<THE HARRY JONES S&P 500 PORTFOLIO>
(August 19, 1999) -- In the first edition of his classic A Random Walk Down Wall Street, Burton Malkiel suggested that the ideal investment vehicle for the individual investor would be a "minimum-fee, no-load" mutual fund that would own shares in all the companies that made up a given stock market index. This would not only allow investors to diversify their portfolios, but it would allow them to reap the benefits of what Malkiel saw as the inevitable upward rise of the market. If you kept your money in the fund for the long term, this would be as close to a risk-free investment as could be imagined.
At the time of A Random Walk's publication in 1973, no such investment vehicle existed. The individual investor looking to match the market's performance was out of luck. Within three years, though, one of the more momentous changes in stock market investing was introduced. In 1976, Vanguard created the Vanguard Index 500, which fit Malkiel's prescriptions exactly. Investors in the fund were able to own every stock in the S&P 500. If the market as a whole did well, so too would they. And since the S&P 500 had, at the time, returned better than 7% annually, these investors seem to have found a sure thing.
There are a number of ironies in Malkiel's advocacy of index funds and in Vanguard's decision to create one. Malkiel believed an index fund was the best vehicle for the individual investor because he believed that the price movements of individual stocks were random and therefore not predictable. Although Malkiel was never an advocate of what's called the efficient markets theory (which holds that at all times a stock's price reflects all the relevant available information about it), he was skeptical of claims that it was possible to beat the market. And since it wasn't possible to beat the market, it made much more sense to join it.
Vanguard, meanwhile, was offering the index fund in the wake of the most devastating market crash since the Great Depression. In the 1973-74 period, the value of equities in U.S. companies dropped nearly 50% on average. The pre-crash highs reached in 1973 would not appear again until 1982. From one perspective, Vanguard's decision was canny. For many, the crash had seemed to demonstrate that picking stocks was a futile pursuit, and that it inevitably led to speculative excesses. In particular, the fate of the Nifty Fifty -- of which we'll have more to say later -- seemed to indicate that the stock prices of even the most solid companies could prove to be built on air. Investing in the market as a whole required no work, and provided greater protection at a time of economic insecurity.
From another perspective, though, Vanguard's decision had something daring about it. It wasn't, after all, just the Nifty Fifty that investors had become leery of. On the contrary, they had become skeptical about the market as a whole. Although stock prices rebounded after 1974, the sense of certainty that animates investors today was absent from the equity markets of the 1970s. And in that sense, investing in an index fund could easily have been seen as setting sail on a ship without lifeboats. Today, we understand that even if some stocks struggle, many will flourish; the opposite seemed true then. Diversifying your portfolio was maximizing risk, not necessarily reward.
In any case, investors did not take to index funds like the proverbial ducks to water. Although the funds did grow steadily in popularity over the next ten years (with the help of institutional investors in the 1980s), it was not until after the crash of 1987 that individual investors began indexing. It's only in the last few years that these funds have grown to the point that observers are raising cautionary questions about their impact on the market as a whole.
The steady rise of the S&P Index has led to concerns about a new Nifty Fifty phenomenon. During the late 1960s and early 1970s, investors flocked to hot large-cap stocks that seemed guaranteed to grow forever. These companies were almost uniformly solid, well-managed companies of a substantial size competing in markets they had the potential to dominate. They were, in other words, smart investments at fair valuations.
But the obsession with the Nifty Fifty, many argued, drove valuations beyond the bounds of reason. Polaroid found itself trading at a P/E ratio of more than 70, while McDonald's passed 60. Investors thought they had discovered the secret of printing money. Once the fervor wore off, and people found themselves with shares of companies which could not justify (earnings-wise) their prices, panic set in; the Nifty Fifty plunged.
Next week, how some people compare this history to the recent popularity of index funds.
[Please note, this column was originally published on February 12, 1997. Timeless, isn't it?]
To discuss or ask questions, please visit the Harry Jones board.
|Recent Harry Jones Portfolio Headlines|
|08/26/99||Is it a Nifty 500? Part II|
|08/19/99||Is it a Nifty 500? Part I|
|08/12/99||Illuminating Index Funds, Part Two|
|08/05/99||Illuminating Index Funds|
|07/29/99||The Foolishness of Index Funds|
|Harry Jones Portfolio Archives »|
Day Month Year History HARRY +1.01% 0.87% 5.17% 5.17% S&P: +0.98% 0.59% 9.31% 9.31% NASDAQ: +1.03% 0.37% 20.78% 20.78% Rec'd # Security In At Now Change 1/4/99 16 S&P Depos 127.63 133.91 4.92% Rec'd # Security In At Value Change 1/4/99 16 S&P Depos 2042.00 2142.50 $100.50 CASH $5.12 TOTAL $2147.62 Yesterday Today Change S&P Depos 135.56 133.91 +1 11/32
</THE HARRY JONES S&P 500 PORTFOLIO>
Recommended Foolish Products:
Foolish Four Investing Without a Silver Spoon
More from The Motley Fool
6 Ways to Make Your Retirement Savings Last
Breaking a big retirement rule is one of them.
Can You Really Make Money Mining Bitcoins?
Profits are not easy to come by. Expensive hardware and risky cloud mining deals are the main challenges.
3 Things to Watch in the Stock Market This Week
Look for Netflix, P&G, and Starbucks to make big moves over the next few trading days.