In the latest edition of the Animal Spirits podcast, the two hosts were joined by one of the grand old men of the investment world, Burton Malkiel. Malkiel published the first edition of his bestseller ‘A Random Walk Down Wall Street’ back in 1973. The book has been continuously updated and is now available in a 12th edition from January 2020 and is on my list of the best investment books of all time.
In the interview, Malkiel talks about the ideas behind the first index funds and the massive resistance he faced from Wall Street at the time. Back in the 1970s, there were no index funds or Exchange Traded Funds, ETFs. Malkiel helped Jack Bogal and Vanguard found the first index funds.
The basic idea hasn’t changed over the 40+ years, and is based on the premise that it’s better for the average investor to have a low-cost, broadly diversified portfolio that automatically follows a certain part of the market than to continually try to pick the top few companies. A competition where index funds, according to Malkiel, win in 9 out of 10 cases over a longer period of time. A premise that Malkiet has confirmed again and again over the decades.
The odds of beating markets consistently over a long period of time are significantly against the active investor and index funds should therefore be part of every investor’s toolbox and portfolio. For myself, I have taken the consequence and invested my entire pension portfolio in a number of index funds. Similarly, I use index funds for part of my portfolio of unrestricted funds.
Why the price of a stock is ALWAYS wrong
One of the things that has always puzzled me about the book is the title itself. The term ‘random walk’ is used in statistics and in this context means that a stock takes a random and unpredictable path that makes all methods of predicting the stock price impossible in the long run. However, the stock market is not completely random and certain forms of factor-based investing such as small cap (small companies), value (low price to equity/earnings etc.) and momentum investing are recognized in academic literature as a real way to outperform the market.
Malkiel admits in the interview that the market is not fully efficient and therefore does not always price stocks correctly. In fact, he turns the premise on its head and says that the price of any stock is always wrong. Price is what a seller is willing to sell for and a buyer is willing to pay. And it won’t always reflect the true value of the company’s assets and cash flow.
But why is there such a thing as momentum? According to Malkiel, there are two main explanations. Firstly, markets are fundamentally inefficient. News is only slowly reflected in the market and not all investors have the same information available. Secondly, we have human tendencies that affect the way we make decisions. The companies that rise a lot tend to get the most headlines (think Tesla) and this can become a self-reinforcing effect, with more and more people talking about the company and more and more people writing about the company. And being social creatures, we don’t want to be left out and miss the party. So more and more people are buying the company, recommending it to others and generating more interest. Until something unexpected happens that ends the upward spiral, often resulting in a significant drop in the market price.
“Some people say that efficient markets means that the price is always right. If that was the way the efficient market hypothesis was stated, it’s clearly wrong because we know perfectly well that the price is often wrong. In fact, I would say the price is always wrong. It’s just that we don’t know for sure whether it’s too high or too low. It’s not that crazy things don’t happen.”
Alternative to bonds
One of the biggest challenges facing older or less risk-averse investors today is the extremely low interest rates on bonds. Over time, the mantra of many investment and pension advisors has been that a 60/40 portfolio with 60% equities and 40% bonds should be the starting point. Jack Bogal, the founder of Vanguard and one of Malkiel’s close friends and business partners, believed that the proportion of bonds in your portfolio should follow your age. If you are 30 years old, 30% should be in bonds. 60 years – 60% etc.
Even Benjamin Graham, the father of value investing, believed that the aggressive investor should always have mine. 20% bonds in its portfolio to hedge the portfolio against large drops in the stock market, provide an opportunity to buy in these situations, and act as a behavioral safeguard against selling prematurely.
But what do you do when bonds are yielding 0% interest, inflation is around 2% and there is even the possibility that interest rates will rise in the longer term and your bonds could fall significantly in value?
Malkiel makes an interesting recommendation here that I didn’t expect from him. With interest rates actually providing a negative return after inflation, his recommendation is to consider alternatives to bonds. This can be to diversify the portfolio and limit volatility or if you need an ongoing return, e.g. for older investors who use the return from dividends to pay for living expenses. Malkiel suggests selecting a number of large, stable companies with a relatively high dividend of 3-5% per year. He calls it a ‘surrogate bond portfolio’. He specifically mentions IBM, AT&T and Kraft Heinz as examples of companies that have the desired characteristics.
This alternative will not provide the same protection as bonds in the event of a major fall in the stock market. But in return, it will provide a significantly better ongoing return in the form of dividends, be relatively protected against inflation, as companies can typically increase the price of their products/services with the general price development. In addition, this type of large, stable company will typically see a smaller drop in share prices than the rest of the market, which we also saw during the corona crisis in 2020.
“The role of bonds in the portfolio is really something that needs to be reconsidered and needs to be a much smaller proportion than previously thought.”
While not the perfect alternative, stable dividend companies are a sensible alternative to bonds. For example, if your portfolio would normally be 40% bonds, a sensible solution would be to place 20% in stable dividend-paying companies and 20% in short and long-term government bonds.
You can listen to the full interview with Burton Malkiel here.
