(FORTUNE Small Business) – If you know anything about investing, you'll probably be surprised to learn that John "Jack" Bogle was a subpar college student. Even though Bogle would eventually create the first index mutual fund and revolutionize the industry, he performed so poorly at Princeton that the school threatened to revoke his scholarship. It wasn't a question of dedication--Bogle was studying economics and working hard--but, he shrugs, "I just didn't get it." So while his peers were regurgitating Adam Smith and John Maynard Keynes in their senior theses, he tried a different approach: finding out everything he could about the nascent business of mutual funds. The product of that thesis--the index fund--is an investment vehicle so elegantly simple that it has become a staple in the financial world; about 450 such funds are now in existence, and $331 billion is invested in them.

Index funds put money into an entire basket of stocks, like the S&P 500, rather than letting a manager pick and choose what he wants to buy. Bogle's theory was simple: No fund manager could beat the overall market in the long run, so why not invest in the market itself? That may seem elementary now, but his first index fund--the Vanguard 500--was virtually stillborn when it opened to the public in 1976. The fund was so unpopular that he didn't have enough money to invest in all 500 stocks until 1979.

Today that same fund is the second largest in the country, with over $64 billion in assets, and the Vanguard Group is the second-largest fund company. Bogle stepped down from the helm of Vanguard after a heart transplant in 1996, but he hasn't slowed down much. At 73, he still serves as an advisor to Vanguard and remains the loudest cheerleader for index investing. As for the argument put forth in his thesis back in 1950, it is reconfirmed every passing year. Since 1977 no actively managed fund has beaten the basic S&P 500 on a year-in, year-out basis. Not too bad for an underperforming student with some wacky ideas. --Andrew Rafalaf

"It was a sunny day in December of 1949, and I was sitting in the Firestone Library at Princeton University. I was a junior trying to decide on the topic of my senior thesis. My objective as a student in the economics department was to write on a subject that no one had ever written a thesis on before. I opened a copy of Fortune magazine, and there was an article called "Big Money in Boston" about the mutual fund industry. I had never heard of the mutual fund industry at that point. The Fortune article described it as tiny but contentious, and I knew in an instant that I didn't want to write on Karl Marx and I didn't want to write on Adam Smith and I didn't want to write on John Maynard Keynes, because they had been written about a lot.

In the course of that thesis I did a lot of research into the industry. I used anecdotal evidence of the records of mutual funds. In the case of the half-dozen funds whose performance I did examine with some care, I came to the conclusion that "mutual funds can make no claim to superiority over the market averages."

In that thesis were a whole lot of prescriptions that can be read as the ideas that created not just the index fund but Vanguard itself. I said mutual funds should reduce their sales charges and management fees, and we did just that--except we eliminated all sales charges. I said mutual funds should look at their prime function as management, not all these peripheral things funds do, like marketing. I said--prophetically, if you will--that mutual funds should be managed in the most efficient, honest, and economical way. The significance was not that I knew all this was coming and that I designed a company around it and was just biting at the opportunity to create the company. Basically, it was a real, pervasive set of idealistic principles: Can't we make the world a little bit better? Idealism is the rule when you're 19 years old. The difference with me is that I've maintained it. It's gotten worse and worse and worse. I'm more idealistic today than I was all those years ago.

Because in the financial world, cost is everything. That is to say, it's a simple formula--the gross market return minus the cost of financial intermediation is the net return investors will see. That cost can be estimated at something like $500 billion a year. [That's the net profit taken in by all financial companies in the country in a given year.] So if you eliminate those costs, or virtually eliminate them, you can give your shareholders this wonderful thing that is as predictable as the clock: their fair share of the market's return.

In 1951, I sent my thesis off to Walter Morgan, the founder of Wellington Funds, based in Philadelphia. He read it, had others in the organization read it, and as a result offered me a position. I was the young, fair-haired boy from Princeton. He would tell people, after he read my thesis, that I knew more about the mutual fund industry than he did. It wasn't true, but it was a gracious thing for him to say. Clearly he was impressed with the unusual work that I had created at Princeton.

In a small company like Wellington--I'd say there were 75 people at most, many of them clerical in nature--there weren't many levels of management, so by the time I was 30 everybody knew I would be president someday. I didn't actually become president until 1967, but two years before that, Walter Morgan came to me and said that we had problems and that I should go out and fix them. To be honest, I was too young, too immature, too self-confident, and probably too arrogant.

In 1966, I did a very unwise thing. I became captivated by the go-go era. Wellington was a very conservative fund group, but stocks had gone up 42% cumulatively over the previous three years. I was convinced that we needed an aggressive fund--wrongly, stupidly--and that we needed to be in the investment-counseling business as well as the mutual fund business. I was disappointed with the managers we had at Wellington. We needed new managers, I thought, and all of a sudden this opportunity emerged with a firm in Boston called Thordike Doran Pane & Lewis. It had an aggressive fund and a rapidly growing investment-counseling business, and it had four of what I thought were good investment managers. They were hotshots. So we merged with it.

At that time Walter Morgan got a call from Bernard Cornfeld. He's the crook who started something called the Fund of Funds in Switzerland, selling to military personnel all over the world with the slogan "Do you sincerely want to be rich?" He was ultimately convicted, but back then he owned some of Wellington Management's stock. He called up and said he'd sue to stop the merger because he knew these guys. Mr. Morgan sent me off to Switzerland to talk to him. I was this little kid, 35 or 36. I talked Cornfeld out of suing, but at the end of the conversation he said, 'The problem with those guys you want to merge with is not that they're sons of bitches, but that they're stupid sons of bitches. You'll find that out, and when you do, you won't fire them, they'll fire you.' He was right.

In the year or two leading up to January of 1974, my new rivals in Boston started to question my leadership just as I started to question their management. As we got into early 1974, with the market falling apart and sales volume dropping, the guys in Boston brought together an alliance of Wellington Management directors, who asked me to resign. I wouldn't resign. I told them they'd have to fire me, so they did. But due to the interesting structure of this industry, I remained the chairman of Wellington Funds.

Here I was, essentially out of work, and I had to get myself up at 5:30 the next morning to catch a 6:30 train to New York, where the Wellington Funds board was meeting [which is separate from the board of directors for Wellington Management]. Opinion was divided at that meeting about my firing and about the way Wellington Management was running the funds. Essentially I made an appeal to the board: I suggested we get the independence required to run the funds our way and get the results we wanted. They agreed to give me time to create a study.

So I did a series of reports called "The Future Structure of the Wellington Organization." I gave them a bunch of options, and they picked the least disruptive. What I was pushing for was a clean break--the fund board would buy Wellington Management and give my Boston rivals back their investment-counseling business, and we'd keep the funds. The fund directors were paralyzed with fear. This had never been done before, they said. I said, 'Tell me about it.' It's hard to expect a group of conservative directors to know anything. Instead, they went with an alternative--my least favorite. 'Wellington Management can be in charge of investment management (i.e., the stock picking) and in charge of distribution (i.e., selling the funds), and Bogle, you can be in charge of administration.' It wasn't necessarily boring, but I wasn't going to create a great business out of administration.

This was a terrible deal, and I knew it, of course, but I thought I could get control of investment management even though we had a written agreement saying I couldn't manage money for them. One of the guys from Boston said to me, 'Aren't you going to be bored in that job?' I said, 'Little do you know, pal.' Deep down, both sides won. Vanguard would not have existed if I hadn't been fired, and it's possible that Wellington may well be a better company without me there.

Vanguard incorporated Sept. 24, 1974. We began operations May 1, 1975. Virtually the first thing I did was work on the index fund. Even though I was barred from actively managing money, the index fund would be essentially unmanaged and a way for me to get back in. I added up how all the funds had done--there were only 50 or 60 of them then--over the past 25 to 30 years and compared them with the S&P index. The index won by about 1.5% a year. I did a comparison that showed $10,000 invested in the funds vs. $10,000 in the index over this 30-year period. I thought, Oh, my God, this is never going to fly. The difference was something like $60,000 vs. $90,000. So I decided I would show the directors a $10 million investment, so it became $90 million vs. $60 million. It looked more like an astounding amount.

The directors said, 'Of course, you can't manage money,' and I said, 'Aha, I'm not managing money.' No one there wanted to manage it either, because there were no management fees, so Vanguard itself became the "manager," and that was our entree. It was called "Bogle's Folly" for years: Let him play in his own little sandbox, and it'll never amount to anything.

I'm a very contrary person so I never doubted the success of the index fund. I was taught by Walter Morgan that the crowd was always wrong. The idea is a no-brainer. If you can own the market at an infinitesimally small cost, you will beat the players in the market who operate at substantial cost. Would it work? Of course it would work. It was guaranteed to work.

We underwrote the index fund in August 1976. It was a horrendous job to get Wall Street to underwrite it. It wasn't like putting an ad in the paper and having people flock to it. The underwriters thought we could raise $150 million, and we ended up with $11 million. It was a bomb, but we had the first index fund. Someone asked me if I was disappointed, and I said, 'Don't you realize we have the world's first index fund? Don't you realize we've done something?' I used to tell people, 'Stop being in a hurry. Just think of a bottle of fine wine. You make the best bottle of wine you can, and what do you do with it? You don't sell it. You stick it down in your basement and give it a nice turn every year or so. If you take that bottle out 15 years from now, you'll say, "Wow." So what's the hurry?'

We didn't have enough money to buy all 500 stocks. But Wellington had an old fund that wasn't going anywhere, so around 1979 we merged that into the index fund, and it caused utter chaos. Someone told us, 'You're trying to get another fund to pull your chestnuts out of the fire,' and that was probably accurate. It wasn't until 1979 that we were finally big enough to own all 500 stocks.

And then we started working on getting control of selling the funds, known in the business as distribution. I had an idea that had always appealed to me--no-load funds, or funds without sales charges--and I really thought it would be the wave of the future. The country was growing wealthier, people were getting better educated, they understood what they were doing, they were learning the importance of diversification and of the penalty that sales loads would exact. Our goal was to be a low-cost provider, so I thought, What's the point of being a low-cost provider if you're still charging a fee to buy the fund? When I went to the directors with the idea, they said, 'You can't take over distribution.' I said I wasn't taking over distribution, I was eliminating distribution. By a vote of eight to five, we eliminated sales commissions on the index fund and the Wellington funds. It was not a good day for anyone but the individual shareholders.

I think the largest mistake I made was getting too aggressive from a marketing standpoint and starting a sector fund in 1985. I was too competitive, but competition doesn't necessarily require you to start something stupid, and I'm afraid that starting a sector fund was stupid. I knew my thesis said sector investing doesn't work, but Fidelity had just started one, and we thought we had a better theory. We'd pick sectors that had prospects that could differentiate themselves: gold, health care, technology, and service companies. These were all actively managed funds--another mistake. We tried to make them very low cost, and we tried to limit trading so that managers wouldn't jump around, but fundamentally it just wasn't a good idea.

The technology sector fund did rather badly. Everyone said we needed to get another manager. I said, 'I have a much better idea: Let's bag the technology fund altogether.' This was probably in 1991 or 1992. Money would have poured into it throughout the 1990s, but it would have cost investors almost their entire investment on the way down. In fact, the only successful sector fund has been our health-care fund. It's a huge fund, $17 billion in assets, run by the same guy since the beginning, Edward Owens. He's done it right. It's been a great sector, but unfortunately that success doesn't offset the other failures.

Vanguard has changed since I left. We've always had actively managed funds, but we've started a lot more in the past few years. Vanguard has become more of a marketing company, and I leave it to wiser heads whether that's good or bad. Was it inevitable? I don't think anything is inevitable in this life. It takes people to do things. I think by and large the rock-bottom principles are pretty much intact: the mutualized structure, the low cost, and the focus on the long term. It would be fair to say there may be a fraying around the edges of those values, but nothing has fundamentally compromised them.

At a recent conference, someone in the crowd had the nerve to take a shot at index funds in light of the current market. I said, 'Let me assure you that not only do index funds work this year, but they work every day, every week, every year.'"