[Music] hello I'm Andrew Lowe and welcome to in pursuit of the perfect portfolio today I have the great pleasure and privilege of speaking with one of the founders of the mutual fund industry John Bogle or jack as he prefers to be called Jack thank you so much for joining us today my pleasure so we're really thrilled to have the opportunity to find out a little bit more about the beginnings your beginnings and how you got started so if you don't mind I'd like to take you back to 1949 and this article that came out in Fortune magazine called big money in Boston can you tell us a bit about that and how that influenced you sure and the person was one of the great brakes of my lifetime no question about that and I was in Firestone library at Princeton just open brand-new beautiful library and I remember the Sun coming in over my shoulder and I can remember opening fortune magazine at a time when December of 1949 and when one was thinking about one's senior thesis and I was gonna graduate in 1951 you can't start too early at all and I was a very contrarian young thinker your finger is a good word and very skeptical of everything any knowledge that was delivered and I said wait a minute you know let's take a really close look at that and so I didn't say I was a contrarian I wanted to write a thesis on the subject and nobody had ever written one before and I opened Fortune magazine and there is big money in Boston the name of the article that mass investors trust the oldest the largest and perhaps importantly compared to what happened later on the lowest-cost fund in the field a very diversified basically S&P 500 like portfolio not any magic there and the industry was described as tiny but contentious its total assets were around two or two-and-a-half billion and I thought well by God I'm tiny and I'm contentious and no one's ever written on this before I knew I there may have been something later but I have never seen it and I picked on the spot in the library that topic for my thesis well the open-end investment company or the mutual fund and it was very very little research available on very little very few articles some in the legal journalist but the value of diversification for estates and things like that and then we had things like critical articles article from the head of the SEC chairman the SEC saying mutual funds were gonna change the marketplace this tiny size and I haven't done it yet but maybe they will someday but there was I wrote to the investment company Institute then known as the National Association of investment companies and asked them for the data that they had and seven months later I got a reply mm-hmm it's just a one-man shop and he finally got around to me I think it took seven months and so the ambit of my research was gonna be very limited so I made it as deep as I could I got all these old wiesen Berger so-called books that were historically coming out every year and looked into the industry and made some opinions about it and read everything I could find from the hearings the 1940 act Bestwick Company Act of 1940 which was only at that point nine years old and it seems amazing to me and I was on my way the thesis is just an extraordinary volume that I would recommend everybody read because I was blown away by some of the things that you covered so I want to mention a couple of things about the thesis first of all you began as a sophomore in terms of doing your research and the fact that you actually covered so many different aspects of open and funds and we had a lot of data and turnover and all those kind of things mutual fund turnover was portfolio Turner's about the same as the market for the mutual funds for 1% of the market then they weren't gonna do very much and now mutual funds are I guess 25 30 % of the market and but that gets anticipating where we go from here and if mutual fund industry today was the same way it was when I wrote the thesis or thereafter would all be actively managed funds that was the business right and it was all in those days this is a very important thing it happened and it was very diversified just about every major fund looked like the Dow Jones Industrial Average and you could look at the volatility wiesen Berger would score that in his annual volumes and you could find a couple of funds that were maybe 7% more valhalla morgan and you could find some funds that were 10% less volatile but the idea of 30% more about 30% less followed is one there except balanced funds different case of course they were found just as follows it as they were supposed to be that is two thirds of volatility of the market so it all those things developed but then the industry changed and we had the boom of the go-go era right and yet the idea of a S&P 500 like fund this before the S&P 500 index was even created the index fund was even created everybody went into the go-go thing they totally dominated gogo funds what is that funds that are created to have remarkable records to buy junk oftentimes to by letter stock from company founders at 50 cents in the dollar and put it into their portfolio at a hundred cents in the dollar this is a very easy way I wanted to get their performance so after graduation what then so I definitely wanted to be in Philadelphia if I could possibly find and so I looked at a bank here I look at a brokerage firm if you can imagine me in a brokerage firm oh my god and and I looked at well again fund and mr. Morgan who I'd met at Princeton called RL Morgan my great mentor who I met when he was 50 and knew him for 50 more years Wow he died three months after his 100th birthday in 1998 and so he was a great mentor he obviously like me um he said publicly after I'd gone through this tremendous change in his company did hiring me was the best decision he had ever made certainly a nice compliment to read an article we had a great time together and I he actually did not to be clear spent a lot of time with me hmm but enough time to get he knew what I could do and when I couldn't do he exposed me to this little seventy-five percent approximately Wellington management company had 145 million in assets when I walked in the door and it was probably the let me say the seventh largest firm in the business and the largest balanced fund that was our stock in trade well we offered with the balanced fund in those days but it was those were great times happy times he was an extraordinary man a pillar of integrity very much a Renaissance man he was interested in all aspects of the business there's also an outdoors many went hunting and fishing and all those kind of things she just couldn't have and a more thoughtful well man who lived a great life mm-hmm so I was glad to be a little part of it now in 1960 you published an article under the pen name John Armstrong and this was perhaps the beginning of your thoughts regarding indexation can you talk a bit about that yeah actually the beginning of my thoughts go all the way back to the thesis score and I do do explain why the index at how it works when I say that mutual funds can make no claim to superiority little superficial and we didn't have the kind of database we had today probably just as well and but then the industry changed and before it changed we had really a pretty good industry we weren't selling a bunch of wild funds and this is an industry group direct distribution was coming into play and that was the strongest part of the industry for a while but we're selling middle-of-the-road funds their stock funds were balanced funds and concentrating on that and working through broker dealers who had some with our with our wholesalers through broker dealers who had some idea of not suitability I don't think that was in the books though in those days might have been but kind of a not a nice speculative market at all and then all of a sudden comes to change the go-go era well the era I described in 1960 in that article and let me first be very very blunt about it of course I'm a party-line guy that's why I wrote the article mm-hmm and we ran a managed fund and I'm happy to prove that that the the idea of an index fund is bad and that actually is a poor formulation on my part because it was really there should be a Dow Jones Industrial Average index on it and when you go through what it takes to run one it's an extremely complex average to operate and the amount of turnover you've had and the amount you have to have to change the holdings so with some frequency because it's price related and non priced for lady but market by the number of stocks have to have to always total 30 and so I and it would be very expensive to do so I look at this terrible index really a bad index alone in the long run it's it produces like any other diversified portfolio about the same returns as the market every every diversified portfolio really does that and but it was a bad index in a good industry in an industry was just playing everything down the middle and no they're not winning by anything because they have costs we didn't have a big performance race but it was a kind of a slow-moving conservative industry and if you put your money into a mutual fund by and large you were not gonna get hurt and then we have and that's when I wrote the article but math didn't work and then I did comparisons the funds had actually done better than the than the Dow Jones and but better I think then than the S&P I did have a couple of other data points and then everything changes we get a good index a great index market cap weighted index it was available then but people weren't paying any attention Standard & Poor's 50 it was then and it was not you know particularly well known or popular it was all a dial the dial the Dow the Dow up 20 points down 20 points in those days big up a hundred points every once in a while later on but in weak men and along comes a band industry this industry became a total marketing business it became an opportunistic business it became a business creating expectations on test performance that could never possibly be duplicated in the future said not the whole industry but a large part of it and very very few sponsors were exempt from this little disease called gogo ISM wrong whatever you want to call it so sonorous to summarize of course that was defending the status quo because I was been in the business for nine years what the heck am I supposed to do but it was a reasoned right status quo indexing yes the Dow Jones average was a terrible thing to have tried to emulate and I don't think anybody has ever even bothered it so um and then things changed so there's a true reason and then there's the fact that that the times change and because I think it's justice frankfurter said Andy sometimes we them comes late mmm sometimes wisdom never comes so even when it comes late it's a good idea to honor it [Laughter] so in the 1960s there was a merger between Wellington and I vest and you've called that one of the worst ideas of a merger in history can you tell us a little bit about that and how that maybe started you know creating the seeds of the Vanguard fund but was sure and and number one even before we get to that and my first real exposure to investment performance if you will was working with the wholesalers and also doing a lot of data for them on performance so I was well aware of the difficulties Welling and fun was having beekeeping its competition they didn't pay the world didn't pay that much attention the gaps were not large we're at the very much a mediocre balanced fund but with all the strength of our or wholesaling force and our uniqueness everybody else largely selling stock but we made we were the best selling fund in the marketplace year after year in the fund marketplace so when performance started to slip we started to get new managers and the new manager was not as good as the old one and they turned over faster and those things changed and I realized this is a very hard business and it's hard to be good and the more you try sometimes the worse it is right maybe you should stop trying it's a very tough business so then comes the change in the marketplace in the go-go era and our balanced funds the dominant fund and he had been the balanced fund share of the marketplace cash flow troughs from 40 percent to 1 percent Wow and it's like the example I use it is I've got this nice little bagel shop and it's nutritious it's far and crusty it's good for you and all around or these donut shops and they're sweet they offer nothing in the way of nutrition except something bad they crumble but if everybody else in the street is selling Donuts and nobody's buying bagels mm-hmm the bagel shop owner has one option right start selling doughnuts yeah I hate that argument mm-hmm but that's the business argument and for all the preaching about idealism if you don't have a vehicle yeah with which to offer that idealism you go out of business so you have to adjust so I tried to I tried a number of I knew we had to have an equity fund that was my first level of thinking by the way in the middle of all this mr. Morgan called me into his office one day and said I don't want to deal with this presently I don't understand it I'm too conservative and how much is starting the company today and I thought of course you surely picked the right man I was 35 years old yeah with a lot more self-confidence than my and my experience would have would have indicated and so I knew the first step I'd no doubt I thought about it a lot before this meeting and I had no doubt we had to have bring an equity fund into the business so there we were and along comes this opportunity with I best friend and they seemed to meet go beyond are our expectations yes they've got the Go Go fund which had a pretty shaky record I knew that I think they deep down they beg they'd never admit it but you know is when they were a bunch of private investors and they could produce some data had trouble getting it past the NASD mm-hmm and that was my job to do for the company and I did and I was honest but maybe not quite as honest as I should have been about my own skepticism so when I was an important part of NASD investment companies committee so I knew the people down there and they probably were more likely to take my word and so then and my word was good but a little did I know what I was getting into so we have the the Gogel fund and that a year after we acquired it it had the best record in the mutual fund industry or maybe the second best I don't want to talk about its validity mm-hmm but there it was in the numbers and so they all said it both had a small pension business its own a great accompaniment to the fun business always thought and then they had of course just we needed for Welling it fund brilliant managers mm-hmm brilliant managers right that dad and I can remember one of the saying before the merger took place on June 6 1966 I can't wait to get my hands on Wellington fund and they got their hands on Wellington fund and it was a disaster it has typically had about a sixty five percent equity ratio at the high the market at the end of seventy three it an eighty three percent ratio the equity ratio eighty three percent in stocks this conservative Bella's fund would more junk than you would want to have as compared to blue chips of the old days and Welling and fund and their 10-year tenure had the worst ten-year record of any balanced phone in the industry and the funny thing about investing is it's just as hard to be worst as it is to be but they did it yeah and they're their best phone they created a couple more funds one was called trustees equity which is not structures if a trustee should own it but they were offered that and it collapsed along with i-best and then they started a fund called techne best fund this they were the money guys mm-hmm and I was the marketing administrative overall head of the company but there was no question that they were supposed to know more about than I did I hate to say it sounds kind of bragging but they didn't they didn't superficial um persuasive suited for the go-go era but not suited for what followed right and so you know it said that but mouth swallow the elephant was one of the things event something like that mm-hmm after the merger took place and I knew it was a gamble an interesting sidelight I knew it wasn't gonna be durable so I gave each of them as our celebration dinner a little silver card tray mm-hmm and in the middle of each one I had soldered a u.s. silver dollar huh and on it is said piece but there was to be no peace everything fell apart yeah you know they fired me and they tried to put out a press release said I resigned and I said no no no you fired me oh don't put over something I wouldn't resolve it for anything in the world and so I'm on my own mm-hmm and how do i recoup if you will at the poker table what I lost at the craps table mm-hmm I looked around and a couple of institutions here in town to see if they wanted to get it more active in the mutual fund business and there was no interest I tried to buy thought about buying at least a little company down in Delaware owned by the DuPont family not a large mutual fund company I thought I could do something with that and somehow that never came to pass I guess they decided not to sell it or I decided I didn't want to buy it so I'm left with one option to persuade the directors of the Wellington fund where I'm chairman of the board and chief executive yeah to not do what they did at Wellington management company their supplier of services which is fire the chairman of the board and chief executive and so they said well I'll give us some more options they didn't like that so proposal 2 was to leave them an investment management although I have to head after the job they had done how a responsible director could have done that it is beyond my his beyond my Ken and and we do distribution and and distribution was kind of complicated very difficult for funds to spend their own money on it at that time and asila is in a certain way and so I'm left with will be the administrator and there will be the distributor and the investment manager and we agreed to stay out of distribution and investment so it gets done and we got started on September 24th 1974 and interesting enough unlike the question us we actually took over operations on September 19th 1974 but before there was even a company and all that happened in May is 75 I'm trying to get the management to understand this well I've written about it incorrectly myself is all happened on May 1 1975 that the shareholders approved new fee agreements with Wellington management company with lower fees this is not an exciting date it's a pro forma date so for me Founders Day if you will is September 24th 1974 and we started off we had 28 people counting me we were doing you know making sure what we had was called the belly up theory we would be in charge we Vanguard the new van Gogh or the name I picked out of a book in naval history and without any consulting with anybody either naturally and the so we started and we were legal complete or a compliance shareholder record keeping and fun financial portfolios know that and that was that and we had agreed not to go into us I think I said not to go into marketing and not to go into investment management so here we are with what we shall call a Pyrrhic victory mm-hmm and so I wouldn't you know obviously gonna be happy with a Pyrrhic victory and I'm one of them said to me aren't you gonna be bored one of my adversaries and I best aren't you gonna be bored I'm in the sand hang but I thought my thought was just you wait and so the door opens this is the magical part of it and the door opens and that idea of the index fund written about my thesis is a human shield and it was importantly very importantly as I recall the hell influenced by the article Paul Samuelson wrote in the first issue of the journal of portfolio management what timing yeah that was October 1st of 1974 and I read I read these journals I'm not sure many of my counterparts in the industry do and most of them I cannot understand I'm not trying to brag about that but I'd like to see what academic thinking intelligent thinking logical thinking is is doing because they often see the execute and there is this article called challenge to judgment by dr. Paul Samuelson and I thought you know let me do first a little research and I did a little research and took the average performance of the equity funds the previous 35 years and showed that the SP and one by one point three percent a year I think was the number and then I compounded it for 35 years and you can imagine what that looked like and then i based showed the directors what a $10,000 investment would be worth in the two and then I crossed that out I actually have my working papers cross it out and put basically if you will the hell with $10,000 let's do it with Amelia you can see it all scratch right down there you have to make it more impressive and implied that we'd be good for pension funds to at least and so that 1.3 percent a very crude number I don't mind saying that at all was about the cost of funds a little bit different and so I I had the the economic research back up but that would have gotten me nowhere without the imprimatur of somebody who really was universally respected for his intelligence and wisdom and that would be dr. Sanderson so the directors I think they voted unanimously to favorite one of them decided to want to serve on the board he didn't believe in it but as a director at Vanguard he bought it to start it and so we got the vote unanimous and in part because of my research in part because of dr. samisen and in part I think the board was just sick and tired of controversy I wanted to give me something they sent of course first you can't get into Investment Management that was the agreement and I said this fund is not managed now you're laughing amazing that's just amazing it's true and I said it with a straight face and so we were off and running the Unruh and the underwriting was a complete flop the underwriters were gonna do two hundred and fifty million dollars and they did eleven point two million and I said oh my god we can't even buy around lots of all five hundred of stocks and they said well why don't we just give everybody their their money back kill the underwriting I said wait a man we have the first world's first end that going don't give that back right so so kind of go back to the origins of the very first index fund because one of the things that you don't nearly mention as much as I think deserves is the role that research your research has played into this we typically think of the index fund is relatively simple and passive but there is nothing simple or passive about the effort that it took to change people's perspective of what an index fund could accomplish and in particular there's a lot of numbers and a lot of thinking involved in the construction of the index fund so is that fair to say that you were probably the first real quant in that you actually spent a lot of time thinking about numbers and working out the implications of these kinds of structures from a research perspective before any dollar was ever invested well I think that's right although my research was superficial I'm the first to admit that and I wrote about this in one of my books but I was kind of I used this in a different context I was kind of an arithmetic quant and the people didn't like our algorithmic wants and and Paul Samuelson was very much in the pragmatic side of indexing rather than the theoretical side and challenge to judgment his article in the journal of portfolio management said there is no brute evidence was afraid he used that actively managed funds can beat the standard metal and managed and reverse 500 index so why doesn't someone start one mm-hmm he challenged basically challenged made and no at the time just start one so I think there's a lot of misunderstanding about how it is the fun came a bad and I Bridal would be that the idea that it has something to do with Modern Portfolio theory when the efficient market theory or French and FOMA I'd never heard of either of them sure and Nord I heard about the people at Wells Fargo right who were pursuing this a highly quantitative way basically looking for a way to beat the market us how it started out there and then they did the pension fund for Samsonite first index account mm-hmm which of course failed right because they had used yet another index New York Stock Exchange index which had to be changed had changed support follow every way it was an equal weighted index yeah right and there's just a very foolish index underneath right there also brilliant but I don't know why they pick such a such a silly index but the the index fund from my standpoint I'll give Samuelson great credit for the inspiration but the the ideas behind it efficient market theory Modern Portfolio theory or whatever it might be had nothing to do with nothing I didn't even know those things were right and so it was an original in a in that sense but it's a it's a pragmatic issue for me I looked at the record funds didn't do it why would they do it in the future they have costs and all this kind of emerges into a very cogent overall theory and it worked then in a work sale of course Paul Samuelson is the consummate economic theorist and has written extensively about investing but he was particularly captivated by what you were doing and gave Vanguard a bit of a shot in the arm in his Newsweek article didn't he to say the least I am as we were getting towards the underwriting I'm pretty sure of my dates here maybe maybe July of the 1976 he wrote oh he had a regular column in Newsweek magazine full-page and probably show it to you let's take a second here I know it's in here somewhere if you want a little visual oh is it this one yeah that's it hmm there it is Wow and he doesn't mention Vanguard mm-hmm he talks talks about first index investment trusts the name I chose mm-hmm because we were first and I wanted to brag about it yeah it later on became Vanguard 500 index when those kind of things didn't matter and the SEC did a lot of research on the name and they couldn't find anybody else that did it so we are the first index fund index mutual fund no question about that and so he was hoping that someone was starting index fund and they did where there is the man nature will find a way sooner than I dared expect my implicit prayer has been answered there's something coming about market I see from a crisp new prospectus something called the van Gogh first index investment trust meets for my burden requirements available for the person the modern family of modern means fifteen hundred dollars to a million or more proposes to match the S&P 500 being essentially unmanaged number three its management and expenses charge will be only about two-tenths of one percent mmm and number four the Commission's fretted away and turnover should be extremely low for an index fund best of all such an index fund gives that broadest diversification needed to maximize mean return with minimum portfolio balance variance and volatility then he adds this is interesting a professor's prayers are rarely answered in full this is a no load fund this is not a no load fund right off the top year - a comes a 6% Commission good ideas like bad ones are not what a parent they have to be sold well he wrote that in August 776 a little bit later than I said and by the time we got the index offering done on August 31st 776 the beginning of the next year Vanguard took over distribution and made everything no load Wow so the professor's prayers were answered in full six months later eight months later and that's an extraordinary difference from the rest of the industry because in those days five or six percent was not unusual yeah actually if they were higher we had Wellington was seven and a half percent my goodness and the there were eight and the rate and it has because dealers needed to be paid for basically they didn't look at it this way I'm afraid but basically needed to be played for locking up that money this was not a heavy trading industry at all so given the challenging beginnings what do you think are the factors that explain the incredible success of Vanguard you just passed the four trillion dollar mark I was never in this to build a big well a big business I tell people and even I never had a goal of building a colossus but i was too stupid to realize the game investors the best deal I would ever get you'd build a colossus see that's our stupidity is quite on quite unlimited so what what did what was the key well there I'm gonna call a mechanical key structural keys you start with the structure mm-hmm and the mutual structure you're designed to serve shareholders you're talking about cost advantages you're talking about Wrigley in the bond area is so obvious and you can take you know what to reach for yield to have a competitive yields in the marketplace because your expense ratio is you're gonna run 12 basis points compared to 82 so you you're gonna win if you can narrow the marketplace into segments where they'll be much less obscuring of what true performance is and that led to the rise of the of the Defiant defined maturity bond funds long intermediate short note fussing around you choose you tell us how you want to balance risk and income and so it's just it's a pro forma thing there are money market funds even easier the higher the cost to lower the return because you can't do much treating in in the money market area and in the long run the same thing proves to be true in the stock market not evident in the short run but so it's structure structure structure and then strategy focus on the place where cost makes the most obvious difference and that would be the index fund where when index fund is gonna be identical to the other and whoever has the lowest cost will win or bond funds money market funds or any fun that's the more like commodity in nature and so structure and not quite me as van der Rohe here I think he said opposite but strategy follows structure and that's the mechanical for it but beyond that there is the missionary port I've written just finished my eleventh book and I think I have five hundred and sixty speeches [Laughter] I can't imagine a more eloquent spokesman for this business and this industry than you and all of the writings and speeches you've given and in fact in dealing with some of the academic theories like the EMH or the efficient market hypothesis in 2003 you proposed the CM H and which I thought was brilliant and I teach it to my students now do you want to tell us a little about that oh I'm a great one for playing with ideas to try and make them a little more interesting and so I wanted something that paralleled the EMH the efficient market hypothesis and it didn't take hours to figure out if you say cost matters like pathi says you've got cm H and the one thing we know everybody knows academics brokers whatever might be investors is the efficient market hypothesis is often right but it is not always right and you can me know if you think the markets are highly efficient and they're not you're gonna pay a penalty for that and that happens periodically along the role of the markets now but the CMH always works it is the even Morningstar with their sophisticated Morningstar statistical funds Statistical Service the best one around the there there with all their sophisticated means of identifying star funds and so on they say when it comes down to it you would be better off picking funds in the basis of their cost than you would on the basis of our or rating system mm-hmm now that's a pretty good concession the CMH is never quite caught on and so i'm of course working out another one which I'll sneak in here my favourite subject I am trying to get the industry and the press the media I guess I should say to focus on the difference between ETS and TIFs another play on words exchange-traded funds of all kinds of every way shape and form in traditional index funds based on the original Vanguard platform broad diversification doesn't have to be the S&P 500 total stock market is fine total international market is fine total bond market is fine very broad very durable over time you're not picking a segment of the market you're picking the whole market very low cost and the TIFs or much less volatile in their cash flows ETF bubble is like this you never know what's gonna happen and in a given month it can look like investors are fleeing the market and it's just the spider that's twenty billion dollars of redemptions for the month and so it's the the data ought to be active funds traditional index funds exchange-traded funds but I can't sell it to anybody I've been trying for years and I'm not giving up wonderful but it's a it's a very different thing and in this this during the 2005 to 2009 the 2007 to 2009 period uh-huh there was on a single month in which T is had an outflow not a single month in that period the the active funds were probably averaging a negative 35 billion or something and and the exchange-traded funds actually had more in total but they had one month where they took in seventy billion dollars toward the market high and another month toward the market low when they when they redeemed forty billion in just to those two months the swing a hundred one hundred billion dollar swing and cash flow between the high month and the whole month and the swing for for the traditional index funds might have been two billion dollars so there's a difference a difference in holdings a difference in how you look at the market in the years ahead this is a very different market and it's a trading market it's a speculative market it's a it's an entrepreneurs market entrepreneurs like those of the go-go era mm-hm they're in business nish nish as they say in the marketplace that nobody has touched yet 10 million it was a good or not it's an idea what can we do to sell and hardening it hardly a traditional index fund has started I don't think in the last five or six years and while everything is it's easy to get into the business it's easy to make a big noise about how good your performances it's easy to claim smart beta mm-hmm absolutely without any statistical backup at all them do well and no question has yet to outperform over ten years seven years five years three years in one year the average smart beta fund has yet to outperform the S&P 500 right you know for somebody who is so modest about his forecasting abilities you actually have an amazing track record I'm making some incredible forecasts I remember in 2007 you were asked what was going to happen to the Dow in ten years and if I'm not mistaken you said something about Dow at 20,000 in 2017 and at the beginning of January of 2017 the Dow hit to 20,000 so that was a pretty prescient an amazing at forecasts over a decade how do you how to do it what what what I'm tempted to say are sharks but well you obviously had something in mind I mean I don't mean first I don't like to do asked sure I don't know why I fell for doing it but I don't do it without work mm-hmm and so I used a little formula I developed which I'll talk about more in a second where market returns come from the source of market returns that's what john maynard Kidd says don't pay any attention to past returns unless you know their sources and that I read in Princeton University in 1951 1950 1950 now and even a certain part of my research and the thesis cousin that Cannes chapter on on how the markets work is powerful it's the best I think is the best chapter I could ever ask anybody to read to understand the markets so I developed this sources of returns he talked about investment in speculation there so I talked about in those were the two sources of he didn't quite call him that but that's what they were and when I read that I thought they were my sources so I said investment return is the current dividend yield plus future earnings growth and I estimated future earnings growth based on the earnings growth over the past ten years very simple and speculation is what market valuations do to that investment return speculative return does that if Pease go way up it's a double over a decade that will add seven percent to the return mm-hm if they're gonna add 50 percent let's say they go from 22 to 40 100 percent 7% a year and the investment return that's we got in the 80s and 90s believe it or not all add from just speculation and if they go down from from a twenty to ten that's also 7% backward and so all you have to do is figure out where the PE will be in ten years later compared to the present and what I have used is is the PE I use earning throath for 10 years I didn't do a lot of research on this and PE for 30 years and figured it would come back to the main so what happened in been put in predicting the Dow well 10 year earnings growth was about 5% 6% I guess in the previous 10 years and the PE was then around 20 and I expected it to go down to about 20 22 I think I'm expected to go down to 17 or 18 and that costs the point of that return mmm so we had 7 percent minus 1 is 6 percent and actually the number came out to be 5 so it must be it must be 6 percent that's the point of speculative return negative 2 5 and what happened the market return was 5 percent actually there was a little spread not worth talking about and wasn't quite as accurate as I thought but it was a funny little number because that PE that I expected to go up go down actually went up and gave a point to the market return but the earnings growth was not six but four so we got five from both them so I tell people and my talk about this in my book not for that particular example and after telling him how good by my system has worked over 25 years I say hold the applause because it can come from different sources and you know I don't I don't look at it as predicting and may have looked that way a lot and then the Dow thing but I look at it as creating reasonable expectations the idea is to give some investor not wasted speculate in the market because if a p/e is between 15 and 25 and I don't think it's worthwhile speculating upper then although we do know the p/e is below 10 the odds were about 85% it will go up during the next decade as a PE is above 25 the odds of 85% will go down the next decade no guarantees but a way of looking a way of framing so I started doing this in 1990 with with the SP and I should come back to the dapper just a second in case I didn't make it clear the Dow doesn't have any dividend so the market return was higher than 5% by probably the dividend yield was 2% I would give it a 7 percent overall Margaret returned put the Dow doesn't know it so I left it on I'm the great genius there and so I started doing this in 1990 and documented it in an article in the JPM in great detail each decade since and the there were erratic times the first one was a disaster because I expected the market the p/e to go from 13 to 10 and it went from 13 to 26 and yet and this is the this is the ticklish thing about any kind of prediction or reasonable expectations three years later it was back to 11 right because we got that big problem with overvalued yeah and so you've got to take that into account a little bit but it doesn't count when you count the data but if you take all my fifteen ten year periods to make up the twenty five and I think my average return on the S&P was let me say nine point two percent and the actual average return of the SP was nine point five so it averages out but there are some bad periods in there right no point in not acknowledging that because there's life in this business so you know people haven't really particularly adapted it I call the sources of market return right out of Keynes original notion and it's not perfect and of course right now we're at a time when it's amazing how opinion is varied and - in terms of what we're facing it's hard for me to believe we're the new higher level of PE very hard to believe that so it's hard to me to believe the market isn't fully valued but it seems dumb even to say that today when all this bullishness in the air so we'll see how long it lasts yeah but now this brings us to the main point of our discussion with you which is to get your advice for our viewers about what you consider to be the perfect portfolio now we know there's no such thing as perfect but I suspect that tifs will play some role in this what would you say to the typical investor now today looking forward how should we be managing our wealth well let me I tried to cover this you'd be surprised at some of the what I've done in the asset allocation chapter in my book a little bit because I've come inclusion there's really not a very good answer and I've concluded that regular rebalancing is not terrible but not necessary yeah and I've come to conclude that it's 60/40 portfolio is probably the best option rather than going from 8020 to 2080 in a target retirement plan hmm maybe right and I may be rolling on that and I find it something very individual and and and clearly I mean everybody knows this into Italy at the beginning there are no easy answers to this so I'll come to exactly what I'm doing but when I was in what I did I got a letter from clearly a young man who was really worried about how he should be investing in what his allocation should be and he said you know the dangerous risky world out there and he didn't mention that but of course he's right you have potential nuclear war global warming much more than just potential and racial divisions in the country right now and threats the world trade and division of wealth all over the world but most often been very heavily in the u.s. between the haves and the have-nots all those things are worth worried about but I said to him you don't know and I don't know what's gonna happen any of them the market doesn't know nobody knows so you just have to put them out of your mind and forget it what you want to think about is how much risk you can afford and that's very much a personal thing and has a little bit to do with whether you're investing regularly and things like that and then I said don't if it's helpful to you I will tell you what I'm doing now I'm a eight years old and have an unusual kind of planning my estate and I said I'm 50% bonds and 50% stocks I don't happen to rebalance around that just seems to come out that way particularly in recent years and it's been higher than that and been lower than that but right now I'm very comfortable at 50/50 although I spend half my time worrying and I have too much in stocks and the other half of my time worrying that I have to live one's stuff and I think that's the way most investors feel mhm they don't know what the right number is and when the markets going up they said God why don't have Moores in the morning stocks when it's going to see your own worst enemy in all this but having some stability without automatically rebalancing I don't think I need to do that mm-hmm and it's very clear you know and anybody understanding it kind of certainly understands this but the more the less you rebalance the more you're gonna have because you're always selling the better performing asset if you don't know whether it'll do in the long run but I also look at it as as very importantly and this is this is kind of an interesting thing I think the most important thing you need to know about the performance of the stock market the next 30 40 50 years is what is the GDP of the United States gonna do corporate profits are correlated at 96% S&P dividends are correlated at 96% with with the GDP of the United States across the guchi DP doesn't grow quite as fast but not a big difference 6.7 compared to 7.5 or something like that and then they'd be nominal and I think so what what interests me is in Peter Lynch's book something about Wall Street and one up on Wall Street or something he says there's no number that could interest him less than the GDP number isn't going up for death and what that is is a statement if the short term is more important than the long term and I don't believe this the short term is more important than the laundry and then you even get in Freakonomics those wise guys had a nice interview with me I'm heard all of it yet but I will someday um say pay no attention as a GDP well it's everything right but it's not everything today and tomorrow you know the GDP probably rose today about to three hundred and sixty fifths of one percent or something whatever it is and we don't pay any attention to it but it all comes down to for your you know the best portfolio is are you investor or are you a speculator and if you're gonna keep changing things you were speculating because we can't know if we're gonna put commodities in there the ultimate speculation it has nothing going for it no internal rate of return no dividend yields no earnings growth no interest coupon nothing except the hope largely vain probably that you can sell it to somebody else for more than you paid for it how that could be even considered gold let's say an investment I do not know so it's I'd like to take the mystery out of it and say that the perfect portfolio first I think for MS fuge proportion over ninety percent certainty of the investors should be limited to marketable securities they don't need the liquidity today but and we may have you know too much marketability and then as too much sensitivity to prices as they change day by day but you want to get out of the idea that you always have to do something and I have said in my books you know something happens and that Reserve does something and the traders all at the beginning a day I think it's gonna cause the market to get a they sell and everybody else says there's nothing to do with anything for you and when you hear news and your broker calls up and says do something it's just telling my rule is don't do something just stand there and it's it's a lot of the rules that apply the investments are not rules that apply ordinary life and so don't do something just stand it so get a rough idea of what you want to allocate you know I I do I mean really entirely indexed at my fifty-fifty although oh my and I can't give you the proportions so I don't remember them but my bonds that are in my retirement plan our bond index funds and the bonds that are in my my personal account or municipal was Vanguard municipal bond shortened intermediate and so I'm reasonably comfortable with that so I think I'm too conservative for the average investor so I'd say the perfect portfolio and it should be well let me just mention one other issue and tried a little bit differently Blair Academy and I have a scholarship foot that I'm allowed to manage and I don't want it if anytime on I don't so here is exactly what I've done on the assumption that nobody will touch it for a long time when I'm gone I mean maybe they will maybe they won't but what I did this is probably ten years ago we say put half of it in Wellington fund ahead but balanced an excellent the idea was not all in balance index fund because there could be things that happen and a manager needs to adjust to neither of them have an international component and that's fine with me that's I believe that's the better strategy so that's and they would be together ninety percent of the fund and then against two contingencies just in case I put five percent in emerging market index and I hope you're sitting down five percent in gold really yeah and in the event is that a five percent hedge against some kind of catastrophe and now I wouldn't call that the perfect portfolio but I I mention it only because that's one does distinctive meaning you cannot touch it and at least theoretically can't touch it it's designed to be held through all extremes and so that's gonna give you with the two ballast funds roughly sixty two percent in equities mmm-hmm that's gonna be with Welling and fund more corporate bonds than the better than the index fund has I think the index is something that we should be very very careful about because it has the one of a better expression too damn much in government's right I don't think any individual would have a bond account seventy percent in governments and 30 percent corpus maybe it should be the reverse I think that makes more sense can I prove that no I'm sorry I can't so it's looking at the long term looking at the numbers looking at cost above all there's nope there's no ideal portfolio perfect portfolio that ignores cost now you know I've seen these articles saying well for example commodities no internal rate of return silly and including gold except that's the if nobody's gonna nobody's looking and we have something explosive that will help and it probably shouldn't hurt you too much this portfolio actually had fun rather well in the last couple of years and it's fine in the long run and so you know I actually may be doing better than my own but I don't but I look at my performance because I'm so conservative right I look at I look at the funds yeah but it's almost all indexed and I do have Wellington fund from those days with mr. Morgan mm-hm and I wouldn't give that up as a sentimental matter but I but I should well I'm sure you've heard this before jack that what you've done for the typical investor is really to democratize finance you more than any other single individual in the history of financial markets have placed the power of investment in the hands of the uninitiated you know the the the individual who doesn't have expertise and yet they can still manage portfolio thanks to what you've accomplished at Vanguard well we have to be producer ace we've got to be good stewards of those assets or we won't get anywhere and we've got to have good good values and you know a lot comes down oh and this is this is about the success of Vanguard ultimately it's amazing how this is somebody mesh actually measures this the trust that people have in us and I think that's not only because the ideas have been good because we've operated an honourable manner we've maybe done a little more marketing than I would like I regard that as a negative but nowhere near how much this formally investment now marketing business mutual fund business generally has become so I think we've earned their trust and I trust the people here my successors will realize that when you lose the trust it's a lot easier to lose than to build and you know I know I'm trusted I got large and share always every day literally every day sometimes I go out and say to Emily around noon time any letter I haven't gotten alaria didn't come in late in the morning that's it's kind of hyperbole but but not without some some basis in fact well to follow the nautical theme I think you are the Horatio Hornblower of the industry and who if the trumpet shall be uncertain who shall prepare himself for battle yes that's st. Paul on behalf of all shareholders investors institutional and individual I want to thank you for all you've done for all of us and thank you for spending time with us and telling us this amazing journey and giving us advice about what the perfect portfolio is well it's been fun to talk to you and I hope it'll be helpful to your viewers absolutely readers yeah thank you very much John I am very much do
