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Random Walk Redux
Landmark investing volume still holds up 35 years later
"A blindfolded monkey throwing darts at a newspaper's financial pages could
select a portfolio that would do just as well as one carefully selected by the
experts." Imagine the scornful reception this premise received back in 1973.
Burton Malkiel's strongly worded viewpoints, expressed in his pivotal investing
treatise, A Random Walk Down Wall Street, were about as welcome as fire ants at
a family picnic.
Eight editions, a million copies, and thirty-five years of market results later,
Malkiel's opinions are still an irritant to fundamental and technical analysts and
much of the mainstream investment establishment. Nonetheless — his bold and
colorful language aside — the central plank of Malkiel's platform has shown to be
completely sound. Malkiel, a Princeton finance professor, describes the
movement of stock prices as a "random walk in which future steps or directions
cannot be predicted on the basis of past actions."
This simple random walk assertion, strongly supported by decades of empirical
data, confounds the notion that a smart investor or analyst can recognize a stock
that is more likely to rise than fall. Like a coin flip, each move in a stock's price
is independent of all previous moves.
The random walk is closely aligned with the efficient-market theory, which says
that any information that could provide an advantage in picking stocks is so
quickly (efficiently) reflected in stock prices that trying to make any stock
choices based on new information is pointless. As Malkiel states: "Investors
would be far better off buying and holding an index fund than attempting to buy
and sell individual securities or actively managed mutual funds."
Clear evidence
Malkiel was brash in his assertions. And clearly on target. With each Random
Walk edition he points to a longer history of stock returns that support his
theory. As he predicted, the S&P 500 index has outperformed the average active
manager by more than 50 percent over the last 38 years. Ten thousand dollars
invested in 1969 in the S&P 500 is now worth $422,000, versus $284,00 for the
average actively managed mutual fund. Furthermore, in the after-tax real world,
where individual investors live, the index triggers a much smaller tax tab than
the actively managed portfolio. The difference is too vast to ignore.
Buying and holding market-matching indices is not very exciting. But the payoff
has been exquisite. The average stock market performance over the last 80+
years has been a 10% annual return. That means that, on average, money is
doubling every seven years, and multiplying eight times every 21 years. Those
who want even higher potential returns can seek riskier investments like
emerging markets and distressed situations — these are available as indices too.
With so many index instruments available, working hard to beat the averages
seems of little incremental value, especially when taxes are considered.
Simple, powerful advice
So what does Malkiel recommend for the individual investor? Despite all of the
technology changes since his first edition, his fundamental suggestions are as
relevant today as during the early 70s. His recommendations include:
Index heavily — A broad index is likely to outperform a portfolio of securities
selected through some kind of analytical technique. Malkiel asserts there's just
no evidence A) that an active money manager can beat the market over an
extended period, or B) that an investor could reliably pick a genuine
outperforming manager if one existed.
Beyond the significant implications of efficient markets, high expense charges,
trading costs and capital gains taxes can severely erode actively managed
returns. (See our March 2007 article: "Fees Matter: How investment costs drive
bottom line results" and our May 2007 article: "Tax Efficient Portfolio
Management: Keeping more of what you make".)
At OCM, we recommend that clients rely on indexing for a majority of their total
portfolio, turning to active management only when indexes are not available
(e.g., municipal bonds) or where specialized knowledge or access is important
(e.g., private equity). And actively managed assets should be relegated to tax-
deferred accounts, such as 401(k) plans.
Accept and use the efficient market — "The market prices stocks so efficiently
that the chances of using professional winners is a fool's errand." Fundamental
analysts are tripped up by random unpredictable events — breakthrough
products (iPod), natural disasters, war, defects, and scandals (Enron).
Even Warren Buffett, possibly the greatest active manager of modern times,
favors low cost index funds for most investors. As he said at the most recent
Berkshire annual meeting, "A very low cost index is going to beat a majority of
the amateur managed money or professionally managed money." At OCM, we
think this is especially true on an after-tax basis. We have never seen a
documented case of an active manager beating the Dow or S&P on an after-tax
basis over a generational (20 year) timeframe. What we have seen supports our
strategy of buying and holding these mainstream indexes.
Use the changes — When Random Walk was in its first edition, being an index
investor was a lonely endeavor, with few index funds available and Exchange
Traded Funds (ETFs) still 18 years off. Now investors have hundreds of index
ETFs and index funds choose from. Index instruments are now available that
track not only the major exchanges, but also countries, continents, industries,
currencies and so on. Investors can now enjoy the benefits of indexing across
almost any asset class.
Know thyself — Understand behavioral finance —
why people invest the way they do. Overconfidence,
biased judgments, herding, loss aversion and
impulse buying can subvert any strategy. Many
poor investment decisions relate to risk. It is
important to understand that risk can be managed
in two primary ways — through time and through
asset allocation. Longer holding periods have shown
historically to reduce risk, and so does a prudent
distribution of money across different asset classes. Reducing volatility can be as
simple as increasing the allocation to bonds, rather than seeking some magic
combination of active managers.
Practice common sense — When it comes to common sense, diversification is at
the top of the list. An avalanche of books, articles and research studies preach
the proven benefits of diversification. Still, many portfolios fail to take
advantage of spreading assets across domestic, international, emerging markets,
REITs, bonds and other classes.
Know the score
Based on the wisdom of Malkiel and other index advocates, we encourage
investors to gauge the performance of their own portfolios against relevant
indices. Ask for benchmark indices to be added to your quarterly performance
reporting for comparison purposes. Check your performance — apples to apples,
and after-tax — against the indices to see if you are getting what you pay for.
OCM can help you do this analysis if you like.
John Osbon, Chief Investment Officer
June 2007
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