An Investor with minimal curiosity will learn that the shortest and surest route to top-quartile performance is bottom-quartile expenses. – John C. Bogle, Vanguard founder and index fund pioneer
The efficient market hypothesis (EMH) states that capital markets are highly efficient, and that any new information about a company’s stock is almost immediately reflected in the stock’s price. Academics and investment professionals have been arguing about the validity of the EMH since it was introduced, with most academics defending it and most investment professionals claiming that the market is not that efficient, and that skilled investors can make money off its inefficiencies.
The goal of an index fund is to match the market, not beat it, so you would think that Vanguard founder and index fund pioneer John C. Bogle would be a proponent of the EMH. That would not be entirely true. Bogle states, “…we didn’t rely on the EMH as the basis for our conviction [that index funds would be successful]. After all, sometimes the markets are highly efficient, sometimes wildly inefficient, and it’s not easy to know the difference.”
So if Bogle wasn’t relying on the EMH, what was he relying on? He explains: “Rather, we relied on a theory that is not only more compelling, but unarguably universal. The CMH – the Cost Matters Hypothesis – is all that is needed to explain why indexing must and will work. In fact, the CMH enables us to quantify with some precision how well it works. Whether or not the markets are efficient, the explanatory power of the CMH holds.
Starting with a single index fund in 1976 Vanguard has grown into one of the largest and most successful mutual fund companies in the world. The key to Vanguard’s success is the extremely low costs they charge in relation to their competition. Bogle was not only correct in predicting that indexing would work, he was also correct in identifying lower costs as the reason for its success. In fact, a recent study of the performance of 3,000 actively-managed stock funds from 1979 to 2011 confirmed Bogle’s Cost Matters Hypothesis.
The study, conducted by Lubos Pastor, a professor of the Booth School of Management at the University of Chicago, found that actively managed funds beat market benchmarks before costs, but significantly underperformed benchmarks after investment costs were considered. Pastor concluded, “There is indeed skill, but the average extra return managers generate is not enough to offset the average extra fees that come with active management.” In other words, just as Bogle predicted, investments costs are the difference that makes index funds the wise choice for most investors.
The quickest, easiest, and surest way to improve investment performance is to minimize investment costs. The less money you pay in investment fees, the more you keep for yourself. Costs truly do matter.
John C. Bogle built one of the largest and most successful mutual fund companies in the world on the foundation of low investment costs. You can achieve investment success by following Bogle’s example and minimizing the costs you pay to invest.
Mutual fund companies do everything they can to make investment costs invisible and difficult to understand. Most investors don’t have any idea how much they are paying in investment costs, or how they pay it. The first step in lowering investment costs is understanding how they work. My next several posts will give you a basic understanding of investment costs, so stay tuned and keep reading. It is knowledge that could be worth tens, or even hundreds of thousands of dollars over your investment lifetime.