The Random Walk Guide to Investing by Burton G. Malkiel Chemical Bank Professor of Economics Princeton University The Random Walk Guide to Investing “Everything should be made as simple as possible”—Albert Einstein The rules for achieving financial security through savings and investment are extraordinarily simple. The challenge is not in knowing the financial world inside and out. The challenge is in the self-sacrifice of savings versus spending, and the discipline of sticking with a plan for the long-term. Basic point #1: Fire your investment adviser It is not hard to learn enough about investing to be able to do it yourself If you can do it yourself, why pay someone to do it for you? Malcolm Forbes: The way to get rich from investment advice is to sell it—not to take it. If brokers/advisers really knew what was going on in the market, they would be investing for themselves and not giving this info to the public. The mere fact that they are selling this info is a sure sign that it isn’t very valuable. Basic point #2: Focus on four investment categories The four: cash, bonds, stocks, real estate Cash investments: any “money market” investment Bonds: provide stability for a portfolio (lower std.dev.), can be used to “immunize” a future liability like college tuition payments; particularly useful for retirees. Avg. annual returns of 5-6%. Stock: Avg. annual returns of 8-9%, higher risk Real estate: Owning a home, REITs Basic point #2: Focus on four investment categories The stock market is usually quite efficient, but history shows some key failings. The housing bubble and the dot.com bubble are two examples just in the past decade. From late 1998 to March of 2000, the NASDAQ went from 1,800 to over 5,100. From 3/00-9/02, it went down to 1,400. Over $7 trillion in market value was lost. When equities bottomed on November 21, 2008, the MSCI World index had fallen 55 per cent since October 31, 2007. This amounted to a global loss of $21 trillion. The index fell even lower in March, but have since recovered slightly. Basic point #2: What lessons should we learn All excessively exuberant markets succumb to the laws of gravity. The difficulty lies in staying the course while your friends are raking in (temporary) easy money. By diversifying over many types of stocks and over several asset classes, you avoid such mistakes (to the extent possible) and help ensure the preservation and growth of your capital. Basic point #2: Real estate Owning your own home offers significant tax advantages and the opportunity to profit from rising home prices. You should never pay rent to others when you can pay yourself instead through mortgage installments. Obviously, in some markets this isn’t possible. Try buying an apartment in Manhattan with your first year’s salary. But saving money for a down-payment for a future purchase is a wise choice. Basic point #2: Real estate For many people, the equity they have in their home is greater than their other investments. These people are already over-invested in real estate. But if your home equity is only a small portion of your total portfolio, investment in REITs may be an option. A REIT functions like a closed-end mutual fund and give the shareholder ownership in a (usually) diversified portfolio of real estate. Basic point #3: Understand the risk/return relationship Minus 39 to plus 52 9% Common stocks Minus 5 to plus 15 6% Long-term corporates Plus 1 to plus 9 3-4% Cash Range of Annual Returns (%) Average Annual Rate of Return (%) Risk Indicator Historical returns Basic point #3: Understand the risk/return relationship—bear markets 19 10 13 33 Average -- -- 17 54 2007-09 24 9 36 45 2000-03 5 5 3 20 1990 24 18 2 34 1987 3 2 13 22 1981-82 64 20 21 48 1973-74 22 9 18 37 1968-70 6 5 9 22 1966 14 10 6 29 1961-62 12 11 3 20 1957 100% 75% Months % Year recover from low the decline Months to Extent of Rule One: Start saving now, not later: time is money Albert Einstiein: Compound interest the “greatest mathematical discovery of all time.” If you invest $1.00 at age 22 at an annual return of 9%, it will be worth $31.41 when you are 62. If you waited until you were 32, you would need to invest $2.37 to have the same amount at age 63. If you wait until 42, you would need to invest $5.60. At age 52, you would need to invest $13.26 to get the same amount as you would have from investing just a dollar at age 22. Rule One: Start saving now, not later: time is money Trust in time rather than timing. Even though your early years of salary will likely be much smaller than your later years’ salary, don’t wait and play catch-up. Every dollar you can save now makes a difference. Rule two: Keep a steady course: The only sure road to wealth is regular savings Pay yourself first: The best way to ensure that you don’t spend every nickel of every paycheck is to set up a plan so that you never get your hands on the money in the first place. If you learn nothing else from this class, learn this: the smartest financial choice you may ever make is to maximize your “employer match” in your 401(k). You not only get a tax break, but get free money from your employer. Start doing this with your first paycheck and you won’t miss the money. Rule two: the 401(k) windfall 401(k) investments, up to $15,500 annually, are not taxed. This is like getting a tax break of roughly 25% from Uncle Sam right off the top. All investment gains are tax-deferred. Most employers match a certain amount of your contributions. For example, if the match is “75% of the first 6%”, your employer will put 75 cents into your account for each dollar you invest up to 6% of your annual gross income. You can put in up to $15K; employer can put in up to another $29K ($44K max/year). Rule two: the 401(k) windfall Let’s say you make $4000/month and put in $400/month into your 401(k). First, this reduces your taxable income from $4000 to $3600. If you pay 25% in taxes, that’s a $100/month gain right there. If your employers matches “75% of the first 6%”, the match is: ($4000*.06*.75)=$180. This increases your investment from $400 to $580. That’s an immediate 45% return on investment. Rule two: the 401(k) windfall If you invested $580 every month for your first year, earned 9%/year, and kept it invested for 40 years, it would be worth $217,157 after taxes. If you invested $400 in an ordinary brokerage account (no employee match, no tax-deferral, taxes paid on gains each year) and earned 9%/year, you would have $112,360. You nearly double your investment by setting aside $400/month in your 401(k). Let’s extend the argument. Rule two: the 401(k) windfall If you start by investing $400/month for the first year and assume that you get a 4% raise each year and increase your contributions accordingly, investing at 9%/year, you will have $3.8MM at age 62. But if you wait until age 32, you will only save $2.0MM. Many of you will get raises and promotions at a rate faster than 4%/year, and many people increase the dollar amount of their retirement contributions as they get older and their earnings grow faster than their savings. Your earnings might be higher. Rule two: Make out a budget, change your spending habits, think in terms of opportunity costs While this is boring to do, keeping track of every dollar you spend over the course of a few months is very enlightening. You will invariably be surprised at just how much you spend on eating out, entertainment and impulse purchases. Malkiel by no means suggests that we should not have fun. But making a budget can help us view future decisions more clearly in terms of true needs instead of “wants”. Rule two: Make out a budget, change your spending habits, think in terms of opportunity costs Many people fail to save because they want to keep up with trends. Marketers love these people. They buy new cars when they don’t need them. They buy new clothes that they rarely wear. They buy the latest computers, a/v equipment, video games, etc. “Most of our houses in America are simply overloaded with unnecessary stuff.” Rule two: Be saving in your spending, pay off your credit cards You can save money on just about every purchase by looking for discounts and doing research on the web: cars, computers, electronics, insurance, etc. Even if you are paying only 10%/year interest on your credit cards, paying off the balance is like a risk-free 10% return on investment. Investing in your retirement plan is the only better deal. Pay off your balances every month and look for a card that gives cash back—you will make money off of the credit card companies rather than them making money off of you. Rule three: Don’t be caught empty-handed: Insurance and cash reserves While the goal of this book is to help you plan for the long-term, we need to plan for short-term needs as well. Cash reserves and insurances protect against unforeseen losses: job layoffs, accidents, medical emergencies, maintenance, etc. The goal should be to cover potential liabilities as best possible, then have a cash reserve to cover the rest Rule three: cash reserve The recommended cash reserve should amount to 3-6 months of your monthly expenses. This money should not sit in a savings account. Find a good money market account (or CDs or T-bills) that will get you the best interest rate while still being a safe place to store the money. Rule three: Insurance Don’t ever go without health insurance if you can avoid it. Don’t scrimp on liability insurance on your auto. Go for a 100/300/100 policy or more. You can increase your deductible if you want to lower the premium. Don’t forget renter’s insurance. Disability insurance is often offered through your employer. It is cheap and worth the money. Life insurance: buy level-premium term. Shop around. Rule four: Stiff the tax collector We want to maximize our net return, meaning our return after taxes. The 401(k)—have I mentioned?—is the first, best choice for investment. The IRA, while having no employer match, does offer pre-tax investment and tax deferral. A Roth IRA has no tax deduction today, but all of your gains are tax free. The choice of traditional vs. Roth is not always clear, but there are calculators to help. Rule four: priorities First, fund your 401(k) up to the limit of the employer match. Second, fill up your cash reserve Third, continue to put money in your 401(k) up to the $15,500 limit. Fourth, fund your IRA. Fifth, variables annuities have no tax deduction, but are tax deferred. Find one with low fees. Sixth, muni bonds and mutual fund investments made in after-tax accounts (ordinary brokerage accounts). Rule four: Caveat Retirement investments (401(k), IRA, Roth IRA, variable annuity) restrict withdrawals until the investor is 59 ½ years old, unless you become disabled. Money removed before this time is subject to a 10 percent penalty and taxes. Other needs such as saving for a house down-payment, buying a car, funding college tuition, etc. should be funded through ordinary brokerage accounts Rule four: 529 accounts 529 accounts allow parents to save for college without paying taxes on the investment gains. Some states also offer tax breaks on contributions (New York is one). You can invest in other states’ plans, but you only get a tax break on your state’s plan. Other educational savings programs are Education Savings Accounts and savings bonds. Rule four: The best tax strategy of all Owning a home gives you two significant tax breaks: deductions on interest paid and tax exempt capital gains up to $500,000. Renting offers neither of these breaks. Rent increases over time, so you pay more money and get no tax benefit from it. If you buy a house, your payment stays the same, which typically means it becomes a lower percentage of your monthly income over time. If you plan to stay at least 5 years, buy if you can. Rule five: Match your asset mix with your investment personality: How to allocate your assets Three factors: Your investment horizon, your financial circumstances and your temperament should determine your asset mix. 100 20 years and longer 66 10-20 years 33 5-10 years 0 1-5 years Exposure (%) Period Maximum Equity Expected Holding Rule five: Capacity for risk Even if you have the stomach to take risk, your age and financial situation may make risky assets imprudent. A widow who is unable to work and on a fixed income should not own common stocks. However, young investors generally have the green light to invest aggressively for the long-term. Shorter horizon investments: new car, home down-payment, should be less aggressive Rule five: Your temperament Suppose you have saved $100,000 to invest. What is the maximum loss you could stomach? Plan equity exposure accordingly. 100 50 90 40 80 35 70 30 60 25 50 20 40 15 30 10 20 5 Equity exposure (%) Max. tolerable loss (%) Rule five: Rebalancing Over time, your stocks should outgain your bonds. This will alter the weights in your portfolio—stocks will be a higher fraction of the total value. Many people rebalance by moving money from stocks to bonds (or vice versa), to rebalance the portfolio People also rebalance as they age, with the goal of reducing the equity exposure as people near retirement age. Rule six: Diversity reduces adversity Cash investments generally don’t need to be diversified. Bonds and stocks do, however. Company stock is often an option in retirement plans. Avoid except in small amounts (<5% of total portfolio value). If your company goes bankrupt, you get hit twice: you lose your job, and your company stock plummets. How many stocks should you own to be properly diversified? Rule six: Go for equity mutual funds You may need as many as 100 stocks in your portfolio to be properly diversified. Since buying 100 stocks is a nuisance, not to mention costly in commissions, the equity mutual fund is the smart choice. Not only do equity funds provide easy diversification, they also provide convenient record-keeping. Put most of your equity investments in funds, you can play around with individual stocks with small fractions of your portfolio if you wish. Rule six: International diversification International diversification has value. Markets do not move in lockstep across the world, so global investments can improve total diversification. It is not vital, however. Many U.S. companies have global operations; owning these stocks makes you globally invested. In addition, market correlation increases in recessions—the diversification helping you less when you need it the most. Rule six: Diversify across asset classes A diversified stock portfolio is not a diversified total portfolio. Even diversified stock portfolios fell in value by roughly 40 percent over 2000-2003. Owning bonds and REITs can further reduce the volatility of a portfolio. International stocks, as previously noted, also improve diversification. Bonds and REITs should be added first, then international stocks if desired. Rule six: Diversify over time Regular monthly investment, in a 401(k) or elsewhere, offers another diversification advantage: dollar-cost averaging. Investing the same dollar amount every month ensures that you don’t invest at market peaks. When prices are high, you buy fewer shares; when prices drop you buy more. DCA works particularly well in volatile markets. This does make calculating returns difficult, however. An IRR works well here. Rule seven: Pay yourself, not the piper Remember Rule two. Pay off your credit cards. Interest and finance charges paid to credit card companies is money wasted. Since you are making all the investment decisions, you should try to minimize commissions and expenses on your investments. Jack Bogle, CEO of Vanguard: “The surest route to top-quartile performance is bottom-quartile expenses.” Rule seven: Expenses Small difference in expenses make big difference in the long run. $1 invested at 9% for 40 years becomes $31.41. $1 invested at 8% for 40 years becomes only $21.73. The extra 1% amounts to a 50% difference over time. Again, the web is a great resource for shopping around on investments, insurance, etc. Rule eight: Bow to the wisdom of the market Jack Bogle: “Never think you know more than the market. Nobody does.” Over ten and twenty years, respectively, the S&P500 index beat 84 and 88% of all large-cap equity funds. The index beats the average equity fund by two percent per year over those periods. Out of 851 funds with assets of more than $100MM, the top twenty funds over 1997-1999 had an average rank of 801st over 2000-2002. The past does not predict the future. Rule eight: Some of my investing experience Didn’t buy NASDAQ puts at 5100 in 2000. Did buy NASDAQ calls at 2200 in March 2001. They expired worthless. Did buy UYG (Financial sector fund) at $1.59 on March 6, 2009 and made 82% before selling it at $2.90 on 3/24. Have bought and sold UYG a couple of more times and made a little more money, but nothing huge. Rule eight: Some of my investing experience Even with a Ph.D in finance, I have made good and bad bets in the market. But I only place bets with a small portion of my portfolio (5-10%). The rest is in index funds. Even so, I find I spend too much time staring at my trading screen looking at my individual bets—time that could be better spent. Rule eight: Some of my investing experience The market has been terrible, but the bright side is that the money I’m putting in each month now buys more shares (DCA). I’m staying in the market for the long haul. Rule nine: Back proven winners: Model portfolios of index funds If the market cannot be predicted successfully, then index funds are a good strategy. The expenses are usually far lower than average. They are also tax-efficient: low portfolio turnover leads to deferred capital gains. They simplify investing. Look for a “Total Stock Market” index fund: Wilshire 5000 or Russell 3000 index fund, e.g. Bond and real estate index funds also exist. Rule nine: Exchange-traded funds (ETFs) ETFs invest in similar fashion to index funds, but they trade throughout the day like a closed-end fund. The “Spider” (SPDR) tracks the S&P500; the “Cube” (QQQ) tracks the NASDAQ100, the “Diamond” (DJIA) tracks the Dow 30. If you are making periodic payments into a retirement, the ETF may not be the best choice. Each transaction may have a cost, as well as reinvested dividends and capital gains. If so, stick with index funds. Rule ten: Don’t be your own worst enemy: Avoid stupid investor tricks Overconfidence. Remember rule eight. Herding. Stay with the plan, don’t run with the pack. Illusion of control. Again, rule eight. Ignoring costs. Remember rule seven. Getting entranced by new issues (IPOs). While insiders get the big first-day returns, subsequent investors do poorly. Summary Focus on what you can control: the amount you save, the amount you spend, how hard you work, how you allocate your assets, and minimizing fees. Keep cash for emergencies. Have adequate insurance. Basic risk management. Time and effort spent trying to beat the market is generally not fruitful. If it is, it is probably luck, and will come back around eventually. Better to spend that time working, because success in your career is something under your direct control; the market is not. One thing Malkiel doesn’t mention: marry right the first time. I hope this book and this class will help you on your way to financial security. Thank you for choosing my course. I’ve enjoyed teaching you.