A Random Walk Down Wall Street: The Best Investment Guide That Money Can Buy

by Burton G. Malkiel

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

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.

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.

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 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.

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.

General guidelines can be extremely helpful in determining what proportion of a person’s funds should be deployed among different asset categories. But the key to whether any recommended asset allocation works for you is whether you are able to sleep at night. Risk tolerance is an essential aspect of any financial plan, and only you can evaluate your attitude toward risk.

If you panicked and became physically ill because a large proportion of your assets was invested in common stocks, then clearly you should pare down the stock portion of your portfolio.

For those in their twenties, a very aggressive investment portfolio is recommended.

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 during periods of ultra-low interest rates. 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. The proportion of bonds and bond substitutes increases, and the stock portfolio becomes more conservative and income-producing and less growth-oriented. In retirement, a portfolio heavily weighted in a variety of bonds and bond substitutes is recommended.

A general rule of thumb used to be that the proportion of bonds in one’s portfoli...

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...

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

It is called the “life-cycle fund,” or “target date fund,” and it automatically does the rebalancing and moves to a safer asset allocation as you age. Life-cycle funds are particularly useful for IRAs, 401(k)s, and other non-taxable retirement plans. They can have adverse tax consequences when used in taxable accounts.

When bond yields are extremely low, I tend to favor the life-cycle funds that are more aggressive—i.e., that start off with a larger allocation to equities and use fewer bonds.

Sturgeon’s Law, coined by the science fiction writer Theodore Sturgeon, states, “95 percent of everything you hear or read is crap.”

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.

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.

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 offer annuities with low costs and no sales commissions.

Under the “3½ percent solution,” you should spend no more than 3½ 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.

But there are two reasons to limit the take-out rate. First, you need to allow your monthly payments to grow over time at the rate of inflation. Second, you need to ensure that you could ride out several years of the inevitable bear markets that the stock market can suffer during certain periods.

When you start taking federally mandated required minimum distributions from IRAs and 401(k)s, you will need to use these before tapping other accounts.

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.

Third, you can sit on a curb and choose a professional investment manager to do the walking down Wall Street for you. Professional advisers can choose the mix of investments best suited for your capacity and willingness to accept risk and ensure that you have the benefits of broad diversification. Unfortunately, most investment advisers are expensive and they often have conflicts of interest.

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.

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.

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.

You should not believe the active manager who claims that her fund will move into cash at the correct times. We have seen that market timing does not work.

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 Total Market Index, the CRSP Index, or the MSCI U.S. Broad Market Index—not the S&P 500.

Total stock market index funds have consistently provided higher returns than the average equity mutual-fund manager.

Economies with younger populations tend to grow faster.

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.

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

Morningstar.

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.

Buy stocks whose P/Es are low relative to their growth prospects.

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

Rule 4: Trade as little as possible.

But I do not recommend too much patience in losing situations, especially when prompt action can produce immediate tax benefits.

Second, I have become increasingly convinced that the past records of mutual-fund managers are essentially worthless in predicting future success.

If you follow the recommendations in this book carefully, you really don’t need an investment adviser.

TLH is the crown jewel of tax management. It involves selling an investment that is trading at a loss and replacing it with a highly correlated but not identical investment. Doing so allows you to maintain the risk and return characteristics of your portfolio while generating losses that can be used to reduce your current taxes.

Automating the process, one can continuously look for losses to realize. It has been shown that tax-loss harvesting can add a meaningful amount to the annual after-tax return of the investor.

Software is uniquely suited to maximize the benefits of TLH. By monitoring portfolios 24/7, the automated adviser can take advantage of temporary dips in the market.

“Although men flatter themselves with their great actions,” La Rochefoucauld wrote, “they are not so often the result of great design as of chance.”

Those timeless lessons involve broad diversification, annual rebalancing, using index funds, and staying the course.