This week, Professor Burton Malkiel of Princeton University published the latest 50th anniversary edition. A Random Walk Down Wall Street: A Guide To The Best Investing Money Can BuyMore than any other book, it disseminated the idea of indexing as an investment strategy and why you can’t beat the market. Malkiel was a close friend of Vanguard founder Jack Bogle, and served on Vanguard’s board of directors for 28 years.
Malkiel will be on CNBC’s “The Exchange” today at 1:30 PM ET. Below are excerpts from a series of emails from her interview. Lightly edited for style and clarity.
You recommended index funds 50 years ago, even before index funds existed. Do you still believe it and what is the evidence?
I believe more strongly than ever that index investing is the best strategy and that index funds should be at the core of every portfolio. Standard & Poor’s publishes an annual report comparing actively managed and index funds. About two-thirds of active managers underperform their index funds each year. And the third that outperforms one year doesn’t tend to be the same as the third that outperforms the next. Measuring performance over 10 years, her 90% of active managers outperform broad index funds. On average, active managers underperform the market by about 1% per year.
You famously said that stocks tend to follow a “random walk”. What is random walk?
A random walk means that the past stock market price history cannot be used to predict the future. Sometimes there is momentum in the market, but momentum strategies don’t work reliably and prices change randomly. Value and small-cap stocks can outperform, but they can underperform for years. So-called “factor funds” have underperformed the market for the past 15 years.
Despite the evidence, most people seem unwilling to believe the evidence. Why can’t stock prices follow a random walk?
Streaks are more memorable than randomness, so people fool themselves when they see obvious patterns. Even people in sports believe that streaks exist and that they have “hot hands.” For example, behavioral psychologists have looked at the free-throw records of college and professional basketball players and believe that the more successful free-throws you make in a row, the more likely you are to succeed on your next shot. The evidence is quite the opposite. 50% Free His slow shooter has a 50% chance of succeeding on the next shot, regardless of the number of previous shots.
You are a proponent of the Efficient Market Hypothesis (EMH), which states that asset prices reflect all available information. However, he pointed out that this does not mean that the prices are always accurate. EMH, defines what it says and what it doesn’t say.
An efficient market does not mean that prices are always correct. Even if everyone values stocks as the present value of future cash flows, the future can only be estimated. So the price is often the “wrong” one. According to EMH, no one knows when it’s too high or too low. EMH admits there may be bubbles, but no one knows how much they will expand before they burst. Alan Greenspan suggested that the market was “irrationally frenetic” in 1996. The bubble burst in 2000. Meme stocks like GameStop sold at bubble levels, but hedge fund Melvin Capital went bankrupt after shorting them. Markets are not perfectly efficient and can make terrible mistakes. But very hard to beat.
Exchange traded funds (ETFs), mostly tied to index funds, continue to attract money. What do you think about ETFs?
I like ETFs if they are broad index funds. I don’t like very technical stuff that really represents active management. I believe that anything that takes leverage (such as his 3x up and down market move) is actually a gambling contract, not an investment product.
Last time we spoke, you said the next revolution in index funds would be in investment advice. Most advisors charge her 1% or more. 0.25% online. Are there signs of an “advice revolution” taking place?
Just as indexing itself was revolutionized, so too is investment advice services being revolutionized. Investment advisors charge a fee of 1-3% per year to manage an individual’s portfolio. A software company can effectively do that with 25 basis points for a company that embraces fully electronic management and 50 basis points for a hybrid model that allows for occasional human conversations. I work with his Wealthfront (fully electronic) and his Rebalance (hybrid) investment manager. An electronic or computer manager can also offer a direct index that allows the fund to efficiently recover tax losses while maintaining pre-tax broad market exposure.
A few years ago, you wrote a highly critical op-ed in The Wall Street Journal, calling ESG (Environmental, Social and Governance) funds a “self-defeating strategy”. Since then, they have come under further scrutiny. Do you still feel that way? why?
ESG funds promise to contribute to society through investment and at the same time bring good economic results. But there is disagreement about what constitutes a “good” investment. Are natural gas companies good because they are the cleanest burning carbon and a necessary bridge for decades on the road to a carbon-free world, or are they bad because they are pollutants? Are munitions makers good because they supply Ukraine with defense weapons, or bad because their products kill people? ESG funds also charge high fees and underperform standard index funds.
You have always preached the benefits of a diversified portfolio. What should a diversified portfolio look like?
Portfolios should be broadly diversified, but circumstances vary from person to person. Young people need to maintain dollar-cost averaging by investing almost exclusively in stock index funds on a regular basis (it’s not appropriate to bond her 60/40 stocks for young people). Investors in their 70s and his 80s are receiving the minimum required distributions and need a larger percentage of term bonds.
The S&P is down almost 20% last year. A year of 20% decline usually recovers the following year. What can we expect from stocks in 2023?
I do not make short-term stock market forecasts. You can’t do this right with consistency. However, the cyclically adjusted price/earnings ratio (CAPE) offers the best prediction of long-term stock returns. CAPE today is well above average. This suggests that returns over the next decade are likely to be below the historical long-term stock market returns of 9% to 10%. Investors should keep expectations modest and consider that returns may be only half of their historical averages.