This post has my notes on the article, Don’t Count On It: The Perils of Numeracy by John Bogle
“To presume that what cannot be measured is not very important is blindness.”- John Bogle
1. Attributing certitude to history
We make the implicit assumption that stock market history repeats itself when we know, deep down, that the only certainty about the equity returns that lie ahead is their very uncertainty. We simply do not know what the future holds.
There are just two broad reasons that explain equity returns.
- Investment return: Initial dividend yield on stocks+ subsequent earnings growth.
- Speculative return: Changes in valuation or discount rate that investors place on that investment return. This is measured by the earnings yield or its reciprocal, the P/E ratio. The earnings yield is also dependent on the risk free bond yield. In the US, the historical correlations have been in the range of 0.4 to 0.7. This means 15-50% of the change in earnings yield can be explained by the change in risk free bond yield(0.4 x 0.4=0.16, 0.7×0.7=0.49)
Total return= Investment return+ Speculative return
This is what we are likely to get. Not the long-term 10-12% a year.
2. The bias towards optimism
The stock market returns that we see are themselves an illusion.
- Say gross return is 10%
- Intermediation costs could take out 2% a year
- Taxes could take out 2% a year
- Inflation is say 3% a year
Actual return is only( 10-(2+2+3))= 3% a year
Profits of corporate America( or any country) cannot grow faster than their GDP. Historically after tax profits have grown at 5.6%( compared to 6.6% growth for GDP) in America.
The earnings that the companies often report are not correct. Creative accounting is common and this is nothing but disguised dishonest accounting. A lot of the investment decisions that a company makes to improve the numbers does not actually improve the business.
With all of this, the best solution for investors is:
With only the will to do so, equity investors can count on (virtually) matching the market’s gross return: Owning the stock market through a low-cost, low-turnover index fund—the ultimate strategy for earning nearly 100% rather than 60% of the market’s nominal annual return.
3. The worship of hard numbers
When you have a constant quote on the investments you hold, you get tense.It’s easier on the psyche to own investments that don’t often trade. We believe that the momentary precision reflected in the price of a stock is more important than the eternal imprecision in measuring the intrinsic value of a corporation. We have to understand that the price of a stock is not truly a consistent and reliable measure of the value of a corporation. Stocks are over inflated at times and stock options do not link the interests of the management with the interests of the long-term shareholder. Investing has become short-term speculation rather than long-term holding and that has not given higher returns to the average investor who is easily swayed. Speculative returns might not add to investment return in the future and values might not raise to the level of high stock prices.
4. The adverse real world consequences of counting
When investors think they are entitled to annual returns of 10-12%, they ignore the inevitable uncertainty of investment returns and the even greater uncertainty of speculative returns. This leads them to make wrong decisions. By taking advice from experienced investment professionals( not Wall Street), educating themselves and reading good books, they can make proper decisions.
Corporations try to grow faster than they can and in the process make wrong mergers and acquisitions, engage in financial speculation rather than organic growth and fall prey to the six-sigma syndrome.
“The first step is to measure what can be easily measured. This is okay as far as it goes.The second step is to disregard that which cannot be measured, or give it an arbitrary quantitative value. This is artificial and misleading. The third step is to presume that what cannot be measured really is not very important. This is blindness. The fourth step is to say that what cannot be measured does not really exist. This is suicide.”
There is, then, a futility in excessive reliance on numbers, and a perversity in trying to measure the immeasurable in our uncertain world. So when counting becomes the name of the game, our financial markets, our corporations and our society pay the price.
Numbers are a necessary tool and a vital one. But they are a means and not an end, a condition necessary to measure corporate success, but not a condition sufficient. To believe that numbers—in the absence of the more valuable albeit immeasurable qualities of experience, judgment, and character—are all that illuminate the truth is one of the great failings of our contemporary financial and economic system.