PDF Summary:The Little Book of Common Sense Investing, by John C. Bogle

With various companies vying to manage investors’ money, investing can feel overwhelming. John Bogle, however, argues that the winning strategy for novice investors is simple: Invest in traditional index funds and hold them indefinitely.

In his 2017 book, The Little Book of Common Sense Investing, Bogle outlines the reasons why investors typically make more money with index funds than the primary alternative—actively managed mutual funds. Because the costs of mutual funds vastly outstrip those of index funds, Bogle argues that mutual funds deliver reduced returns, and those relative losses compound over time.

In this guide, we’ll discuss Bogle’s arguments about the superiority of index funds over mutual funds, in addition to his proposed allocation of stocks to bonds in your portfolio. We’ll also dig deeper into the data that underlie Bogle’s arguments and examine how the book’s predictions have panned out since its publication.

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The Hidden Cost of Taxes

In addition to turnover fees, Bogle also argues that mutual funds lose more money to taxes because of their high turnover rates.

Mutual funds are tax-inefficient, Bogle claims, because stocks held for less than a year are considered short-term gains. Further, because short-term gains are susceptible to personal income tax, mutual funds with high turnover rates can leave investors on the hook for personal income tax—up to 37% for the highest tax bracket.

Profit from index funds, on the other hand, is considered a long-term gain, since index funds are normally held for longer than a year. Consequently, index fund investors only pay a capital gains tax, which is normally 15%. So, Bogle concludes that mutual funds cost investors more in taxes than index funds.

How to Minimize Taxes Owed on Investments

To maximize your return on investment, experts recommend a variety of strategies to reduce the taxes that you owe. These strategies include:

• Purchase government bonds, the returns of which are typically exempt from federal income tax.

• Consider investing in a traditional 401(k), which decreases your current taxable income. Or consider investing in a Roth IRA, which you invest in with post-tax money, making your later withdrawals tax-exempt.

• Implement tax-loss harvesting by selling underperforming stocks, which in turn reduces net capital gains from other successful stocks, decreasing your amount owed in capital gains taxes.

How Index Funds Statistically Outperform Mutual Funds

Despite their higher costs, mutual funds could nonetheless be superior to index funds if they generated proportionately higher returns. In this section, however, we’ll examine Bogle’s arguments to the contrary: Mutual funds generate significantly lower returns for investors than index funds.

Historical Data

First, Bogle examines historical data to see whether mutual funds have outperformed index funds in the past. In this regard, the data are clear: Low-cost index funds have consistently outperformed the vast majority of mutual funds since 1970.

(Shortform note: Although advocates of actively managed funds grant that index funds have outperformed most mutual funds, some argue that doesn’t mean index funds are always a better option. In particular, they claim these historical data only show index funds are better than the average mutual fund. Consequently, these advocates recommend finding mutual funds with gifted managers who are able to outperform the market over the long term.)

To show as much, Bogle turns to the records of the 355 mutual funds that existed between 1970 and 2016. Of these 355 funds, 281 of them—about 80%—are no longer in business. Because you can’t invest for the long term in funds that don’t exist for the long term, Bogle concludes that low-cost index funds—which don’t go out of business—have been superior to these 281 funds.

Of the 74 remaining funds, Bogle notes that 29 of them significantly underperformed relative to the market, with returns that were more than 1% below the S&P 500’s returns. Moreover, 35 of those funds essentially matched the market average, with returns that were within 1% of the S&P 500 in either direction.

Consequently, Bogle concludes that only 10 of the original 355 funds in 1970 outperformed the S&P 500 by over 1%. In other words, only 3% of the mutual funds that existed since 1970 delivered clearly above-market returns.

(Shortform note: Since The Little Book of Common Sense Investing’s publication in 2017, the historical trend of mutual funds underperforming has continued. Indeed, a 2022 study from the S&P Dow Jones Indices found that no actively managed funds consistently beat the market from 2017 to 2022.)

The TIF, conversely, delivered returns that were only 0.1% below the market average—a result of its substantially lower operating costs. So, the TIF delivered returns equal to or greater than 97% of mutual funds since 1970. Rather than searching for the few high-performing mutual funds, Bogle concludes that investing in index funds is the superior strategy.

(Shortform note: Although the proportion of passive assets like the TIF consistently grows larger in the US, actively managed funds still constituted 57% of investment companies’ total assets in 2021—despite their markedly lower performance. To explain this phenomenon, researchers have argued that actively managed funds outperform passively managed funds in down markets. Because investors are most concerned with their assets in down markets, they suggest this could explain why a large proportion of individuals continue to invest in active funds.)

Compound Interest

Moreover, Bogle notes that these small differences in returns between mutual funds and index funds yield outsized long-term results because interest compounds over time—in other words, it grows exponentially instead of linearly.

To see the effects of compound interest, imagine two funds: a mutual fund that earns 8% annually, and an index fund that earns 9% annually. If you initially invested $100,000 in each fund, they would deliver the following returns over time:

• After one year, the mutual fund would return $108,000, while the index fund would return $109,000.
• After 10 years, the mutual fund would return $216,000, while the index fund would return $237,000.
• After 50 years, the mutual fund would return about $4.7 million, while the index fund would return over $7.4 million

So, while a 1% difference would only cost you $1,000 after the first year, it would cost you over $2.7 million after fifty years!

The Reality of Compound Interest in a Volatile Market

Although compound interest’s impact is straightforward when annual returns are stable—say, at 9% annually—its effect is less straightforward when returns are volatile. The stock market, for example, is notoriously volatile. Stocks experience frequent price swings, and although the market increases about 10% annually on average, it also drops 30% every 12 years, on average.

To see how this bears on compound interest, imagine that you invest $1,000 in an S&P 500 index fund for two years, and the market increases by 10% in the first year and drops 10% the second year. In this case, you would have $1,100 after one year, but only $990 after two years, because 90% of $1,100 is $990. So, although the average market return was 0%, you would have actually lost money.

In other words, your losses also compound when the market dips. In practice, this means that your actual return on investment might not match the market’s average return. For instance, although the Dow Jones—a prominent US stock index—grew an average of 7.3% annually in the twentieth century, the compounding of market drops means that an investor in 1900 would’ve only earned about 5% annually by 2000.

To offset compounded losses in down markets, experts recommend various strategies, such as purchasing bonds or emphasizing stocks that pay dividends. These investments can provide financial protection even during bear markets (prolonged periods of declining stock prices).

Monte Carlo Simulation

Beyond historical data, Bogle also uses a Monte Carlo simulation—a statistical model predicting how likely different outcomes are—to determine the likelihood that actively managed mutual funds will outperform TIFs in the long term. Mirroring the historical data, this simulation predicts that only 2% of mutual funds will outperform index funds over a 50-year period.

(Shortform note: Experts have argued that Monte Carlo simulations have various advantages over relying on historical data. For example, while a historical outcome could have been a fluke, Monte Carlo simulations examine thousands of possibilities to determine which outcomes are anomalous and which are normal. Moreover, Monte Carlo simulations can tweak inputs to examine the likelihood of different outcomes given different initial conditions; historical data, by contrast, are limited to whichever initial conditions held true historically.)

Bogle’s Monte Carlo simulation relies on two key assumptions: First, mutual funds are volatile, meaning their performance relative to the market varies yearly; and second, mutual fund management will cost about 2% annually, while index fund management will cost 0.25%. Because TIFs actually cost about 0.1% annually, while mutual fund costs can run north of 2%, Bogle observes that this simulation gives mutual funds the benefit of the doubt.

Given these assumptions, the simulation predicts that after one year, 29% of actively managed mutual funds would beat index funds. However, after five years, only 15% of mutual funds would beat index funds, and after 50 years, only 2% of mutual funds would outperform index funds.

(Shortform note: Bogle’s projections are largely in line with recent data comparing actively managed mutual funds to the S&P 500 index; the S&P’s Indices Versus Active report (SPIVA)—a comprehensive report comparing actively managed funds with relevant market indices—found that only 21% of mutual funds outperformed the S&P 500 in 2021. Because traditional index funds essentially mirror the S&P 500, we can assume that 21% also represents the proportion of mutual funds that outperformed traditional index funds in 2021.)

Reversion to the Mean

According to Bogle, fewer mutual funds outperform index funds over time because of reversion to the mean—the statistical tendency for assets to converge to the average price over time. Because of reversion to the mean, mutual funds that initially outperform index funds are likely to see returns drop below index funds’ returns in the long run.

(Shortform note: Because index funds closely match market-average returns, as Bogle notes, they don’t suffer from reversion to the mean relative to the entire market. Rather, their returns remain nearly identical to market averages.)

For example, imagine that you flip a coin five times and it lands on heads four times—80% of the time. While this result is unsurprising in the short term, if you kept flipping the coin—say, 100 times—you’d expect the frequency to level out to about 50%.

Similarly, while a sizable percentage of mutual funds can beat index funds in the short term, few mutual funds can sustain this performance for the long term. Just like you shouldn’t expect a coin to keep landing on heads 80% of the time, the Monte Carlo simulation shows that you shouldn’t expect mutual funds to keep outperforming index funds in the long run.

Why We Fail to Grasp Reversion to the Mean

In Thinking, Fast and Slow, Daniel Kahneman illuminates one reason why many investors overlook reversion to the mean—to the detriment of their returns. He argues that our minds are predisposed to seek patterns, even amidst total randomness. For example, individuals playing roulette might commit the gambler’s fallacy, concluding that the ball is more likely to land on red after landing on black several times in a row. Although the distribution of reds versus blacks isn’t actually governed by any pattern, we attempt to find patterns nonetheless.

In a similar vein, when we witness a case of reversion to the mean—for instance, when a mutual fund thrives during one quarter and flounders during the next—Kahneman claims that we’re inclined to look for causal explanations of this variance. In fact, however, this variance is often the product of statistical randomness. Consequently, any attempts to explain particular instances of reversion to the mean will be unsuccessful.

With respect to investing, this pattern-seeking tendency explains why many investors select mutual funds on the basis of past performance. However, research indicates that mutual funds’ past performance is a poor indicator of future success; rather, mutual funds that outperform one year are likely to revert to the mean in the long term. So, failure to grasp reversion to the mean actually harms our investment strategies.

Future Projections

Beyond the Monte Carlo simulation, Bogle also makes specific projections about the future prospects of mutual funds versus index funds, from 2017-2027. Due to lower dividends, lower rate of gross domestic product (GDP) growth, and lower speculative returns in the current market conditions, he predicts the gap between index fund returns and mutual fund returns will increase in the future, with index funds increasingly outperforming mutual funds.

To make his predictions, Bogle analyzes the three factors that contribute to stock prices: dividends, earnings growth, and speculative returns. First, Bogle notes that in 2017, the average dividend yield—the ratio of a company’s dividends per share compared to its share price—was lower than the historical average. Indeed, the dividend yield in 2017 was 2%, far below the historical average of 4.4%. Consequently, if you owned stock in a company at $100 per share, you could expect $2 in annual dividends per share.

(Shortform note: Since Bogle published The Little Book of Common Sense Investing in 2017, the S&P 500’s average dividend yield has dropped further; as of 2023, it sits at 1.68%, though in 2021 it dropped as low as 1.29%. So, this particular aspect of stock returns is even lower than Bogle predicted thus far.)

Second, Bogle notes that earnings growth is correlated strongly with GDP—the total value of goods and services in a given society. And although the US’s GDP has historically increased about 6% annually, projections suggest it will increase at a slower rate of 4 to 5% annually from 2017-2027. To be cautious, Bogle assumes earnings growth will increase about 4% annually.

(Shortform note: Because of the Covid-19 pandemic, which saw businesses close and unemployment rise, the US GDP actually shrunk by 3.5% in 2020. Consequently, the Dow Jones dropped 37% between February 12th and March 23rd of that year. Despite this crash, however, the market quickly recovered, and the S&P 500 actually ended 2020 up 16%.)

Finally, Bogle agrees with Wall Street projections that P/Es—price-to-earnings ratios indicating how much investors would pay per dollar of earnings growth, which are the best proxy for speculative returns—will decrease from 23.7 in 2017 to about 20 in 2027. This decrease, he asserts, would lead to a 2% drop in speculative returns.

(Shortform note: Since Bogle’s predictions in 2017, P/Es have fluctuated dramatically. In December of 2020, for example, P/Es reached 39.9 for the S&P 500, nearly twice their level in 2017. In September of 2022, however, P/Es were at 19.2, just below Bogle’s prediction of 20 in 2027. So, it remains to be seen whether Bogle’s predictions will prove accurate.)

Considering these factors, Bogle predicts that the average market return will be about 4% in 2017 through 2027: 2% from dividends, 4% from earnings growth, and -2% from lower speculative returns. This falls well short of the market’s average return of 9.5% since 1900.

However, this 4% market return ignores two costs: inflation, and the costs of investing in mutual funds versus index funds. Inflation, Bogle assumes, will continue to rise about 2% annually, meaning the 4% market return will amount to 2% in real value. Additionally, Bogle assumes that actively managed mutual funds will cost 1.5% annually, while low-cost index funds cost about 0.1% annually.

(Shortform note: Bogle’s estimated costs of mutual funds vary slightly throughout The Little Book of Common Sense Investing. For example, when he sums the costs of expense ratios, sales loads, and portfolio turnovers, he concludes that mutual funds cost between 2-3% annually, as opposed to 1.5% here. To stay true to the book, we’ll stick with the estimates he uses in each respective section, even if they differ slightly.)

Consequently, we can actually expect mutual funds to return about 0.5% annually, and low-cost index funds to return about 1.9% annually. To recap:

Average market return: 4% → Adjusted for inflation: 2%

Mutual fund: (2% market return) - (1.5% annual costs) = 0.5% annual return

Index fund: (2% market return) - (0.1% annual costs) = 1.9% annual return

In other words, index funds will yield nearly four times greater annual returns than mutual funds from 2017 to 2027.

Looking Past Returns: Investing in Socially Responsible Index Funds

In his defense of traditional index funds, Bogle focuses largely on the superior returns that they deliver to investors. However, some investors have moral scruples about investing in broad index funds that include companies with dubious moral practices—Amazon, for example, has recently been criticized for allegedly inhumane working conditions.

In light of these concerns, so-called “socially responsible” mutual funds have grown popular.

Put simply, socially responsible funds seek to invest in companies that are environmentally, socially, and governmentally sound. Consequently, so-called “sin stocks”—such as stock in tobacco or gambling companies—are excluded from these funds.

As experts have observed, ethical investing has become more popular in the 21st century. Indeed, even Bogle’s own company, Vanguard, boasts various socially responsible index funds. So, for investors who aren’t only concerned with high returns, these ethical index funds are worth considering.

Bonds and Asset Allocation

While Bogle primarily discusses equity investments, he also discusses bonds—loans that investors pay to governments or corporations in exchange for interest over time. For example, if you purchase a $1,000 10-year Treasury bond at 3% interest, the Treasury agrees to pay you $30 annually the next 10 years, and also repay the $1,000 principal in 10 years.

Because their returns are less volatile than returns on equity, Bogle argues that bonds belong in your investment portfolio. In this section, we’ll discuss Bogle’s reasons for investing in bonds, why he favors bond index funds to bond mutual funds, and his suggested investment ratio of equity to bonds.

Bonds vs. Equity

To begin, Bogle concedes that equity investments, or stocks, have historically generated greater returns than bonds: Annual returns on bonds have been 5.3% since 1900, while annual returns on stocks have been 9.5%. Nonetheless, he claims you should invest in bonds for three reasons: Bonds can beat stocks over short stretches; bonds provide protection during market drops; and bond yields are still greater than current dividend yields.

(Shortform note: Bonds have existed far longer than stocks have—in fact, the first recorded bond dates to 2400 B.C. in Mesopotamia, guaranteeing the payment of grain by a set time. Moreover, in the late 17th century, the Bank of England created the world’s first government bond to fund war against France, a trend that continued into US history with Liberty Bonds helping to finance the American effort in World War I.)

First, Bogle observes that from 1900 to 2017, bonds outperformed stocks in 42 of those years. So, in years when the stock market’s returns are below average, bonds can offer a better return on investment.

(Shortform note: According to some experts, bonds could be a better investment than stocks in 2023. In particular, they argue that we haven’t fully exited the equity bear market, and companies’ profit increases are unsustainable. Consequently, bonds might be the safer—and more lucrative—investment in 2023.)

Second, because bond returns are largely fixed by bond interest rates, Bogle notes that they’re much less volatile than stocks. For example, while nobody can guarantee Apple’s stock returns from year to year, a one-year Treasury bond at 4% interest effectively guarantees a 4% return on your investment. Consequently, bonds can stabilize your investment portfolio amidst the stock market’s ebbs and flows.

(Shortform note: Although bonds are less volatile than stocks, there’s a risk that your bond issuer will default and fail to make your scheduled repayments. In the case of government bonds, this can occur when governments lack the tax revenue to repay bond owners, while corporations can default on bonds when they suffer from unexpected revenue dips.)

Finally, Bogle points out that in 2017, bond yields (the annual return on bonds relative to their price) remained higher than stocks’ dividend yields: The average bond yield was 3.1%, while the average dividend yield was 2.0%. So, bonds can generate a greater flow of liquid income than stocks.

(Shortform note: Bond yields and dividend yields also have different tax implications. For example, although municipal bonds issued by local and state governments are exempt from federal income tax, dividends are typically subject to corporate gains taxes of 15%.)

Bond Mutual Funds vs. Bond Index Funds

Just like you can purchase equity via actively managed mutual funds and index funds, you can also purchase bonds via bond mutual funds and bond index funds. In the case of bond mutual funds, managers actively purchase and sell bonds using fund assets, whereas bond index funds purchase bonds that reflect certain bond indices. Because bond index funds are more cost-efficient, Bogle argues that they deliver better returns than bond mutual funds.

To defend this claim, Bogle examines the two primary types of bond funds—government and corporate bonds—in addition to three maturity segments—short-term, intermediate-term, and long-term. Further, he uses SPIVA to compare bond mutual funds in these six cross-sections to similar bond index funds.

(Shortform note: These terms have fixed lengths: Short-term bond funds mature in one to five years, intermediate-term bond funds mature in five to 10 years, and long-term bond funds mature in more than 10 years. Although long-term bond funds can offer the highest return, they’re also susceptible to long-term fluctuations in interest rates, making them more volatile.)

From 2001 to 2016, SPIVA demonstrates that 85% of bond indices outperformed similar bond mutual funds. In particular, long-term bond indices outperformed 97% of long-term bond mutual funds, both in government and corporate segments.

(Shortform note: According to SPIVA’s 2022 mid-year report, this trend has continued: Considering risk-adjusted returns, 96% of bond indices outperformed similar government bond funds from 2007 to 2022. General corporate grade funds fared slightly better, but 72% of bond indices still outperformed similar corporate grade funds over the same period.)

According to Bogle, bond index funds are a better investment than bond mutual funds for the same reason that equity index funds outperform equity mutual funds: They have lower expense ratios. The average bond index fund’s expense ratio was 0.1% annually, while the average bond mutual fund’s expense ratio was 0.75% annually.

(Shortform note: Bond funds’ expense ratios have steadily decreased since 2000 in the US, both for bond mutual funds and index funds. According to one report, the average expense ratio of actively managed bond funds in 2021 dropped to 0.46%, compared to 0.06% for bond index funds. So, Bogle’s data are dated.)

The Ratio of Equity to Bonds

Beyond arguing that you should invest in bonds, Bogle also considers the ideal ratio of equity to bonds in your portfolio. He concludes that the ideal ratio of equity to bonds depends on your financial position and your personal degree of risk aversion.

To start, Bogle cites Benjamin Graham’s advice in The Intelligent Investor that your portfolio should be split 50-50 between stocks and bonds. Although Bogle considers this a good starting point, he argues that it’s too rigid: Certain investors should incur more risk, investing more in stocks, while other investors should incur less risk, investing more in bonds.

(Shortform note: To further diversify your portfolio, some experts recommend alternative investments beyond just stocks and bonds. For example, investing in real estate can provide additional income and is generally less volatile than the stock market. Moreover, you can consider investing in gold, which is fairly insulated from the stock market’s ebbs and flows. Such investments can provide further protection against dips in the stock and bond markets.)

Bogle argues that your financial position affects your ability to take risks. For example, those with financial liabilities looming in the near future—like purchasing a home, or paying to raise a child—should be less risky with their investments. After all, if they’ve only invested in stocks, then they might not be able to cover these liabilities if the market crashes. By contrast, investors with fewer liabilities can afford a riskier allocation of stocks to bonds.

Beyond financial position, Bogle argues that your personal preferences for risk aversion should affect your asset allocation. For example, if the ebbs and flows of the market cause you extreme stress about potentially losing money, then your portfolio should contain fewer stocks and more bonds. On the other hand, investors comfortable with greater risk to earn higher returns should have a higher ratio of stocks to bonds in their portfolios.

(Shortform note: One reason why many of us struggle to cope with the market’s fluctuations is that we suffer from loss aversion—the notion that the pain of losing is psychologically stronger than the joy of winning. For example, the pain most investors experience when their portfolio dips by 2% is stronger than the happiness they experience when their portfolio rises by 2%. However, because loss aversion doesn’t maximize expected utility, some have argued that it’s irrational and should be suppressed.)

More generally, Bogle advises that your ratio of stocks to bonds should be as high as your financial position and risk aversion allows. For example, he counsels an 80-20 split of stocks to bonds for young investors with low risk aversion who want to grow their wealth. Conversely, for retirees whose portfolios fund their retirement, Bogle counsels a 25-75 split. Because retirees are more concerned with short-term stability than long-term growth, they benefit from the stability of bonds rather than stocks.

(Shortform note: Because stocks provide greater long-term returns than bonds, it’s tempting to think that young investors should invest exclusively in stocks. However, other experts caution that this practice fails to consider investor psychology: Because investors are often inclined to sell when stocks are down, investing only in stocks can yield unwise decisions when markets drop. Conversely, owning bonds provides psychological comfort that minimizes the risk of selling stocks when they drop.)