Guest User

May 11, 2023

Episode 252: Prof. Burton Malkiel: 50 Years of A Random Walk Down Wall Street

Guest User

May 11, 2023

Mr. Malkiel is the author of A Random Walk Down Wall Street, 50th anniversary edition, 2023. He is the Chemical Bank Chairman's Professor of Economics Emeritus at Princeton University and was the Dean of the Yale School of Organization and Management. He served on the President's Council of Economic Advisers.

Understanding market efficiency is an important part of investment decision-making. It can help investors to identify the most appropriate investment strategies and develop realistic expectations for their returns. In this episode of the Rational Reminder Podcast, we sit down with Professor Burton Malkiel, the renowned economist, and author of the classic investing book A Random Walk Down Wall Street. Professor Malkiel is a distinguished figure in the world of economics and academia. He holds the prestigious title of Chemical Bank Chairman's Professor of Economics Emeritus and Senior Economist at Princeton, where he has made significant contributions to the field over the years. In our conversation, we discuss Professor Malkiel’s views on the stock market, the efficient market hypothesis, how behavioural finance relates to investing, and why index funds should be at the core of every portfolio. Throughout the episode, Professor Malkiel shares his insights on a wide range of topics related to personal finance and investing, including the benefits of index funds, the dangers of active stock picking, the impact of fees and taxes on investment returns, factor investing, and expensive asset classes. He also discusses research on socially responsible investing and how investors can incorporate ethical considerations into their portfolios without sacrificing performance. In this episode, listeners will gain a better understanding of the vital principles of investing and how to apply them to achieve their financial goals. Whether you're a novice investor or an experienced pro, this episode offers valuable insights and advice from one of the most respected economists in the field, Professor Malkiel.

Key Points From This Episode:

Professor Malkiel explains the efficient market hypothesis and what the term “efficient market” means. (0:03:42)
What the media tends to get wrong about the concept of market efficiency and the mathematical theory behind a random walk market. (0:07:04)
We discuss investing in index funds rather than actively managed strategies. (0:09:44)
How his book, Random Walk, was received by professionals and academics in the industry (0:13:08)
Hear about the inspiration behind the concept covered in his book, and how his investment advice has changed over the last 50 years. (0:19:18)
Why index funds have become widely accepted, and the difference between investing and speculating. (0:23:38)
He unpacks why past market bubbles are vital for managers to understand and shares some wise words for those who want to participate in market speculation investing. (0:28:21)
How the existence and persistence of bubbles throughout history relate to markets being efficient. (0:32:10)
Find out how the multiple, non-diversifiable risks in today’s financial markets impact the advice in his book, and learn about factor investing. (0:35:42)
He shares advice and insights for people looking to invest in cheaper funds and his perspective on trending investment strategies. (0:37:55)
Learn how the general findings from behavioural finance influence his advice on investing in index funds. (0:41:33)
We explore the value of risk parity strategies and the problem with backtests, and he shares his view on expensive asset classes. (0:44:09)
What impact super-low bond yields had on the return of bonds, and whether you should focus on the value or yield. (0:54:16)
The importance of saving as opposed to an optimal investment strategy to investor outcomes. (0:57:56)
Insights into investing according to your desired outcomes and whether Professor Malkiel thinks it is better to rent or own a home. (1:03:55)
We discuss inflation and possible future trends and the role of financial planners and investment advisors. (1:10:29)
Hear his concerns regarding the growth of index fund assets. (1:14:52)
Details about his book writing journey and his definition of success. (1:18:46)

Read The Transcript:

Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 252. Pretty special week this week, Ben. And we welcome Professor Burton Malkiel who is an absolute legend in our business and investing in general. And we've some notes about our intros that I think people know by now that our intros are not scripted. And at the end, when we were wrapping up our conversation.

Got me thinking about the first time I read his book back in the 90s and the impact that book had. But you think of the career that Burt has had, it is incredible. His book is incredible, obviously. He just released his 50th-anniversary edition, the 13th edition of the book. Sold over 2 million copies of his classic book, A Random Walk Down Wall Street.

His message from day one – and the book came out before index funds were available. Three years before they were available. Which is incredible to me, right? And his investment advice has been simple all along. Investors would be far better off buying and holding index fund rather than attempting to buy and sell securities or actively manage mutual funds. The book was ahead of its time. And he hasn't wavered a bit in 50 years.

Ben Felix: Well, he's had no reason to. And he talked about why. When he wrote the first edition, academia was starting to find that active managers weren't outperforming. But it was not widely accepted. And as he talks about in our conversation, he was heavily criticized when the first book came out. But then since then, the evidence has continued to mount. The academic research has continued to cover the topic and show similar results. His conviction, as he explained to us, has only gotten stronger over time. Even though they're in the early days, he said his conviction was never shaken. But since then, it's only gotten stronger that index funds are the way to go.

Cameron Passmore: A bit of his bio, which is simply unreal. He's the Chemical Bank Chairman's Professor of Economics Emeritus and Senior Economist at Princeton. And he's a former Dean of the Yale School of Management. Get this, he was a member of Gerald Ford's Council of Economic Advisors. Then left to join Vanguard's board. Pretty cool, right?

He's also formerly the Chair of the American Stock Exchange's New Product Division, which created the ETF. He's also an investment banker at Smith Barney. And for those who remember our interview with Robin Wigglesworth, Burt was one of the main characters in his book Trillions.

Ben Felix: Oh, yeah. He's been right in there since the early days of the index fund revolution.

Cameron Passmore: He also serves on the board of Theravance Biopharma and Genmab A/S. He's the Chief Investment Officer of Wealthfront, which provides robo-type advice, and computerized low-cost portfolio management services. He's also an advisor to Rebalance IRA, which provides a similar service for individual retirement accounts.

He chairs the investment committee of Wavefront, which is an individual management firm focused on China and other emerging markets. Often in the Wall Street Journal, Financial Times. And he's everywhere. He's incredible. Absolutely incredible career.

Ben Felix: Yep. And his book, which this new edition just came out. And we talked about the book quite a bit. But the book is – it's one of the foundational books of smart investing. It belongs on that bookshelf of a good financial decision-making.

Cameron Passmore: I agree. Ben, anything else to add?

Ben Felix: No. I think that's good. Let's go ahead to this excellent conversation with Professor Burton Malkiel.

***

Professor Burton Malkiel, welcome to the Rational Reminder podcast.

Glad to be here.

It's very exciting for us to get a chance to meet. We've been a big fan of your work for a long time. So we're very grateful. How do you describe what the term efficient markets means?

Basically, there are two ideas behind the so-called efficient market hypothesis. The first one is that information gets recorded into stock prices without delay. If you say you have a drug company that announces that their phase three results from a new cancer drug have been absolutely wonderful, people have gone into remission. There are few if any, side effects. And that that information is sufficient to have a big effect on the stock price. Suppose the stock was selling at 20. And with this new cancer drug, it should be selling at 40. That it will go to 40 right away. It won't go slowly over time. It'll go right away because people will know that the stock now is worth 40. And anytime you buy it below 40, you're going to make a profit.

Now, obviously, one can never be sure that the FDA is going to approve the drug even though the phase 3 results were great. You never know exactly what the sales are going to be. You never know whether side effects are going to pop up later. Whether there's going to be a competing drug. No one is ever absolutely sure that the stock is going to be worth 40.

And some people may overreact and push it above. Some people may underreact and it will go below. But the point is – and this is the second idea of the efficient market hypothesis, and that is that there are no arbitrage opportunities. There is no obvious opportunity for excess risk-adjusted profits that the market gives you.

The way this is often described in academia is the efficient market professor is walking along the street with one of his graduate students. They notice a $100 bill on the ground. And the student bends down to pick it up. And the professor says, "Don't bend down to pick it up. If it were really a $100 bill, it wouldn't be there."

Well, I'm not quite that extreme. I would tell my graduate student, "Pick it up right away because it certainly isn't going to be there long." In an efficient market, these wonderful arbitrage opportunities, are opportunities for these fantastic profits without risk. If they did exist, someone is going to pick them up right away. If you see it, do it immediately because it certainly isn't going to remain there as this wonderful profit-making opportunity.

It's a great explanation. What do you think the media tends to get wrong about the concept of market efficiency?

I think what media gets wrong is the idea that efficient markets means that market prices are always right. That's not the case. In fact, market prices are always wrong. How could they be right? In theory, the price is the discounted present value of all of the future cash flows. These cash flows can only be estimated with enormous amounts of error. Some people are going to estimate them too high. Others too low. Market prices are always wrong. What the efficient market hypothesis means is that nobody can be sure whether they're too high or too low.

What is a random walk?

Basically, a random walk is a mathematical concept of a series of numbers where the next number is not predictable from the numbers that went before. If I give you a series of numbers; 1, 2, 4, 8, 16, 32 and I ask you what the next number is going to be, you would probably say, "Well, I see where you're going. The next number is going to be 64."

In a random set of numbers, you have no idea what the next number would be. The next number would be just a random pick from a whole bunch of numbers. And the idea of applying this concept to the stock market is that the stock market is actually very close to being a random walk.

There are technicians who will tell you the way a stock has meandered in the past will tell you what it's going to do tomorrow and next week. That there are trends in the market that make predictions easy to do.

In a random walk market, it says, "No. Look. Yeah, sometimes there are things that look like trends but then they completely disappear." And a random walk market means an unpredictable market, where just because the stock went up yesterday, just because it went up last week, doesn't mean it's going to go up today. And a random walk market is an unpredictable market.

Okay. With that background, with market efficiency and the random walk in the background, how do you explain the logical arguments for investing in index funds rather than actively managed strategies to try to beat the market?

Well, exactly. If, in fact, the market isn't always right, but it does a pretty darn good job of reflecting information. That it doesn't leave the $100 bills around. That it doesn't leave the opportunities for professional investors to say, "Oh, no. This is clearly an undervalued stock. And if I just put undervalued stocks into my portfolio, I will beat the market."

If the market is sufficiently good at reflecting that information, if the market then is incredibly hard to beat, which I think it is, then rather than buying an actively-managed fund where the manager looks to buy a particular stock, then sell it when it's gone up and switch it to something else, that that manager is not going to beat a simple index fund that just buys all the stocks in the market and holds them.

And there are two other advantages of buying an index fund. First of all, you can, today, buy these index funds either as mutual funds or as exchange-traded funds at close to a zero commission. We're talking about expense ratios of one or two basis points, which means two one-hundredths of 1%. Whereas the typical active fund charges a management fee of 1%. Then the argument is that the index fund will then outperform by those differences and costs.

And even more, suppose the active manager has a few stocks that did go up and the manager sells them and then tries to find other great bargains, what you find is that they actively-managed funds tend to give people a 1099 at the end of the year where they have realized capital gains on your behalf.

I think one of the things that just amazes people now that it's just after-tax time in 2023, is that people will say, "How come my actively managed fund went down over 20% but I got this 1099 showing that capital gains were realized in my account?"

The index fund, because it doesn't trade, doesn't tend to realize capital gains. And so, on an after-tax basis, it's even more efficient than indexing. So that's the argument for why people and why I have thought, really for 50 years since I wrote the first edition of Random Walk, that people would be better off buying index funds than actively-managed funds.

Okay. This is the question I really want to ask you. How was this advice received when you first published that book over 50 years ago?

Well, first of all, there weren't index funds 50 years ago. In fact, one of the things I said in the first edition was when I tell people they ought to be invested in index funds, people would say you can't buy the index. And I said, "That's right. But it's just about time that you should." It was three years later that Vanguard started the first index fund that you could buy.

But in general, the book was very poorly received by professionals because they thought, "How can you say that an index fund is going to be an actively managed fund where, here, I'm a professional who's been in the market for 20, 30 years. What do you mean that I can't do better than a simple index?”

In fact, I suppose, since I always tried to write in a way that was entertaining, I said in the first edition that I thought a blindfolded chimpanzee could select stocks that would do as well as a professional manager. And professional managers don't like to be compared to apes. I had terrible reviews from professionals.

And in fact, when Jack Bogle started the first Index Fund three years after Random Walk was first published, his reaction was just about as bad as the professional reaction to my book. Jack wanted to do an initial public offering of what was called the first index fund. He went to underwriters and wanted to do 250 million of an offering. The underwriters came back to him and said, "Well, we think we can only do about 150 million. Let's set the offering for 150 million." That's what they did.

When the books were closed, they had sold only $11 million of the first index fund. The offering was an abject failure. It was called "Bogle's folly". It was one of the worst IPOs that you could imagine.

And in fact, for years, the index fund had very few holders and very few investors. I used to kid with Jack Bogle then I thought he and I were the only investors in the first index fund. And it wasn't until many years later that the idea finally caught on.

Was your conviction ever shaken?

No. Certainly, in my mind, the conviction was never shaken. It was never shaken in Jack Bogle's mind. And in fact, as the evidence accumulated, I feel even more strongly today than I did 50 years ago that indexing should be the core of everybody's portfolio.

Now Standard and Poor's does something called a SPIVA study, S-P-I-V-A, which stands for Standard & Poor's Indexes Versus Active Management. And they compare each year. How did active managers do? How did the Standard and Poor's, in this case, index do?

And every year you get about the same results. In a single year, it's about two-thirds of active managers are beaten by, or are outperformed by the index. One-third win. But the one-third who win in one year aren't the same as the one-third who win in the next year.

So that when you compound this over several years, what you find is that, say, over 10 years, it's 90% of the active managers are beaten by the index. And over 20 years, it's more like 95% of the active managers are beaten by the index.

I'm not saying that nobody can outperform. There are that few who can outperform. There are the Warren Buffetts of the world who actually did outperform for 30, 40 years in the past. But looking for them is like looking for a needle in a haystack.

And when you go and try to be active, you're much more likely to be in the 90%-plus part of the distribution where you underperform rather than in the 10% or less where you outperform. And you can't predict those 10% winners by just looking at who did it before. Because even Warren Buffett, over the last decade, has not beaten the index. And Warren Buffett himself has said that he has given instructions in his will that the monies from his investments be invested in an index fund.

Even with a Warrant Buffett where he did outperform, that doesn't mean he's going to do it in the future. Look, there'll be another Warren Buffett. There'll probably be many Warren Buffetts in the future. But you don't know who they are and I don't know who they are. And when you try to do it, you're much more likely to be in that part of the distribution where you underperform and underperform significantly.

Today, like you're saying, the evidence has continued to mount. And it's common to accept investing is smart today. But when you wrote the first edition of your book, that wasn't the case. Why do you think you were able to come up with such contrarian thoughts at the time?

Well, because there started to be evidence accumulating in academia that the emperor really did not have the clothes that the emperor suggested that he had. That when you looked at the numbers, the numbers seemed to show that some of the broad-based indices seem to do at least as well, if not better, than the actively-managed funds.

And there was work done at MIT, at the University of Chicago. I did a number of academic studies early in my career where I started comparing active managers to simple indices. Found the same results. The results were starting to accumulate. And these things were done long before Standard and Poor started to do the studies. There's much more evidence today. But the evidence did start to accumulate and it was true even then.

And in fact, it's almost more true now than it was 50 years ago. Because you might have argued, 50 years ago, when 90% of the trading was done by individuals. And you might say, "Well, look, individuals make mistakes all the time. Maybe there are going to be these $100 bills on the ground." Today, 90% of the trading is done by institutions and is done by professionals. It's even less likely that it will occur today. But the evidence was still there even 50 years ago.

How has your investment advice changed over the last 50 years?

Well, it's changed remarkably in some sense. The basic idea that markets are reasonably efficient. The basic idea that you ought to index hasn't changed at all. But as we just said, index funds didn't exist. I think the investment advice actually that was in the first edition was look to buy so-called closed-end investment companies that were selling at discounts from their net asset value.

It's not that I said that the managers would be able to outperform. But if you can buy a $100 portfolio for $80 or $70, maybe you'd be able to do a bit better. Those discounts are closed now. And that strategy doesn't work. And there are index funds that you can buy.

And the whole idea of what's available today has remarkably changed. As I said, there weren't index funds. Today, there are a variety of index funds. Competition has driven the expense ratios down close to zero. There weren't exchange-traded funds 50 years ago. There weren't money market funds 50 years ago. There weren't index bond funds 50 years ago. There weren't tax-exempt funds 50 years ago. There weren't bond funds of different durations, different maturities.

The whole landscape of what's available to individual investors has totally changed. And that's one of the reasons why the book has gone through 13 editions. That in each edition, we talk about exactly what's available. What are the best of the funds that are available? How you can put them together? What makes sense for somebody in their 20s? What makes sense for somebody in retirement? What are the different portfolios? How do you do it? And so, the book is fundamentally different than it was then. But the idea that what you want is the core of your portfolio is low-cost index funds. That hasn't changed at all.

Why do you think that idea has become, at this point, widely accepted compared to like what you talked about when you released the first edition?

I think it is widely accepted because it works. Things like the Standard and Poor's SPIVA reports. The fact that you have more and more evidence accumulating each year. I mean, again, we know we were talking about Warren Buffett before.

You might recall that a few years ago, Warren Buffett made a bet with a hedge fund executive. And he said, "Look, let's bet a million dollars." They weren't betting for themselves. The idea was whoever won would pick their favourite charity. “Let's bet a million dollars, and I'll pick the Standard and Poor's 500 and you pick five of the best hedge funds that exist.” They started the bet. It was a five-year bet. At the end of the bet, Buffett won, hands down, all of these expensive hedge funds way underperformed the market index. And Warren Buffett's favourite charity was very much more wealthy because of it.

I think the reason that it's more and more accepted now is that it works. And people now know that it works. And eventually, truth will come out, and people are wising up to know that indexing is not mediocre.

It used to be said, "Well, who wants to be average?" In fact, the index fund investor isn't average. The index fund outperforms and has been outperforming by about 1% a year for many, many years now. And the lessons are getting more and more distributed out there. So that when I would talk to professional investors 50, 40, or 30 years ago, people would be skeptical. Now even professionals understand that indexing is a superb strategy.

How do you articulate the difference between investing and speculating?

Well, I think investing is putting your money to work in some asset in the hopes of achieving long-run rates of return. And I think it's really the horizon that probably is the difference. That, you know, now, real estate has been suffering in some of our major cities. And in the short run, it's been a bad investment. But you hear people saying, "Well, gee, maybe I should pick up some of these office buildings in New York that are now available at discounted prices." Because over the next 10 or 20 years, we think that this will give us decent rates of return.

I would say that speculation is investing in something because you think that you will get a short-run rate of return. The idea that, again, recently people were saying, "Well, gee, Bitcoin's at $25,000. I think by a couple of weeks from now it'll be $30,000. Let me go and buy Bitcoin. Or now maybe I should sell Bitcoin short because maybe it'll go down several thousand dollars."

Speculation is really in some sense, for my mind, gambling on what short-term changes will be in a market price. And just as we were talking about what's the idea of a random walk, in my view, the market is largely unpredictable.

I mean, if you actually look at Bitcoin prices, if there's anything that looks terribly random to me, it's how these prices develop. And I know there are people who believe they see trends, they see patterns. But again, it's the time period and the idea that I'm going to make a short-term gain. And don't worry, I'll get out before they collapse if they do in the future.

Good definition. One of my favourite parts about your book is the overview of past market bubbles. I mean, it's just an incredible segment of the book. And it goes back to like the 1600s right up until today. Why do you think that aspect of market history is important for investors to understand?

Well, I think it's important to understand because I think there are repeatable bubbles in asset prices. There's a classic one in Holland where a single tulip bulb became priced as highly as a nobleman's castle. And then several years later, tulip bulbs would be lying on the street worth less than a simple onion.

We saw it in the South Sea Bubble in England in the 1800s. We saw it at the beginning of the internet in 1999 and 2000 when internet stocks sold at not 10 times earnings, or 50 times earnings, or 100 times earnings, but several hundred times earnings. And the thing about these bubbles is that they typically collapse. And there are really two things about investing that are important.

One is to do the right thing and the other is to do the wrong thing and not get swept up in the enthusiasm that often is created by one of these bubbles. And I think we've seen it with Bitcoin, which recently sold for almost $70,000 and then went down to $18,000. It's now going up. It's the enthusiasm.

And particularly with the internet now and how misinformation gets sent around the world through social media, it's so much easier now to get caught up in something like that and avoiding that kind of mistake is really one of the most important things that you can do in investing.

But Burt, what advice would you have for people who are compelled to participate in some kind of speculation?

Well, look, people ask me why I've been interested in the stock market since I was a teenager. I didn't have any money but I was still – I grew up in the city of Boston. And for some reason, I followed the stock market, not investing, because I had no money to invest. But I knew the price of General Motors stock just as well as I knew Ted Williams' batting average.

Nobody who spends a lifetime studying this does so without something of a gambling instinct. And frankly, I buy some individual stocks from time to time. I like gambling. I like going to Las Vegas. I like sitting down at the blackjack tables. I understand that people would like to do this. And so, what I say is, "Look, as long as the core of your portfolio is in diversified index funds, as long as you're serious money, as long as your retirement money."

I mean, my retirement money was 100% invested in index funds. And then if you want to have fun around the edges, fine. Go and do it. And you can do it with much less risk if you know that you're really important money is indexed.

Okay. We talked earlier about randomness, and the random walk and how it relates to market efficiency. Then you just told us about the repeatable pattern of bubbles. How does the existence and persistence of bubbles throughout history fit with markets being efficient?

As I said, first of all, the big mistake is, when I say it's efficient, I don't think it's always right. Now the point you've just made has been made and it's been made by many academics. In fact, there is – will not mention a name. But there's an academic who said that the efficient market hypothesis is probably the most important error that's been made in the history of economics.

How can the market be efficient when we saw internet stock sell at hundreds of times earnings? How can the market be efficient when a company like GameStop, who was selling through stores video games that were at that point always being distributed online and they were losing scans of money? But some internet mob decided that this was an important thing to buy. And the stock doubled, and then doubled again and then doubled again. Doesn't this prove that, in fact, you can beat the market?

Well, let me tell you why I don't think this is inconsistent with the efficient markets. As I said, markets make mistakes. Some of them are doozies. But let's take the internet bubble. Wasn't it obvious that stocks were overvalued? And that's what the people who criticized efficient market say. Didn't even Alan Greenspan, the Head of the Federal Reserve, know that markets were overvalued? Didn't he give a speech in which he coined the term “irrational exuberance” and said that the market was showing irrational exuberance? Yep, he did.

But what people forget is Alan Greenspan made that speech in 1996. The top of the internet bubble was in February or March of 2000. If you had bought the day after Alan Greenspan's speech, you would have done extremely well. How about the GameStop? Well, there was the hedge fund, Melvin Capital, who was convinced. This was absolutely crazy. We ought to sell GameStop short. And Melvin Capital went bankrupt.

What I said efficient market and hypothesis means is there are no clear arbitrage opportunities. There are no clear opportunities for gain without taking risks. And yep, markets go crazy sometimes. And avoid it. Don't go anywhere near it. But don't think you can time the market and you can short these things. Because you're more likely to have the result of a Melvin Capital than anyone else. And there are some horrible stories of very smart people who lost their whole companies trying to bet against bubbles.

How does the idea that there are multiple, non-diversifiable risks in financial markets? How does that affect the investment advice in your book Random Walk?

Well, there is a thought now that, in fact, you can look at individual stocks. And let's kind of try to break down why they go up and why they go down. And obviously, one thing that happens is the economy goes up and down. Another thing that happens is some are very sensitive to interest rates. We've just seen in the banking crisis that we've just gone through that as interest rates went up, this was a real problem for many of the regional banks. Particularly those who got caught in a mismatch between the duration of their assets and duration of their liabilities.

Let's look at the different factors that makes prices go up and down and that create risks for being in the stock market. And the idea is it's called factor investing. And they're very popular now. Funds that are available that presumably can smooth out some of these so-called factor risks.

The problem is they're actively managed. They're expensive. And in the 50th-anniversary edition, I've just looked at the last five-year records of these factor funds and they have underperformed the standard index funds.

Sure, there are a lot of different risks. There are a lot of different factors. And we understand more why stocks go up or down. But if you think you can put this together in a portfolio that will do better than just holding everything, which is what an index fund does, I think you're mistaken.

Interesting. It was a pretty rough five years for things like value, recently, I guess. If someone thinks that they do want to do that, that they do want to tilt their portfolio toward smaller companies or cheaper companies like value stocks, how do you think they should make that decision?

I think if you want to do that, I think what you want to do is, one, try to find a fund that does this in an indexed fashion. In other words, a fund that just buys everything with that characteristic.

And let me give you an example of where it might make sense. Certainly, for an accumulator, for someone in their 20s, 30s, 40s saving for retirement, I want you in a broad-based index fund. But let's say you're in retirement now. It might be that having a portfolio that's tilted a bit more toward the value and dividend growth part of the market might very well make sense.

And so, I would say, if you want to have some part of your portfolio tilted that way, but do it with a manager that, A, charges very little. And B, that uses a broad-based set of securities and doesn't try to pick "the right ones".

I like your treatment of this topic in the book. One of the other things you said that resonated with me was, as opposed to approaching single factors, like tilting toward just value, looking at a multi-factor approach where you're looking at multiple factors together to select the stocks or overweight the stocks might make more sense.

Yeah. Again though, I've got to tell you though, that if you think that doing that will mean that you will outperform a broad-based index fund, I think you're going to be disappointed.

What do you think about momentum and trend following as investment strategies?

Well, again, the momentum following and trend following became particularly popular just before the COVID world upset us. And again, I remember giving a talk and saying you're going to be better off with an index fund. And someone in the audience said, "Come on now. Cathie Wood's fund, that was basically a momentum fund of small high-tech companies, the market was up 20% and she was up 100%. You're crazy. Why don't you just buy Cathie Wood's ARKK Innovation Fund?" And it was selling at $150 a share at that time.

All I can tell you is that the problem with momentum is that it can end in a heartbeat. And Cathie Wood's ARKK Innovation Fund is selling for less than $40 a share now. Sometimes it works.

And back to the idea, you want to be a gambler and think you can get in for a few days and the right time when it's going up, go ahead. But that's gambling. That's not investing. And I certainly don't recommend it for your serious money.

Yeah, your treatment of momentum in the book is great. Because you talk about it twice at the beginning when you're talking about technical analysis and chartists. And then again later when you're talking about the concept of factor investing. And you're very, very critical of it, which I appreciated.

How do you think that the evidence from behavioural finance, which pretty explicitly suggests that markets are not efficient, how does that affect the investment advice to just buy the index?

It doesn't, in my view. But in my view, it's very important however. And that as I said, investing means, in my mind, doing the right thing but avoiding the wrong thing. And what the good part of behavioural finance, in my view, is that it shows you how we can get caught up in some of these bubbles and get caught up in doing the wrong thing. In some sense, there's nothing that kind of upsets you more than having your neighbour tell you that your neighbour just bought this great stock that doubled and your neighbour's doing better than you are. And particularly with social media now, it's so easy to get caught up.

And so, understanding how we are so susceptible to these kinds of problems and avoiding mistakes is tremendously important. And one of the new things that was in the book that wasn't in the first edition is a whole chapter on behavioural finance. At the end of which I say, "Here are the lessons that you ought to learn from it. The lessons are very important. But I don't think behavioural finance in any sense means that you ought to do anything different than index funds.”

One of the leaders in behavioural finance, it's a professor in the University of California system, Meir Statman, he and I have sometimes had debates about efficient markets and behavioural finance. Even he would agree that while he doesn't think the market's necessarily efficient, he knows perfectly well that it's incredibly hard to beat. And I know perfectly well that being aware of what tricks our psyche can play on us can make us better investments.

Professor Statman is an upcoming guest. That'll be interesting to carry on this conversation. What do you think about risk parity strategies like Bridgewater's All Weather fund?

Well, again, I do try to cover in the book all of the new ideas that there are. And I was in fact taken by it in that there is a certain element of truth in it. And the element of truth is this, that it's interesting that, in all markets, riskier gambling contracts sell for higher prices than are justified.

Let me give you an example of the racetrack. In a racetrack, if you look at the odds of each horse and you bet on every horse in the race, you would have a winning ticket. But what would happen to you is that you lose 20% of your money because they figure the payoffs after deducting 20% for taxes and the profits of the racetrack.

But if you bet on just the favourite in every race, you'd lose 5%. And if you bet on the longest shot, you'd lose about 40%. In other words, people over-bet long shots and under-bet favourites. Well, that's the basic idea of risk parity. If, in fact, these safe assets are kind of mispriced relative to the expensive assets, the gambling assets, then here's a strategy. We'll buy the safe assets and we'll buy them on margin. We'll leverage them up. We'll borrow money to increase the risk and increase the volatility. And by doing that, we will get a higher rate of return than we would from buying the expensive assets.

And unfortunately, the trouble with risk parity is that the really safe assets that typically get used are bonds and government bonds. You can make a government bond much riskier by leveraging it. By buying it on margin. But unfortunately, if you go through a period, as we have recently, where interest rates have risen dramatically, you can get absolutely slaughtered.

And unfortunately, risk parity funds have not been average investments recently. They have been much worse than average. You want to gamble? You want to speculate? And you think that the Federal Reserve is going to immediately go into a cycle of reducing interest rates? And incidentally, it's not my – I'm not saying that'll happen. But suppose you think that's going to happen?

Maybe some risk parity funds will do well. But they prove to be extremely risky and they have not proved to be very good investments because a large part of the portfolio was in "safe bonds" leveraged up and the returns have been disastrous.

Yeah, that's interesting. It would look pretty good in the backtest from maybe 1970 to now. But not so much with the recent returns or the returns in earlier periods.

Well, that's in fact one of the problems. Everything works extremely well in a backtest. If you had bought bonds right after Paul Volcker had made the long-term treasury bonds yield 15% or more, and you bought them in March and you would have done very, very well.

I've never met a backtest I didn't like. But be very, very careful of somebody who says, "Look, here's something that's worked very well over the last year, the last five years, the last 10 years." Remember that, unfortunately, there's so much randomness in this world. And the one thing that I am sure about is, if you have a low-cost index fund, you're going to do just fine.

And let me just say, in terms of investment advice, I think any of us who talk about investing need to be very modest about what they know and what they don't know. But I'll tell you, the only thing about investing that I am absolutely sure of, and that is the lower the fee that I pay to the purveyor of the investment service, the more that's going to be for me.

I, in my life, was very friendly with the late Jack Bogle. And one of the quotes that I love to use of Jack on the same topic was, "In investing, you get what you don't pay for."

Yeah, it's a great quote. Speaking of expensive asset classes, you alluded to the bet with Warren Buffett earlier. More generally, what do you think about asset classes like private equity, venture capital and hedge funds in investor portfolios?

Look, there is no doubt about the fact that there is a premium that you get in terms of return for accepting illiquidity. This goes back to the question that you asked, "Are there factors that actually have influences on returns?" And the answer is absolutely yes. And illiquidity can work well.

And this was a theory that was popularized by David Swensen, who used to run the Yale Endowment. And what David Swensen understood was that universities are perpetual institutions. When someone gave the money for the chair that I held at Princeton University before I retired, that money was given to Princeton in perpetuity. That money was going to be in Princeton's endowment forever.

And therefore, a university could accept illiquidity and therefore could get perhaps a higher rate of return than was available from a portfolio of marketable securities. And that was the David Swensen endowment model, which served Yale very well. It served my own university, Princeton University, very, very well.

But there are two things I would say to individuals. One, you're not Yale and Princeton. If you are saving for retirement, presumably, in retirement, you want to start spending that money. And in fact, if you have saved money in a tax-advantaged way as I did throughout my career, you're in a situation now where you have required minimum distributions. I mean, even if you don't need the money, you've got to take it out. Number one, realize you're not Princeton, you're not Yale. You're going to have to take that money out at some point particularly if you're in a tax-advantaged SEP IRA or something, or Roth IRA or something like that. Something where you do have to take the money out.

Secondly, the Yales and the Princetons of the world have staffs that can analyze who are the people who can actually have done well in buying commercial real estate. And the commercial real estate market is not an efficient market. Merck common stock is seen by thousands of investors every day. That office building in New York, that a hotel in Charleston, South Carolina is not seen by more than a few investors.

You need professionals to be able to do that. And what happens is the Yales of this world, because the whole strategy was associated with Yale, Yale gets the best of these. If you're an individual, someone will try to sell you one. But you're not likely to get the really good ones. And so, for individuals, I say stay away. It's not for you. You're not capable of analyzing them. You're not capable of getting the best of them. Please don't do it.

You mentioned bonds earlier. What impact did the recent era of the super-low bond yields have on the role of bonds in a portfolio?

Well, I have thought that, particularly a couple of years ago, when long-term bonds yielded less than 2%, and the inflation target was 2%, that bonds were a sure loser. And I appreciated the idea that bonds can give you, particularly short-term bonds, some stability in your portfolio. But I really worried that — was this the thing you wanted even if you were in retirement and wanted to live off your income?

And so, what I had developed was, in part, during periods where bonds had inadequate yields. And by inadequate, I mean, yields that seemed less than the inflation rate. That maybe a better strategy was to buy a portfolio of dividend-yielding stocks where at least you were likely to be able to have returns that had a chance of exceeding the inflation rate.

Bonds today are much better Investments because they do give you a yield now. But I do think that this strategy of at least for part of what otherwise might be a bond portfolio be invested in dividend-paying value stocks for retired people may make a good deal of sense.

And again, one of the things that's in the book, and I think is very important to realize, the same portfolio is not right for all individuals. Someone in their 20s saving for retirement needs a different portfolio from someone in their 70s who has begun to take required minimum distributions.

I've got to ask on the dividends. Is it more about the dividend yield or is it more about a value-tilted portfolio of stocks?

It's not easy to separate the two. Because if you think of what value stocks are, there are many ways in which – some people do it in different ways. But often, one of the criteria for a value stock is that it has a high-dividend yield. I'm not sure that you can completely separate the two. I think if you are buying a dividend growth portfolio or a high-dividend yield portfolio, you are, in effect, going to be tilting toward value.

Makes sense. I guess the question is, is it better to go to get a value portfolio by sorting by dividends or to get a dividend portfolio? Should the focus be the value or should the focus be the yield?

Well, as I say, I think if you look at these things, you look at the "value portfolios" and you look at some of these dividend ones, I think what you're going to find is that they have very much the same companies in them.

Yeah, that's probably true. Okay. We've talked a lot about investing, which was great because that's where a lot of your book focuses. And it's been fantastic to talk about. I want to do a bit of a shift though. How important is saving as opposed to an optimal investment strategy to investor outcomes?

Well, saving is absolutely critical. You can talk about investing all you want. But if you have not saved any money and not put money into the investment, whatever you think, you may be the most brilliant investor in the world, but you won't have any wherewithal in order to invest.

It all starts with saving. And one of the things that I tried to show is that even saving a little bit of money each week, you can have a wonderful retirement. And there's an example that I use in the book of let's say that we have somebody who starts saving a bit over $20 a week. Maybe one or two times a week, we don't go to Starbucks and have our latte and have our big muffin. Let's see if we can spirit away 20 bucks a week.

And I have a chart that shows starting with when the first index fund was available in 1978, that by investing $100 a month in an index fund through the current period, it's just amazing how much money one would have. And the answer is close to a million and a half dollars.

People say there's no way I can have a million-and-a-half-dollar retirement portfolio. I've never made a lot of money in my life. And yet, by saving, by just putting a little money in each week, you can in fact do it. And for me, I think the thing that makes me feel best about the book is the people who have written me who said that, "You know, I read your book a long time ago. I did exactly what you said. And this is the amount of money that I have now. Thank you." And nothing would please me more than getting letters like that. It is possible.

Now let me go back to another thing we've discussed, and that's behavioural finance. It's very hard to save. That's something we know from behavioural finance. If you can't resist going to Starbucks for that latte and that big bun, have it done automatically by having your employer take a little out of each seller's check that gets put into hopefully some tax-advantaged way of doing it. So you don't have to pay taxes on your investment earnings and have it done automatically.

Because one of the best ways to make sure that you have put money into saving is that it didn't come to you in the first place so you could spend it. And for people who live paycheck-to-paycheck, okay, let's do the paychecks after the money has come out.

And again, getting back to the lessons of behavioural finance, there's just a brilliant idea that people have. And I've suggested this to people. And people have done it and started saving this way. They say, "Look, I can't do it. I can't tell my employer to take out $20 a week because I'm spending every single money to put food on the table."

And so, I've said, "Okay, do the following. On your next raise, take some part of the next raise and have it go into this savings plan so that you'll still get an increase in salary. And this way you won't feel deprived of the money coming out. It's called the save more tomorrow plan. Make sure you do it." And that's a brilliant behavioural finance way to start a savings program. But is savings important? Absolutely. It's not just important. It's essential.

In addition to those savings, how important is it for investors to figure out what their objectives are?

Well, in a sense, what I'm saying is that one’s objectives do dictate what you're going to want to invest in. The person in their 20s, who's basically investing for a comfortable retirement, is the common stock investor. The investor in his or her 70s who's taking required minimum distributions, the objective is to make sure that money will be able to come out in a way to have the required minimum distributions available to you and you need a much safer portfolio.

Whether you call it objectives or whether you call it what are you investing for, I guess that's objectives. Sure. That is important. And there are different portfolios for different people particularly for different people of different ages.

I want to keep going on that idea. How do you think investors should decide with, of course, time horizon being one of them? Just like you were talking about. How should investors decide how much risk to take with their investments?

Well, I absolutely think that young people should be essentially 100% common stock investors. I fully understand that there are some people who simply can't take it. I've done a lot of investment advising to individuals and the chief investment officer of Wealthfront where we are robo-advisors. I've had a lot of experience.

And I know perfectly well that while I think that horizon is the most important, I know that there are some people for whom, looking at the value of their investments and going through a year like 2022 where the market went down 20%, makes one almost sick to one stomach and makes one not able to sleep. And so, I think, clearly, one's psychological makeup is another part of it that's very important.

I tell the story in the book about the person who went to J.P. Morgan and said, "I don't know what to do about my investments. My investments are going up and down so much that I can't sleep at night.” And J.P. Morgan said correctly, "Well, you should sell down to the sleeping point."

If you are that kind of individual, I still would like you to have at least some of your investments in a broad-based index fund. But if you absolutely told me that you psychologically couldn't stand it, I would not object if you told me today that you had to have something that was absolutely stable. And I tell you, "Look, you want to put a third of your portfolio in one-year treasury bills that yield 5% today? Sure. Go ahead and do it."

But if we do in fact have a recession and the Federal Reserve turns the corner and starts reducing interest rates, you may be very sorry in the future that you've done it. There are costs in doing it. Don't think it's going to be something that's absolutely a win for you. But at least the monetary value of your portfolio will be much more stable.

And for people who cannot stand the volatility, fine, go and do it. But I would also caution them that what you want is a big hunk of money for retirement. And you really shouldn't worry too much about the quarterly volatility because that's not what's important. It’s what you're going to have when you get to retirement and you want to start spending the money.

Yeah, that's such an important point. The difference between volatility as a risk and future consumption as a risk. And in that framing, bonds are actually riskier than stocks.

Yeah, exactly, exactly.

Here's a separate question for you, Burt. Do you think people should rent or own their home?

I am actually quite concerned that we are going to be living in the future in an inflationary age. For one thing, the demography in this country is just terrible. Populations are not growing. The population that's there is aging rapidly. Fertility rates are very low. I think we are going to have a perpetual labour shortage. Politically, we find immigration a very hard thing to accept. I think there are going to be pressures on labour costs in the future that will prove to be inflationary.

I think, also, that the current political climate, where we would like to disassociate ourselves from China, where we're going to try to balkanize supply chains, trade has been something that has been a big inflation reducer in the past, will be less important in the future. And I think as we move much more to America first and we want to do everything we can in the United States, this is likely to be inflationary.

And third, we seem to have intractable budget deficits and we have enormous amounts of government debt relative to our GDP, relative to the size of our economy. And I think we will get rid of that debt the way countries have gotten rid of dead throughout history. Namely by inflating it away.

If I am right, one ought to think there's at least a strong possibility that it won't be easy to get back to the 2% inflation target. That we'd be very lucky if we got down from five, to four, to three. But then we're going to have significant inflation. And therefore, I would like to have people invested in things that are traditionally good inflation hedges. And common stocks have traditionally been an excellent inflation hedge and so has real estate. And so, if you possibly can, I say own your house. Don't rent.

The idea of owned homes as a hedge against future housing costs is a – it's a pretty nice argument. I've got to ask though, we talked earlier about market efficiency obviously. Would what you just said be an argument that the market is currently mispricing expected inflation?

Given that you actually look at market indices – and there are a variety of futures markets where you can actually see what the market thinks inflation is going to be. What the market thinks interest rates are going to be in the future. The market is expecting somewhat lower inflation than the forecast that I have given you.

Now let me just be very clear. Just as nobody can predict what the stock market is going to do next week, next month, next year, nobody knows what the economy is going to do next month, next year. Nobody knows what inflation is going to be. Forecasters have been absolutely wrong. The Federal Reserve has been completely wrong on their forecasts for the economy and for inflation.

While I have given you a forecast, take it with a grain of salt. I completely understand if you say, "No. I don't agree with you." I'm simply saying this is my forecast. And I think that at least you want to consider that it could be right. And if it is right, let me look at my portfolio and see if my portfolio is somewhat consistent with that possibility of it being right.

Am I sure? Absolutely not. I say this with great trepidation. But I will just tell you that my own forecast is that I think we're going to have a much tougher time getting rid of inflation than a lot of experts think and that the market thinks.

You know, it's interesting to hear you say it. Because as I'm sure you know, when you run the numbers, you can make renting and only look similar in terms of the impact on wealth, but a lot of it hinges on that inflation assumption. And if you assume a higher rate of inflation, renting looks terrible and only looks amazing. Anyway, it's a very interesting point to consider.

One of the things in your book that you did not speak highly of was investment advisors. Do you see a role though for financial planners or fee-only investment advisors who focus on financial planning while recommending low-cost index funds?

My worry is that many investment advisors charge, I believe, exorbitant fees. And if you can do it yourself, if you can take a book like mine that tells you, "Here's the exact instruments that you might use," I would much prefer that you did that. But if you do need specific tax advice and if you need somebody to nudge you into saving more, fine.

And if you do get a financial advisor, make sure that financial advisor is a fiduciary. And be very, very careful. Ask upfront what the fees are. Because the financial advisor might be great. But the point is you want to make sure that, after-fees, you do okay and you're not simply making additional money for the financial advisor.

We spoke with John Campbell at Harvard recently. He kind of said something similar, where he talked about all the mistakes that households make with respect to their personal finances. And that advice could theoretically be helpful. But then there are a lot of problems with the market for financial advice, which sounds kind of similar to what you're talking about.

My question, Burt, I'm sure you've been asked hundreds of times; with incredible growth in index fund assets, is there a point where you become concerned about? Could it be market efficiency or corporate governance being negatively affected?

Well, first of all, would it matter for market efficiency? And the paradox of efficient markets is that you need some active managers to make sure that information does get reflected. And the paradox is that, obviously if everybody indexed, who would make the market efficient?

And so, I understand that you do need some active managers. But I believe markets are now a little over half indexed. I believe it could be 75% indexed. I think it could be 90% indexed. I think it could be 95% indexed. There would still be plenty of people to make the market efficient.

In fact, suppose it was 100% indexed, and we go back to my original example. There's the drug company that's found the cure for cancer. The stock should be at 40. Not 20. Can you imagine in a capitalist system there isn't somebody who would then say, "Hey, wait a minute, there's an opportunity here I'm going to go in and buy the stock until it gets up to 40."

I am not worried whatsoever about not having enough active managers to make the market efficient. What I do worry about somewhat is the other question that's implicit. And that is the voting power that just a few companies might have. You know, there are three big companies that index; State Street, BlackRock and Vanguard.

And very often, they could hold more than half of the stock. They could in fact influence how the company is run. And in fact, there have been papers that suggested that look, in the airline industry, these three have a majority stake in the airlines. What they will do is have the airlines collude to raise prices so that the airlines can make more money.

Well, first of all that, doesn't make any sense. Because if I were an index investor, maybe the airlines would make more money. But other businesses that send their people by plane to different factories, to different customers, they're going to be hurt. So why would I want one industry to do better than the other? And there's no evidence that people have done that. But it does raise questions about voting.

And I think one of the things we're going to have to find is some way particularly when institutions own a lot of the index funds that are in the Vanguard, and BlackRock and State Street portfolios, that they will find some way of allowing the ultimate holders to have some say in how the shares are voted.

An answer to your question, in terms of making the market less efficient, I'm not worried. In terms of voting, yeah, there's a possibility. And I think we're probably going to have to find some ways of letting the ultimate holders have something to say about how the shares are voted.

Interesting. Your comment about collusion, when you own all of the companies, is great though. That's an interesting perspective.

You touched earlier on letters that you've gotten from investors who have followed your advice and been successful 50 years after writing your book and many, many editions. Looking back, what's been the best part about writing such an impactful book?

Well, I think that is the best part. I mean, look, in life, one hopes that you made a difference. And you hope that the difference that you've made is a difference that may have helped people. And I think that for me is, without question, what pleases me the most about it.

I mean, obviously, I'm delighted that the book has now sold more than 2 million copies. But I'm even more delighted that, for a lot of ordinary people, they have written and said their life is better because they read the book. And the fact that I wrote the book that made them better, there's nothing that could please me more.

Our final question for you, Burt. How would you define success in your life?

Well, again, I would say, for me, it's having made a difference. And I think, also, having done a lot of interesting things. I've spent most of my life being a teacher. And I think that that has been important and hearing from generations of college students who I might have influenced over time and who've had very successful and happy lives. That's certainly been what's important.

I think doing different things has been important for me. I spent two years in Washington as a member of the President's Council of Economic Advisors. Having been in the policy-making arena. Seeing how policy is made and maybe having a bit of influence on how policy is made has been important. Certainly, has been rewarding for me.

I've been a corporate director. I've been a member and sometimes chairman of investment committees both for the profit world and the non-profit world. And so, having done a lot of different things and having done a lot of interesting things.

And I would say, also, being intellectually challenged throughout my life. I am not someone who, in moving to Emeritus status, has simply sat on a beach and watched the waves come in. I mean, I do like to sit on a beach and watch the waves come in.

But I think continue to be active next for a very continuing, interesting life. I think all of those things were important. But again, I think the most important one was did one make a difference? Did one make a difference with one's own family? One's own children? Grandchildren? Wife? These are certainly important. But having some wider influence is a wonderful feeling for me.

Amazing. I must say, Burt, thank you for your time today. This has been incredible. But I must also thank you for your incredible books. I read your book for the first time back in the late 90s and it changed how we delivered financial advice. And has been a big part of what we've been doing ever since. Thank you for this time today and thank you for all your work over the years.

Thank you very much. I really appreciate it.

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