In a world where there are more mutual funds than stocks, many of us can be forgiven for asking the age-old question, "What the heck should I be invested in?" Burton Malkiel is one who took on that question in earnest. Thirty years ago, the Princeton professor of economics wrote the investment classic, A Random Walk Down Wall Street, a book in which he asked questions like "What really happens when a dart-throwing monkey is pitted against a Wall Street professional in a stock picking contest?"
A revised Random Walk was released in its eighth printing last month, and Malkiel joined David and Tom Gardner on The Motley Fool Radio Show. We weren't able to broadcast their whole discussion, so we're publishing it in its entirety here, exclusively on Fool.com. Join us May 5-9, to read a new portion of their conversation each day.
TMF: A lot of renewed hope now that the war is over. What is your take on what is playing out with the stock market?
Malkiel: Well, I think the stock market has been beset by what Alan Greenspan likes to call "geo-political uncertainties," and perhaps they are resolving themselves. But I think the stock market is certainly also reflecting an economy which is more sluggish than any of us would like.
My guess is, although I don't think anyone can make short-term predictions about the stock market, is that once the economy starts to do better I think there will be a somewhat more positive tone to the market. Not a short-term prediction, but I think prices are reasonably valued in the stock market today. Once there is a little better news in the economy, my guess is that the stock market would do somewhat better.
TMF: Professor Malkiel, a couple of quick follow-ups there. You said some interesting things. First of all, when you mentioned that you don't think people can predict the stock market in the short term. We agree. I am curious. What is the cutoff, at what point does short term become long term and at what point do stock markets become predictable?
Malkiel: Well, I think over the very long term, and I will try to define that, you have a reasonable chance at estimating what sort of rate of return you would get. Now what do I mean by reasonably long term? I guess I am talking about certainly more than five years and maybe ten years. There is actually a very simple formula that one can use to get some idea of what the stock market is likely to produce for investors. 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%. That is kind of my best guess as to what the stock market is likely to do over let's say the next decade or decades.
TMF: Obviously we haven't talked about inflation, something we do talk about a fair amount on this show because as you well know, the real return in the end is what matters. So if we are all used to a stock market at 10% but inflation was 3%, eating away at that 10% each year, then 8%, with let's say 1% inflation, is about comparable.
Malkiel: It could very well be comparable. My guess is that inflation is very well under control. I'd probably use 2%-2.5% rather than 1%, but I don't see, in this global economy, inflation breaking out anything like what we experienced in the late '70's and early '80's.
TMF: Let's talk about your investment classic, A Random Walk Down Wall Street. A book which has just been revised and updated. What do you mean by "random walk" and how does it apply to the stock market?
Malkiel: Well, what it means is just what we have been talking about. That at least over the short run, you can't predict what the stock market is going to do. The stock market will be pretty efficient, it will adjust itself very quickly to news, but true news is random. True news is not predictable and therefore certainly from day-to-day and month-to-month, the stock market is not predictable.
Now you in fact mentioned earlier what the implication of that is and the way I put it in my book when it was first published was that this blindfolded chimp could select a portfolio as well as the experts. Now in fact, the practical advice is not to throw darts, but rather to throw a towel over the stock pages, and what I have recommended from the first edition of this book in 1973 and continue to recommend is that people who are investing in the stock market will do better with simply buying and holding a broad-based index fund than they will trying to select the best individual stocks or the best individual fund managers.
TMF: But do you believe it is possible for somebody to select individual stocks that consistently over long periods of time outperform the market's average?
Malkiel: Well, I think I would distance myself a little from that. What I do think is the following: I think that one of the lessons that you can learn from a book like mine is how to avoid the real mistakes and if you can avoid the real mistakes, I think you have got yourself a good chance of being ahead of the game.
Now what do I mean by "the real mistakes"? Well, we have seen one quite recently and in this new 8th edition of the book, I have added a chapter called "Surfing on the Internet: The Biggest Bubble of Them All" because of what we have just lived through. The market usually gets things right. Usually it does not make horrendous mistakes, but it sure did in 1999 and early 2000.
The Internet Bubble erased $7 trillion of wealth from this country and it is frankly one of the reasons why I think the economy is as slow as it is today. I think what you maybe can do is at least avoid the real problem of "go and sell your diversified portfolio of stocks and bonds and real estate, go sell your index funds and let's all hop into the tech stocks because we all know they were the ones that were doubling and then doubling again." I do think that if you can avoid those mistakes, that can put you somewhat ahead of the game.
Tuesday in part two: Malkiel's three rules for buying stocks.