Why John Bogle Calls The Stock Market 'A Distraction'

Includes: SPY
by: Tim McAleenan Jr.

How many of you have seen a headline on The Wall Street Journal or CNN Money or one of the business channels on cable that say things like "People are buying stocks" when the market is going up, or "People are selling stocks" when the market is going down? Of course, these types of descriptions are misleading -- there were no more people buying than selling stocks in 2000 right before the dot-com bubble burst, nor were there more people selling stocks than buying them in March 2009 when the Dow Jones industrial average (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) were trading at lows.

For example, Coca-Cola (NYSE:KO) currently has 2.3 billion shares outstanding, which necessarily implies that someone, somewhere, happens to own each and every one of those shares in existence. This is true for every company: When General Electric (NYSE:GE) fell to $6 during the financial crisis, for every person selling shares of the company, there was someone on the other side of the transaction lining up to buy shares. This is important to keep in mind because it teaches us to move away from thinking of the stock market as something that goes up and down, but rather, as a highly liquid exchange medium that allows us to buy small ownership interests in highly liquid companies.

As John Bogle points out in his book Enough, the return of the stock market that we talk about is merely the sum of the results of different investment returns. Bogle gives a synopsis of what investing boils down to by looking at the 20th century and pointing out that, in a nutshell, investors paid $15 for every $1 of earnings their investment represented, in exchange for an average dividend yield of 4.5% coupled with earnings growth of 5.0%:

In the very long run, all of the returns earned by stocks are created not by speculation but by investment-the productive power of the capital invested in our business enterprises. History tells us, for example, that from 1900 through 2007 the calculated annual total return on stocks averaged 9.5 percent, composed entirely of investment return, roughly 4.5 percent from the average dividend yield and 5.0 percent from earnings growth. (Dare I remind you that this return reflects neither the croupier costs of investing nor the erosion of inflation?) What I call the speculative return-the annualized impact of any increase or decrease in the price-earnings ratio or P/E multiple-happened to be zero during this period, with investors paying a little over $15 for each dollar of earnings (P/E=15) at the beginning of the period, and about the same at the end. Of course, changes in the P/E can take place over long periods; but only rarely does the long-term speculative return add more than 0.5 percent to annual investment return, or subtract more than 0.5 percent from it. [Bogle, Enough, page 53.]

I really like this Bogle passage a lot, and although I do wish he would expound a bit on the half a percent numbers that he uses, I nevertheless think that the Vanguard founder makes a good point. At the end of the day, long-term stock investing is only as good as the proportional long-term growth of the companies that you have an ownership stake in. Since 1930, Johnson & Johnson (NYSE:JNJ) has grown its earnings by 11% annually over the course of the past 81 years. And that's the long-term return that investors in Johnson & Johnson on the whole have received (minus frictional costs such as taxes and trading fees) during that time period.

Personally, I disagree with Bogle when he takes his conclusions to the next step -- he argues that the best solution for American investors is to buy an index fund that tracks the 500 largest American firms, pay rock-bottom expenses in doing so, and compound the results over time. While that option is not by any means bad, I think it's possible to do better.

I want to identify the greatest 20 to 30 firms in American business -- companies like Johnson & Johnson, Coca-Cola, Procter & Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), and PepsiCo (NYSE:PEP) -- and buy them when the prices are attractive. After all, it was possible to buy Coke at $40 per share and Colgate-Palmolive at $55 per share in the past three years.

I think investors can look forward to significant compounding by buying these types of excellent firms when the price gets irrationally low such as when the "world is falling" mentality took over during the financial crisis of 2008-2009. If you can buy these companies at attractive prices, secure 7-11% annual dividend raises, and hold on for 20-30 years while reinvesting the money and letting compounding take care of the rest, I think the long-term results of owning these companies can be quite impressive. The key, of course, is to remain steady and ignore the background noise that could lead you to sell your investment prematurely just because of a price decline, for as Bogle says:

The message is clear: In the long run, stock returns have depended almost entirely on the reality of the relatively predictable investment returns earned by business. The totally unpredictable perceptions of market participants, reflected in momentary stock prices and in the changing multiples that drive speculative returns, essentially have counted for nothing. It is economics that controls long-term equity returns; the impact of emotions, so dominant in the short term, dissolves. Therefore, as I wrote in my Little Book of Common Sense Investing, 'the stock market is a giant distraction from the business of investing.' (Bogle, Enough, 53)

At first, it sounds a little kooky to argue that the stock market is beside the point when it comes to investing. But Bogle's words remind me of the famous Benjamin Graham quote, "The stock market is there to serve you, not instruct you." I really like that Bogle calls the stock market a distraction, because for the most part, "stock market news" represents what other people are doing.

Let's say that you own the stock of 15 large American companies. When people talk about the performance of the S&P 500 on a given day, they are referring to the buying and selling of 485 companies that you have absolutely no ownership of! Instead of worrying about what other people are doing when prices are going up and down, you should use stock quotes as an opportunity to find a "mispriced gamble" to pour your money into so that you can generate the greatest amount of profits for yourself at the lowest risk-adjusted price instead of falling for the distraction of letting what other people are doing with their money affect you.

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