How To Become A Great Investor

If you want to get the best returns from stock-market investing, then here's the smart and simple way to do it.

As a financial writer, I frequently receive review copies of books on investing. Most go straight onto my bookshelf to gather dust, largely because they promise something that they simply cannot deliver. You can judge these books from their titles: Investment Secrets of the Pharaohs; You Can Beat Warren Buffett; Beat the City and Become a Billionaire -- all complete nonsense, of course!

However, last month, I read a book which genuinely provides investors with the ideal strategy for making the most of stock-market investing. The book is The Little Book of Common Sense Investing by John C Bogle (available from the Fool Bookshop for £8.55 plus postage, a 35% discount off the cover price of £12.99).

It's said that, when it comes to money, "people in mansions don't take advice from those in mud huts". In other words, when someone's telling you how to get rich, be sure to inspect their wealth before listening.

In 1974, Jack Bogle founded investment firm Vanguard Group, which now manages more than $1 trillion of assets. In 1999, he was named as one of the four "Investment Giants" of the twentieth century by Fortune magazine. In short, this is a book from a brilliant and wealthy man who has helped millions of people to get rich, too.

Jack Bogle's advice to you as an investor is simplicity itself: your goal is to capture the maximum returns from investing in businesses. The only way to guarantee your fair share of market returns is to throw your net as wide as possible and keep your expenses to an absolute minimum. In other words, your goal is to grab almost the entire return -- capital growth and dividends (the income paid to shareholders) -- generated by UK plc.

The best way to do this is to buy a fund which passively holds the entire market, known as an index fund. The index fund is a basket (called a portfolio) that holds a large number of eggs (shares) and is designed to mimic the overall performance of the stock market at low cost. By buying the entire market, you take away much of the risk of investing in individual companies, market sectors and overpaid fund managers.

Index investing lacks the excitement of other investing strategies. Indeed, it's the dullest and simplest possible way to invest. However, in the long term, index investing is incredibly exciting, because it absolutely thrashes other investment approaches.

The first reason why most stock-market strategies are destined to underperform the market is that investing in equities is what mathematicians call a zero-sum game. In other words, any extra return gained by one investor means a balancing shortfall for another. The second reason is what Bogle calls "the relentless rules of humble arithmetic": grinding transaction costs reduce the gains of the winners and increases the losses of the losers.

Indeed, as things stand at present, almost the entire investment industry in the UK is living a bare-faced lie. The only sure winners in the investing game are the middlemen: the stockbrokers, investment bankers, fund managers, lawyers, accountants and other City players. By creaming off billions of pounds a year in fees and expenses, these financial croupiers are milking UK investors on a colossal scale.

Bogle illustrates this argument by comparing the returns of the US stock market to those earned by private investors.

Over the past 25 years, the S&P 500 Stock Index produced a total return which averaged 12% a year (returns in the UK have been similar). Over the same period, a typical investor underperformed this by around 2.5 percentage points, bringing down his/her return to a more modest 9.5% a year. For investors in managed funds, returns have been even lower, thanks to ongoing management and other charges (what I call the "Ferrari Factor"), poor market timing, following investment fashions, and so on.

The difference between earning 12.5% a year and 9.5% is vast. Over 25 years, $1000 would grow to $19,002 at 12.5% a year. At 9.5% a year, your final pot drops to $9668, or almost half as much. Thus, by trying to beat the market, at least four-fifths (80%+) of investors, amateur and professional, are turning a winner's game into a loser's game.

The simplest, time-tested strategy that delivers the greatest return to the greatest number of investors is index investing. Indeed, around a quarter (25%) of City institutions' funds is invested in index funds.

I believe in putting my money where my mouth is. For example, my little boy's sole stock-market investment is in the UK's cheapest index fund (more details below). My wife's annual bonus and extra pension contributions go into an index tracker which charges a mere 0.07% a year. In actual fact, roughly half of my family wealth is invested in cheap index funds.

Finally, when investing for the long term, be sure to shelter your gains from the taxman inside a shares ISA (Individual Savings Account). By doing this, you'll hang onto your entire profit and get richer that much faster.

Summary: the UK's cheapest FTSE All-Share index trackers

Many thanks to Lipper Fitzrovia for providing this data.