A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

by Burton G. Malkiel

In general, the exhibit shows that investors have earned higher total rates of return from the stock market when the initial P/E of the market portfolio was relatively low, and relatively low future rates of return when stocks were purchased at high P/E multiples.

measured P/Es are often referred to as CAPEs—cyclically adjusted P/E multiples. The CAPEs are available on Robert Shiller’s website, and the earnings are calculated as average earnings over the last ten years. (Similar calculations can be obtained by averaging the past five years of earnings.) The Shiller CAPE in 2014 averaged just over 25. CAPEs do a reasonably good job of forecasting returns a decade ahead and confirm the expectation presented here of modest single-digit returns over the years ahead. But if your investment period is for less than a decade, no one can predict the returns you will receive with any degree of accuracy.

According to Roger Ibbotson, who has spent a lifetime measuring returns from alternative portfolios, more than 90 percent of an investor’s total return is determined by the asset categories that are selected and their overall proportional representation. Less than 10 percent of investment success is determined by the specific stocks or mutual funds that an individual chooses.

The key principles are: 1. History shows that risk and return are related. 2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return. 3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment. 4. Rebalancing can reduce risk and, in some circumstances, increase investment returns. 5. You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.

But this return came only at substantial risk to investors. Total returns were negative in about three years out of ten. So as you reach for higher returns, never forget the saying “There ain’t no such thing as a free lunch.” Higher risk is the price one pays for more generous returns.

On average, investments over all twenty-five-year periods covered by this figure have produced a rate of return of slightly more than 10 percent. This long-run expected rate of return was reduced by less than 3 percentage points if you happened to invest during the worst twenty-five-year period since 1950. It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.

Don’t be alarmed by the fancy-sounding name. Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of some index mutual fund, at regular intervals—say, every month or quarter—over a long period of time. Periodic investments of equal dollar amounts in common stocks can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.

Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

No matter how scary the financial news, no matter how difficult it is to see any signs of optimism, you must not interrupt the automatic-pilot nature of the program. Because if you do, you will lose the benefit of buying at least some of your shares after a sharp market decline when they are for sale at low prices. Dollar-cost averaging will give you this bargain: Your average price per share will be lower than the average price at which you bought shares. Why? Because you’ll buy more shares at low prices and fewer at high prices.

it’s usually a good time to buy after the market has fallen out of bed. Just as hope and greed can sometimes feed on themselves to produce speculative bubbles, so do pessimism and despair react to produce market panics.

The table shows that the volatility of the market value of the portfolio was markedly reduced by the rebalancing strategy. Moreover, rebalancing improved the average annual portfolio return. Without rebalancing, the portfolio returned 8.14 percent over the period. Rebalancing improved the annual rate of return to 8.41 percent with less volatility.

I suggested that Carl and Joan had a highly problematic portfolio. Both their income and their investments were tied up in GM. A negative development that caused a sharp loss in GM’s common stock could ruin both the value of the portfolio and Carl’s livelihood.

Always keep in mind: A specific need must be funded with specific assets dedicated to that need. Consider a young couple in their twenties attempting to build a retirement nest egg. The advice in the life-cycle investment guide that follows is certainly appropriate to meet those long-term objectives. But suppose that the couple expects to need a $30,000 down payment to purchase a house next year. That $30,000 to meet a specific need should be invested in a safe security, maturing when the money is required, such as a one-year certificate of deposit (CD). Similarly, if college tuitions will be needed in three, four, five, and six years, funds might be invested in zero-coupon securities of the appropriate maturity or in different CDs.

For those in their twenties, a very aggressive investment portfolio is recommended. At this age, there is lots of time to ride out the peaks and valleys of investment cycles, and you have a lifetime of earnings from employment ahead of you. The portfolio is not only heavy in common stocks but also contains a substantial proportion of international stocks, including the higher-risk emerging markets. As mentioned in chapter 8, one important advantage of international diversification is risk reduction. Plus, international diversification enables an investor to gain exposure to other growth areas in the world even as world markets become more closely correlated.

general rule of thumb used to be that the proportion of bonds in one’s portfolio should equal one’s age. Nevertheless, even in one’s late sixties, I suggest that 40 percent of the portfolio be committed to ordinary common stocks and 15 percent to real estate equities (REITs) to give some income growth to cope with inflation. Indeed, since life expectancies have increased significantly since I first presented these asset allocations during the 1980s, I have increased the proportion of equities accordingly.

I said earlier that everyone should attempt to own his or her own home. I believe that everyone should have substantial real estate holdings, and some part of one’s equity holdings should be in real estate investment trust (REIT) index mutual funds described in chapter 12.

A new type of product has been developed during the 2000s just for those investors who want to set up a program and then forget about it. It is called the “life-cycle fund,” and it automatically does the rebalancing and moves to a safer asset allocation as you age. Life-cycle funds are extremely useful for IRAs, 401(k)s, and other retirement plans.

While older Americans (between the ages of fifty-five and sixty-four) have, on average, $308,000 in retirement savings, that amount would not be sufficient to replace more than 15 percent of their household income in retirement.

First, one can annuitize all or part of one’s retirement nest egg. Second, the retiree can continue to hold his investment portfolio and set up a withdrawal rate that provides for a comfortable retirement while minimizing the risk of outliving the money. How should one decide between the two alternatives?

An annuity is often called “long-life insurance.” Annuities are contracts made with an insurance company where the investor pays a sum of money to guarantee a series of periodic payments that will last as long as the annuitant lives. For example, during mid-2014 a $1,000,000 premium for a fixed lifetime annuity would purchase an average annual income stream of about $68,000 for a sixty-five-year-old male. If a sixty-five-year-old couple retired and desired a joint and survivor option (that provided payments as long as either member of the couple was alive), the million dollars would provide fixed annual payments of about $59,000.

Annuities have one substantial advantage over a strategy of investing your retirement nest egg yourself. The annuity guarantees that you will not outlive your money. If you are blessed with the good health to live well into your nineties, it is the insurance company that takes the risk that it has paid out to you far more than your original principal plus its investment earnings. Risk-averse investors should certainly consider putting some or even all of their accumulated savings into an annuity contract upon retirement.

Annuitization is inconsistent with a bequest motive, it gives the annuitant an inflexible path of consumption, it can involve high transactions costs, and it can be tax inefficient.

Under the “4 percent solution,” you should spend no more than 4 percent of the total value of your nest egg annually. At that rate the odds are good that you will not run out of money even if you live to a hundred. It is highly likely, too, that you will also be able to leave your heirs with a sum of money that has the same purchasing power as the total of your retirement nest egg. Under the 4 percent rule, you would need $450,000 of savings to produce an income in retirement of $1,500 per month or $18,000 per year.

By spending less than the total return from the portfolio, the retiree can preserve the purchasing power of both the investment fund and its annual income. The general rule is: First estimate the return of the investment fund, and then deduct the inflation rate to determine the sustainable level of spending. If inflation is likely to be 2 percent per year, then a 3½ percent spending rate would be more appropriate.

My advice is to start out spending 3½ or 4 percent of your retirement fund and then let the amount you take out grow by 1½ or 2 percent per year. This will smooth out the amount of income you will have in retirement.

For most investors, especially those who prefer an easy, lower-risk solution to investing, I recommend bowing to the wisdom of the market and using domestic and international index funds for the entire investment portfolio. For all investors, however, I recommend that the core of the investment portfolio—especially the retirement portion—be invested in index funds or ETFs.

Today, S&P 500 index funds are available from several mutual-fund complexes with expense ratios of about of 1 percent of assets, far less than the expenses incurred by most actively managed mutual funds or bank trust departments. You can now buy the market conveniently and inexpensively. You can als buy exchange-traded S&P 500 index funds offered by State Street Global Advisors, BlackRock, and Vanguard.

Index funds have regularly produced rates of return exceeding those of active managers. There are two fundamental reasons for this excess performance: management fees and trading costs.

To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration because the earlier realization of capital gains will substantially reduce net returns. Index funds do not trade from security to security and, thus, tend to avoid capital gains taxes.

Like greyhounds at the dog track, professional money managers seem destined to lose their race with the mechanical rabbit. Small wonder that many institutional investors, including Intel, Exxon, Ford, American Telephone and Telegraph, Harvard University, the College Retirement Equity Fund, and the New York State Teachers Association, have put substantial portions of their assets into index funds. By 2014, about one-third of investment funds were “indexed.”

Many people incorrectly equate indexing with a strategy of simply buying the S&P 500 Index. That is no longer the only game in town. The S&P 500 omits the thousands of small companies that are among the most dynamic in the economy. Thus, I believe that if an investor is to buy only one U.S. index fund, the best general U.S. index to emulate is one of the broader indexes such as the Russell 3000, the Wilshire 5000 Total Market Index, the CRSP Index, or the MSCI U.S. Broad Market Index—not the S&P 500.

As I argued in chapter 8, investors can reduce risk by diversifying internationally, by including asset classes such as real estate in the portfolio, and by placing some portion of their portfolio in bonds and bondlike securities, including Treasury inflation-protection securities. This is the basic lesson of modern portfolio theory.

One of the biggest mistakes that investors make is to fail to obtain sufficient international diversification. The United States represents only about one-third of the world economy.

The chart below indicates that the overwhelming majority of actively managed emerging-market equity funds are outperformed by the MSCI emerging-markets index. Even though emerging markets are not likely to be as efficient as developed markets, they are costly to access and to trade. Expense ratios of active funds are far higher than is the case in developed markets. Moreover, liquidity is lower and trading costs are higher in emerging markets. Therefore, after all expenses are accounted for, indexing turns out to be an excellent investment strategy.

A SPECIFIC INDEX-FUND PORTFOLIO FOR AGING BABY BOOMERS Cash (5%)* Fidelity Money Market Fund (FXLXX) or Vanguard Prime Money Market Fund (VMMXX) Bonds and Bond Substitutes (27½%)† 7½% U.S. Vanguard IntermediateTerm Bond (VICSX) or iShares Corporate Bond ETF (LQD) 7½% Vanguard Emerging Market Government Bond Fund (VGAVX) 12½% Wisdom Tree Dividend Growth Fund (DGRW) or Vanguard Dividend Growth Fund (VDIGX)† Real Estate Equities (12½%) Vanguard REIT Index Fund (VGSIX) or Fidelity Spartan REIT Index Fund (FRXIX) Stocks (55%) 27% U.S. Stocks Schwab Total Stock Market Index Fund (SWTSX) or Vanguard Total Stock Market Index Fund (VTSMX) 14% Developed International Markets Schwab International Index Fund (SWISX) or Vanguard International Index Fund (VTMGX) 14% Emerging International Markets Vanguard Emerging Markets Index Fund (VEIEX) or Fidelity Spartan Emerging Markets Index Fund (FFMAX) *A short-term bond fund may be substituted for one of the money-market funds listed. †Although it doesn’t fit under the rubric of an index-fund portfolio, investors might consider putting part of the U.S. bond portfolio in Treasury inflation-protection securities. The dividend growth and corporate bond funds are also an exception since they are not standard index funds.

Exchange-traded index funds (ETFs) such as “spiders” (an S&P 500 Fund) and “vipers” (a Total Stock Market fund) can be more tax-efficient than regular index funds because they are able to make “in-kind” redemptions. In-kind redemptions proceed by delivering low-cost shares against redemption requests.

EXCHANGE TRADED FUNDS (ETFS) Ticker Expense Ratio Total U.S. Stock Market Vanguard Total Stock Market VTI 0.05% iShares Russell 3000 IWV 0.20% Developed Markets (EAFE) Vanguard Europe Pacific VEA 0.09% iShares MSCI EAFE EFA 0.35% Emerging Markets Vanguard Emerging Markets VWO 0.15% iShares MSCI Emerging Markets EEM 0.67% Total World Ex-U.S. Vanguard FTSE All World (EX U.S.) VEU 0.15% SPDR MSCI ACWI (EX U.S.) CWI 0.34% Total World Including U.S. Vanguard Total World VT 0.18% iShares MSCI ACWI ACWI 0.34% Bond Market U.S.* Vanguard Intermediate-Term Corporate Bond VCIT 0.12% iShares Investment Grade Corporate Bond LQD 0.15% *Taxable investors should consider the closed-end municipal bond funds listed on page 405.

Even if you want to buy individual stocks, do what institutional investors are increasingly doing: Index the core of your portfolio along the lines suggested and then take active bets with extra funds.

Rule 1: Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years.

Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value. Although I am convinced that you can never judge the exact intrinsic value of a stock, I do feel that you can roughly gauge when a stock seems to be reasonably priced. The market price-earnings multiple is a good place to start: Buy stocks selling at multiples in line with, or not very much above, this ratio.

Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.

My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however. With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason for this timing is that losses are deductible (up to certain amounts) for tax purposes, or can offset gains you may already have taken. Thus, taking losses can lower your tax bill.

Picking individual stocks is like breeding thoroughbred porcupines. You study and study and make up your mind, and then proceed very carefully.

One adjustment that I make in my own indexed portfolio is to overweight China relative to its weight in the world index benchmark. I do so because I believe that China gets too low a weight relative to its economic importance. Certain peculiarities about China’s stock markets lead to China’s being underweighted both in emerging-markets index funds and in total world indexes.

China gets only about 2 percent of the weight in the world indexes, whereas, adjusted for purchasing-power parity, China’s GDP is about 13 percent of the world’s GDP and is growing rapidly.

Morningstar is one of the most comprehensive sources of mutual-fund information an investor can find. For each mutual fund, it publishes a report crammed full of relevant data.

the Morningstar ratings do not guarantee an investor continued superior performance. In the past, five-star funds have not done better than three-star or even one-star funds. The wise investor will look beyond the stars in making appropriate investment decisions.

High expenses and high turnover depress returns—especially after-tax returns if the funds are held in taxable accounts. The best-performing actively managed funds have moderate expense ratios and low turnover. The lower the expenses charged by the purveyor of the investment service, the more there will be for the investor.

Closed-end funds differ from open-end mutual funds (the kind discussed in the preceding section) in that they neither issue nor redeem shares after the initial offering. To buy or sell shares, you have to go to a broker.

Diversified portfolios of emerging-market closed-end funds selling at discounts are a viable—and probably a preferable—alternative to an emerging-market index fund. When discounts of 10 percent or more exist, it is time to open your wallet to closed-end funds.