Gambling on Wall Street

Posted Jan. 11, 2011, at 7:22 p.m.

With the stock market rising amid signs of economic recovery, it’s tempting to start playing the stock market. A new book by John C. Bogle, the founder of index funds, has some timely and salty advice.

His book, “Don’t Count on It!” describes trading in equities or managed mutual funds as “a loser’s game.” He acknowledges that the stock market is a closed system, with someone buying a stock and someone else selling it. But there are always the “croupiers,” the paid middlemen who also charge management and advisory fees. So it’s not a zero-sum game.

Mr. Bogle founded the Vanguard Group of index funds in 1974 and headed it until he retired in 2000. His inspiration was an article by the Nobel laureate economist Paul Samuelson challenging anyone to put together a portfolio that tracked all the stocks in the Standard & Poor’s index. Mr. Bogle took up the challenge and created a fund that passively mimicked the entire equities market and now is Vanguard’s Total Stock Market Index Fund.

A total index fund’s big advantage is low cost. Unlike actively managed mutual funds, it needs no highly paid stock pickers and analysts. It also has a lower turnover, the buying and selling of securities, requiring expensive management and possible capital gains tax charges. Finally, it is totally di-versified.

In theory at least, a total stock market index fund in the long run can beat any managed portfolio, even though its meager management charges mean that it never can beat the target index.

If index funds are safer, more diversified and more profitable, why don’t all investors put their money there?

Facing this question, Mr. Bogle notes that Vanguard’s annual expense ratio (0.18 percent for its Total Index Fund) compares with an average of 1.5 percent for actively managed mutual funds. Yet Vanguard’s funds, together with those of the three other major very low-cost firms, accounted last year for only about one-third of all industry cash flow.

He tries to explain this gap with arcane references to “brand-name commodities” versus “caveat emptor commodities.” A simpler explanation is that many investors think they can beat the market or have hired a financial adviser who can (at 1 percent or so of their portfolio). And the financial press, which rarely mentions index funds, is loaded with tips on which stocks and which mutual funds have the best recent records. The truth, often stated but often disregarded, is that past performance is no indicator of future performance.

The end result is that most investors, like casino patrons, enjoy the excitement of a possible big win while knowing deep down that winners are few, losers are many, and the house comes out ahead in the long run.

Similar articles:

ADVERTISEMENT | Grow your business
ADVERTISEMENT | Grow your business