Burton Malkiel Quotes

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.

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.

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 paradoxical result of this analysis is that overall portfolio risk is reduced by the addition of a small amount of riskier foreign securities. Good returns from Japanese automakers balanced out poor returns from domestic ones when the Japanese share of the U.S. market increased. On the other hand, good returns from U.S. manufacturers offset poor returns from foreign manufacturers when the dollar became more competitive and Japan and Europe remained in a recession as the U.S. economy boomed. It is precisely these offsetting movements that reduced the overall volatility of the portfolio.

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.

A random walk is one in which future steps or directions cannot be predicted on the basis of past history. When the term is applied to the stock market, it means that short-run changes in stock prices are unpredictable. Investment advisory services, earnings forecasts, and chart patterns are useless. On Wall Street, the term “random walk” is an obscenity. It is an epithet coined by the academic world and hurled insultingly at the professional soothsayers. Taken to its logical extreme, it means that a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do as well as one selected by the experts.

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.

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.

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.

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.

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.

Why are memories so short? Why do such speculative crazes seem so isolated from the lessons of history? I have no apt answer, but I am convinced that Bernard Baruch was correct in suggesting that a study of these events can help equip investors for survival. 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 to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored.

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.

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.