Friday, March 24, 2023
HomeMarketEconomist Burton G. Malkiel Still Favors Index Funds Over Stockpickers. Here’s Why.

Economist Burton G. Malkiel Still Favors Index Funds Over Stockpickers. Here’s Why.

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Burton G. Malkiel is fond of saying that, as a boy growing up in Boston, he knew the price of General Motors’ stock as well as he knew Ted Williams’ batting average. The Princeton University economist was just 10 when he started thumbing through the newspaper to reach the stock tables. “I was fascinated with the numbers that appeared on the stock pages from day to day,” says Malkiel, now 90. “I was curious about how the share prices had changed, why they had changed, and whether there were any interesting patterns in the numbers.”

And so he set out to learn more—at Harvard College and Harvard Business School, on Wall Street as an investment banker, and then at Princeton, where he earned a doctorate in economics and later taught. Along the way, he also served as a board member of Vanguard, and wrote a best-selling book, A Random Walk Down Wall Street, which celebrated its 50th anniversary in January.

While working at Smith Barney, Malkiel says, he noticed that when the firm published a stock recommendation, the price of the recommended company’s shares would go up, and then retreat to where they had been trading before the research had been published. When he compared the returns of mutual funds to indexes such as the Dow Jones Industrial Average and S&P 500, they didn’t seem to deliver better performance. In his telling, Malkiel began to suspect that “the emperor”—highly paid active fund managers—“had no clothes” and couldn’t beat the market, and that investors would be better off buying and holding a broad-based index fund. “I was convinced that a blindfolded chimpanzee throwing darts at the stock pages could select a portfolio that would do as well as the experts,” he says.

Malkiel would still vote for the chimpanzee, as he explained in a Jan. 20 interview with Barron’s. He isn’t too keen on
or retirement, either. An edited version of the conversation follows.

Barron’s: The Efficient Market Hypothesis has been central to your work. How would you describe it?

Burton G. Malkiel: The idea of efficient markets is that information gets recorded quickly into stock prices. If something good happens to a company, the stock price will go up now; it won’t go up slowly over time. It may be that it goes up too much. Maybe it goes up too little. In that sense, the prices are never completely accurate.

You can almost say that prices are almost always wrong, but nobody knows for sure whether they’re too high or too low. And there are certainly no arbitrage opportunities. The Efficient Market Hypothesis suggests that the market is pretty darn good at reflecting new and existing information so that there aren’t going to be opportunities for unusual profits.

Do you still think your hypothetical chimpanzee is better than the experts?

I believe even more strongly in my hypothesis today than I did 50 years ago. Standard & Poor’s puts together a Spiva score card, which stands for S&P indices versus active management. They have done this year after year, and year after year two-thirds of the active managers are outperformed by a simple index fund. In the tables in my book, I used the S&P 1500—and only one-third [of active managers] beat the index each year. And the one-third that win in one year aren’t the same as the one-third that win in the next year.

When you compound the returns over 10 years, or 20 years, these Spiva reports show that 90% of the active managers are outperformed by a simple index fund. The same results hold in international markets and the bond market. I’m not saying that no one can outperform. But when you try to go active, you are much more likely to be in the 90% of the distribution where you underperform, rather than the 10% where you outperform. There’s so little consistency in performance, and it is so hard to outperform, that I say it’s much better not to look for the needle in the haystack but to essentially buy the haystack, which is the index funds. The core of every portfolio ought to consist of broad-based index funds.

The U.S. market environment appears to be more favorable now for active managers. We take it you’re still not convinced.

I’m a financial news junkie. Every year I read that it’s going to be a stockpicker’s market, and every year it turns out not to be a stockpicker’s market.

Now, let me put an admission into this that I have found in my own empirical work. In markets such as last year’s, which was down almost 20%, active managers underperformed, but by a little less. In other words, in down markets, the deficit of active management is a little bit less compared with the index fund. The reason is that all mutual funds keep a cash reserve of 5% to 10% because there could be redemptions. Even index funds have a cash reserve of 5% to 10%. The difference is that the index fund, because it has to track the index, offsets that cash reserve with a long position in the futures market. So, the index fund is always 100% invested, whereas the average active manager might be 92% or 93% invested. That explains whatever difference there is in down markets. There is a difference, but it isn’t because people pick better stocks in down markets than up markets.

What is in the latest—13th—edition of the book?

There is a good deal of skepticism about Bitcoin and other cryptocurrencies and a discussion about how people got caught up with the so-called meme stocks. I also talk about some of the innovations in finance, such as exchange-traded funds, which are great and low cost.

Also, there’s no question that markets go absolutely crazy from time to time, so I touch on behavioral finance. There are two important things about investing: One is to use index funds, and the second is: Don’t shoot yourself in the foot. Don’t make mistakes.

How do most investors shoot themselves in the foot?

Overconfidence is one way, so thinking you know better than the market is a problem. Another is the fact that we let our emotions get control of us and there’s this so-called FOMO, or fear of missing out, so you jump in. Understanding behavioral finance and cognitive biases will make people better investors and give them much better financial outcomes.

What do you make of Bitcoin?

If you want to buy it the same way that you buy a lottery ticket, fine, but it isn’t an investment. It isn’t something that belongs in a 401(k) plan. Investors should avoid it. It isn’t a usable currency. If I want to go to Starbucks and get a latte, I don’t want a currency that could go up or down 10% or 20% each day. Now, I will admit there is a use for it as a currency: for illicit transactions.

You mentioned financial innovations. Active ETFs are one example. What do you make of them?

I am not a fan—they don’t have zero expense ratios. And I’m skeptical of so-called factor investing. There’s a lot of empirical work on this, but by the time you put these things together and charge the additional expenses involved, they aren’t likely to outperform.

My great friend Jack Bogle had a quote that I love: “In the investment business, you get what you don’t pay for.” The problem with a lot of these innovations is that investors need to look carefully at the expense ratios because what you’re going to find is that the purveyors of the products are making good money. But the investor is the person who is paying the fees, and you get what you don’t pay for. The beauty of indexing is that competition has brought expense ratios down essentially to zero.

You and Jack [founder and former CEO of Vanguard] agreed on almost everything about investing. Where did you diverge?

We disagreed on two things: Jack didn’t believe in international diversification. He thought that since he was buying multinationals, he was getting some international diversification with a U.S. portfolio, which is right. However, you get even more diversification with international stocks. The second thing is, Jack didn’t like ETFs. I like ETFs and was the chair of the new-products committee for the American Stock Exchange when we introduced the SPDR [Standard & Poor’s Depositary Receipt], which was the first ETF. [The
SPDR S&P 500 Trust
(ticker: SPY) tracks the
S&P 500.

Jack thought it was crazy that investors could buy and sell ETFs on the same day. Jack worried that ETFs would encourage too much trading and that investors would end up harming themselves by rapidly buying and selling ETFs.

You’re a champion of passive investing. But you love picking stocks.

There is no one who has spent their entire career in financial markets who doesn’t have something of a gambling instinct. So, yes, I like to buy individual stocks, but I want to emphasize that I buy individual stocks because my retirement account is 100% invested in diversified index funds. You buy individual stocks as an add-on, and because it’s fun. I do it because it’s fun, not because I think I am an expert stockpicker—not because I think this is the way to get rich.

What stocks do you like?

I’m not going to talk about individual stocks because my ideas of which stocks to buy are no better than anyone else’s. And frankly, they have been no better than my blindfolded chimpanzee.

Switching gears, what is your stock market outlook for 2023?

I don’t think you can make short-term forecasts. But one valuation metric has a fairly good correlation with future returns—the CAPE ratio, or the cyclically adjusted price/earnings multiple of the market. It isn’t useful in predicting the market a year ahead, but it is the best valuation metric for predicting future 10-year rates of return. The CAPE today is in the high 20s. Its average is in the midteens. High CAPEs have been associated with lower-than-average future stock rates of return. The market has given 9% to 10% returns over the past 100 years. But when the CAPE has been well above average, those returns have been more like 5% or 6%. Valuations are somewhat stretched, and it would be wise to think of future returns as being no higher than mid- to high-single digits.

Any plans to retire?

I am not regularly teaching at the university [Princeton], but I do give lectures. And I still follow markets and write from time to time because it’s fun. In general, people retire too early, and they would be better off and even happier if they continued to do some work in retirement. So, do I have plans to just kick up my feet and sit on the beach? No.

Thanks, Burton.

Write to Lauren Foster at


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