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

by Burton G. Malkiel

Thanks to their low overhead, they can offer rates significantly above both typical savings accounts and money-market funds. And, unlike money-market funds, those Internet banks that are members of the Federal Deposit Insurance Corporation can guarantee the safety of your funds.

The Internet banks generally post the highest CD rates available in the market.

Treasury Bills

Popularly known as T-bills, these are the safest financial instruments you can find and are widely treated as cash equivalents. Issued and guaranteed by the U.S. government, T-bills are auctioned with maturiti...

T-bills offer an advantage over money-market funds and bank CDs in that their income is exempt from state and local taxes. In addition, T-bill yields are often higher than those of money-market funds. For information on...

Tax-Exempt Money-Mar...

If you find yourself lucky enough to be in the highest federal tax bracket, you will find tax-exempt money-market funds to be the...

EXERCISE 4: LEARN HOW TO DODGE THE TAX COLLECTOR

But I do mean to suggest that you take advantage of every opportunity to make your savings tax-deductible and to let your savings and investments grow tax-free. For most people, there is no reason to pay any taxes on the earnings from the investments that you make to provide for your retirement.

Individual Retirement Accounts

Let’s start with the simplest form of retirement plan, a straightforward Individual Retirement Account (IRA).

Investors may also choose another form of individual retirement account called a Roth IRA. The traditional IRA offers “jam today” in the form of an immediate tax deduction (provided your income is low enough to make you eligible). Once in the account, the money and its earnings are taxed only when taken out at retirement. The Roth IRA offers “jam tomorrow”—you don’t get an up-front tax deduction, but your withdrawals (including investment earnings) are completely tax-free. In addition, you can Roth and roll.

Moreover, there are no lifetime minimum distribution requirements for a Roth IRA, and contributions can continue to be made after age seventy and a half.

On the other hand, if you are far from retirement and are in a lower tax bracket now, you are very likely to come out well ahead with a Roth IRA.

Be an educated consumer and contact a company such as Vanguard for a no-load, low-expense alternative.

EXERCISE 5: MAKE SURE THE SHOE FITS: UNDERSTAND YOUR INVESTMENT OBJECTIVES

Determining clear goals is a part of the investment process that too many people skip, with disastrous results. You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket. The securities markets are like a large restaurant with a variety of menu choices suitable for different tastes and needs. Just as there is no one food that is best for everyone, so there is no one investment that is best for all investors.

Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. The decision is up to you. High investment rewards can be achieved only at the cost of substantial risk-taking.

Generally, the longer a bond’s term to maturity, the greater the risk and the greater the resulting yield.† You will find some useful information on how to buy bonds in Exercise 7.

Although stock prices do plummet, as they did so disastrously in the early 2000s and in 2007, the overall return during the entire twentieth century was about 9 percent per year, including both dividends and capital gains. At their prices in 2014, I believe that a portfolio of domestic common stocks will have a 6 to 7 percent return, reasonably close to the annual rates of return during the twentieth century but somewhat lower. Comparable returns are likely from the major companies in developed foreign markets.

These are the stocks in younger companies in newer technologies, where the promise of greater growth exists. Such companies are likely to be more volatile, and these issues can easily lose half of their value in a bad market year. But your average future rate of return for the twenty-first century could be 7 to 7½ percent per year.

Portfolios of smaller stocks have tended to outperform the market averages by small amounts. If you have no trouble sleeping during bear markets, and if you have the staying power to stick with your investments, an aggressive common-stock portfolio may be just right for you. Even greater returns, as well as greater market swings, are likely from portfolios of stocks from many emerging markets such as China, India, and Brazil that have tremendous growth potential in the twenty-first century.

I’ll argue in Exercise 6 that individuals who can afford to buy their own homes are well advised to do so.

I believe that real estate investment trusts (REITs) deserve a position in a well-diversified investment portfolio.

I realize that my table slights gold and omits art objects, venture capital, hedge funds, commodities, and other more exotic investment possibilities. Many of these have done very well and can serve a useful role in balancing a well-diversified portfolio of paper assets. Because of their substantial risk, and thus extreme volatility, it is impossible to predict their rates of return; Exercise 8 reviews them in greater detail.

On the other hand, if you are in a low tax bracket and need high current income, you should prefer taxable bonds and high-dividend-paying common stocks so that you don’t have to incur the transactions charges involved in selling off shares periodically to meet income needs.

You can’t seek safety of principal and then take a plunge with investment into the riskiest of common stocks. You can’t shelter your income from high marginal tax rates and then lock in returns of 6 percent from high-yield taxable corporate bonds, no matter how attractive these may be.

EXERCISE 6: BEGIN YOUR WALK AT YOUR OWN HOME—RENTING LEADS TO FLABBY INVESTMENT MUSCLES

In sum, real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics.

Because Congress wanted to encourage home ownership and the values associated with it, it gave the homeowner two important tax breaks: (1) Although rent is not deductible from income taxes, the two major expenses associated with home ownership—interest payments on your mortgage and property taxes—are deductible; (2) realized gains in the value of your house up to substantial amounts are tax-exempt. In addition, ownership of a house is a good way to force yourself to save, and a house provides enormous emotional satisfaction.

You may also wish to consider ownership of commercial real estate through the medium of real estate investment trusts (REITs, pronounced “reets”).

First, ownership of real estate has produced comparable rates of return to common stocks and good dividend yields. Equally important, real estate is an excellent vehicle to provide the benefits of diversification described in chapter 8. Real estate returns have often exhibited only a moderate correlation with other assets, thereby reducing the overall risk of an investment program. Moreover, real estate has been a dependable hedge against inflation.

Individuals could stumble badly by purchasing the wrong REIT. Now, however, investors have a rapidly expanding group of real estate mutual funds that are more than willing to do the job for them. The funds cull through the available offerings and put together a diversified portfolio of REITs, ensuring that a wide variety of property types and regions are represented.

There are also low-expense REIT index funds (listed in the Address Book), and I believe these funds will continue to produce the best net returns for investors.

Bonds were a poor investment until the early 1980s because the interest rates they carried did not offer adequate inflation protection. But bond prices adjusted to give investors excellent returns over the next thirty years.

bonds proved to be excellent diversifiers with low or negative correlation with common stocks from 1980 through 2014. In my view, there are four kinds of bond purchases that you may want especially to consider: (1) zero-coupon bonds (which allow you to lock in yields for a predetermined length of time); (2) no-load bond mutual funds (which permit you to buy shares in bond portfolios); (3) tax-exempt bonds and bond funds (for those who are fortunate enough to be in high tax brackets); and (4) U.S. Treasury inflation-protection securities (TIPS).

But their attractiveness for investment varies considerably with market conditions. And with the very low interest rates of the mid-2010s, investors must approac...

Zero-Coupon Bonds Can Be Useful to Fund Fut...

called zero coupons or simply zeros because owners receive no periodic interest payments, as they do in a regu...

Instead, these securities are purchased at discounts from their face value (for example, 75 cents on the dollar) and gradually rise to their face or par values over the years. If held to maturity, ...

The main disadvantage of zeros is that the Internal Revenue Service requires that taxable investors declare annually as income a pro rata share of the dollar difference between the purchase price and the par value of the bond. This is not required, however, for investors who hold zeros in tax-deferred retirement plans.

No-Load Bond Funds Can Be Appropriate Vehicles for Individual Investors

Open-end bond (mutual) funds give some of the long-term advantages of the zeros but are much easier and less costly to buy or sell. Those that I have listed in the Address Book all invest in long-term securities.

these funds do offer long-run stability of income and are particularly suitable for investors who plan to ...

Because bond markets tend to be at least as efficient as stock markets, I recommend low...

In no event should you ever buy a load fund (a fund with a commission fee).

Tax-Exempt Bonds Are Useful for High-Bracket Investors

There is one nasty “heads I win, tails you lose” feature of bonds. If interest rates go up, the price of your bonds will go down. But if interest rates go down, the issuer can often “call” the bonds away from you (repay the debt early) and then issue new bonds at lower rates. To protect yourself, make sure that your long-term bonds have a ten-year call-protection provision that prevents the issuer from refunding the bonds at lower rates.

Hot TIPS: Inflation-Indexed Bonds

Now a lead shield is available to investors in the form of Treasury inflation-protection securities (TIPS). These securities are immune to the erosion of inflation if held to maturity and guarantee investors that their portfolios will retain their purchasing power.