The most effective way to accumulate wealth is to keep pace with the annual returns offered by the financial markets and then profit from a long-term investment portfolio.

Just as apples fall to the ground, the frenzied sectors in the stock market will eventually revert to the mean level—this year's excessive gains imply potential declines next year, and vice versa. At the same time, even the best returns will eventually revert to a normal level—good harvests today imply bad harvests next year, and vice versa. Newton's law of universal gravitation and the mean reversion applicable to various financial markets will help us thoughtfully formulate wise investment strategies, which are then executed with simple common sense.

John Bogle, known as the "father of index funds," founded the mutual fund company Vanguard Group in 1974. His book "Bogle on Investing: The First 50 Years" was published in 2001, elaborating on the great financial ideas Bogle gained over his 50-year investment journey. The fundamental idea is that due to the enormous investment friction costs, the possibility of long-term gains is very low, perhaps less than 1 in 30. Therefore, the most effective way to accumulate wealth is to keep pace with the annual returns offered by the financial markets and then profit from a long-term investment portfolio.

Advertisement

Complex strategies lead to failure. In the last 20 years of the 20th century, the U.S. stock market set a record high for nearly 200 years, with an average annual growth rate of 17.7%, and stock prices doubled every four years. The rapid growth was determined by the interaction of only two factors: one is investment returns, composed of dividend yields and earnings growth rates; the other is speculative returns, generated by stock price movements.

Bogle likens investment returns and speculative returns to bagels and doughnuts, respectively. Bagels are hard, difficult to digest, while doughnuts are soft, sweet, and fattening. Bagel-style investment returns are efficient; in a long-term bull market, corporate profits and dividends are the basic returns, which are also the result of the efficient long-term prosperity of the U.S. resilient economy. Doughnut-style speculative returns represent the public's expectations for stock price fluctuations, ranging from sweet optimism to sour pessimism. Price-to-earnings ratios can be high or low, reflecting estimates of future economic prospects.

Bagel-style mutual funds are resilient, invest for the long term, and have low operating costs. Doughnut-style mutual funds search everywhere for market growth points, with a turnover rate of 90%, which is merely short-term speculation rather than long-term investment. Most funds fail due to excessive cost expenditures, while some funds temporarily set their expenditure costs very low, which is a lure.

If the bagel and doughnut investment theory is correct, then the speculative funds that stimulated the stock market rise between 1980 and 2000 were at a disadvantage, which was indeed the case. Because if the stock market return is only 5.2%, the cost of speculative funds would reach 2.5%, consuming almost half of the returns, with the final return being only 2.7%. However, the value of investment funds does not shrink with the market's adverse environment, and the minimum return can still be maintained at 5%. Practice has proven that those who are willing to invest are more likely to succeed than those who invest reluctantly.

The biggest secret to investment success is that there is no secret. Long-term experience and judgment have told Bogle that complex investment strategies will ultimately lead to failure. Charlie Munger once pointed out that if the basic asset investment in the stock market is too complex, it will bring huge cost expenditures, leading to low returns. If the market return is 5% and the total cost expenditure is 3%, the net profit is only left with 2%. If this analysis is extended to a 10-year period, this wealth will shrink by 26%, by 46% after 20 years, and by 60% after 30 years.

Fund managers generally use complex investment strategies. They have the authority to decide on investment strategies, evaluate individual stocks, determine when the price will fall in the future, and adjust the investment asset portfolio accordingly. However, all these complex investment strategies have led to failed investment results. In the first 15 years of 2001, out of 287 funds, only 42 funds successfully survived, with 14% of the funds' returns exceeding the returns of the entire market's Wilshire 5000 Equity Index, while the other 245 funds all went bankrupt. Moreover, only the top 10 funds (i.e., 3.44%) achieved what experts call "a statistically significant number," a number that fully proves the huge fluctuations. The losers always hope to choose funds that can greatly exceed the average market returns, hoping to find funds that can always obtain high returns, but the fact is that its past investment returns have proven that it has no high value in the future. Therefore, complex investment is meaningless.Simple investing refers to a buy-and-hold investment strategy. For Bogle, it means investing through index funds. The reason it is considered simple is that it represents an investment in the entire stock market and is a diversified investment strategy that encompasses all publicly traded companies in the United States. It essentially avoids high-cost portfolio turnover and is very cost-effective. If one observes the long-term investment market, index funds play a decisive role in successful investing. Bogle has always been creating an investment that serves long-term investors, buying and holding, being a hedgehog that knows one big thing rather than a fox that knows many things, introducing simplicity rather than complexity into the investment field.

Most of the time, most active capital managers will not be able to beat the market. Because to a large extent, the fund is the market. Therefore, on average, even if they have no costs, operate with the highest efficiency, and do not generate any tax burdens, they cannot possibly do better because they adopt the "fox strategy."

Foxes are known for their cleverness, cunning, and shrewdness, and most funds, including other financial institutions, are similar to the nature of foxes. These "foxes" often try hard to show that they have very attractive backgrounds, such as excellent educational backgrounds, years of industry experience, skilled operational skills, and even some speculative tricks. They adjust their investment portfolios on an hourly basis, continuously monitor the investment portfolios they hold, and often change the stocks they hold at a surprising frequency.

The strategy of most successful investors in the United States is an example of long-term investment. Buffett buys shares of a few companies and holds them for a long time, but ignores the noise created by what he calls "Mr. Market," who walks by him every day and offers different prices for the company stocks in his investment portfolio. However, cunning fund managers are exactly the opposite; they quickly trade stocks of different companies in their investment portfolios at a turnover rate of 50%-200% per year. They rarely pay attention to the intrinsic value of a company but react quickly to the prices set by Mr. Market at every moment.

Some fund foxes hope to secretly sell stocks when market prices rise and then buy them back when market prices fall. However, this low-buy-high-sell strategy only works to a limited extent - and only for a relatively small number of funds - because the costs they incur are so high that they consume any increased returns. This is the fundamental reason why most active capital managers cannot beat the market and ultimately fail, and it is also the only outcome of their adoption of the fox strategy.

Dimensions on the Investment Coordinate Graph

There are four important dimensions on the investment coordinate graph. Return is the first and most important dimension, but we cannot control returns. Stock market returns in a short period in the future are completely unpredictable. Unless we can understand the market more than we do now 25 years ago, long-term stock market investment returns are also unpredictable. But we can control the other three basic determinants of investment: time, risk, and cost.

Time can accelerate the growth of investment returns. For a certain asset, through the application of the time dimension, the value of financial assets will be multiplied. The Book of Proverbs has long warned: "The true competition is not a race of speed, not a contest of strength, neither is it the sustenance of knowledge, nor the wealth of understanding, nor the favor of skilled craftsmen, but time and the opportunities they encounter."

Stock investments have a high short-term risk, but time can correct the risk fluctuations. Bogle calls it the "portfolio investment correction chart." Standard deviation is a measure of the fluctuation range of the actual return rate of stocks. Measuring the risk of stock investments with standard deviation can reduce the asset value by 60% (from 18.1% to 7.5%), which is just the change from the first year to the fifth year. After 10 years, 75% of the risk will disappear. Risk will continue to decrease, but the greatest reduction in risk is in the first 10 years.

The significant fluctuations in the securities market imply economic risks inherent in investment behavior. Since the expected returns generated by investments are uncertain, the greater the uncertainty of the market, the greater the investment risk, and the greater the chance of investment loss for investors. Risk will always be with us. Especially when the return rate reaches its peak, the risk is also the greatest.The securities market is a notorious arbitrage market, arbitraging between past performance and future expectations. The problem lies in the fact that future expectations do not align with future realities. Sometimes hope dominates, sometimes greed takes over, and sometimes fear prevails, with no new paradigm in sight. Hope, greed, and fear constitute the eternity of the market. Traditional market wisdom has been encapsulated by the "Efficient Market Hypothesis" theory. The Efficient Market Hypothesis posits that since financial markets encompass all the wisdom of all investors, they must be efficient, always perfectly priced. Bogle disagrees with this. It fails to explain why the market was optimally priced on August 31, 1987, January 2, 1973, and September 8, 1929, yet still experienced such massive market value plunges, with declines ranging from 35% to 85%.

John Maynard Keynes once pointed out the cause of securities market fluctuations in his work "The General Theory of Employment, Interest, and Money": the net value of assets invested by individual investors continues to increase, and due to the lack of professional investment knowledge among individual investors, they lack precise estimation of investments; short-term changes in business operations can have an actual excessive impact on the securities market; the traditional valuation method for stocks is based on the psychological expectations of a large number of individual investors lacking professional knowledge, and a valuation method based on the expected returns of securities as an independent element may have a violent impact on it; even professionals and experts cannot influence the public opinion in the securities market, so they try to predict changes in public stock prices. Therefore, the securities market is referred to as "the battlefield of wisdom to predict changes in the basis of valuation in the coming months, rather than predicting the returns generated by investments in the coming years."

Time can amplify the impact of costs, costs reduce returns, and do so gradually without anticipation. The longer the time, the more costs increase. Assuming the long-term average annual return of the stock market is 10%, and the average annual return of mutual funds is 8%, then its net cost rate is 2%. Low cost can reduce the impact on returns, and the importance of low cost becomes more prominent over time.

Peter Bernstein tells us in his book "Capital Ideas" that in 1908, French economist Louis Bachelier presented a clear and harsh fact in his paper: "The mathematical expectation of speculative results is zero." However, Bachelier was taken advantage of by many casino managers in the market because he neglected investment costs.

James Gleick, in "Chaos: Making a New Science," uses relevant scientific principles to explain the "Noah Effect": "The Noah Effect is automatic interruption: when a certain quantity begins to change, it changes at a rather fast pace. If the price of a stock falls from $60 to $10, and at some point during this process it is sold at $50, then this stock market strategy is doomed to fail."

From this perspective, buying stocks is a dangerous game. When stock prices are high, everyone tries to buy; on the contrary, when stock prices fall, it seems even harder to sell. It is clear that the stock market crash has led a group of "rational" investors to stay away from the stock market. "If you can't stand the heat of the kitchen, then stay out of it." Bogle strongly agrees. In his view, rational and patient long-term investors should continue to wait for market conditions to emerge.

Although stock prices show transitional, short-term, and even violent fluctuations, in the long run, they are ultimately determined by two fundamental factors: the book value of stocks and dividends, both of which grow at a fairly stable rate in the long term. The real rate of return and dividend rate of American businesses over the past two centuries have been close to 7%, almost equal to the actual return rate of 7% for stock prices. Therefore, in the long term, it is the fundamentals of investment, not market value, that determine everything. However, in the short term, fundamentals usually give way to the huge noise of speculation—the price-to-earnings ratio. The impact of this noise can last for a long time.

Bogle also noted that between 1966 and 1987, the dividends of the S&P 500 index increased by 320%, the reset book value increased by 750%, and the price increased by 370%. That is to say, the average annual growth rate of dividends at 5.5% supported the average annual growth rate of stock prices at 6% and the average annual growth rate of stock book value at 8% over nearly 30 years. (This study comes from the 1987 annual report of Vanguard Fund. Its research began in 1960.) If an investor started holding stocks in 1987 and continued to hold them through the stock market crash and its aftermath until 2001, the returns were also considerable. For example, the S&P 500 index achieved a return of 17% in just 19 months. This is a good return for those lucky or prescient investors. However, no investor is lucky enough to liquidate their stocks at the high point in August 1987 and buy them back at the end of that year. Moreover, investors cannot gamble their future returns on luck alone.

Physics in Investing

Bogle has a unique understanding of the principle of mean reversion, and he does not simply regard it as a contrarian strategy as some people do. He believes that this theoretical principle from academia is fully applicable in the actual financial market, and both the relative and absolute returns of the entire stock market have proven this law.Mean reversion represents a kind of "law of universal gravitation" in the financial markets, as returns often magically revert to some mean level. Do investors have to invest in certain sectors of the stock market that perform well over the long term to achieve excess returns? No, there is no lasting systematic bias that supports a particular sector. Even over long periods, mean reversion will cause each sector to take turns in the limelight, albeit with varying durations for each.

The traditional investment philosophy holds that value investing is superior to growth investing, largely because few have truly studied investment history. Market records show that between 1937 and 1968, growth investing strategies were completely dominant, emerging as clear winners. At that time, the returns from investing in value stocks were only 62% of those from growth stocks. It wasn't until around 1976 that value stocks began a significant turnaround, almost entirely making up for the early shortfall in returns. Then, growth stocks took the lead again from 1977 to 1980, while value stocks outperformed from 1981 to 1997, and by 1998, growth stocks began to shine once more. Over this entire 60-year cyclical fluctuation, the compound total return of growth stocks was 11.7%, while that of value stocks was 11.5%, a negligible difference, with both sides effectively tying. This is evidence of mean reversion.

It is commonly believed that the returns of small-cap stocks will always exceed those of large-cap stocks, seemingly an unbreakable investment myth. In reality, the high returns of small-cap stocks are also intermittent. Over the 39 years from 1925 to 1964, the returns of large-cap and small-cap stocks were identical. In the following four years, the returns of small-cap stocks were more than double those of large-cap stocks, but in the subsequent five years, the advantage of small-cap stocks was completely lost. By 1973, the returns of small-cap stocks and large-cap stocks were roughly the same over nearly half a century. The reputation of small-cap stocks for high returns was mainly established during the 10 years from 1973 to 1983. Then, mean reversion began to take effect for the fifth time, and after 1983, it was the turn of large-cap stocks to have high returns. Over this entire period, the compound annual return of small-cap stocks was 12.7%, while that of large-cap stocks was 11.0%. This difference led to the terminal value of small-cap stocks being three times that of large-cap stocks. Bogle believes that without the brief upturn of small-cap stocks between 1973 and 1983, the annual return of large-cap stocks would have been 11.1% and that of small-cap stocks 10.4%. In any case, the relationship between the two, even if not entirely controlled by the law of mean reversion, is also influenced by the gravitational pull of the market.

It can be seen that Newton's third law, "For every action, there is an equal and opposite reaction," may be more suitable for interpreting the reality of financial markets. Although mean reversion may sometimes take decades to take effect, it is a historically objective principle that continues to exist. Even the most intelligent investors, if they ignore it, may face significant risks because it will persist. Therefore, Bogle says he always bets on the law of mean reversion. Peter Lynch also elaborates on a similar view in his book "One Up On Wall Street," and he is one of the investors who is best at applying this law.

Academic research on mean reversion, that is, historical statistical data, shows that mean reversion has always been effective and is almost reflected in every aspect of investment. If we theoretically accept this point, we should appropriately diversify our assets. For example, if there is a longer time before retirement (15-40 years), one should hold more stocks (i.e., 90% stocks and 10% bonds or cash), while more conservative investors with a shorter investment horizon (1-15 years) and relatively less accumulated capital may only need a 35/65 split. This balanced strategy has been effective for centuries, not because it can provide the highest returns, but because it provides more stable long-term returns without adding extra short-term risks. Bogle prefers index funds that track the entire U.S. stock market. These funds, because their portfolios include a variety of stocks such as large-cap, mid-cap, and small-cap, ultimately make the best response to the mean reversion of the stock market.

Just as apples fall to the ground, the crazy sectors in the stock market will eventually fall to the mean level - if they rise too much this year, it means they may fall next year, and vice versa. At the same time, even the best returns will eventually fall to a normal level - a good harvest today means a bad harvest next year, and vice versa. Newton's law of universal gravitation and the mean reversion applicable to various financial markets will help us to thoughtfully formulate wise investment strategies and then execute them with simple common sense. When we accumulate capital, we must benefit from applying this concept.

Today, the Vanguard Group manages a total asset amount of $7.8 trillion, becoming one of the world's largest public fund management companies, with more than 30 million investors, achieving remarkable success. This great process has lasted for 50 years to date. As Bogle said, his financial ideas let us truly see that "active investment managers, whether ringing the bells of heaven or hell, are calling for death, while index funds are not."