343: The Evolution of Money Management with Wall Street Legend, Burton Malkiel
Today, I'm thrilled to be speaking with Burt Malkiel. You probably know him as the author of A Random Walk Down Wall Street, originally published 50 years ago and is now in its 13th edition. In the book, he made a compelling case to make index funds the core component of one's investment portfolio. Keep in mind that index funds weren’t publicly available at that time.
Having written one of the most influential books in the history of investing is an extraordinary achievement. And Burt's accomplishments are many, including several lifetime achievement awards from professional investment organizations.
Burt is the Chemical Bank Chairman's Professor of Economics at Princeton University. He has also served as a member of the Council of Economic Advisers, president of the American Finance Association, the dean of the Yale School of Management, and spent 28 years as a director at the Vanguard Group.
It was such an honor to have Burt on the show, and I'm so excited to share our conversation with you. You'll hear how he got to where he is today, from his humble beginnings as a poor kid in a Boston tenement house to his published work that transformed investing forever. He'll also share his thoughts on how today's inflation compares to the 1970s, the challenges we face to get it under control, and so much more!
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In this podcast interview, you’ll learn:
- Why Burt believes education is so important–even though neither he nor I ever woke up excited to go to school.
- Why Albert Einstein called compound interest “the eighth wonder of the world.”
- How A Random Walk Down Wall Street slowly but surely changed investing as we know it today.
- What makes financial planning for growth and planning for preservation so drastically different.
- How to invest in individual stocks and make bets on businesses you believe in without putting your money at risk.
- How Burt structured his portfolio to generate safe, reliable fixed income once he needed to start taking RMDs.
- How high net worth individuals often get into financial trouble.
- How Burt thinks our current era of inflation compares to the stagflation of the 1970s–and why he’s pessimistic about our ability to get inflation under control.
- "90% of active managers are outperformed by a simple index fund." - Burton Malkiel
- "If you want to find the next Microsoft or Apple, fine. You can do that as long as the core of your portfolio is invested in index funds. It’s fun to do, and it’s intellectually rewarding." - Burton Malkiel
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Casey Weade: Burt, welcome to the podcast.
Burton Malkiel: Casey, I’m delighted to be here.
Casey Weade: Well, Burt, I’m really excited to have you here. You were introduced to us by Jeremy Siegel, and I just was so excited about the interview that we had with Jeremy Siegel. He introduced you, and I said, “Oh, my gosh, I can’t wait.” I’ve always wanted to have a conversation with this man. What a brilliant mind that we’re bringing here into the show and someone that’s made such a positive impact in my life and the lives of countless others.
And I really wanted to start the conversation with you, not on a random walk down Wall Street. I wanted to talk a little bit about you personally, and I find it really intriguing, the lives of individuals that have made such an impact, such as you, what really created that. And I find that that happens at a very young age and in those formative years. I’ve got myself, we have a two-year-old, a five-year-old, a seven-year-old, and I would love to raise those children up to be as successful as you have been and to live such a great life of purpose and meaning.
With that, I wanted to talk about your unique experience from an educational standpoint. I think today, there are a lot of individuals like myself that are raising young children, asking, what are we to do today when it comes to educating those children? There are questions about private school and public school. There are Montessori schools. There are so many options today that we never had before.
And you had a pretty unique high school experience at the Boston Latin School. And I was curious, what was that experience like at the Boston Latin School? And how did that lend itself to your success? If you want to add in there how we might be able to leverage some of those things for our own kids today, please, layer them up.
Burton Malkiel: Well, I think what was important for me was I grew up as a poor kid in a tenement house in the Roxbury section of Boston, Massachusetts, and certainly, my family couldn’t have afforded any kind of private school, but I was fortunate enough to have in the city of Boston a great public school, the Boston Public Latin School. I had a family who correctly thought that education was the key for not only a successful and meaningful career but a way of getting out of poverty. So, it was just very fortunate that the Latin school was available. I didn’t like it at the time. It was tough.
We had six years of Latin. We had to translate 60 lines of Latin a night. I always felt overwhelmed with the work, but it was precisely that kind of experience that was so important to me. And I’ve often said that, well, I’ve had a lot of educational experiences and great ones since the formative ones were the early ones of having a tough, good education as a kid. And I think it was probably the most important formative aspect of my life, enabling me to do the things that I’ve done.
Casey Weade: And for myself, selfishly here, raising a two, five, and seven-year-old, what kind of advice would you have for myself and maybe others, even raising, not just their own children, but helping to raise grandchildren on ensuring that they are getting off on the right foot?
Burton Malkiel: Well, I think what’s important is for many kids, myself included, and my own son included, school was not considered the best part of life, and it was considered a drag and it was considered something that we weren’t waking up, at least I wasn’t. And my son wasn’t waking up thinking, oh, boy, I got to go to school today. It was quite the opposite. But I think impressing on them just how important that is and that, in fact, later in life, as you look back at things that you’ve done as a little kid, there’s just nothing more important. I mean, I think that’s the key just to stress the importance of education.
And I mean, I’m an economist. We see this throughout the world. What made China finally grow and lift hundreds of millions of people out of poverty? It was that there was a reverence for education that goes back to Confucius. And when Deng Xiaoping reintroduced a form of capitalism and let the spirits of individuals do what they wanted, that, together with the education, was able to lift hundreds of millions of people out of poverty.
Why is India doing so well now? Again, you’ve got this idea of a reference for education. And so, I see this not only in my own personal life, in the life of my children, but I think I see it throughout the world. That’s the answer. And it’s not a natural thing that kids will take to or at least it wasn’t for me. Maybe there are kids who love to go to school. It wasn’t true for me. But I think trying to inculcate the importance of education is, I think, the most important thing you can do for a kid.
Casey Weade: And I can relate. I never once woke up and just couldn’t wait to get to school. I dreaded it, I think, every single day, every year through college, I didn’t want to go to school. And now, I see my kids that are excited to wake up and go to school every day. I go, wow, I need to continue to encourage this.
And another thing that’s unique, I think, about the way that a lot of our audience and fans are raising their children is it’s significantly different than the way that they were raised. I know my children are going to grow up in a much more privileged environment than I did, and yours had a similar experience, especially your grandkids. And I wonder what your thoughts are about the way that your relationship with money and your experience with money as a child form the way you think about money in finance today and throughout your life, how it impacted you, and what would be your guidance or advice to individuals that now they’ve made it, they are successful, and they’re trying to raise children that they can have a healthy relationship with money while they’re raising them in a much different environment that’s not poverty-stricken?
Burton Malkiel: Well, I think that what’s very important, and again, is not something that people take to naturally is to try to get some understanding of what it would mean to save regularly, and how regular savings will be so important later in life. Again, people in their youth, you think you’re never going to get old. You talk to a teenager about retirement, and they think that you’re out of your mind.
But the lessons of, number one, understanding compound interest, which Albert Einstein once called the eighth wonder of the world and the most powerful force in the world, and the fact that maybe if you give up the gummy balls for today and I’ll put that dollar aside in a savings and investment account that it could be worth a huge multiple of that later in life. And while I certainly never had any kind of money as a kid, I never thought of investing. I did have a piggy bank and I did start the moment I was able to make any money to save regularly and the power that regular savings, that sort of giving up the pleasure of the moment, the pleasure of the day. When you then look back on it and look back on the resources that you have as you have grown up and as you finally reach your retirement age, I think the understanding of just how powerful it is to save even the little tiny amounts regularly and do it consistently.
There’s a table in my book that I think in some sense tells the whole story. And it’s the idea of somebody saving $20 a week starting off. This was done 45 years ago rather than 50 because it was put into a so-called index fund that we may talk about later, and they weren’t available until about 45 years ago. But just the idea of putting the $20 a week off, okay, I won’t have my latte today, I’ll just have a regular cup of coffee in the office. And I’ll put that aside that somebody who had no huge incomes during the week, during their lifetime, but just was able to put the $20 a week aside and invest it, that by the time 45 years had passed, that was worth almost a million and a half dollars.
And if one could then think of doing this and maybe giving up the latte, giving up the extra beer after work, what that could mean, and if you’re fortunate enough to work for an employer who will match it, it could be the amount of $3 million. And people, I don’t think quite realize what the discipline of maybe giving up a few pleasures earlier in life and consistently saving can mean for their future livelihood and their future security and the things that they then will be able to do. It’s not easy for young people to understand that, but I think that’s the kind of lesson that is so important.
And incidentally, on compound interest, I have three grandchildren and I recently did a seminar for them of that– let me tell you what compound interest is. There’s a cartoon I love where the father looks at the son and says, you know, now you’re old enough for the talk and the talk about compound interest. So, I think that’s getting back to your question of what are the lessons that one wants to teach a kid. What are the lessons you want them to have? I would say other than to make sure that they know that they have your unconditional love, these would be the things that I would just say get a good education and understand that don’t necessarily just live for the moment and what you might give up for a few hours in one day or the latte or the beer or so forth, what it might mean later in life.
Casey Weade: Well, I think some people would have paid a pretty darn good penny to be in that compound interest seminar done by Hubert. And then what a great opportunity those kids have had. I would love to be part of that. And I think so many times we overcomplicate, especially in this world, raising financially successful children. It doesn’t have to be much more, as you said, than teaching them how to save, teaching them about compound interest.
Well, with that, I want to set aside some of my personal interest there and get into a random walk down Wall Street, the best investment guy that money can buy. And the way I wanted to get into this conversation was talking about what it was like back in 1973 when you originally released the original book. You were dismissed by your peers when you published that book. And I kind of wanted to have you tell us what it was like at the time. Why did this book and your thoughts and your philosophy is coming under so much criticism? How did that make you feel?
Burton Malkiel: Well, it made me really just evolved what– I had actually started my career working on Wall Street. And before I became an academic, I had worked full-time in Wall Street. And I’m a skeptical kind of person. I mean, I like when someone says something works. I don’t accept it right away. I say, “Okay, let me look at the evidence.”
And I had realized that when Wall Street was making all of these recommendations of here’s the stock you ought to buy and the firm that I worked for was a very important firm. And so, the stock price might go up a bit right after the recommendation was made because the firm had a lot of influence, but then it would fall back to where it was. And I sort of scratched my head and said, “Was this really worthwhile?”
And then there were the money managers I knew who charged 1% or 2% or 3% and were absolutely convinced that this is something you can’t do yourself. This is something that you need our expertise to do. And I looked at those returns and did some calculations and looked at some of the market averages and thought, there’s no there there. The emperor really doesn’t have any clothes. And so, I came up with the idea in the first edition of the book in 1973 that you would be much better off just simply buying and holding a simple index fund, a fund that bought and held all the securities in the market.
And the way I put it in the first edition was that I thought that a blindfolded chimpanzee throwing darts at the stock gauges could select a portfolio that would do as well as the experts. Now, you said, why was the reaction so tough? Well, well-paid Wall Street people don’t like to be compared to chimpanzees throwing darts. And Wall Street people are paid very, very well. And they’ve got a vested interest in making sure that the public knows that they can’t do it themselves, that they need our expertise. And so, I think it was, in fact, quite natural that they did not take to the idea. They called an index fund a guaranteed mediocrity. Why would you want to be average when we, the professional money managers, are going to give you above-average performance?
And three years after my book was published, Jack Bogle at Vanguard actually brought out the first index fund. And it’s an interesting story. Jack went to the Wall Street investment bankers, who’s going to do an initial public offering of the first index fund. And it was called the first index fund. And Jack said, “We want to sell $250 million.” And the underwriters came back and said, “Well, the demand is a little weak. We’ll try to do a $150 million offering.”
Well, when the tally was finally made, the first index fund sold $11 million. It was thought of as an absolutely failed public offering. It was called Bogle’s folly. It was called this remarkable error. I used to joke with my friend, the late Jack Bogle, that he and I were the only people who were invested in the fund. And it took a long time for indexing to take off. But it took off because the evidence was there that it really worked and that consistently, index funds beat two-thirds of the actively managed funds, and the one-third that won in one year weren’t the same as the ones that would win in the next year so that when you compounded it over 10 or 20 years, and Standard & Poor’s actually publishes these studies year after year. You find that 90% of active managers are outperformed by a simple index fund.
Now, I’m not saying it’s impossible to outperform. There are some examples. There is the example of Warren Buffett, who has just done absolutely brilliantly. There are examples, but there are so few and far between, so that if you try to think that I’ve got the best investment manager, you’re much more likely to be in the 90% of the distribution than that 10%. And let me just say about Warren Buffett that even in the last decade, he has outperformed. He did last year. But in the last 10 years, he hasn’t. And Warren Buffett in his will has said, “I want my executor to invest only in broad-based index funds.” So, I think it was very slow to catch on and very slow to catch on because when you’re making a lot of money selling actively managed products, you don’t want people telling you that you don’t have any clothes.
Casey Weade: What a beautiful evolution we’ve seen in the world of money management over the last 50 years. And I’ll often have individuals that come to me that are younger, people in their 20s or 30s say, “Hey, can you manage my money?” I mean, most people don’t need a financial advisor or financial planner when they’re– I mean, the vast majority of people don’t need one. They’re in a position where they just want to achieve the highest rate of return they possibly can in the most tax-efficient manner. And they need to focus on saving and keeping their costs low. What’s better than using a passive index fund for that particular purpose?
I believe that at some point, during individuals’ lives, either their income or their assets get to a certain point where the goal shifts, where it’s no longer about growth, where it becomes about preservation, and that can be estate planning and tax planning and income planning. And maybe they need a different type of planning to help preserve that wealth. But if it’s all about growth, as you said, it’s just not that hard.
However, what you also added historically, you recommended that investors, and now, I’m quoting you on this and maybe I’ve got the quote a little bit wrong, so feel free to adjust me here. But you said that you recommend that all investors use passively managed index funds as the core of their investment portfolios. So, I just raised the question for me, I said, well, if passive is the core, what’s the crust?
Burton Malkiel: Well, first of all, someone like me who was sort of good with numbers and always had a bit of a gambling instinct, I don’t think you studied the stock market all your life if you don’t have something of a gambling instinct. And I have said, if you want to go and try to find the next Microsoft of the next 30 years, or you want to find the next Apple of the next 30 years, fine, you can do that because as long as the core of your portfolio is invested in index funds, you can do that. And it’s fun to do. It’s intellectually rewarding, particularly if you get something that has worked.
And I buy individual stocks. I buy individual stocks because I have a– it’s actually a SEP IRA and a 403(b) because most people have 401(k)s in educational institutions. The equivalent is called a 403(b), but I’ve got those entirely in index funds and they are enough where I am of an age now that I’m taking required minimum distributions. I can live on that and I can have fun looking for the new Microsofts, but I can’t do it because the core is safely invested in broad-based index funds that also have not only common stocks but real estate, some bonds, and is very nicely and safely invested in those assets.
So, I say that’s what you want for your core. Then if you want to find the next Microsoft, you can do that. If, in fact, you feel that you’re going to feel better because you’re invested in a company that makes solar panels or that makes wind towers, you go and do that too. You can do that, but again, do it as an add-on, but just make sure that you’re serious. Retirement money is invested in broad-based index funds.
Casey Weade: You use the word safely invested. And yet, do you believe that that is truly safe money, given that it is a security and that most would say you are taking on risks? Do you believe that’s a riskless investment or what do you mean by...
Burton Malkiel: Well, actually, this is a very good question and this is exactly why I’ve written an investment guide like Random Walk. As one gets older and as one gets to the point where one is in fact living off of these growth investments that started off, that you start off with equities and you start off and you dollar cost averaging, you put the $20 a week in the stock market, and the stock market may be up sometimes and sometimes it’s terrible. Sometimes it goes down 20% in a day, as it did in 1987. But you keep buying, and that’s your growth portfolio for young people.
When you are then in retirement, although I’m still working at 90 years old, but in general, if I were just sitting on the beach and just doing nothing more than living off of my retirement, you want a different portfolio. And for example, let me tell you what’s actually and why I said my portfolio is in fact quite safe because the required minimum distribution that I need to take in 2023 is invested in a one-year Treasury bill. And yes, that’s perfectly safe.
And you know what? The RMD that I’m going to have to take in 2024 is invested in a two-year Treasury bill. So, I’m saying safe because as you get to the point where you’re going to be taking the money out, you don’t want it all in equities because you can have a year like 2022 when the market’s down 20%. And so, you need a portfolio that’s got a fair amount of that income that will give you that stability. But in the accumulation phase there, I say, I’m an equity investor. And I think over the long run, I’m not going to bet against the United States of America. I want a broad-based index fund, including all the companies of this country.
Casey Weade: There are some different philosophies around creating that buffer. So, you’ve created a buffer for your income. So, you’ve bought yourself two years for the market to go through its ups and downs before you need to replenish those Treasury bills. And maybe it’s longer than that. Do you believe in a two-year buffer or a five-year buffer? Or what kind of bond ladder do you believe you need to build in order to have enough time for the market to go through that?
Burton Malkiel: It’s a good question. And let me say, first of all, that it is not the case that the exact same portfolio is the right portfolio for everybody. I’m someone who has done a little investment advising for people. I’m kind of the informal adviser to a number of widows in my university. So, I’m the Princeton Widows investment advisor. And I fully understand that for some people who will get physically sick, when they see the market declining, when I’ve got a widow who has come into my office in 2007 when, remember we had a world financial crisis, the sky is falling, and who is crying and saying, I just can’t take it anymore? For that person, I think the majority of the portfolio had to be in bonds, relatively short term and without any risk, that would be the US Treasury securities.
For other people who were able to sleep at night, I would still want some amount of equities because even, if let’s say, 65 is the retirement age or 68 is the retirement age, you get lots of years ahead of you and there’s likely to be a fair amount even if the Federal Reserve was successful in getting us down to a 2% inflation rate. Remember compound interest, 2% inflation adds up and prices then will be a lot higher 10 years from now, even if the Federal Reserve is successful. So, I think you still need some equities. But again, it’s also the case of what you emotionally can stand. So, this is why there isn’t a simple rule. X percent is right for everybody.
JPMorgan was once asked by an individual who said, “What should I do? I’ve got so many equities in my portfolio that I can’t sleep at night.” And JPMorgan was quoted as saying, “Well, sell down to the sleeping point.” And those sleeping points, the amount that you can take, you’ve got to realize who you are and you don’t hold in retirement a lot of equities unless you’ve got the stomach for it because the one thing we know about equities is they are going to fluctuate. And if you can’t stand that kind of fluctuation, then your portfolio ought to be tilted much more toward the fixed income.
If you can stand the fluctuations, I think you’ll be better off the more that’s in equities because equities, we know over the long period of history, and this goes back to Siegel’s wonderful book, Stocks for the Long Run, over the long run, stocks have done about twice as well as fixed income. So, you do, in the long run, pay for that feeling of more security, of avoiding the ups and downs that sometimes can give you a stomachache.
Casey Weade: Burt, we’re talking here about the uniqueness of individuals now, the uniqueness of the average individual is what you’ve discussed now. But I also want to talk a little bit about the ultra-high net worth or high net worth individuals. And what I see with individuals that I’ve worked with that continue to become more and more wealthy, maybe they go through a private equity acquisition, and now, they’re all of a sudden super wealthy, maybe have $10 million, $100 million.
And also, when working with advisors, I’ll see advisors that I’m interviewing or bringing on, saying what type of sophisticated strategies do you have access to? Private equity, hedge funds, limited partnerships. They want to know that because they say, “Well, my more sophisticated high net worth clients, they need that.” And I know my position on this and I have a feeling that it aligns with yours, but hey, do you think when you say all investors use passive managed index funds as the core, and even when I look at these ultra-wealthy individuals, I just question, do they really need these advanced strategies? Are these advanced strategies really adding that much value at the end of the day? They don’t need to take that level of risk. Should they be taking that level of risk? So, long story short, do the ultra-high net worth need a different strategy other than something as simple as an index fund?
Burton Malkiel: Well, let me tell you and remind your listeners about a wonderful bet that Warren Buffett made with a hedge fund manager. He said, “Let’s bet a million dollars and I will take a broad-based index fund and you select five of the best hedge funds that you can find. And let’s see who wins after five years.” Now, both of these people were ultra-high net worth people, and so they weren’t doing it to make money themselves. The prize would go to the charity of the person, a charity of choice of the person who won the bet. Well, Warren Buffett won the bet handily. The index fund beat these five hedge funds.
And so, the answer to your question is that I think the answer is generally, no, that you don’t need these fancy things with two exceptions. And one exception is that you do get paid as an investor for bearing illiquidity. And since I worry a lot that we will continue to be living in an inflationary environment, I do want some real estate in a portfolio both because of its inflation hedge characteristics and because, in our country, Congress has determined that real estate will have a large number of tax advantages.
So, alternative one would be, do I need all of the fancy private equity and all that stuff? No, but I would want some real estate and possibly some private real estate investments. Number two is an innovation that I think is very important that is called direct indexing. Now, what direct indexing is, is something that wealthy people can do. If you’ve got $100 to invest, you can’t buy all the stocks yourself. You have to buy a fund. If you have $10,000 to invest, you can’t buy all the stocks yourself. You need an index fund. But if you are a multimillionaire, you could actually do the indexing yourself. You could buy all the stocks.
Now, what’s the advantage of that? Well, the advantage is that instead of buying all 4,000 stocks, let’s say, that are in the market, you only buy 2,000, but you choose them so that they have the same industry composition, the same size composition, the same value growth composition as the market. And then what you do is you tax loss harvest. And what that means is you’ve got a lot of drug companies in your portfolio, and let’s say the drugs are down, so you sell Pfizer and buy Merck or vice versa, or you sell General Motors and buy Ford or vice versa, you harvest all of the tax losses that you can and you won’t outperform because you basically have set up the stocks you hold to go just like the index would hold. But after tax, you get what they call an after-tax alpha. In other words, you outperform after tax.
And one of the reasons that I joined Wealthfront is that this offers a direct indexing. And it’s direct indexing, not for 1% a year or 2% of a year, but we charge one-quarter of 1%. And the amount that you get from those tax benefits will more than cover the expenses. And so, just to summarize, for the ultra-wealthy, the two things that I think they might think about is some real estate and maybe some good real estate, private equity funds, some direct indexing rather than simply buying index funds. But again, I’d still say keep it simple and you don’t need all of the fancy hedge funds and fancy private equity funds. And let me just tell you that one of the other reasons you don’t want it is that for most individuals, to the extent that there are some of these that are really good, you probably can’t even get into them.
Again, I’ve done a lot of work on university endowment management, and universities have done pretty well with some of these fancier investments. They have done very well because when money goes into a university for its endowment, it’s permanent. They don’t need to take it out so they can’t accept the illiquidity and they also generally were able to get into the few of these, maybe the 10% that really do outperform. And also, let me tell you the sort of secret that people are necessarily aware of, that universities, when they get into some of these fancy hedge funds, because when David Swensen at Yale University who invented this idea of endowment management, he doesn’t pay 2% and 20%. Most of these charge 2% a year and 20% of the profits. He gets a much sweeter deal.
So, just be very careful even to the extent that some of these may work. It’s some of the David Swensen said the world that were able to get into the good ones and also paid much less than you will pay as an individual. So, I’m with you. I think it’s very dangerous to think that you’re missing out on not having all of the private equity venture capital and hedge fund investments. You’ll do perfectly well with direct indexing and some real estate.
Casey Weade: And that’s when we see many high-net-worth individuals start to get into trouble.
Burton Malkiel: You’ve got it absolutely.
Casey Weade: They start with too much wealth, and then they feel like they need to start gambling or going out on a limb and doing some things they think other rich people do. So, from you, you said real estate direct indexing, couple of other things to add to a passive index portfolio. That’s awesome. Really appreciate that insight.
I want to talk a little bit about the market. I think we’d be remiss not to ask some of the current market environment questions, given someone that’s had the level of experience you have had throughout your career. And I want to point to a recent CNBC interview that you gave four days ago prior to this interview. So, we’re having this conversation January 11th. So, four days ago, I saw you on CNBC and you shared during that interview the expected annualized rates of return for the broader stock market to be in the 5% to 6% range over the next decade.
And the reason you gave was the CAPE ratio. You cited the Shiller P/E 10 of the CAPE ratio as your basis of why you would expect a return of 5% to 6%. Now, CAPE Shiller has been something that we’ve discussed here at Howard Bailey for the last 10-plus years, and we’ve been having this conversation and there’s been significant controversy around it saying, oh, well, look what happened. It didn’t come true. Look at the returns of the market. It didn’t come true.
And I would say, specifically, going back to January of 2018, so in January of 2018, the CAPE ratio was at 33.31, and today, it’s around 28 as we’re having this conversation. And many might have said, January of 2018, CAPE is 33. We expect lower returns in the stock market moving forward. And then we follow it up with some of the biggest years we’ve seen in the stock market in recent history. And people go, duh, that’s garbage. It’s not true. How do you reconcile that?
Burton Malkiel: Well, first of all, no one ever said that the CAPE ratio predicted short-run rates of return. The correlation of the CAPE ratio with the return over the next year is zero. The correlation of the CAPE ratio with returns over the next two years is zero. The correlation of the CAPE ratio with returns over the next three years is essentially zero. Where the CAPE ratio seems to work is that in predicting 10-year rates of return, if you look at all of the things that you might use, the current price earning is multiple, the current price to book, multiple. Whatever metric you use, the best one for predicting 10-year rates of return is the CAPE ratio, and the correlation is above 0.4. Not great, but it’s the closest thing we’ve got to be able to predict 10-year rates of return.
And today, with the CAPE ratio being well above average, it suggests that probably even though the long-run rate of return is 9% to 10%, that, generally, the longer-run returns when the CAPE ratio is well above the average and the average is somewhere in the mid-teens, that the 10-year rate of return has been below average. And when the CAPE ratio was in single digits, the long-run rate of return wasn’t 9% or 10% but within the teens. So, is it perfect? Absolutely not. Does it work for the short run? Absolutely not. But it does work for the long run to some extent. And would I make a huge bet on it? No. But I think realistically, what it says to me that investors in saving for retirement ought not to simply assume the long-run stock market rate of return is 9%. That’s what I’m going to get because that valuation metric is well above average. You probably realistically ought to assume that you’ll get something less than average rates of return over the next decade.
Does it have anything to do with what 2023 is going to do? Absolutely not. Nobody, and I mean nobody can tell you over the short run what the market’s going to do. The CAPE ratio doesn’t do that. Nobody ever suggested that it did. The two economists, Campbell and Shiller, who did the empirical work about how good the CAPE ratio was, they wouldn’t tell you it’ll work over the next year, two years, or three years. But it does have some predictive power over the longer term.
Casey Weade: You mentioned longer term. He said long-term and short-term quite often there. And I think investors quite often aren’t really sure what long term really means, what short term really means and to relate that back to something you said earlier. Maybe 10 years is long-term. You said that the core of your portfolio being broad-based index funds means this is my safe money. But in the short term, it’s not your safe money. At what point does that predictive power become likened to safe money, right? We can look at a portfolio of equities of S&P 500 and say, “Well, over 20 years it’s pretty safe.” But over five years, it’s pretty risky. I mean, what do you see as long-term? And at what point does a passive index fund portfolio become relatively safe to you?
Burton Malkiel: Okay. First of all, long term for me does mean 10 years and longer. And that’s what I’m saying when I say long-term. But this brings up something else about why equities can actually be relatively safe, even though the market is quite volatile. And that is something that I’ve stressed in my book that I think is so important for people who are accumulators, who are building for retirement. And that’s the idea of dollar cost averaging.
Now, again, this is a very simple concept, but look, let’s take a period of 10 years where the market did nothing. We had what has been called the dot-com bubble, which ended around January or February of 2000. The dot-com bubble, because the Microsofts of the world, the Amazons, the Cisco Systems sold at 100 times earnings, a company that would add dot-com to their name would go and soar in price and we had a real bubble. We had a CAPE ratio that was practically 40 at the time. And the market for the first decade of the 2000s did nothing. The S&P ended up in 2010, about the same place that it was in 2000. So, were equities the wrong thing to do for an accumulator? Or were they actually relatively safe?
Now, let’s go back to my example of the $20-a-week guy who is putting money into the market regularly. What dollar cost averaging means, and it works perfectly in a very volatile market that when the prices are down, you buy more shares of that index fund. And when the prices are up, you buy fewer shares so that even though the price ended up exactly where it began because you were buying more shares when the market was very volatile and has gone down 40%, your average cost was less than the average of the prices over the whole period so that, in fact, you made 5.5% on each dollar you invested even during the first decade of the 2000s.
And the other so important thing to think about is that in addition to compound interest, dollar cost averaging means that even in a market that is terrible, that’s flat, as long as it fluctuates a lot, you can still make money because you’re buying. No one can time the market. But if you invest regularly, you’ll be putting some money in when the market is way down, and thus, your average cost will be below the average of the prices during the whole period. And that’s what makes regular equity investing in a very volatile and apparently risky market actually less risky.
Casey Weade: Burt, some people look at you and say you’re not a long-term investor, you can’t be a long-term investor. You’re 90. Should we be investing for the long term? Because a lot of people adhere to the rule of 100, they look at that rule of 100 and they say, well, at 60, I should be 60% fixed income, at 90, I should be 90% fixed income. I would love to hear your thoughts around the rule of 100 and why you don’t adhere to it.
Burton Malkiel: Well, first of all, as I told you before, all people are different. If you’ve got the resources to live on, you don’t need the money. I’m investing for my children and grandchildren. And it’s their horizon. Not my horizon. That is important. I’ve got enough money so that for myself and my wife, we’re going to live comfortably whatever happens to security markets.
So, again, people are different also in terms of some of these rules, which I think are absolutely wrong. Your proportion of bonds should be your age so that when you get to be 60, 60% of your portfolio ought to be in bonds. When you’re 70, 70% of your portfolio ought to be in bonds. Look, if one eats well, tries to exercise regularly, 60 and 70-year-olds have lots of time ahead of them to think about. So, the horizons are a lot longer than those simple rules would suggest.
Casey Weade: Well, I love that you’re talking about something I always share. You’re not really investing for yourself anymore. And that is something that I think we just get so focused on our own little environment that we forget about what’s actually going to happen to the wealth someday and who we’re really investing it for. And I also wanted to get your thoughts around something that I’m a believer in, and that is the increasing equity glide path. That is, as we step into retirement, we over time actually increase the equities in our portfolio.
Some of the latest research from our Wade Pfau, Michael Kitces, has shared that an increasing amount of equity instead of retirement is more likely to give us better long-term results than actually increasing our fixed income throughout our retirement, which also makes sense given the shorter period of time we actually need the funds.
Burton Malkiel: No, I think that’s right. And I think that’s absolutely right. However, my dollar cost averaging example is not something that you want to do out of equities when you need to take required minimum distributions because what helps you in the accumulation phase will hurt you in the accumulation phase. Because what it means, if you are taking RMDs and your portfolio is entirely in equities when the equity market is down, you’re going to be selling more shares than if the market is up. So, that, again, if you need to take the RMDs, then I would disagree with it because I think you need some fixed income to assure that you’re not getting the downside of dollar cost averaging of selling too much of your equities in a year like 2022 when the market is down 20%.
Casey Weade: The last thing we want to do is reverse dollar cost average.
Burton Malkiel: Exactly, right. Right.
Casey Weade: And I’ve got so many things I want to ask, but I cannot miss this. You were on the President’s Council of Economic Advisors from 1975 to 1977. Alan Greenspan was the head at the time. I am curious how you would compare. Many people want to compare our current situation of interest rates and inflation to what was experienced in the 70s. How do you compare those two? And where do you think it’s going from that aspect?
Burton Malkiel: I think it’s very comparable and exactly the same arguments which I hear all the time that go the following way. Look, the inflation that we have today was largely caused by the war in Ukraine, the supply shortages, tankers steadily increasing, and not being able to get into the port of Los Angeles. Monetary policy is not what’s going to fix that. The Federal Reserve is crazy.
In the 70s, Arthur Burns was faced with exactly the same situation. The inflation that increased during the 1970s was we had OPEC that got together for the first time and engineered a doubling and then another doubling of the price of oil. We had droughts throughout the world causing food shortages, and Arthur Burns was told no, tight money is not going to solve OPEC. That’s not going to make them reduce the price of oil. Tight money is not going to mean the crops are going to be better, that wheat is going to be able to be grown faster than otherwise. So, don’t tighten monetary policy.
So, what happened? What happened was inflation got ingrained. Inflation got into people’s expectations. And so, people then said, well, the Federal Reserve is simply going to underwrite this. Therefore, inflation will continue. And my expectation is that it will continue. And then it accelerated so that we had almost double-digit inflation by the time Paul Volcker came to head the Federal Reserve. It was a terrible mistake. And I don’t want to repeat that same mistake. So, the people who criticized the Federal Reserve today because look, it’s the war in Ukraine, the tight money is not going to help that. There are still supply shortages. The Federal Reserve’s tight money is not going to help that. The Federal Reserve has to go and keep tight.
I am not a critic of Jay Powell and what’s being done. He has to do that so that inflation doesn’t get ingrained and doesn’t get into people’s expectations that inflation is here to stay. So, I think we don’t want– might he overdo it? Absolutely. But then he’ll be able to reverse it. But I think that you don’t want to repeat the mistakes of Arthur Burns in the 1970s. And I was in Washington at the time. I was part of all those discussions. I heard him loud and clear, and it was a bad mistake what was done. And it then took the tremendous pain that Paul Volcker inflicted on the economy to finally end it. We don’t want to do that. I would rather that the Fed overdid it a little now than risk that the 70s get repeated.
Casey Weade: So, do we get inflation under control this year?
Burton Malkiel: I think we’re going to have– will we get it down to 2%? We’ll certainly get it down. I doubt that we’ll get it down to 2%. I think we would be very lucky getting it down to 3% to 4% this year. And I think over the long run, I’m actually not as optimistic as many people are for two reasons, one, that the demography in the country is just terrible. The populations are not growing. The workforce is not growing. We’re aging rapidly. There are crazy people like me who keep working into their 90s. But most people don’t. And most people did not come back into the labor force when they were in their 60s and they got laid off.
So, I think we’re going to have some labor shortages, not only in the United States, but the demography is even worse in Europe and even worse in Japan. Japan will lose a third of its population by 2050. And Japan’s population is aging more rapidly than in the United States and Europe. So, I worry about labor shortages. Also, as an internationalist, I think that globalization has been really helpful in keeping a lid on prices. And I’m frankly, someone who is not happy about the America first. Let’s deglobalize and make sure that we reshore all of our manufacturing because I think that’s going to be inflationary.
So, I’m a little more pessimistic than most people that we’re going to get inflation back down to a 2% target of the Federal Reserve. I think we’d be lucky to have it at 3%, 3.5%. And I think we’re not going to have the growth in the economy that we’ve had in the past. But again, I want to come back to my feeling about dollar cost averaging. Let’s talk about the other period where the economy was terrible, inflation was too high, and growth was too low. Stagflation, back to that period in the 70s, the stock market didn’t do a thing during the 70s, but the dollar cost accumulator, even in the 70s, made 5.2% during that terrible decade.
So, even if that’s right, even if you’re as pessimistic as I am, that doesn’t mean you don’t want to be an equity investor. It’s still going to be the best game in town. And in terms of an inflationary environment, stocks are still the best in inflation hedge for the long term.
Casey Weade: Oh, that’s great. I wish we could stay on this for longer, but I know you’ve got other places to get to. We’re going to be giving away your book, though. We’re going to give away A Random Walk Down Wall Street, the best investment guide that money can buy. And before we do that, I would love for you to share with the audience, in your opinion, why should they be picking this book up.
Burton Malkiel: Well, I’ll tell you what makes me really happy about the book, and that is the letters. And I mean, they’re mainly emails now, they’re not letters, but the people who have written to me who have said, “I just want to write to you to thank you. I never made a lot of money in my life. I did exactly what you said. I saved regularly very small amounts of money, bought index funds, and I’m now able to have a comfortable retirement, enjoy life, enjoy my children and grandchildren. Thank you.”
And in life, you’d like to think that what you’ve said has really helped people and that you’ve made a difference. And I really do believe that following the advice in the book will make people’s financial lives a little bit better. And nothing could please me more than being able to say that I’ve had a role in doing that.
Casey Weade: That’s right. You’ve definitely left an impact on myself, our audience. You have a beautiful legacy to leave behind. If you’d like to get a copy of that book, that’s why we want to get it in your hand exactly what Bert just said, if you’d like to get a copy of the book, all you have to do is write an honest rating and review over on iTunes for the podcast. Shoot us an email at firstname.lastname@example.org with your iTunes username. We’ll send you the book for free. It’s really that easy. Hey, Burt, thank you so much for the time. It was a true pleasure.
Burton Malkiel: Thank you, Casey. I really enjoyed it.