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

by Burton G. Malkiel

Under the second system, you jog down Wall Street, picking your own stocks and perhaps overweighting certain industries or countries.

Third, you can sit on a curb and choose a professional investment manager to do the walking down Wall Street for you.

THE NO-BRAINER STEP: INVESTING IN INDEX FUNDS

The Standard & Poor’s 500-Stock Index, a composite that represents about three-quarters of the value of all U.S.-traded common stocks, beats most of the experts over the long pull.

The Vanguard 500 Index Trust purchased the 500 stocks of the S&P 500 in the same proportions as their weight in the index.

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 als buy exchange-traded S&P 500 index funds offered by State Street Global Advisors, BlackRock, and Vanguard.

Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. The

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. Public index funds and exchange-traded funds are run at fees of of 1 percent or even less. Actively managed public mutual funds charge annual management expenses that average 1 percentage point per year.

Index funds are also tax-friendly. Index funds allow investors to defer the realization of capital gains or avoid them completely if the shares are later bequeathed.

Index funds do not trade from security to security and, thus, tend to avoid capital gains taxes.

With index funds, you know exactly what you are getting, and the investment process is made incredibly simple.

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.

The index fund does all the work of collecting the dividends from all of the stocks it owns and sending you each quarter one check for all of your earnings (earnings that, incidentally, can be reinvested in the fund if you desire).

By far the most popular index used is the Standard & Poor’s 500-Stock Index, an index that well represents the major corporations in the U.S. market. But now, although I still recommend indexing, or so-called passive investing, there are valid criticisms of too narrow a definition of indexing. 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.

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...

diversified portfolio of small companies is likely to produce enhanced returns. For this reason, I favor investing in an index that contains a much broader representation of U.S. companies, including large numbers of the small dynamic companies that are likely to be in early stages of their growth cycles.

S&P 500 represents 75 to 80 percent of the market value of all outstanding U.S. common stocks. Literally thousands of companies represent the remaining 20 to 25 percent of the total U.S. market value.

The Wilshire 5000 Index contains all publicly traded U.S. common stocks. The Russell 3000 and MSCI Index contain all but the smallest (and much less liquid) stocks in the market.

Such index funds usually go by the name Total Stock Market Portfolio.

Thus, investors should not buy a U.S. stock-market index fund and hold no other securities.

index funds currently exist that mimic the performance of various international indexes such as the Morgan Stanley Capital International (MSCI) index of European, Australasian, and Far Eastern (EAFE) securities, and the MSCI emerging-markets index. In addition, there are index funds holding real estate investment trusts (REITs).

Finally, Total Bond Market index funds are available that track the Barclays Aggregate Bond Market Index. Moreover, all these index funds have also tended to outperform activel...

One of the biggest mistakes that investors make is to fail to obtain sufficient inter...

the emerging markets of the world (such as China, India, and Brazil) have been growing much faster than the developed economies.

Indexing also is an extremely effective strategy in emerging markets.

overwhelming majority of actively managed emerging-market equity funds are outperformed by the MSCI emerging-markets index.

The table on page 389 presents specific index-fund selections that investors can use to build their portfolios.

Those who are not in their mid-fifties can use exactly the same selections and simply change the weights to those appropriate for their specific age group.

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)

Remember also that I am assuming here that you hold most, if not all, of your securities in tax-advantaged retirement plans. Certainly all bonds should be held in such accounts. If bonds are held outside of retirement accounts, you may well prefer tax-exempt bonds rather than the taxable securities. Moreover, if your common stocks will be held in taxable accounts, you might consider tax-managed index funds. Finally, note that I have given you a choice of index funds from different mutual-fund complexes.

wanted also to suggest a number of non-Vanguard funds. All the funds listed have moderate expense ratios and are no-load. More information on these funds, including telephone numbers and websites, can be found in the Random Walker’s Address Book, which follows this chapter. ETFs may be used in lieu of mutual 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.

ETFs are an excellent vehicle for the investment of lump sums that are to be allocated to index funds.

ETFs require the payment of transactions costs, however, including brokerage fees* and bid-asked spreads. No-load index mutual funds will better serve investors who will be accumulating index shares over time in small amounts.

I suggest that you avoid the temptation to buy or sell ETFs at any hour of the day and to...

In the table on page 392, I list the ETFs that can be used to build your portfolio. Note that for investors who want to make their stock buying as easy as possible, there are Total World Index funds and ETFs that provide total international diversification with one-stop shopping.

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%

If you want an easy, time-tested method to achieve superior investment results, you can stop reading here. The indexed mutual funds or ETFs that I have listed will provide broad diversification, tax efficiency, and low expenses. 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.

You should be an avid reader of the financial pages of daily newspapers, particularly the New York Times and the Wall Street Journal. Weeklies such as Barron’s should be on your “must-read” list as well. Business magazines such as Bloomberg Businessweek, Fortune, and Forbes are also valuable for gaining exposure to investment ideas.

You should, for example, try to have access to Standard & Poor’s Outlook and the Value Line Investment Survey.

proposed four rules for successful stock selection.

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.

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. Look for growth situations that the market has not already recognized

Beware of stocks with very high multiples and many years of growth already discounted in their prices.

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

But stocks are like people—some have more attractive personalities than others, and the improvement in a stock’s multiple may be smaller if its story never catches on. The key to success is being where other investors will be, several months before they get there.

Is it a story on which investors can build castles in the air—but castles in the air that really rest on a firm foundation?