By Christine Benz | 10-14-11 | 12:00 AM | Email Article

Christine Benz: I’m Christine Benz for Morningstar.

I recently attended the annual Bogleheads Conference, and I had the opportunity to sit down with the event’s namesake, Jack Bogle. Jack is the founder and former chairman and CEO of the Vanguard Group.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Jack, thank you so much for being here. It’s always a real treat to talk to you.

John C. Bogle: Good to be with you again--especially at the Bogleheads meeting.

Benz: Right. This day is all about you, this week.

Jack, I’d like to talk about where you think stocks are currently. There's been some discussion about whether stocks are cheap right now or whether they're actually pretty fairly valued, if not slightly overvalued. What do you think is the utility of Shiller P/E? Some people have used that to debate stocks valuations currently.

Bogle: I like the Shiller P/E. I like the Shiller P/E for two reasons: One, it's focused on a longer period of time, not just on the moment, and that's very important thing to do because earnings can do all kinds of things in short periods.

Benz: So it’s cyclically adjusted.

Bogle: It’s focused on history and a lot of people compute these P/Es by looking at next year's earnings, which we'll see. We shall see.

And the other thing I like about it is, he uses reported earnings from companies and not operating earnings. All the Wall Street pundits use operating earnings. Why? Because they are higher than reported earnings. The difference between operating earnings is what the company does in its normal course of business, and we take away from that, in order to get to reported earnings, all the mistakes they've made in investments, bad decisions, changing past decisions, things of that nature. And so it is actually reported earnings that give you the true, long-term picture of the company itself.

So those two reasons, a long-term focus and the right earnings number and reliance on history, I go with Shiller. And by his numbers, I think he has about a 17 times P/E as the norm, and it’s around 21 times today. I wouldn’t regard this data, being data, as a major imbalance, but it would suggest the market is probably more or less properly valued, correctly valued, or maybe somewhat overvalued.

But I don't worry so much about that, because my analysis of market returns put together over years and years and years is, stock returns you should look at--not currently particularly--but for the long run, and for the long run, I use 10 years. And I have been doing this for a long time, and it's worked out marvelously well. You start with the current dividend yield and then you take the earnings growth, and add that to the dividend yield, and then you estimate what change you will get in the price/earnings multiple.

Now think about this for a minute, Christine. The dividend yield you know; today’s dividend yield is a known fact. Earnings growth tends to be very similar to the rate of GDP growth at around 5%, 6%, and that's nominal. So we've got to be careful about that. And P/Es if they are over 20, the odds are great that they will be lower at the end of the decade, and if they are under 10 or 12, the odds are they will be much higher at the end of the decade.

So we know much more than we think we know. And using that analysis, I'd say the 2%-plus dividend yield, let’s say a 5% or 6% earnings growth, let’s call it a 7% return, and maybe a loss of a point in a lower P/E, or maybe not. So putting it all together, you get around a 7% forecast outlook for stocks, which is not bad, because you are going to double your money, in nominal terms again, double your money over a decade if we are fortunate to get that 7% return. That's well below the historical norm, however, of 9%. And I think that's reasonable, if only because the dividend yield, a crucial part of this, is, over the long term, 5%, over 100 years, and now it's 2.25%. So that suggests lower returns in the future.

For bonds, we have to think about a very simple fact, and that is today's bond yield gives you a remarkable representation of the return you will get from that bond over the next decade. Now the benchmark bond yield, of course, is the 10-year Treasury, 10-year U.S. Treasury note, and that yield today is a little over 2%. It has been actually down in the 1s recently. So that looks pretty pathetic, although it makes stock returns look quite generous.

I don't think most people can afford to settle on a 2% bond return. That would be more or less ... I guess our Total Bond Market Index Fund is around 2.3%. So, a little better because it has some corporates in there, while it’s heavily dominated by Treasuries and mortgage-backed securities, maybe 70% of the index, 65% or 70% are in those super-safe, very short, mostly very short, maturity bonds.

So I think investors are going to have to be willing to go out a little bit longer in maturity over that 10 years maybe, and a little bit down in quality, maybe investment-grade-quality bonds, which is today, according to the press, I think this is a high number, but what I read in The Times every morning, is about 4.8% for a long-term investment-grade bond.

So I think you can put together a package of bonds without taking excessive risk that will give you maybe 3.5% return over the next 10 years. Well, the math is kind of fun because 3.5% will compound to a 50% gain on bonds, and as I mentioned 7% will compound to 100% gain on stocks. So, there are going to be a lot of bumps along the way and reasonable expectations are a long way from firm predictions, but I think the stock market seems about right today.

Benz: Okay. Well, Jack, I am talking to a lot of investors who are looking at what they think will be meager bond market returns in the future and saying I can't just index, I can’t just sit there. I need to be a little more active, maybe go with an actively managed fund. What's your take on that thinking?

Bogle: They should have their heads examined. Let me be honest about it. I mean the magic of the bond market fund--and it may be you should make a variation on the actual Total Bond Market Fund because of the heavyweight in Treasuries, but when you take a tenth of 1% out of that return for costs in an index fund or two-tenths of 1% out, that's a far cry from most bond funds, which charge nine-tenths of 1%. Can actively managed bond funds overcome that manager [expense] drag? They can't. And sometimes it looks like they can, and of course, the investment world being the investment world, someone is going to show you half a dozen bond funds that have outperformed the market.

I have great respect for Bill Gross, but he happens to be about, I think, 400-500 basis points behind the Total Bond Market Fund this year, because he didn't like Treasuries. He'd be the first to say he was wrong at least in the short-term, and I mean no disrespect for him. He is one of the great managers of all times and his [colleague], El-Erian, is also I think pretty terrific, but that can happen anywhere.

So you don't know. You've got to pick the manager. You've got to make sure you get the cost out of the equation, and ... the odds that you're making a losing bet are extremely high.

Benz: So it sounds like for fixed-income investors what you would advise is maybe use the Total Bond Market Index as an anchor, and then make some adjustments around the margins using very low-cost products.

Bogle: Yes, exactly.

Benz: So that’s the topic of the book that you are working on currently, the fact that speculation in many ways has been in the driver’s seat for the past couple of decades, really.

Bogle: ... Growing all throughout that period. And now it’s reached a ridiculous point. You look at, for example, and it’s sometimes hard to find these, because people do it so unevenly, but the most actively traded stock today, everyday, is the SPDR, the Standard & Poor's 500 exchange-traded fund. And it turns over at about 10,000% a year. 10,000% a year! And I think 25% is a high turnover.

Another very good example is, that I will use in my book, is, how do we measure investment? Well, the idea of our financial system, our capitalistic system, was a system that directs capital to its highest and best uses, the best companies, the best growth prospects, making the best products at the best prices. Put it that way.

Well, in a typical recent year, ... our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that’s 200 times as much speculation as there is investment. One only has to understand that all this trading back and forth, by definition, doesn’t enrich the investor, because if I buy, you sell and vice versa, but what it does is enrich the croupier in the middle, which we call Wall Street, which has a bunch of very angry people sitting on its doorstep as we speak.

Benz: So some of that trading, even for buy-and-hold investors, might be necessary, as we all rebalance and maybe shift our portfolios into more conservative investments as we get older. But you think beyond that, it just fuels this speculative frenzy?

Bogle: Yes, ... the effect of that kind of trading on the market is infinitely smaller.

Benz: De minimis.

Bogle: There’s also a question about whether rebalancing is that valuable. We know that in the long run, the higher yielding asset is the one you want the most of, and we know that stocks inevitably will be, not in every period, but much more often than not, the higher-yielding asset. So, if you keep rebalancing, you will be cutting into your long-term returns.

Now you will take on more volatility. I’m not a big fan. I don’t object to it at all. But I think we may overdo the kind of precision of rebalancing. I think it should be done less frequently than a lot of people do it, and only at bigger margins. In other words, if you want to be 50-50, let it go to 56% or 57% or 58%, maybe even to 60% before you rebalance. And the other way, let it go to 40% before you rebalance. Don’t try and turn this into a science, because if there’s anything that our markets are, they are non-scientific…

Benz: There has been a lot of interest in alternatives, retail investors embracing alternative products. You have done some work looking specifically at college endowments, many of which have been quite heavy on alternatives. What have you found about their performance and what does that say about retail investors' ability to jockey among these investments?

Bogle: Well, it's a curious thing: A couple of weeks ago, I gave a talk to endowment fund managers, some 300 or 400 strong down in Washington. And it happens that, for the common fund, 15 years ago, pretty much exactly, I had given some investment advice, how I would run an endowment fund, and that's all in their book along with other comments by Sir John Templeton and Michael Price and Barton Biggs, 10 or 12 of Peter Bernstein--all had ideas about how they would manage their college endowment funds. And I said, look, keep it simple: go 50% stocks, 50% bonds, both cases indexed, and that produced a return of about 7%. The average college endowment fund had a return of 7.2%.

There are two caveats on that. One, the average college endowment fund was about 30% more volatile. As a result, for example, in 2008, my little package went down I think it was 10%, and the average college endowment fund went down 20%. That's a big difference in volatility. So, I was very comfortable of giving them basically the markets return and not doing anything else.

However, that number is raised way up by the huge success that Yale, David Swenson, Princeton, Harvard, to some extent Duke ... who have been using a lot of alternatives with great success. They would, and in particular David Swensen would tell you, don't you do that yourself, because you can't, we can. We've got all the staff. We've got an infinite time horizon, think about that. We have no tax liabilities, and we can do it, and you can't, and they all had very good years. 21% gain last year I think, which was not that much more than the S&P 500. That would have been a lot more than my 50-50 portfolio because of the bond position.

So, I would tell people, don't try and do that. Watch out for alternatives. Now there are two kinds of alternatives. When you get to private equity, David Swensen himself says, look, private equity on the record does about the same as the S&P 500 on average. So you've got to do a lot better than that. Same volatility, there is a lot of high jinks played in the private equity game, and a lot of grabbing from the cookie jar by the managers, and I just don't think that's a good idea for the average investor to do.

The other part of it is hedge funds. And hedge funds, it's kind of interesting, because they have had an era ending in 2007 in which their returns were quite good, but not any higher than, for example, the old Wellington Fund, our Vanguard Wellington Fund, about the same returns with more risk and much less tax efficiency. So, there's nothing really write home about from them. And now in retrospect, we are looking at things like, how much of those past hedge fund returns were created by people doing illicit market timing in mutual funds? How much of those returns were created by people who were on their way to jail for insider trading? How can you rely on the past records of these hedge funds? I'd say there are certainly some good ones. I'd say they are very difficult to identify, and they are really beyond the ability or reach of the average person, just because of the minimums that would be involved.

Now people seem to talk about funds of hedge funds. That's a another layer of cost, and I think that's just a loser's game. So I'd do the stretch straight and narrow.

Another alternative, of course, commodities, and I've been saying this for a long time that the problem with commodities is they have no internal rate of return. When you buy a commodity, gold, wheat, pork bellies I guess are still around, you're betting that you can sell it to somebody for more than you paid for it--the ultimate speculation. Stocks get bailed out in the long run by earnings growth and dividend yield. Bonds get bailed out in the long run by interest rates, interest yields. But there's nothing to bail out commodities. They are a rank speculation. I don't think for most of us it's a good idea to speculate. Now I look at gold, and it keeps going up, and I think, "Oh my gosh, you're wrong again, Bogle," and that's always possible, of course.

Benz: It's been going down recently, though.

Bogle: Yeah, a little bit, a little bit. And I just don't know how to deal with that. I have been tempted to put maybe 1% of my portfolio or 2% into gold, but my whole life tells me, and my investment experience tells me, when you're tempted to do something, don't.

Benz: How about inflation, though? I know that people have gravitated to commodities to try to add a layer of inflation protection to their portfolios. Do you think there's a better way to do it? Is it TIPS alone?

Bogle: Inflation is kind of a funny thing. Commodities, of course, cannot protect you against inflation over the long term. I mean I have in one of my books said the wholesale commodity price index in London at the end of ... World War I was at the same level it was at the time of the Great Fire in London in 1666 or something like that. That's a long time for no change, and so beware of that.

There's no rate of return. Basically commodity prices are going to have to grow at 3% or 4% or 5% or 6% year after year, and it doesn't do that. If you put the price of gold on a long-term chart, it looks terrible. You can look at it for 200 years. It's never produced anything except price appreciation, mostly in great fits and starts--the late 1970s, obviously the ... first decade of the 2000s.

And so, I don't like unpredictability. And the focus is always on what's done well, that we investors have. Our neighbor is doing better. He owned gold or he owned growth stocks, or value stocks did nothing. That was true at the end of the '90s. And the moment the temptation gets to its highest level, that's the moment when people start to think I've got to change now, and that's the worst time to do it. So I'm still a "stay the course" person. Own the stock market, own the bond market, as modified to meet your needs, and don't peek. One of the greatest rules for investing ever made…

Benz: Don't peek at what your neighbor is doing or saying he's doing.

Bogle: Don't even peek at your own account, don't open those 401(k) statements. If you don't look at your 401(k) statement--this sounds outrageous but it's true--for 45 years, you start when you're 20 and you don't open a single statement for the next 45 years, when you open that statement the day you retire, you are going to go into a dead faint of amazement about how much money you've accumulated.

Benz: Just using that hands-off approach.

Bogle: Yeah, but if you watch those fits and starts, they are just reflections of the stock market enthusiasms, basically, and as I said in yet another one of my books, it turns out that the stock market is a giant distraction to the business of investing. Stocks don't produce anything. They are means of owning companies who produce something. They are once removed from the reality. And so if people would just get their arms around investing and stop speculating, they would definitely accumulate much, much greater.

Benz: I know that you have been an outspoken critic of the proliferation of ETFs, especially the very narrowly focused ETFs, but I think someone could step back and say, well there are arguably some tax benefits of equity ETFs anyway, and now that investors can trade commission free in some cases, why are they so bad? If I buy a total market ETF, why is that a negative?

Bogle: Well, there is no reason in the world that buying a total stock market ETF and holding it for the rest of your life is a bad idea. At least at Vanguard, you are going to pay the same six or seven basis points that you’d pay if you had over $10,000, which I think is the threshold now for Admiral shares, you'd pay the same price for not having the ETF.

So, what’s the matter with having the flexibility to trade? Well, I think you can argue nothing is the matter with it, except it’s there and it’s tempting. I always thought being able to get your money out when I first learned about this industry 111 years ago, or was it 211 years?, I thought it was remarkable, you could take your money out on any day, and now it’s any second.

So, how much of that is going on in ETFs? ETFs by the long-term investor looks to be fairly small, and you can do a lot of things with them that are not self-destructive, but the overall picture is very, very high turnover. I mean there’s an emerging-market ETF from iShares, I think theirs is about 1,200% to 1,300%, less than the [S&P] 500, which is a big speculative thing for institutions often. And the same thing for Vanguard; it's lower, but not a lot lower, it's like 700% to 800% a year. So, the trading is going on there, and it is that which I object to. So it’s using a long-term investment and trading it.

And then I also think it's just very foolish to allow investors to make their choices. I like technology, so I’ll get out of my financial stocks, get into technology, and then into, I don’t know, consumer goods, ... energy,  health care. Because the record is very clear, that the investors in ETFs don’t earn anywhere near as much as the ETFs themselves do. In other words, we know what the returns on those various indexes are, and in ETFs, the investor falls, I think the last time I looked, ... the average return was maybe ... 4%, and the average ETF investor return was minus 2%--a 6% gap. That’s an awful lot, and you compound that over a decade, and it’s really futile.

There may be some people that have the answer, but I am still, Christine, a stay-the-course kind of person. Don’t let all these little diversions get in the way of a sound investment program.

Benz: So, do you think that there any structural remedies to help combat that speculation that seems to run rampant in so many areas?

Bogle: I guess what I would say is, I think the people who are betting on these ... it’s so interesting that we had a way to leverage the market 2-to-1 and then a way to leverage it 2-to-1 on the downside, and that proved to be inadequate. The competition took it up to 3-to-1. Well, that is just a sheer unadulterated gamble. Should it be banned? I don’t know how you ban it, and I think the people that are doing it are well aware of the hazards, and so, let them do it. I think I might, in some cases, put a red bold-faced type legend on the cover of the prospectus, which these people don’t get anyway, and say, these securities are very risky. But I think most people are aware of that, and they just make bad choices.

So I don’t see how we can really do much in the way in the regulation to limit them. I do think there are an awful lot of things that are going on in this area, which we see in UBS' case, of speculation within the dealers group, and we also see a certain amount of fraud surrounding ETFs. So I think of a Goldman Sachs partner earlier in the year, who got in trouble for trading ETFs in the wrong way. I am not sure exactly what he did. And when you get this activity, these frenzies, ... and this interest in finding an easy way through a tough market in a tough economy, and that’s what breeds speculation.

So, it surprises me, we are so far away from the original index idea, that first index fund, Bogle's Folly as it was called, which was buy-and-hold forever. And now it’s buy and ... as the original SPDR ad, as I’ve often quoted, "Now you can trade the S&P 500 all day long in real time," to which my consistent response has been, what kind of a nut would want to do that?

Benz: Surely they have better things to do with their time.

Benz: Jack, last question for you. I know that you're always doing new research and contemplating new ideas. You said you could write an op-ed piece practically every day. But I'd like to talk about your reflections on your career. I know that you have spent a fair amount of time reflecting on what you've accomplished. So I would like to hear what you think are your biggest achievements over your career and also things that you still want to work on?

Bogle: Well, interestingly enough I really don't spend very much time on that. I suppose if I was to reflect on, it, I don't know, I would hope that out of all this would come a major change in the way the financial investment business in the U.S. operates--to go away from speculating and toward investment, which serves everybody but Wall Street. Wall Street is too big a part of the equation, and [we need] to get them out. That's a major sociological change, a major change for a society, a major improvement in the ability to accumulate money and retirement plan. You see, you look at these things like say a 401(k) or whatever might be, and a 1% difference in the long-term return and the lifetime return is staggering.

Benz: So cheap fund versus expensive fund?

Bogle: And funds you buy and hold and don't get tempted by the machinations of the market, and so the big thing would be a slow, probably quiet revolution to return to the basics of what investing is all about. And I think that will be something that somebody will say, "He saw it coming. He saw it coming," and it's not going to happen in my life time.

Certainly, the Vanguard Structure was a major innovation, and the fact that it has never been copied shows how A) good it is for investors; and B) bad it is for managers, because the manager is pretty much cut out of the equation, not entirely. The managers who run money for Vanguard make an awful lot of dollars because our name and reputation brings a large asset base. So if you're making 6 or 8 or 10 or 20 basis points on that, you're a very rich person. And so, I don't apologize to them at all.

Certainly the index fund, and I know there was a little controversy over the source of the idea of indexing, which either goes back to my Princeton thesis in 1951 or back to Jeremy Grantham in 1971 or back to the guys at Wells Fargo, in I guess the early '70s or late '60s. I've described that a hundred times. The ideas were all over the place, but as I keep telling people, there is one fact that emerges from all this. I did start the first index fund; that's incontrovertible. And the fact that Milton Friedman wrote to somebody at TIAA-CREF and said, "You ought to have fund that owns the S&P 500," I'm not sure what to do about that. I mean talk is cheap. They didn't do it. And I've said this in another context to our Vanguard crew over years and years and years, don't forget this: Ideas are a dime a dozen, but implementation is everything.

So, I guess what I have tried to bring to the table is don't just stand there and dream big ideas, test them and go in the face of opposition. And so I feel good about that. I know I feel good about the reputation I have with investors.

A day doesn't literally or almost literally doesn’t go by without my getting the most amazingly beautiful letter from investors at Vanguard. And it's really a comfortable place to feel.

But as for reflecting on the past ... I do it just a tiny bit. I'm reminded of the quote or paraphrase of a quote from Sophocles that I used in my book, to close my book Enough, and that is "one must wait until evening to enjoy the splendor of the day," to which I would say, "My evening is not here yet," but when it comes, I will enjoy the splendor of the day.

Benz: Well, I would say your evening is definitely not here yet, Jack. It's always great to hear your insights. You always have so much to share, and so we very much appreciate you being here with us.

Bogle: Well, thank you. It's fun to be with you.

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