Princeton professor Burton Malkiel is the author of the best-selling classic A Random Walk Down Wall Street, now in its eighth revised printing. Malkiel recently chatted with 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 through May 9 to read a new portion of their conversation each day.
TMF: Professor Malkiel, let's talk a little bit more about emerging companies for a minute. You mentioned that "firm foundation" of value, your Rule No. 2. Does that mean you do not advise investors to invest in companies that have not yet shown earnings, but show big prospects like, let's say, Amazon.com
Malkiel: Oh, that is a very good question. I think that's a mistake people made in the heady days of the late 1990s, when some stocks sold at billion-dollar capitalizations even though they didn't have revenues, let alone earnings. You are absolutely right. They may have a wonderful idea, but I am going to wait until they have some tangible evidence of sales and earnings before I would buy them.
TMF: I guess Amazon in particular interests us because that was a company that actually did have a lot of revenues. The question was earnings. But it is a company that the stock went, as you well know, I think up to something like $95 in modern-day terms, and dropped down to $7, now it is back around $25 with $4 billion in sales and some earnings. From its IPO to today, it has been a market-beating stock.
Malkiel: Right. Look, as I told you, in this game you are not going to pick every stock that does well with these kinds of rules. I am sure you won't. But what you are going to do is avoid the real blow-ups of the other companies in that period, let's say the Globe.com, or you can name any single one of them.
Malkiel: Exactly. Yes, I may miss a few of them that worked, but what I am going to do is avoid the real bombs by using these rules.
TMF: Just to close out on that one, I think it is interesting because I think the eToys we just mentioned, and Dr. Koop.com, I will throw that one in, a lot of those companies were second- and third-tier players, but when we look at the business landscape today, I mean you do see billion-dollar valuations for companies like eBay
Malkiel: I think you are absolutely right.
TMF: Let's talk a little bit about the mutual fund industry. What do you make of the fact there are more mutual funds today than there are stocks?
Malkiel: Isn't it amazing? There really are more mutual funds than stocks, and here one of the things that I have done in the eighth edition of my book is I have looked very, very carefully at the actual record of these 5,000-plus mutual funds and compared them with index funds. It is just amazing to me how the basis that, in general, the index fund is going to beat the typical mutual fund has held up really for decades.
If your listeners do want to buy some stocks on the side, and I do... 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 I'd advise having 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 beat the index in one period are not the same people who beat it in the next period.
Again, there is a chart that I put in the eighth edition that looks at the top 20 mutual funds in the period 1998 through 1999. These were the winners. These were the guys written up in the money magazines as "This is the fund to own." Their return in that period was double the market. Well, I then continued them into the 2000s and, as I am sure you can guess, they were simply the funds that had loaded themselves up with overpriced Internet stocks and they did three times worse than the market during the first three years of the 2000s.
So, even if you want to buy some individual stocks, and I don't say don't do it, but have an index fund be the core of your portfolio -- and if you have a 401(k) and an IRA, it is the index funds that are absolutely the things to have in those vehicles.
Thursday in part four: Malkiel looks ahead at investing for the next few decades.