gains of the winners and increases the losses of the losers. So who wins? You know who wins. The man in the middle (actually, the men and women in the middle, the brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system) is the only sure winner in the game of investing. Our financial croupiers always win. In the casino, the house always wins. In horse racing, the track always wins. In the powerball lottery, the state always wins. Investing is no different. After the deduction of the costs of investing, beating the stock market is a losers game.
Yes, after the costs of financial intermediationall those brokerage commissions, portfolio transaction costs, and fund operating expenses; all those investment management fees; all those advertising dollars and all those marketing schemes; and all those legal costs and custodial fees that we pay, day after day and year after yearbeating the market is inevitably a game for losers. No matter how many books are published and promoted purporting to show how easy it is to win, investors fall short. Indeed, when we add the costs of these self-help investment books into the equation, it becomes even more of a losers game.
