Burton Malkiel Quotes

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.

There are, I believe, five factors that help explain why security analysts have such difficulty in predicting the future. These are (1) the influence of random events, (2) the production of dubious reported earnings through “creative” accounting procedures, (3) errors made by the analysts themselves, (4) the loss of the best analysts to the sales desk or to portfolio management, and (5) the conflicts of interest facing securities analysts at firms with large investment banking operations. Each factor deserves some discussion.

This chapter’s review of the Internet and housing bubbles seems inconsistent with the view that our stock and real estate markets are rational and efficient. The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality—albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But, eventually, true value is recognized by the market, and this is the main lesson investors must heed.
I am also persuaded by the wisdom of Benjamin Graham, author of Security Analysis, who wrote that in the final analysis the stock market is not a voting mechanism but a weighing mechanism. Valuation metrics have not changed. Eventually, every stock can only be worth the present value of its cash flow. In the final analysis, true value will win out.

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.

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.

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.

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 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.

Determining clear goals is a part of the investment process that too many people skip, with disastrous results. You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket. The securities markets are like a large restaurant with a variety of menu choices suitable for different tastes and needs. Just as there is no one food that is best for everyone, so there is no one investment that is best for all investors.

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.

Behavioral-finance theory also helps explain why many people refuse to join a 401(k) savings plan at work, even when their company matches their contributions. If one asks an employee who has become used to a particular level of take-home pay to increase his allocation to a retirement plan by one dollar, he will view the resulting deduction (even though it is less than a dollar because contributions to retirement plans are deductible from taxable income up to certain generous amounts) as a loss of current spending availability. Individuals weigh these losses much more heavily than gains. When this loss aversion is coupled with the difficulty of exhibiting self-control, the ease of procrastinating, and the ease of making no changes (status quo bias), it becomes, as psychologists teach us, perfectly understandable why people tend to save too little.

Portfolio theory begins with the premise that all investors are like my wife—they are risk-averse. They want high returns and guaranteed outcomes. The theory tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek. It also gives a rigorous mathematical justification for the time-honored investment maxim that diversification is a sensible strategy for individuals who like to reduce their risks.

As a random walker on Wall Street, I am skeptical that anyone can predict the course of short-term stock-price movements, and perhaps we are better off for it. I am reminded of one of my favorite episodes from the marvelous old radio serial I Love a Mystery. This mystery was about a greedy stock-market investor who wished that just once he would be allowed to see the paper, with its stock-price changes, twenty-four hours in advance. By some occult twist his wish was granted, and early in the evening he received the late edition of the next day’s paper. He worked feverishly through the night planning early-morning purchases and late-afternoon sales that would guarantee him a killing in the market. Then, before his elation had diminished, he read through the remainder of the paper—and came upon his own obituary. His servant found him dead the next morning.
Because I, fortunately, do not have access to future newspapers, I cannot tell how stock and bond prices will behave in any particular period ahead. Nevertheless, I am convinced that the moderate long-run estimates of bond and stock returns presented here are the most reasonable ones that can be made for investment planning decades into the twenty-first century. The point is not to invest with a rearview mirror projecting double-digit returns from the past into the future. We are likely to be in a low-return environment for some time to come.

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.

To the great relief of assistant professors who must publish or perish, there is still much debate within the academic community on risk measurement, and much more empirical testing needs to be done. Undoubtedly, there will yet be many improvements in the techniques of risk analysis, and the quantitative analysis of risk measurement is far from dead. My own guess is that future risk measures will be even more sophisticated—not less so. Nevertheless, we must be careful not to accept beta or any other measure as an easy way to assess risk and to predict future returns with any certainty. You should know about the best of the modern techniques of the new investment technology—they can be useful aids. But there is never going to be a handsome genie who will appear and solve all our investment problems.