How to invest? How to get rich from the stock market? This summer I dove into one of the classics on investing. Of course, I used a book of my own Top 10 books about money you nééd to read too read. This article is a summary and review of one of the classics: The Little Book of Common Sense Investing. In short, this books outlines the fundamental principles of the stock market, how to begin investing without prior knowledge and how YOU can use the stock-market in to your advantage.
If you every wanted to start investing but didn’t really know where to start, this is the book for you. The version I read also contained different economical experts and successful people, like Warren Buffet. These people explain why the theory works and add to the credibility of the book while they are also very interesting to read. Even though I have a master in Accountancy and passed many subjects in Finance, this book was of more value to me than the entire study every could be. It is by far the best book to read when you want to start investing. Bogle is an expert and world-renowned economist who stands at the foundation of passive investing and is one of the founders of Vanguard, the cheapest option for passive investing. Either way, Bogles theory of passive investing still holds. Recession after recession. Even after many technological developments like the internet, the start of social media and the current climate change struggles the theory has proven its value. A timeless theory described in a timeless book. Bogle explains in a simple and clear way how the stock-market works and his theory on how to profit from the stock-market. You do not need a lot of background to start reading the book but some terms might be new to you. I will first describe some basic terms you need to know, in case you don’t know them already. I will then explain the theory, although I can still highly recommend to read the full book to get a better grasp of the concept and why it works.
First, some terminology. The stock-market is a place were stocks are sold. Stocks are tiny pieces of ownership in a company that often also give voting rights. As an owner of a company you earn the profit that the company makes, the same counts for your tiny piece of ownership. Dividend is the piece of profit the owner of a stock receives. Next to stocks there are also bonds. Bonds are tiny pieces of loans to companies. Just like with normal loans, companies pay interest on the loans and pay back the loans. The interest and loan repayments are called coupons. When a company goes broke, stock-owners are often last in line while bond owners are earlier in line. This makes bonds a safer investment than stocks. Because of the risk of stocks, the price of a stock is volatile. If bad news about a company comes out, people will want to sell their stock to avoid losing the full value of their stock. This results in the stock price to decrease. On the other hand, companies that are not doing well financially pay high interest on loans because less people are willing to lent money to a company that is in danger of going broke. This means that interests rates are high which makes them more appealing to people. If more people want to buy a bond, the price of a bond will rise.
Now you know the basic terminology and concepts!
Bogles Theory of Passive Investing
As you might have noticed, owning a bond or a stock is risky! In gambling there is a saying “don’t bet all your money on one horse” because if the one horse loses, you lose all of your money as well. A similar concept is true for the stock-market. If you buy stocks in one company and the company files for bankruptcy, you are likely to lose all of the invested money. For many years, people therefore decided to not put all the eggs in one basked but instead invest in multiple stocks. This “spread” reduces the risk. Although bonds are less risky, the same concepts apply.
Even better is to also invest in different business sectors. For example, when a recession strikes and people have less money to spend they still need to do groceries while they might cut back on holiday expenses. Companies like Unilever and Proctor & Gamble (PG) are therefore safer investments than for example Booking.com. If you spread the amount of money you invest equally over different companies in different sectors you reduce the risk of losing all your money at once. Thankfully, you don’t have to pick all those stocks yourself. Mutual funds were created to enable people to buy multiple stocks or bonds at once. A financial professional manages the portfolio of a mutual fund, so you don’t have to figure out what business sectors are risky and safe. However, over the years a lot of people started creating mutual funds. Mutual funds that followed indexes, like the S&P 500 or Dow Jones. These indexes are often based on the value of companies. The S&P 500 for example, follows the 500 biggest companies in the US. Some mutual funds were based on the financial analyses performed by big companies of other companies. However, just like individuals on the stock markets, some people and companies were better at managing mutual funds than others… During the recession of 2000 and 2008 a lot of people lost money to the charlatans of the market. This is where Bogle’s theory comes in.
Bogle analysed the stock-market and realised something interesting. Ideally, a person would like to buy every company in the country in equal proportion to its contribution to the economy. That way, if the economy goes up so does your investment. However, it is very difficult and expensive to do so. Therefore he was looking for a shortcut and found one in the form of the S&P500. The biggest 500 companies in the US make up the majority of the economy in the US. This means that the S&P500 closely follows the general economy. If the economy goes up 10%, generally so does the S&P500. One big company goes bankrupt? No worries, it will only be a small percentage of your investment that is probably made up by other companies that make a profit. Bogle analysed the S&P 500 and multiple other mutual funds and realised that over the course of 50 years the S&P500 outperformed every other mutual fund. In the first few years that difference didn’t seem that obvious but the longer the period, the more mutual funds fell behind. Even the most famous investor and the 3rd richest person on earth, Warren Buffet, had to admit to his investors that his investment company can’t compete with the S&P500 anymore. Bogle revealed the underlying concepts that made the S&P500 so profitable.
The first concept had to do with short-term versus long-term investing. As you might have noticed on wall street, most traders are running around like crazy. The want to buy low and sell high and do that as much as possible. These traders are short-term investors. They basically try to predict and beat the market. Sometimes people succeed, like George Soros. He bet against the Bank of Engeland and won, profiting around $1 billion. However, most traders lose money in the long term because you can’t always out-beat the market, just like you can’t beat the house when gambling. Bogle analysed the stock-market and realised that passive index investing, in the long-term, always beats short term investors. So just putting all your money in the S&P500 and waiting will eventually yield more profit than the best investors in the world can get you. Now there are two reasons for this.
That brings us to the second concept, compound interest. According to Bogle one of the reasons that passive-index investing in the S&P500 is so profitable is because it makes use of the concept of compound interest. This basically means that you receive (or pay!) interest over interest. Albert Einstein already figured out that compound interest is of incredible value and even called it the eight wonder of the world because of it. In this way every dollar having a dividend of 3% will double in 24 years. Every dollar with 9% dividend will double in 8 years! If you want to know how long the doubling takes, just divide 72 by the interest rate (so 72/3 and 72/9). Now one dollar might not seem like much but what if you invest 1200 euro’s a year when you are 20 against a dividend rate of 9% per year. That first 1200 euro’s will double in 8 years giving you 2400. Another 8 years later (so 16 years later) that amount will double again, giving you 4800. Another 8 years later (so 24 years) it will double again giving you 9600, another 8 years later 19200 and another 8 years 38400. You didn’t have to do anything for it but by the time you are 60 years old you and nearing your retirement you will have increased your initial investment 32x. Imagine saving 100 euro’s a month, year after year! But wait, where do you get a 9% rate of return nowadays? Well definitely not in your savings account. However, have a look at the S&P500. The average annualised total return for the S&P 500 index over the past 90 years is… 9.8%. The total return is composed of the stock market increases and the dividend value when you reinvest your dividend. So every time dividend is paid out, you immediately reinvest it in the S&P500 again. There is one catch to this concept.
That catch is the 3rd concept that we will discuss, costs. Participating in the stock market costs money. Buying stocks and bonds costs money and sometimes so does reinvesting dividends. As Albert Einstein already states in its quote, you can earn compound interest or pay it. Every dollar spend on fees is not a dollar that will double. Just as earnings grow exponentially so do costs, they take up a growing proportion of your possible earnings. The less you trade, the less costs you make, the more money has time to double. Hence the concept of passive investing: you invest and then let the market run its course. Ups and downs, recessions and economic boom, you don’t touch your money and it will generate a profit for you. The more a manager of a mutual fund is shifting around in the fund, the more costs you make and the less profit. Only the manager can profit from shifting around in funds in the long term. The best fund is an index fund not a manager manages mutual fund and among the index funds the S&P500 rules them all. Because the costs are so vital, Bogle set out to create a company in line with its vision: with the lowest possible cost. This company is Vanguard and still one of the biggest investment agencies in the world. The vision of Vanguard? Decrease the costs of holding a broad index fund so the participants in the fund get the most value for their money. Vanguard is not a for-profit company, although it does make profit. Although their portfolio has been expanding and they have been adding more mutual funds, they also still provide the lowest cost S&P500 index fund. Unfortunately, in my country I can’t even buy them but I can highly recommend everyone to look into it.
The strategy of passive investing is simple: buy and hold. Just because this strategy is simple, doesn’t mean it’s easy. If every other trader is running around screaming BUY or SELL or RECESSION or OPPORTUNITY you will still have to sit on your hands and wait sometimes years before your point is proven. You will have to resist a lot of social pressure and yes some people, just like with the lottery, will strike the jackpot. However, for the majority of people this strategy remains the one solid way to earn a solid profit in a complex stock-market. For a beginner, it is an easy way to start and if you manage to stay put long enough you can be sure to outsmart even the best investors in the world. Even you can be the king of investing.
Please note that this article is for informational purposes and not investment advice. I do not take any responsibility as a result of actions taken based on the information provided in the article. The information in this article is derived from the theory described in the book “The little book of common sense investing” by J.C Bogle. I do not own the copyright to this book.