Book Review: The Little Book Of Common Sense Investing

The Little Book Of Common Sense Investing is one of the more famous books written by Vanguard founder and former CEO John Bogle. If you know the name, you've got a good idea of what the book will be about - how low cost index fund investing consistently beats the pants off any other method of stock market investing in the long term.

This should be obvious by now. Studies have been done confirming this. The greatest indicator of how well a mutual fund will perform is its expense ratio. The lower it is, the better it is for investors.

For those that still don't grasp this, Bogle gives a detailed analysis of why this not only is the case, but must be the case, according to the "relentless rules of humble arithmetic," a favorite phrase of his that appears many times throughout the book.

The Relentless Rules Of Humble Arithmetic

The case for low cost indexing is rather simple. No one can consistently beat the market. Rather, Bogle argues, the best you can do is mimic the market. In fact, there is not even a need to beat the market. Simply matching the market's performance over time is enough to make you a millionaire. Further, the best way to mimic the market is to own a little piece of every company that trades in the market. Hence, a whole market mutual fund that owns shares of every single stock in the market in the same proportion they exist in the market, weighted by market capitalization, is the best way to mimic the market.

If you have such a mutual fund and it charges no fees at all, it will perfectly mirror the market. Therefore, simple math tells you the more fees you have to pay, the more the fund's performance will diverge from the market's. Humble arithmetic.

Destroying the Counter Arguments

Once that premise has been firmly established. Bogle goes on to address various claims that other strategies can better this performance. He shows how each one is false.

Actively managed funds, those where a person or persons is involved in picking stocks, simply can't beat the performance of a broad based index fund. First, actively managed funds have higher fees, so right off the top, the investor loses some returns to pay those fees. Second, most actively managed funds buy and sell stocks frequently. This incurs commission costs, which of course, are passed on to the investor. Third, frequent trading results in a higher tax bill due to short term capital gains taxes. If the investor is not holding the fund in a tax-free or tax-deferred account, these are more costs that will need to be paid. And lastly, the stock market is a zero-sum gain. For every seller, there is a buyer and for every buyer, there is a seller. They can't all be right all the time. Fund managers that do well one year, inevitably do poorly the following year. Bogle has the data to back this up.

When you add emotion into the mix, things get even worse. It's human nature to chase performance. This leads investors to throw money into sectors that did well in the past. They buy high, in other words. Then that sector drops and another one becomes hot, so they sell again and buy the latest hot sector. They sell low and buy high again. This is a recipe for disaster.

Broad based, low cost index funds, which have low turnover greatly reduce the losses due to taxes and trading commissions. The result is a performance that is impossible to beat in the long term.

Bogle also spends some time talking about bond funds, where the same rules apply - low cost, broad based wins the day. He then talks about exchange traded funds (ETFs), which sound good, but actually are just as bad, due to their short term nature - again commissions and taxes gnaw away at overall returns.

But don't just take Bogle's word for it. At the end of each chapter, he provides quotes from other finanicial giants supporting his claims - everyone from Warren Buffet and Charlie Munger to Noble prize-winning economists.

The book made a great impression on me, even though I already knew the benefits low cost, buy and hold funds provide. In fact, after reading it, I went and changed my future 401(k) contributions to be split 90% into low cost Vanguard funds and 10% in a low cost bond fund. This book is highly recommended.