Buffett versus the apes

It's now 30 years since the Princeton professor first published his seminal A Random Walk Down Wall Street, and Mr Malkiel is adamant that his investment advice has stood the test of time.

In an empowering book for individual investors, Mr Malkiel argued that markets are essentially efficient: any information about a company is already reflected in the share price. There's no such thing as a 'cheap' stock - you get what you pay for. Sometimes it will go up, sometimes it will go down, but there's no way to tell in advance which way it will go. So any person (or primate) picking stocks can do as well as any professional.

But in a blow to a generation of stock market tipsters, Mr Malkiel's research also suggested it was best not to pick any stocks at all. Although index funds did not exist at the time of his book's first edition, he argued that following the index was best - because it reflects the (generally) upward movement of the whole market. "It's really like looking for a needle in a haystack, and I prefer to buy the haystack," Mr Malkiel explains.

"I'm more convinced than ever that this is the right strategy," says Mr Malkiel, who met the IC at his office on the leafy campus of Princeton University, New Jersey. Whether it's chartists touting technical analysis or equity analysts basing their share price projections on hard-to-predict fundamentals, such as future earnings growth, the results are the same. "The evidence in market after market is that each year, two-thirds to three-quarters of active managers are beaten by the index, and if you compound that over 10 or 20 years, it's more like 80 per cent are beaten by the index," he says.

Transaction costs

This calls into question the transaction costs - whether it's a management fee or the brokerage costs, the bid-offer spread or the market impact cost. Mr Malkiel says: "The average difference between the actively managed funds and the index fund is about 2 to 2.5 percentage points a year, which is the difference in expenses."

Buying and selling stock picks is simply not a good idea, according to Mr Malkiel. And this is something that remains the case even if you don't believe markets are truly efficient. "Too much trading is really going to hurt you," he says. "There's a study I've done on mutual funds. We have 8,000 mutual funds in the US and there's a very clear correlation with the turnover: the higher the turnover, the worse the return."

Mr Malkiel points to the new academic field of behavioural science, which suggests markets and investors are really very irrational. And yet the conclusions are the same as his: "I'm an efficient market person, and the behavioralists think that markets make a lot of mistakes. But we really come up with the same advice: because the behavioralists also say people are overconfident, and that they way overtrade."

What then to make of fantastic IC share tips, such as Hornby or Gresham Computing? Any investor who bought Hornby at 210p when the IC first recommended it in August 2001 could have sold it at 1,063p last week. Punters holding Gresham Computing would have seen their investment rise 16-fold. "I grant you that in any period there are some people who win," admits Mr Malkiel. "But the people who win in one period aren't the ones who win in the next period. And there's no consistency." In other words, if the IC's tips have been brilliant sometimes, they may have been balanced out by not-so-hot tips at other times.

That's not to say there aren't extremely successful investors. As Mr Malkiel points out: "There's a Warren Buffett in the US."

But for Mr Malkiel it is Mr Buffett's active involvement with a company's management that explains the phenomenal success of Berkshire Hathaway. "It's not that Warren Buffett... bought stocks at low price to book value - it's not as simple as that," he says.

Mr Malkiel recalls meeting Katherine Graham, then chief executive officer of the Washington Post, when it was nearly going under. Its turnaround was one of Buffett's great success stories - but he didn't achieve it by just buying and holding the stock. "I said Warren help me, the place is going bankrupt," Mr Malkiel recalls Ms Graham saying. "I asked him to go on my board, I asked him to spend a lot of time in Washington and he straightened the whole firm out. We would have gone bankrupt without him."

"I think Warren Buffett is a great businessman, but his record was not because he was a stock-picker," Mr Malkiel argues. "He did beautifully with Geico... he turned the Washington Post around, but it's not just that he knows how to pick stocks. And, in fact, he doesn't move from stock to stock. Warren Buffett has said that the right holding period for a stock is forever."

Even at Salomon Brothers, one of Mr Buffett's unsuccessful investments, Mr Buffett was chairman of the board, Mr Malkiel points out. So for IC readers, looking to make their fortune by stock-picking, Mr Malkiel has some words of warning: "I would say that this is unlikely to be a successful strategy".

Indexing your portfolio

For him, stock-picking seems to be akin to putting down a few chips on the roulette table, good for a quick flutter, but not something you want to put your life savings into. "Investing is fun," he says. "And I don't think there's anybody interested in the stock market who doesn't have a bit of a gambling instinct. I buy individual stocks. But, in my retirement plan for my serious money, it's indexed. I fully understand the motivation [of stock-picking], but I would say at least index the core of your portfolio and then if you want to do some playing around the edges, that's fine."

He adds, of his own investments: "I don't think I do any better with the individual stocks than I do with holding my index funds, but I'm going to continue to do it because it's fun. And I know that telling somebody they can't beat the market is like telling a six-year-old kid that Santa doesn't exist. So I'm not going to tell anyone, by no means should you ever buy an individual stock."

Still, he argues that avoiding fees and transaction costs by taking a hands-off approach is more important than ever in the current environment. "The stock market in the US from 1982 to early 2000 had an 18 per cent rate of return. And Europe did very well in that period as well. My sense is that we're in a low-return environment now. Bond yields all over the world are much lower than they were. I think we're in a single-digit world. So if we are in a much lower return environment, then those extra expenses are really going to kill you."

But before you get depressed, Mr Malkiel does offer a scrap of excitement for diehard stock-pickers: the advent of exchange-traded funds (ETFs) that offer broad exposure to a particular industry. "Suppose you believe that it's now been a disastrous investment area for the past three years, but telecommunications is the field for the future, then I would say, 'Okay, buy an ETF that's in that industry'. And I would definitely have a broad-scale ETF as the core of the portfolio because at the very least that will lower your risk."

Now in his 70s, Mr Malkiel's wonderful irreverence for the world of Wall Street and stock market professionals still jumps out at you in the latest edition of his book. But, in the US at least, his heretical notions have, over the past 30 years, pretty much become orthodoxy. "At the beginning, it was really bad. My book was first reviewed by a technician in Business Week, who said this is the biggest piece of garbage that he'd ever seen in the world and it was just horrible," recalls Mr Malkiel.

"And I think at the beginning I was a real pariah. But I think it is now far more accepted than it was. I'm frequently invited to speak at investment conferences, and I think Wall Street has learned a lot from this." His wry sense of humour - and feel for irony - is in evidence when he points out: "And now that Wall Street has these ETFs - which are growing rapidly as products to sell - they're even inviting me to come and talk about why you should buy an ETF."

Index funds have also become common - pioneered by companies such as Vanguard, on whose board, it should be pointed out, Mr Malkiel has sat since 1977. "It's now quite an accepted concept in the United States, where about one-quarter of institutional money is either indexed or quasi-indexed," he says.

But Europe remains to be converted. Indexing is "a much more foreign concept in Europe", he says. "There's almost no indexing in Europe."

And yet, he argues that his findings are applicable in any stock market - whether developed or emerging. "Internationally it works just as well as domestically," he says. Ignoring a skew caused by an overweighting of Japan in Morgan Stanley's Europe-Asia-Far East (EAFE) index - which has now been corrected - the indices still beat professional fund managers. "If you look at the European part of EAFE and European managers, the index beat the Europeans hands down. And the Far East managers were worse than the Far East part of the index."

Indexing even works in emerging markets, some of which can hardly be described as efficient. Mr Malkiel explains that this, paradoxically enough, is the case because a variety of taxes and transaction costs makes buying and selling stocks in these kinds of markets particularly costly. "The evidence I have suggests that the Morgan Stanley emerging market index actually beats well over half of the actively-managed funds," he says.

Cogs in a wheel

So much for the usefulness of analysts and fund managers. In Mr Malkiel's universe, they are simply cogs in a wheel, needed because otherwise markets wouldn't be efficient, but with not much else to offer. "Do I think there are too many security analysts around? Absolutely," he says (in his book, Mr Malkiel isn't particularly flattering about their levels of intelligence either. He spent three years on Wall Street, so claims to speak from first-hand experience).

Not that investment banks are entirely redundant: they still have important capital-raising functions. Mr Malkiel says he tells his Princeton students who have offers from investment banks to go into corporate finance: "Go do something useful... there's too much research around."

In a non-politically correct comment in the post-Eliot Spitzer world - a world in which research is supposed to be unbiased and totally separated from investment banking - he is also of the view that: "To the extent that research guys are good, they're good because they bring new investment banking clients in."

Nor has Mr Malkiel finished his assault on the reputation of entire industries. He says he's currently working on a paper on the hedge fund industry, where, (surprise, surprise), "I am suggesting that a lot of the claims about how good hedge funds are, are actually wrong".

He points out that hedge fund data are significantly biased to show good returns, partly because of survivorship bias, in part because reporting is voluntary. "Suppose you decide you're going to start reporting your hedge fund because you want to get more money. You've been going for six years and the last three were very good - so you only put in the last three. When Long Term Capital Management went out of business, the returns for the last 10 months weren't in the database. So the numbers are severely biased upward."

So what happened to the chimpanzee, who featured on the pages of the Wall Street Journal for more than a decade, pitting his wits against those of industry professionals? "By one set of reckoning, the experts beat the darts," Mr Malkiel admits. But he argues that's because the Wall Street Journal started measuring from the day before the announcement of the experts' picks. The announcement itself, as experts outlined why they had chosen and why they liked a particular stock, helped drive up the price. "Suppose you took the prices not from the previous day's closing price, but from the opening price the next day, once the market opened and reflected the publicity. All the experts' advantage disappeared," he argues. The experts and the chimpanzee "came in about equal", he says.

What about the ultimate test: how Mr Malkiel's own investments have done. Is he a millionaire? Reflecting, perhaps, an academic's disdain for crass materialism he's coy on that one. "I don't particularly want to answer that question," he laughs. "I have certainly done okay."

Burton Malkiel's book, A Random Walk Down Wall Street - now in its eighth addition - is available from the investors chronicle bookshop:

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