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 is part one of two.
The bad old days
MintLife: Take me back to 1973, when the first edition of Random Walk came out. What does the investing landscape look like? There are no index funds, no IRAs. What are my options?
Malkiel: What you typically had at that time were full-service brokers, and the biggest one was Merrill Lynch. If you made a modest, say, $1,000 or $2,000 investment, you would have a registered representative, usually suggesting a stock to you, and you would pay a commission that might be as much as $100. So that was the investing landscape.
Alternatively, the registered representative would say, “Hey, you need diversification. You ought to buy this mutual fund.” And the typical mutual fund at the time had a 7% load fee. So a $2000 investment might mean $140 in essentially a commission, of which the registered representative would get a certain proportion of it, usually 30, 35%, depending on the broker. So I would say that that was the investing landscape then, in that most of the mutual funds were load funds. There were no index funds.
And the view was, when my book first came out, “What a stupid thing to say. We know that investment professionals can do much better than the market.” And there was certainly a view that people couldn’t do things on their own. They needed these professional brokers, professional investment managers, and it was ridiculous to think that anybody could do it on their own. The idea of buying a dumb index fund was absolutely stupid.
MintLife: It’s amazing to me that you hear this criticism these days that the system is rigged against the individual because of high-frequency trading and institutional dominance of the market. It seems like it was much more rigged against the individual then.
Malkiel: I think that’s absolutely right. In fact, on high-frequency trading, look, there are some bad things you can do, like these kind of flash orders that are trying to manipulate the market that really aren’t real orders. So I’m not saying everything that’s done there is right. But one of the things that I like about it is, since I believe in index funds and ETFs, which now are the biggest growth investment product that there is, with way over a trillion dollars in it–the reason I like high-frequency trading is that it means that those things are going to be efficiently priced.
I want the guy on the street who buys a SPDR, or who buys VTI, which is the Vanguard Total Stock Market ETF–these things with less than ten basis points (0.1%) of expense–I want to make sure that they are priced appropriately relatively to the underlying stocks. Take the example of the SPDR. If the SPDR, which is an S&P 500 ETF, if it gets a little bit out of line with the underlying stocks, what the high-frequency trader does is–say the ETF is too high–short the ETF, buy the individual stocks, trade them in for ETF shares to cover the short. And this is a good thing, because what it means is, the guy on the street’s getting the right price.
So I think if anything, these things make the market more efficient and make it more likely that the individual will do, in my view, not only as well as the experts but better. And if there are a couple of loose pennies for the high-frequency traders to pick up, that’s terrific, because that makes the market more efficient.
The LinkedIn IPO and efficient markets
MintLife: Let’s talk about market efficiency. You hear lots of objections to the efficient market hypothesis, and I think a lot of them have to do with the name. People have this idea that saying that the market is efficient is equivalent to saying that the market should never go down.
Malkiel: That’s a very good point, because I think people misrepresent what the efficient market hypothesis means.
MintLife: So what does it really mean?
Malkiel: Okay, here’s what it really means. First of all, let me say what it doesn’t mean. What it doesn’t mean is that the price is always right. How could prices be right? The price of a stock, what I teach my students is, that any stock is worth the discounted present value of all of the future cash flows. So what does that mean? That means that somebody’s got to estimate a bunch of future cash flows, and nobody knows what they’re going to be. Is LinkedIn (LNKD) a bubble or not? Well, who the hell knows what the future cash flows are going to be for LinkedIn?
Nobody knows! And some people are going to think it’s a bubble because the market is discounting tremendous growth, and other people will think, hey, you don’t understand, this is really something new, and this is something that is just in its infancy, and the amount of earnings that you’re going to get from it is going to be absolutely enormous. When Google came out, people thought, oh my God, it’s a bubble, it’s a terrible thing, and in fact, Google turned out to be cheap. On the other hand, Pets.com turned out to be, if you’ll pardon the expression, a dog.
So nobody knows. The efficient market hypothesis doesn’t mean the market’s always right. The market’s always wrong. But nobody knows whether any price at any time is too high or too low. So what does it mean? What is does mean is that there are no arbitrage opportunities, by which I mean: the market, it may not be right, and in fact it’s always wrong, but nobody can beat the market.
Now, if a hedge fund is long stocks and the stock market goes up and they’re leveraged up to the eyeballs, they will beat the market, but they’ve taken on much more risk. Sometimes 25% of hedge funds go out of business in a year.
MintLife: What do you think of the argument that, okay, indexing, that’s just one philosophy among many. You can be an indexing kind of person, you can be a “watch the 200-day moving average” kind of person, and it’s just a matter of taste and there isn’t a preponderance of evidence one way or the other.
Malkiel: Well, there is a preponderance of evidence, I believe. To take your example, is the technician who follows the 200-day moving average going to do any better than the index guy? What I’ve done in every edition of the book is to say, okay, this was a thesis, that the index fund is going to do better than the vast majority of professional managers, so did it work? And every time I do the book, including the 2011 edition, I look at the data and ask whether it worked, and I would argue that the data are very clear that it works and it continues to work.
I’m not that sort of super extreme and dogmatic, but what I do say–and this is in the 10th edition–there’s at least enough evidence that indexing isn’t average, it’s above average. There’s enough evidence that it works that at least the core of one’s portfolio ought to be in index funds. Then, you know, investing’s fun. You want to go out and buy some individual stocks? You really think LinkedIn is the way to go? Go do it! You can then do it with much less risk if the core of your investment fund is indexed. So what’s in the book is kind of a core-satellite approach, and it’s really based on evidence. The evidence is that it works.
MintLife: I had someone ask me how he could use his 401(k) to buy into the LinkedIn IPO, and I said, “Maybe consider using some fun money for that instead.”
Malkiel: Well, exactly. In other words, your important money, your 401(k) money ought to be in index funds. You want to have a little fun? And it is fun. Investing is fun. I buy some individual stocks. But I can do it with much less risk because my core IRA money, and at universities we have something called a 403(b), which is the same as a 401(k), that’s basically invested in index funds.
This interview has been condensed and edited.