Animal Spirits Podcast - A Random Talk with Burton Malkiel

Episode Date: October 2, 2020

On today's show we sat down with Burton Malkiel, author of the classic book A Random Walk Down Wall Street.   Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions and the securities discussed in this podcast. On today's show, Ben and I spoke with Burden Malkeel. He's best known for a book that he wrote, a seminal book in finance called A Random

Walk Down Wall Street. He's also the chief investment officer for Wealthfront, who is one of the original automated online investment solution platforms. And thank you to Wealthfront very much for setting up this conversation. So, Ben, that was something. Yeah, we don't do a lot of interviews like this, but we couldn't really say no to this one because he is a monster in the industry. And it's kind of crazy to think that he wrote a book that basically laid it all out for setting up index funds. And I don't think Jack Bogland Vanguard necessarily took his advice to the T, but he saw it coming way before anyone else and apparently got a lot of blowback because of it. I can't imagine the amount of hate mail that he got at the time,

because he spoke about the idea of why you shouldn't really be picking stocks before index funds were even a thing. Right. So I actually told him respectfully that the first time I read this book, I probably got 20 pages in. I thought it was complete trash. I said, you got to be kidding. Why am I wasting my time reading a book on why you can't pick stocks?

I want to learn how to pick stocks, damn it. And then, of course, you know, some bumps and bruises later, I saw the light and I reread it probably, I don't know, two or three years ago, and boy, does it hold up. And I was dead wrong. Well, it's definitely a book, too, that causes a lot of emotions on both sides. some people throw up their hands and say, no way markets are efficient. This is crazy. It doesn't make any sense. And on our interview with him, he dispels some of those rumors and talks about what market efficiency really is and how, of course, markets aren't perfectly efficient, but that doesn't mean they're easy to beat. And that's the whole point of it, too. And his whole stuff about random walk and how he even mentions, like, I mean, a lot of it is probably just a good marketing play. Because like Tim Ferriss, he doesn't really mean that you should do a four-hour work week, but that name just stuck. And the same thing with Malkiel, he doesn't really think that everything is completely random, but a lot of the stuff that we think is happening for a reason is more random than people

give it credit for. You know, one thing I forgot to ask him, where did the name Random Walk come from? All right. That's true. We didn't get to that. Again, it was great, great marketing. Yeah. So I hope you enjoyed this conversation with Burnham Malkiel.

If you're interested in learning about Wealthfront, go to Wealthfront.com. And here is our conversation with Burnhamalkiel. We are sitting here today with Bert Malkiel, who wrote one of the seminal books of investing and has written a lot of stuff that has shaped our views on the world. So you wrote your first book, the first version of the book, published in 1973. And at the time that Dow was roughly 1,000, today it's over 27,000. If you include dividends, the S&P's up 12,000 percent in that time. I mean, did your original thesis get borne out pretty much as you? you expected? It absolutely did. I mean, basically, it was a book that praised equity investing

as a way of benefiting from the growth of the economy. And what it did was to recommend index funds. There were no index funds in 1973. And one of the things the book said was there ought to be one. I suggested that maybe the New York Stock Exchange would want to start one. The book was not well received in Wall Street. It was reviewed by a market professional in Business Week who said this was the biggest piece of garbage that they had ever read, that it was an absolutely crazy idea, that obviously you wanted professionals to manage a portfolio. Well, that certainly has been borne out because, as you know, within the mutual fund industry, there's more money in index funds than there are in managed funds, and the amount of

indexing is growing every year. You've now got ETFs that the biggest ones are all broad-based index funds. The ATFs are growing rapidly. Indexing has certainly taken off. And it has worked. Standard in Poor's publishes what they call SPIVA reports twice a year. The latest one covered results of active managers versus the index through the beginning of this year. And the results were basically every year, two-thirds of active managers are beaten by the index. In other words, the index fund does better. And the one-third who win in one year are not the same as the one-third who win in the next year. So that when it's compounded over 15 years, what Spiva reports find is that over 90% of active managers are beaten by the index.

So it's not that it's impossible to outperform. It is possible, but it's like looking for a needle in a haystack. If you try to go active, you might outperform, but the overwhelming odds are that you would do very much better with a low-cost index fund. That was my original thesis. And I'm very pleased because I think not only has it been borne out by the evidence, but it's also been borne out by the market in that the market is talking now and the money

is flowing into index funds, not because they're advertised widely, but because they work. So I first found your book when I was probably, I don't know, 23 years old or so. And the way that I found it was like a lot of young investors, I Googled Best Investment Books Ever. And yours is right at the top of the list. And I opened it up and I probably made it about 20 pages and I said, this is total garbage. There's no way that stocks follow a random walk. I don't believe it. And I'm going to go prove it wrong. Fast forward almost 15 years. And I reread it. And of course, you were right. Of course, everything you said, I had to experience on my own. And I think one of the reasons why I had such trouble digesting it as a new investor was this idea of randomness is so

hard to accept. Why is it in our nature to just reject this idea of a random walk? Well, because I think when we see streaks, those capture our imagination much better than the idea of randomness. We talk in baseball about so-and-so is such a streak hitter. So-and-so has hit safely in so and so many games. And we always think of Joe DiMaggio in the old times of hitting safely in 56 consecutive games. So that captures the imagination. What doesn't capture the imagination is the idea that, in fact, most of the time, there is no streak. Most of the time, it's absolutely random. And the psychologists have done this with basketball players. I mean, we always hear this in basketball. So-and-so is the streak shooter. If you've made a basket the last time,

you're much more likely to make it the next time. And when the psychologists then, and they've done this, they've done this with college basketball teams, they've done this with professional basketball teams. When you go and you do the statistics, you realize that it's not there, but what captures the imagination is, oh my God, Kobe Bryant, he's a streak shooter. We know that that's the case. So I think it's human nature that we reflect on the things that are unusual and we tend to think that they're far more usual than they are. It's not that there aren't some streets. But when you are flipping coins, it is possible if you just sat in your room and flipped coins, that you would flip ten heads in a row. And boy, when that happened, you would say,

wow, what a coin flipper I am. I am able to get heads every single time. So that's what we remember. We don't remember the fact that usually there aren't these patterns, there aren't these streets. And when the psychologists presented the material to the basketball players themselves, they didn't believe it either because they were convinced that in fact, once they had made a couple of baskets in a row, they were much more likely to make the next basket. So one of the things professional investors like to poke fun at is the idea of efficient markets. And every time you see a tiny stock that rises 2,000% in a day because of a piece of news that was totally uninvolved with the company and it shoots up because investors maybe got the

ticker wrong or something. They say, oh, see, there's no way markets are really efficient. What do these people get wrong about efficient markets? And what does that concept mean to you? Okay. I think what they get wrong is the idea that some people say that efficient markets means that the price is always right. If that was the way the efficient market hypothesis was stated, it's clearly wrong because we know perfectly well that the price is often wrong. In fact, I would say the price is always wrong.

It's just that we don't know for sure whether it's too high or too low. It's not that crazy things don't happen. it's not that in 1999 when you added dot com to your name that your price of your stock would double it's not that you don't have the same kinds of crazy things happening today in fact i'd say you almost have more of it happening today because as people have been stuck at home there's been a gambling pandemic. People are betting on sports more than ever. People are betting on the stock market more than ever. So it doesn't mean the price is always right. The price is always wrong. What it says

is that you and I, or at least I'll say it for myself, that I don't have any idea whether the price is too high or too low. And therefore, there's no reason to think, even though the prices are wrong of all the stocks that the tableau of prices that you see in the market isn't as good a reflection as what things are worth as anything else. Ben has gotten swept away in the gambling mania. He's pushed his asset allocation. He was in the 2050-5 target date fund. Now he's going out all the way into 2070. He's speculating like there's no tomorrow. So one of the biggest challenges to the efficient market hypothesis is the empirical evidence, that we've seen in price momentum. What do you think causes this effect and what do you think

the ramifications are for stocks really being a random walk? Okay. It's absolutely the case, and I admit this in the book, the market is not a perfect random walk. In fact, if you look at the mathematical properties of a random walk, you will find that market prices actually fail that. And they fail it for the reason you've just mentioned. There is some momentum in the stock market. Now, it's also the case that there are momentum crashes, that the things that did so very, very well, Tesla was selling at a very much higher price a few weeks ago than it is today. So there are momentum crashes that price of Tesla. stock is still very, very hard to predict, even though there is some momentum. So why is there

momentum? Well, there really are two explanations. One is that it shows you that markets are inefficient, that when news arises, it only slowly gets reflected in prices. That's the explanation that's anti-efficient market. The other one is simply that a stock is going up. That's what gets the headline. People are excited about it. You tell your neighbor, I just made 15% on my Tesla holdings yesterday. The neighbor runs out to buy Tesla and maybe makes money and tells somebody else. And it's cocktail party conversation. And there is this kind of flow of information and mimicking what somebody just said they made money on and it feeds on itself until something happens, which you can't predict, that then ends it.

But it is a psychological thing. It is the idea that particularly with social media, that these kinds of ideas get transmitted now very quickly from person to person. And it's, in fact, like COVID-19, it's an epidemic. And it works fine until it doesn't work anymore. So one of the groups that uses momentum, probably more than any other, is technical analysts. You have some choice words in your book about them. And I thought the funniest line you had in the whole book was that you always hear the excuse from technical analysts that the biggest problem is they didn't follow their own charts. How much hate mail have you received from technical analysts over the

years? And what do you think about any of the stuff that they do that is useful? Okay. The answer to your first question is yes. I've received a lot of hate mail. And as I said, the first review of the book was that it was garbage and there were still many, many people who thought this was absolutely wrong. Now, there are people who use it who are actually somewhat sophisticated. That is to say, there is a popular method of investing called factor investing. And the idea is you look at certain factors that at least statistically have been related to stock returns. And momentum is one of them. Now, I find in my review of these things is that relying on,

one or two factors has been, A, very dangerous, and B, while it may have worked in history, it's not clear that it works in the future. This is certainly true of two factors that are typically involved. One is, quote, the value factor, because it is true that over history value stocks have done better than growth stocks. And it's also true that small, stocks have had a higher rate of return than large cap stocks. So two of the factors are that we will look for these, tilt the portfolios in those ways. Somebody like Rob Arnaut, who does fundamental analysis, basically puts a value tilt and a small cap tilt in his portfolio. and, in fact, the last several years, he has underperformed and underperformed badly.

So what people now do is they say, okay, maybe that doesn't work all the time, but let's use a multi-factor model, because when value does badly, that's precisely the time when momentum does particularly well. So let's put all of the factors together. will do a multi-factor approach, and frankly, the multi-factor approach, where you don't just tilt on one factor, but you look at all of them, and since they're uncorrelated, it is possible that you might get a little less volatility in your portfolio by doing that. Now, the jury is still out, but clearly in terms of factor investing, if you want some kind of consistency, there has been a bit of it

with multi-factor models, there's been a bit of less volatility, and therefore a so-called higher sharp ratio, which is your return adjusted for volatility. And so the jury is still out. there have been some multi-factor funds that have actually done reasonably well, and I would point to dimensional fund analysis, which is a firm that does multi-factor investing, and they have had reasonable results. So again, I think the jury is still out, but if you're going to rely on momentum or you're going to say value is so cheap relative to growth now that I want to be a value investor. I say don't go to one of these, but maybe if you used a multi-factor approach, at least the

evidence is not that you're going to make an enormous amount more money, but you might have a bit less volatility because these factors are so negatively correlated with one another. So in 1973, when the first version of the book came out, like you said, there were no index funds. So what was your headspace like in 1975 when Jack Bogle and Vanguard launched the first index fund? And what was your relationship like with Jack Bogle? Well, I was actually in Washington at the time. It wasn't until I left Washington in 1977 that I joined the Vanguard board. So I will tell you that my relationship with Jack Vogel was always considered him a very close friend. I spent 28 years on the Vanguard board, and clearly Jack and I were soulmates with respect to indexing.

And I give Jack all the credit in the world because it's one thing for an academic to go and write and say there ought to be index funds. It's another for a guy to bet his whole company on index funds. And believe me, Jack was so criticized. And the first index fund, which is what Jack called the first index fund, was called Bogel's Folly. And everyone thought he was crazy. And he picked up just an enormous amount of criticism. and when I joined the Vanguard board after I came back from Washington, I used to kid with Jack that he and I were the only investors in the first index fund

because it was not a commercial success. You may know the story that they did this as an underwritten first offering, an IPO. They expected to raise $250 million. The underwriters couldn't sell it. They sold $11 million of the first index. fund. It was just an IPO that totally failed. And it remained a very, very small fund for years after that. As I say, Jack and I, it was a success. It worked, but it was not a marketing success. It really wasn't until considerably later that people started to realize, hey, wait a minute, this kind of low-cost

idea of you buy the market at low cost really works. And then it actually eventually took off. And I think we now have ETFs. We have the index providers like standard and fours, publicizing how well it works, and the rest is history. Believe me, it was roundly criticized at the beginning. And it was not a commercial success for years. So you could argue that the stock market for people who are saving and investing for retirement or any other goals is arguably never been as important as it is today because there's effectively zero yield on high quality bonds. What are some of the unintended consequences of this for investors? And what are they supposed to do? Because I think you could argue this is maybe the hardest environment we've ever had to invest in because there's no safe yield anywhere.

I think that is absolutely right. and you had mentioned earlier in this interview, the target date funds, and frankly, one of the reasons why I am not very enthusiastic about a lot of the target date funds is that they do still use a lot of bonds, and you're absolutely right that bonds do not give you a positive yield today. the 10-year treasury yields 0.66% as of the moment. Inflation is running near 2%, which means after inflation, you have a negative yield. In Europe, more than half of the bonds traded in Europe, and also in Japan, have negative nominal yields. So even larger negative real yields after inflation, and it's very, very very, tough. And my own view has changed and changed over time that I think that bonds, the role of bonds in the portfolio is really something that has to be reconsidered and needs to be a far smaller

proportion than previously thought. I mean, Jack Bogle had this idea that maybe your proportion of bonds ought to equal your age. So if you were 60, you ought to have 60% in bonds. If you were 80, you should have 80% in bonds. I don't think that works anymore. So what do you do? Well, I think one thing that one might do, and it's something that I have recommended, is that for the safer, more stable part of the portfolio, maybe the thing that one ought to do is use some bond substitutes. And one type of bond substitute might be blue chip companies that have very good dividend yields where there's clearly going to be somewhat more volatile than actual fixed income securities, but they will give you some more stability and they will at least give you some

rate of return. What kinds of companies am I talking about? Well, something like IBM that has about a 6% dividend yield. Kraft Heinz, about a 6% dividend yield, AT&T. These are stocks. They're not as volatile as most stocks. And I have recommended that for the bond part of the portfolio, maybe one thinks of a surrogate bond portfolio, of maybe a portfolio, a diversified portfolio of high dividend stocks will give you at least some of the stability and at least a rate of return that is meaningful. You said that you've changed your mind. on bonds, and I assume that's obviously a response to where interest rates are. I wish we were living in a world with five, six percent yields, but we have to invest as the world is not as we wish

it to be. What other ideas have you changed your mind on over the years, if any? I would say that that is maybe the most important change. I think I would also say that very frankly, my views about indexing have gotten stronger. And particularly if you live your whole life working on markets, you really need to be very modest about what you think you know and don't know. I'm really now absolutely more and more convinced that indexing and low cost is the way to go, that I often say the only thing I'm absolutely sure about is that the lower the fee I pay to the purveyor of the investment product, the more there's going to be for me. And I am absolutely convinced of that. And you know, you had mentioned Jack Bogle earlier. I'm very fond of one of his lines

that I often quote. And that was, in the investing world, you get what you don't pay for. So I would say that's been not really a change because I believe that 30, 40 years ago, but I believe it even more strongly today than ever before. I would say one other thing that I think particularly now, where it's not popular, I mean, we're so anti-international now. It seems that both parties in the election are fighting with each other as to who's harder on China than the other. And there are a lot of people who wouldn't touch emerging market equities. But right now, in terms of valuation metrics, foreign markets are much cheaper than U.S. markets. Emerging markets, while the valuation metrics for the U.S. are among the highest they've ever been,

the valuation metrics for emerging markets are among the lowest they've ever been. And I would say that today I am much more positive. I've always been for broad diversification. I've always been for international diversification. But I would think today, if you have no international stocks in your portfolio, and if you have no emerging market stocks in your portfolio, you really ought to reconsider it because they are cheaper than any other stocks and they deserve a portion of the portfolio. I love in your most recent edition of the book how you talk about all the things that didn't exist in 1973. So of course index funds didn't, which you were a proponent of being created, but you talked about how there was no Roth IRAs or 529 plans or smart beta strategies and all

these other things that are just relatively new. So is there anything else that you see could help people, or do you think investors have enough tools today to help them accomplish their goals? Well, I think the other thing that is new, and this was one of the few things that Jack Bogle and I disagreed on, the other thing that is new is the exchange traded fund. I was a governor of the American Stock Exchange, and I chaired the New Products Committee when we brought to market the first ETF, which was the spider. And that now is a really big deal. And ETFs have certain tax advantages. And ETFs now have been competition, has brought the management fee down essentially to zero. It's certainly the tool that people have. That's the way to go. And you buy them through a

discount broker and you pay no commission, that is a change, and that is an additional tool. Now, Jack headed ETS. He would say, why do you want to buy the market at 10 o'clock in the morning and then sell it at 1 o'clock in the afternoon? You'll cut your throat with it. And I would say to Jack, well, look, you don't think that's a good idea, and I don't think it's a good idea. But people are going to do it anyway. If they do it with an ETF, at least they're not going to create costs for the other shareholders. If you do it within the context of a mutual fund, they could create tax costs and other costs for shareholders.

So it's not that I think you ought to go and speculate with them, but for the long-term investor, it's a wonderful tool. It's a new tool, and people absolutely ought to use it. If I could just mention one other thing that this interview was arranged by Wealthfront, where I serve as the chief investment officer. And what we do is we put together portfolios, diversified portfolios of index funds. We tax manage them.

We rebalance them. We do this for an overall fee of 25 basis points, one quarter of 1%. And the next revolution that I see in investment management is going to be the revolution for advice. Most investment advisors today charge 1%, 2%, 3% to manage your portfolio. When it's done online by a firm like Wealthfront, it's a quarter of 1%. This is the next revolution of reducing expenses

and is, I think, something that all investors ought to consider. We'll certainly link to that in the show notes. This has been such an honor. We've learned so much from you over the years. Thank you so, so much for coming on and speaking with us today. Thank you very much. All right, thanks again to Wealthfront. Thanks to Bert and Malkill for doing that.

That was an honor. Really, definitely a conversation that I never thought that we would have the opportunity to have. If somebody told you 10 years ago that you would be interviewing Bert Malkill, probably wouldn't believe him. Yes, exactly. Yeah, that was one of the, like you, it was one of the first book I ever read. So that was definitely pretty cool.

Check it off the list. All right, Animal SpiritsPod at gmail.com. Thank you for listening. Have a great weekend, and we will see you on Wednesday.