Faster is not always better. So says an energetic 83-year-old Jack Bogle, the Vanguard Group founder who spent his career promoting long-term investing and striving to protect the individual shareholder.
In 1951, he says, 15% of all stocks changed hands in a given year. Today, annual turnover stands at 250%. This means that the average stock changes hands two and a half times each year, and the average holding period is less than five months. We went from being investors that hold shares to speculators that flip stocks to make short-term profits. For those who find it hard to imagine how this benefits anyone but middle men, you’re not alone.
Bogle has a name for this tendency. He calls it “short-termism.”
“We must seek an investment sector in which a culture of stewardship and longer-term thinking dominates a culture of speculation, short-term trading, salesmanship, and marketing, however necessary they may be in moderate doses,” he writes in his new book, The Clash of the Cultures: Investment vs. Speculation,
So how did our financial industry become dominated by short-term thinking? The major shift in investment ownership that Bogle helped foster through Vanguard Group’s index funds is partly to blame.
As investing has become democratized, less-educated investors are increasingly influenced by savvy marketing campaigns. Behavioral science studies conclude that individuals, by nature, make for poor investors. Funds with the highest historical returns receive the most new investment dollars despite the warning label that “past performance is no predictor of future results.” This buy-the-winners behavior encourages financial institutions to spend the most marketing dollars on those funds in high-performing sectors, instead of steering clients to a more rational balanced portfolio.
Bogle illustrates how that obsession with short-term performance has a trickle-down influence on corporate management, as well. A great amount of energy is wasted on managing short-term earnings guidance that can sap the long-term productivity of a company. Bogle points to creative accounting strategies like stock buybacks, premature recognition of revenues and “cookie jar” reserves to project steady short-term growth. Executives put too much attention on the next quarter and too little on the next 10 years.
Although both retail investors and money managers are to blame for this short-termism, Bogle directs his criticism toward his peers. He argues that too many money managers are happy to market to the untamed emotions of retail investors rather than act with fiduciary care. In a moralistic tone that only those who have gained the respect of a tribal elder can get away with, Bogle shamelessly scolds his peers saying, “Enough!”
Bogle offers several solutions to limit the influence of short-termism. One idea is a tax on very short-term capital gains that would be paid even for securities held in tax-free or tax-deferred accounts. Alternatively, he suggests a small transaction tax that would affect both buyer and seller.
Such a transaction tax would limit high-frequency trading done by computers, often with no human input. Lightning-fast algorithms identify incoming trades before they are matched with a buyer or seller. High-frequency traders only extract value from the markets. Sure, the spreads tighten, but whatever value a buyer receives is lost by the seller. This is the polar opposite of Bogle’s buy-and-hold mentality, but surprisingly, he seems to let high-frequency institutional traders pass with little more than a question on the value of their services.
Bogle also calls for individual investors to “wake up” and demand more from the industry he is part of. “Investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.” To help investors, Bogle has created a rubric to rank investment management companies by their level of stewardship. This Stewardship Quotient includes factors like the amount of money they spend on marketing and the level of their fees.
I was most interested in the Stewardship Quotient ranking for the corporate structure of investment funds. A mutual company, gets the highest score in this category because it is owned by its shareholders. Privately held companies are ranked next best, then publicly held companies, and finally investment management companies owned by financial conglomerates get the lowest score in this category. This concept matches my experience that funds owned by large banks are typically laggards. This question about structure offers great insight into the likelihood that management will seek the best interests of shareholders in the future.
To combat short-termism, Bogle also calls for a federal fiduciary standard that will require all fund companies to put the interests of their clients first. Applying a fiduciary standard to fund companies would open them up to litigation if shareholders can prove that their business practices fail to seek the investors’ best interests. On this issue, I disagree with Bogle. Forcing investment companies to “behave” ignores the conflict of interest between shareholders returns and their own company profits. I have more trust in individual investors identifying fund companies that have a history of acting in good faith than I do in a government-regulated behavior. For those investors who feel overwhelmed by this type of due diligence, we believe it is important to work with a financial adviser who upholds a fiduciary standard and avoids any conflicts of interests between fund recommendations and their own compensation.
Despite our small disagreements, savvy individual investors should read Bogle’s book and heed his advice. When it comes to restoring law and order of the financial markets, no one deserves the sheriff’s badge more than Bogle.
Part 1 of this series can be found here.