Graham Hand: Thanks for signing my copy of Random Walk. Note it is the sixth edition from 1996 so I didn’t just buy it for you to sign. And your book’s now into its 10th edition.
Burt Malkiel: And I’m about to start working on the 11th edition.
GH: Can you tell me what’s changed in investing over the decades since the first edition?
BM: What’s changed is that the first edition, there were no index funds. First edition was in 1973, the first index fund was in 1976. It is meant to be an investment guide, and there have been dramatic changes in the kinds of instruments available to investors.
There are three major things I do in different editions. One, the new instruments available. For example, more recent editions have featured ETFs. Two, the changing regulations like tax laws facing investors. Then finally, the academic research over the period. Two things I will put in the 11th edition are the low volatility products available, and I think that option writing is interesting. I have some colleagues who have done fascinating research that they can replicate the hedge fund index and get 300 to 400 extra basis points by writing puts. You’re basically selling insurance.
You know, in the early days when I said “Just go and buy index funds”, I had a reviewer say in Business Week, “This is the biggest load of garbage”, so I keep saying, “I said go buy index funds, did it work?” and every time I look at the last four or five years, yes it did work. The book has changed a great deal, but the basic message hasn’t changed, even if the advice on what to use has changed.
GH: If I look at some of the criticisms of the book, where people say there are some managers who have had long-term success outperforming the market, but as I read your book, you acknowledge this. For example, in my edition it says, “I walk a middle road. I believe that investors might reconsider their faith in professional advisers, but I am not as ready as many of my academic colleagues to damn the entire field. While it is abundantly clear that the pros do not consistently beat the averages, I must admit that there are exceptions to the rule of the efficient market. Well, a few.” So you’re not just an efficient markets person.
BM: And that was actually another change. I’m not saying you should necessarily index everything, but there’s enough evidence in favour of it, the core of your portfolio ought to be indexed, and then if you want to trial something active around the edges, you do so with much less risk. But just remember, there is this distribution of returns (Burt draws a normal bell curve, then a vertical line near the y-axis representing 1% fees) and if there were no fees, half would be above and half would be below. If you can get the market return, the typical active manager will be 1% less than the market. You’re much more likely to be on the negative side of the distribution with active managers. But you can definitely try it.
I will also be writing about financial repression in the next edition (GH comment: this is where the government interferes with free market operation). I would not buy a bond index fund today.
GH: It’s really interesting to hear that because if we focus on asset allocation rather than manager selection, how do you feel about the various investing models that are recommended to retail clients, say invest 70/30 and stick with that.
BM: There’s no question that in my advice to the Princeton widows, they want to be able to draw some income out without having to sell all the time. They want to do it easily. I don’t want them to get their income from a US bond portfolio, they should get it from emerging markets bonds where there’s no financial repression, or in dividend growth stocks, which takes me back to a low volatility strategy. This is asset allocation, but I don’t feel badly about doing it. If there’s somebody in retirement who wants income, yes, I don’t want them to buy Google and Facebook, I want them to buy a particular type of stock, but that’s fine.
GH: And you also don’t want them to buy a bond yielding 1%.
BM: Exactly, because I think they’re going to get killed.
GH: So in that situation, the so-called lifecycle funds with an increasing allocation to the bond market …
BM: I don’t like them, that’s another thing going into the next edition. I’ve been a director of Vanguard, I’m on the Vanguard International board now, but I don’t like lifecycle funds because at the end, they’re putting 80% into precisely the securities that I think are going to give people an enormous amount of trouble.
GH: Let’s turn to Wealthfront, which looks like it’s gaining some good momentum.
BM: It’s amazing. As I said in the panel discussion, I’m not sure about a lot of things, the only thing I’m absolutely sure about is that the lower the fee I pay, the more there’ll be for me. So what we do at Wealthfront is we’re using the lowest cost ETFs, we are also charging a wrap fee for doing the asset allocation of 25 basis points. So it’s kind of ‘Vanguardising’, if you wish, the advice business. I have been with them since the end of 2012 and they’ve got $210 million of assets from almost nothing in that time. They are doing this using a lot of technology – we’re not going to hold your hand, you can’t do that for this price – and the marketing is done through e-invites, the clients are from places like Google and Facebook and Salesforce and they are happy to be serviced online. I don’t think my Princeton widows would be comfortable with this approach, and if you want to pay more for advice, fine if there’s someone who will hold your hand.
GH: I assume there’s some process of risk assessment.
BM: Yes, we use some of the expertise from behavioural finance people, Meir Statman was one who helped us design the questionnaire so it’s not simply age. That’s too simple, people are all different. There are people for whom a very aggressive portfolio makes them sick to the stomach when it goes down.
GH: They can’t sleep at night.
BM: More than that. They can’t sleep at night, but one of the things we know about the mistakes people make is that they’re more likely to sell when the market falls. They can’t take any more. When people try to time the market, they usually get in at the top and get out at the bottom. You see it with mutual fund flows, you see it with pension funds. Are we doing it perfectly, probably not, this is not an easy thing to do. We have added people who know something about survey techniques, people who know behavioural finance, we get the questionnaire filled out and then we put people in particular buckets.
Just to give you an idea, I’m a client, and given my age, they had me in a safer portfolio than I wanted to be, and I said you can’t just do it with age because I’m not investing for myself, I’m investing for my grandchildren. It’s the horizon of the people you are investing for.
GH: Given your comments about low bond rates, if someone profiled as conservative, where do they go?
BM: As I said, the bonds we are using are bonds from countries not engaged in financial repression, have younger demographics, have reasonable interest rates, low debt and better fiscal balance. I am the Chief Investment Officer and I design these things for exactly the reasons we discussed earlier.
Let me tell you the other things we can do. We do rebalancing with an automatic formula, and for taxable accounts, we do tax loss harvesting. Let’s say you’ve got a US equity position, and the equity has gone down. We’ll sell the Vanguard ETF and buy the Schwab ETF, it is essentially the same thing but it’s not a wash sale when you do it that way, and take the tax loss, and particularly for the clients we have now, they can use the tax loss because their portfolios might be 98% in Facebook stock which they will be taxed on. This works well.
GH: One last question. You said recently, “We should be modest about what we actually know.” Do you have any feeling of disappointment about progress we’ve made in investing. If I were a surgeon or a pianist, after 35 years, I’d be very good.
BM: I think the reason we have not made much progress is that it is probably one of the most overpaid professions there is. It’s an inefficiency, with investment professionals paid regardless of the results. I’ve been an educator, and I just try my best in everything I do. I went to Wealthfront because I like the idea of doing good for humanity and I get paid in stock and I might do well financially at the same time. The real problem with us making enough progress in our industry is the misaligned incentives. But now, at least there’s a lot of competition in ETFs and fees have been driven down to close to zero.