A Random Walk Down Wall Street is designed as an accessible guide to financial markets for the individual investor. Written by Burton Malkiel, an economist (Ph.D., Princeton) with years of practical experience on Wall Street, the book covers everything from buying life insurance to pricing commodities to understanding credit default swaps. But, for the most part, Malkiel’s focus is on common stocks—shares in individual firms—and the stock market.
Although Malkiel offers a wealth of information that investors can use to make individual investments on their own, he repeatedly emphasizes the advantages of index investing. If you only take one thing away from A Random Walk Down Wall Street, it should be this: Investors are better off putting their money in a passively managed index fund—a total market index fund, to be precise—than trading stocks themselves or investing in an actively managed mutual fund. For example, an investor who put $10,000 into an S&P 500 Index Fund in 1969 would have had a $1,092,489 portfolio in April 2018 (assuming all dividends were reinvested). An investor who put the same amount of money into an actively managed fund would’ve only had $817,741.
The one-page summary is divided into two parts. The first part covers the first three parts of A Random Walk Down Wall Street, guiding you through the key financial concepts Malkiel discusses as well as “Malkiel’s Take” on those concepts. The second part covers Malkiel’s practical investment tips.
There are two basic theories for stocks’ valuation, one based on stocks’ actual characteristics, another based solely on human psychology.
The firm-foundation theory holds that assets have an “intrinsic value” based on their present conditions and future potential. The firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.
Once an intrinsic value is established, the investor will make buying and selling decisions based on the difference between the actual price of the stock and the intrinsic value (because, according to the theory, the price will eventually regress to the intrinsic value).
The castle-in-the-air theory of asset valuation holds that an asset is only worth what someone else will pay for it. In other words, no asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth.
A castle-in-the-air investor makes her money by investing in stocks she thinks other investors will value.
There are glaring flaws with both theories of stock valuation.
With the firm-foundation theory, the problem is its reliance on future estimates. No analyst can know for certain how much or how long a stock’s dividends will grow—or even if they’ll grow at all.
With the castle-in-the-air theory, the challenge is timing. The successful castle-in-the-air investor needs to buy an asset just before mass enthusiasm causes its price to rise (and sell before that enthusiasm wanes).
The two primary methods of security analysis that financial professionals use are technical analysis and fundamental analysis.
Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements.
Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa).
Fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams.
Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along.
Although Wall Street professionals today continue to use these methods of security analysis, the empirical evidence indicates that neither is a particularly reliable way to make investment decisions.
Regarding technical analysis, the key finding among researchers is that a stock’s past performance is no indication of its future performance. (In fact, stocks’ price movements resemble a “random walk” that’s similar to the results of flipping a coin.) Any method of analysis that relies on stocks’ “momentum”—whether a stock is generally moving either up or down—is sure to prove faulty.
Regarding fundamental analysis, no matter how lucid and well-founded a fundamentalist’s value determination is, he or she simply cannot account for randomness—the appearance of a groundbreaking technology, a new legal regime, or a catastrophic event like a public-health or environmental emergency. Fundamentalists can also make random mistakes in their analysis that result in bad bets.
There’s also the problem of bad actors. Firms can fudge their earnings reports, leading fundamental analysts astray. And fundamentalists’ reports can be unduly influenced by their own employer’s clients, resulting in conflicts of interest in their buy or sell recommendations.
Modern Portfolio Theory (MPT) builds on the “efficient market hypothesis” (EMH), which holds that stock prices already reflect all relevant information. According to the EMH, no analyst can determine whether a stock is under- or overvalued, and thus there’s no way for an analyst to “beat” the market. The only way to realize greater returns is to take on more risk.
Modern Portfolio Theory (MPT) offers a strategy of managing that risk: diversification.
A diversified portfolio is one that features holdings in a variety of industries, countries, and asset classes. The idea is that, when your holdings in one industry, country, or asset suffer, your holdings in other industries, countries, and assets will offset your losses.
Malkiel, who accepts the EMH as a given, is a firm believer in the benefits of diversification, especially international diversification. He notes, from 1970 to 2017, a portfolio with 82% US stocks and 18% developed-foreign-country stocks provided the highest returns with the lowest volatility of any mix of the two (including 100% US).
MPT led to a number of advances in the analysis of risk, including the distinction between unsystematic risk and systematic risk.
Unsystematic risk describes the variability in a stock’s returns due to aspects of the stock in particular, whereas systematic risk describes a stock’s sensitivity to shifts in the stock market in general.
The key characteristic of systematic risk, better known as “beta,” is that it cannot be diversified away by strategies like MPT. And researchers found that because it can’t be diversified away, beta is the only kind of risk that pays a “risk premium”—that is, a higher return for the higher risk.
Beta forms the starting point for a number of investment technologies including the “capital asset pricing model” (CAPM), which calculates an asset’s expected return based on its beta (among other factors) and “smart beta,” which involves the customization of indexed portfolios to lower risk.
Beta is a valuable metric, but not in the way its originators or proponents imagined. This is because scholars of finance have found that higher betas don’t result in greater returns.
Nevertheless, beta does accurately describe risk, and so investors with little stomach for volatility can gravitate to stocks with low betas—which, the research shows, will produce the same returns in the long run as stocks with high betas.
(“Risk parity,” another newer investment strategy, advocates investing heavily in low-beta assets. The way risk parity generates risk—and thus greater reward—is by encouraging investors to invest on margin.)
Behavioral finance is an approach to financial markets and economic research that foregrounds human behavior. It proceeds from the premise that, contrary to most economic and financial models, people are not fully rational decision makers. In fact, research has shown that people are irrational in systematic and predictable ways. According to the progenitors of behavioral finance, Daniel Kahneman and Amos Tversky, our irrationality stems from factors like overconfidence, groupthink, and loss aversion. (Shortform Note: For more details, see our summary of Thinking Fast and Slow).
Malkiel believes the behavioral finance literature has produced some key insights for investors, some of which dovetail with his own findings. Two key takeaways are:
1) Don’t Follow the Crowd
Studies in behavioral finance have shown that word of mouth is a frequent driver of stock purchases. When some new investment is the talk of the town, it’s natural to want to take part. But resist the urge: Stocks or funds that are hot one quarter are almost invariably losers the next. It’s generally better to stick with “value” stocks—securities issued by tried-and-true companies with steady revenues—than gamble on “growth” stocks with high risk.
2) Don’t Overtrade
When investors trade to realize short-term gains, they tend to incur high transaction costs and taxes. One study of 66,000 households found that the households that traded the most earned an 11.4% return on their investments—while the market returned 17.9%.
If you have to trade, trade losers. The tax benefits of incurring a loss are likely better than the gains of selling a winner.
Valuable for the novice and experienced investor alike, these 10 principles are essential to realizing returns.
In investing, there is truly no such thing as getting rich quick. The best way to realize returns is to begin investing as soon as possible and keep investing steadily, whether through the automatic reinvestment of dividends or regular contributions to a tax-advantaged retirement plan.
Even the most successful investor needs liquid assets that can be called upon in a pinch (or the financial protection of insurance). In terms of cash reserves, if you have decent health and disability insurance, three months’ worth of living expenses is a good benchmark.
As for insurance, home, auto, health, and disability are musts. As is life insurance, if you’re the primary breadwinner for a family with dependents. Malkiel favors buying low-premium term life insurance.
Keeping your cash in a low-interest savings account can be a losing proposition when inflation outpaces the interest you’re earning.
Malkiel believes money-market mutual funds are the best product in general for cash reserves. Make sure to choose a low-expense option like those offered by Vanguard or Fidelity. There are also tax-exempt money-market funds that are ideal for high-income investors.
If you know the date of a sizable future expenditure, certificates of deposit (or “CDs”) are your best choice.
Additional products include internet banks, which can offer higher interest rates because of low overhead, and U.S. Treasury bills, which can offer decent (and tax-free returns).
There is no good reason you should pay taxes on investment earnings for retirement or expenses like college tuition.
First, take advantage of individual retirement accounts (IRAs). Earnings on IRA holdings aren’t taxed, and, by the time you actually withdraw the funds from the IRA, you’re likely to be in a lower tax bracket than you are currently.
There are also Roth IRAs. The key difference between a traditional IRA and Roth IRA concerns tax advantages: With traditional IRAs, contributions are tax deductible, but you’ll pay taxes when you eventually withdraw your funds; with Roth IRAs, you pay taxes upfront, but withdrawals (including earnings) are tax-free.
Which IRA is best depends on your personal financial situation. Investors with low taxes now might opt for a Roth IRA. Investors with high taxes now might go with a traditional IRA.
If you have access to a retirement plan like a 401(k) or 403(b), which are tax-free, Malkiel’s advice is to max them out wherever possible. And if you want to save for a child or grandchild’s college tuition, tax-advantaged “529” accounts are the way to go.
One way to align your goals with the products available is to determine your tolerance for risk. Those who are nearing retirement (or who just want to sleep well at night) should opt for “low” and “moderate” risk assets like broad market index funds and high-quality corporate bonds. Younger (or thrill-seeking) investors might opt for high-risk assets like small-cap stocks and/or equities in developing nations.
Owning a home has proven to be a reliable means for families to hedge against inflation and realize returns. For those investors without the means or desire to buy a home, real estate investment trusts (or REITs) provide a nice alternative. REITs consist of real estate assets—apartment buildings, offices, and the like—packaged into securities that can be traded like common stock.
Bonds are an essential component of a well-diversified portfolio. There are a number of bond options in addition to the traditional, interest-earning bond, including zero-coupon bonds (or “zeroes”), which sell at a discount and simply pay out their face value at maturity, and tax-exempt bonds, which comprise state or municipal debt that earns interest tax-free.
If you’re planning to buy bonds directly—rather than gaining exposure through a mutual fund—then your best bets are new issues. Newer bonds generally offer better yields than established bonds, but only buy bonds rated A or above by Moody’s or S&P.
Investors interested in exposure to a wide range of bonds can opt for bond mutual funds from companies like Fidelity and Vanguard. Popular bond substitutes include Treasury inflation-protected securities (TIPS), whose face value rises to keep pace with inflation, and high-dividend stocks.
Assets like gold, fine art, baseball cards, and commodities futures are extremely fickle and don’t pay interest or dividends. Unless you have ample resources in other instruments, assets like these should only occupy a modest part of your portfolio.
With the advent of commission-free brokerage services, stock trading has become accessible to even the humblest investor. That said, there are still high-expense products that investors need to be aware of and avoid.
Steer clear of “wrap accounts.” Offered by various brokerages, these accounts can run you up to 3% per year, which makes outpacing the market almost impossible.
You should also be wary of mutual funds and ETFs with high expense ratios. (An expense ratio is the percent of a fund’s assets deducted annually for operating expenses.) Anything above 1% is worth second-guessing. Index ETFs and mutual funds, for example, can be had for a few hundredths of a percent.
The key to consistent and positive returns over the long run is (a) diversification among asset classes (stocks, bonds, REITs, and so on.) and (b) diversification within asset classes (negatively correlated common stocks, a mix of corporate bonds and TIPS, etc.).
Age may be the most important factor in deciding how to allocate your investments. For example, a fully employed 30-year-old, with many years of labor income ahead of her, can weather more losses (and thus tolerate more risk) than a retired 70-year-old who relies on his investment income to get by.
In terms of age-dependent investing, Malkiel’s advice boils down to this: The longer you’re able to hold on to your investments, the more common stock you should have in your portfolio.
For example, a fully employed person in their mid-twenties should have a high-risk allocation: 70% stocks, 15% bonds, 10% real estate, 5% cash. A person in their sixties and about to retire should have a low-risk allocation: 40% stocks, 35% bonds, 15% real estate, 10% cash.
Retirees’ investment options depend on how much they’ve been able to save.
For retirees with low savings, the options are narrow. Malkiel suggests continuing to work part time—which can have ulterior health benefits by keeping seniors active and social—and delaying taking Social Security for as long as possible to maximize those benefits. (Seniors in poor health with lower life expectancy might opt to begin taking Social Security as soon as possible to realize the benefits while they can.)
For retirees who’ve managed to build up a nest egg, there are two primary options: annuitizing your savings or holding onto your portfolio and establishing a spending rate. Malkiel recommends at least a partial annuitization of your retirement savings and, if you choose to manage your own investments, spending only 4% of the total value of your nest egg annually.
An “annuity”—or “long-life insurance”—is a contract with an insurance company for regular payments as long as the purchaser lives.
Malkiel’s take is that while annuities offer the security of never running out of money, they can be tax inefficient and unwieldy, especially if you want to vary your spending year over year or leave a bequest to descendants.
Retirees who opt to manage their investments themselves—or only annuitize a portion of their nest egg—should spend no more than 4% of their retirement savings annually (the “4% rule”).
First, 4% is likely to be below the average return rate of a diversified portfolio of stocks and bonds minus inflation. This means that the portfolio will continue to offset the reduction in purchasing power inflicted by inflation.
Second, 4% protects you from the inevitable volatility in returns. If you limit your annual withdrawals in bull years, you create a backstop against bear markets.
Once you’ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is to decide which precise securities to purchase. Malkiel proposes three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.
The autopilot strategy consists of purchasing broad index mutual funds or exchange-traded index funds (ETFs) rather than individual stocks or industries.
The autopilot strategy is Malkiel’s preferred method of investing. No matter how knowledgeable or engaged the investor, Malkiel advises building the core of a portfolio around index funds and only making active bets with excess cash.
While the S&P 500 index funds are generally the most popular type of index fund, Malkiel actually recommends that investors choose a total market index fund over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks that, historically and on average, have outperformed larger ones. Try to find a fund indexed to the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI US Broad Market Index.
Of course, diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: There are funds that track REIT, corporate bonds, international capital, and emerging market indices.
No matter what, for large sums like your retirement savings, a diverse portfolio of index funds is the strategy that Malkiel recommends. That said, some investors—for example, those with a taste for gambling—will find indexing an entire portfolio boring and may want to try their luck picking winners. Malkiel advises that thrillseekers only speculate with secondary monies that they can afford to lose, and that they follow four key principles.
Simply put, earnings growth is what produces winners. Not only do consistently above-average earnings boost dividends, they also result in higher price-earnings (P/E) multiples. That means higher capital gains on top of dividends.
The ideal stock is reasonably priced with positive growth prospects. Although determining the precise value of a stock is effectively impossible, you can tell whether a stock is reasonably priced by comparing its P/E multiple to that of the market as a whole. If a stock’s P/E is well beyond the market’s, you might be wise to stay away. (Note that it’s OK to buy stocks with P/E multiples greater than market’s as long as growth prospects are above average as well.)
If you come across a firm-foundation stock around which buzz might build—for example, because the company is about to hire a charismatic CEO or debut a new technology—those are stocks worth purchasing. The key is to buy in before the builders of castles of air drive the price up.
You should hold your purchases as long as possible, and, if you have to trade, sell your losers before your winners—the tax benefits of incurring a loss are likely to be more beneficial than the tax burden of realizing a gain.
Some investors might prefer to entrust their money to a professional. But Malkiel’s years of studying actively managed mutual funds have yielded two key insights: One, that fund managers’ past performance has little bearing on future performance, and two, actively managed funds rarely beat the average market return for long.
With over 1.5 million copies sold and 12 editions, Burton Malkiel’s A Random Walk Down Wall Street is one of the most popular investment books ever published. Malkiel holds a bachelor’s degree and MBA from Harvard and a Ph.D. in economics from Princeton, where he’s currently a professor of economics. In addition to A Random Walk, by far his best-known work, Malkiel has published influential technical papers in scholarly economics journals and was a longtime trustee of Vanguard mutual funds. Before moving into academia, he worked on Wall Street as a stock analyst and portfolio manager, then as director of an investment company.
A Random Walk Down Wall Street is designed as an accessible guide to financial markets for the individual investor. Malkiel covers everything from buying life insurance to pricing commodities to understanding credit default swaps. But for the most part, Malkiel’s focus is on common stocks—shares in individual firms.
Readers interested in Malkiel’s full tour of finance are encouraged to read the summary from beginning to end. Readers looking for Malkiel’s practical investment recommendations might choose to skip directly to Part 4.
Whatever your priority, if you only take one thing from Malkiel’s book, it should be this: Investors are better off putting their money in a passively managed index fund—a total market index fund, to be precise—than trading stocks themselves or investing in an actively managed mutual fund. For example, an investor who put $10,000 into an S&P 500 Index Fund in 1969 would have had a $1,092,489 portfolio in April 2018 (assuming all dividends were reinvested). An investor who put the same amount of money into an actively managed fund would’ve only had $817,741.
Before a novice investor can begin to make the right decisions about how to invest her money, she must know how stocks are valued. Traditionally, there are two primary theories of asset valuation: the firm-foundation theory and castle-in-the-air theory. (There’s a third—called “the new investment technology”—that Malkiel describes later in the book.)
Both theories, as we’ll see, are flawed, and Malkiel is skeptical of them both as a reliable source of returns (though, in the short run, either may produce better-than-market-average returns).
Adherents of the firm-foundation theory argue that assets have an “intrinsic value” based on their present conditions and future potential. For example, if the asset being valued is a common stock, the firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.
Once an intrinsic value is established, the investor will make buying and selling decisions based on the difference between the actual price of the stock and the intrinsic value (because, according to the theory, the price will eventually regress to the intrinsic value). If the stock price is below the intrinsic value, the investor will buy more shares; if it’s above, she’ll sell.
Given its simplicity and logic, the firm-foundation theory has earned its share of proponents, among them Warren Buffett, one of the most successful investors of all time.
However, a major problem with the firm-foundation theory is its reliance on future estimates. No analyst can know for certain how much or how long a stock’s dividends will grow—or even if they’ll grow at all.
Most closely associated with economist John Maynard Keynes, the castle-in-the-air theory of asset valuation states that an asset is only worth what someone else will pay for it. In other words, no asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth. (The theory earns its name because investors will build “castles in the air” about certain assets, thereby juicing their value.)
Keynes’s understanding of the castle-in-the-air theory made him a fortune. His process was as follows: Because no one can know with any certainty the future revenues or dividends of a given stock, he invested based on what he thought other investors would value. For example, if he sensed there was prevailing optimism in a certain sector of the economy, say in steel production, he would invest in steel companies regardless of their underlying fundamentals, simply because he anticipated other investors would soon rush into steel.
The key to the castle-in-the-air theory is timing: The successful investor will buy an asset just before mass enthusiasm causes its price to rise and sell before that enthusiasm wanes. A less charitable name for the castle-in-the-air theory is the “greater fool” theory—the less attuned an investor is to the prevailing winds, the more likely she’ll end up owning a stock that’s worth far less than she paid for it.
Speculative bubbles, of course, are examples of the castle-in-the-air theory run amok. In a bubble, investors completely disregard firm foundations for fantastical notions of assets’ values, often with disastrous results. And while some investors are savvy enough—or lucky enough—to sell just before the crash comes, most are left holding the bag.
Arguably the most famous—or infamous—speculative bubble in history, the tulip mania that struck 17th-century Holland perfectly illustrates the dangers of castle-in-the-air investing.
The craze centered on specific bulbs, called “bizarres” by the Dutch, that were infected with a nonfatal virus that caused the petals to develop vivid colors and patterns. The demand for these striking flowers caused tulip merchants to buy bulbs in bulk, which resulted in a rise in prices and attracted value investors as well as speculators. The craze became self-perpetuating: Prices continued to rise due to ever greater investment, which led to even higher prices and then even more investment. In 1634–1637, the years just before the crash, people began bartering valuables like jewelry and land to buy tulip bulbs.
Adding to the speculative frenzy was the “call option,” a financial instrument that allowed investors to buy bulbs at a fixed price (plus a premium) during a certain period and then sell the bulbs later for a profit. Options enabled less-well-off investors to enter the market: These investors could buy an option on a tulip bulb, say for $100, and fork over a $20 premium. If the price rose to $200 in the defined period, the option holder could exercise the option and sell the bulbs immediately, clearing $80 ($200 minus $120).
Although some economic historians, including Peter Garber, have attempted to argue that prices during the craze were rational, few can justify the 20x increase in tulip-bulb prices that occurred in January 1637—or the equivalent crash in prices the very next month. Simply put, once the mania abated, the tulips’ lack of intrinsic value became manifest and prices plummeted.
Speculative crazes like the tulipmania in Holland and the South Sea Bubble in 18th-century England—during which a trading firm called the South Sea Company rose in value by nearly 700% in a matter of months and fell by the same amount shortly thereafter—aren’t just a thing of the distant past. The stock market crash of 1929, which precipitated the Great Depression, is another example of irresponsible castle-in-the-air thinking.
Wide prosperity in the U.S. had boosted the stock market, and increased optimism among investors, and investing on margin—that is, borrowing to speculate in the stock market—had become commonplace. Traders were also engaging in some unsavory practices, like forming investment pools, to manipulate stock prices. (An investment pool consisted of a group of traders who would collude to bid up a stock price and then sell once those outside the pool began buying the stock.)
A key indicator of investors’ irrational optimism was the price of shares of closed-end funds. (Closed-end funds are pooled assets managed by an investment company, in which investors can buy shares.) Shares in these funds typically sell at small discounts compared to the total market value of their component stocks. However, during most of 1929, shares in these funds were selling at premiums of 50% or more over their composite stocks’ values. In other words, an individual investor could buy a share of, say, GE, from the company itself for $5, but if the investor wanted a slice of the fund, she’d have to fork over $10 for the same stock. The higher prices were completely driven by irrational confidence that stocks would continue to rise in value.
On September 3, 1929, despite a recent downturn in business activity, the stock market reached an all-time high, one that wouldn’t be reached for another 25 years. Two days later there was a sharp decline, followed by months of uncertainty. In late October, brokers began making margin calls, many of which went unmet due to insolvent borrowers. On October 29, the market collapsed, with some major firms like GE and Bethlehem Steel losing 95% or more of their value.
Given the dangers presented by speculative bubbles, novice investors have turned to finance professionals—portfolio managers—to handle their investments. The thinking is that these professionals, backed by esteemed and successful financial institutions, won’t be swayed by the madness of the crowd.
The truth, however, is that financial institutions, and the human capital they employ, are just as susceptible to irrational optimism as we are. That optimism typically manifests itself in the “price-earnings multiple” applied to a firm’s common stock—that is, the number by which a stock’s earnings is multiplied to determine the price of the stock. Deriving this number is not an exact science: The personalities and cognitive biases of securities analysts can play a role, and all too often a hot new issue (initial public offering, or IPO) will cause institutional investors to adopt castle-in-the-air thinking.
A note about IPOs: It’s worth remembering that the people selling shares in an IPO are the company’s managers themselves. In other words, an IPO is timed to take advantage of favorable earnings, good buzz, or both, and minimize flaws in a company’s business model or long-term prospects.
Examples abound of financial institutions’ tendency to indulge in irrational optimism. Here are a few of the famous crazes of the last 60 years.
In the early years of the decade, companies with “electronics” or related words in their names, regardless of their actual product or profitability, enjoyed large price-earnings multiples that were quickly shown to be inflated. Many of these companies—Boonton Electronic Corp., Hydrospace Technology—which traded at high prices in the early 1960s, no longer exist.
Firms were able to impart the perception of growth by absorbing companies of equal or lesser value, often in wildly different industries from themselves. The crux of this boom was, again, the price-earnings multiplier: As a conglomerate absorbed more companies, thereby raising earnings, its multiplier would grow as well—but the multiplier would often outpace the actual earnings. When the conglomerates’ earnings came in far lower than the multiplier’s calculation, prices tumbled.
In the later years of the decade, risk-taking fund managers banked on so-called “concept” stocks—shares in firms with a dynamic leader or good “story.” Of course, in many cases, the stories were too good to be true—the firms had no revenue-generating potential, and the stock prices were revealed to be absurdly inflated.
After the boom and bust of conglomerates and concept stocks in the ’60s, finance professionals placed their bets on so-called “blue-chip” companies: Firms with household names, like IBM, Disney, and McDonalds, whose growth potential was taken for granted. Fund managers began speculating on these companies, however, raising price-earnings multiples to 80 or 90—a near impossible ask for a large-capitalization company. (Large capitalization companies with high dividends can’t grow fast enough to justify the huge premiums on their prices.) Between 1972 and 1980, the price-earnings multiple for McDonald’s went from 83 to 9; for Polaroid, 90 to 16.
As with the early 1960s, the early 1980s saw professional investors flocking to flashy new issues, in this case primarily companies in the biotechnology and microelectronics fields.
One overvaluation that exemplified the era concerned a carpet-cleaning company called ZZZZ Best. Founded by an entrepreneur named Barry Minkow when he was just 15, ZZZZ Best found considerable success in just a few years, turning Minkow into a millionaire by the time he was 18.
However, it was Minkow’s flair for self-promotion—he drove a Ferrari and had an enormous Z painted on the bottom of his home’s swimming pool—that drew investors to the company. At the height of the company’s rise, its price-earnings multiplier was 100. Unfortunately for these investors, what earnings ZZZZ Best did report were due to a money laundering deal Minkow had struck with the mob. Minkow ended up doing time in a federal prison, and the company folded.
One might imagine that with 300 years’ worth of economic experience, during which societies suffered steep recessions and depressions due to speculative bubbles, humanity would have improved its mechanisms for recognizing and mitigating those bubbles. Not so. In fact, the crashes of the early 2000s—the internet bubble at the beginning of the century and the real-estate bubble 10 years later—illustrate that castle-in-the-air thinking is just as prevalent today as it was in 18th-century Holland.
The investing principle we should take away from any bubble, the internet and housing bubbles not least among them, is this: There is no “sure thing” or “get rich quick” in the market. Invest in industries that have profit-making and profit-sustaining potential, rather than industries that purport to transform society. Avoid getting caught up in the hype of a new sector or technology; stay calm and keep your portfolio as broadly diverse as possible.
In the financial world, the early 2000s were marked by the rise of Internet stocks. Even though many of these “dot-com” companies had zero earnings (and zero potential for realizing earnings), they were valued astronomically highly.
According to Nobel Prize–winning economist Robert Shiller, these stocks were valued so highly on account of “positive feedback loops.” Because the Internet was a new and exciting technology, any company associated with it attracted interest. This interest attracted investment, which attracted media coverage, which attracted more investment, which attracted more media coverage, and so on. However, positive feedback loops can only drive prices as long as there’s someone willing to pay the new high price for the stock. Once there are no more “greater fools” who believe the stock will continue to rise, the bottom falls out.
Of course, this is precisely what happened. In January of 2000, the price-earnings multiples of stocks in the NASDAQ Index—the index of technology and Internet stocks—were over 100, and investors expected returns of between 15 and 25 percent on Internet stocks. When the bubble burst later in the year, many Internet stocks became worthless, and blue-chip Internet stocks like Cisco and Amazon lost 86.5% and 98.7% of their value.
(Shortform note: From a high of $75.25 in 2000, Amazon fell to a low of $5.51 in 2001–2002. In May 2020, Amazon stock traded for $2,411.03.)
Driving the absurdly bullish attitude toward tech stocks were the finance professionals with whom many Americans trust their life savings.
One major moral hazard that encouraged financial professionals’ magical thinking was the porous boundary between Wall Street firms’ research and investment banking arms. An investment company’s analysts are supposed to work on behalf of investors, communicating information as truthful and accurate as possible to the ones risking their money. A firm’s investment banking business, on the other hand, caters to corporate clients who benefit from inflated valuations.
To boost tech stocks’ prices, financial analysts developed an array of specious metrics for valuing companies. Rather than examine boring balance-sheet mainstays like revenues and profits—both of which, in the case of many new start-ups, were nonexistent—analysts priced stocks on the basis of website visits and the amount of time shoppers spent on a particular webpage.
Drugstore.com, for example, was valued at a high of $67.50 based largely on the fact that 48% of the people visiting the site were “engaged shoppers”—visitors who spent more than three minutes viewing the site. The only problem was that few of these “engaged shoppers” actually bought something. A year after its high in 2000, Drugstore.com was a “penny” stock.
Perhaps no other company (another contender is WorldCom) so epitomizes the speculative mania of the early 2000s as Enron.
Enron bewitched investors and analysts with its cutting-edge approach to an old industry: energy. At the company’s height, observers believed Enron would not only dominate the energy space, but also lead in broadband internet and e-trading and e-commerce.
Unfortunately for investors—and to the shame of professional analysts—Enron was obfuscating poor financial performance through an array of fraudulent activities. One noteworthy example concerns a joint venture Enron entered with Blockbuster (which, of course, went bankrupt itself in 2010). The venture failed, but Enron had already secured a loan from a Canadian bank for $115 million in exchange for future profits from the Blockbuster deal. Enron counted that $115 million as profit from the venture, and an accounting firm certified the company’s books as “fairly stating.” (Shortform note: Read our summary of The Smartest Guys in the Room.)
The 2008 financial crisis was, by and large, the handiwork of finance professionals.
Its proximate cause was the shift from an “originate and hold” system of mortgage financing to an “originate and distribute” system. In the “originate and hold” system, which was the standard in the 30 years prior to the financial crisis, banks originated (or created) mortgage loans and then held on to those loans for the life of the loan. Because loan officers would be held responsible if one of these loans went into default, they were much more careful about whom they financed.
In the “originate and distribute” system, which became the norm in the early 2000s, banks originated mortgage loans but then sold them to investment bankers, who bundled them together into “mortgage-backed securities”—essentially derivative bonds collateralized by the underlying mortgages’ principal and interest. Because mortgage issuers (and their loan officers) immediately offloaded the mortgages, they were much less scrupulous about whom they were loaning to. Not only did many homebuyers receive loans without putting any money down, many received so-called “NINJA” loans—loans where borrowers showed “no income, job, or assets.”
Investment bankers then sold a second derivative—credit-default swaps—on the mortgage-backed securities. A credit-default swap is essentially an insurance policy—if an owner of a bond (or a mortgage-backed security) is worried that the bond issuer might default on the loan, she can purchase a credit-default swap, which promises a payout if the bond issuer does indeed default. Advocates of credit-default swaps argued that because they spread risk so widely, isolated defaults wouldn’t hurt the overall economy. But when large numbers of mortgage holders began defaulting on their loans and the swaps were triggered, the sellers of the swaps were saddled with huge payment obligations—obligations they simply couldn’t meet.
The fallout was extraordinary, with some of the most storied and successful financial institutions of the 20th century—Bear Stearns, Merrill Lynch, Lehman Brothers, AIG—suffering staggering losses. Some of these firms, like Lehman, declared bankruptcy; others, like Merrill, merged with more stable institutions; still others, like AIG, had to be rescued by the US government.
(Shortform note: To learn more about the 2008 financial crisis, read the summary of The Big Short.)
Although considerably less far-reaching in their implications—because the markets are comparatively small—bubbles in cryptocurrencies like bitcoin are the latest iteration of castle-in-the-air enthusiasm. Malkiel’s advice is to stay away.
Created in 2008–2009 by an anonymous inventor (or group of inventors) who goes by the name Satoshi Nakamoto, bitcoin is an exclusively digital peer-to-peer currency. Bitcoin “tokens” are tracked and exchanged via an encrypted and anonymous public ledger called a blockchain. The blockchain records the ownership and transference of each of the 21 million tokens currently in circulation. Bitcoin evangelists see the currency in utopian terms—as a global and fraud-proof form of money.
In the years since its creation, the value of bitcoin has fluctuated wildly. For example, in 2010, a bitcoin token could be purchased for less than a penny. By December 2017, the value of a single bitcoin was fluctuating between $14,000 and $20,000!
For some, these fluctuations have been lucrative: Early investors—like the Winklevoss twins, who famously sued Mark Zuckerberg for stealing their idea for Facebook—have become bitcoin billionaires. For others, they’ve been torturous: Values of individual tokens have occasionally fallen by 50% in a matter of days.
But is bitcoin a bubble? Malkiel says yes. The rapid rise in the price of a bitcoin is one indication; the proliferation of competing cryptocurrencies—with some, like dogecoin, acknowledging their own absurdity—is another. Bitcoin, due to its anonymity and ease, is also the currency of choice for various illegal transactions, from drugs to assassinations, and it’s more than likely that governments will eventually crack down on its use.
One of the dominant theories of finance is that markets are “efficient”—that is, asset prices always already reflect all available information about the assets. (See Chapter 6 for more on the “Efficient Markets Hypothesis.”) In effect, the efficient-markets theory means no investor can “beat” the market, because no investor can gain an “edge” on any other.
The Internet and housing bubbles would appear to refute the efficient-markets hypothesis—because the stock and real-estate markets were absurdly overvalued during the booms, their prices clearly didn’t reflect all available information about their assets.
But, in fact, it’s the crashes that prove markets are efficient. Prices eventually, albeit slowly, reflected the true value of the assets. The market corrected itself.
Consider the basic theories of valuation—and valuations run amok—in light of your goals.
What are the two primary methods of stock valuation? Despite their shortcomings, which seems more useful to you and why?
What are some current investment fads that you might be wary of? List two or three, and then, using Malkiel’s concepts, explain why they seem suspect to you.
What strategies might you use to avoid getting caught up in a bubble? If you were affected by the dot-com or housing bubbles, you might draw on your experience here.
As established by their role in speculative bubbles, professional portfolio managers, for all their experience and expertise, are as susceptible to castle-in-the-air thinking as the rest of us. “But,” a portfolio manager might say, “in the long run and on average, we manage risk for our clients and provide returns that beat the market—that’s why so many Americans trust us with their life savings and why we deserve our fees and commissions.”
Unfortunately for portfolio managers, academics have compared managers’ returns with those provided by a market index fund—a mutual fund with holdings that replicate a market index—and found that portfolio managers simply aren’t worth the money. That is, no investor can do better in the long run than a market index fund.
Why can’t portfolio managers consistently outperform index funds? Fatally flawed methods of analysis.
Security analysts typically use one of two methods for predicting the movement of stock prices: fundamental analysis (discussed at length below) and technical analysis.
Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements. (Because of their reliance on charts, technical analysts are also called “chartists.”) Technical analysts subscribe to the castle-in-the-air theory of asset valuation: They believe that stock prices are more a product of investors’ psychology than a sober accounting of a firm’s profit-making potential.
Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa). It’s completely inconsequential to the chartist what industry a company is in or what’s happening in the world at large. To the chartist, all that matters is past and future price changes.
In practice, what this means is that technical analysts will study a stock’s charts to deduce trends. If there’s an “uptrend”—in other words, the stock price has risen over the course of a day or several days—then the chartist will be bullish on the stock. A head-and-shoulders pattern—where there’s a rise and fall, a greater rise and fall, and then a rise and fall similar to the first—indicates that a stock may have reached its “resistance level” and is due for a downturn.
Despite its seeming arbitrariness, technical analysis does indeed have a logic.
Does Technical Analysis Work?
The short answer is no. Academics studying the financial world and the performance of portfolio managers have determined that technical analysis—which requires a high volume of trading as stock prices rise and fall (which in turn entails considerable commissions and fees)—does not result in a greater return than a “buy-and-hold” strategy (as epitomized by a long-term investment in an index fund).
One of the technical analyst’s core principles is that price trends tend to be self-fulfilling—that is, if a stock’s price is rising, it will continue to rise for no other reason than the trend itself.
Researchers have found, however, that a stock’s past doesn’t reliably indicate its future. (Shortform note: Anyone who has read a fund’s prospectus will have seen the disclaimer that “past performance is no guarantee of future results.”) Although there’s some evidence to suggest there are brief spells of market momentum, there are just as many sharp reversals in momentum.
When enough price data is compiled, what researchers have discovered is that stock prices resemble a “random walk”—a mathematical concept that describes a value moving randomly up or down in a succession of “steps.” A classic example of a random walk is flipping a coin: If one is using a fair coin, there’s always a 50% chance one will flip either a head or a tail. The outcome of the flip is always random, and previous outcomes have no effect on present or future outcomes.
Although stock prices don’t conform precisely to the mathematical random walk—Malkiel calls market movement a “weak random walk”—enough comparative research has been done to establish that technical analysis doesn’t consistently outperform buy-and-hold strategies.
Technicians have criticized Malkiel for presenting a simplistic and unfair caricature of their processes. But when one examines chartists’ tools in more detail, those tools’ flaws are just as obvious.
Many technical analysts will adhere to a filtering system, whereby they trade stocks on the basis of certain amounts of price movement. Such is the thinking behind “stop-loss” orders, which trigger sales of stocks when a price falls a certain percentage or below a certain price.
Although the rationale of stop-loss orders is protecting an investor from further losses, longitudinal studies have shown that, when the transaction charges of these kinds of orders are taken into account, they don’t beat simply holding the stock.
Another common tool of a technician concerns index peaks. When an index like the Dow or S&P records a new peak value, technicians will label that peak a “resistance area.” When the index rises above that peak, it becomes a “support area” and the peak becomes the “resistance area.” Technicians assume that when an index rises above a resistance area, it will continue to rise (a bull-market signal); when an index falls below its support area, it will continue to fall (a bear-market signal).
Again, the problem with this theory is that the evidence of actual market movements doesn’t support it. For example, an index might break through a previous peak and then collapse the very next day, or fall beneath its support area one week only to set a new record the next. That is, the “signals” don’t predict the market’s actual performance.
One of the more wild technical theories, though not likely in wide use, is the assumption that the length of women’s skirts signals market movement. According to this theory, shorter skirts indicate a bull market, whereas longer skirts are a bear signal.
As you might expect, market movements have contradicted this theory again and again. (That said, some correlations have been observed: long skirts were the rage right before the 1987 crash.)
As noted above, technical analysis requires investors to engage in a high volume of trading—investors must always be ready to sell at a market peak and buy when the market is in a trough.
There are two major problems with this mode of investing:
The other major method of stock valuation employed by finance professionals is fundamental analysis; in fact, most security analysts see themselves as fundamentalists. Its method, which takes into account a number of factors in addition to past price movement, including revenues, growth rate, and management skill, would seem to be superior to technical analysis. But studies have shown that fundamental analysis is just as unreliable as technical analysis.
Whereas technical analysis focuses exclusively on the movements of a stock’s price, fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams.
Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along.
Investors using the fundamental method adhere to four principles when choosing to buy a stock. These principles are derived from four evaluative factors.
A company’s growth potential is arguably the most important factor in determining a stock’s value. This is because of compounding: the fact that dividends can be reinvested in a stock to increase returns. For example, if a company is paying a dividend of $1 today but dividends are growing at a rate of 25%, you stand to see a dividend of $3.05 in year five (rather than $2.25).
One shortcut for estimating a company’s growth rate is to look at its price-earnings multiple. Studies have shown that high P/E multiples correlate with high expected growth. In addition to providing an idea of a company’s growth potential, P/E multiples also allow for useful comparisons within industries. For example, if a particular pharmaceutical stock has a P/E multiple of 50 when most of its competitors are in the teens, you might wonder if that stock is overpriced.
Generally speaking, the fundamentalist investor will pay a higher price for stock in a high-growth company (especially if that company is built to last).
Depending on a company’s size, management, and capital strategy, the percentage of a company’s earnings paid out in dividends will vary. Which presents a dilemma for investors: Should one invest in a high-growth-potential stock that pays near zero in dividends (as high-potential stocks commonly do)? Or go with a near-peak company that pays out a lot in dividends but won’t grow much larger?
If two companies have the same expected growth rate (in other words, the same or similar P/E multiples), the fundamentalist investor will pay a higher price for the company that disburses a higher proportion of earnings as dividends.
Stock prices often reflect the relative risk of an investor’s stake. For example, a “blue chip” stock—that is, stock in a well-established company more or less resilient to recessions—will sell at a premium, whereas shares in an unproven company will likely be cheaper.
Fundamentalist investors examine the swings in a company’s stock price over the course of several years to determine whether the company is a risky bet. If the price typically trails the market in both up- and downturns, then that’s a stable stock worth its premium. If a stock outstrips the market in both bull and bear situations, then that’s a stock a risk-averse investor would want to avoid.
Investors invest to realize a return—that’s why the inherent risks of the stock market are tolerable. If you stand to make a competitive return in some other asset—corporate or Treasury bonds, for example—then you might be better served investing in those vehicles than common stock.
That said, if interest rates are low, most investors will be putting their money into stocks, thereby driving up prices. The fundamentalist investor will pay a higher price for stock when interest rates are low.
1) Remember: Future performance cannot be determined with exactitude. That is, past growth, dividends, price stability, and interest rates don’t guarantee similar performance going forward. No matter how detailed one’s analysis is, unforeseen circumstances can always make a mockery of expectations.
2) Precise measurements of value are impossible. Take, for example, Company X. After a granular analysis of Company X, you decide that the company can grow at a rate of 25% a year for 10 years, but its share price reflects 25% growth for 11 years. What do you do? Well, you can either pass on the stock—or simply change your calculation of constant growth to 11 years. The point is, calculations of the rate and amount of future growth are little more than guesswork.
3) Beware overpaying for growth. All investors want to see the companies in which they own stock grow, but the question is: How much should an investor be willing to pay for growth? Companies with growth potential will have larger-than-average P/E multiples—but, as the dot-com bubble illustrates, those P/E multiples can occasionally be castles built on (hot) air. Simply put, there’s no surefire way to know whether a large P/E multiple is justified. The best one can do is compare the current pricing of growth stocks with pricings in the past (see caveat #1).
Some analysts actually use a combination of technical and fundamental analysis to place their bets. For investors looking to mix the two techniques, Malkiel suggests adhering to three rules:
When it comes to investing, earnings growth is the key marker of success: Not only will a high-growth company reward your stake with increasingly generous dividends, its price-earnings multiple may rise as well (thereby increasing the value of your initial stake). Also, the longer the growth continues, the more your investment compounds in value.
Although the “true” or “correct” value of a stock is ultimately impossible to determine—because present values take into account future earnings, which cannot be predicted with certainty—it is possible to tell whether a stock’s price is within reason. The way to do this is to compare a stock’s P/E multiple with the market’s multiple as a whole. If a growth stock’s multiple is more or less in line with the market’s, then that’s probably a promising stock to invest in.
The danger with this strategy comes when a promising stock’s P/E multiple already reflects its future revenue growth—that is, when you have to pay a premium for the stock which, to some extent, offsets the growth. The solution is to buy growth stocks with P/E multiples at or around the market’s. That way you increase the odds of the “double bonus” described just above: You receive the benefits of the earnings growth as well as the increase in the P/E multiple.
Market enthusiasm, though it often leads to devastating bubbles, can also be used to the savvy investor’s advantage. If you discover a stock that has sound fundamentals as well as a compelling story—that is, one that is likely to produce steady returns while simultaneously attracting the interest of speculators—then that’s a stock worth considering.
To identify a “castle in the air” stock, simply think about whether the “story” of the stock could catch fire—for example, if the company has invented a new technology or its CEO has an impressive background or CV. Another simple way to pick a castle in the air is to see which stocks are beginning an uptrend.
Although the debate about the effectiveness of fundamental analysis is ongoing, scholars of finance are mostly in agreement that fundamental analysis is as useless as technical analysis.
There are five primary reasons fundamentalists fail to beat the market.
No matter how lucid and well-founded a fundamentalist’s value determination is, he or she simply cannot account for randomness—the appearance of a groundbreaking technology, a new legal regime, or a “Black Swan” (surprise event) like a public-health or environmental emergency.
Financial history is littered with “sure things” derailed by randomness; even utility stocks, which are widely seen as some of most consistent, are at the mercy of state authorities and global fuel dynamics. Cautionary tales are especially prevalent in pharmaceuticals. In 2013, Celsion Corporation lost 90% of its value due to a failed trial of a promising liver cancer drug.
Fundamental analysts stand by their valuations because they’re based on essential information about the relevant companies. But that means the valuations are only as good as the information underlying them. If a company fabricates a high quarterly earnings report through accounting sleight of hand, then the investor banking on that report may be in for a nasty surprise.
One obstacle to correct interpretations of firms’ revenues is the difference between “pro forma” earnings and actual earnings. Pro forma earnings are earnings excluding any “extraordinary” or “non-recurring” costs, which companies can define more or less how they choose.
Examples abound, especially within the last 30 years, of accounting malfeasance. Enron’s, of course, is the most notorious. But there are many other instances of bad-faith accounting, including Xerox, which padded its short-run profits by allowing international units to count long-term lease revenue as cash in hand.
Reason #3: Analyst Error
Even when a fundamentalist’s data is solid, there’s still the possibility that he or she can make a mistake. Malkiel has a low opinion of security analysts’ perceptivity and critical thinking skills—he witnessed some egregious errors when he worked on Wall Street—and he puts little stock in their predictions.
His skepticism seems warranted when one considers analysts’ forecasting errors. A relatively recent miscue concerns General Electric (GE). By 2016, the company had minimized its financial unit and seemed to have gotten back to its core business after the 2008 financial crisis. Analysts rated GE shares a “strong buy”—a share was trading in the $30 range—and recommended it to conservative investors looking for a consistently high dividend. But by June 2018, GE’s CEO had been fired, its dividend was cut in half, and it had been dropped from the Dow Jones Industrial average. (Shortform note: As of June 2020, a share of GE traded for $7.31.)
Reason #4: Analyst Attrition
It’s a curiosity of the financial services industry that talented security analysts don’t stay security analysts. If the analyst is articulate and agile in a conference room, he or she will end up a de facto salesperson, spending most of his or her time presenting to institutional clients. Or, if the analyst is truly outstanding, he or she is likely to be poached by a hedge fund to be a portfolio manager. This means that the people actually analyzing securities and making investment recommendations are often the B team.
Reason #5: Conflicts of Interest
In the 1970s, major banks’ retail and institutional investment divisions—that is, the departments responsible for individual and institutional clients’ money—were their primary sources of revenue. But as financial deregulation progressed in the ’80s and ’90s and discount brokerages came onto the scene, banks shifted their emphasis to investment banking: the provision of underwriting and advising services to major firms.
In isolation, this shift wouldn’t necessarily be a problem. But it’s become an issue because security analysts—whose valuations and recommendations are supposed to be objective—have been co-opted by their employers’ investment banking operations. Rather than providing their best judgments about companies’ prospects, even if those companies are clients of the investment bankers, analysts now fudge their work to bolster investment banking clients.
One way this moral hazard manifests itself is in the disparity between “buy” and “sell” recommendations. Contemporary analysts are hesitant to make “sell” recommendations for fear of alienating current or potential clients. One study found that analysts’ “strong buy” recommendations underperformed the market by 3% per month, and other researchers have found that analysts working for Wall Street firms without an investment banking business performed much better than those at firms with an investment banking division.
Perhaps the most glaring piece of evidence for fundamental analysis’s shortcomings is the actively managed mutual fund. Mutual funds are helmed by the most talented and respected finance professionals in the industry, and the funds they manage typically charge hefty commissions to benefit from those managers’ expertise.
Unfortunately, according to numerous academic studies, investors in actively managed mutual funds would have done just as well over the long run having invested in a passively managed index fund. For example, from 1992 to 2017, the S&P 500 notched a return of 9.69%, whereas the average mutual fund’s return was only 8.55%.
In fact, scholars of finance have shown that rank amateurs picking stocks nearly at random can outperform professional portfolio managers and the major stock indexes alike. For example, one study took a famous line of Malkiel’s—that a “blindfolded monkey throwing darts” at stock listings could be as successful as the professionals—and simulated it: Working with a “universe” of 1,000 stocks, the researchers randomly generated 100 portfolios of 30 stocks each for every year from 1964 to 2011. Incredibly, for each year, 98 of the 100 randomly generated portfolios performed better than the index of the 1,000-stock universe!
At its most basic level, the Efficient Market Hypothesis (EMH), formulated in detail by Nobel Prize-winning economist Eugene Fama, theorizes that all stock prices already reflect all relevant information—that is, no analyst can determine whether a stock is under- or overvalued.
(A common misconception about the EMH is that it means that stock prices are always “correct.” Rather, EMH simply means that stock prices always already reflect everything there is to know about a particular firm.)
In practical terms, what this means is that there’s no way for an analyst to “beat the market,” because any information an individual analyst might use to “buy low” or “sell high” is always already reflected in the current price. For example, a fundamental analyst looking at companies’ balance sheets and management teams will never find either an under- or overvalued stock—the prices will always reflect the stocks’ value as entailed by the available information about them.
However, since the formulation of the EMH, scholars have distinguished among three forms of the theory in order to better characterize analysts’ performance. The forms are:
Malkiel concedes that insider information can benefit analysts (at least in the short run)—but, of course, insider trading is illegal. The consensus among scholars is that the “semi-strong” form of the EMH holds true: that, in the long run, investors are always better off putting their money in a passively managed index fund. Even Benjamin Graham, whose Security Analysis is the bible of fundamental analysis, confessed shortly before he died to agreeing with the EMH.
Consider how security analysis and the EMH affects you.
If you’re an investor, which theory of security analysis—technical or fundamental—best describes your own process of picking stocks? If you haven’t invested before, which seems more useful to you?
What is the efficient market hypothesis? How might it affect which method of security analysis you decide to use?
With the two canonical methods of security analysis roundly debunked by empirical studies, scholars set out to develop their own theories of stock valuation. These “new investment technologies” include approaches like “smart beta” and “risk parity” (discussed below) that, at least according to their innovators, improve on technical and fundamental analysis.
Arguably the most prominent of the new investment technologies is “Modern Portfolio Theory (MPT).” Basic enough to have been widely adopted on Wall Street, MPT proceeds from the recognition that most—if not all—investors want to maximize their returns while minimizing their risk.
(Note: Although Malkiel views some of the new investment technologies favorably, he still believes traditional index funds are the best bet for investors.)
Developed by Nobel Prize–winning economist Harry Markowitz, MPT in its purest form uses complex mathematics to diversify a portfolio in such a way that it earns a particular return with the smallest amount of risk. More basically, it asserts that a diversified portfolio—one that features holdings in a variety of industries and countries—is more likely to be profitable than a homogenous one.
The EMH would seem to indicate that it’s impossible to make money in the market, because whatever you know about a stock has always already been factored into its price. Yet people make money investing in stocks every day—in fact, the best long-term study comparing the most common investment vehicles (stocks, bonds, Treasuries) found that common stocks provided the best returns. What gives?
According to the new investment technologists, money isn’t made in the market by virtue of the strength of information or analysis, but rather the appetite for risk. That is, those who are willing to assume more risk stand to reap greater rewards.
Economists of finance typically define risk in terms of returns’ “variance” from the mean return. Simply put, the more widely dispersed real returns are around the average, the more risky the stock. For example, consider Stock 1, whose returns over the last three years are -5%, 0%, and 5%. The mean return for Stock 1 is 0%. Now examine Stock 2, whose returns over the last three years are -25%, 3%, and 22%. The mean return for Stock 2 is also 0%, but the variance is greater due to the wider dispersion around the mean—that is, an investor in Stock 2 will be assuming more risk.
Essentially, MPT mitigates a portfolio’s overall risk by offsetting the risks of certain stocks with those of other stocks. These various levels of risk are determined by analyzing the “covariance”—that is, the relative variance—between two or more stocks and deducing a “correlation coefficient”—a single number between 1 and -1 that defines their relation.
For example, take two stocks, one an airline company, another a commercial aircraft manufacturer. If real-world events—say, a global pandemic—severely reduce consumers’ air travel, both stocks will suffer (because demand for both companies’ products will drop). A parallel relationship between two stocks means they’re positively correlated—if one goes up or down, the other will go up or down. Positively correlated stocks, of course, have positive coefficients.
Now take an airline company and a company that provides video-conferencing software and services. When the global pandemic curtails travel, the airline company’s stock suffers—but the video-conferencing-software company’s stock rises (because consumers who would otherwise travel for business now have to hold meetings digitally). These two stocks are negatively correlated—when one goes up, the other goes down (and vice versa). And, no surprise, negatively correlated stocks have negative coefficients.
What Markowitz and his acolytes discovered is that for any pair of stocks with a coefficient less than 1—in other words, for any pair of stocks whose relationship isn’t perfectly parallel—some amount of risk reduction is possible. This is because stocks with less than perfect correlation may have loss-mitigating responses to market downturns.
What does MPT look like in terms of actually constructing a portfolio? Diversity in terms of industry is key, especially when investing in U.S. equities. A common benchmark in terms of diversification is 50 U.S. stocks, equally sized and operating in a range of industries.
However, scholars have found that diversification in terms of industry can only get you so far. In fact, studies have shown that 50 is a kind of magic number: A portfolio of this many (equally sized and well-diversified) stocks reduces risk by over 60%, but the further addition of US equities has little to no effect on risk reduction.
To reduce risk further, investors have to look beyond U.S. stocks—they must diversify geographically and in terms of asset class as well.
Financial analysts have often noted that global markets move in the opposite direction of U.S. markets. Take, for example, a jump in the price of oil. This sort of event can have a negative effect on countries with a large industrial sector or high demand for fuel, for example Europe, Japan, or the U.S. But it can also have a positive effect for oil-producing firms in the Middle East and Southeast Asia.
An analysis of portfolios with various combinations of U.S. and EAFE (developed foreign country) stocks illustrates the point. From 1970 to 2017, EAFE stocks boasted a better average annual return than the S&P 500, though the stocks were more volatile year to year. It turns out that during that period, a portfolio with 82% U.S. stocks and 18% EAFE stocks provided the highest returns with the lowest volatility. That is to say, adding some degree of specific risk to the portfolio actually reduced the portfolio’s risk overall.
With greater globalization has come higher correlation coefficients among US and international stocks (though geographical diversity in your portfolio can still mitigate risk). An additional measure that can offset risk is holding bonds as well as stocks among your investments.
For example, during the financial crisis of 2008, when returns on stocks plummeted and retirement wealth evaporated, Barclays bond index fund had a 5.2% return. Bond markets can provide returns when stocks go haywire.
As described in the previous chapter, the efficient market hypothesis means that better information or analysis doesn’t yield higher returns; rather, it’s an investment’s relative level of risk that holds the possibility of windfall gains.
But this principle raises any number of questions: What exactly do we mean by “risk”? How do we measure it? And how does it produce greater returns for investors?
Scholars of finance like Nobel laureate William Sharpe, John Lintner, and Fischer Black applied themselves to these questions in the 1980s and 1990s. Building on MPT, whose key finding was that diversification could reduce a great deal of risk but not all, they argued that greater long-term returns only accrue to a specific kind of risk—systematic risk, or “beta.”
(It’s important to note that Malkiel—along with scholars like Nobel laureate Eugene Fama and Kenneth French—has proven empirically that a higher beta does not in fact produce higher returns on average. In order to measure risk at all accurately, analysts need to incorporate further factors like national income, inflation, and interest rates, among others.)
In the scholarly literature on finance, a stock’s “unsystematic” risk describes the variability in its returns due to aspects of the stock in particular. For example, a biopharmaceutical company that has recently gone public might suffer a setback in its research, an executive departure, or the failure of a clinical trial. These events, considered part of the unsystematic risks associated with the stock, might result in a decline in the stock’s price.
The key component of unsystematic risk, at least as far as returns are concerned, is that it can be diversified away. For example, if an investor is worried about that biopharma company’s prospects, he or she can invest in an established blue-chip stock to offset the volatility in the biopharma stock.
A stock’s “systematic” risk—its “beta”—consists in its sensitivity to the stock market in general. For example, say that the biopharma company we’ve been discussing has received funds for five years of work. For those five years, the company might have relatively low systematic risk—given the fact its funding is already in hand, its operations might not be much affected by market volatility.
As you might expect, beta cannot be diversified away. This is because all stocks, to some degree or other, parallel the market (that is, when the market falls, by definition so too do stocks in general). At least in terms of common stocks, there is no such thing as a risk-free investment; even the most diversified holdings—for example, those contained in a broad market index fund—entail some risk.
Individual betas are calculated using relatively high-level mathematics, but the concept behind the math is simple: A stock’s beta consists in a comparison of its price movements over a certain period of time with the market’s movements over that same period.
In practice, beta analysis looks like this: A broad market index is assigned a beta of 1, and stocks’ betas are calculated based on how big or small their price swings are in relation to the market’s. If a stock’s price drops twice as much as the market when there’s a downturn, that stock earns a beta of 2; if a stock gains half as much as the market when there’s an upswing, that stock has a beta of 0.5.
What financial innovators like Sharpe, Lintner, and Black realized was that if diversification could mitigate almost all unsystematic risk, investors wouldn’t receive a “risk premium”—an above-average return—for holding that type of risk. Rather, investors would only receive a risk premium for investing in assets with higher betas.
We can illustrate this fact by a thought experiment involving two well-diversified batches of securities. Each batch contains 60 stocks and features a beta of 1 (that is, its systematic risk is the same as the market’s). The only difference between the two batches is that each of the stocks in Batch 1 has higher unsystematic risk than each of the stocks in Batch 2.
Now, before the advent of MPT and beta, financial analysts believed both unsystematic and systematic risk (together, total risk) were rewarded with higher returns. Under the old thinking, Batch 1 would confer higher returns, because investors were taking on more total risk investing in those securities. (Those higher returns are generally realized by dint of lower initial prices for the riskier stocks.)
But what MPT proved is that a well-diversified portfolio of 60 stocks will essentially eliminate unsystematic risk. That is to say, even though each individual stock in Batch 1 has higher unsystematic risk than each individual stock in Batch 2, the aggregate unsystematic risk of the two batches is the same (0, or close to it). Because the systematic risk—the beta—of the two batches is the same as well, returns for the two batches over the long run will be the same.
Another way to think through this logic is to consider investor behavior if the above weren’t true. For example, say that Batch 1 did confer greater returns than Batch 2. If that were the case, investors would flock to Batch 1 securities. This investor interest would drive up Batch 1 prices (thereby reducing their returns) and reduce prices of Batch 2 securities (thereby increasing their returns). Before long, the securities in the two batches would reach equilibrium—neither would be more profitable than the other.
In the end, what matters for returns is beta—stocks’ sensitivity to market shifts.
Created by Sharpe, Lintner, and Black, the capital-asset pricing model (CAPM) was the go-to method of asset valuation on Wall Street in the late ‘80s and early ‘90s—and it made beta the hot concept among security analysts.
CAPM provides a means of valuing a stock according to its (systematic) risk and potential reward. At its most basic level, CAPM compares a stock’s potential return based on its beta with the “risk-free” rate of return (typically represented by the interest rate on a government-insured savings certificate). CAPM shows that as beta rises, so do returns.
For example, an investor with all his money in a government-guaranteed savings certificate has a beta of zero, because the rate of return isn’t affected by movements in the market. According to CAPM, that investor’s returns increase as his beta increases—for example, by investing in an index fund or investing on margin.
Beta’s influence among security analysts is due, in part, to its simplicity: It consists in a single number that heralds future returns. But simplicity doesn’t necessarily equal correctness.
In a famous 1992 paper, financial economists Eugene Fama and Kenneth French used stock-return data from the period 1963–1990 to show that stocks with higher betas did not realize higher returns. In other words, Fama and French found that there was no relationship between a stock’s beta measures and its returns.
Malkiel has confirmed Fama and French’s findings through his own study of mutual funds—according to Malkiel’s research, mutual funds with higher betas also don’t produce higher returns over the long run.
Nevertheless, Malkiel isn’t quite ready to consign beta to the dustbin.
For one, even if a higher beta doesn’t necessarily entail bigger long-run returns, it does provide investors with actionable intelligence. For example, if Fama and French are right and higher betas don’t confer higher returns over the long-run, investors can use that knowledge and gravitate toward lower-beta stocks (which will secure them the same long-run returns with less volatility).
Also, it’s important to note that beta is nearly impossible to measure precisely. Many measures of beta use the S&P 500 Index as a proxy for the “market”—but the S&P 500 is actually a relatively select snapshot of the thousands of domestic and international stocks that comprise the market. More recent studies of beta than Fama and French’s have shown that, with more capacious indices of the market and more sophisticated measures of beta, higher betas are in fact predictors of higher long-run returns.
Because the usefulness of beta continues to be disputed, scholars of finance have sought alternative models for measuring risk and predicting returns. Two of the most well-known approaches are arbitrage pricing theory and the Fama-French three-factor model.
Pioneered by MIT economist Stephen Ross, arbitrage pricing theory (APT) builds on the (correct) insight that undergirds CAPM: that investors shouldn’t be rewarded for carrying unsystematic risk.
Where APT advances on CAPM is in its calculation of systematic risk. Whereas CAPM limits itself to beta—the sensitivity of stock or portfolio returns to those of the market in general—APT considers a host of systematic risk factors in addition to beta, including changes in national income, inflation, and interest rates.
Nevertheless, although APT’s more sophisticated calculation of risk shows promise, it still isn’t a foolproof method of measuring risk. (Shortform note: Malkiel doesn’t explain why it isn’t foolproof.)
APT is what’s known as a “factor” model—it “factors” an array of systematic risks into its calculations.
Another factor model, the Fama-French three-factor model, advances on CAPM by including two factors in addition to beta: the size of the company whose stock is being evaluated and the ratio of that company’s stock price to its “book” value. (A company’s “book” value is its total assets minus liabilities.) Fama and French argue that smaller companies are inherently riskier due to lower revenue streams or less robustness; they also argue that a low market price and high book value is a bear signal for that stock.
In short, the logic underlying both Fama-French and APT is the same: When assessing a stock’s systematic risk, measuring beta alone simply isn’t enough.
Building on the concepts embodied in advancements like MPT, CAPM, beta, and the like, scholars of finance have developed even more sophisticated models of portfolio construction. At present, two of the most influential are “smart beta” and “risk parity.”
As always, although both strategies show potential—especially for high-net-worth investors who can afford more risk—Malkiel avers that the core of every portfolio should be a broad-based market index fund, which offers a better return for the risk than most, if not every, other financial product.
Although definitions vary, a “smart beta” strategy can be defined as a rules-based, relatively passive model of portfolio construction that yields greater returns than the market without a commensurate increase in risk.
Essentially, smart beta strategies take a broad, market index portfolio—which, of course, has a beta of 1—and customize (or “flavor”) it in ways to increase returns without taking on unnecessary risk. For example, a “smart beta” investor might flavor her portfolio for “value” stocks over “growth” stocks, or small companies instead of large ones.
Smart beta investors determine the risk/return profile of various flavors by using a statistic called the “Sharpe ratio” (created by William Sharpe, one of the developers of CAPM). In the numerator of the ratio goes the difference between the portfolio’s return and the risk-free return rate (typically represented by a Treasury bill return); in the denominator goes the risk of the portfolio, as expressed by the returns’ standard deviation from their mean. The higher the Sharpe ratio, the better the risk-return tradeoff. If an investor can devise a portfolio that has a higher Sharpe ratio than the market—which, since 1927, has had a Sharpe ratio of .42—then that portfolio should provide better returns for the risk than the market.
Four common portfolio flavors that investors tend toward include:
Preached by early investment sages like David Dodd and Benjamin Graham—and later adopted by Warren Buffett—“value” investing consists in buying stocks with (1) low price-earnings multiples and (2) low price–book value ratios. More rudimentarily, it means investing in companies that are realizing revenues currently and consistently rather than those promising exponential future growth.
A portfolio flavored in favor of smaller stocks may result in larger returns. One study examined returns from 1926 to the present and found small-company stocks produced returns about 2% higher than large-companies’. The Sharpe ratio of small-company stocks over approximately the same period was .23—which means that a diversified portfolio with a tilt toward smaller stocks might raise the overall portfolio’s ratio above the market’s.
As noted above, in the long run, there’s no discernable “momentum” in stocks’ prices—rather, their price increases and decreases resemble a “random walk.” However, in the short run, there is some evidence to suggest that stocks do have momentum (that is, price increases will be followed by further increases, declines by further declines). And, thus, a portfolio tilted in favor of stocks with momentum may produce higher returns.
Momentum is measured by examining stocks’ returns over the previous 11 months. A portfolio flavored toward momentum might be long the top-performing 30% of stocks over the previous 11 months and short the worst-performing 30%. Between 1927 and 2017, a portfolio with this flavor would have had a Sharpe ratio of 0.58—0.16 higher than beta.
Because the empirical evidence has shown that there’s no difference in terms of returns between low-beta and high-beta stocks, investors stand to realize a better Sharpe ratio by being long in low-beta stocks.
One simple strategy is to fashion a portfolio with a beta of 0.5 (that is, a portfolio half as volatile as the market). Evidence indicates that this portfolio will have the same returns as the market as a whole with less volatility.
So far, the evidence supporting the flavoring of a portfolio in terms of a single factor—for example, “value,” or “momentum”—is thin. In fact, although there are hundreds of exchange traded funds (ETFs) that flavor their holdings in terms of a single factor, history shows that these funds do not perform better than a broad market index fund.
A better bet for those investors interested in smart beta strategies is what’s known as a “blended factor” portfolio—a portfolio flavored in terms of two or more negatively correlated factors. Blended factor portfolios leverage the benefits of diversification: Because the factors are negatively correlated—that is, one offsets the other—blended factor portfolios minimize risk and enhance returns.
In one study, a blended portfolio that divided its holdings according to four flavors—broad market, small-cap, value, and momentum—ended up with a Sharpe ratio of 0.73! (Recall that the broad market’s Sharpe ratio is 0.42). That blended portfolio, however, produced slightly lower returns than the market (though, as represented by its high Sharpe ratio, with much less volatility). And the study didn’t take into account any fees or transaction costs that might impact returns even further.
There are a number of blended funds currently in operation, including Dimensional Fund Advisors (DFA) funds (ticker symbols DFSVX and DFLVX) and the Goldman Sachs Active Beta ETF (ticker symbol GSLC). Although these funds have shown promise, there are drawbacks; for example, one can only buy DFA funds through investment advisors who charge fees.
All in all, Malkiel advises investors to build their portfolios around a broad market index fund. If a particularly engaged investor is willing to accept a less reliable risk-return ratio, that investor might invest moderately in a blended fund with low expenses and fees.
Popularized by Ray Dalio, the founder and principal of the successful hedge fund Bridgewater Associates, “risk parity” involves taking long positions in low-risk assets—even borrowing money to do so—to increase returns. The theory undergirding this strategy is that low-risk assets often boast higher returns than their risk level would indicate and that high-risk assets are often overpriced.
There are several ways to develop a risk parity portfolio, all involving buying low-risk assets on margin. For example, an investor might borrow to invest in low-beta stocks or bonds. Of course, by borrowing, an investor increases his or her risk—but he or she also increases returns. An investor who bought only bonds between 2007–2016, 50% on margin, would have produced returns just under 2% better than the S&P 500 with slightly less volatility. (This example assumes no cost of borrowing, however.)
A baseline allocation for institutional portfolios—for example, retirement or pension funds—is 60% common stock, 40% bonds. The idea is to net investors the higher returns of the stock market while insuring them against market corrections with the consistency of bonds.
However, using risk parity, investors might be able to achieve greater returns with the same level of risk as a 60/40 portfolio. The way to do this is to create a portfolio whose stock/bond allocation has the same risk and return as the “riskless” rate (in other words, the interest rate on a Treasury bill), and then buy that portfolio on margin. By buying on margin, one can increase volatility to the point where it’s the same as a 60/40 portfolio but with better returns.
Another way to achieve risk parity and outearn a 60/40 portfolio is to invest in a wider array of assets. For example, Bridgewater Associates includes real estate assets (REITs), Treasury inflation-protected securities (TIPS), and other products in its portfolios. As long as these additional assets are negatively correlated—that is, they increase the diversification of the portfolio—then risk is further minimized.
The recent evidence has been positive, if not overwhelming, for risk parity portfolios. In a comparison between Bridgewater Associates’ All Weather Fund—the most prominent risk parity fund—and a variety of index funds, the All Weather Fund came in with slightly lower returns than S&P 500 and total market index funds, but it also had less volatility. (Its Sharpe Ratio was 0.51.)
If the options for increasing risk are buying more high-risk assets (in other words, small-cap or growth stocks) or investing in low-risk assets on margin, Malkiel is in favor of the latter because it promotes better diversification. However, borrowing to invest comes with its own set of risks, and only high-net-worth investors, with the means to absorb losses, should really consider risk parity approaches.
Analytical concepts like the efficient market hypothesis, modern portfolio theory, beta, and the capital-asset pricing model all rely on a foundational assumption: that each decision an investor makes is intended to maximize gain and minimize loss—that is, that each investor is fully rational.
A group of financial analysts influenced by behavioral psychologists like Daniel Kahneman and Amos Tversky has challenged this assumption, however, and in so doing has founded a new area of economic research: behavioral finance. (Shortform note: Read our summary of Kahneman’s Thinking Fast and Slow.)
For the reader looking for investment advice from the behavioral finance literature without the background, the key points are four:
1) Don’t Follow the Crowd
Studies in behavioral finance have shown that word of mouth is a frequent driver of stock purchases. When some new investment is the talk of the town, it’s natural to want to take part. But resist the urge: Stocks or funds that are hot one quarter are almost invariably losers the next. It’s generally better to stick with “value” stocks—securities issued by tried and true companies with steady revenues—than gamble on “growth” stocks with high risk.
The advice is the same for booms and busts in the market: If everyone’s getting out of the market in a slump, stay in (because, unless civilization ends, the market will rise again eventually); and if the market’s hot, stay out (because you’ll have bought high only to see the market drop, as it invariably will).
2) Don’t Overtrade
Overconfidence is one of the key factors in investor irrationality (see below), and it often manifests itself in hyperactive trading. (This is because an investor confident in her judgments will tend to buy and sell rapidly based on those judgments.) However, when investors trade to realize short-term gains, they tend to incur high transaction costs and taxes. One study of 66,000 households found that the households that traded the most earned an 11.4% return on their investments—while the market returned 17.9%.
As always, a buy-and-hold strategy is superior to trying to beat the market.
3) Sell Losers, Not Winners
If you do decide to trade, make sure you sell your losers, not your winners.
Most investors think it’s best to unload stocks that have risen in value (to realize a gain) and hold on to stocks that have declined in value (to avoid realizing a loss). As noted above, selling a winning stock can result in prohibitive tax liability.
And although holding on to a sinking stock can be worthwhile—if the stock has a chance to rebound—it’s often better to unload that stock and realize the tax breaks of the loss.
4) Don’t Fall for IPOs
Even the savviest investors are prone to falling for “get rich quick” schemes, and few are as prevalent and as pernicious as highly publicized initial public offerings.
Simply put, an individual investor should never buy an IPO at its initial price. Though the stock may pop right after trading begins—because institutional investors are snapping up the stock at the offering price—studies have shown that IPOs underperform the stock market by about 4% per annum. And it’s common to see IPO values drop exactly six months after going public—the date when insiders are finally allowed to unload their stock.
Behavioral finance is an approach to financial markets and economic research that foregrounds human behavior. It proceeds from the premise that, contrary to most economic and financial models, people are not fully rational decision makers. In fact, research by Kahneman and Tversky has shown that people are irrational in systematic and predictable ways. According to Kahneman and Tversky, our irrationality stems from five key factors:
One of the most consistent findings in behavioral psychology is that people tend to make mistakes of judgment because of an unjustified belief in their own knowledge or capacities.
The classic illustration of this cognitive bias comes from surveys that ask participants how they would rate their own driving ability. In studies focusing on college students, 80% to 90% said they were better drivers than their classmates. How, one might ask, can 90% of a population be above average?
This species of overconfidence affects investors as much as it does college students. In one experiment, Kahneman asked participants to provide an estimate of the Dow Jones’s value one month from the date of the experiment. He also asked the participants to pick a high number such that they were 99% sure the Dow would be below that number a month later, and a low number such that they were 99% sure the Dow would be above that number. The upshot of the estimates was that participants were 98% sure the Dow Jones’s value would fall in between the two numbers.
The results of the experiment showed that the investors, though they were 98% sure of their estimates, were wrong 20% of the time!
In actual market behavior, overconfidence manifests itself in a number of different ways:
Much irrational behavior in the market stems from systematic cognitive biases that cloud humans’ judgment.
One particularly problematic bias is our illusion of control: our perception that we can dictate events that are effectively random.
As noted above with regard to technical analysis (see Chapter 5), price movements in the market look more or less like the results of a coin flip or “random walk.” Yet investors persist in seeing patterns in these movements—for example, hot streaks or stock “momentum”—that cause them to make bad decisions.
Another judgment bias that can compromise our wealth is our tendency to substitute “representativeness” or “similarity” for cool, probabilistic analysis.
A classic example concerns skyrocketing prices for a buzzy new IPO. Although the data for much-touted IPOs show mixed results, investors will look at the new hyped stock and think “Amazon” or “Facebook”—that is, their judgment will be biased toward a “representative” case that may not reflect the reality at all.
As illustrated above by the tulip craze and dot-com bubble (see Chapter 2), the madness of crowds can wreak havoc in the markets. “Herding” (or “groupthink”) is the behavioral finance term for humans’ tendency to coalesce around a consensus judgment—even if that judgment is wrong.
One astounding study illustrates the point. In the experiment, social psychologists had a single person stand on a street corner and stare at the empty sky for exactly a minute to see how many people would stop and look also. Very few did. But when the researchers put five people on the corner, four times as many people stopped; when the researchers put 15 people on the corner, almost half of the people passing by stopped to look at the empty sky with them.
When word of mouth and media buzz tout a particular stock or industry, herd thinking can take hold, resulting in an onrush of investment and massively inflated prices. The psychologists refer to this phenomenon as the “epidemic” model—overexuberance about certain investments tends to spread like a disease.
Herd thinking can also lead to severe timing penalties. Because buzz spreads when stocks are up, investors will buy in when equities are already costly; when the prices of those equities fall, these investors are also the most likely to jump ship.
One of Kahneman and Tversky’s most influential discoveries is that humans mourn losses more than they relish gains. In other words, humans are naturally—and occasionally detrimentally—risk averse.
In one well-known experiment, Kahneman and Tversky offered participants a bet on a coin flip: If the coin came up heads, the subject would win $100; tails, and the subject would have to pay $100. Even though the odds of winning and losing were exactly the same—50/50—most declined to take the bet. Only when the possible winnings reached $250 (and losses remained $100) did subjects agree to the bet. In other words, a dollar loss is 2.5x more undesirable than a dollar gain is desirable.
Associated with Kahneman and Tversky’s findings concerning loss aversion is their concept of “framing.” That is, humans’ loss aversion can increase or decrease depending on how a particular choice is worded or presented.
(Shortform example: Imagine two identical funds, Fund A and Fund B. Fund A’s prospectus describes the fund solely in terms of its risk profile and the losses it might incur; Fund B’s prospectus, on the contrary, describes the fund solely in terms of its potential returns. According to Kahneman and Tversky’s research, even though the funds are identical, people will opt for Fund B because of how its risk is framed.)
The natural human dispositions of pride and regret can also cause problems for investors.
On the pride side, investors are often all too happy to advertise their successes, and there’s evidence to suggest that this pride in making a winning bet leads investors to make bad decisions—for example, selling a stock at a profit and incurring capital gains taxes (if the sale is made outside of a retirement account).
As far as regret goes, investors try to avoid it by holding onto losing stocks far longer than they should in the hope the stock will start rising. In a situation like this, it might actually be better to sell the stock and realize the tax deductions for the loss.
The core tenet of behavioral finance—that individual investors are frequently irrational—militates against the efficient market hypothesis, which states that stock prices reflect all relevant information about a particular stock. In many cases, according to the behavioralist, prices are completely divorced from the available information about a stock, due to irrational investor exuberance or decision-making.
Advocates of EMH respond to behavioralists by pointing up the correcting effects of “arbitrage”—which, in its loosest definition, means the purchase of undervalued stocks and sale of overvalued stocks (“buying low and selling high”). Believers in the EMH argue that professional portfolio managers will correct price distortions by (1) “shorting” overpriced stocks (“short selling” is when traders borrow securities and sell them, believing that the price of those securities will eventually go down and the trader can buy them back at a discount) and (2) investing in comparable stocks (so that if prices continue to rise, the managers will have offset their short positions by going “long” on similar stocks). When traders short stocks, demand tends to dry up and prices fall.
The main problem with this faith in arbitrage’s corrective power is arbitrage’s inherent riskiness—and, as a result, traders’ hesitancy to engage in it.
For example, say that a trader believes there’s going to be an oil shock in the next few months (and, as a result, a jump in oil prices). She might short car-manufacturer stocks (because, with gas prices high, people may buy fewer cars) and go long on petroleum company stocks. But what happens if the oil shock doesn’t come to pass? Or, even worse, petroleum companies find a new source of oil, driving gas prices down rather than up?
In fact, historical studies have shown that hedge funds, far from correcting prices with their positions, actually drive irrational exuberance in the market. The internet bubble of the late ’90s and early 2000s is a case in point (see Chapter 4).
Consider how financial theory can help you invest.
What is modern portfolio theory? (You might just name the central principle.) How might its findings affect your own investment decisions?
Are you guilty of any of the biases revealed by behavioral finance? If so, propose some ideas for how you might avoid them in the future. If not, write down what techniques you use to avoid them.
In this part of A Random Walk Down Wall Street, Malkiel turns from the theoretical to the practical: What investments boast the best returns? How should I save for retirement? How can I anticipate future movements in the market? The balance of the book is devoted to actionable advice for investors, novice and experienced alike.
Before exploring specific investment vehicles and strategies, however, it’s vital to have some basic financial principles under your belt.
In investing, there is truly no such thing as getting rich quick. The best way to realize returns is to begin investing as soon as possible and keep investing steadily, whether through the automatic reinvestment of dividends or regular contributions to a tax-advantaged retirement plan.
One simple way to increase your saving, if your employer offers a retirement plan, is to increase your voluntary contributions to the plan on a regular timetable, for example annually.
Rainy days happen, and even the most successful investor needs liquid assets that can be called upon in a pinch (or the financial protection of insurance).
In terms of cash reserves, if you have decent health and disability insurance, three months’ worth of living expenses is a good benchmark. And for large future expenses—for example, a son or daughter’s college tuition—certificates of deposit with a maturity date shortly before matriculation are your best bet.
As for insurance, home, auto, health, and disability are musts. As is life insurance, if you’re the primary breadwinner for a family with dependents.
The two primary types of life insurance are high-premium products that combine the insurance with an investment account and low-premium term products that only offer death benefits.
Although the high-premium products have advantages—primarily tax-free contributions—the commissions and fees can be prohibitive. Thus Malkiel favors buying low-premium term insurance and investing the difference between the high-premium product and the low-premium product in a tax-deferred retirement plan.
(The same advice applies to variable-annuity products, which typically tack on an insurance feature to an investment product like a mutual fund. These products often entail steep commissions and fees—unnecessary expenses for the typical investor. Only extremely high-wealth individuals who’ve maxed out all other tax-deferred alternatives should consider annuities.)
Ideally, the term insurance product will be renewable without the need for a doctor’s visit and feature an “A” rating from A.M. Best (don’t buy anything with a rating lower than “A”). And you should shop around for the best product on your own rather than consulting an insurance agent—the agent’s commission will be tacked onto your premium payment.
Keeping a robust cash reserve is essential for emergencies, but it can also be a losing proposition if your savings account interest rate is lower than the inflation rate.
There are a number of alternatives to your run-of-the-mill savings account that will allow your cash to keep pace with inflation.
With higher interest rates than your standard savings account but with similar liquidity—you can write checks up to $250 against your account balance—money-market mutual funds are the best product for cash reserves.
That said, make sure to choose a low-expense option like those offered by Fidelity or Vanguard.
If you know the date of a sizable future expenditure in advance, certificates of deposit (or “CDs”) are your best choice.
Safe and simple, CDs offer a guaranteed return by the date of maturity. For example, if you know that you’re going to need to pay college tuition in a year, two years, and three years, you might buy three CDs, each maturing a year after the other.
The primary drawback to CDs is its relative illiquidity. Make sure that you’re willing to live without your funds for the duration of the CD’s term.
Due to their lower overhead—all business is conducted electronically—internet banks often offer higher rates on deposits. A simple Google search for “internet banks” will return dozens. Try to choose a bank insured by the Federal Deposit Insurance Corporation (FDIC), which will protect your deposit in case of a bank failure.
Arguably the safest investment in the world and one offering tax-free returns, Treasury bills (or t-bills) are financial instruments issued by the U.S. government. They’re offered with various maturities, at a minimum of $1,000 face value. You can purchase t-bills directly from the U.S. government at www.treasurydirect.gov.
Individuals in the highest federal tax bracket will find tax-exempt money-market funds the best choice for their cash reserves. These funds invest in short-term issues by local and state governments. You can write checks up to $250 against these accounts; and though tax-exempt funds offer lower interest rates than taxable funds, their yields end up being better after taxes are taken into account.
Tax-exempt funds are especially attractive for individuals who live in areas with high income taxes. The key to reaping those benefits is making sure the fund only invests in issues from the state in which you pay taxes.
With the surfeit of tax-advantaged retirement plans and investment alternatives on offer, there is simply no good reason you should pay taxes on investment earnings for retirement or expenses like college tuition. Here are the primary products and their central features.
The most basic retirement plan consists in an individual retirement account (or IRA). As of 2018, most individuals could contribute up to $5,500 to their IRA and deduct that amount from their taxable income. Earnings on IRA funds aren’t taxed, and, by the time you actually withdraw the funds from the IRA, you’re likely to be in a lower tax bracket than you are currently.
(High-income individuals can’t take advantage of the $5,500 deduction, but they can reap the other tax benefits of IRAs.)
To illustrate the power of tax-free earnings, consider this example: If you’re in the 28% tax bracket and you put $5,500 per annum into an IRA for 45 years at a 7% return, you’ll have $1.6 million at the end of the 45 years. If the account weren’t tax free, you’d only end up with $900,000.
Investors looking toward retirement also have the option of Roth IRAs. The key difference between a traditional IRA and Roth IRA concerns tax advantages: With traditional IRAs, contributions are tax deductible, but you’ll pay taxes when you eventually withdraw your funds; with Roth IRAs, you pay taxes upfront, but withdrawals (including earnings) are tax-free.
Which IRA is best depends on your personal financial situation. If you’re in a low tax bracket now and anticipate entering a higher tax bracket later in life, you might opt for a Roth IRA (because you’ll pay low taxes now and no taxes later). If you’re in a high tax bracket now and anticipate entering a lower tax bracket when you retire, a traditional IRA might be the better choice. (Mutual fund companies and other financial services firms often offer Roth calculators, which might be helpful in making your decision.)
Whether you’re self-employed or working for a Fortune 500 company, there are pension options that allow you to maximize earnings while avoiding the taxman. Malkiel’s advice is to max out these options wherever possible.
The two most common pension plans are 401(k)s (for private employers) and 403(b)s (for educational institutions). Contributions under these plans are tax-free, and many employers will either make contributions on behalf of their employees or match a percentage of their employees’ contributions.
Designed specifically for self-employed individuals, SEP IRAs offer the same tax advantages as traditional pension plans. Individuals can contribute up to 25% of their self-employment income tax-free.
Few expenses can give parents heartburn like college tuition bills, but with tax-advantaged “529” college savings accounts, parents (and grandparents) can invest on their children’s behalf and avoid taxes on withdrawals for educational purposes. (As of 2018, individual donors could contribute as much as $75,000 without gift- or estate-tax exposure; couples could contribute up to $150,000.)
Be wary though: Some companies offering 529s can charge hefty commissions or fees (always be on the lookout for low-expense options from companies like Vanguard). And colleges likely will consider 529 assets when determining financial aid, so if you think your child might be eligible for need-based aid, you might opt to keep your assets in your own name.
All too often new investors will begin researching their options—or, worse, opt into a particular product—without taking the time to think about what they hope to achieve with their investments.
One way to align your goals with the products available is to determine your tolerance for risk. If you’re nearing retirement (or you want to sleep well at night), you might choose instruments with “Low” and “Moderate” levels of risk. If you still have many working years ahead of you (or you’re a thrillseeker who’s willing to suffer sleepless nights), then you might opt for assets with “High” risk levels.
Another consideration is your tax liability and income needs. If you’re currently in a high tax bracket and don’t need to generate income from your investments, you might opt for tax-exempt bonds and low-dividend stocks that promise high capital gains (on which taxes won’t have to be paid until the gains are realized). If you’re in a low tax bracket and need income in the present, taxable bonds and high-dividend stocks are your best bet.
The table below lists the main categories of investment assets. There are more exotic options—fine art, commodities, and hedge funds among others—not included here, but returns on those options are impossible to predict.
| Level of Risk | Asset Type | Expected Rate of Return (Pre-Tax, 2018) | Time to Realize Expected Rate of Return | Notes |
| Very Low | Bank checking/savings accounts | 0%–2% | No specific time period to realize return. | Near zero risk of losing your investment. Deposits up to $100,000 guaranteed by FDIC. Likely to be outpaced by inflation. |
| Low | Money-market funds | 1%–2% | No specific time period to realize return. | Most offer check-writing. Funds are invested in gov’t securities and bank certificates. Not usually insured. |
| Low | Certificates of Deposit (CDs) | 0.5%–2.5% | Funds must be left on deposit for term of certificate. | Early withdrawal of funds is usually subject to penalty. |
| Low | Treasury inflation-protected securities (TIPS) | 0.5%–1% plus inflation | Investments must be held until maturity. Securities mature over longer periods (>5 years) | Prices vary if security is sold before maturity. |
| Low/Moderate | Highly rated corporate bonds (prime-quality public utilities) | 3.5%–5% | Investments must be held until maturity (anywhere from 5 to 30 years). | Prices vary if security is sold before maturity |
| Moderate/High | Diversified common stock portfolio comprising US blue-chip or developed foreign country stocks | 5.5%–7% | No specific time period to realize return. Estimate assumes relatively long investment period. | Returns may in fact be negative in bear markets. Good hedge against inflation in the long run. |
| Moderate/High | Real estate | 5.5%–7% | No specific time period to realize return (if REITs). Estimate assumes relatively long investment period. | Returns may in fact be negative in bear markets. Good hedge against inflation in the long run. |
| High | Diversified common stock portfolio comprising smaller growth companies | 6.5%–7.5% | No specific time period to realize return. Estimate assumes relatively long investment period. | Returns may in fact be negative in bear markets (risky stock portfolios have lost 50% or more of their value). Good hedge against inflation in the long run. |
| High/Very high | Diversified common stock portfolio comprising emerging market stocks | 8%–9% | No specific time period to realize return, but anticipate holding for 10+ years. | Highly volatile. (Value can fluctuate 50%–75% in a year) Returns may in fact be negative in bear markets. |
| Very High | Gold | N/A | No specific time period to realize return. | Highly volatile. Returns are impossible to predict and depend on speculative crazes. Useful as a balance to a diversified portfolio. |
People who rent their domiciles miss out on the tax breaks, earnings potential, and personal gratification of owning a home. For example, under the US Tax Code as of 2018, mortgage debt interest up to $750,000 and property taxes up to $10,000 are tax deductible. Capital gains on real estate up to $500,000 are also tax-free. Although housing bubbles have happened—see the account of 2008 in Chapter 4—owning a home has proven to be a reliable means for families to hedge against inflation and realize returns.
For those investors without the means or desire to buy a home, real estate investment trusts (or REITs) provide a nice alternative. REITs consist of real estate assets—apartment buildings, offices, and the like—packaged into securities that can be traded like common stock. REITs offer competitive dividends and returns; and, since real estate prices are only moderately correlated with stock prices, they are an important part of a fully diversified portfolio.
Some REIT mutual funds that Malkiel recommends are Fidelity Real Estate Index Fund (FRXIX) and Vanguard Real Estate Fund (VGSLX). Some ETFs include Fidelity (FREL) and Vanguard again (VNQ), plus Schwab (SCHH) and iShares (USRT).
In the post-WWII period through the ’80s, bonds were a losing bet—with low interest rates and growing inflation, many bondholders actually saw negative returns by the time their bonds reached maturity.
Now, however, with more inflation protection attached to high-quality debt, bonds are a worthwhile component of a well-diversified portfolio.
There are six primary types of bonds you should be aware of.
Zero-coupon bonds (also called “zero coupons” or just “zeros”) offer discounts on their face values in lieu of periodic interest (or coupon) payments. (A typical bond entails interest payments to its holder for the duration of a specified term, after which the principal is paid back in full.)
The central advantage of a zero-coupon bond is its mitigation of reinvestment risk. With a standard bond, depending on market conditions, you might not be able to reinvest coupon payments at a return rate equal to that of the bond. With a zero-coupon bond, however, you’re guaranteed a consistent rate of return on the principal (up to the face value of the bond).
The central disadvantage of zeros is that holders must pay income tax on a prorated difference between the purchase price and face value of the bond. Smaller investors can also be priced out of zeros by high commissions.
Ideal for investors who plan to live off interest income, no-load—or, commission-free—bond mutual funds allow purchasers to invest in a variety of bonds with a minimum of ancillary expenses. Funds like the Fidelity Corporate Bond Fund (FCBFX) and the Vanguard High-Yield Corporate Fund Admiral (VWEAX) offer stable returns comparable to zero-coupon bonds.
Best for high-tax-bracket investors (whose tax liability makes taxable bonds less attractive), tax-exempt bonds are issued by local, state, and other governmental authorities and offer comparable returns to corporate bonds.
If you’re planning to buy these bonds directly—rather than gaining exposure through a mutual fund—then your best bets are new issues. Newer bonds generally offer better yields than established bonds. Two key considerations: Make sure you’re only buying bonds rated A or above by Moody’s or S&P, and try to limit your bond purchases to bonds issued in your own state (which are typically exempt from state income tax).
Also, make sure the bond you’re shopping has a 10-year call-protection provision. This prevents the bond issuer from paying off the debt outright and reissuing the bond if interest rates fall.
Tax-exempt bond fund options include Blackrock Municipal Income Investment (BBF) and Nuveen NY Quality Municipal Income Fund (NAN). These are best for a high-tax-bracket investor only investing a small amount. Investors with more to spend should focus on individual high-quality bonds covered by bond insurance.
Inflation is a bondholder’s nemesis: It tends to cause interest rates to rise, lowering the price of your bond, and it reduces the purchasing power of your coupon payments.
Enter Treasury Inflation-Protected Securities (or TIPS).
TIPS are Treasury-issued instruments whose face value rises to keep pace with inflation. Say, for example, your TIPS totaled $1,000. If the consumer price index—the default metric for measuring inflation—rose 3%, the face value of your bonds would rise to $1,030 and your coupon payments would be assessed on this new face value.
Although TIPS are a great inflation hedge and portfolio diversifier—because they don’t react to changes in prices like stocks and bonds do—they feature high tax exposure: Both the coupon payments and the rise in face value are taxable. Thus TIPS are best used in tax-advantaged retirement plans.
So-called “junk bonds” are bonds with higher yields but lower credit ratings from agencies like Moody’s and S&P. That is, just like with stocks, bonds can offer higher rewards for higher risk.
And just like with common stock, your investing in junk bonds should depend on your tolerance for risk and income needs. If you’re an older investor dependent on interest income (or just risk averse), junk bonds probably aren’t the right investment for you. If you’re a younger investor with a well-diversified portfolio, junk bonds offer considerable upside. In 2018, junk bonds generally yielded 5.5%–7%, whereas investment-grade bonds only yielded approximately 5.5%.
Another option to further diversify a portfolio is foreign bonds (emerging-market bonds in particular can feature high yields). These bonds can be risky, however, so make sure they’re offset by high-quality U.S. assets.
Low interest rates—which have been in effect more or less since the 2008 financial crisis—are anathema to bondholders (because low interest rates equal lower coupon payments).
One strategy to protect yourself against low returns on bonds is to substitute high-dividend stocks. For example, take a company like AT&T. AT&T’s 15-year bond yield is about 4.5%, while its common stock has a dividend yield of 6% and growing. With value companies like these, returns may be better—and equally as consistent—on their stock than their bonds.
Assets like gold, fine art, baseball cards, and commodities futures are extremely fickle and don’t pay interest or dividends. Unless you have ample resources in other instruments, assets like these should only occupy a modest part of your portfolio.
Take gold for example. At the beginning of the 1980s, an ounce sold for over $800. By the early 2000s, it sold for $200. As of 2018, it sold for $1,200. Simply put, it’s too volatile to be a large part of your investments, but a modest position (say, 5% of your total portfolio) can be worthwhile in a well-diversified portfolio.
Hedge, private-equity, and venture-capital funds also aren’t a wise choice for the average retail investor. These investments entail considerable commissions and fees, and the portfolio managers take a considerable chunk of the funds’ profits.
With the advent of commission-free brokerage services—from companies like Fidelity, Robinhood, and Charles Schwab—stock trading has become accessible to even the humblest investor.
That said, there are still high-expense products that investors need to be aware of and avoid.
One such product is a “wrap account.” Offered by various brokerages, these accounts are actively managed by a professional manager who picks an array of assets for your portfolio. Fees for these accounts can run you up to 3% per year, which makes outpacing the market almost impossible. Steer clear.
You should also be wary of mutual funds and ETFs with high expense ratios. (An expense ratio is the percentage of the fund’s assets that the managers of the fund keep for fees and expenses.) There are ample low-cost alternatives—for example, passively managed index funds offered by companies like Vanguard—that boast competitive returns for minimal fees. (The expense ratio for Vanguard’s flagship S&P 500 fund is 0.04%.
The key to consistent and positive returns over the long run is (a) diversification among asset classes (stocks, bonds, REITs, etc.) and (b) diversification within asset classes (negatively correlated common stocks, a mix of corporate bonds and TIPS, etc.).
But remember: Diversification can only work if you stick to it. Overtrading, biting on hot new issues, betting the house on a stock your dentist recommended—these common pitfalls (described in Chapter 11) are bound to lead to disappointment.
Explore Malkiel’s 10 essential investment principles.
Why is investing in real estate so important? If you don’t already own your home, how might you go about investing in real estate?
Why might it be better to contribute to your 401(k) than open up a brokerage account on your own?
How would you rate your risk tolerance—high, low, or moderate? Review the table in Principle #5 and write down the assets you think would be best for you. (You can compare these with Malkiel’s suggested allocations in Chapter 14.)
If you already own a portfolio, review your holdings. Are you adequately diversified? How might you increase your diversification in light of Malkiel’s recommendations? (If you aren’t already investing, how might you invest to ensure you’re adequately diversified?)
Market projections in the short run—a month, or even a year, from the present—are generally a fool’s errand, but, by knowing which variables to examine, it is possible to make relatively accurate projections of returns in the long run.
In the following, Malkiel outlines the determinants of returns, and how they’re affected by market conditions, before offering his own predictions for asset returns in the coming years. As of late 2018, Malkiel foresaw quite modest long-run annual returns on bonds (about 1%–2%) and slightly higher returns on stocks (around 7%).
Very long-run (at least 50 years) stock returns can be calculated using a simple formula:
Long-run equity return = Initial dividend yield + growth rate.
A stock’s “dividend yield” is the ratio of its dividend to its price; its growth rate is its percent growth in earnings and dividends. In plain language, you can estimate your long-run return on a share of common stock by adding its dividend yield at the time of purchase to the growth rate of earnings and dividends.
(Shortform note: The drawback of this method is that you have to estimate the growth rate of the stock you’re attempting to analyze. Of course, growth rates are impossible to predict with certainty and are vulnerable to unforeseeable (or “Black Swan”) events. Read our summary of The Black Swan.)
For example, say you purchase a share of Thingamajig Inc. for $100. At the time of purchase, Thingamajig pays an annual dividend of $5 a share, which means the dividend yield on the stock is 5%. Then say you estimate an annual growth rate of 5%. Your projected annual return on Thingamajig is thus 10% (or close to it: The formula above doesn’t result in a precise rate of return).
To calculate returns in the short run, investors must include a third term: the price/earnings multiple. (Analysts will also sometimes use the price/dividend multiple). These ratios of share price to earnings/dividends are highly variable year to year, and so they better reflect the impact of short-run market conditions on returns.
Take Thingamajig again. You’ve bought a share at $100, with a dividend yield of 5% and an estimated annual growth rate of 5%. Let’s say Thingamajig reports earnings of $10 per share. That means its P/E multiple is 10 (because a share of Thingamajig sells for 10x its per-share earnings). Now, imagine a year after you bought Thingamajig, the market enters a recession, and its price plummets to $50. Even if earnings and dividends stay constant, you end up with a lower return at the end of that year—because the P/E multiple has been reduced by half.
Some security analysts argue that dividends are no longer a useful indicator of future returns. This is because more and more companies are electing to distribute profits to shareholders through stock buybacks rather than dividends.
The rationale for preferring buybacks over dividends is twofold:
Determining returns on bonds held to maturity is an easier task than calculating returns for stocks.
When bonds aren’t held until maturity, determining returns can be a little more difficult. The key factor in this scenario is interest rates. If interest rates rise after you’ve purchased the bond, the price of your bond will likely fall (because demand will be higher for newly issued bonds with higher coupon payments). If interest rates fall, the price of your bond will increase (because demand will be higher for your bond than for new issues at the lower rates). To earn the best return on a bond sold before maturity, interest rates will have to have fallen.
Inflation is another factor that can affect bond returns. If there’s a rise in inflation, your bond returns will suffer. This is because inflation hits bond holders twice: Once, because it reduces the real value (purchasing power) of your coupon payments; and a second time, because interest rates will rise to provide competitive returns to new bond shoppers, causing your bond—which you bought before the rise in inflation—to drop in price.
(Stocks are considered an inflation hedge, because, the theory goes, their earnings and dividends rise in concert with prices.)
The best way to see the determinants of returns at work is to examine particular historical periods and study how prevailing market conditions affected those determinants.
The post-WWII period was an advantageous time to be invested in common stocks, less so in bonds. Due in large part to Kennedy’s tax cut in the early ‘60s and government spending to finance the war in Vietnam, employment was high and consumer spending considerable. By 1968, P/Es were north of 18, and stocks were returning 14% annually on average.
However, bonds did not fare nearly as well, posting an average annual return of 1.8% during the period (returns including inflation were actually negative for the period). The main factors contributing to bonds’ poor performance were low initial interest rates—the government had pegged government bonds’ interest rates at a maximum of 2.5% to finance WWII cheaply—and rising interest rates as the years wore on.
The financial story of the period between 1969 and 1981 is all about inflation. A concatenation of events—increased demand caused by Vietnam War stimulus and oil and food shocks in the mid-1970s—resulted in an inflation rate of 6.5% by the end of the 70s. By 1981, inflation had risen to double digits, forcing US Fed Chairman Paul Volcker to raise interest rates significantly. Unfortunately inflation didn’t immediately slow down, and unemployment spiked (so-called “stagflation”—inflation combined with a stagnating economy).
Returns on stocks and bonds suffered mightily from these rough economic conditions. Although the average annual return on stocks was 5.6% for the period, returns were negative after factoring in inflation. Bonds suffered even worse: Yields in 1969 anticipated a 3% inflation rate; with inflation nearing 8%, returns were utterly wiped out.
Careful readers will wonder: If stocks are supposed to be an inflation hedge, why did they also underperform during this period? The answer lies not in falling earnings or dividends—which, the evidence shows, remained robust—but rather in stocks’ P/E multiples. Simply put, investors were scared—they weren’t willing to pay a premium for solid earnings and dividend growth. Thus stock prices dropped precipitously, slashing returns.
Considered by Malkiel to be the golden age of asset returns, this era found stock and bond prices adjusting to the inflationary environment and offering attractive returns.
In bonds, average annual rates of return over the period were around 13.6%, a very attractive number. One reason returns were so high was high initial yields (approximately 13%). Because inflation was high at the outset of the period (around 8%) and investors were wary after the bond market catastrophe in the previous period, issuers had to offer high yields to attract investment. When interest rates fell and inflation moderated over the course of the period, bondholders reaped the benefits.
In stocks, average annual rates of return over the period were even better at 18.3%. Again, the poor returns of the previous period created a pessimistic environment wherein assets were undervalued. In 1982, P/E multiples were 8, signaling investor skepticism about companies’ prospects for solid future growth. However, by 2000, P/E multiples had nearly quadrupled to 30. This new investor optimism raised returns to unprecedented heights.
If 1982–early 2000 was the high for investors, 2000–2009 was the comedown.
During this period, often referred to as “the lost decade,” average annual returns for stocks were woeful: –6.5%. First there was the bursting of the dot-com bubble, which saw P/E multiples plummet. Then there was the 2008 financial crisis—caused by another bubble, this time in housing—which caused stock prices to decline even further.
One of the few bright spots during this spell was the bond market. Bonds posted an average annual return of 6.4%, offsetting some of the pain of stocks (if you were diversified enough to have bonds in your portfolio).
As was the case in 1982, 2009 offered the kind of pessimistic conditions that could—and did—lead to windfall returns.
During this period, as the economy recovered from the financial crisis, earnings grew by double digits and P/E multiples rose as well, resulting in an average annual return on stocks of 17.5% (just a point behind the golden age of 1982–2000).
Bond returns during this period, though far less sensational than stocks, were still positive at 3.8%.
Malkiel’s predictions for long-run returns in the years to come are based on the determinants as they stood in mid-to-late 2018.
As noted above, initial yields on bonds are a good measure of the long-run returns on those bonds.
Initial yields on investment-grade corporate bonds are 4.5%, while yields on 10-year Treasuries are 3%. If the inflation rate holds at 2% or lower, investors can expect to see a positive though humble return. (Of course, if interest rates and/or inflation rise, that modest return could disappear.)
As of mid 2018, dividend yield for the S&P 500 Index was just south of 1.9%. If earnings growth averages 5%—a reasonable supposition given restrained inflation and historical averages—then you’re looking at a long-run return of around 7%.
Note that P/E multiples, which are more important for short term estimates, weren’t included in this calculation. One way to incorporate this variable into a long-run estimate is a smell test: Do P/E multiples in the present seem high relative to the historical averages? In 2018, the P/E multiple for the S&P 500 was in the high teens—somewhat higher than its historical average of 15.81. Thus one might anticipate a modest correction in the next 10 or so years, especially if interest rates and/or inflation rise.
(Shortform note: As of August 2020, the S&P 500 P/E multiple was 28.33, nearly double its historical average.)
Calculate future returns on assets.
A share of Widget Corp. sells for $20, pays a $1 dividend annually, and has an estimated growth rate of 5%. What is the estimated annual return on Widget Corp.?
A zero-coupon bond with a face value of $1,000 sells for $600 on the market. What is the estimated future return on the bond?
To estimate stocks’ short-term returns, investors must consider a third factor in addition to dividend yield and growth rate. What is that third factor and how does it affect returns?
Age may just be a number, but it’s vitally important when deciding how to allocate your investments. For example, a fully employed 30-year-old, with many years of labor income ahead of her, can weather more losses (and thus tolerate more risk) than a retired 70-year-old who relies on his investment income to get by.
In terms of age-dependent investing, Malkiel’s advice boils down to this: The longer you’re able to hold on to your investments, the more common stock you should have in your portfolio. If you have many years of working ahead of you, your allocation should be mostly stocks; if your working years are winding down, you should have a heavier share of bonds.
In order to choose your assets as wisely as possible based on your age, adhere to these five key principles.
Historical returns have shown conclusively that assets with higher volatility hold the potential for higher returns.
For example, between 1926 and 2017, small-company common stocks, which had the highest volatility of the standard investment instruments, also boasted the highest average annual return. Stocks have provided an average compounded rate of return of over 8% since 1790, but they’ve also posted negative returns in three out of every 10 years, on average.
Although certain assets are inherently riskier than others—for example, stocks as an asset class are generally riskier than bonds—those risks can increase or decrease depending on how long you hold the asset.
For example, between 1950 and 2017, the range of returns on common stocks held for just one year was +52.6% to -37%, whereas common stocks held for 25 years had a range of +17.9 to +5.9%.
Bonds, too, mellow with age. If you’re able to hold a bond until maturity, you should see a return at or near the initial yield. If you have to sell the bond a year after you’ve purchased it, though, you might see a null or negative return.
As noted above, the longer you can hold onto your investments—that is, if you’re currently earning a wage and have no need to sell assets to maintain your quality of life—the more common stock you should have in your portfolio. If you’re past working age and need a reliable stream of income from your investments, a higher concentration of bonds is the more prudent choice.
Dollar-cost averaging is simply a fancy term for investing in fixed amounts at regular intervals over a long period of time. The classic example is electing to contribute some percentage of your monthly paycheck to a 401(k). By investing regularly and in consistent amounts over an extended period, you mitigate the risk of buying into the market at inflated prices (because the market will fluctuate over the period you’re investing).
For example, if you had made an initial investment of $500 in Vanguard’s 500 Index mutual fund (which tracks the S&P 500) in 1978 and added $100 every year through 2017, you’d have invested less than $49,000 and lived through major crashes in 1987, 2000, and 2008—and ended up with a portfolio worth more than $760,000.
There are some analysts who object to dollar-cost averaging. For example, if the market just goes up rather than fluctuating, one would be better off investing a large amount initially. That said, dollar-cost averaging provides some insurance against a bear market.
If you want to be able to move quickly to take advantage of a deflated market, rather than wait for your regular investment, Malkiel recommends keeping a small cash reserve in a money-market fund that you can draw upon to strike while the iron’s hot.
“Rebalancing” (or “reallocating”) your portfolio simply means to shift its ratios of various asset classes.
Say, for example, you have a portfolio that’s 60% stocks and 40% bonds, and one year stocks take off, resulting in a balance of 70% stocks and 30% bonds. Because this balance is slightly riskier than 60/40, you might “rebalance” by selling off some stocks and returning your portfolio to a 60/40 split.
Rebalancing reduces risk and optimizes opportunity for returns by taking money off the table. For example, an investor who rebalanced his portfolio to 60/40 annually between 1996 and 2017 would have seen a slightly higher return with less volatility than an investor who hadn’t. This is because that investor would have reduced his exposure to stocks during the upswing of the dot-com bubble in 1999–2000, shifted out of bonds when they were strongly positive (and stocks were still in bear territory) in 2002, and again drawn down stocks in 2007 before the 2008 financial crisis.
No matter how daring you may be personality-wise, your capacity for risk depends on your age and economic situation.
For example, a 75-year-old retiree whose sole source of income is her investments doesn’t have the capacity for great risk (no matter how much a risk-taker she might be temperamentally). This is because, if her portfolio were to suffer a significant loss, her quality of life would be in danger.
A 25-year-old consultant, on the contrary, whose primary source of income is his wages, has considerable capacity for risk. This is because, if his portfolio were to suffer a significant loss, he still has his wage income to fall back on.
It’s also important to keep in mind that age isn’t the only important factor in determining risk level. Consider the 55-year-old Enron employee whose wage income and investments were tied to the company. When the company declared bankruptcy, that employee was faced with financial ruin. Remember: Diversification minimizes risk.
As noted above, the general rule of thumb is: The more working years you have ahead of you, the more common stock and fewer bonds you should have in your portfolio (and, vice versa, the fewer working years you have ahead of you, the fewer stocks and more bonds you should have).
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A common default for corporate retirement plans, lifecycle funds are pegged to a holder’s prospective year of retirement. As the retirement year approaches, the fund automatically rebalances to a more conservative allocation.
Most major mutual-fund companies like Vanguard and Fidelity offer lifecycle funds. Simply pick the fund pegged to the year you plan to retire. Before you do, make sure to check the expense ratio so that you’re not compromising your returns by paying hefty fees.
The data show that Americans in general are poorly situated financially for retirement. For example, only half of Americans have retirement accounts (of any kind); among the poorest quartile of Americans, that number is 11%.
For underprepared retirees, the options are narrow. Malkiel suggests continuing to work part time—which can have ulterior health benefits by keeping seniors active and social—and delaying taking Social Security for as long as possible to maximize those benefits. (Seniors in poor health with lower life expectancy might opt to begin taking Social Security as soon as possible to realize the benefits while they can.)
For those retirees who’ve managed to build up a nest egg, there are two primary options for ensuring your money lasts as long as you do: annuitizing your savings or holding onto your portfolio and establishing a spending rate. Malkiel recommends at least a partial annuitization of your retirement savings and, if you choose to manage your own investments, spending only 4% of the total value of your nest egg annually.
An “annuity”—or “long-life insurance”—is a contract with an insurance company for regular payments as long as the purchaser lives.
For example, as of mid-2018, a $1,000,000 premium for a fixed lifetime annuity guaranteed a 65-year-old male an annual income of $67,000. (Thus, to earn out the premium, the 65-year-old would have to live at least another 15 years.)
Annuities come in a variety of shapes and sizes. One important variation is the “variable” annuity. This is an annuity whose payments adjust based on the underlying asset (typically a mutual fund). For example, if the stock market rises and the underlying fund posts an above-average return, the annuity payment will rise (by the same token, if the market falls, so does the payment). A variable annuity can be an inflation hedge, because a fixed-payment annuity doesn’t adjust to rising prices.
The biggest advantage annuities have over investing your nest egg yourself is the guarantee that you won’t outlive your money. If you’re a particularly risk-averse senior, you might consider devoting some or all of your savings toward an annuity.
There are four primary disadvantages of annuities.
1) Bad for Bequests
Retirees with solid income-producing assets might choose to forego an annuity, even if it offers the promise of a higher annual income. This is because, if the retiree uses all of his savings to purchase the annuity, there will be nothing left over for bequests to family or charity.
2) Inflexibility
Even with a variable annuity, the annuitant’s annual income is relatively static. This can become burdensome if circumstances change and the annuitant wants to increase his or her consumption.
Say, for example, a 65-year-old purchases an annuity, then suddenly discovers he’s terminally ill. He might like to cross some expensive items off his bucket list—traveling the world, let’s say—but he wouldn’t be able to increase his consumption drastically: he’d be constrained by his annuity payment.
3) Costliness
Along with the premium, costs of annuities can include the fees and expenses of the seller and commissions for the selling agent. These extra expenses can make annuities a much less attractive investment.
4) Tax Inefficiency
Variable annuities especially, due to their turning capital gains into ordinary income, expose annuitants to greater tax liability. It’s also important to note that partial annuitizations of retirement accounts doesn’t negate required minimum distributions (the minimum amount retirees must withdraw from their account after age 72) from the non-annuitized portion of the account.
Retirees who opt to manage their investments themselves—or only annuitize a portion of their nest egg—need to devise a spending plan that ensures they stay solvent through their golden years.
Malkiel’s solution is the “4% rule.” According to this rule, retirees should spend no more than 4% of their retirement savings annually.
Why 4%? Two reasons:
1) Regularize Your Withdrawals by Gradually Increasing Them
Because the value of your portfolio will fluctuate each year, maintaining a consistent 4% withdrawal rate may result in wide fluctuations in income. To reduce these disparities, begin with 4% but increase your withdrawal rate gradually—perhaps by 1.5% to 2% per annum.
2) Realize Gains by Rebalancing the Portfolio
It’s likely that the sum of bond interest and stock dividends won’t be enough to get you to 4% of the value of your portfolio. In this case, you should make up the difference by selling assets that have become overweighted. For example, if stocks have a banner year and your allocation has gone from approximately 50/50 to 60/40, then you should sell stocks to realize income and reduce risk. (Rebalancing annually is a good idea anyway, even if you don’t need to do so for income reasons.)
3) Put Off the Taxman
If you have monies in both taxable and tax-deferred accounts, it’s wise to withdraw from the taxable accounts first (because the more you gain in these accounts, the more you’re taxed). If you intend to leave a bequest to your children or heirs, draw on your ROTH IRA last (because there’s no required minimum distribution from these accounts, and their earnings are tax-free).
Review how age and investing are related.
Why is it important, in general, to hold onto investments for the long run?
Considering your age and tolerance for risk, what might be an optimal allocation for you? Sketch that allocation below.
Now imagine ten years have passed. How might you “rebalance” your allocation to reflect your new age?
Once you’ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is to decide which precise securities to purchase. But, with approximately 2,800 companies listed on the New York Stock Exchange, where does one start?
Malkiel proposes three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.
Ideal for the prospective investor who wants to take advantage of stock-market returns but isn’t interested in specifics, the autopilot strategy consists of purchasing broad index mutual funds or exchange-traded funds (ETFs) rather than individual stocks or industries.
(Some of the tax differences between traditional mutual funds and ETFs are described below, but the general rule of thumb is: If you have a large lump sum that you want to invest in index funds, ETFs are generally the most advantageous choice. If you’re going to be purchasing index fund shares in smaller amounts over a longer period of time, traditional mutual funds are your best bet.)
The autopilot strategy is Malkiel’s preferred method of investing. No matter how knowledgeable or engaged the investor, Malkiel advises building the core of a portfolio around index funds and only making active bets with excess cash.
The rationale behind the autopilot strategy is simple: Long-run returns of the S&P 500 Stock Index, which represents almost three-quarters of the value of the entire stock market, typically beat returns on portfolios designed by the most seasoned investment professionals. In short, if you were to invest in a mutual fund that holds a weighted representation of the stocks in the S&P 500, you would do better on average than trying to pick winners yourself or entrusting your money to an investment advisor.
Not only are returns better with broad market index funds, fees and expenses tend to be, too. Because index funds are passively managed—that is, they adjust their holdings more or less automatically on the basis of market values—they tend to have extremely low expense ratios (.0005% or less for some). And because index funds only trade to rebalance their weights, they incur low trading costs as well.
While the S&P 500 index funds are generally the most popular type of index fund—and they will outperform actively managed funds on average—Malkiel actually recommends that investors choose a total market index fund over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks that, historically and on average, have outperformed larger ones. Try to find a fund indexed to the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI US Broad Market Index.
Of course, as Modern Portfolio Theory teaches (see Chapter 8), diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: There are funds that track REIT, corporate bonds, international capital, and emerging market indices.
Here are some specific funds you might consider in each of the primary asset classes (cash, bonds and bond substitutes, REITs, and stocks). Consult the age-dependent allocations in the previous chapter to determine how much of each asset you should hold.
A short-term bond might be substituted for one of the money-market funds, and investors might include some Treasury inflation-protected securities (TIPS) among their bond holdings.’
As always, availing yourself of tax-advantaged options is critical in investing. Whenever possible, use IRAs and ROTH IRAs to make investments. If you must hold your assets in taxable accounts, you might opt to buy tax-exempt bonds or ETFs and use tax-loss harvesting to reduce your tax burden.
Although traditional index mutual funds are by and large tax friendly, they can occasionally incur capital-gains-tax exposure (usually due to buyouts of companies in the index or the sale of shares to redeem fundholders).
ETFs—funds traded on the market like common stock—can sometimes offer greater tax advantages than traditional index mutual funds. This is because they can redeem shareholders via “in kind” redemptions—transfers of the fund’s underlying assets rather than cash. In-kind redemptions don’t trigger capital gains taxes (because the gain isn’t realized as cash but rather as the underlying assets). ETFs also feature extremely low expenses.
That said, holding ETFs isn’t completely free. There are transaction costs associated with them, and there’s also the temptation to try to trade your shares on a daily basis to realize a quick gain. Don’t. The taxable gains you stand to realize on an ETF trade pale in comparison to the benefits of holding the ETF for the long haul.
| Some ETFs | ||
| Type | Name | Expense Ratio |
| Total US Stock Market | Vanguard Total Stock Market (VTI) | 0.04% |
| SPDR Total Stock Market (SPTM) | 0.03% | |
| Developed Markets (Europe, Australasia, and the Middle East) | Vanguard Europe Pacific (VEA) | 0.07% |
| iShares Core MSCI Intl. Developed Markets (IDEV) | 0.07% | |
| Emerging Markets | Vanguard Emerging Markets (VWO) | 0.14% |
| SPDR Emerging Markets (SPEM) | 0.11% | |
| Total World (excl. US) | Vanguard FTSE All World (VEU) | 0.11% |
| iShares Core MSCI Total International Stock (IXUS) | 0.11% | |
| Total World (incl. US) | Vanguard Total World (VT) | 0.10% |
| iShares MSCI ACWI (ACWI) | 0.32% | |
| Bond Market US | Vanguard Total Corporate Bond Fund (VTC) | 0.07% |
| Schwab US Aggregate Bond (SCHZ) | 0.04% | |
Tax Loss Harvesting (TLH) allows investors to defer taxes by trading stocks at a loss and replacing those stocks with correlated, but not identical, stocks. This move allows the investors to realize a loss—thereby lowering their tax bill—but also maintain the risk/return ratio of their portfolio.
For example, say that values of large automobile manufacturers have declined across the board. You decide to sell your shares of GM to realize a loss and reduce your tax burden, but at the same time you purchase Ford at a comparable price, thereby maintaining your position in automobile stocks. Although you’ll eventually have to pay taxes on those shares of Ford (if their value increases and they pay dividends), you’ll come out better than if you’d just pocketed the savings from the GM loss. This is because (a) your investment in Ford will compound over time and (b) the tax rate on your Ford capital gains is likely to save you more money than the GM capital loss did.
Many investment companies, for example Vanguard and Fidelity, now offer automated investment advisers that automatically engage in TLH. These companies also offer packages that include access to human advisers as well, but beware hefty expenses and fees.
Holding a diverse portfolio of index funds is a low-maintenance and moderate-risk strategy ideal for large sums like your retirement savings. That said, some investors—for example, those with a taste for gambling—will find indexing an entire portfolio boring and may want to try their luck picking winners.
Malkiel advises that thrillseekers only speculate with secondary monies that they can afford to lose, and that they follow four key principles.
Simply put, earnings growth is what produces winners. Not only do consistently above-average earnings boost dividends, they also result in higher P/E multiples. That means higher capital gains on top of dividends.
Expensive stocks with bloated P/E multiples can burn you twice over if earnings don’t materialize (because both dividends and capital gains will decrease).
What you want are reasonably priced stocks with positive growth prospects. Although determining the precise value of a stock is effectively impossible, you can tell whether a stock is reasonably priced by comparing its P/E multiple to that of the market as a whole. If a stock’s P/E is well beyond the market’s, you might be wise to stay away. If the P/E is comparable to the market’s and there’s the promise of growth, that’s a better bet.
(Note that it’s OK to buy stocks with P/E multiples greater than market’s as long as growth prospects are above-average as well.)
If you come across a firm-foundation stock around which buzz might build—for example, because the company is about to hire a charismatic CEO or debut a new technology—those are stocks worth purchasing. The key is to buy in before the builders of castles of air drive the price up.
With the advent of commission-free brokerage products, the expenses of trading have been considerably diminished. Nevertheless, you should hold your purchases as long as possible, and, if you have to trade, sell your losers before your winners.
This is because selling your losers reduces your tax burden. Before the end of a calendar year, Malkiel will sell off most of the stocks on which he’s seen a loss to lower his tax bill. There are special cases in which it makes sense to hold a loser—for example, when the company has solid growth prospects—but, in general, you stand to gain by offloading at a loss.
Rather than play the stock market yourself, you might choose to pay a professional to play for you. But Malkiel’s years of studying actively managed mutual funds have yielded two key insights: One, that fund managers’ past performance has little bearing on future performance, and two, actively managed funds rarely beat the average market return for long.
In short, if you index the majority of your savings and (perhaps) hold a little back to speculate with, there’s no need to invest in an actively managed fund. If you decide to anyway, make sure you choose one with a low expense ratio and a low turnover rate. The higher the expense ratio, the more of your returns you’re giving to the manager; and the higher the turnover rate, the more you’re handing over in capital gains taxes.
As of 2018, investors have the option of choosing a standard (living, breathing) advisor, an automated advisor, or a hybrid service. However, like actively managed funds, investment advisors are typically an unnecessary expense. If you follow Malkiel’s precepts, you should be able to build and rebalance your portfolio on your own.
Standard advisors typically charge a fee of either 1% of your total assets or $1,000–$1,500, whichever is higher. Some advisors also earn commissions on selling particular products—often high-expense-ratio and actively managed funds.
If you decide to hire an investment advisor, make sure it’s a “fee only” advisor that won’t direct you into high-cost products.
Automated investment services offer a low-cost alternative to human advisors (automated services’ fees are typically a quarter of 1% of the investor’s total assets). Automated advisors develop a profile of the investor through an online interview that includes questions about the investor’s tolerance for risk and investment goals. The advisor then develops a risk score and a portfolio that matches that level of risk.
To keep costs down, automated advisors typically invest in index funds via ETFs, and rebalances are handled automatically. Automated advisors can engage in TLH automatically as well.
A number of financial services firms, including Vanguard and Charles Schwab, offer investment advising that combines the ease of automation with the personal touch of a human advisor.
These services can be costly, however. Vanguard’s hybrid service, which allows clients to speak directly to an advisor by phone or video chat, has a minimum investment of $50,000 and charges a fee of .30 of 1% of the investor’s assets. Schwab’s “Intelligent Portfolio” service, meanwhile, ushers users into Schwab’s own high-expense-ratio funds in lieu of charging a fee.
Explore what the autopilot strategy, the interested-and-engaged strategy, and the trust-the-experts strategy mean for you.
Are you a set-it-and-forget-it type, or do you like to tinker? Which do you think is the best investment strategy for you and why?
What are the four main asset classes? If you already own a portfolio, are all four represented in your portfolio? Why is it important to have some of all four in your portfolio at all times?
Imagine you hold 20 shares of Delta, and at the end of the calendar year you see that the stock price has gone down. What might you do to practice tax-loss harvesting?
If you’re thinking about engaging an investment advisor, what kinds of questions might you ask of him or her?
As of 2018, 40% of the amount invested in ETFs and mutual funds was in index funds. In response to the rapidly growing popularity of indexing, firms that rely on the fees and commissions attached to actively managed portfolios have criticized the practice. They believe that with greater indexing will come two issues: (1) prices will no longer reflect new information, because there will be no active investors to take advantage of, say, a positive clinical result for a new pharmaceutical; and (2) index-fund providers like Vanguard, Blackstone, and Fidelity will garner outsize ownership (and thus influence) in publicly traded companies.
In response to (1), Malkiel notes that there will always be active traders seeking arbitrage—that is, price–value disjunction—opportunities. Consider the example just above: If a pharmaceutical company develops a new therapeutic for cancer, is it conceivable that no investors will buy the stock and bid up the price? Of course not.
As for (2), anti-competitive or collusive behavior on the part of the major index-fund providers is illogical. For example, say Vanguard ends up with a majority stake in America’s airline companies and decides to use its shareholder vote to raise ticket prices. A move like this may raise revenues for airline stocks, but it will reduce revenues for companies who rely on cheap airfare for business travel. Given index funds’ index-wide holdings, an intervention in one sector will likely be offset by effects in other sectors.
Simply put, as far Malkiel is concerned, index funds are a clear positive for individual investors—and for society as a whole.