A Random Walk With Burton Malkiel

Burton Malkiel, professor of financial economics at Princeton University, is the intellectual midwife of the indexing phenomenon. In his classic A Random Walk Down Wall Street, first published in 1973 (the eighth edition was published last month), Malkiel argues that stocks are priced so efficiently that no professional can exploit temporarily mispriced stocks with any consistency. In fact, a blindfolded

Burton Malkiel, professor of financial economics at Princeton University, is the intellectual midwife of the indexing phenomenon. In his classic A Random Walk Down Wall Street, first published in 1973 (the eighth edition was published last month), Malkiel argues that stocks are priced so efficiently that no professional can exploit temporarily mispriced stocks with any consistency. In fact, “a blindfolded chimpanzee throwing darts at The Wall Street Journal can select a portfolio that performs as well as those managed by the experts,” Malkiel avers in his book. The quest to beat the market gets even harder for individual investors, since they have to pay management fees, trading costs and taxes.

Malkiel's solution? Invest in low-fee index funds (or ETFs) and go home. While the Random Walk Theory tends to frighten many financial advisors, Malkiel says it needn't. Malkiel says that investment advisors play an important role in a retail investor's life — efficient markets or not.

Registered Rep.: We've just experienced one of the biggest, if not the biggest, bubble in history. If stocks are so efficiently priced, how can a bubble happen? And if bubbles and other periods of irrationality can happen, doesn't that suggest that, aided by fundamental security analysis, you can recognize when stocks are momentarily mispriced?

Malkiel: That's one of the reasonable arguments against the efficient market, that markets sometimes go to the loony bin. And there's no question in my mind that stock markets went to the loony bin during the period of 1999 and early 2000, at least. I call myself a “random walker with a crutch” — I admit that the market is not always perfect. What I don't see is evidence that anybody can consistently, day in and day out, find those stocks that are over- and under-priced, and run a portfolio accordingly. It was the best funds in 1998 and 1999 that in fact fell absolutely flat on their faces in the 2000 through 2002 period.

Registered Rep.: But nevertheless, there were some naysayers out there, value investors and hedge funds, who saw the bubble for what it was and invested accordingly.

Malkiel: Yep, there were a lot of naysayers, and in any period, there will be some naysayers who get it right. The question is, do those guys over the long pull outperform a passive index? And my evidence suggests that there are very few of them who do. Those that do in one period are not the same ones who do it in a second period. The best funds of the 1960s were not the best funds of the 1970s. The best funds of the 1970s were not the best funds of the 1980s. The best funds of the 1980s weren't the best funds of the 1990s. And you'll see in the newest edition of my book that the best funds of the late 1990s were just terrible in the early 2000s. Therefore, my advice is, rather than looking for that needle in a haystack, buy the haystack.

Registered Rep.: But during bear markets or sideways markets, you're saying indexing is more effective? What about from 1966 to 1981 or 1982, when The Dow traded between 500 and 1000? There weren't index funds then, but what would have happened to an investor in such an index then?

Malkiel: What we do is simulate a broad-based index and then charge the 20 basis points or less of expense. And in all of the periods that I have studied, you find that the professionally managed funds don't seem to outperform.

And let me just say something else. I fully understand that not everyone is going to agree with me, that telling an investor that there's no way to outperform is like telling a kid that there's no Santa Claus. This is a real tough thing to do. So what about trying the following strategy: Suppose you index the core of your portfolio, and then if you want to try some active managers or you want to try some individual stocks around the edges, fine — at least you've got the security that a major part of your portfolio is not going to underperform. You have bought diversification, and that strikes me as, even for a skeptic, a very reasonable strategy.

Registered Rep.: Diversification, that word is back in vogue. Do you remember how concentrated funds and strategies became all the rage?

Malkiel: Well, I believe in broad diversification, not only in a stock portfolio, but I also think that investors need to diversify among asset categories. I suggest that you not only buy stocks, but you want bonds, you want real estate and you want cash. For the late 60-plus-year-old and retired investor, I'd recommend only 25 percent regular equities, 15 percent in an index of real estate investment trusts, and 50 percent in a bond index and 10 percent cash. That portfolio actually had a reasonable rate of return, even over the last three years, because while you lost money in the stock portion, there were good, positive returns in the bond portion.

And I'm true to my beliefs. What I've used is a bond index fund, the Lehman Aggregate Bond Index Fund, and for REITs, I've used the REIT Index Fund, based on the National Association of Real Estate Investment Trusts, called NAREIT. You don't want to just buy one REIT, because REITS are specialized by property type and by region. You wouldn't want an office REIT in Silicon Valley. What you want is broad diversification.

But, at any rate, what I'm saying is I think that the lessons of diversification really proved their mettle over the last several years.

Registered Rep.: Let me ask you about the whole Spitzer investigation. In your book you mention commission-hungry brokers, investment bankers, cheerleading analysts, but you also call investors greedy.

Malkiel: There's not just one villain. I think everybody deserves some share of the blame. But definitely you don't have this sort of thing happening without the public jumping on the bandwagon and coming to the conclusion that this is the best thing since night baseball.

And that's another point financial advisors should keep in mind. Avoiding horrendous mistakes is a major part of success in investing. You just have to make sure that clients who need nice, safe, diversified portfolios; don't get crazy. In the 1990s, you had people who came to their advisors saying, “I'm not getting enough activity … My buddy at the golf club tells me his tech stock portfolio just doubled over the last month.” Individuals get greedy, get absolutely wrapped up in the hype, that things are different this time, that this is a new era, and so on. You have to prevent your clients from getting too caught up in whatever happens to be hot.

As for the retail client, I don't know that he's been scarred permanently. I think the fact that a lot of unfortunate things happened is not uncharacteristic of a bubble period in the market. We saw a lot of this in the 1920s. There were a lot of unscrupulous things that happened and brokers were scarred for at least a decade. We saw this back in the railroad age when a lot of people lost money on railroad stocks where you had a bubble. So I think it's not unusual. I think there is a scar, but I don't think it's a permanent damage. Particularly if Wall Street, as I think it has to a considerable extent, cleans up its act.

Registered Rep.: So, what do you think of the role of financial advisors should be?

Malkiel: People do think that I want to get rid of all financial advisors. I don't think that at all. I think what the financial advisor can do is in fact to set up the diversified portfolio that's appropriate for one's age, that's appropriate for one's income, what's appropriate for one's risk-tolerance. And right now one of the worst mistakes would be to quit equities entirely. I've seen this at the University recently, people saying, “I just can't take it anymore.” Well, the equity market is never going to be a smooth ride. That's why one's risk-tolerance is extremely important in setting up one's portfolio, and I think the main job of a financial advisor is not to pick this stock or that stock, is not to say that's a great mutual fund, or this is a bad mutual fund, but rather to make sure that their clients are invested in a portfolio that's suitable to their age, their risk-tolerance, their other sources of income and so forth.

Registered Rep.: So an advisor is more for asset allocation.

Malkiel: Yes, what I'm saying is that there are things from advisors that aren't useful and things from advisors that are useful. And the useful part of what an advisor can do is asset allocation, but I don't want to limit it to that. It's not only asset allocation. Advisors can play an enormously important role in guiding people around mistakes. I mean, the mistakes people make. They put tax-exempt bonds in their IRA. And what that does is it'll take tax-exempt income and make it taxable income.

Registered Rep.: What do you think of the managed account?

Malkiel: I tell you what troubles me about the managed account. I happen to think that the stock market is reasonably priced today for the long run. Having said that though, I believe that we are living in an era of single digit returns, rather than double-digit returns. Now my worry about many managed accounts is the expense. If your charging small investor 200 basis points, that's going to be a major share of the total return. And I am concerned then that these managed accounts may not be in the best interest of the consumer.

Registered Rep.: Do you use an advisor?

Malkiel: No. I'm my advisor.

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