Editor's Note: John C. Bogle is founder and former chief executive of the Vanguard Group, a major investment management company. His newest book, "Enough, True Measures of Money, Business, and Life," addresses many of the themes in this commentary. Bogle has said that virtually all his investments are in Vanguard funds. The views expressed in this article do not necessarily reflect the opinions of Vanguard's present management.
John Bogle says Wall Street and regulators broke faith with investors, causing the current crisis.
(CNN) -- "Investing is an act of faith." That simple declarative sentence begins my 1999 book, "Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor."
I included in that definition: 1) faith that our corporate stewards "will generate high rates of return on our investments"; 2) faith that the "success of the U.S. economy and the nation's financial markets will continue in the future"; and 3) faith that our professional money managers "will be vigilant stewards of the assets we entrust to them."
Paradoxically, "Common Sense" was published only months before the stock market reached its all-time high, followed in turn by a 50 percent collapse in 2000-2002, led by the stocks of the so-called "New Economy." That crash, in turn, was followed by a smart rally, and then by another market collapse in 2007-2008 of more than 40 percent from high to low, a reflection of the global financial crisis in which we find ourselves today.
So of course investors have lost faith in what we loosely call "Wall Street," a confederation of investment banks and brokers, players in the financial markets, institutional money managers and corporate executives.
While it is often said that "victory has a thousand fathers, but defeat is an orphan," the defeat suffered by investors in the present devastating financial crisis seems to have, figuratively speaking, a thousand fathers.
Fathers of the crisis
There is plenty of responsibility to spread around: The Federal Reserve and Alan Greenspan, keeping interest rates too low for too long after the 2000-2002 crash, and failing to impose discipline on mortgage bankers; our banks and investment banks, which designed and sold trillions of dollars worth of toxic mortgage-backed bonds and tens of trillions of dollars of derivatives (largely credit default swaps).
These institutions also brought us "securitization," severing the traditional link between lender and borrower. With that change, the incentive to demand the credit-worthiness of those who borrow almost vanished.
Our market regulators, too, have a lot to answer for: The Securities & Exchange Commission was almost apathetic in its failure to recognize what was happening in the capital markets. The Commodity Futures Trading Commission allowed the trading and valuation of derivatives to proceed opaquely, without demanding the sunlight of full disclosure.
And let's not forget Congress, which passed responsibility for regulation of the derivatives market to the CFTC almost as an afterthought. Congress allowed -- indeed encouraged -- risk-taking by our government-sponsored (now government-owned) enterprises Fannie Mae and Freddie Mac to expand far beyond the capacity of their capital, and gutted the Glass-Steagall Act, which had separated traditional banking and investment banking.
Our professional security analysts also have much to answer for, especially in their almost universal failure to recognize the huge credit risks assumed by the new breed of bankers and investment bankers, far more interested in earnings growth for their institutions than in the sanctity of their balance sheets; as do our credit rating agencies, for bestowing AAA ratings on securitized loans in return for enormous fees -- paid in return by the issuers. (It's called "conflict of interest.")
Yes, there's plenty of blame to go around, finally rooted in the American citizenry at large with our insatiable demand for "more" and our growing appetite for self-indulgence rather than the well-being of our system.
"This time's different"
The loss of faith by investors, hardly surprisingly, has been reflected in the stock market's plunge, the tenth bear market (defined as a decline of at least 20 percent) of my 57 years in finance. Naturally, this one is different, because history never repeats itself exactly (even though, as it is said, "history rhymes"). Here are three major differences:
(1) This is the first bear market of my life (well, not quite, I was born in 1929) in which short-term speculation, not long-term investing, called the tune. Investors -- holding shares of businesses for the long pull -- are now a vanishing breed. They have been largely replaced by speculators -- betting on whether the prices of stocks and derivatives would rise or fall during the next hour or day or month.
(2) This bear market was preceded by an era of rife credit availability, too often easily accessed by borrowers of dubious creditworthiness. Real (after inflation) interest rates on U.S. Treasury bills was negative for four full years, meaning that credit was arguably free. So why not borrow to one's full capacity, or even beyond?
(3) This is the first bear market I can recall in which the distress in the financial markets so profoundly affected the real economy of goods and services, and the lives of ordinary people, especially those who had no way of participating in the boom, but are paying the penalty for the market's excesses in the bust that followed.
So what is an investor to do? In the midst of a crisis of faith, it might be helpful to focus on some of the things that we know to be true:
(1) Stocks represent a better value today than they did just a few months ago. If you have the ability to ride out the current market storms, and continue to make regular contributions to your savings plans, you should expect to be rewarded with higher returns over the long term than we might have expected a year ago.
(2) The vast majority of investors are best served by buying and holding a broadly diversified portfolio, owning a mix of stocks and bonds. Tilting too far, toward either extreme caution or unnecessary risk, can cause even the most rational investors to abandon their strategy at precisely the wrong time. An asset allocation that balances both your needs and ability to take risk will help you sleep soundly, and best enable you to reach your long-term goals.
(3) Costs matter. Wise investors will always seek to pare their investment expenses to the bare-bones minimum, thereby increasing their share of whatever returns the stock and bond markets provide.
A $1,000 investment in a total stock market index fund charging 0.2 percent in expenses and earning 7.8 percent annually would be worth $9,500 after 30 years. In the average equity fund, burdened by expenses of 2.5 percent, the total would be only $5,000, with nearly 50 percent of the market's long-term return consumed by Wall Street fees.
Minimizing expenses allows you to benefit from the majesty of compounding returns, and shields you from the tyranny of compounding costs.
All crises are accompanied by opportunity, and I pray that our nation's leaders use the current crisis to finally address the ills of our financial system. (A good first step in that direction would be the creation of a centralized regulatory framework that, in part, finally establishes federal oversight of our vast derivatives markets.)
But as badly as our faith has been shaken in the past few months, and as much needs to be done to restore confidence, I remain resolute in one important area: my faith in the strength and resilience of the American economy.
Our economy has survived -- even thrived -- through two world wars, a Great Depression, recessions, terrorist attacks and numerous other wars, crises and scandals. I have little doubt that our economy will eventually work through these current troubles, and resume its steady march upward, slowly enriching, along the way, those investors who had the wisdom and ability to stay the course.
The opinions expressed in this commentary are solely those of John Bogle.