Burton G., Professor Emeritus of Economics at Princeton University. Malkiel speaks at the John C. Bogle Legacy Forum on Tuesday, January 31, 2012 in New York, US.
Peter Foley Bloomberg | getty images
This week, Princeton professor Burton Malkiel has published an updated, 50th anniversary edition A Random Walk on Wall Street: The Best Investment Guide Money Can Buy, More than any other book, it popularized the idea of indexing as an investing strategy and also explained why you can’t beat the market. Malkiel was a close friend of Vanguard founder Jack Bogle and spent 28 years on Vanguard’s board.
Malkiel will be on CNBC’s “The Exchange” today at 1:30 pm ET. Below are excerpts from a series of email interviews. These have been lightly edited for style and clarity.
You recommended index funds 50 years before index funds even came into existence. Do you still believe in it and what is the proof?
I believe more strongly than ever that index investing is an optimal strategy and that index funds should be the core of everyone’s portfolio. Standard & Poor’s publishes annual reports showing how actively managed funds compare to index funds. About two-thirds of active managers underperform index funds each year. And the one third that performs better in one year is not the same as the one third that performs better the next year. When you measure performance over a decade or more, 90 percent of active managers outperform broad-based index funds. On average, active managers underperform the market by about one percent per year.
You famously said that stocks follow a “random walk.” What is random walk?
Random walk means that the past history of stock market prices cannot be used to predict the future. Sometimes there is some momentum in the market, but momentum strategies do not work reliably, and prices change randomly. Sometimes value stocks and small-cap stocks perform better, but they can underperform for years. So-called “factor funds” have underperformed the market over the past 15 years.
Despite the evidence, it seems most people don’t want to believe the evidence. Why can’t we accept that stocks follow a random walk?
People fool themselves when they see clear patterns because stripes are more memorable than randomness. Even sports giants fool themselves into believing that this trend exists and that they have the “hot hand.” For example, behavioral psychologists have examined the basketball free throw records of college and professional players, believing that if they make several free throws in a row, they are more likely to have success on the next shot. The evidence is completely contrary. A 50% free throw shooter has a 50% chance of success on the next shot, regardless of how many previous shots were made.
You are a big proponent of the efficient markets hypothesis (EMH), which says that asset prices reflect all available information. But as you point out, that doesn’t mean the prices are always accurate. Define EMH, what it says and what it does not say.
Efficient markets do not mean that prices are always right. Even if everyone values the stock as the present value of future cash flows, the future can only be predicted. Therefore the prices are often “wrong”. The EMH says that no one knows for sure whether they are too high or too low. The EMH accepts that bubbles may exist but no one knows for sure how much they swell before they burst. Alan Greenspan suggested that the market was “irrationally euphoric” in 1996. The bubble burst in 2000. Meme stocks like GameStop sold at bubble levels but hedge fund Melvin Capital went bankrupt and shorted them. The market may not be perfectly efficient and may have serious errors. But it is very difficult to defeat.
Exchange traded funds (ETFs), most of which are linked to index funds, are constantly raising money. How do you feel about ETFs?
I like ETFs if they are broad-based index funds. I don’t favor the elite people who actually represent active management. I believe that leveraged ones (such as three times the up or down movement of the market) are actually gambling contracts, not investment products.
Last time we spoke you said that the next revolution after index funds is in investment advice. Most advisors charge 1% or more. When it is done online it is 0.25%. Are there any signs that a “mentoring revolution” is taking place?
I think there is a revolution going on in investment advisory services, just as the indexes themselves were a revolution. Investment advisors charge between 1 and 3 percent per year to manage individuals’ portfolios. Software companies can do this effectively for 25 basis points for those that accept fully electronic management and for 50 basis points for a hybrid model where you can also talk to a human from time to time. Are. I work with Wealthfront (a fully electronic) and Rebalance (a hybrid) investment manager. Electronic or computer managers may also provide direct indexing where the fund can efficiently offset tax losses while maintaining pre-tax exposure to the broader market.
A few years ago you wrote an op-ed in the Wall Street Journal highly critical of ESG (environmental, social and governance) funds, saying they were a “self-defeating strategy.” Since then, they have come under even greater scrutiny. Do you still feel that way? Why?
ESG funds promise that you can do good for society with your investments as well as do good financially. But there is no consensus on what a “good” investment is. Is natural gas a good company because it is the cleanest burning carbon and we will need it for decades on the road to a carbon-free world? Or is it bad because it is a pollutant? Is a munitions manufacturer good because it is providing defensive weapons to Ukraine or bad because its products kill people? Are META and VISA good because they are not major polluters, or are they bad because they can cause extreme suffering for teenagers and because they charge poor people exorbitant interest rates? ESG funds also have higher fees and are underperforming standard index funds.
![Why Wall Street veteran Burton Malkiel isn't a fan of ESG investing?](https://image.cnbcfm.com/api/v1/image/107175307-16730307681673030763-27578147490-1080pnbcnews.jpg?v=1673031716&w=750&h=422&vtcrop=y)
You have always preached the benefits of a diversified portfolio. What should a diversified portfolio look like?
Portfolios should be widely diversified, but will be different for people in different circumstances. Young people should dollar cost average by investing regularly and almost exclusively in equity index funds (60/40 stocks to bonds is not appropriate for young people). An investor in his 70s and 80s requires a large portion of limited duration fixed income to meet required minimum distributions.
The S&P was down nearly 20% last year. In years in which it has declined 20%, it generally bounces back the following year. What can we expect for stocks in 2023?
I don’t make short-term stock market predictions. No one can do this correctly with any consistency. But cyclically adjusted price-earnings multiples (CAPE) give the best forecast for long-term equity returns. Today CAPEs are well above average. This suggests that returns over the next decade are likely to be 9%-10% less than long-term historical stock market returns. Investors will then have to temper their expectations and consider that returns may be only half of the historical average.
![Wall Street veteran Burton Malkiel says returns are likely to be 5 to 6 percent over the next decade](https://image.cnbcfm.com/api/v1/image/107175307-16730307681673030763-27578147490-1080pnbcnews.jpg?v=1673031716&w=750&h=422&vtcrop=y)
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