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The Clash of the Cultures: Investment vs. Speculation Hardcover – August 7, 2012
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"Rebound" by Kwame Alexander
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Featured Guest Review by William J. Bernstein
There's something rotten at the core of the American financial system; we all know it.
Before I go any further, I'll have to put my own biases on the table. While I'm in general a big believer in the power of free markets, there are certain things they don't do particularly well. Consider, for example, airline safety. Free market fundamentalism would dictate leaving it in the hands of consumers, who would logically shun those companies that killed too many passengers. We're smarter than that, of course; in large part because of government regulation, the average year passes without a major airline crash. Ditto the interstate highway system; does anyone really believe that Smith's invisible hand would have produced anything like this gem at the heart of our economy had not Dwight Eisenhower not been so impressed with Hitler's autobahns?
Of course, there are some activities that the government should stay out of: it should regulate airlines, but it shouldn't run them; and it shouldn't produce food, automobiles, and almost all other goods. This begs a much larger question: just where do free markets fail?
Which brings me to Jack Bogle's marvelous book about American finance, a system that, as we've seen in the past few years, has failed in a number of areas. As the author shows, it has done so by maximizing profits for managers, minimizing them for owners, and the customer be damned. For more than half a century, Mr. Bogle has not only observed this evolving spiral of immorality and self-interest from the inside, but has also been instrumental in creating, almost singlehandedly, what is thus far the major alternative to it: the customer-owned Vanguard Group.
There's a paradox at the heart of The Clash of the Cultures that should rivet any capital markets participant: just how is that the more market oriented an investment company is, the poorer are its results? The author recounts in painful detail the sorry performance of mutual funds managed by the large publicly traded financial companies, and the poor stewardship at the heart of that failure. The superb performance of the funds run by Vanguard, which is essentially a non-profit organization, stands in stark contrast. And it's not just Vanguard; it turns out that TIAA-CREF, which is also essentially a non-profit, the government-run Thrift Savings Plan, and privately held fund companies all do much better than large publicly traded finance companies. It's as if, say, the Red Cross, Department of Labor, and Salvation Army had all founded nonprofit automobile manufacturers that turned out better and cheaper cars than General Motors and Toyota.
Bogle identifies the speculative (as opposed to investment) mind set of the publicly traded companies as the chief culprit; because of their next-quarter/short-term focus, they trade frequently (as do their customers), pay scant attention to the costs of these activities, and often extract revenues from their funds and their shareholders in less ethical ways as well.
But that's only part of the story. The Clash of the Cultures gets to the heart of this remarkable and, for our nation, critical, conundrum of how in some economic spheres, nonprofits can outperform the invisible hand. It's required reading for every concerned citizen and every worried investor, and food for thought for anyone with an open mind and a curiosity about the world.
“The Clash of the Cultures: Investment vs. Speculation” is a must read for investors who want to understand the forces that are working against them and what they can do about it to maximize their investment returns. It should come as no surprise to those who know Jack and his philosophy that the final words of his final book are: ‘Stay the course!’—Forbes
“The Clash of the Cultures: Investment vs. Speculation is . . . an enjoyable read that ends with 10 lessons for investors that, while simple, are deeply valuable to the general public. . . Clash of the Cultures is a great summary of the breadth of Bogle's 60-plus years in the investment field. He offers observations on the shocking change in the culture of finance that he has witnessed first-hand. Among the most important of the shifts is that short-term speculation has crowded out long-term investment. Though this has been great for the financial sector, it has come at the expense of the public.” —CBS MoneyWatch
“Bogle, as the Godfather of index investing, has ideas that are timeless and based on simple math, and at the same time exhibit uncommon sense and a routinely overlooked view of how investors are consistently overcharged by the financial services industry. Fortunately, his wisdom is widely available to everyone. Much of that wisdom has been assembled in Bogle's most recent book The Clash of the Cultures: Investment vs. Speculation (Wiley, 2012). While most of the insights are time-honored themes in the Bogle canon, they are very useful for individual investors.” —Reuters
“Bogle's latest book tackles what looks like an artificial distinction. His Clash of the Cultures title conjures thoughts of world war and social strife. But he's talking about ‘investment vs. speculation’. . . As in his previous books, Bogle is a master of the clear point and the pithy quote - from the investment writings of John Maynard Keynes and Benjamin Graham, pension adviser Keith Ambachtsheer and Bogle's old mentor the late Walter L. Morgan, as well as the Gospels of Luke and John.”—Philadelphia Inquirer
“You know what to expect when opening a book by John Bogle, founder of the Vanguard mutual fund group and inventor of index funds: a lament about the fall from grace of the US mutual fund industry, and a restatement of his strong conviction that COSTS MATTER!!! Mr Bogle’s new book, The Clash of the Cultures , Investment vs Speculation, does not disappoint on either count, but it is also very much in tune with the zeitgeist in its focus on stewardship and fiduciary duty. It lambasts US mutual fund managers for neglecting to act as responsible owners of the companies they invest in on behalf of the savers whose money they look after, and for their own governance failures.”—The Financial Times
“[The Clash of the Cultures] echoes many familiar . . . themes worth repeating, because they are too often ignored. Investors spend so much time chasing hot asset classes and hot fund managers that they end up buying high and selling low, all the while incurring transaction costs. In Mr Bogle’s words, ‘investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.’ . . . The American pension-fund industry has been particularly bad at understanding these long-run fundamentals. Many schemes assume, on the basis of past performance, a return of 7.5-8%, a figure that is highly implausible given the current low yields. . . Meanwhile, many employees in the private sector have been switched into defined-contribution schemes. . . But employees are not saving enough, are not allocating their portfolios efficiently and are incurring too many costs. It is hard to disagree with Mr Bogle that the ‘system of retirement security is imperilled, heading for a serious train wreck.’ But will anybody listen to him, when they haven’t in the past?” —The Economist
“John Bogle’s latest book, as much a piece of history as is it a playbook for how to repair financial markets scarred by two bear markets in 10 years and a loss of confidence, is one of those books on finance that ought not be left unread. The Clash of the Cultures is the latest and perhaps best book by the founder of Vanguard Group. . . Plus, for those not familiar with Bogle’s prose, the man can turn a phrase, which makes the book all the more enjoyable.”—IndexUniverse
“If the Occupy Wall Street movement is serious about helping people with real financial issues, then its leaders should read John Bogle’s book and embrace his ideas for change.”—Rick Ferri, Forbes.com
“John Bogle’s story is an oft-told tale, yet even Bogle junkies will learn some fascinating new facts from The Clash of the Cultures. Bogle takes of the cudgels on behalf of investors, who he believes have been poorly served by most of the industry. Bogle brings invaluable historical perspective to current issues ranging from high-frequency trading to the looming crisis in the U.S. retirement system to the use of mutual fund investors’ money to promote the growth of assets under management. Every thoughtful investor can benefit from his wisdom, served up with refreshing modesty by a giant in a field notorious for outsized egos.” —Financial Analysts Journal
“The book is a gem. Well-researched and carefully argued, there's simply no way to argue with Bogle's premises -- that the little guy always loses, that the more you churn the more you lose, that most people's retirements are dramatically underfunded, that management looks out for itself and not the stockholders, and that greed is driving the bus. . . Read Bogle, not just to learn about how to protect your investments and understand what really happens on Wall Street. But more than that, read The Clash Of The Cultures and declare yourself into the three percent who have ideas and aren't afraid to use them.” —The Huffington Post
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Keynes’ famous quote appears a number of times in Bogle’s (2012) book. Bogle’s copiously documented contention is that the stock market increasingly resembles a casino. And, just as Lord Keynes warned, it’s doing its “job” increasingly poorly. It does a bad job of capital formation or funneling investment into capital equipment. It does a bad job of generating a safe retirement for shareholders. It played a central role in the financial crisis of 2008, which saw an $8T loss of market value; and the collapse of the dot-com bubble of 2001, which saw the loss of $5T. The market does, however, do very well by those who play the role of the bookies.
What forces have dictated the market’s evolution? For one, institutional investors now dominate trading activity. In 1945 they accounted for 8% of trading. By 2011 it had risen to 70%. Professionally managed funds need to demonstrate their worth to their clients, consequently they invariably seek short-term yield. While it is in the individual investor’s interest to find and hold a good stock “forever.” The fund manager has an interest in finding new investment products, in market volatility, and in “churn.” In 1950, a share was held for 5.6 years on average. By 2011, it was held for just over a year. Hedge funds experience annual turnover rates of between 300-400%. As a result of increasing trading volumes, and despite a decline in transaction costs, Wall Street’s total commission revenues have doubled over the past decade.
At the same time, in order to maximize “shareholder value,” corporate management has been expected to generate larger profits every quarter even at the expense of the corporation’s long-term prospects. Plus, corporate management has insulated itself from the shareholder. Management prefers to conspire with its board of directors and with fund managers, whose interests do not necessarily coincide with that company’s shareholders’ interests. The conflict of interest is further aggravated when a fund goes public. Its first obligation is then to its own shareholders as opposed to the clients whose funds they’re managing.
Publicly-held investment managers serve two masters, in other words. They become salesmen. They use revenues gleaned from their existing clients to pay for advertising to increase their client base. The original clients gain no benefits from this transaction. Not to mention the fact that the advertising invariably promises a return that is impossible to achieve over the long run in the real world. This, in turn, explains why so many pension plans are now underfunded. Pension fund managers projected annual returns in the 8-9% range when they should have been projecting 2-3%.
Not surprisingly, since privately-held investment management firms have no shareholders they need to please, they achieve a better yield than their publicly-held counterparts. Equally unsurprising, privately-held firms are becoming the exception. Bogle points out that not-for-profit managers achieve the best results of all. He suggests a mutual fund which is truly “mutualized” would hire its own fund managers.
With added layers of managers, also comes added cost, but with no added value. In fact, just the opposite.
Those added layers often suck up some 60% of the returns that ordinary retirement savers could otherwise earn on their money, such that an investor who put her money into a no-cost rather than an actively managed fund could look forward to a 20% higher standard of living in retirement. Bogle refers to these profit-skimmers as “money-changers” who, for the sake of their clients, should be “banished from the temple.” Personally, this strikes me as unnecessarily humane.
And why do the clients keep coming? Two main reasons: 1) Ignorance, and 2) TINA. There Is No Alternative . . . to the stock market, that is. Individuals hoping to save for their retirement or for their children’s college fund become “forced capitalists” because no better returns are available anywhere else.
Bogle’s advice to these forced capitalists is to pull their money out of an actively managed account and to put it into a true mutual index fund of the type he pioneered. Avoid the hefty management fees, pocket the savings, and realize a return approximately equal to the return the market as a whole yields.
His advice to congress and the federal government is to reinstate the provision of the 1933 Glass-Steagall Act that separated commercial-bank activities from investment banking activities. He also encourages a return to the Dodd-Frank regulations before they were watered down by lobbyists. He’s a strong supporter of the Consumer Financial Protection Bureau. He believes financial managers should be required to act as true fiduciary agents, giving the interests of their clients a higher priority over their own. He would like to see a financial transaction tax imposed, stringent limits on leverage, public reporting of derivative trades, and higher penalties for insider trading, Ponzi-like schemes, and unrevealed conflicts of interests.
It is not clear, however, that even if everyone followed his advice, the market would perform its primary function---as an entity charged with channeling investment into socially-useful, productive enterprises---any better. Bogle makes this stunning revelation in his book’s preface: “In recent years, annual trading in stocks---necessarily creating, by reason of the transaction costs involved, negative value for traders---averaged some $33 trillion. But capital formation---that is, directing fresh investment capital to its highest and best uses, such as new businesses, new technology, medical breakthroughs and modern plant and equipment for existing business---averaged some $250 billion. Put another way, speculation represented about 99.2% of the activities of our equity market system, with capital formation accounting for 0.8%.” That’s a ratio of 1:124, for anyone who’s counting.
Mary Schapiro, former SEC chair, posed the central relevant question this way: “At the end of the day, if the markets aren’t serving their true function—which is as a place to raise capital for companies to create jobs, build factories, manufacture products—if the markets are not functioning as a rational way for investors to allocate their capital to those purposes, what’s the point of markets?” Good question, right?
The corollary to Ms. Schapiro’s question is: If the markets aren’t fulfilling their primary, socially-useful function, why don’t we just get rid of them? Bogle’s unspoken answer seems to be TINA; i.e. without markets, saving for retirement, etc. would be even worse than it is.
The easiest solution to this conundrum would seem to be fairly obvious: The government should offer to all US citizens the option of a federally insured retirement savings account. It would guarantee an interest rate equal to the annual growth rate of the GDP plus the rate of inflation. If the GDP grew at a rate of 2%, for example, and inflation was 1.5%, the saver would realize a 3.5% return on her savings in that year. (It should be noted that government tax revenues will have grown at the same rate over the same period.) The retiree would receive a safe, solid, no-risk return on her savings without having to share it with a middleman/bookie. The government would have money it could invest in research, infrastructure, corporate or municipal bonds that might otherwise go begging. It could even become a venture capitalist and participate in high-risk, but socially useful, start-ups. If markets could offer a better return, then they would continue to attract investors. But at least the participants would no longer be “forced capitalists.” Fewer forced capitalists would likely mean fewer asset bubbles; probably fewer Enrons, Tycos, WorldComs, etc., and could conceivably allow for less government regulation of the market.
In sum, John Bogle has made an excellent case for putting your retirement money into a mutual index fund. In my estimation, he has made an even better case for the government’s offering a “public option” retirement savings account.
So, in theory, one could take a pass on reading the book and walk away with this advice (which, actually, has been around forever)for free. But that's not the purpose of the book. What the book does is explain, in incredibly persuasive detail, WHY Bogle believes what he does, and why his approach makes sense. Unless you understand the realities of why his approach is preferable, then it is unlikely you will seriously consider his advice.
Indeed, the book does have some shortfalls. Probably the most egregious shortfall is one that is common in virtually every "how to" or "self-improvement" book: failure to kick the readers in the butt and place some of the blame for their problems on themselves. Have you ever read a psychology "self-improvement" book that told the readers they were screwed up and that the problems they had were their own fault? Of course not. You don't want to get your readers angry, even though this is what they really need to hear. In "Clash of Cultures," Bogle NEVER blames individual investors for their problems (i.e., stock market losses). He blames everyone else possible: Congress, the judiciary, public accountants, the press, security analysts, corporate directors, fund managers, and so on. If you operate under the assumption that your problems are everyone else's fault, then you end up in "victim mode," and you wait around for the other people to decide to become honest and nice, so that your life can change. It ain't gonna happen. If you want to solve your problems, you have to take action yourself, and that involves placing the blame squarely where it belongs - on yourself. As the old saying goes, "When you point the finger of blame at someone else, there are three other fingers pointed right back at you." In other words, one shortcoming of this book is Bogle's reticence to make it clear that investors are responsible for themselves. More specifically, they can't expect to succeed unless and until they educate themselves. Handing money over to other people to manage for you, and then sitting back "fat, dumb and lazy" hoping the other people will do the right thing with your money and have your best interests at heart, is a prescription for disaster.
Another shortcoming of the book is that, given Bogle's 61 years in the mutual fund industry, he has a fondness for it over other investment vehicles, such as ETFs. He doesn't bash ETFs. He simply points out the fact that people who own mutual funds tend to hold them for long periods of time, while people who own the same basket of stocks in ETFs tend to buy and sell on a regular basis. This isn't a slam against ETFs. It is a slam against the people who own the ETFs. In other words, there is no requirement that, if you purchase an ETF, you have to sell it quickly. Bogle does admit (but glosses over this fact very quickly in only a couple of phrases in a couple of sentences in the book as quickly as he can) that ETFs can be less expensive than mutual funds in terms of fees. As such, logic seems to dictate that, if you want to purchase a broad market fund and are willing to hold it for a long time, then an ETF makes much more sense than a mutual fund, simply because the ETF will have lower fees in the long run. Again, though, Bogle doesn't come right out and emphasize this.
Other than these two shortcomings (letting individual investors off the hook and not more actively publicizing the lower costs of ETFs), this book is monumental. If you currently invest with a belief that you are smart enough to "beat the market" long-term and/or someone who prefers speculation (in and out buying and selling) to investment (buy and hold), reading this book might actually change your mind - and make you more money in the long run.