Having been an investor for over four and a half years now, I suppose I may not be exactly a “newbie” anymore. However, that hardly makes me an expert either, and I continually aim to deepen my understanding of the world of investing. The more that I learn, the better of an investor I feel I will be.
With that in mind, I just finished re-reading Burton Malkiel’s 1970s investing classic, “A Random Walk Down Wall Street”* . “Random Walk” is a highly-readable book that presents what to me is now a very familiar refrain (and the cornerstone of my personal investment philosophy). I will refer to said refrain here, with all due reverence (and certainly some levity), as “the Gospel of the Index Fund” š
Historically, when people invested in the stock market, they had to take their chances buying individual stocks. This experience no doubt was thrilling when it worked. If the individual companies did well, then so did the investor’s investment. On the other hand, investors faced the very real threat of a company going bankrupt, thus swallowing up their investment with it. This risk has always made stock-picking potentially hazardous (and/or terrifying).
Our grandparents and great-grandparents learned the hard way the risky nature of stock investing. Starting in 1929, a market crash sent stocks tumbling and the world reeling. The Great Depression extended well into the 1930s, and the optimism of the “Roaring Twenties” gave way to terror and literal depression, setting the stage for World War II.
If they did not pick their own stocks, investors usually had no choice but turn to fund managers, who often charged exorbitant fees, and even so, often did not pick investments that won out in the long-term.
Certainly, both stock-picking and expensive fund managers still exist. They are both big businesses! Yet nowadays we have financial instruments which automatically protect investors from the fate of the unlucky stock-picker or the hands of the problematic broker. We call these instruments index funds.
Index funds do not prevent portfolios from dropping when the market drops. On the contrary, since by definition, index funds buy the market as a whole, they ride the wave of the market as it expands (or contracts). However, because they are broad-based by nature, index funds inherently protect investors from losing their investment entirely (which happens when you invest in a company that goes bankrupt!).
At the same time, index funds have proven the advantage of owning the market as a whole. Betting on index funds is a betting on the idea that, in the long-run, stocks will grow. Index funds allow investors to take advantage of these happy odds without putting all their money at risk in one company’s fate (or several).
With index funds, it seems that humanity learned from the perilous experiences of the past. Certainly, we did not take the risk out of investing. How can we? Without risk, there is no reward, and the ultimate purpose of investing is to gain the benefit of capitol appreciation (ie “reward”).
Nonetheless, starting in the 1970s, a swelling chorus of individuals began a revolution that allowed the average investor to throw their hat in the ring while minimizing the chances of being scathed. This revolution was spear-headed by two men who had the vision to foresee a new way to organize investments. These two men were Burton Malkiel and Jack Bogle.
I have honored the late Jack Bogle in a previous post. He was a man of self-less commitment to giving the average investor a fair shake. His company, Vanguard, launched the index fund as a viable option for investors, way back before index funds were the darling of the investment industry.
If Jack Bogle was the hand that manifested the index fund into flesh and bone, Burton Malkiel, in writing “Random Walk,” was the visionary who first articulated the idea that it could be done. His support for the index fund was founded on the belief that people could not consistently beat the market… so why should they try? Why not own the market as a whole instead?
He writes:
A random walk is one in which future steps or directions cannot be predicted on the basis of past history. When the term is applied to the stock market, it means that short-run changes in stock prices are unpredictable. Investment advisory services, earnings forecasts, and complicated chart patterns are useless… Taken to its logical extreme, it means that a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.
“A Random Walk Down Wall Street,” p26
While he dismisses actively-managed funds and stock picking, Malkiel extols the virtue of index funds:
When you buy an index fund, you give up the chance of boasting at the golf club about the fantastic gains you’ve made by picking stock-market winners. Broad diversification rules out extraordinary losses relative to the whole market; it also, by definition, rules out extraordinary gains… But experience shows conclusively that index-fund buyers are likely to obtain results exceeding those of the typical fund manager, whose large advisory fees and substantial portfolio turnover tend to reduce investment yields. Many people will find the guarantee of playing the stock-market game at par every round a very attractive one.
“A Random Walk Down Wall Street,” p394-5
Certainly, investing is no walk in the park (though it may be a “random walk”). As recently as 2007-2009, many of us learned the hard way just how risky investing can be. However, to me, it seems a blessing that the Index Fund was created.
I am happy to preach the Gospel of the Index Fund!
*Note: “A Random Walk Down Wall Street” was first written in the 1970s. However, I read the 2012 version, which is completely revised and updated, with many discussions of the Dot-com Bubble and the Financial Crisis.