Earlier this year, Sound Investing interviewed Vanguard founder John Bogle, who isn’t afraid to say what he thinks and who has always sided with individual investors over Wall Street. In an edited transcript of the interview, Bogle tells why he doesn’t think Wall Street is doing a good job for investors and what he thinks about Treasuries as a safety net against inflation.

TOM COCK: If your most passionate interest is space exploration, then you probably want to talk with Neil Armstrong, the first guy on the moon.  And if you want to get to the heart of investing in mutual funds, the person you'd want to talk to is our guest today, John Bogle.  John is the founder of Vanguard, the mutual fund family going way back to the mid 1970s.  He's a terrific advocate for investors, and in 2004, “Time” magazine listed him as one of the world's 10 most powerful and influential people. John is a prolific author who has a new book titled "Enough:  True Measures of Money, Business and Life."  It’s our distinct pleasure to welcome John Bogle to Sound Investing.  

JOHN BOGLE:  Well, it's a great pleasure to be with all of you.

PAUL MERRIMAN: It’s always a pleasure to have you on our show, John. In your new book, you write about a huge sea change of ownership of individual securities, saying that 50 or so years ago about 92 percent of stocks were owned by individuals and only 8 percent were in the hands of institutions.  Today it’s almost the reverse, with more than three-quarters of stocks owned by mutual funds and pension funds and less than a quarter in the hands of individuals.  

It seems to me that this is a good thing, since investors have a very poor track record with individual stocks. Yet you paint this as a problem. Why?

JOHN BOGLE:  Well, there are really two reasons this is a problem. First, the professionals, the agents for these individual investors, haven't done a very good job of protecting the interests of those investors.  It costs a lot of money to employ those professionals, much more than it should cost. Through these institutions we investors collectively capture the total return of the market, yet as a group we lose the amount of the institutional costs we pay.  In other words, the mutual funds and pension funds subtract a layer of costs from the investment return.  Over an investment lifetime, it turns out that the  miracle of compounding returns is overwhelmed by the tyranny of compounding costs, and the investor ends up not with 100 percent of the market's return but maybe as little as 25 or 30 percent, believe it or not, over 50 or 60 years.

The second reason it’s a problem is that these institutional investors sometimes turn out to actually be institutional speculators. This happens when portfolio managers in mutual funds, hedge funds and pension funds trade the holdings in the portfolios they are managing for others at a ferociously high rate. All this turnover adds high trading costs to already-high management costs.

And higher levels of trading often lead to higher tax costs as well. Most fund managers ignore the effect of taxes, even though about half the money in equity funds is in taxable accounts. So the owners of those accounts pay a penalty of another 1.5 to 2.5 percent a year in taxes that they would not have to pay if their portfolios weren’t involved in trading. So the system has gone off the rails, in my opinion.  

PAUL MERRIMAN:  John, it seems to me that the issue of trust is at the heart of what people actually do with their money. Who should they trust? I remember an old TV show called “Let’s Make a Deal” where the contestant had to choose one of three closed doors and the prize would be whatever was behind that door. I think investors are in a similar position when it comes to choosing who they trust.

Behind Door No. 1, when you open it up, is Wall Street, which always has plenty of ideas of what people should be doing with their money. Behind Door No. 2 is Main Street, which I think means our neighbors, somebody at the office, a relative or somebody you sat next to on an airplane. A lot of people give great credibility to recommendations from Main Street, yet these recommendations seem to be totally hit-or-miss. And behind Door No. 3 is the academic community, the people who spend their lives trying to figure out what really works for investors

John, what do you think about going behind those three doors for investment advice?  

JOHN BOGLE:  Well, to me it's very simple: The academics are the ones who have it right.  The academic door is the one to open because they understand a couple of things that everybody should understand about investing, and it begins with the fact that as a group, all investors together are indexers. Together we own all the value of stocks out there. So if there were no intermediaries or costs, then as a group we would capture the return of the whole stock market.
 
Think about it this way:  Suppose that half the shares of each of the 500 stocks in the S&P 500 were owned by speculators trading back and forth with one another and the other half were owned by investors who never traded.  The latter group, the investors, would by definition capture the market return;† let's assume it’s 8 percent a year. But the speculators who were trading with one another have to support a big investment infrastructure in the middle, the money managers, brokers, investment bankers, lawyers, dealmakers, all the work that we call Wall Street.  And so when the speculators trade back and forth, they don't capture the market return. They capture the market return minus all those costs.  So it is mathematically correct to say that investors win and speculators lose.  So don't be a speculator.

DON MCDONALD:  John, as you know, for a couple decades I've been working really hard to try to get people to buy stocks and just hold on to them for a long time. Some of them finally started doing that the past few years and now many of them are thinking they should not have done that.  What happened?  

JOHN BOGLE:  Well, what happened is the stock market bestows its blessings unevenly. The market goes up and it goes down.  We had a very poor decade in the 1970s; you know, the real return on stocks was probably 1 percent per year or something like that.  Then we had a fabulous decade in the 1980s, a 17 percent return on stocks; probably a real return of 14 percent.  And we knew that could never happen in the 1990s because it had never happened two decades in a row.  But it did happen in the 1990s, and so we got another phenomenal return, probably in the range of 14 or 15 percent real return for the second decade in a row.  

So it shouldn't be any surprise that we came out of that decade with stocks being very expensive.  The dividend yield, which historically has averaged 4.5 percent, was 1 percent as the year 2000 began.

And so stocks were expensive early in the year 2000. You can’t sustain a market that's selling on a 1 percent dividend yield and a 35 or 40 price-earning multiple.  Investors won’t continue paying $35 or $40 for one dollar of earnings when the long-term norm is about $15.  

So the warning signs were there, although I should quickly say that nobody, certainly not Bogle, knew just when the collapse would come.  In this business you may think that you know what’s going to happen, if you just do the simple math, but you don't know when it will happen.  We had an almost 50 percent crash in stock prices in the early 2000s, then a nice little comeback, probably recouped about a quarter or a third of all those losses, and then a second bump and that's the bump we're in now, another 50 percent market decline.
 
The market is risky. I think the main thing I would say is that the past does not foretell the future.  It's times of bad returns, like the '70s, that set the stage for times of good returns, which I hope we're in for now; although there's no certainty of that.  There's no certainty in investing.

DON MCDONALD:  John, you mentioned safety, and right now I would hazard a guess that most investors don't feel that anything is safe.  What do they do?
 
JOHN BOGLE:  Well, I'd have to say that safety depends a little bit on your time horizon, and investors ought to think about that.  For example, I'm inclined to think that the government inflation protected treasury bond is a pretty safe place to be, something that will protect us from inflation if it lies ahead.  
Now the yield on that bond today is probably about 1.8 percent.  You might be able to give me a better number than that, but that's pretty close.  So if we have 3 percent inflation down the road that would give you a 4.8 percent real return.  That looks pretty good to me.  And the safety of the U.S. Treasury is, I think, unquestioned.

Although as we start to increase the debt of this great country to unimaginable proportions with unimaginable deficits, somebody has to realize that our capacity to finance all this is not unlimited.  

TOM COCK: We're talking with John Bogle, the author of "Enough" and of course the founder and former CEO of the Vanguard Mutual Fund Group, right here on Sound Investing.

PAUL MERRIMAN:  John, we have four books we recommend to investors. I think the best book on index investing is “The Little Book of Common Sense Investing,” which of course you wrote. The other three we recommend are "Mutual Funds For Dummies" for the basics about mutual funds, "Your Money and Your Brain" on the emotional hurdles that investors have to face, and of course "Live It Up Without Outliving Your Money" for asset allocation, fund selection, distributions and retirement.  My question for you, John, is do you have a list of books you would recommend to our listeners as your top picks?

JOHN BOGLE:  Well, certainly I would include many of the books you mentioned.  I would probably add a wonderful little book by Bill Schultheis called "The Coffeehouse Investor." That a very simple book, maybe a little bit simpler even than "Little Book of Common Sense Investing."  And for something a little more complex, I like Professor Burton Malkiel's "A Random Walk Down Wall Street," which is now in probably its 12th edition or something.  Even if it maybe tells you a little bit more than you need to know, it's worth reading. "Enough" is not really an investment book in the traditional sense.  It doesn't have a lot of investment advice.  I've got a half a dozen books that do give investment advice, going all the way back to "Bogle on Mutual Funds" 1993, which may be the best book I ever wrote.  
 
TOM COCK:  John, we appreciate all the good work you've done for investors as an author, a speaker and an advocate. Thanks for your generous time today here on Sound Investing.

JOHN BOGLE:  It’s a pleasure to be with Sound Investing and all of you once again. Good luck to you and to your listeners.