How to Invest Smarter After the Recession

Mutual-fund pioneer Bogle discusses what went wrong, how to fix it, and what to teach our children.

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John Bogle opens his seventh book by recalling a 2005 poem by Kurt Vonnegut called "Joe Heller." Vonnegut writes of an exchange with his friend, the Catch-22 author, at a party tossed by a billionaire. Vonnegut observes that the host made more money in one day than Heller made from Catch-22 since it was published in 1961. "I've got something he can never have," Heller replies. "The knowledge that I've got enough."

Many of us don't, apparently, which compelled Bogle, founder of the Vanguard mutual-fund firm, to write Enough: True Measures of Money, Business, and Life. Bogleheads, as fans of the financial pioneer are known, will recognize some familiar themes: Most money managers charge exorbitant fees that severely cut into returns for the average investor, for example. But Bogle also shows prescience in describing the housing bubble and other problems that sank the economy, in a book written mostly before Lehman Brothers failed in 2008, igniting a financial rout. I spoke recently with Bogle about how the recession and other factors will change the way we spend money and plan our financial lives. Excerpts:

How are the recession and the financial meltdown changing the way people need to think about their financial future? What happened in the '80s and '90s is a completely nonrecurring phenomenon. Two 17 percent-return decades in a row. That's without precedent. PEs [price-to-earning ratios] went from 8 to 16 to 32. For those returns to continue, PEs would have to go to 128. That may happen someday, but I don't want to be around to see it.

[See why a housing rebound could take 20 years.]

People made a lot of money in those years. Weren't those formative years that helped define expectations for people on the verge of retirement today? That was phantom wealth based on the idea that prices would keep going up, sold to you by the people on Wall Street who excel at destroying wealth. That phantom wealth we mistook for real wealth. We forgot what investing is all about, which is dividend yield and earnings growth.

Dividend yields were at 1 percent in March 2000. They're up to about 2.5 percent now. The dividend yield is the product of two numbers: dividends and price. Dividends tend to go up over time.

Long-run returns are constructed 100 percent around how business performs. And corporate earnings grow at about the same rate as the economy grows. Typically, corporate profits are between 4 and 8 percent of our nation's gross domestic product. In 2007 they got up to 9.5 percent. Now they're at 7 percent. So what our economy is going to do is extremely important for long-term investors.

What's your outlook on the economy? The economy's probably not going to grow at the old historical rate of 3 percent. It will probably grow at about 2 percent. That's one-third less, which is very, very likely. There will be more saving and less spending. Is that good for the economy? No! But it's a necessity for the family. With lower overall economic growth, corporate earnings will grow maybe 5 percent per year.

[See 6 confirmation questions for Ben Bernanke.]

I'm updating my 2000 book, Common Sense on Mutual Funds, to include thoughts on the stock market as of 2010. The market now is much cheaper than in 2000, thanks to a decade of negative returns. Stocks fell by 55 percent from their peak in 2007 to their low in March. At one point in August, they were up by 55 percent from those lows. But I have to remind people: When stocks fall by 55 percent, then increase by 55 percent, you're not even! You're still 30 percent in the hole.

How do investors need to change their expectations? Investors have been too beguiled by a rising stock market. Long-term returns in the stock market will probably be similar to what they've been in the past, before the '80s and '90s. The market has gone down so much that the old rules will start to apply again. Remember, sharp market declines are terrible for sellers, but they're wonderful for buyers.

People have also forgotten that stocks don't only go up. We've also forgotten about bonds, which I say should roughly equal your age. If you're 60, you should have about 60 percent of your investments in bonds. If you're 80 like I am, then 80 percent. If you're 20, it doesn't really matter that much. Why? If you're older, there's a lot more money at stake. If you've got $300,000 built up by the time you retire, you've got a lot more to lose. The older you are, the less time you have to recoup losses. You have to rely on investment income, not your salary, and bonds produce much higher income than stocks. And when you get older, you get a little more nervous during crazy times in the stock market, like we've had.

[See 9 firms least likely to pay back their bailout money.]

You can thank Wall Street for generating innovative new products that destroy wealth. It's just like Vegas or the track. Talking about how stocks can return 12 or 15 percent per year is nonsense. Over the long term, corporate earnings grow at the rate of the economy. There's no way around that.

What lessons do you feel people should be learning from the recession and the way we're reorganizing our lives? For the last two decades, we have ourselves to blame, our advisers to blame, our brokers to blame, our fund managers to blame. There's one obvious lesson that people will never learn because it seems so trivial: How much you pay for investing services is critical. If an investor's annual expenses average 2.5 percent over an investment lifetime of 60 years, the investor gets 25 percent of the market's return, and Wall Street gets 75 percent. Mutual funds are also incredibly tax inefficient, which might reduce the real return, after inflation, down to 0. People should be thinking about just the ABCs of investing. Like the three R's of primary school.

Investing is a long-term game. Don't trust the history of the stock market returns to tell you anything. Don't pay attention to all this baloney fed by brokers and mutual fund managers and all these other intermediaries. Cost is important. Don't speculate. Don't chase performance. And don't think you can pick tomorrow's winners. Investment returns are only what the stock markets are generous enough to give us or mean enough to take away. As an investor, you're bound by the returns on stocks and bonds. Don't gamble, because you don't know what's coming next. Be careful, because nobody knows what's ahead.

[See 8 industries that will sit out a recovery.]

Do you think we're in the midst of permanent changes in our economy? Or at some point will everything go back to the way it was before the recession? All of this conspicuous consumption, it looks like it won't be in the driver's seat anymore. We have to be content with a little bit less. It might not be the end of the world, and it might be the beginning of a better world.

How might it be better? It might be a big plus for our society. We are still very wealthy, and we're also very parochial. Americans don't have much awareness of the privations people suffer in other parts of the world. Maybe we'll become more aware.

For people hoping to retire soon, what kinds of changes do they need to be thinking about? Are their expectations realistic? A lot of older people believe they should not spend their last dollar on the last day of their life. A lot of parents want to leave a nice little nest egg to their children. That's nice but not essential. I don't believe anybody should live in destitution so they can leave something to their children. They're adults. Most of them should be able to take care of themselves.

Do you think this is a historic moment in American society? I think we're at an inflection point in American history. The economy, the stock market, the housing market, community values, the works. In The Battle for the Soul of Capitalism [2005], I rewrote the first two paragraphs from Gibbon's history of the Roman empire, except I wrote them about America, not Rome. It's amazing how little rewriting I had to do. We still have a chance to fix things, politics and investing and values, and get our national priorities in order. But it's not going to be easy. Some people say the problem with Rome was self-love. You could say the same thing about America.

The fiscal status of America is not disastrous, but it's awful. It's going to be hard to fix. Hard to grow out of it.

What will it take to fix those problems? What we need is more community, more awareness. That's a word you don't hear very often, awareness.

We've had a stock market crash. It fell 55 percent. That's the second worst ever, after the depression, when it fell 90 percent. Can we face up to the fact that we're not going to live the way we used to? We need more caution, more savings; we may have to work harder. Maybe we need more people who like to work and don't count down every day till retirement.

Is there anything wrong with working longer? I think work is good. You're accomplishing something. Isn't that the point of a good life? To accomplish something? What else is it? Playing? Sleeping?

Where do we start? It all starts with family and what parents teach their kids. It's not what people say, it's what we do. Parents have a huge role to play. We live in an age where discipline seems to be against the Constitution. Parents need to discipline their kids and teach them how to accomplish something. I don't know what kids are doing when they spend so much time on the computer, but my guess is they're not reading the Encyclopedia Britannica.