Part I

INVESTMENT STRATEGIES FOR THE INTELLIGENT INVESTOR

IN MY MISSION to bring the simplicity of investing to American families—the wisdom of focusing on the long term, the futility of trying to outguess the market, and the powerful burden that the high cost of investing places on investment success— I've constantly strived to translate abstract financial ideas into down-to-earth terms to which ordinary human beings can relate. Perhaps my efforts to do so will be obvious in the opening three chapters of this book. Chapter 1, “Investing in the New Millennium: The Bagel and the Doughnut,” was inspired by an essay by New York Times journalist William Safire. While he was writing about, well, bagels and doughnuts, I use these baked goods as an analogy for both the stock market (the hard-crusted nutrition of corporate earnings and dividends versus the tempting but transitory sweetness of price-earnings multiples) and the mutual fund industry (the solid, patient index fund versus the frenetic, but finally undernourishing, actively managed mutual fund).

The next two chapters pursue the same theme in different ways, with “The Clash of the Cultures in Investing” describing the disappointing records achieved by four groups of moneymanagers and financial advisers following traditional active strategies. These approaches face long odds, I conclude, so gamblers should use them only for their “funny money account.” I contrast them with passive strategies such as indexing, my preferred choice for the “serious money account.” Perhaps unsurprisingly, I recommend that no more than 5% of the investor's assets be allocated to funny money. Next, in “Equity Fund Selection: The Needle or the Haystack,” I rely on Cervantes’ timeless warning against looking for a needle in a haystack. The odds against finding the winning mutual fund in the stock market haystack are demonstrably long, so I conclude: Don't bother looking. Just buy the all-market haystack.

In these heady market days at the turn of the century, I thought it would prove wise—perhaps even prescient—to remind investors about the importance of risk and risk control, the subject of Chapter 4. When the day comes that the stock market falls flat on its face, as it does periodically, investors will need to keep their perspective. So, in Chapter 5 I present a speech delivered in 1988, with the stock market still pale, sickly, and, well, hungover, after the abrupt 35% market decline that took place in September–October 1987. My title, “Buy Stocks? No Way!,” was a quotation from a cover story in Time magazine in September 1988 that warned investors to stay away from the stock market: “. . . one of the sleaziest enterprises in the world . . . a dangerous game . . . a crapshoot.” Even then I was beating the index fund drum, urging “low cost, unmanaged index-oriented investing as a core portion of the equity portfolios of most investors.” Ever the contrarian, I took the Time story as a sign that investors “should avoid liquidating equity holdings at prices that reflect fear and pessimism, (hold) common stocks as the centerpiece of their financial programs,” and stay the course. It may well be that not too far down the road, the long bull market of 1982–2000 will face its ownWaterloo, and I'll have to dust off that perspective and once again air some consummate good sense. Who really knows?

I've also talked often to professional audiences about, not only the remarkable value of stock market indexing, but the critical need for the managers and marketers of index funds to face up to the limitations of indexing and the risks in dragging this inherently simple concept too far from its roots: Owning a passive portfolio that represents the entire U.S. stock market. The speeches in Chapters 6 and 7, delivered at The Superbowl of Indexing in 1998 and 1999, respectively, present some of these issues. The former talk challenges the essay published by a deservedly respected investment banking firm entitled “The Death Rattle of Indexing” and concludes, Macbeth-like, that “the knell that summons thee to heaven or hell” was in fact tolling for the death, not of indexing, but of active managers. The latter talk celebrates the growth of the assets of Vanguard's 500 Index Fund to $100 billion, a milestone that serves to mark “the moment that heresy (the idea of market indexing) finally turned to dogma.” Even so, I express concerns about overmarketing the index concept, cautioning that “there is a difference between designing a product that sells, and creating an investment that serves.”

Chapters 8 and 9, both dating back nearly a decade, presentmy ideas on the successful selection of equity funds and bond funds. In both cases, I stress the need for careful analysis of past returns and risks, consistency of investment policies, emphasis on high quality and broad diversification, avoidance of strategic gimmickry, and focus on funds with the lowest sales charges (or, even better, none) and the lowestmanagement fees and operating expenses. Most of these ideas date to my Princeton thesis.