Burton Malkiel on Tech | Ticker

Burton Malkiel on Tech | Ticker

Source: Tech Ticker

Burton Malkiel – Transcript January 7, 2011


Burton Malkiel: “Markets Aren’t 100% Efficient But You Still Can’t Beat ‘Em”

Gross: We’re joined today by Burton Malkiel the Author of “A Random Walk Down Wall Street”; now in it’s 10th Edition and has been in print for 40 years, more than a million and a half copies sold. This book completely shook the world when you published it in 1973.

Malkiel: Well, it’s interesting. It was really thought of a being the silliest idea in the world when it first came out and yet now I think Wall Street has caught up with the idea. The idea was most investors would be much better off simply buying and holding a low- cost index fund and now we’ve had this burgeoning of exchange-traded-funds which are index funds and so I think in some sense what was just a ridiculous new idea is now, ETF’S are taking over share from mutual funds.

Blodget: It’s almost gone mainstream, look at the performance of mutual funds over the last forty years, it’s clear that the low cost index funds like Vanguard’s have a huge advantage over the other guys. I think one thing that always stops people about the title though “A Random Walk”, is it sounds like you’re saying that stock prices move completely randomly, that it’s for no reason at all that they could go up or down and I think a lot of people would say “no, no, they do track fundamentals over the long haul, it’s not random, they do wander around but they’re wandering around a fundamental trend. So what are you saying?

Malkiel: That’s a very good point. What this means is it’s not that stock prices are capricious, and in a sense quite the contrary, it’s when news arises the stock market really reflects that news very quickly without delay. But true news is random. That is to say if you see a headline “Stores on Madison Avenue having Post-Christmas Sales”, that’s not news, we could have written that six months ago, a year ago, three years ago. But if in fact North Korea aims some rockets at South Korea and that scares the world, that’s news but true news is random and what you mean by random is simply unpredictable. And essentially what the random walk idea is, don’t think you can predict the short term ups and downs of the market, it’s essentially unpredictable, not capricious, but unpredictable because true news is unpredictable.

Gross: And you say one of the kind of basic points of this is that you can’t beat the market, we sort of know that, the average actively managed fund trails behind the broader index as passive and yet we still, all around us, have this gigantic industry and industries of active money management, people who are looking to beat the market on their own, in their funds, hedge funds, asset allocations, why does this persist?

Malkiel: I think for two reasons. First of all, telling someone that you can’t beat the market is like telling a six year old that Santa Claus doesn’t exist. We all want to try to do this. Look, I index most of my investments but investing is fun and I buy some individual stocks. The second reason and the more fundamental one is that, in fact, people make money selling you actively managed funds. The average actively managed fund has an expense ratio of plus to 1 percentage point a year, it’s a darn good business and that’s why you have it. And so, Wall Street in some sense wants to ensure that you tell people “this is too complicated, you can’t do it yourself”. The fact of the matter is you can do it yourself, do it very easily. And that’s one of the reasons why I wrote the book, I think you can do it yourself, you want to have some fun buying some individual stocks, go ahead, do it. But you can do it then with much less risk if the core of your portfolio is in low expense, very broadly based index funds.

Gross: To a large degree this is sort of a brief for the “Efficient Market Hypothesis”. The notion that all the information that gets out there is processed into the stock prices and aren’t just sort of pennies waiting to be picked up. But the “Efficient Market Hypothesis” has taken something of a beating in recent years, not just with the spectacular bubble we had but also with the work of the behavioral economists who are looking at irrational behavior and how that affects things. How do you think the “Efficient Market Hypothesis” holds up?

Malkiel: I think it holds up very well. The “Efficient Market Hypothesis” does not mean that prices are always right, how could they be? I teach a course in financial markets, I teach my students that the fundamental principle of valuation is that a stock ought to be worth the discounted present value of the whole stream of cash flows, future cash flows, and that’s the key word, future. Who knows what the future is going to be. The market is efficient enough so that it’s unbeatable and the fact that every time I do the book I say, okay, did it work, I do a new edition every three or four years, and every time I do it two-thirds of the active managers are beaten by the index and the ones who win in one period aren’t the same as the ones who win in the next period.

Blodget: And if you look at it over the long haul, it’s a tiny percentage of managers that actually deliver over decades market beating returns. So given that, as Dan was saying earlier, turn on the CNBC, it’s a parade of people who evidently think they can do, obviously they’re getting paid, they know your research, they know the facts. Are they dishonest or are they deluding themselves?

Malkiel: Well, I think actually, and this is what we have learned from behavioral finance, people really do believe that they live in Lake Woebegone, that they are better than average. I think that something in human nature, to believe, actually maybe we’re fooling ourselves, but I think in some sense it’s not necessarily dishonesty as delusion.

Blodget: And it’s a delusion they’re getting paid quite handsomely for.

Malkiel: When you’re getting paid handsomely to do it, it’s very easy to be deluded.

Gross: Right, exactly. We should all have such well paying delusions.

Blodget: Thank you for sharing with us.