Burton Malkiel Quotes

The efficient-market hypothesis does not imply, as some critics have proclaimed, that stock prices are always correct. In fact, stock prices are always wrong. What EMH implies is that no one knows for sure if stock prices are too high or too low. Nor does EMH state that stock prices move aimlessly and erratically and are insensitive to changes in fundamental information. On the contrary, the reason prices move randomly is just the opposite. The market is so efficient—prices move so quickly when information arises—that no one can buy or sell fast enough to benefit. And real news develops randomly, that is, unpredictably. It cannot be predicted by studying either past technical or fundamental information.

The lessons of market history are clear. Styles and fashions in investors’ evaluations of securities can and often do play a critical role in the pricing of securities. The stock market at times conforms well to the castle-in-the-air theory. For this reason, the game of investing can be extremely dangerous.
Another lesson that cries out for attention is that investors should be very wary of purchasing today’s hot “new issue.” Most initial public offerings underperform the stock market as a whole. And if you buy the new issue after it begins trading, usually at a higher price, you are even more certain to lose.

Our survey of historical bubbles makes clear that the bursting of bubbles has invariably been followed by severe disruptions in real economic activity. The fallout from asset-price bubbles has not been confined to speculators. Bubbles are particularly dangerous when they are associated with a credit boom and widespread increases in leverage both for consumers and for financial institutions.

A widely held belief is that the ticket to a comfortable retirement and a fat investment portfolio are instructions on what extraordinary individual stocks or mutual funds you should buy. Unfortunately, these tickets are not even worth the paper they are printed on. The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline. Without a regular savings program, it doesn’t matter if you make 5 percent, 10 percent, or even 15 percent on your investment funds. The single most important thing you can do to achieve financial security is to begin a regular savings program and to start it as early as possible. The only reliable route to a comfortable retirement is to build up a nest egg slowly and steadily. Yet few people follow this basic rule, and the savings of the typical American family are woefully inadequate.

History, in this instance, does teach a lesson: Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. “In crowds it is stupidity and not mother-wit that is accumulated,” Gustave Le Bon noted in his 1895 classic on crowd psychology. It would appear that not many have read the book. Skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation. Unsustainable prices may persist for years, but eventually they reverse themselves. Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover. Few of the reckless builders of castles in the air have been nimble enough to anticipate these reversals and to escape when everything came tumbling down.

Investors should certainly be aware of new methods of portfolio construction. And high net worth investors might consider adding a multifactor smart beta offering or a risk-parity portfolio to the overall mix of their investments. Factor investing can potentially increase returns at the cost of assuming a somewhat different set of risk exposures than those of a standard broad-based index fund. And investors who are able to accept the added risks inherent in leverage might profitably add a risk-parity portfolio to their set of investments. Such offerings should only be considered, however, if they are low cost and if their potentially adverse tax effects can be offset in other parts of the overall portfolio. And I continue to believe that a broad-based total stock market index fund should be the core of everyone’s portfolio. Certainly, for investors who are starting to build an equity portfolio in planning for retirement, standard capitalization-weighted index funds are the appropriate first investments they should make.

Fraud aside, we should have known better. We should have known that investments in transforming technologies have often proved unrewarding for investors. In the 1850s, the railroad was widely expected to greatly increase the efficiency of communications and commerce. It certainly did so, but it did not justify the prices of railroad stocks, which rose to enormous speculative heights before collapsing in August 1857. A century later, airlines and television manufacturers transformed our country, but most of the early investors lost their shirts. The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. And history tells us that eventually all excessively exuberant markets succumb to the laws of gravity. The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. As we shall see later, an investor who simply buys and holds a broad-based portfolio of stocks can make reasonably generous long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.

Investing requires work, make no mistake about it. Romantic novels are replete with tales of great family fortunes lost through neglect or lack of knowledge on how to care for money. Who can forget the sounds of the cherry orchard being cut down in Chekhov’s great play? Free enterprise, not the Marxist system, caused the downfall of the Ranevsky family: They had not worked to keep their money. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money. Armed with the information contained in this book, you should find it a bit easier to make your investment decisions.

As I’ve already pointed out, some ready assets are necessary for pending expenses, such as college tuition, possible emergencies, or even psychological support. Thus, you have a real dilemma. You know that if you keep your money in a savings bank and get, say, 2 percent interest in a year in which the inflation rate exceeds 2 percent, you will lose real purchasing power. In fact, the situation is even worse because the interest you get is subject to regular income taxes. Moreover, short-term interest rates were abnormally low during the 2010s. So what’s a small saver to do? There are several short-term investments that are likely to help provide the best rate of return, although no very good alternatives exist when interest rates are very low.

Part of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it. The instruments that enabled tulip speculators to get the most action for their money were “call options” similar to those popular today in the stock market.

The strong form of the EMH is obviously an overstatement. It does not admit the possibility of gaining from inside information. Nathan Rothschild made millions in the market when his carrier pigeons brought him the first news of Wellington’s victory at Waterloo before other traders were aware of the victory. But today, the information superhighway carries news far more swiftly than carrier pigeons. And Regulation FD (Fair Disclosure) requires companies to make prompt public announcements of any material news items that may affect the price of their stock. Moreover, insiders who do profit from trading on the basis of nonpublic information are breaking the law.

Remember Murphy’s Law: What can go wrong will go wrong. And don’t forget O’Toole’s commentary: Murphy was an optimist. Bad things do happen to good people. Life is a risky proposition, and unexpected financial needs occur in everyone’s lifetime. The boiler tends to blow up just at the time that your family incurs whopping medical expenses. A job layoff happens just after your son has totaled the family car. That’s why every family needs a cash reserve as well as adequate insurance to cope with the catastrophes of life.

Most people need insurance. Those with family obligations are downright negligent if they don’t purchase insurance. We risk death every time we get into our automobile or cross a busy street. A hurricane or fire could destroy our home and possessions. People need to protect themselves against the unpredictable.

The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something’s actual price with its firm foundation of value.

In principle, common stocks should be an inflation hedge, and stocks are not supposed to suffer with an increase in the inflation rate. In theory at least, if the inflation rate rises by 1 percentage point, all prices should rise by 1 percentage point, including the values of factories, equipment, and inventories. Consequently, the growth rate of earnings and dividends should rise with the rate of inflation. Thus, even though all required returns will rise with the rate of inflation, no change in dividend yields (or price-earnings ratios) will be required. This is so because expected growth rates should rise along with increases in the expected inflation rate. Whether this happens in practice we will examine below.