Source: Qilehui.

John Bogle's "The Little Book of Common Sense Investing" was published in 2001. This is a book we read over 20 years ago. Bogle is the 'father of index funds' and founded Vanguard in 1974. 'The Little Book of Common Sense Investing' expounds on Bogle's great financial ideas acquired over 50 years of investment experience.

Basically, the fundamental idea is that due to huge investment friction costs, the probability of long-term profitability is very low, perhaps less than 1/30. Therefore, the most effective way to accumulate wealth is to keep pace with the annual return provided by the financial market, and then profit from the long-term investment portfolio.

1. Complicated strategies lead to failure

In the last 20 years of the 20th century, the US stock market had its highest record in almost 200 years, with an average annual growth rate of 17.7%. The price of stocks doubled every four years, which was due to the interaction of only two factors: investment income, composed of dividend yield rate and income growth rate, and speculative income, produced by stock price changes.

Bogle compared investment income and speculative income to biscuits and donuts. Biscuits are hard and difficult to digest, while donuts are soft, sweet, and fattening. Biscuit-style investment income is efficient, and the profits of companies' earnings and dividends are basic returns in long-term bull markets. This is also the result of the long-term prosperity and efficiency of the US elastic economy.

Donut-style speculative income represents public expectations of stock price fluctuations, ranging from sweet optimism to sour pessimism. The PE ratio can be high or low, both reflecting estimates of future economic prospects.

Biscuit-style mutual funds are resilient, conducting long-term investments with low operating costs. Donut-style mutual funds are looking for growth points in the market everywhere, with turnover rates of up to 90%, which is short-term speculation rather than long-term investment.

Most funds fail due to excessive expenditure, but some funds temporarily position the expenditure cost as low, which is a bait. Low cost is always better than high cost.

If the theories of Biscuits and Donuts investments are correct, then in the 20 years from 1980 to 2000, the speculative funds that stimulated the stock market to rise were at a disadvantage, and so it was in fact.

Because if the stock market yield rate is only 5.2%, the cost of speculative funds will reach 2.5%, which almost consumes half of the income, and the final income will only be 2.7%. The value of investment funds will not shrink with the adverse market environment, and the minimum return will remain at 5%. Practice has proved that people who are willing to invest are often easier to succeed than those who invest reluctantly.

The biggest secret of successful investment is that there is no secret. Bogle's long-term experience and judgment tell him that complex investment strategies will ultimately only lead to failure. Charlie Munger once pointed out that if the investment in the underlying assets of the stock market is too complex, it will incur huge costs and low returns.

If the market return is 5% and the total cost expenditure is 3%, the net profit will be only 2%. If this analysis is extended over a period of 10 years, this wealth will shrink by 26%. After 20 years, it will shrink by 46%, and after 30 years, it will shrink by 60%.

Fund managers generally adopt complex investment strategies. They have the right to decide on investment strategies, evaluate stocks, determine when prices will fall in the future, and adjust investment portfolios accordingly. But all these complex investment strategies have resulted in failed investment results.

In the first 15 years of 2001, of 287 funds, only 42 funds survived successfully. 14% of funds had a return rate exceeding the market equity index of the entire market, while the other 245 funds all went bankrupt. Moreover, only the top 10 funds (i.e., 3.44%) achieved what experts called "statistically significant figures". This number fully demonstrates their huge volatility.

Losers always hope to choose funds that can greatly exceed the market's average return, and hope to find funds that can always achieve high returns, but in fact, their past investment income has proved that they have no high value in the future. Therefore, complex investment is meaningless.

The simple investment strategy is to buy and hold. For Berg, simple investment means investing through index funds. The reason it is called simple is because it invests in the entire stock market and is a diversified investment strategy that includes all listed companies in the USA. It basically avoids high cost portfolio turnover and has very low cost.

If we look at the long-term investment market, index funds have a decisive role in successful investment. Berg is always creating a service for long-term investors, buying and holding, knowing one big thing like a hedgehog instead of a fox who knows many things, introducing simplicity rather than complexity into the investment field.

Most active capital operators cannot beat the market in most of the time. Because, to a large extent, funds are the market. Therefore, on average, even if they do not have costs, operate with the highest efficiency, and do not generate any tax burden, they cannot do better because they adopt the "fox strategy".

Foxes are known for their cunning, slyness, and shrewdness, and most funds, including other financial institutions, have similar traits to foxes. These foxes often show off their highly appealing backgrounds, such as excellent educational backgrounds, years of industry experience, skillful operation skills, and even some speculative tricks. They adjust their investment portfolios by the hour, continuously monitor their holdings, and often change their stocks held in their hands at surprisingly fast frequencies.

The investment strategy of most successful American investors is an example of long-term investment. Buffett buys a few stakes in companies and holds them for a long time, but he never pays attention to the noise created by the "market master" who walks by his side every day and provides different prices for the company's stocks in his investment portfolio.

However, cunning fund managers are just the opposite. They trade stocks of different companies in their investment portfolio quickly with a turnover rate of 50% to 200% per year. They pay little attention to the intrinsic value of a company but respond quickly to the price set by the market master at every moment.

Some fund foxes hope to secretly sell stocks when the market price goes up and then buy them back when the market price goes down, but this buy-low-sell-high strategy works only to a limited extent, and only for a relatively small number of funds. The costs they incur are so high that they consume any additional income.

This is the fundamental reason why most active capital operators fail to beat the market and ultimately fail. This is also the only outcome of their fox strategy.

2. The dimensions of the investment coordinate map.

There are four important dimensions on the investment coordinate map. Return is the first and most important dimension. But we cannot control that. In the short term, the stock market return is completely unpredictable.

Unless we knew more about the market 25 years ago than we do now, the long-term investment return of the stock market is also unpredictable. But we can control the other three basic determinants of investment: time, risk, and cost.

Time can accelerate investment returns. For a certain amount of assets, the application of time dimension can increase the value of financial assets exponentially. This also applies to bonds. Ecclesiastes has long warned: "The real competition is not a comparison of speed, not a competition of physique, nor a food for knowledge, nor a wealth that pleases people, nor a preference for skilled craftsmen, but time and the opportunities they encounter."

Stock investment has high short-term risk, but time can correct risk volatility. Berg calls it the "correction chart of portfolio investment". Standard deviation measures the range of volatility of stock actual return rate. Using standard deviation to measure the risk of stock investment can cause asset value to shrink by 60% (from 18.1% to 7.5%), which is only the change from the first year to the fifth year.

After 10 years, 75% of the risk will disappear. Risk will continue to decline (down to 2.0 in 25 years, down to 1.0 in 50 years), but the reduction in the first 10 years is the greatest.

The economic risk caused by the large fluctuations in the securities market is implicit in investment behavior. Since the expected returns generated by investment are uncertain, the greater the uncertainty of the market, the greater the investment risk, and the greater the probability that investors will lose investment. Risk will always be with us. Especially when the rate of return reaches its peak, risk is also the greatest.

The securities market is a famous arbitrage market that coordinates past performance and future expectations. The problem is that future expectations and future reality do not match. Sometimes we hope to control the situation, sometimes we are very greedy, and sometimes we are deeply afraid, and there is no new paradigm. Hope, greed, and fear constitute the eternal nature of the market. Traditional market wisdom is wrapped in the theory of "efficient market hypothesis".

The efficient market hypothesis theory believes that since the financial market includes all the wisdom of all investors, it must be efficient and always the most perfect pricing. Berg disagrees with this because it cannot explain why the market was priced best on August 31, 1987, January 2, 1973, and September 8, 1929, but still experienced such a huge market value crash, with a drop from 35% to 85%.

John Maynard Keynes pointed out in 'The General Theory of Employment, Interest and Money' the reasons for fluctuations in the securities market:

① The net asset value of assets invested by individual investors continues to increase. Due to the lack of professional investment knowledge of individual investors, investment is lacking in accurate estimation.

② Short-term changes in a company's business operations can have a real over impact on the securities market.

③ The traditional valuation method of stocks is based on the psychological expectations of individual investors who lack professional knowledge and are numerous in quantity, but the valuation method based on expected securities returns as an independent element may have a severe impact on them.

④ Even professionals and experts cannot influence the public opinion in the securities market, so they try to predict the changes in public stock prices. Therefore, the securities market is called 'the battlefield of intellect that predicts changes in value basis for the future months rather than predicting investment returns for the coming years'.

Time can increase the impact of costs, reduce returns, and gradually decrease in unforeseen circumstances. With the passage of time, costs increase. Assuming that the long-term annual average return rate of the stock market is 10%, and the annual average return rate of the mutual fund is 8%, then its net cost rate is 2%. Low cost can reduce the impact of returns. With the passage of time, the importance of low cost is becoming more and more prominent.

In his book 'Capital Ideas', Peter Bernstein tells us that in 1908, French economist Louis Bachelier pointed out a clear and cruel fact in his paper: 'The mathematical expectation of speculative results is zero.' However, Bachelier was because he ignored investment costs. It was plundered by many market gamblers.

James Gleick in 'Chaos: Making a New Science' used the relevant scientific principles to explain the 'Noah Effect': 'The Noah Effect is automatic interruption: when a certain Quantity begins to change, it will change at a relatively fast speed. If the price of a stock falls from $60 to $10, and it must be sold at a price of $50 at some point during the process, then the strategy of this stock market is doomed to fail.'

Therefore, buying stocks is a dangerous game. When stock prices are at high levels, everyone tries to buy; on the contrary, it seems more difficult to sell when stock prices fall. Obviously, the stock market crash led to a group of 'rational' investors staying away from the stock market. 'If you can't stand the heat in the kitchen, stay away from it.' Berger fully agrees with this ancient maxim. In his opinion, rational and patient long-term investors should continue to wait for the market to appear.

Although stock prices show transient, temporary, and even violent fluctuations, in the long run, they are ultimately determined by two basic factors: the book value and dividends of stocks, and both are with a relatively stable growth rate in the long run.

The real rate of return and dividend rate of US companies in the past two centuries are generally close to 7%, almost equal to the actual rate of return of 7% of stock prices. Therefore, fundamental investment, not market value, determines everything in the long run. However, in the short term, fundamentals usually give way to the huge noise of speculation-PE ratio. The impact of this noise can be sustained for a long time.

Berger also noticed that from 1966 to 1987, the dividend of the S&P 500 index increased by 320%, the reset book value grew by 750%, and the price rose by 370%. That is to say, the annual average growth rate of dividends of 5.5% supported the annual average growth rate of stock prices of 6% and the annual average growth rate of stock book value of 8% for nearly 30 years.

If an investor held stocks from 1987, experienced the stock market crash and its subsequent impact, and continued to hold it until 2001, his return would be considerable. For example, the S&P 500 index achieved a return of 17% in just 19 months.

This has good returns for lucky or foresighted investors. But no investor will be lucky enough to liquidate their stocks at the high point in August 1987 and buy them back at the end of the year. And investors cannot gamble their future returns on luck alone.

III. Physics in Investment

Berger has a unique understanding of the principle of mean reversion. He does not simply see it as a counter-trend strategy like some people do. He believes that this theoretical principle from academia is completely applicable in the actual financial market, whether it is the relative or absolute returns of the entire stock market, which proves this law.

Mean reversion represents a kind of 'universal law of gravitation' in the financial market, because returns usually return to a certain average level. Do investors have to invest in some good-performing sectors of the stock market in order to obtain long-term excess returns? No, there is no persistent systematic deviation that will support a particular sector. Even if it takes a long time, mean reversion will make each sector take turns, but each sector will last for different lengths of time.

Traditional investment philosophy believes that value investment philosophy is superior to growth investment philosophy, because few people have really studied investment history. Market records show that from 1937 to 1968, the growth investment strategy was completely dominant and was clearly the winner.

At that time, the return on investment in value stocks was only 62% of that of growth stocks. It was not until around 1976 that value stocks began to have a huge turning point and almost made up for the shortcomings of early returns. Then, it was the growth stocks that dominated from 1977 to 1980, while the period from 1981 to 1997 was a period of outstanding performance for value stocks, and growth stocks began to emerge again in 1998.

Throughout the 60-year cyclical fluctuations, the final return on investment in value stocks was equivalent to 90% on growth stocks.

Over the entire 60 years, the compound total return rate of growth stocks was 11.7%, while that of value stocks was 11.5%, with a negligible difference, resulting in a tie. This is proof of mean reversion.

It is commonly believed that the return on investment of small-cap stocks will definitely exceed that of large-cap stocks, which seems to be an unbreakable investment myth. In fact, the high returns of small-cap stocks are also intermittent. From 1925 to 1964, the returns of large-cap stocks and small-cap stocks were the same.

In the next 4 years, the return on investment of small-cap stocks was more than twice that of large-cap stocks, but in the following 5 years, the advantage of small-cap stocks was almost lost. By 1973, the returns of small-cap stocks and large-cap stocks were almost the same in nearly half a century. The reputation of high returns on small-cap stocks was mainly established between 1973 and 1983.

Immediately afterwards, mean reversion began to take effect for the fifth time, and after 1983, it was the turn of high returns for large-cap stocks. During this entire period, the compound annual return rate of small-cap stocks was 12.7%, while that of large-cap stocks was 11.0%. This difference resulted in the final value of small-cap stocks being three times that of large-cap stocks.

Burg believes that if small-cap stocks had not risen sharply in the 10 years from 1973 to 1983, the annual return rate of large-cap stocks would be 11.1% and that of small-cap stocks would be 10.4%. In any case, the relationship between the two, even if not completely controlled by the mean reversion rule, will be affected by the universal attraction of the market.

Therefore, Newton's Third Law, which states that "every action has an equal and opposite reaction," may be more suitable for interpreting the reality of the financial market. Although mean reversion may sometimes take decades to take effect, it is a historical and objective principle that even the smartest investors may bring huge risks if they ignore it, because it will continue to exist.

Therefore, Berg said that he always bets on the law of mean reversion in his investment. Peter Lynch also expressed a similar view in his book "One Up On Wall Street", and he was one of the best investors who applied this law.

Academic research on mean reversion, that is, historical statistical data shows that mean reversion has always been effective, and it almost appears in every aspect of investment. If we accept this theoretically, we should appropriately diversify our assets.

For example, if there is more time (15-40 years) before retirement, you should hold more stocks (90% stocks and 10% bonds or cash), and those who are more conservative and have a shorter investment period (1-15 years) and relatively small capital may only need 35/65.

This balanced strategy has been effective for several centuries, not because it provides the highest returns, but because it provides relatively stable long-term returns without increasing additional short-term risks.

Burg prefers index funds that track the entire US stock market. These funds have the best response to the mean reversion of the stock market because their investment portfolios include various types of stocks such as large-cap, middle-cap, and small-cap.

Just like an apple falling to the ground, the crazy sector of the stock market will eventually fall to the mean level- if it rises more this year, it means that it may fall next year, and vice versa. At the same time, even the best possible returns will eventually fall to normal levels - a good harvest today means that next year's harvest may be bad, and vice versa.

Newton's law of universal gravitation and mean reversion applicable to various financial markets will help us to develop wise investment strategies and then use common sense to implement them. When we accumulate capital, we must benefit from the application of this concept.

The total assets managed by today's Vanguard Group have reached 7.8 trillion US dollars, making it one of the world's largest public fund management companies, with over 30 million investors and remarkable success over the past 50 years. As Berg said, his financial ideas allow us to truly see that "active investment managers, whether ringing the bells of heaven or hell, are calling for death, while index funds are not."

Editor / jayden