Introduction
Our society has put its trust in numbers without realizing how ephemeral they often are and how easy it is to manipulate them. We’ve taken the status quo for granted, blithely projecting yesterday’s trends and today’s circumstances into the future, even the distant future. These deceptions played a major role in our unwillingness to recognize the profound flaws that have developed in modern-day capitalism. But the global financial crisis and the stock market collapse of 2007-2009 have finally forced us to examine those flaws. As the past three years have demonstrated, ignoring reality comes with a cost. This book attempts to explain how our society got to the place it is today and how we can begin to repair the widespread damage we have suffered.
More broadly, Don’t Count on It! is a book about how we deceive ourselves, and the consequences our society suffers when we fail to accept the realities of life. The purpose of the book is to present an anecdotal account of recent financial history, rife with examples of self-deception. Don’t Count on It! also aims to encourage our citizens to better understand our complex financial system—to examine it, to debate it, to challenge it, and to fulfill our duty to ask simple questions and demand answers that are understandable, intelligent, and above all, wise.
Clearly, we deceived ourselves by ignoring the forces that would lead to the disastrous recession that began in 2008. While I didn’t predict the housing meltdown that initiated the recession, I warned in October 2007 that such an unpredictable event had become a near certainty. The main clues were soaring debt; extreme market swings fostered by the triumph of speculation over investment; a shift from an economy focused on services to one dominated by finance; and a massive increase in financial complexity.
Well before disaster struck, I questioned what proved to be the catastrophic creation of credit default swaps (CDSs), collateralized debt obligations (CDOs), and structured investment vehicles (SIVs), which together played a starring role in the stock market crash and economic collapse of 2008-2009. In 2007, I worried about the impact of these “mind-bogglingly complex and expensive” products, and warned, “Now is the time to face up to these realities.” The Dodd-Frank legislation that was signed into law by President Obama in July 2010 represents the first attempt to reform the financial system and prevent future speculative collapses. The new reform law cannot guarantee such an outcome, but it may have made a repeat of the recent era less likely.
Part One, “Investment Illusions,” describes the folly of placing too much trust in numbers, and the catastrophic consequences that can follow. Among these illusions are the absurd notions that past returns on stocks foretell the future; that mutual funds as a group can earn the market’s return; that fund investors actually earn the returns reported by the funds themselves; and that we can treat the financial reports of corporate managements—buttressed by the imprimatur of their “public” accountants—as reality.
I then discuss what went wrong in “The Failure of Capitalism” (Part Two), largely the consequences of our belief—now shattered—that self-interest and free markets alone can be trusted to guide our economy and our society to optimal effectiveness. I offer some solutions aimed at repairing the widespread damage from which our nation continues to suffer. Foremost among them is the establishment of a new fiduciary society, focused on requiring institutional money manager/agents—who now control corporate America—to put the interests of their client/principals as their highest priority. It’s called stewardship.
Here’s how Anatole Kaletsky, editor-at-large of the
Times of London, sums up where we went wrong, buttressing my analysis in the first two parts of the book:
Keynes never published an economic forecast, and neither did Hayek, Ricardo, or Adam Smith. What economics did claim to offer was a set of analytical tools to explain reality and suggest sensible responses to unexpected events . . . . Substituting probability distributions for observable facts does not solve the problem of uncertainty. It merely covers up the true problem . . . ignoring the role of inherent unpredictability in finance. . . .
The propensity of modern economic theory for unjustified and over-simplified assumptions allowed politicians, regulators and bankers to create for themselves the imaginary world of market fundamentalist ideology, in which . . . efficient, omniscient markets can solve all economic problems, if only the government will stand aside. . . . [But] the self-serving assumptions of efficient, self-stabilizing markets have [now] been discredited.
1The mutual fund industry, in which I have spent my entire career, has proven a major exemplar of these flaws, as suggested by the quotation marks that I use in the title of Part Three—“What’s Wrong with ‘Mutual’ Funds.” (I know of only a single fund organization—Vanguard, the company that I founded 36 years ago—that meets the definition of mutual: owned by its participants). Capitalizing on the investor ebullience fostered by the greatest bull market in stocks in all history, conventional actively managed mutual funds became among the fastest growing financial “products” of all times, growth built on a record that could not—and did not—recur. By the time the market boom ended early in 2000, following two decades in which annual returns on stocks averaged an incredible 16 percent, $10,000 invested in the stock market in 1980 would have grown to $183,000. And that was the end of the boom. It would be followed, as always, by bust.
The growth in industry assets during that period—driven largely by equity funds—from $135 billion to $7.3 trillion belies the fact that few mutual funds succeeded in matching those gains. In fact, it has been passive ownership of stocks, not active equity management, that has proven to be the most effective means of capturing whatever returns are generated in the stock market. And the ability to do precisely that—by simply owning virtually the entire universe of publicly owned U.S. corporations through a stock market index fund (or, in the U.S. bond market, through a bond index fund)—has now been available for more than three decades.
In recent years, index mutual funds have come into their own, a development that I discuss in “What’s Right with Indexing” (Part Four). Simply because of the reality of humble arithmetic—gross market return, minus investment costs, equals the (much smaller) net return that investors receive—indexing is only at the beginning of its ascent. The intellectual foundation of indexing is based—not on some notion of “efficient markets”—but on low costs, wide diversification, and tax-efficiency. That’s the reality. By contrast, the intellectual foundation of active management does not exist; the superiority of active managers as a group is an illusion.
In Part Five, I address the subject of “Entrepreneurship and Innovation,” where the idea that a spirit of driving determination aimed at serving the greater good of society is far more important than simply the desire for self-serving monetary gain. After all, it was more than two centuries ago that in his
Theory of Moral Sentiments, Adam Smith, whom many believe to be the patron saint of capitalism, asked more of our business leaders:
The private man must . . . acquire superior knowledge in his profession, and superior industry in the exercise of it. He must be patient in labour, resolute in danger, and firm in distress. These talents he must bring into public view, by the difficulty, importance, and, at the same time, good judgment of his undertakings. . . . Probity and prudence, generosity and frankness, must characterize his behaviour upon all ordinary occasions; and he must, at the same time, be forward to engage in all those situations, in which it requires the greatest talents and virtues to act with propriety, but in which the greatest applause is to be acquired by those who can acquit themselves with honour.
2In mid-2010, Adam Smith’s view was echoed by the Times of London’s Kaletsky, quoting (of all people) Machiavelli, who said that honor and the greater good drive the ambitions of leaders—presumably not only politicians but entrepreneurs as well. Machiavelli “described the accumulation of worldly ‘glory’ as the motivating principle that drives leaders to undertake ‘great enterprises’ and do ‘great things’ on behalf of their fellow citizens and not just themselves.” In my discussion of entrepreneurship, I present 17 rules for success, including a final rule that echoes Adam Smith: “Our greatest rewards come when we help to build a better world.” This part of the book also looks at innovation, a topic closely related to entrepreneurship. While recent financial innovations have created fabulous profits for Wall Street, most have hurt those who invested in them. But there are exceptions, including six innovations in the mutual fund arena that have met the important criterion of serving investors.
Lest we forget, idealism has always played a role in the American tradition, and the notion that we can count things that prove transitory and unimportant at the expense of priceless ideals and values that can’t be quantified takes us far from that tradition. I tackle the subject of “Idealism and the New Generation” (Part Six) in the form of exhortations to our nation’s students, as they undertake the callings of the various careers that lie before them, to heed the better angels of their nature. Included here is the speech “Enough,” which I later expanded into a book. Many writers and leaders who have inspired me, including Rudyard Kipling, Kurt Vonnegut, Woodrow Wilson, Theodore Roosevelt, William Shakespeare, and Winston Churchill, find their way into this part of the book.
Even as I aspire to share my values with tomorrow’s leaders, I pay homage to the great mentors of my career, who inculcated in me their own high values. In Part Seven, “Heroes and Mentors”—for the dear men whom I describe there have indeed been heroes to me—I pay tribute to an extensive roster of mentors who helped me to develop my character along the long road of my career, indeed the long road of my life. The roles played in my life by Walter Morgan—my boss at Wellington Fund for 23 years—author Peter Bernstein, economist Paul Samuelson, and cardiologist Bernard Lown each merit a chapter, but every one of the 29 remarkable mentors that I list have been not only my greatest friends and supporters, but credits to their professions. History will enshrine many of them as rare icons who stood on principle during the madness of capitalism’s recent era.
How to Lie with Statistics
I haven’t looked at Darrell Huff ’s classic 1954 book, How to Lie with Statistics, for years. But I haven’t needed to. Every day I see numbers that, if not outright lies, are gross distortions of reality. For example, consider that during the three years, 2007-2009 inclusive, operating earnings for the companies in the Standard & Poor’s 500 Stock Index totaled $1.67 trillion. But after write-offs of overvalued assets, high-priced acquisitions, and other stumbles by management, reported earnings totaled just $1.17 trillion. Nearly $500 billion of earnings had vanished into thin air. (Yes, I picked that period. But I can tell you that since 1970, in which the differences between these two methods of calculating earnings began to be reported, there has not been a single year when the gap between the illusion of operating earnings and the reality of reported earnings has not existed.) Yet with almost clock-like regularity, our Wall Street investment strategists rely on operating earnings, not reported earnings, as the basis for their market valuations. Given the number of tricks in the accounting trade, even reported earnings likely overstate the reality. As the late Robert Bartley, respected longtime editor of the Wall Street Journal, has observed: “True profits are represented by cash—a fact—rather than reported profit—an opinion.”
Our government also contributes to the distortion of reality. David Einhorn, leader of Greenlight Capital, has observed that “over the last 35 years, the government has changed the way it calculates inflation several times. . . . Using the pre-1980-method, [inflation] would be over 9 percent, compared to about 2 percent in the official statistics.” Another example: The Bureau of Labor Statistics reports that our mid-2010 unemployment rate is 9.7 percent. But the number we count as unemployed excludes workers too discouraged to look for a job; part-time workers looking for full-time jobs; those who want a job but aren’t actively searching for one; and those who are living on Social Security disability benefits. If we include these unemployed souls, the unemployment rate would likely double to nearly 20 percent—30 million human beings who aren’t able to find useful work. The posted unemployment rate suggests that our economy is in recession; the real rate suggests something considerably worse.
Torturing the Mutual Fund Data
Even when the figures we rely on are sound and accurate, the deliberate distortion of data to prove one’s point is all too easy. As I have often observed, when one controls both the metric and the time period, the data can be, as the saying goes, “tortured until they confess.” The mutual fund industry is hardly an exception to that syndrome.
Every few years, for example, the Investment Company Institute is pleased to report that fund expenses are declining. Of course, the ICI is the lobbying organization for mutual fund managers (albeit paid, finally, by mutual fund shareholders). In the 2010 reincarnation of these data, ICI research reports that “mutual fund fees and expenses have declined by half since 1990.” But the fact is that fees during that period actually soared from $12 billion to $69 billion, a fivefold increase.
When the ICI purports to talk about falling fees, it is confusing fee dollars with fee rates—a wholly different metric. By the latter standard (fees as a percentage of assets), the expense ratio of equity funds has dropped from 1.00 percent to 0.86 percent. When we include their calculation of annualized sales loads—which are said to have dropped from 0.99 percent to 0.13 percent (I doubt it)—the ICI calculates that the total cost (they really mean “total cost as a percentage of assets”) of purchasing equity funds has fallen from 1.98 percent in 1990 to 0.99 percent in 2009.
When we consider another equally important metric—expenses as a percentage of dividend income—the picture also shows that fee rates are not declining, but rising. Fund expenses consumed a quite-healthy-enough 19.5 percent of equity fund dividend income in 1990; by 2009, that figure had nearly doubled to 38.5 percent. (In 2000, it reached an astonishing 51 percent.) Now think of that confiscation of dividend income in the context of the fact that dividend yields, as noted earlier, have accounted for one-half of the long-term return on stocks (4.5 percent out of 9 percent). Fund fees and costs, then, are now consuming almost 40 percent of that major contributor to stock returns. With that confiscation of income, combined with today’s far lower stock market yields, the average equity fund currently delivers a dividend yield of a puny 1 percent to its shareowners.
Now let’s change the period selected by ICI from the short term to the long term—here, the past half-century. Even using the conventional expense ratio standard shows not a decrease, but an astonishing increase of some 60 percent. The 1960 ratio, 0.54 percent of fund assets consumed by fund expenses; the 2009 ratio, 0.86 percent. The expense-to-dividend ratio is up by more than 100 percent, from 18.3 percent of fund dividend income to 38.5 percent. During that same half-century, total equity fund fees—obviously, it is dollars that are the ultimate metric—have risen 800-fold, from $50 million in 1960 to $40 billion in 2009. While equity fund assets also rose sharply, from $10 billion to $5 trillion, or 500-fold, that increase was dwarfed by the increase in costs. Are mutual fund fees really declining, as the ICI would have you believe? Don’t count on it!
Conclusion: The huge and widely recognized economies of scale entailed in managing other peoples’ money have been largely ar rogated by fund managers to their own benefit, rather than to the benefit of their fund shareholders. The illusion of falling expenses that the ICI presents through its careful selection of both time period and metric is clearly punctured by the reality: The long-term drain of rising expenses—under all three metrics—has cost fund shareholders dearly.
“A Lantern on the Stern”
Sometimes numbers are accurate and complete, covering the entire period for which they are available. (Albeit even such a period—call it “inception date to current date”—is by definition a selected period.) Yet when we rely on the past to help us foretell the future, we are all-too-likely to reach invalid conclusions. One of my favorite targets here is the giving of a Gospel-based credulity to the historical record of long-term stock market returns. The list of distortions created by such a reliance on past returns as a reference point for future returns seems almost infinite.
First, these returns are measured in nominal terms (current dollars) rather than real terms (inflation-adjusted dollars). Thus the 9.4 percent average annual nominal return on stocks over the past 50 years has increased the value of a $10,000 initial investment to $893,000 in nominal terms (including reinvested dividends). But after accounting for the 4 percent inflation rate over that period, the resultant 5.4 percent real return would result in total wealth accumulation (say, for a retiree) of $138,700. Even that sum sounds handsome—but only until you realize that it ignores investment costs and taxes, which are inevitably deducted in nominal dollars, year after year. Those costs could easily total 3 percent per year, reducing that 5.4 percent return to 2.4 percent. The value of the retirement fund now tumbles to $32,700. That’s the reality for investors, and it clearly (and sadly) trumps the illusion of $893,000.
Next, the past is not prologue, simply because while the sources of future stock market returns are the same as the sources of past returns (dividend yields, earnings growth, and changes in market valuations), the numbers themselves are rarely the same. Simply put, during the past 110 years, one-half of the 9 percent long-term investment return on stocks was generated by a 4.5 percent dividend yield. So with the mid-2010 dividend yield at about 2.25 percent, we ought to reduce our expectations for future stock market returns by two percentage points or so compared to historic norms.
Notably, “Monte Carlo simulations”—which are widely used by investment professionals to forecast a range of future returns on stocks—take no account of these changes in fundamentals. Such simulations, therefore, are fatally flawed. The general failure of the financial community to recognize this simple point—as well as to face the nominal-dollar versus real-dollar issue—is intellectually dishonest, to say nothing of self-serving on the part of Wall Street, striving to put the best possible face on the potential rewards of equity investing.
But even if we accept the illusion of historical market returns as the reality, don’t count on its being repeated. As Wall Street Journal columnist Jason Zweig has observed, the earliest stock return data for most of the 19th century “isn’t really valid . . . excluding 97 percent of all the stocks that then existed . . . and including only the bluest of blue-chip survivors.” (In the early part of the century, it was bank and insurance stocks that dominated the data; in the latter part, it was railroads; neither is the case today.) Even when the data takes on a greater validity beginning in 1884, with the first calculation of the Dow Jones Average, it consisted solely of 11 transportation stocks. By 1896, when the Dow Jones Industrial Average appeared, the new index was more diversified by sector, but included only 12 stocks, including American Cotton Company, American Sugar, U.S. Leather Company, and Distilling and Cattle Feeding Company, along with stalwarts American Tobacco, National Lead, and General Electric, today’s sole survivor of that early average.
In the modern era, where market returns have been more carefully refined, who is really to say that the data that we now accept as Holy Writ doesn’t have serious problems? The Standard and Poor’s data begins in 1926, for example, but today’s redoubtable S&P 500 index consisted of only 90 stocks from that inception until 1948. The University of Chicago Center for Research in Securities Prices (CRSP) has produced data purported to reflect the entire U.S. stock market (also beginning in 1926) but it excluded “over-the-counter” (NASDAQ) stocks until 1972, when the number of stocks in its market universe leaped from some 2,000 to 5,000. When one stands back and looks at the entire 84-year period for which we have what are generally accepted as valid stock return data—including only about 50 years of solid evidence—it’s obvious that we’re considering a relatively short period, dominated (at least until 2007) by a powerful—perhaps a once-in-a-lifetime—bull market in the most prosperous nation in the world.
But even if we could develop data on stock market returns over the past two centuries that approached perfection (i.e., reality), the idea that future returns will center around past returns is an illusion. The world changes, in ways unimaginable and unpredictable. Nations rise and fall; war and peace reorder the global society; free-market competition disrupts the old order; technology changes once-reliable ground rules. So, the past simply cannot be a reliable prologue to the future. Samuel Taylor Coleridge uncovered an important kernel of truth when he warned that history is “a lantern on the stern, which shines only on the waves behind us.”
The Wisdom of the Economists
Of course we need numbers to help us to understand the past, to manage the present, and to appraise the future. But there is so much more to capitalism than numbers. Two eminent economists and a poet confirm this view. Joseph Schumpeter (1883-1950) is said to be the first economist to recognize the entrepreneur as the moving force of economic development. Schumpeter focused not on the numbers that might validate his hypothesis, nor on the financial rewards of successful entrepreneurship, but on the character and motivation of the successful entrepreneur: “First, the dream and the will to found a kingdom. Second, the will to conquer, the impulse to fight, to succeed for the sake of success; not of the fruits of success, but of success itself. Third, the joy of creating, getting things done, of simply exercising one’s energy and ingenuity.” I can say from personal experience that these qualities—not mere money—have been the main drivers of my own long career.
John Maynard Keynes (1883 - 1946), the great British economist whose theories have returned to the fore in recent years, went even further in disassociating numbers from achievement. When he put forth “animal spirits” as the basis for successful investment, he gave us a phrase that remains in common use to this day:
... a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation . . . whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.
It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits. . . . Human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist.
3While the English author and poet Rudyard Kipling was no economist (probably just as well!), his poem “The Gods of the Copybook Headings”
4 beautifully captures the thinking of Schumpeter and Keynes. Here are some excerpts:
As I pass through my incarnations in every age and race, I make my proper prostrations to the Gods of the Market Place. Peering through reverent fingers I watch them flourish and fall, And the Gods of the Copybook Headings, I notice, outlast them all.
We moved as the Spirit listed. They never altered their pace, Being neither cloud nor wind-borne like the Gods of the Market Place . . . They denied that Wishes were Horses; they denied that a Pig had Wings; So we worshipped the Gods of the Market Who promised these beautiful things.
Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters, and Two and Two make Four And the Gods of the Copybook Headings limped up to explain it once more.
What Kipling is telling us is that the reality of arithmetic—“that two and two make four”—ultimately trumps the illusion of the marketplace—the “beautiful things [promised by the] smooth-tongued wizards . . . the Gods of the Market.” His oft-forgotten rhymes neatly summarize the central thesis that permeates this book: that the real market of intrinsic value ultimately triumphs over the illusory expectations market of speculation, hyperbole, and self-interest.
An Increasingly Fragile World
Even if we come to understand the value of simplicity in the things that we can count on, in a world where complexity seems to actualize only the things that can be counted, we have to do our best to deal with the challenges we face in the modern—and largely untested—global society in which we exist. The challenges include the interconnectivity and interdependence of our nations; the struggles that divide the world—often between the “haves” and “have-nots,” and often based, paradoxically enough, on religion—and the soaring dependence on the role of technology in our lives. Together this combination has given us an increasingly fragile world. Since the beginning of history, totally unexpected events have suddenly erupted. But today these disruptions—now often man-made—impact vast swaths of human beings.
These kinds of events have come to be known as “Black Swans,” events at the outermost edge of the probabilities by which we order our lives. But other disruptions can’t be measured in terms of probability; they are uncertainties, often without historical precedent. But in either case, we human beings live our day-to-day existence as if they will never occur. But they do occur, and in this fragile modern age, they occur with seemingly increasing frequency. Consider:
• The 2010 explosion of an oil-drilling rig off the Louisiana coast, poisoning the vast Gulf of Mexico with hundreds of millions of gallons of oil, destroying marine life, birds, beaches, and the livelihoods of the local populace. It took our best engineers and scientists more than five months to close down the well.
• The explosion of the Challenger spacecraft in 1986, the result of a single flaw in an infinitely complex engineering project.
• The devastating obliteration of the Twin Towers of New York’s majestic World Trade Center in 2001. Who could have predicted that in a matter of moments, two airplanes would fly into these monuments to American finance, setting the stage for our nation’s decision to launch two wars, half-way ’round the world, both, nearly a decade later, still carrying huge costs in blood and treasure?
• The overwhelming force of Hurricane Katrina in 2005—an act of Nature—combined with the failure of the levees in New Orleans—an act of man—that left one of our nation’s major cities devastated.
• Global warming that could change our very way of life—higher temperatures, rising sea levels, health challenges, along with many other potentially dire changes. This warming appears—to most objective scientists—to be largely man-made, as carbon from our factories and automobiles, and lots more, become increasingly omnipresent in our lives.
• The world financial crisis that began in 2007—continuing to this day—the result of, among many other contributing factors, cheap money, high leverage, a plunge in real estate prices, the stock market crash, and immensely complex financial instruments that involved risk that seemed to be measurable but wasn’t.
Yes, things that we can’t imagine happening actually happen, and things we ignore because we assume that the probabilities of their happening are too remote to bother with actually happen as well. When we contemplate the possibility of a catastrophic event, as
New York Times journalist David Leonhardt has noted, “[where] nothing like that has ever happened before, even imagining it is difficult. It is much easier to hope that the odds of such an outcome are vanishingly small. In fact it’s only natural to have this hope. But that doesn’t make it wise.”
5Challenging the validity of accepting numbers as reality, Temple University professor and author of
Beyond Numeracy, John Allen Paulos struck just the right balance: “No method of measuring a societal phenomenon . . . exists that can’t be second-guessed, deconstructed, cheated, rejected, or replaced. This doesn’t mean we shouldn’t be counting—but it does mean we should do so with as much care and wisdom as we can muster.”
6Our financial system is both a measure of the kind of complicated society we have become and a major participant in its complexity. As recent financial history has taught us, complexity breeds deception. It is my prayer that my mission, my crusade (if those are not too-lofty characterizations of my career) will help the financial services industry to rethink its values and accordingly be of greater service to growing millions of investors all over the globe. If we do that, quoting Virgil, “through chances various, through all vicissitudes, we make our way....”
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JOHN C. BOGLE
Valley Forge, Pennsylvania
August 2010