When “A Random Walk Down Wall Street” was first published in 1973, author and Princeton University Professor Burton Malkiel didn’t expect to earn more than $10,000 in royalties from it. In the nearly four decades that followed, however, this plainspoken investment guide, which champions index funds and a low-cost buy-and-hold strategy, became a huge hit with readers, selling over a million and a half copies.
In January, W.W. Norton released the tenth edition of the book. Malkiel, who has been a governor at the former American Stock Exchange and a member of the White House Council of Economic Advisers, says he still gets fan mail from satisfied investors—“It’s almost like doctors getting grateful patient letters.” He’s also feeling validated these days as mutual funds and exchange traded products explode in popularity. Malkiel talked recently with Registered Rep. about what’s new in the latest edition, the hazards of writing popular books when you are a university professor, and how he’s become “more appreciative” of the role that financial advisors play with their clients.
Registered Rep.: What made you decide 40 years ago to write this book?
Burton Malkiel: While I was working in Wall Street, I got very suspicious that active management with all of its attendant expenses was probably not the best thing in the world for individual investors. And then when I got to Princeton and became an academic — knowing all the research in the field and doing a lot of it myself — I became absolutely convinced that that was right. We know the stock market’s been a pretty good place in the long pull, but you have active management taking at least 100 basis points off the return, and that compounds over time. Well, I think these things were becoming very well known in the academic community, but I thought they were not particularly well known in the broader community, and particularly for individual investors. That made me decide it would be a pretty good thing to write something for a broader audience.
Frankly, I’ll tell you I did this right after I got tenure. You don’t get tenure at a university writing a popular book. That’s one of the nice things about tenure. Somebody can’t say, “Oh my God, he writes popular books!” Because I’d already paid my dues. I started off making sure I was writing stuff that would be unintelligible to the general public.
When it was first published, it was not well received. People in Wall Street thought this was utter garbage. I had a review in BusinessWeek by a Wall Street professional saying this is just the stupidest idea in the world. What’s particularly pleasing to me today, 10 editions later, is that Wall Street has really caught up with it. It’s not considered a dumb idea. In fact it’s almost perceived wisdom that institutional investors have a core satellite strategy, and that the core is in index funds. What’s the fastest growing investment product now? It’s ETFs. And ETFs are, by and large, index funds and very, very low cost. Whether it’s State Street, Vanguard, what have you, you’ve got broad-based index funds that cost less than 10 basis points. ETFs now are over a trillion dollars.
RR: Yet most of Wall Street still believes in active management.
BM: Sure, they have a good reason to believe that, because a lot of people want to say, “This is too complicated, you can’t do it yourself, you need these high-cost products,” and there’s a sort of self-interest to perpetuate it.
Some people would say, “Are you disappointed that the majority of professionals still believe in active management?” And I say not at all. I’m not looking at the glass being half-empty. I’m just amazed that an idea that started in the academy has this much traction.
RR: You write, “You can do as well as the experts — perhaps even better.” That philosophy must drive financial advisors crazy.
BM: In a way, you really need to interpret that. I’ve become frankly more appreciative of what a financial advisor can do. For me, it’s keeping people from beating themselves. Keeping people on an even keel. It’s easier said than done. It’s very hard work.
I’m sort of an informal financial advisor for all of the Princeton widows. I remember so many of them would come in with tears in their eyes in the third quarter of 2008 when it looked like the world was falling apart — “and I have to sell all of my equities!” That’s what I mean by keeping people on an even keel.
What financial advisors can’t do, they cannot pick the best mutual funds, they cannot pick the best stocks. But boy, it is really important to emphasize diversification. To emphasize, if you’re dollar cost averaging, don’t stop during a period like 2008, when people come in and say, “Listen, I’ve lost money on every investment I made. It just keeps going down. I can’t stand it anymore.” If you stop at the bottom when the sky is falling, then you lose all the advantages of it.
RR: What are some of the biggest changes in the new edition?
BM: Probably the biggest change in the tenth edition is showing how people are insufficiently diversified internationally. I stressed diversification in the first edition. But in the first edition, we were well over the half of the world’s GDP. We’re 20 percent of the world’s GDP now. The rest of the world is growing so much faster than we are now, particularly China, India, Brazil.
RR: Have your views changed at all since you started writing “Random Walk?”
BM: I feel even more strongly about indexing today than I did before. One thing I do in every edition is say, “OK, you had an idea. Did it work?” And every time, two-thirds of active managers are beaten by the index and the third that win in one period are not the same as the third who win in the next period.
There’s a lot of stuff in there about buy and hold. I don’t think it’s dead. Obviously if we knew how to time the market, buy and hold shouldn’t be the right strategy. But we don’t. What I show is when people actually try to do it themselves, they tend to buy at the top and sell at the bottom. More money went into equity mutual funds in the first quarter of 2000, at the height of the Internet bubble, than ever before. And more money came out of equity mutual funds in the third quarter of 2002, which was a low. And then money gushed out in the third quarter of 2008, which turned out to be exactly the wrong time to do it.
RR: Don’t the wealthy need more active management because of their complex financial situations?
BM: I am very skeptical about the idea that, if you’re high net worth, you therefore should get into all these exotic things like commodity funds and hedge funds, which basically don’t beat the market. Do some of these people need a lot of good tax advice and estate planning advice? Sure. But do they need advice about different instruments that they ought to use? I’m much less certain about that.
RR: Where should China fit in a portfolio?
People definitely ought to have more in emerging markets. China’s the fastest growing economy in the world. It’s going to be the fastest growing economy over the next decade, and probably for decades. And most people have zero in China.
RR: It’s not a country that’s known for its transparency.
No question it’s risky. I would say the index funds of H- and N-shares, any Chinese company that trades in Hong Kong, reports by international financial reporting standards. The companies that listed in New York, like Baidu, report under GAAP.
RR: Your thoughts on alternatives?
There’s no doubt in my mind that private equity investors who accept illiquidity can make higher rates of return. You get paid for bearing illiquidity. This is the (Yale Chief Investment Officer) David Swensen endowment model. This is what’s done at Yale, at Harvard, at Princeton. But I think the individual investor is going to get the dregs of these sorts of things, and the individual investor should stay away.
RR: Is there any criticism of “Random Walk” that bothers you?
The meaning of random walk is that basically the next steps are unpredictable. You can’t predict what the market’s going to do next week, next month. Not that the market’s capricious. The reason for random walk is market pressures change with news, but true news is random. True news is something you didn’t know before. If you read a headline, “Retailers are going forward with post-Christmas sales,” that isn’t news. But, “Eric Schmidt is out as CEO of Google and Larry Page is in,” that’s news, and that’s what moves markets. But that’s unpredictable.
The efficient market hypothesis doesn’t mean that markets are always right. How could markets be always right? I teach my students that a stock should be worth the present value of all the future cash flows. Let’s say all stocks are priced that way, efficiently. The word is “future.” Nobody knows the future. Market prices aren’t always right. The problem is, nobody knows at one time which ones are too high and which ones are too low.
RR: Has “Random Walk” had an impact?
BM: Indexing is growing over time. I’m delighted that there’s a trillion dollars in ETFs. Vanguard is the largest mutual fund company, not because of actively managed stuff but because of the index business. I think the book certainly had a part to play in it. I don’t mean to suggest the book was totally responsible for this, but I do think it helped.