The Little Book of Common Sense Investing

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The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books, Big Profits) 

The Little Book of Common Sense Investing by John C. Bogle, the originator of the first index fund and the founder of Vanguard Group, is one of the books that we found to be the most informative and practical.

In this book, Bogle demonstrates why investing in a low-cost index fund that closely mirrors the market is the greatest method to ensure that you will eventually receive your fair share of stock market profits. He also highlights the drawbacks and disadvantages of actively managed funds, which frequently underperform the market while charging hefty fees.

Key Takeaway #1: The stock market returns are determined by real investment returns, not by speculation

In the long run, according to Bogle, real investment returns made by actual businesses are what drive stock market returns. The annual dividend yield and the subsequent rate of earnings growth make up these real returns.

For instance, a company's actual return is 8% per year if it pays a 2% dividend and increases its earnings by 6% annually. This is the long-term return that shareholders of the company can anticipate.

But in the short run, speculation—a shift in investors' expectations and feelings about the company's prospects for the future—also has an impact on stock market gains. The stock price may differ from its intrinsic value based on actual returns due to speculation.

A company's price could be bought up over its true value, for instance, if investors become too bullish about its potential for future earnings growth. As a result, investors who purchased the stock at a discount will see a positive speculative return. In contrast, if investors have a tendency to overestimate a company's potential for future earnings growth, they may choose to sell its stock for less than it is actually worth. As a result, investors who purchased the stock at a higher price will experience a negative speculative return.

According to Bogle, speculation tends to cancel out over time since it is erratic and inaccurate. As a result, rather of basing their choices on speculative outcomes, investors should consider the actual returns on their investments.

Key Takeaway #2: The best way to capture the market returns is to own an index fund

According to Bogle, choosing particular companies or actively managed funds that will outperform the market cannot guarantee success. According to him, it is exceedingly challenging to constantly spot and take advantage of market inefficiencies and that individual enterprises come and go.

He also says that actively managed funds have several disadvantages compared to index funds, such as:
  • Higher costs: Fees for management and operating costs are greater for actively managed funds. Also, they pay more when the fund buys and sells securities, which is known as portfolio turnover. For investors, these expenses result in lower net returns.
  • Lower diversification: Compared to index funds, actively managed funds often hold fewer equities, which exposes them to higher idiosyncratic risk (the risk specific to individual companies or sectors). Also, they typically exhibit greater style drift (the departure from their declared investment goals or benchmarks) and overlap (the duplication of holdings among different funds).
  • Higher taxes: Index funds do not produce as many capital gains distributions as actively managed funds, and these distributions are taxed to the investors. In comparison to index funds, they frequently have worse tax efficiency (the ratio of returns after taxes to returns before taxes).
Bogle demonstrates that these drawbacks cause actively managed funds to perform worse over time than index funds. He cites research demonstrating that past performance is not a good predictor of future performance and that only a small minority of actively managed funds outperform their benchmarks over extended periods. Bogle advises investors to hold an index fund that follows the entire market, such as the S&P 500 Index, in their portfolios.

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