Morningstar’s Director of Personal Finance Christine Benz talks to the founder of the Vanguard Group, Jack Bogle, about his expectations for returns of stocks and bonds, why he says that the stock market is basically for losers in the game of capturing returns, and what should determine an investor’s fixed income position.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We're at the Bogleheads Reunion outside of Philadelphia, and it’s a real privilege to be here today with Jack Bogle.
He is founder of the Vanguard Group and also the main person at this event.
Jack, thanks so much for being with us.
John Bogle: Good to be with you, Christine.
Benz: So, Jack I have a lot questions for you, but one thing I'd like to start out with is your expectation for returns of stocks and bonds going forward. You have a very common-sensical approach at arriving at projected returns. I wonder if you can talk us through it and also talk about where you are coming down in terms of what you expect to see from stocks and bonds?
Bogle: Certainly. Number one, there is no point in looking out for a day or a week or a month or a year. I happen to like to look at five-year periods, because markets are crazy, they are highly speculative. But in the long run, it is investment value that creates returns in the stock market. It's how our corporations do that produces the returns. The stock market produces nothing. It reflects those returns, but then subtracts its croupiers' take, like the people out in Las Vegas or at the race track or state lotteries; they exact their toll.
So the stock market is basically for losers in the game of capturing returns. Let's call it here now American business earnings. So what does American business earn? How do you calculate that?
Well, first there is a dividend yield, and today that dividend yield is around 2%, let's call it 2.25%. Then the second component of that fundamental return, investment return, is earnings growth, and nobody knows what earnings growth is going to be. But we do know this, and it’s an important thing to know, that corporate earnings grow at the same rate as America grows, as our gross domestic product grows.
So it’s a very, very stable number--not the same every year but in the range of--corporate profits usually run in the range of 4% to 8% of GDP and average about 6%, a remarkably stable economic statistic.
So let's say that America is going grow at a nominal rate of 5% in the future, so corporate earnings should grow at 5%. They're not going to grow a lot faster, they're not going to grow a lot slower as far as anything we know, and so that's about a 7% investment return and that's it.
Now, speculative return, how much people will pay for $1 of earnings, the price to earnings ratio, can take that up or down. If the P/E goes from 15 to 30, that's a double and that will add 7% a year to your return. Now, that's not going to happen, but just to make the point. So the P/E now looks to me to be about 18 times, and I would expect that that would more or less neutral. It might come down a little bit over the next 10 years.
Nobody knows that, least of all myself. But I would look for P/Es, I don’t believe they are too excessive right now, could come down a little bit and may be take a point or so, maybe a point off that investment return. So let's call it a net investment return on stocks, may be around 6% to 7%, let's say. So that’s what stocks should produce.
Now, there is a big risk here because America is a troubled nation. Will GDP grow at 5%? I think someone as eminent as Bill Gross from PIMCO is going to tell you there is a "new normal," a phrase that is pervasive in its adoption. He is a good phrase-maker and a smart bond manager. So maybe the economy will grow a little slower, maybe we're in for a bad recession, a double-dip. Nobody knows that. But I think reasonable expectations would suggest about a 7% return on stocks over the next decade.
Benz: Okay, and how about fixed income?
Bogle: Well, fixed income is easy because over a 10-year period there is no P/E to go up and down. A 10-year bond is worth 100 cents in the dollar 10 years from now, not complicated. So it’s the interest rate when you buy in that determines the future rate of return on a bond. Today the interest rate is really low. The intermediate term Treasury is one benchmark is around a little below 2.5%. So you can say with considerable security and certainty, but not total certainty, that the bond market as measured by the intermediate term Treasury, will be somewhere between, let's say, 2% and 3% over the next 10 years. It’s going to be hard to get around that.
For the longer-term bonds, it will be a little bit higher, maybe 3.5%, for corporate bonds maybe 4.5%, but there will be some defaults along the way; there always are. So you won't get a full 4.5% out of the corporate market.
But for the total bond market I think it’s reasonable to say that the return will be in maybe something in the range of 3.5% a year as compared to 7% in stocks. So think about this for a minute. 3.5% a year will mean you’ll make 50% in your money compounded over a decade roughly, and 7% return on stocks will mean you make a 100% on your stocks. So I think it’s a decade coming up, which we're into now, where the return on stocks, where investing in stocks, will be rewarding relative to investing in bonds.
However, of course, there is always however, and that is they’re going to be a lot of bumps along the way. These are troubled times, and I think people need a pretty significant bond position and depending on A) their sensitivity to all this going on in the market and B) depending on their age. I have a rough rule of thumb that your bond position should equal your age because when you get older, as I do, you are more interested in income; well, the bond income advantage is small now, and you have more wealth at stake, and you get a little, I think as you get older, a little more nervous when you get these gyrations in the market, and that kind of nervousness is apt to make you sell something when times are worse and buy something, buy stocks when times are good.
You don’t want to do those kind of things. You get captivated, captured by your emotions. So some bond position, as you grow older, larger, is I think a good idea.
Benz: So, it sounds like you are saying, even though you are expecting relatively muted returns from bonds, as a stabilising force it’s still worth holding them because of the peace of mind that they impart.
Bogle: Exactly.
