In other words, investors were screwed. Into this wasteland came A Random Walk Down Wall Street, by an economist, Burton Malkiel, who compared stock market analysts to dart-throwing monkeys and argued that we’d all be better off if we could just invest directly in the S&P 500. Two years later, John Bogle established the first index fund (the Vanguard 500, VFINX). If you own an indexed stock or bond fund–and you should–you owe a debt to Burt Malkiel.
Random Walk came out in its tenth edition this year. It now covers behavioral finance (that is, stupid investor tricks), the ongoing economic crisis, financial innovations good and bad, and why indexing still wins. Malkiel, 78, is professor of economics at Princeton University and spent nearly three decades as a director at Vanguard. He spoke with MintLife’s Matthew Amster-Burton.
This part two of two.
Pop! Asset bubbles, gold, and bonds
MintLife: You talk a lot about asset bubbles, going back to the first edition of the book, and I recently reread Bill Bernstein’s book, The Four Pillars of Investing, which came out right after the dot-com crash. And the book has held up really well, but he says that since we’ve just had this incredibly painful asset bubble pop, people have memories and it’s probably not going to happen again very soon. Were you surprised that we had another enormous asset bubble so quickly?
Malkiel: Not at all. I know markets go crazy. But what I do say about the bubble is that you never know until after the fact that it was a bubble. Take the internet bubble. Bob Shiller said we were in a bubble in 1992. Bob Shiller gave a paper to the Federal Reserve in December 1996 saying the market was ridiculously overpriced. And that actually led Alan Greenspan to make his famous speech in December ’96 where he coined the term “irrational exuberance.” Well, the market went up sharply for the next four years. We know now that it was 1999 and the first quarter of 2000 that we were in the bubble.
The 10-year treasury went to 4%, and people said we were in a bond market bubble. Well, the 10-year treasury is now much lower than that, the price is much higher. So it’s not that bubbles don’t exist. It’s that you only know them ex-post, you don’t know them ex-ante, that’s the problem. It’s only after the fact that we know now that we had a huge housing bubble.
MintLife: Right, it seems extremely obvious in retrospect, but I remember at the time thinking, “I’ve got to get in on this now.”
Malkiel: And think of how many people are calling different things bubbles today.
MintLife: Gold, bonds, things all over the place.
Malkiel: People said gold was a bubble at $1000. It’s now $1400. Is it a bubble today? You know, might be. Could go down to $1000. Nobody knows. The gold price is either too high or too low, I’m sure of that. And nobody knows whether it’s too high or too low. That’s what you mean by the efficient market. I don’t know that the gold price is right. I don’t think any price is right.
MintLife: All of a sudden, even more so than last year, you’re hearing all this talk that there’s going to be a slaughter in the bond market, that either there’s a bond bubble, or the US is going to default on its debt. Is this meaningless noise, or is there something to it?
Malkiel: Look, there are plenty of worries. It could very well be that bonds are overpriced. Nobody knows. Let me give you another scenario which would suggest they’re not overpriced. We’ve got a sluggish, terrible recovery. We have got a horrible economy. All the data that’s come out in the last two or three weeks has been just miserable. Interest rates could stay very low for a very long period of time. I think you want some bonds in your portfolio. You’ll rebalance over time, and you know? We’ll see whether they’re too high or too low. Again, I don’t think anyone can tell.
MintLife: We’re talking a lot here about investor psychology, and you’ve had a chapter for the last couple of editions about behavioral finance. The thing I always wonder is whether knowing about the big mistakes that investors make because of psychology–I wonder if knowing about it can actually make us better investors. Like, if I want to tie myself to the mast so I don’t sell out the next time we have a March 2009. What should I actually do?
Malkiel: Well, that’s, in fact, one of the main lessons for behavioral finance. We know people buy at the top and sell at the bottom because their emotions get ahold of them. What I say is, you may call it strapping yourself to the mast, but dollar cost average for people who are accumulating money. What that means is, sometimes you’re going to buy at the top, but it also means sometimes you’re going to buy at the bottom. And don’t try to time. Do the dollar cost averaging.
The other thing you can do is to rebalance. And what that will do is automatically help you and save you from doing dumb things. What I show, for example, is, let’s say you had a portfolio of 60% stocks and 40% bonds, and you were going to hold it–I think I did this from 1996 into 2010. I showed that if you rebalanced once a year, you got another 1.5 percentage points of return. In other words, even though the 2000s were lousy, if you started in 1996, just when Alan Greenspan gave his “irrational exuberance” speech, with a 60/40 portfolio, you got–not rebalanced it was something like 10% and rebalanced it was something like 11.5%.
You know that emotions make us do the wrong thing. Go dollar cost averaging and rebalancing, and those are the right things to do. Now, it’s hard to do. I remember even telling some of my economics colleagues, and they said, “Oh my God, I’m not going to continue dollar cost averaging in 2008. I lose money every time I put money in.” So I’m not telling you it’s easy to do, but that’s the answer.
MintLife: Given that rebalancing is likely to have the greatest benefit when it’s the most painful, does that suggest that we should probably gravitate toward balanced funds or target date funds where it’s appropriate to avoid having to do that manually and maybe not be able to press the button?
Malkiel: That is the advantage of some of these funds, if you think you can’t do it. Now, I would prefer you did it with ETFs and pay seven basis points (0.07%) rather than the higher expenses of these other things, but if you say, emotionally, I can’t do it, then I think they’re fine. And that actually leads to another lesson that I really hit in the 10th edition, where we’ve got so many investment products now that cost you close to zero. I think all of us need to be very modest about what we know about investing, but the one thing that I am absolutely sure of, and probably the only thing I’m absolutely sure of, is that the lower the expense I pay to the purveyor of the investment product, the more there will be for me. That’s a certainty.
MintLife: I loved the Morningstar report where they found that expense ratio was as good as star rating as a predictor of future performance.”
Malkiel: Yep, absolutely.
MintLife: Are you going to do another edition of Random Walk?
Malkiel: I do an edition every three, three-and-a-half years, and I’m sure there’ll be new stuff to say, but I will tell you this: every time I’ve done it, indexing shows its true colors. It works, and even if you don’t agree with me 100%, there’s enough data that suggests that it works that it would be a very good idea to have at least the core of your portfolio in index funds.
This interview has been condensed and edited. Read A Random Walk Talk with Burton Malkiel Part I here.