Malkiel unleashed: The full interview with Burton Malkiel
Earlier this month, Wall $treet Week with FORTUNE co-anchor Geoff Colvin visited Princeton University to interview Burton G. Malkiel, author of the classic investing guide, A Random Walk Down Wall Street. Portions were used on the June 20 broadcast. Here is the complete text of their discussion, including parts that did not air:
GEOFF COLVIN: Right now, right this minute, millions of people are trying to choose stocks so that they can beat the market. Are they nuts?
BURTON MALKIEL: I think they are. I'm the guy who said that a blindfolded chimpanzee throwing darts at the stock pages could select stocks as well as the experts.
COLVIN: You've been saying this for 30 years now. Your book is in the 30th anniversary of its publication. What's the typical reaction from people when you say this?
MALKIEL: Well, I think the typical reaction is one of two reactions.
One, it's hard for people to accept because it's like telling someone there is no Santa Claus, and people don't like to believe that.
On the other hand, one of the things that I do in this new eighth edition is to say "Okay, well, did it work?" And the results are just outstanding, that every year about two-thirds of active managers are beaten by a simple index fund that buys and holds all the securities in the market. Two-thirds each year, and when you look over the past 10 years or 20 years, it's over 80 percent. Now, you might say, okay, but can't we find the 10 percent or 20 percent.
COLVIN: Who beat it.
MALKIEL: And the problem is, the people who beat it in one period are not the people who beat it in the next period. And again, this is something that I have got in the new edition, that the best mutual funds of the '60s, they beat the market two-to-one, but in the '70s they were much worse. Then I took the best funds of the '70s -- terrible in the '80s. The best ones in the '80s -- terrible in the '90s. And then for a real horror story, I took the ones that were the best in 1997, 1998 and 1999, where they were two-and-a-half times as good as the market, and they were about three times worse than the market in the early years of the 2000s. And that's the problem. So I say, rather than looking for the kind of needle in the haystack, buy the haystack.
COLVIN: Meaning buy everything.
MALKIEL: Buy everything.
COLVIN: An index fund that holds everything basically.
MALKIEL: The broadest index fund that you can find that holds all of the stocks, and these things are generally called a total stock market index fund.
COLVIN: Why is it so? Why is it that nobody can reliably, consistently beat the market?
MALKIEL: I think there are a couple of reasons.
One, our markets are really for the most part extraordinarily efficient. When information arises about a particular company or about the economy, people pounce on that information right away, so that by the time you and I hear the news, it's already reflected in the price. So it's, first of all ,an argument about relative efficiency of the market.
Secondly, it's a matter of expenses. The typical index fund charges expenses less than two-tenths of one percent a year. The typical actively managed mutual fund charges expenses of over one-and-a-half percentage points a year. Moreover, the index fund doesn't trade. It doesn't buy and sell. So it doesn't have the transactions costs of buying and selling. The typical mutual fund turns over the portfolio once a year, and that cost -- and it's not just the five cents a share brokerage cost, it's the fact that there's a spread between the bid price and the ask price. There's a problem when a big investor comes in and you buy a stock, you start moving the price up against you. When you sell you tend to depress it. And if you look at the difference in the cost, which comes to about two percentage points a year, you get the remarkable conclusion that the typical mutual fund underperforms the index fund by that same two percentage points a year, which represents their extra costs.
COLVIN: Now a lot of people have said that the great bubble of the late '90s, when stocks went sky high for no identifiable reason and then in early 2000 plunged for no identifiable reason, shows that the efficient markets idea is bunk.
MALKIEL: I understand that argument and I have a great deal of sympathy for it. In fact, that's one of the reasons that I call myself a random walker with a crutch. Because I get excommunicated from the temples of efficient market, because I will use the word bubble.
I will say that, yes, from time to time the market goes to the looney bin. And in fact, one of the new chapters in my book is entitled "Surfing on the Internet, the Biggest Bubble of all Time." So I understand that from time to time the efficient market theory doesn't work. And, in fact, one of the reasons that I have several chapters on bubbles in history is that part of the reason, part of the thing that somebody has to know to be a successful investor, is to avoid the horrendous mistakes of, "Well, I'll sell my diversified portfolio because my brother-in-law has found that his Internet stocks doubled last week." And I think it's protecting yourself from these times when the market does go looney, and it did, that you really need to, you really need to be aware of and you need to protect yourself.
Now, having said that, though, one of the arguments that I have with people who think that the market is just a perpetual looney bin is that there were a lot of people who said in 19, in the middle 1990s that already the market was in a bubble. And I think what, you know, if you think back to the famous irrational exuberance speech of Alan Greenspan, that was done in December of 1996, you know that through the end of last year -- and the market's a lot higher than it was now, than it was at the end of last year -- the market return was 7 percent.
COLVIN: From the time of Greenspan's speech.
MALKIEL: From the time of the irrational exuberance speech. So the other problem is, you know, you never know. The size of the bubble, the shape of the bubble is only completely clear in retrospect.
COLVIN: When it's over.
MALKIEL: When it's over. Exactly.
COLVIN: But in the long term, markets are efficient.
MALKIEL: In the long term, I think that they are generally efficient. Though I'll admit they do go crazy from time to time.
COLVIN: But isn't it also possible that there is more to this game than just cranking numbers into a machine, that there's a role for judgment, the human factor in choosing companies, and that some people might be better, might have skill and judgment that other people don't?
MALKIEL: It certainly is a possibility. But for me, the evidence that convinces me is the number of people that we find who have done this consistently, you can count them on the fingers of one hand.
COLVIN: Well, let me ask you your views on a couple of them.
COLVIN: Because I'm sure this is the objection you hear all the time.
COLVIN: Wait a minute, you say you can't beat stocks. What about Warren Buffett?
MALKIEL: Okay, what about Warren Buffett? Let's talk about Warren Buffett. There is no question about the fact that when my book first came out, if instead of buying an index fund you bought Berkshire Hathaway, you would have done twice as well. So let me first of all admit Warren Buffett has had a superb, a superb record. But how did he get that record? It's actually, I think, very interesting.
At one point I had the pleasure of having a two-hour conversation with Katharine Graham, the head of the, the former head of The Washington Post. And I asked her about her experience with Warren Buffett, because that (The Washington Post)was one of his great successful investments. And she told me she was just scared to death when he first bought 10 percent of the company. She thought she was going to get kicked out. When she realized that Buffett really did buy it as an investment, she said to him, "Warren, please come and help me. We are going under. I know something about editorial work. I don't know how to run a paper. Come on my board and help me run this business." And she credits Warren Buffett for turning the Washington Post around and making it a successful investment.
It wasn't that he read Graham and Dodd and bought a value stock. He is a wonderful businessman. He has done that with the Washington Post, GEICO. He buys companies. He sets them up. He does a terrific job with it. Even his mistakes, (such as) Salomon Brothers, that got into trouble with a government bond rigging problem, he became chairman of the board and CEO of Salomon Brothers. So he is, there's no question he is a marvelous businessman. He knows how to run companies. He buys companies, not stocks, but I think his success was not through stock picking.
Now, having said that also, I'm absolutely convinced there will be another Warren Buffett over the next 30 years. And the problem that I have with that strategy is that you don't know who it is and I don't know who it is, and there's no way we can know that in advance. And so it's like looking for the needle in the haystack, and I still think the sensible strategy is to buy the haystack.
COLVIN: Let me ask you another question, a separate question. Do you pick stocks?
MALKIEL: Look, anybody who loves the stock market will want to, this is a wonderful game, and yes, I do own some individual stocks. But in my 401(k) -- for me, it's a 403(b) in my retirement plan -- I'm largely in index stocks. I have a Keogh plan for book royalties and things. It's another retirement plan called an HR-10. I have that invested in index funds. When I go and have some money, do I sometimes buy some individual stocks? Sure I do, because it's fun. But for your retirement plan, for what you really want, where I'm a trustee of my son's trust, that's in index funds.
COLVIN: When you pick stocks, how do you pick them?
MALKIEL: I pick them from all kinds of different ways.
As I have suggested, and I do actually have a section in the book, if you've got that gambling instinct and you want to do a little of this, number one, you avoid the stocks with very high price/earnings multiples. And again, that goes back to all of the discussion that I have about bubbles. You don't go and buy the Ciscos of the world when they're selling at over 100 times earnings, because I did a little calculation. If at the time Cisco was going to grow at 15 percent and the economy grew at 5 percent, in 20, 25 years, Cisco would be bigger than the economy. So a little bit of valuation, that I very definitely avoid those stocks that clearly are already recognized and over-recognized.
I do look for things that I think are going to grow in the future, but you hope you find something that the market hasn't recognized. It's at a reasonable valuation of its earnings, its asset value, and that it's got a story that, from the standpoint of psychology, maybe people would get interested in. Having said that, I continue to do it, but I'm not telling you that I do it any better than anybody else does. And frankly my index funds have been the stability, and because I've got those funds as the core of my assets, that's why I feel I can go off and take these gambles, and it's fun.
COLVIN: How have you done?
MALKIEL: Okay, but nothing spectacular.
COLVIN: You have something in particular to say about closed-end mutual funds. What's that all about?
MALKIEL: Well, in the earlier editions of the book, I thought that I actually had found something that looked to me like an inefficiency. You had so-called closed-end funds. Now the idea of a closed-end fund is --
(First, let's look at situation where) if the mutual fund is open-end. You put new money in at its net asset value, and when you want to take your money out, you get the net asset value.
COLVIN: You just redeem the shares.
MALKIEL: You just redeem the shares.
(On the other hand), the closed-end fund says we're going to sell, say, 100 million shares, and then the books are closed. We don't take in any new money and we don't give you your money back. You want to sell? Fine. You sell to somebody else, and they trade often on the New York Stock Exchange. So these closed-end funds were in earlier editions of the book selling at 40 percent discounts from their asset values. In other words, you could buy a portfolio of stocks at 60 cents on the dollar. Now I was convinced, in fact I said this, that I doubt that the closed-end managers are going to outperform the market, but if I can buy assets at 60 cents on the dollar, that's a darned good deal. And I suggested this in several editions of the book, and I called it the Malkiel step. And the market finally clued up to these things, because now the closed-end funds sell at almost no discount at all.
And again, I think there was an opportunity in the past, but that's what I mean by markets being efficient. Sure, they'll get them wrong from time to time, but eventually true value will out. Now, there's a little funny story that sort-of-efficient-market people tell about the professor and his graduate student, and they're walking along and they see a $100 bill on the ground, and the student starts to bend to pick it up, and the professor says, "No, don't stoop to pick it up. If it were really a $100 bill it wouldn't be there." Well, what I say is if you see the $100 bill, bend down, stoop down and pick it up right away, because it sure won't be there long.
COLVIN: Right. You've said that investing is sort of like making love. What did you mean?
MALKIEL: Well, I was again trying to suggest that it's a lot of fun, and even if you admit to yourself that you can't do it any better than the next guy, you sure don't want to give it up.
COLVIN: Should we go pick some stocks?
MALKIEL: Absolutely. Great.
(They stand to throw darts at a newspaper stock section)
COLVIN: Ok, come on, let's see what you've got.
MALKIEL: Okay. (throws three darts)
MALKIEL: At least I hit the board.
COLVIN: You hit the board right in the center…
MALKIEL: I did this one time (and) it landed on Enron. You never know.
COLVIN: (reading the stocks hit by Malkiel's darts) KLM, presumably the airline. Keithley Instruments. And the one you threw earlier is Pengrowth.
(Colvin prepares to throw)
COLVIN: This is exciting, because if I understand you properly, basically Jack Grubman got paid $20 million a year to do what I'm about to do.
MALKIEL: That's right. (Colvin throws darts) Oooh, good.
COLVIN: (reading the results of his own throws) Now that is Eaton Vance. National Grid Transco, and the Nasdaq stock that I got was, oh, Electronic Arts, that's the big video game company. We just talked about them on the show a few weeks ago.
MALKIEL: This is a cute way of showing, in fact, what I am recommending is: Don't throw darts at all, throw a towel over the stock pages and buy something that holds absolutely everything, and that everything is something like the total stock market fund, which is usually indexed to something like the Wilshire 5000 Index, and that includes over 6,000 stocks. And that's my recommendation. I really don't want you to pick 'em by this method (of throwing darts).
COLVIN: The point being, you pick them just as well this way as any other way if you're going to pick them.
MALKIEL: If you're going to pick them. But I wouldn't pick them (for a core portfolio).
COLVIN: But you also say, "Why stop with stocks?" if you're going to buy everything.
MALKIEL: Oh absolutely, what you need to do, is -- You don't want just stocks, it seems to me you want bonds, you want real estate which are available throught real estate investment trusts, and incidentally, not surprisingly, I recommend to buy bonds, you buy a bond index fund, and to buy real estate, you buy a real estate investment trust index fund that holds all the real estate investment trusts.
And that diversification really showed its worth over the last three years because while everyone knows it's not been a pleasant ride in the stock market over the period 2000, 2001 and 2002 while the stock market went down, the real estate sector went up, and bonds had an absolutely superb performance, so that the investor who was diversified was really taking on very, very much less risk. And in fact the asset allocation that I recommend for older people near retirement actually even made money and a fair amount of money over the last three, three-and-a-half years.