Burton Malkiel is the author of the incredibly successful investment theory book "A Random Walk Down Wall Street" first published in 1973.Thirty years later, his publisher suggested he writes an investment guide capturing the wisdom from "A Random Walk" in a shorter tome aimed at the layperson.Malkiel did exactly that.In this book, he does a beautiful job in avoiding statistics out of reach for the layperson.Yet the investment advice remains sharp and relevant.
Malkiel covers a lot of ground in investments, financial planning, retirement, savings for college, and insurance in just 180 pages.He structures this knowledge through just ten basic rules. Throughout, he includes numerous useful tools.One is the famous rule of 72.If you divide 72 by the investment return, it will tell you how many years it takes to double your investment.Thus, Malkiel covers all the basics and also explores the cutting edge of behavioral economics from the luminaries in this field including Robert Shiller (Irrational Exuberance) and Richard Thaler.This book is just as interesting to the layperson and the investment professional alike.
Malkiel advice can be summarized as follows.Save regularly through 401Ks and other means.Invest in low cost mutual funds and index funds across four asset classes (money market funds, bonds, stocks, and REITs).Invest according to your optimal asset allocation which reflects your time horizon (driven by your age), your financial capacity to absorb losses, and your risk tolerance.Take full advantage of tax advantage investments, including 401Ks, IRAs, Education Savings Accounts.The book includes many more fascinating aspects of investing.
Malkiel outlines eloquently the benefits of index funds.They incur lower operating costs.They have lower turnover, which leads to lower transaction costs and greater tax efficiency.Consequently, index funds beat actively managed funds by 2 percentage points.Malkiel states this superior performance is a direct result of index funds low cost advantage.The higher cost handicap of actively managed funds is insurmountable over time.As a result, the S&P 500 index beats out 84% of large cap mutual funds over 10 years, and 88% over 20 years.
This leads to one of Malkiel most surprising point.Two investors investing $1,000 in an IRA earning respective returns of 6% and 8%; the investor earning 8% will have more than twice as much money in his account after 40 years ($21,725 vs. $10,286).I thought Malkiel made a typo.I calculated the figures, and he did not.This has huge implication in a long term investment environment where single digit returns will become the norm.Costs matter a lot!
On diversification Malkiel includes much original intelligence.He makes a strong case that international diversification is not all what it is cracked up to be.This is because international stock markets move increasingly together when the U.S. one experiences a downturn.Also, he mentions that REITs provide excellent diversification benefits (better than international stocks).I have personally done much research on this subject, using regression analysis.And, Malkiel is correct, even though this fact is unknown to Wall Street.
Malkiel recommends different asset allocations for different age brackets (Life-Cycle investing).He tracks how these different asset allocations performed over the past 20 years (January 1983 to December 2002).It is stunning to note that the most aggressive asset allocation targeted to young people with a 65% stock exposure would have earned a 11.52% return or only one percentage point greater than the most conservative one targeted at senior citizens with only 25% stock exposure which earned a 10.51% return.On the other hand, the most aggressive asset allocation would have suffered 20 quarterly losses with the worst one being minus 14.5%; meanwhile the most conservative asset allocation would have incurred only 16 quarterly losses with the worst one being only minus 5.0%.This gives you pause on how much additional risk is it worth taking.
Malkiel does also a credible job of explaining the superior long term performance of Warren Buffet and Peter Lynch despite the efficiency of the markets and the overall superiority of index funds.Of the two, he states that Peter Lynch record is much less impressive.
He attributes much of Lynch record to the laws of randomness.If you have a 1,000 coin flippers and you make them flip a coin 10 times in a row, you will have one coin flipper who will have flipped tails 10 times in a row.He will be perceived as a genius.But, he was just lucky.Observing Peter Lynch record, his hand got progressively colder as his Magellan fund became larger and his tenure lengthened.This is exactly what Malkiel expected.Lynch genius was to retire close to the top.He retired at the young age of 46, when his record viewed over his tenure could still be perceived as legendary.
Warren Buffet case is completely different.In Malkiel view, he is not so much an investment genius, as a businessman.Buffet has often intervened in running the companies in which he invested when they were faltering.This was the case for the Washington Post, Salomon Brothers, and many other companies Buffet invested in.So, to compare Buffet?s record to the S&P 500 is comparing apples and oranges.Buffet record can't be replicated by any regular investors who have no control over the companies they invest in.
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Beginning investors are sometimes told a few simple maxims to help them manage their portfolios.Never time the market.Buy and hold.Expect 10% annual return on stocks held for the long run (usually defined as seven to ten years).
