Vanguard Founder John Bogle To Investors: Avoid Costs At All Costs

Includes: COP, CVX, KO, PEP, XOM
by: Tim McAleenan Jr.

I recently started reading Vanguard founder John Bogle's 2009 book, "Enough: True Measures of Money, Business, and Life" wherein Bogle takes ample shots at financial advisers, lawyers, tax accountants, and almost anyone affiliated with the financial industry. As you would expect from someone who founded a company dedicated to providing investment opportunities at the lowest cost in the industry, John Bogle is a man who hates, hates, hates the costs associated with long-term investing.

Here's an except titled "The Drain of Costs and Taxes" that demonstrates just how much frictional costs and taxation can harm the total returns of investors.

Let's start with the costs, where it is easiest to see through the haze. Over the past 50 years, the (nominal) gross return on stocks has averaged 11 percent per year, so $1,000 invested in stocks at the outset would today have a value of $184,600. Not bad, right? But it costs money for individuals to own stocks-brokerage commissions, management fees, sales loads, advisory fees, the costs of all that advertising, lawyers' fees, and so on. A good estimate of these costs is at least 2 percent per year. When we take out those assumed investment expenses, even at the rate of only 2 percent, the historic rate of net return would drop to 9 percent, and the final value would drop by more than one-half-to just $74,400. If we assume that as little as 1.5 percent is paid by taxable investors to cover income taxes and capital gain taxes on that return, the after tax-rate of return would fall to 7.5 percent, and the final wealth accumulation would plummet by another one-half, to $37,000. Clearly, the wonderful magic of compounding returns has been overwhelmed by the powerful tyranny of compounding costs. Some 80 percent of what we might have expected to earn has vanished into thin air. (Caveat: In terms of real dollars, reduced by the 4.1 percent inflation rate over the past half-century, the final inflation-adjusted value of the initial $1,000 investment after costs and taxes would be-instead of $184,600 in nominal, precost, pretax dollars-a minuscule $5,300!).

(Source: Bogle, "Enough", page 41)

Let's tackle this in reverse order. Bogle's observation about inflation is something that affects all investments, so there is not a whole lot that we as investors can do to nullify its impact other than put our money into the best-risk adjusted opportunities for growth possible, be they income-focused or total return-focused. Yes, you can put your money into shares of companies that sell commodities that adjust well to inflation (such as oil), so investments in ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP) will most likely hold their value well as the purchasing power of the dollar declines. Likewise, we can look to companies like Coca-Cola (NYSE:KO) or PepsiCo (NYSE:PEP) that sell well-branded products which allow the company to pass the costs on to customers somewhat in an inflationary environment. But of course, no matter where we put our money, we have to achieve a rate of growth greater than the prevailing inflation rate if we wish to increase our purchasing power.

As for avoiding investment taxes, the best bet is to follow the conventional advice-max out your IRAs and 401ks and put as much money as is financially feasible into tax-deferred accounts (this should be the no-brainer part), and if you're looking for dividend-based income, hope that the 15% tax rate on capital gains and dividend income is able to continue (although it's easier to fight taxes compared to inflation by structuring your accounts properly, using past losses to lower tax liabilities, or make charitable donations to lower tax bills, you still have to contend with the whims and tax policies of Congress, which limits your control in this regard).

Of course, Bogle is correct in his hatred of trading fees and frictional cost expenses, which can place a serious drag on portfolio returns. There's a reason very few of us here at Seeking Alpha are touting the viability of mutual funds over individual stock selections-if you have a $300,000 portfolio and pay a 1.25% expense fee, that's $3,750 coming out of your pocket every year, which can pose a significant threat to long-term wealth building. And when it comes to individual stock picking, I think investors are best served trying to keep trading costs down to 1% or less on a round-trip investment. Using Charles Schwab's rate of $8.95 per trade as an example, you will spend $17.90 every time you decide to buy and sell a given security. To keep costs at 1% or less of your investments, that means making stock investments in increments of at least $1,790 if you want to keep a reasonable handle on costs.

In some ways, Bogle's reduction of $184,600 to $5,300 errs slightly on the dramatic side. But he is right to observe the threat that inflation poses to purchasing power, and reinforces the point that it makes a very big difference over the long-haul if you can put aside as much money into tax-deferred (instead of taxable) accounts as possible. But Bogle is most adroit in pointing out that investors should not treat trading expenses as an afterthought. The numbers in the magazines and investment prospectuses that show the benefits of long-term compounding are great, and Bogle is right to suggest that you should zealously guard against anything that threatens to cut a slice out of your compounding pie-as Bogle famously said, "Given the relentless rules of humble arithmetic, investors get precisely what they don't pay for. Paradoxically, then, if they paid nothing, they would get everything!"

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.