There is always a sense of harmless fun in seeing sensible and highly intelligent people struggling to defend the indefensible, as anyone who gets close to the financial markets, with their infinite capacity to throw up shocks and surprises, has to do from time to time. I have been unable to repress a mild chuckle or two reading through the latest edition of Professor Burton Malkiel's classic book about investment, A Random Walk Down Wall Street.
It is 30 years since the first edition of this powerful, well-written book appeared, and we are up to the eighth. When it was published, A Random Walk was a splendid, youthful polemic against the fashionable notion that investment was all about picking stocks or finding the right actively managed fund. Instead, Professor Malkiel put forward the then radical idea that stock markets are essentially unpredictable in anything but the longer term, and investors need to base their investment strategy around this all-embracing insight, essentially by putting the use of index funds at the centre of their approach.
This judgement, which anticipated much of the revolutionary findings of academic financial research over the next 20 years, has been largely vindicated by history. Professor Malkiel is able to point out that an investor who put $10,000 into a low-cost US index fund in 1969 would today have a portfolio worth $327,000, assuming all dividends having been reinvested. But an investor who put his money into the average actively managed fund would today have just $213,000.
There is, of course, a slight flaw in this argument, in that in 1969 there were no index funds around, but the general principle that low-cost index funds reliably outperform the average, expensive, actively managed funds over the medium-to-long-term is about the most robust finding in investment, despite the repeated pot-shots active managers try to take at the arguments. And a few funds consistently outperform the market, but rarely in a way that can be predicted in advance with certainty.
Where Professor Malkiel has had less success is in his provocative claim 30 years ago that "the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at The Wall Street Journal can select a portfolio that performs as well as those managed by the experts". The arguments about the true "efficiency" of markets have raged on, inside and outside academia.
What is clear today, as Professor Malkiel concedes, is that while there are ways to reconcile the views of those on either side, the evidence that markets are not always rationally or efficiently priced is sufficiently strong to mean it is far too risky to base your investment approach on the comforting assumption that markets are so efficient that you do not need to engage your brain by looking for undervalued or overvalued situations, because the market will already have taken account of all relevant information.
The internet bubble is, as Professor Malkiel admits, not just one example, but the most compelling demonstration of them all, that the thesis of market efficiency is absurd. He has fun in the book listing all the many manifestations of absurdity the bubble created. He singles out some of those responsible, "fee-crazy underwriters who should have known better", "research analysts who were cheerleaders for the banking departments" and "corporate executives who used creative accounting to inflate their profits".
But, he adds: "It was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand." The important lesson investors must learn, he says, is that "the market eventually corrects any irrationality, albeit in its own slow, inexorable fashion". Eventually "true value is recognised by the market", to which one can only say, "Well, yes". It is still a long way from the view that efficiency always drives the market, when it does not.
Professor Malkiel knows this perfectly well. He has never been slow to suggest areas where he thinks investors might look with profit, given the assumption - which is his other big theme, again more revolutionary then than now - that investors have a long-term asset allocation plan that reflects their age, tolerance for risk and capacity to save. He has long advocated investing in closed-end funds that trade at an above-average discount to net asset value as a way of generating additional return (though there are not many of those around at present).
He has also made the case for investing in emerging markets, as a potential source of growth and as risk-reducing diversification, and for including real estate investment trusts (not something we have here) as part of the average investor's overall asset allocation. With index funds, his argument is that it is better to go for the widest possible market exposure, a fund that tracks a broad market index, including smaller companies, rather than the S&P 500 or FTSE 100 index.
His model portfolio for a typical baby boomer, someone in his or her early fifties, would be 5 per cent cash, 37.5 per cent in a bond index fund, 12.5 per cent in property investment trusts, and 45 per cent in equity index funds, with three quarters of that in domestic stocks and the balance in global and emerging market funds. Younger people should add some to their risk exposure, older people reduce it.
There is no harm, Professor Malkiel says, in trying to pick individual stocks that outperform the market: just don't expect to succeed, and don't let it interfere with your sensible allocation policy. That part of his thesis, unlike the arguments for market rationality, is not just defensible but irrefutable.Reuse content