Finally we arrive at the hallmark of Malliel’s investment strategy: invest in low cost index funds in the broad market rather than relying on professionally managed funds who can point back at their superior results. Why: the index does better than 85% of such funds and you cannot know who will beat the market in advance. Much more often than not, yesterday’s hot funds, underperform versus the market today. Read on.
Malkiel’s Rule 8: Bow to the Wisdom of the Market
In this chapter is the second foundation for his core investment strategy recommended in the book. The first foundation from Rule 7 is that “costs matter”. In Rule 8 he works to persuade us that market is smarter than not only non-professional investors (not difficult for me to accept) but also the “experts”. He says that 90% of the money in the market is invested through such advisers despite the fact that those investment underperform versus the market as a whole.
Again, he quotes Vanguard founder Jack Bogle: It’s time to face reality: There is no evidence that research – even the research of the Institutional Investor all-stars—adds value. Academic studies only confirm what we all believe: The stock market is highly efficient, and that stock princes incorporate virtually all information. As I’ve often said, “Never think you know more than the market. Nobody does.”
Malkiel goes on to explain why. When news arises about a company, an army of profit-seeking Wall Street professional on it rapidly, driving stock prices up or down depending on the news. He says when we read it or hear it, it is likely already reflected in the market.
Further he says this news is random and unpredictable. “And so market prices (except for the long-term up trend reflecting growth in the economy) move like a drunkard meandering down the stream. This is what financial economist mean when they say the stock-market prices in an efficient market behave like a random walk.” [Thus the name of the book.’
If you recall his first basic point, fire your investment adviser, it is based on this efficient market theory. As the experts can’t predict things any better than the market, it is best to just invest in a low-cost index fund (see next chapter for specifics).
Does this mean the market never make mistakes? No, the internet bubble of the year 2000 is an example of mass insanity of the market. But such incidents are rare and cannot be predicted either.
Having read and embraced this idea, I still wondered if there might be a way to see the big patterns of bull and bear markets and know when to get out of the market for each least some of the bad periods (bear markets). His section “Timing Isn’t Everything” addresses this. He says no one can time the market. He quotes Bernard Baruch, famed investor, who says, “Only liars manage always to be out during bad times and in during good times.” He backs this up with some statistics that a significant amount of the growth in the market occurs in small windows of time, some of which is in the “bad times.” He quotes Charles Ellis, “Investors would do well to learn from deer hunter and fishermen who know the important of being there and using patient persistence – so they there when opportunity knocks.”
Ok, I guess I am convinced (I think; I still might change the stock/bond ratio if I am convinced we are heading for a rough time).
Here are the summary statistics that say the index fund win over the professionals:
- over 10 years, 84% of professional managed funds are beat by the index (e.g. S&P 500); over 20 years, it is 88%.
- Over 10 years, the S&P 500 gained 9.27%/year, the average professional managed fund gained 7.18%. Over 20 years, the spread is even greater.
Why? Expenses drag down the performance of professional managed funds.
Next he addresses the question as to whether there are managers that beat the market consistently. He says that some managers do for a time but they do not do it consistently. He says there is no way to know the best manager in advance; it is only looking back that we can find them. [He addresses the lone exceptions or two in the last part of the chapter.]
He demonstrates that chasing hot performance (using managers who have done best in the most recent two-year period, 5-year period, 10-year period or those listed on Forbes Honor Roll or Morningstar’s 5-star funds) does not beat the market. He quotes Jonathan Clements on this point: “When an investor says ‘I own last year’s best performing fund’, he usually forget to add, ‘unfortunately, I bought it this year.’”
Finally, he spends the last part of the chapter on the Warren Buffet exception. In the end, he says you will never know in advance who the winners will be.
I find this pretty compelling logic and research here. My remaining question: are there not broad segments of the market I can buy into and stay in that beat the market as a whole? Perhaps the answer will be in the next chapter.
Next time: Rule Nine: Back Proven Winners Model Portfolios of Index funds.
The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.