If you'd expect anyone to have his personal investment portfolio devoted to passive investing, it's Dr Burton G Malkiel, professor of Economics at Princeton University and leading proponent of the efficient market hypothesis. Thirty-six years after he first wrote the classic investment book A Random Walk Down Wall Street , he still thinks everyone should invest in index trackers. But he also has a startling admission to make.
"I don't index everything myself," he says. "There's no one who has studied the stock markets for his whole life and not got something of a gambler in him."
Dr Malkiel, in London to bang the drum for Vanguard's low-cost index tracker funds, says he was a fan of index funds before Vanguard started the first index fund in the US in 1976. He still believes that securities markets are efficient, citing the example of Microsoft, which recently disappointed the market by announcing lower revenues and earnings than the market had forecast. "The price of Microsoft did not adjust slowly," he says. "It was down 10 per cent the next day. Markets adjust very quickly to information - that is the hallmark of efficient markets."
However, efficient market theory does not assume market prices are always correct. "The market makes mistakes," says Dr Malkiel. "Telecoms stocks in 1999 and 2000 were way overpriced. Real estate in 2006 was overpriced."
What efficient market theory does assume is that there are no easy ways to make money. "If you see a £20 note on the ground, some academics tell their students that if it were really a £20 note it wouldn't be there. I tell my students to pick it up straight away because otherwise someone else will. I don't believe that £20 notes just keep lying on the ground."
Someone has to be active
Although Dr Malkiel has been promoting indexing since he wrote 'A Random Walk' in 1973, in the US, he says, only approximately 30 per cent of institutional and 10 per cent of private money is indexed.
So, is he disappointed by this? No. "If 95 per cent of people index, who is going to make the market efficient?" he asks. I will be very worried when 50 or 60 per cent of the market is indexed, but there's a long way to go yet. Yes, you do need someone to be active to make the market efficient."
Arguing that, even if markets are not efficient, indexing is an optimal strategy, Dr Malkiel says: "Even if you disagree that markets are efficient, you should like indexing. All stocks have to be owned. If someone owns stocks that do better than the market, then someone has to own the ones that do worse. We can't all do better than the average."
However, he also argues: "Indexing is not guaranteed mediocrity. It's an above-average strategy. When you go active you're far more likely to be in the bottom of the distribution." For example, 107 European active equity funds outperformed the MSCI Europe Index over 10 years to December 31, 2008, compared to 299 that didn't. That's 74 per cent underperforming the index.
Advocating a core portfolio of indexed investments, with a satellite portfolio of active investments, he reveals that actively managed Chinese equity funds form the largest part of his personal satellite portfolio. "I can do this with less risk because my basic return on my portfolio is indexed. If the core of your portfolio is indexed, you can make active bets with less risk," he says.
| BURTON MALKIEL CV |
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| Dr Burton Gordon Malkiel is an American economist and writer, most famous for his finance book, 'A Random Walk Down Wall Street'. The professor of economics at Princeton University and two time chairman of the economics department there, he is a leading proponent of the efficient market hypothesis. He served as a member of the Council of Economic Advisers (1975-1977), president of the American Finance Association (1978), and dean of the Yale School of Management (1981-1988). |
Diversification
The China holdings bring us to one of his of his 'five timeless lessons' for investors: "Diversify, diversify, diversify".
"Diversification is under attack as it did not work well in 2008," he says. "There were few places to hide during the worldwide recession. I'm a bull on China and it went down. But safe bonds, for example, US Treasury bonds, and gold went up. You were still better off with a diversified portfolio."
He says most investors have a tendency to put too much into their domestic market. "In general, people are inadequately diversified. Although if you're living in England and spend money in pounds, you don't want everything overseas."
He believes that China is the place to be, as it has 10 per cent of the world's GDP on a purchasing power adjustment. "Five and 10 years from now, the Chinese yuan will appreciate against the dollar and the pound. That's a bet I'm willing to make. For example, a Big Mac is $3 in New York, $4.5 in London and $1.31 in Shanghai. I'd rather bet on China than on value, small cap, or momentum." He does a weighting to smaller cap in China.
The other lessons are: "Use pound cost-averaging, rebalance yearly, costs matter." And his strongest message: "Do not try to time the market."
"Tying to time the market is one of the most dangerous things to do," he says. "If you do, you will invariably get it wrong."
"I wish I had sold in 2008 and gone into cash. But I don't believe in timing. You've got to be right twice. You've got to get back in again. No one can do this. When things recover they do so quite suddenly.
"Staying the course and just putting money in religiously, period after period, is the best strategy."
• You can buy A Random Walk Down Wall Street in the IC bookstore: www.investorschronicle.co.uk/bookshop
