More gems from our chat with an investing legend.
As I wrote earlier this week, in the wake of a lecture entitled Six Timeless Investment Lessons given at an investment symposium organised by low-cost tracker firm Vanguard, investing legend Burton Malkiel spoke exclusively to Fool UK.
As well as having served alongside index tracker inventor John Bogle as a director of Vanguard for 28 years, Professor Malkiel is of course the author of the best-selling A Random Walk Down Wall Street -- now in its tenth edition, with one and half million copies sold.
On Tuesday, I relayed Prof Malkiel's views on the timing of investments. Today, I'm going to cover what he said on the subject of asset allocation. And on Friday, I'll take a look at what he said about costs.
Diversification
Prof Malkiel, it's fair to say, is a big fan of diversification. In my view, the sections of A Random Walk Down Wall Street that are devoted to the topic are among the most compelling in the book.
What's more, the emergence of new financial instruments aimed at helping investors to achieve diversification at low cost -- bond, gilts, and emerging market and international ETFs and funds, for instance -- mean that today there's really no excuse for not having a diversified portfolio.
Despite that, says Prof Malkiel, he's always encountering people who say, "When the markets go down, they all go down together." Meaning, of course, that there's not much point in diversifying.
But this argument is simply wrong, he counters. While there is a correlation between bond and share prices, it varies wildly, and it also fluctuates between a positive correlation and a negative one.
For most of the last ten years, for instance, the correlation has been a negative one. In other words, the prices of bonds and gilts have -- as theory suggests -- moved in the opposite direction to equity markets.
What's more, he asserts, there have also been large differences in the returns of different asset classes.
During the 'lost decade', for example, share prices in developed world markets grew by just 0.2% per year. Those in emerging markets? 10.1% per year. It's enough to convince Prof Malkiel -- and me.
Rebalance Your Portfolio
Prof Malkiel is also a fan of portfolio rebalancing. And his argument is a persuasive one.
"It systematically forces people to sell when prices are high, and to buy when prices are low. And that's the kind of thing that I want people to do," he says.
Let's say, he argues, that it's January 2000, and an investor has no idea that it's the top of the dotcom-fuelled market. Nevertheless, that investor has a policy of keeping their portfolio split 60% in equities, and 40% in bonds.
But the split at the time is 80% equities and 20% bonds, due to the stock market's love affair with equities, and a matching disinclination to buy bonds. So the investor duly sells some shares and buys some bonds, returning their split to 60-40, and banking a profit in the process.
Three years later, it's January 2003, and the split is 50-50, as shares have tanked and bonds have risen. So the investor duly sells bonds and buys shares, returning the split to 60-40 -- and, of course, once again banking a profit.
"Over the last 15 years, such rebalancing would have delivered an extra 1.5% per year additional return," sums up Prof Malkiel. And while that may not sound much, do the sums and you'll find that it compounds up to 25% extra over the period.
Much the same logic, of course, works with other financial assets, too -- such as emerging market stocks versus developed world stocks.
The chart below, for instance, shows the result of diversification and rebalancing rolled-up together, across a portfolio split four ways: bonds, American stocks, emerging market stocks and developed market stocks.
The red line is the one delivered by American stocks alone (Prof Malkiel is American, don't forget), while the blue line is the one delivered by rebalancing and diversification.
I know which one I prefer.
Next up: Costs
As might be expected given his 28-year directorship of Vanguard, Prof Malkiel is a big fan of low-cost index trackers. But his take on them is slightly different from the one I'd expected.
And it's one that leaves me feeling like Moliere's Monsieur Jourdain, who famously discovered that he had "been speaking prose all my life, and didn't even know it!"
What is it? To find out, you'll have to wait for tomorrow's final lessons from Prof Malkiel.
More from Malcolm Wheatley:
> Malcolm holds index trackers from Vanguard.
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