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

by Burton G. Malkiel

Clearly, there is no dependability of earning an adequate rate of return in any single year. A one-year U.S. Treasury security or a one-year government-guaranteed certificate of deposit is the investment for those who need the money next year.

Although there is some variability in the return achieved, depending on the exact twenty-five-year period in question, that variability is not large. 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.

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.*

These data further support the advice that younger people should have a larger proportion of their assets in stocks than older people.

do not mean to argue that stocks are not risky over long holding periods. Certainly the variability of the final value of your portfolio does increase the longer you hold your stocks. And we know that investors have experienced decades during which common stocks have produced near-zero overall returns. But for investors whose holding periods can be measured in twenty-five years or more, and especially those who reinvest their dividends and even add to their holdings through dollar-cost averaging, common stocks are very likely to provide higher returns than are available from safe bonds and even safer government-guaranteed savings accounts.

If, like most people, you will be building up your investment portfolio slowly over time with the accretion of yearly savings, you will be taking advantage of dollar-cost averaging.

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.

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.

Dollar-cost averaging is not a panacea that eliminates the risk of investing in common stocks. It will not save your 401(k) plan from a devastating fall in value during a year such as 2008, because no plan can protect you from a punishing bear market. And you must have both the cash and the confidence to continue making the periodic investments even when the sky is the darkest. 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.

But it does provide a reasonable insurance policy against poor future stock markets. And it does minimize the regret that inevitably follows if you were unlucky enough to have put all your money into the stock market during a peak period such as March of 2000 or October of 2007.

If possible, keep a small reserve (in a money fund) to take advantage of market declines and buy a few extra shares if the market is down sharply.

I’m not suggesting for a minute that you try to forecast the market. However, it’s usually a good time to buy after the market has fallen out of bed.

The greatest market panics are just as unfounded as the most pathological speculative explosions. For the stock market as a whole (not for individual stocks), Newton’s law has always worked in reverse: What goes down has come back up.

A very simple investment technique called rebalancing can reduce investment risk and, in some circumstances, even increase investment returns. The technique simply involves bringing the proportions of your assets devoted to different asset classes (e.g., stocks and bonds) back into the proportions suited to your age and your attitude toward and capacity for risk.

What kind of alchemy permitted the investor who followed a rebalancing strategy at the end of each year to increase her rate of return? Think back to what was happening to the stock market over this period. By late 1999, the stock market had experienced an unprecedented bubble and equity values soared. The investor who rebalanced had no idea that the top of the market was near, but she did see that the equity portion of the portfolio had soared far above her 60 percent target. Thus, she sold enough equities (and bought enough bonds) to restore the original mix. Then, in late 2002, at just about the bottom of the bear market for stocks (and after a strong positive market for bonds), she found that the equity share was well below 60 percent and the bond share was well above 40 percent, and she rebalanced into stocks. Again, at the end of 2008, when stocks had plummeted and bonds had risen, she sold bonds and bought stocks. We all wish that we had a little genie who could reliably tell us to “buy low and sell high.” Systematic rebalancing is the closest analogue we have.

5. Distinguishing between Your Attitude toward and Your Capacity for Risk

She needs a portfolio of safe investments that can generate substantial income. Bonds and high-dividend-paying stocks, as from an index fund of real estate investment trusts, are the kinds of investments that are suitable. Risky (often non-dividend-paying) stocks of small-growth companies—no matter how attractive their prices may be—do not belong in Mildred’s portfolio.

it is clear that Tiffany’s portfolio belongs toward the far end of the risk-reward spectrum. Mildred’s portfolio of small-growth stocks would be far more appropriate for Tiffany than for a sixty-four-year-old widow who is unable to work.

Never take on the same risks in your portfolio that attach to your major source of income.

1. Specific Needs Require Dedicated Specific Assets

Always keep in mind: A specific need must be funded with specific assets dedicated to that need.

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.

2. Recognize Your Toleran...

You can take some comfort in the fact that the risk involved in investing in common stocks and long-term bonds is reduced the longer the time period over which you accumulate and hold your investments. But you must have the temperament to accept considerable short-term fluctuations in your portfolio’s value.

3. Persistent Saving in Regular Amounts, No Matter How Small, Pays Off

Accumulating meaningful amounts of retirement savings often seems out of reach. Don’t despair. The fact is that a program of regular saving each week—persistently followed, as through a payroll savings or 401(k) retirement plan—can in time produce substantial sums of money. Can you afford to put aside $23 per week? Or $11.50 per week? If you can, the possibility of eventually accumulating a large retirement fund is easily attainable if you have many working years ahead of you.

The table below shows the results from a regular savings program of $100 per month. An interest rate of 7 percent is assumed as an investment rate.

It is clear that regular savings of even moderate amounts make the attainment of meaningful sums of money entirely possible, even for those who start off with no nest egg at all. If you can put a few thousand dollars into the savings fund to begin with, the final sum will be increased significantly.

Pick no-load mutual funds to accumulate your nest egg because direct investments of small sums of money can be prohibitively expensive. Also, mutual funds permit automatic reinvestment of interest, or dividends and capital gains, as is assumed in the table. Finally, make sure you check whether your employer has a matched-savings plan. Obviously, if by saving through a company-sponsored retirement plan you are able to match your savings with company contributions and gain tax deductions as well, your nest egg will grow that much faster.

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 investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and bond substitutes such as dividend growth stocks. The allocation is also increased to REITs that pay generous dividends. By the age of fifty-five, investors should start thinking about the transition to retirement and moving the portfolio toward income production.

For most people, I recommend starting with a broad-based, Total Stock Market index fund rather than individual stocks for portfolio formation. I do so for two reasons. First, most people do not have sufficient capital to buy properly diversified portfolios themselves. Second, I recognize that most young people will not have substantial assets and will be accumulating portfolios by monthly investments. This makes mutual funds almost a necessity. As your assets grow, a U.S. stock-market fund should be augmented with a total international stock (index) fund that includes stocks from fast-growing emerging markets.

make sure that any mutual funds you buy are truly “no-load” and low cost.

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

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.

The major mutual-fund complexes such as Vanguard, Fidelity, American Century, and T. Rowe Price all offer life-cycle funds.

But before you sign up, check the fee schedule. Low fees mean more money in your pocket to enjoy a more comfortable retirement.

There are two basic alternatives. 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.

With respect to the advice regarding annuities, I suspect that the percentage of misinformation is closer to 99 percent.

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.

Variable annuities provide the possibility of rising payments over time, depending upon the type of investment assets (typically mutual funds) chosen by the annuitants. If the annuitant chooses common stocks, the payments will rise over time if the stock market does well, but they will fall if the stock market falters.

Another possibility is an annuity with an explicit inflation-adjustment factor. For example, the Vanguard Group offers an annuity with an explicit inflation (consumer price index) adjustment up to 10 percent per year.

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.

Risk-averse investors should certainly consider putting some or even all of their accumulated savings into an annuity contract upon retirement. What, then, are the disadvantages of annuities? There are four possible disadvantages. 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.

So what should smart investors do? Here are my rules: At least partial annuitization usually does make sense. It is the only no-risk way of ensuring that you will not outlive your income. Reputable companies, such as Vanguard, offer annuities with low costs and no sales commissions.

How do you go about buying stocks? Basically, there are three ways. I call them the No-Brainer Step, the Do-It-Yourself Step, and the Substitute-Player Step.

In the first case, you simply buy shares in various broad-based index funds or indexed ETFs designed to track the different classes of stocks that make up your portfolio.

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.