Why Burton G. Malkiel is More Right Than Wrong
by Alexander Green, Chief Investment Strategist
Monday, July 12, 2010: Issue #1299
At FreedomFest in Las Vegas last week, I debated Burton G. Malkiel, author of the investment classic A Random Walk Down Wall Street.
Malkiel is one of just a few men alive who has profoundly affected modern investment thinking. And his position is straightforward.
He believes that rational, self-interested investors take all public information and immediately incorporate it into the price of stocks. (This is where we get the term "efficient market.")
He therefore concludes that market timing and security analysis is foolhardy... that it's simply not possible to beat the market over the long term... and that you'd be well advised to give up that dream and just own a broad selection of index funds.
I actually agree with much of what Malkiel says. Much... but certainly not all.
For starters, you can count on investors to be self-interested. But rational? Not always. Just take a look at recent history...
- How rational were investors 10 years ago when they bid Internet and technology stocks to the skies, forgoing sales and earnings for financial metrics like "eyeballs" and "web hits?"
- How rational were investors five years ago when they put themselves deeply in hock to flip land, rental properties, vacation homes and condos because "real estate always goes up?"
- How rational were investors when they dumped stocks en masse 16 months ago - with the Dow at 6,500 - and plunked the proceeds into money market funds just as yields reached an all-time low?
It's true that most investors behave rationally most of the time.
But it's certainly not true that all (or even most) investors behave rationally all the time. And that creates opportunity.
Let's take a look at another flaw in the "random walk" argument...
Get the Insider Advantage
Malkiel mentions that investors incorporate all "public information" into the price of stocks. But how about non-public information?
Most investors don't have access to non-public information, that's true. But that doesn't mean no one has access to it.
Some of the best trades I've ever made have resulted from visiting a retailer and asking the manager how regional and national sales are going. Are they supposed to talk about these things? Absolutely not. But do they?
Sometimes they do. Gaining a bit of key information by talking to customers, suppliers, competitors and employees can give you an edge.
And how about company insiders? Officers and directors have access to all manner of material, non-public information. That gives them an enormous advantage over ordinary investors. And that's also why Uncle Sam requires them to file a Form 4 with the SEC, divulging the details of their buys and sells.
If you watch what the insiders are doing, you won't access the non-public information that they possess. But you'll certainly know whether they think their companies' shares are overvalued or undervalued. And that's crucial information.
A 10-Year Market-Beating Performance
In short, Malkiel is right that it's difficult to beat the market. But does that mean it's futile to try?
Not only have men like Warren Buffett and Peter Lynch put the lie to that line of thinking, so has our own portfolio. The independent Hulbert Financial Digest confirms that we've beaten the market by a wide margin over the past decade.
But while Malkiel is wrong on some crucial points, he is absolutely right on several others. For example...
- He believes it's a fool's errand to try to time the market. I agree.
- He insists that an index fund will outperform the vast majority of actively managed funds over time. He's right. They have and almost certainly will.
- He argues that index funds provide a big performance boost due to cost-efficiency and tax-efficiency. Right again - and this is far more important over the long haul than most investors realize.
In short, I agree with Malkiel far more than I disagree with him. His research - and similar work by John Bogle, William Bernstein and others - has had a profound impact on the development of my own investment philosophy.