The questions Burton Malkiel addressed go to the heart of what we do as investors.
Few theorists have influenced the world of investing as much as Burton Malkiel. The questions he addressed go to the heart of what we do as investors, and the ensuing debate about whether we can consistently outperform the market has raged for nearly 40 years.
Born in 1932, Malkiel spent his teenage years attending Boston Latin School, from which he graduated to Harvard University, gaining a bachelor's degree in arts (BA) in 1953 and a master's degree in business administration (MBA) in 1955.
A three-year stint in the Finance Corps of the US Army followed, which led to an associate position in the investment banking department of Wall Street firm Smith Barney & Co. in 1958.
In 1960 he returned to academia, completing a Ph.D. at Princeton University in 1964. He currently holds the position of Chemical Bank Chairman's Professor of Economics at Princeton, in addition to many advisory roles.
Malkiel is best known for his classic book on market efficiency, A Random Walk Down Wall Street, which was first published in 1973. This book spelled out some basic truths about the fund management industry, the main truth being that the industry as a whole will perform the same as the market as a whole.
As he later put it:
"We cannot live in Garrison Keillor's Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms."
From this basis, and from his demonstrations that past results are not reliable indicators of future performance, he argues that there is no benefit to be gained from paying investment professionals to try to outperform.
"The one investment principle about which I am absolutely sure is that the less I pay to the purveyor of an investment service, the more there will be for me."
Needless to say, his opinions have brought him into conflict with many in the financial services industry.
His work has highlighted the futility of forecasting, especially over the short term:
"The short-run changes in stock prices cannot be predicted … Investment advisory services, earnings predictions and complicated chart patterns are useless."
But his belief in market efficiency -- the idea that asset prices already comprehend all relevant available information -- does not preclude him having opinions on the characteristics of a sensible investment. In a Motley Fool interview in 2003 he reiterated his views on value:
- Rule No. 1: Buy only companies that are expected to have above-average earnings growth for five years or more;
- Rule No. 2: Never pay more for a stock than its firm foundation of value; and
- Rule No. 3: Look for stocks whose stories of anticipated growth are the kind on which investors can build castles in the air.
So Malkiel accepts the fact that, regardless of the evidence, investors will try to rise to the challenge of beating the market, but he insists that regular investment in trackers should form the core of any portfolio.
As he recently explained in an interview with Chris Hill of Fool.com:
"The best ideas are to dollar-cost average and re-balance, which is one of the most important techniques for individual investors. If you have got an allocation that is 50% bonds and 50% stocks and the stocks go way up and the bonds go down, take some money off the table and re-balance"
Profits and primates
One metaphor which has famously stuck in public consciousness is that:
"a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts".
While he now prefers the analogy of throwing a towel over the stock listings and buying and holding everything, his basic belief in the efficiency of the markets has taken much criticism during the financial crisis.
Many, particularly from the behavioural investing camp, have asked why, if the markets are 'efficient' and prices are 'correct', we can get such wild volatility in asset prices.
But this to misunderstand the meaning of market efficiency, and on this point Malkiel sticks to his guns:
"I think behavioural finance is actually very important. We are ruled by emotion and there are mistakes that we all make. We are overconfident for example, and I think you can avoid some mistakes by heeding the lessons of behavioural finance. But there's nothing I have seen that suggests to me that any of these things, whether they are adaptive models or behavioural models, give you a way to beat the market."
Financial crisis and solutions
Neither has the market turmoil dampened Malkiel's belief in the primacy of the markets, and this should not come as a surprise -- in the same way that investment 'experts' with their human weaknesses cannot reliably forecast the price of a stock, political 'experts' cannot be expected to perform any better.
"While there have clearly been market failures involved in the current crisis, let us not lose faith in market mechanisms to provide solutions. The US financial markets are the most flexible and innovative in the world and, for all their current problems, they have helped make America an innovation machine. Weakening those markets to calm short-term disruptions would be a serious mistake."
Avoiding the knee-jerk reaction of many commentators, he does however have some suggestions for improvement, such as issuing financial-sector bonuses in restricted stock rather than cash, and ensuring that credit default swaps (CDS) are standardised 'plain vanilla', traded openly on a central exchange and fully collateralised.
In addition to maintaining his basic position regarding active fund management, Malkiel has become more outspoken about the need to diversify, and in particular to look beyond our home-country biases.
He sees emerging markets, especially China, as an important element in any asset allocation; he is Chief Investment Officer of AlphaShares, which specialises in China-focused indices.
At the age of 78, Malkiel is still actively involved in improving our understanding of the markets. It is easy to forget that his initial pronouncements on passive investment were written before the advent of index trackers, and in fact spawned this style of investing.
Malkiel was for many years a director of John Bogle's Vanguard Group, and is currently an advisor to Rob Arnott's Research Affiliates, which specialises in fundamental indexing (although Malkiel and Bogle have criticised fundamental indexing in the past).
According to research firm Morningstar, passively managed funds now account for 20% of all US equity funds, up from 15% in 2000, and every dollar of that is influenced to at least some extent by the work of Burton Malkiel.
Books by Burton Malkiel:
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John Bogle | Anthony Bolton | Warren Buffett | David Dreman | Ken Fisher | Philip Fisher | Robin Geffen | Ben Graham | Bill Gross | Carl Icahn | Seth Klarman | Jesse Livermore | Peter Lynch | Bill Miller | Mark Mobius | James Montier | Charlie Munger | John Neff | Crispin Odey | John Paulson | T. Rowe Price | Jim Rogers | Wilbur Ross | Ian Rushbrook | Jim Slater | George Soros | John Templeton | Nils Taube | Ralph Wanger | Neil Woodford | Martin Zweig