One of the most influential economists of our time has some optimistic words for investors -- especially those who are worried the market might stay depressed for years to come.
Princeton professor Burton Malkiel is the author of the classic A Random Walk Down Wall Street, a huge bestseller that's now in its eighth printing. If you're reading this column, it means you have at least some interest in investing. If you have at least some interest in investing, you should read this book. (I think you see the connection here.)
Consider Random Walk as a collection of all the information you'll need to establish a foundation on the road to becoming a serious investor. Even though Malkiel will attempt to dissuade you from investing in individual stocks (a surprisingly gentle attempt, considering "random walk" refers to efficient market theory), he provides you with the body of knowledge you'll need if you're going to be successful.
Since it had been several years since I first read a library copy of Random Walk, I recently bought it and read it again. That was the seventh printing, which Malkiel wrapped up writing in mid-1998. Think back to that time: The bubble-icious bull market still had almost two more years to go, and many thought spectacular yearly returns would be the norm instead of the exception.
In that climate, Malkiel projected a return of about 8% per year for the S&P 500 for the long run. While that may have seemed depressing back when the market had gained over 150% in four years, today many investors would be happy to average 8% over the next few years.
As I read the book a few weeks ago, I wondered what Malkiel thought now about future returns, considering we're still in the midst of one of the worst bear markets ever. Since then, a new edition of Random Walk has been published, and Malkiel gave us some answers in an interview for The Motley Fool Radio Show.
The good professor is sticking with his projections of 8% returns, on average, for the next decade or so. "There is actually a very simple formula that one can use to get some idea of what the stock market is likely to produce," he says. "That formula simply says you take the dividend yield of the market and add to it the kind of long-run growth rate that we have had for corporate earnings. Well, the dividend yield is a little less than 2%. The long-run growth rate of corporate earnings has been somewhere in the vicinity of 6%. You add them together and you get something maybe a shade below 8%."
Malkiel calls that "kind of his best guess," but says that the formula actually works pretty well. There's accurate data stretching back to 1926, when the market was yielding 4.5%-5%. The growth rate for earnings since then has been about 5.5%. Add them together, and you get a bit more than 10%, which is exactly what the market has averaged since then.
Thus, it may be time for individuals -- especially those who began their investing careers within the past 10 years or so -- to adjust their expectations. "Stock investors made 18% annually from 1982 to 2000," he says. "They got 10%-plus from 1926 to the present. My guess is to expect probably something around 8% -- but with a 10-year Treasury bond rate now of less than 4%, I don't think that's bad."
I should pause here and make it clear that Malkiel is by no means making any short-term predictions. That would go against everything he believes in.
He's simply attempting to project what an investor might expect, on average, over several years. It's also interesting to note he doesn't see the market as overvalued at this point in time. "Not a short-term prediction, but I think prices are reasonably valued in the stock market today."
As I mentioned earlier, the term "random walk" refers to the efficient market theory that says other than long-term trends, future stock prices are nearly impossible to predict. Indeed, Malkiel's advice closely mirrors that of the Fool's: Investing in index funds may be the best way for most people to participate in the stock market.
It was surprising, then, to hear him admit that he actually buys individual stocks. "I mean, there is nobody who loves the stock market who doesn't want to try to find the next winner. I will admit to you that I buy some individual stocks, but have the core of your portfolio be a broad-based index fund because year in and year out, the index fund beats the average manager, and the managers that do beat the index in one period are not the same people who beat it in the next period."
For those who do want to buy individual stocks, Malkiel has four rules to consider:
- Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. "If you look at the stocks which over the long pull have given investors the best returns, like Microsoft
(NASDAQ:MSFT)and Merck (NYSE:MRK)and Pfizer (NYSE:PFE), these have enjoyed an above-average long-run rate of growth."
- Never pay more for a stock than can reasonably be justified by a firm foundation of value. "Cisco
(NASDAQ:CSCO)is a great company, but carried a triple-digit P/E during the Internet craze."
- It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air. "The key to success is being where other investors will be, several months before they get there."
- Trade as little as possible. "The best way to have top quartile performance is to have bottom quartile expenses."
You can find out more about firm foundations and castles in the air in an earlier column of mine or, of course, in ARandom Walk Down Wall Street.
Highly, highly recommended.
[Beginning Monday, we'll run a five-part special on the Malkiel interview, much of which did not air on the radio show.]
Rex Moore salutes another of his former schools, Burnet Jr. High School in Austin, Texas. Heave ho, Sailors go! At press time, he owned shares of Microsoft. You can view his holdings on his profile page and read about The Motley Fool's disclosure policy here.