Investing in broad-based index funds seems unambitious — a fallback for people who lack the confidence to pick stocks that will outperform the market.
Nearly 50 years ago, the economist Burton Malkiel came out with a book that said, in effect, that all of us should be in index funds. The stock and bond markets incorporate new information into prices almost instantly, so trying to beat them is a fool’s errand, Malkiel wrote. Instead of trying to winnow winners from losers, you’re better off saving on brokerage commissions and headaches by spreading your investment dollars across the entire market.
While this has come to be conventional wisdom, it was crazy talk in 1973. A blindfolded chimp throwing darts at the stocks page is as good as a stockbroker? Insulting and ridiculous! BusinessWeek (my former employer) gave the book, “A Random Walk Down Wall Street,” a scathing review.
The amazing thing about the book’s first edition is its advocacy of what we know today as index funds before they even existed, at least as a product available to the general public. It wasn’t until 1976 that Jack Bogle started the first index mutual fund at the Vanguard Group. It was quickly nicknamed “Bogle’s Folly.”
Malkiel and Bogle had the last laugh. By the end of 2021, $12.5 trillion was invested in index mutual funds and exchange-traded funds, representing 43 percent of all investments in long-term stock and bond funds in the United States, according to the Investment Company Institute. (The calculation doesn’t take into account investments by hedge funds, pension funds, life insurers and wealthy individuals, which collectively invest more than all the money invested in long-term funds.)
“It is not often in life that the easy thing to do is the smart thing to do,” Malkiel writes in the book’s latest edition.
I interviewed Malkiel, who is 90, about “A Random Walk Down Wall Street” on the occasion of the 50th-anniversary edition, which will be available in January. This is the book’s 13th edition. It has sold more than two million copies. The full title of this edition is “A Random Walk Down Wall Street: The Best Investment Guide That Money Can Buy.”
A lot of investing has been distinctly unsuccessful lately. The Standard & Poor’s 500 index is down 17 percent year to date, and the tech-heavy Nasdaq Composite index is down 29 percent. Some of the biggest declines have been in companies with large market capitalizations, such as Meta (Facebook), Alphabet (Google), Microsoft, Amazon and Tesla. When you buy a broad-based index fund, you automatically tilt your portfolio toward companies with large market caps, which leaves you exposed at times like this.
So, professor, is exposure to large caps a fundamental flaw of index investing? No, Malkiel said. “There are so many press stories that say, ‘Well, indexing really worked very well during the bull market but now it’s a stock-pickers market.’ Time and time again the data show that in fact indexing continues to work and work well” in down markets, he said.
Research shows that the advantage that index funds have over actively managed funds shrinks a bit in down markets. Apparently that’s because actively managed funds tend to keep more of their money in cash, which, inflation aside, doesn’t lose value along with the rest of the portfolio, Malkiel said.
I asked him about the profusion of indexes that track different subsets of the stock market. Bloomberg reported in 2017 that there were more indexes than stocks. This is a problem. If you stuff a lot of money into a mutual fund or exchange-traded fund that tracks some narrow slice of the market, you’re defeating the purpose of indexing, which is to invest in the overall market.
“Right now there are too many indexes,” Malkiel said. “The narrower you get, the more it resembles stock-picking. Just as I don’t believe that people are going to be able to pick particular stocks, I’m far from certain they’re going to be able to be in exactly those industries or sectors of the market that will outperform.”
Malkiel is quick to acknowledge that “A Random Walk Down Wall Street” is based on academic research by others. They include Harry Markowitz and William Sharpe, who shared with Merton Miller the 1990 Nobel Memorial Prize in Economic Sciences for work on portfolio theory. He also singles out John Lintner, who codeveloped the capital asset pricing model in the 1960s.
“The book tries to put in layman’s terms what’s behind some of these great advances in finance,” Malkiel told me.
In 1999, the finance scholars Andrew Lo and A. Craig MacKinlay came out with a book that seemed like a straight-up rebuke of Malkiel called “A Non-Random Walk Down Wall Street.” It said there are exploitable anomalies in the movements of stock prices. I wrote about it for BusinessWeek.
In fact, “Random” and “Non-Random” books aren’t as contradictory as you might think. Lo and MacKinlay wrote that those exploitable anomalies are hard and expensive to find. The profit that you make from locating them is analogous to the profit a gold-mining company gets from exploring for gold. In fact, that’s exactly why markets are more or less efficient: because of the profit to be made from finding inefficiencies.
Malkiel told me, “It’s not that there aren’t errors. Market prices are always wrong, but nobody knows for sure if they’re too high or too low. I agree there are bubbles, but the timing of those things is absolutely impossible to know.”
Malkiel is an avid follower of the ups and downs of particular stocks, which seems incongruous for an indexing guy. He said he does own shares in individual companies and sees nothing wrong with others doing the same, as long as they don’t overdo it. “Remember that they are bets,” he said. “Only do it when the basic core of the portfolio is indexed, and certainly your important retirement funds shouldn’t have any of those bets. This is something you do around the edges.”
Malkiel, a Boston native, studied at Harvard College and Harvard Business School, served in the Army, worked on Wall Street, got a doctorate in economics from Princeton in 1964, and then spent the rest of his career on the Princeton faculty except for stints on the President’s Council of Economic Advisers in the 1970s and as dean of the Yale School of Management in the 1980s. For 28 years he was a director of Bogle’s Vanguard Group — and a dear friend of Bogle, who died in 2019 at age 89.
“Random Walk” isn’t his only book, but it’s the one that’s had the biggest impact. “For me, one of the things I’m particularly pleased about is the many letters I get,” he said. “Sometimes from people who say, ‘I read your book 25 years ago and I never had a lot of money, but I did exactly what you said, and now I’m comfortably retired.”
I asked Malkiel if this 50th-anniversary edition is the capstone edition of “Random Walk,” expecting him to say yes. “Who knows?” he said. “I still feel good. I’m not the kind of person who’s going to lie on a beach chair.”
Number of the Week
This is the number of Americans who are planning to shop between Thanksgiving Day and Cyber Monday, Nov. 28, based on a survey by the National Retail Federation and Prosper Insights & Analytics. In 2019, the last year before the pandemic, the survey results were almost the same: 165.3 million.
Quote of the Day
“So let us wage a global struggle against illiteracy, poverty and terrorism and let us pick up our books and our pens. They are our most powerful weapons.”
— Malala Yousafzai, in an address to the Youth Assembly at the United Nations, July 12, 2013
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